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The newly found enthusiasm among private equity groups such as KKR, Blackstone, Carlyle and others towards commodities trading is an interesting development, but they all face critical balance sheet challenges before such deals can be considered.
Private equity groups have deep pockets to buy the commodities trading businesses of Wall Street banks, which face new regulation potentially hampering their ability to trade raw materials. For example, several private equity groups have approached Morgan Stanley to discuss a deal involving the bank’s commodities division. Morgan Stanley said the business was not for sale.
But many industry insiders believe the idea of a sale was a non-starter.
The challenge in running a day to day commodities business is access to credit at competitive rates. This is particularly true in the oil sector where prices have risen over the past decade.
In 2002, a trader could buy enough oil to fill a supertanker with less than $50m in credit lines. Today, it needs more than $200m. The same applies to derivatives trading in the oil sector.
Morgan Stanley – the second biggest commodities dealer in Wall Street after Goldman Sachs – requires something like $20bn or so of credit support to make money. Morgan Stanley’s commodities arm gets the financing directly from the bank, but if a private equity group were to buy it, it would need different credit terms. Most likely, credit costs will rise, and profitability will decline.
Industry executives and bankers are not even debating whether a buyout firm could provide enough credit at competitive prices to support the needs of a major commodities trading operation. The consensus is that the private equity groups will struggle.
There is already an example where the credit challenge has hampered a deal. When Credit Suisse and Glencore discussed two years ago forming a joint venture that was, in effect, a spin-off of the bank’s commodities business, both soon realised that the deal did not make financial sense.
The problem? The joint venture would have taken the relatively small Credit Suisse commodities business out of the bank’s balance sheet, depriving it access to cheap credit. As soon as the business needed to finance itself on commercial rates, the business ceased to make financial sense.
Other examples confirm the need of deep pockets to finance the commodities operations at competitive rates. Take Phibro, the former oil trading arm of Citigroup. The bank spun off its subsidiary and sold it to Occidental Petroleum in 2009. The oil company then leveraged its balance sheet to continue providing Phibro with plenty of access to credit.
But there have been success stories of private equity firms and hedge funds owning commodities business too. Hedge funds Ospraie Management and Soros Fund Management and the buyout firm General Atlantic bought out the trading arm of ConAgra Foods – which later they renamed Gavilon – in a $2.8bn deal in 2008. After operating the business for four years, the trio sold the commodities trading business last month to Japanese trading house Marubeni for more than $5bn, including debt.
The examples suggest the key for private equity success in commodities trading would be size, and the “place of birth”. Small to medium-size operations such as Gavilon are within the groups’ reach. Moreover, commodities traders from the non-financial sector are likely to be an easier target than operations from the banking sector.
The Commodities Note is a daily online commentary on the industry from the Financial Times