Richard Friedman’s address (Head of Merchant Banking at Goldman Sachs) turned out to be a whirlwind tour of what he’s seen of the private equity industry over the years, growing from a billion dollars in size in 1991 with 4 key firms to 545 billion dollars in size in 2008 with over 200 major funds. As usual, the barrage of information spawned many questions.
Some things he touched upon:
1> Anticyclical behavior of the industry
The 2001-2003 period had modest activity due to the economic conditions, however, the returns from the investments then varied from 25% to a 100%.
2> Trends in valuations
Alluding to the valuations being optimistic, almost driven by multiples of peak earnings instead of multiples of earnings.
3> Targeting large companies
Specifically points included financing, the 2001-2003 downturn’s lag effects, and compensation limits on management.
Evaluating (read critically questioning) these 3 trends is an interesting exercise, and got me thinking about corporate governance and leadership. More about it in my post on “Private Equity Firms and Large Company Acquisitions”.
The period from 1989 to 1999 saw investments totaling $250 billion, while the 18 month period from 2005 to July 2007 saw 1.2 Trillion dollars worth of investments.
Encouraging an idea out of left field, at the risk of sounding flippant, could you call this the biggest bailout (read takeover, or turnaround, or even protection) of American Enterprise in history? More about it in my blog on “Is Private Equity The American Industry that protects American Enterprise?”
Think About The Future
Equally interesting were thoughts about the future. Where do we go from here?
Bargain Hunting for Investments
Just like the 2001-2003 period, there are bargain purchase opportunities. However, any change of direction from the fund’s stated strategy would concern the LPs.
This leads to a set of follow up thoughts:
What more can GPs do to account for bankruptcy risk?
Does the answer lie in more robust valuation scenarios (akin to the bank stress tests) and due diligence?
Given the increased riskiness of investments, would PE funds start looking like VC funds?
How can GPs and CFOs of the funds work more closely with LPs?
What kind of downside protection can a GP provide an LP?
How do funds deal with liquidity challenges?
Does the senior loan market now resemble that in the 60s and the 70s?
If necessary, how would GPs buy senior debt in their portfolio companies and still ensure incentives are aligned correctly?
How would CFOs of funds categorize their LPs to get buy in on any style drift, assuming that’s a risk they are willing to take, and that there are funds available?
How would your approach be different when it comes to large institutional investors?
Managing Organizations
Given the economic environment, management teams may begin to think that they don’t have the incentives anymore for change. Persistent communication to align the investment perspective and the managers on the ground is a quick start- however; would it make sense to explore other initiatives like team building?
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Saturday, March 14, 2009
Trends in Credit Markets by Edward Altman
Dr. Altman presented an interesting perspective on economic conditions in 2009- backed with the kind of data and research that gets you thinking critically at the economic data you see around you.
Some quick notes on topics touched upon:
1> The High Yield Bond OAS (yield to maturity spreads over treasuries), which were at 260 bps in June 2007, had jumped to 2046 bps in December 2008.
2> Spread index creation, based on weighted averages of spreads, and dropping of companies that go bankrupt, reduces the spreads.
3> Default rates could be a leading indicator of the health of corporate bond market, however, CDS does not define a distress exchange as a default event.
4> The size of the distress debt market, compared to that of the high yield debt market is an interesting economic trend.
5> Hedge funds will find it difficult to make money as the default rate rises.
6> Moody’s downgrade of 50% of CLOs in the $100 billion market is based on a 40% recovery rate on defaults.
7> In 2009, more than 12 companies went bankrupt with over 1 billion in liabilities.
8> Distressed exchange market in 2008 more in value than the the bond market since 1984 (IBM issuance of the convertible bond to finance an acquistion).
Points to note about the credit markets trends:
1> Low equity and debt volatility till summer 07. The VIX fell to 10.
2> Low default rates and high recoveries.
3> Distress debt control investing- loan to own.
4> Rescue financing- essentially a privatization of bankruptcy.
5> Volatility a measure of downside distribution of asset values.
6> Now, volatility high and liquidity low.
What patterns do you see?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist/ speaker interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Some quick notes on topics touched upon:
1> The High Yield Bond OAS (yield to maturity spreads over treasuries), which were at 260 bps in June 2007, had jumped to 2046 bps in December 2008.
2> Spread index creation, based on weighted averages of spreads, and dropping of companies that go bankrupt, reduces the spreads.
3> Default rates could be a leading indicator of the health of corporate bond market, however, CDS does not define a distress exchange as a default event.
4> The size of the distress debt market, compared to that of the high yield debt market is an interesting economic trend.
5> Hedge funds will find it difficult to make money as the default rate rises.
6> Moody’s downgrade of 50% of CLOs in the $100 billion market is based on a 40% recovery rate on defaults.
7> In 2009, more than 12 companies went bankrupt with over 1 billion in liabilities.
8> Distressed exchange market in 2008 more in value than the the bond market since 1984 (IBM issuance of the convertible bond to finance an acquistion).
Points to note about the credit markets trends:
1> Low equity and debt volatility till summer 07. The VIX fell to 10.
2> Low default rates and high recoveries.
3> Distress debt control investing- loan to own.
4> Rescue financing- essentially a privatization of bankruptcy.
5> Volatility a measure of downside distribution of asset values.
6> Now, volatility high and liquidity low.
What patterns do you see?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist/ speaker interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Panel: Middle Market LBO and Changing Capital Structures
The panelists were seeing transactions in the middle market, but these transactions had some sort of distress component. The insight here was about the ownership structure of mid market firms, which had entrepreneurs with strong stakes. Entrepreneurs running firms with strong fundamentals did not have much of an incentive to sell. Quoting a panelist- why sell when you can make as much money and still own the company?
Some numbers from the end of Q1:
The panel had seen loans being sold at a discount of upto 90%. LIBOR floor was at 3.5% and mezzanine coupons were at 15% to 17%. Debt multiples, in terms of EBITDA, for first lien were around 2.5, for second lien, around 3.3 and for subordinate debt, around 4.3. Mezzanine debt had more senior debt than ever.
Transaction multiples had held, however, leverage multiples had gone down, while equity component had gone up. The more complicated structures cause deals to take longer to pull off.
Banks were interested in private transactions, as they provided rates better than LIBOR + 500 bps, and were delivering via mezzanine and equity.
There was an interesting demonstration of over-equalization of seller and buyer expectations with supply of capital as a key factor. It would be interesting to see a similar analysis with supply of transactions as the key factor.
It was pointed out that transaction multiples had held:
1> Is ita real estate like effect in the relatively less liquid middle market where the selling price of the last house sold on the block sets the price for future sales? Or.
2> Are mid market firms with capital left to invest crowding around fewer transactions?
3> Banks investing in private transactions would be an important source of liquidity- how many of these investments were really follow up transactions to investments already made?
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Some numbers from the end of Q1:
The panel had seen loans being sold at a discount of upto 90%. LIBOR floor was at 3.5% and mezzanine coupons were at 15% to 17%. Debt multiples, in terms of EBITDA, for first lien were around 2.5, for second lien, around 3.3 and for subordinate debt, around 4.3. Mezzanine debt had more senior debt than ever.
Transaction multiples had held, however, leverage multiples had gone down, while equity component had gone up. The more complicated structures cause deals to take longer to pull off.
Banks were interested in private transactions, as they provided rates better than LIBOR + 500 bps, and were delivering via mezzanine and equity.
There was an interesting demonstration of over-equalization of seller and buyer expectations with supply of capital as a key factor. It would be interesting to see a similar analysis with supply of transactions as the key factor.
It was pointed out that transaction multiples had held:
1> Is ita real estate like effect in the relatively less liquid middle market where the selling price of the last house sold on the block sets the price for future sales? Or.
2> Are mid market firms with capital left to invest crowding around fewer transactions?
3> Banks investing in private transactions would be an important source of liquidity- how many of these investments were really follow up transactions to investments already made?
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Panel: Venture Capital: Navigating the Current Landscape
The panel started off, interestingly, examining the fundamentals of venture capital investing. Any potential investment must demonstrate compelling value and a feasible exit strategy. The panelists talked about how returns in venture capital are seen in bursts, and average out over time. One panelist talked about a batch mate in business school (early 1980s), now a leader of a successful universal banking group, who forecasted that the SnP500 returns would be greater than that of the venture capital industry that decade. The batch-mate turned out to be right.
The panelist also talked about some of their areas of investments- mobile computing, video games and personal genomics.
At lunch, Jim Long mentioned how important it is to bootstrap your venture.
Given the Sequoia presentation from 2008, it was interesting to see panelists responding to the crisis with a “return to fundamentals” theme.
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
The panelist also talked about some of their areas of investments- mobile computing, video games and personal genomics.
At lunch, Jim Long mentioned how important it is to bootstrap your venture.
Given the Sequoia presentation from 2008, it was interesting to see panelists responding to the crisis with a “return to fundamentals” theme.
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
Panel: Fundraising and Capital Flows
A diverse panel, consisting of
1> the head of treasury managing a large pension fund,
2> a managing director for alternative investments at a large fund,
3> a managing director for fund raising at a fund with investments as diverse as late stage VC to middle market companies, and,
4> a managing partner at a fund investing in industrials,
can definitely get you to “stress test” your thought processes on investment decision making in a downturn.
Some quick thoughts and questions that came up thanks to the panel:
1> How do GPs prioritize their investments, across investment decisions and portfolio companies?
2> Switching perspectives, how would LPs recategorize their top decile funds in the changed economic environment?
3> Have GPs and their LPs considered restructuring funds (changing terms, size, etc.)? At what point does restructuring a fund become in everyone’s best interests?
4> How are funds, whether buyers or sellers, over forced sales and bargain prices of investments, resetting their expectations, as well as the expectations of their stakeholders?
Note: Bargain prices of investments for buyers mean that to drawdown the fund fully, you may have to make more deals.
5> How do you deal with strategy creep when a fund is investing in earlier vintages? A fund of funds perspective may help, however, how do you build the processes to manage conflicts with style drifts?
6> Are we seeing many buyers in the secondary market for new fund turnover? How does that impact the secondary market discount?
One panelist, from a treasury department, talked about challenges in allocations to meet $800 million worth unfunded commitments with $300 million in payments to retirees. He boldly ventured that Modern Portfolio Theory may be dead. Given the volatility seen in the market, and pension obligations to manage, he stated that long only strategies do not work and pointed out the need to deploy derivatives strategies in the context. My take on this was that this perspective only underscores the complexities of managing risk with derivative instruments.
Another panelist talked about investing in long lived, low technology assets and managing macroeconomic and counter party risks. The fund raiser panelist talked about a 15 billion dollar 2008 fund, that was initially expected to invest about 4-5 billion a year, which was considering cross fund investments (say a fund WP10 looking at existing funds WP9 and WP8), with advisory board approval.
A panelist from a Germany based fund ventured that some of the winners in the downturn were global macro, and long short hedge funds. His take was that specialized funds were doing well. However, he was concerned about the liquidity of the hedge funds as drawdowns were being discouraged.
The panelist was also actively looking at the secondary market, besides private markets for capital. His assessment was that new fund turnover was at 3-5%. Some of the factors in the decision making:
1> Bottom up analysis on investments
2> Asset covenants
3> Secondary market discounts
4> Structured finance solutions to relieve or defer capital call responsibility and future unfunded obligations.
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
1> the head of treasury managing a large pension fund,
2> a managing director for alternative investments at a large fund,
3> a managing director for fund raising at a fund with investments as diverse as late stage VC to middle market companies, and,
4> a managing partner at a fund investing in industrials,
can definitely get you to “stress test” your thought processes on investment decision making in a downturn.
Some quick thoughts and questions that came up thanks to the panel:
1> How do GPs prioritize their investments, across investment decisions and portfolio companies?
2> Switching perspectives, how would LPs recategorize their top decile funds in the changed economic environment?
3> Have GPs and their LPs considered restructuring funds (changing terms, size, etc.)? At what point does restructuring a fund become in everyone’s best interests?
4> How are funds, whether buyers or sellers, over forced sales and bargain prices of investments, resetting their expectations, as well as the expectations of their stakeholders?
Note: Bargain prices of investments for buyers mean that to drawdown the fund fully, you may have to make more deals.
5> How do you deal with strategy creep when a fund is investing in earlier vintages? A fund of funds perspective may help, however, how do you build the processes to manage conflicts with style drifts?
6> Are we seeing many buyers in the secondary market for new fund turnover? How does that impact the secondary market discount?
One panelist, from a treasury department, talked about challenges in allocations to meet $800 million worth unfunded commitments with $300 million in payments to retirees. He boldly ventured that Modern Portfolio Theory may be dead. Given the volatility seen in the market, and pension obligations to manage, he stated that long only strategies do not work and pointed out the need to deploy derivatives strategies in the context. My take on this was that this perspective only underscores the complexities of managing risk with derivative instruments.
Another panelist talked about investing in long lived, low technology assets and managing macroeconomic and counter party risks. The fund raiser panelist talked about a 15 billion dollar 2008 fund, that was initially expected to invest about 4-5 billion a year, which was considering cross fund investments (say a fund WP10 looking at existing funds WP9 and WP8), with advisory board approval.
A panelist from a Germany based fund ventured that some of the winners in the downturn were global macro, and long short hedge funds. His take was that specialized funds were doing well. However, he was concerned about the liquidity of the hedge funds as drawdowns were being discouraged.
The panelist was also actively looking at the secondary market, besides private markets for capital. His assessment was that new fund turnover was at 3-5%. Some of the factors in the decision making:
1> Bottom up analysis on investments
2> Asset covenants
3> Secondary market discounts
4> Structured finance solutions to relieve or defer capital call responsibility and future unfunded obligations.
What do you think?
The Usual Disclaimer: This is purely a knowledge sharing resource and I have been careful to protect panelist interests. Ethically, context is everything, and I will gladly retract anything that affects the parties mentioned. Call this my mini OpenCourseWare, if you will, where Open signifies life experiences.
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