The Virtuoso
Why this chapter
To gather everything you have learned into one picture and learn to take any complicated deal apart into simple moves.
An analogy
Picture a chess player who has spent nine chapters learning how each piece moves. They know everything about the knight and the bishop but have never played a game. The tenth chapter is that first real game. No new pieces appear: what appears are combinations, where a knight move sets up a fork three moves later. Big deals are built exactly like that. There is not a single technique in them you have not already seen: there is a sequence of five or six familiar entries, where each next one is paid for by the result of the one before.
How it works
There is no new theory here — here it all comes at once: project finance, the venture ladder, an LBO with securitization, crisis deals in the Buffett style and, at last, a bank of your own.
Remember the virtuoso's three questions before any scheme: 1) Where in this deal is money created, and by whom? 2) Whose capital takes the loss first? 3) What happens to the scheme if tomorrow everyone wants out at once?
If you can answer all three, you understand the deal better than half the people in it.
The words of this chapter
The three virtuoso questions
A set of three questions to ask of any scheme: where money is created here and by whom; whose capital — the owners' money — takes the loss first; and what will happen if everyone wants out at the same time tomorrow.
It was invented as a replacement for studying details endlessly. Three answers give you a better understanding of a deal than half of its participants have.
Non-recourse
A loan for which only the project itself answers: neither its owners nor the state has to pay if the cash flow never comes. The lender gets the project and nothing more.
It was invented for large construction projects, where the risk is too big for one owner's balance sheet but acceptable if it is shared with lenders.
The hierarchy of money
The order in which money of different kinds gets more expensive: money created by a bank against collateral is the cheapest, somebody else's frozen money is almost free, and funds' money is the most expensive.
It appears by itself, because the price of money equals the risk of whoever supplies it and their place in the queue for repayment.
The venture ladder
The sequence of instruments with which a growing company raises money: first a promise of a stake, then the stake itself, then debt against revenue that already exists, then the sale of the business.
It was invented because a company's risk is different at every stage, and one instrument for a whole life will not do.
A white knight
A healthy institution that takes on a sinking competitor together with its customers, and leaves the bad property in a shell to be wound up.
It was invented because the main enemy is panic, and panic is cured by speed rather than by fairness.
Dry powder
Free money and unused capacity, kept deliberately for somebody else's bad day.
It was invented not as caution but as a strategy: in a panic capital sells at a discount to any logic, and the buyer needs nothing but themselves.
What happens to the balance sheet
Take any big deal apart into elementary entries and it stops being complicated. The bank created money for the purchase — that is chapter one. The debt was hung on the company that was bought — chapter six. Part of the business was sold separately and the debt repaid — chapter six again and chapter one again, only in reverse. A pool of loans was packaged and sold — chapter seven. Every entry is familiar; all the complexity is in the order. And that order obeys one rule: every next step is paid for by the result of the one before, not by the hope of it.
Where the money comes from here
Here the one who earns is whoever assembled the structure, not whoever put in the most money. The arranger takes a share of the deal and a fee for making all the parts fit. The bank takes interest and creates money with an entry. The fund takes a multiple for having come in earliest and waited longest. The crisis investor takes an extraordinary return for readiness. The one who loses is whoever's maturities did not line up: the cash flow arrived later than the payment fell due. Here is why this matters to you: in your own big deal the main work is not to find money but to line it up by maturity so that every next payment is covered by an event that has already happened rather than one that is expected.
What people usually get wrong
The common belief. Big deals are built in a complicated way; there is a special financial mathematics in them.
What is actually true. Any great deal is a composition of five or six basic entries, every one of which you already know how to make. The complexity is in the order and the maturities, not in the techniques.
The common belief. To buy something big you need a lot of your own money.
What is actually true. Large construction projects are financed so that only the project itself answers for the debt. Banks created 300 million dollars against a cash flow that did not exist, and neither the sponsors nor the state answered for that debt.
The common belief. Crisis deals go to whoever has the most money.
What is actually true. They go to whoever has money free at that exact moment, and to those whose name by itself stops the running. In a panic the price of capital is set not by the risk but by how many are ready to supply it.
After this chapter you will be able to
- build the queue of losses in a project and know whose money burns first if the launch is delayed
- assemble the capital structure of a project out of money of different kinds, understanding the price and the maturity of each layer
- check whether the risk really left the balance sheet, or whether only its legal shell was sold
- set a price for speed and reputation, when a counterparty needs capital today rather than a quarter from now
- launch an institution in the right order: capital and a correspondent account, then the asset, and only then the liquidity behind it
Check yourself
A project was built on a loan for which only the project itself answers. What will the bank get if the cash flow never comes?
Only the project itself.
Neither the project's owners nor the state answers for a debt like that. So here the bank judges not the borrower's credit history but how realistic the future cash flow is and how good the project itself is.
Over a weekend a healthy bank took on the customers of a sinking competitor. What is its main problem now?
Capital behind a balance sheet that grew.
Customers and property arrive instantly, while the owners' cushion behind them is raised over weeks. The gap between those speeds kills an acquirer more often than the bad loans of the bank it bought.
What does it take to buy a good business at a discount during a panic?
Free money and a reputation.
In a panic capital sells at a discount to any logic, but only someone whose money is free today and whose participation by itself calms the market can get that discount. Keeping such a store costs you yield in every calm year.
In short
In big deals there are no new techniques — there are familiar entries lined up in the right order. In front of any scheme, ask three questions: where does the money appear here, whose money burns first, and what happens if everyone wants out at once. Cheap money is given against collateral and a cash flow you can understand; expensive money against a promise. Large construction projects are financed so that only the project itself answers. And the best deals go not to the richest but to whoever had free money on hand on somebody else's bad day.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.