Five Realities to Consider As We Wait for Prosperity to Return

The dark clouds that loomed over our economy appear to have dissipated, but the sun is still not shining.  Even though second quarter economic data have brought hope for a steady economic recovery in late 2009, there are still systemic issues that require our attention; these issues have been brought on, in part, by  efforts to keep the economic ship afloat.

The good news for business owners and operators, however, is that they can once again expand their focus – keeping both day-to-day and strategic growth and liquidity issues top of mind.  To help with this always-complicated juggling act, I offer five core realities that are essential today – especially since the brave new world we once knew may have been lost in the storm clouds of 2009.

• Taxes Will Increase – In order to underwrite the tab for our massive stimulus and bailout programs, taxes will have to increase.  While it is a foregone conclusion, based on recent campaign rhetoric, that capital gains taxes will increase along with income taxes on the highest income earners, keep your eye on H.R. 436 (”Certain Estate Tax Relief Act of 2009”), better known as the Pomeroy Bill.  This legislation was deigned to restrict perceived abuses of estate and gift planning through the use of business entities.  The Pomeroy Bill, among other things, proposes to eliminate any discount for lack of control and marketability on transfers of non-controlling interests in family-controlled entities.  The net effect will be to drive valuations and taxes up, which will diminish the value of family limited partnerships as an estate planning strategy.

• Changes in Accounting Will Impact the Bottom Line – A number of GAAP changes are currently under discussion, and they are designed – not surprisingly – to increase the amount of taxes paid by businesses and limit their ability to book losses.  The most concerning change for many is the contemplated repeal of last-in-first-out (LIFO) accounting.  LIFO has a dampening effect on net income because of a cumulative downward impact on inventory valuation.  LIFO helps minimize taxes in a period of rising prices if the most recently purchased inventory is used to calculate the cost of goods sold.  A repeal of LIFO would result in higher taxes in the current period as well as in back-tax obligations and future inventory management challenges.

• Inflation Will Rise and the Dollar Will Fall – Quantitative easing, or the purchase of U.S. Treasury bonds by the Federal Reserve, is an inflationary measure that has put pressure on the U.S. dollar.  As evidenced by recent price retrenchment in the bond market, interest rates are rising and inflation is building.  The good news is that this inflationary cycle appears predictable.  Businesses should begin taking steps to adjust prices and lock in labor rates where possible in order to avoid the negative consequences of changes in real income.  As we all know, persistent inflation has the ability to once again undermine the functioning of our economic system.

• Now is the Time to Recruit Talent – National unemployment will likely peak around 10%. While the Pacific Northwest has held up reasonably well relative to the rest of the country, there is talent aplenty seeking new opportunities.  Now is the time to consider upgrading your human capital in areas where you might be vulnerable.

• Don’t Take Your Eye Off Your Bank – While the national banking picture appears to have stabilized, more than 300 banks remain on watch by bank regulators.  Most of these are regional banks in markets where housing prices have decline precipitously.  Talk to other business executives and agents to understand who is lending, and begin to build relationships with back-up lenders in case your line is pulled or reigned in for reasons beyond your control.

For those seeking growth capital or liquidity, multiples remain near their lows; this is, in part, due to a slow lending environment.  While we wait for the markets to thaw, try to get ahead of the curve on the issues we’ve mentioned above.  If you can do that, you stand a better chance for a successful deal dynamic as the recovery takes hold in 2010.

/bryan

 

Pet Industry Market Trends – Spring 2009 Update

Against a backdrop of macroeconomic uncertainty, the pet industry continues to thrive.   While the prevailing theory that the industry is “recession proof” is being sternly tested, market fundamentals of pet ownership remain strong and consumers are skimping on themselves as opposed to their pets and/or children.  Further, the premium demographic continues to have a voracious appetite for efficacious products that are good for their pets as well as the environment.

That being said, the recession has set in motion a number of trends that will, in my view, forever change the pet industry landscape.  While several of these trends are in the “early innings” so to speak, the momentum behind them is significant.  The companies that stand to win during the next phase are those that recognize the seachange and position themselves to take advantage of the wave.  This period will separate the leaders from the pack, to steal a phrase.

Recession Not Found Here?

Pure play equities of pet related companies fell precipitously with the market during the second half of 2008.  However, unlike the general market, these equity began to experience their recovery in November 2008.   The primary driver of equity price contraction was based on fundamentals — earnings for these core names fell 30% from the prior quarter, which spooked the market (in truth some of this could be chalked up to seasonality).

In reality 3Q2008 was up year-over-year from an earning perspective, albeit only slightly.  In a world where flat is the new “up”, this should have been investors first signal that the market was overreacting in this category and  pet related equities were becoming oversold.  Notably, earnings rebounded strongly in 4Q2008 posting year-over-year growth of ~ 4% (weighted by market capitalization), driving a correction with respect to public company valuations.   Thus, the prospects for a technical recession in the pet industry are in fact quite low.

Notably, the macro economic environment did not constrain equity deals in the pet space.  Key deals including Hammond Kennedy Whitney/FURminator, TSG Consumer Partners/Dogswell and Tyson/Freshpet were all announced against a declining or, even abysmal backdrop.   Appetite for pet related concepts has never been higher among growth equity funds due to the prevailing dynamics and long term fundamentals.

Key Trends for 2009

So what are the seismic shifts of which I speak?

First, I believe we are in the early innings of a major shift in the pet retail landscape. PetSmart and Petco are facing significant competition from Wal Mart as they battle to be the one-stop-shop for the mid-tier pet buyer. Wal Mart’s merchandising acumen coupled with their reach and financial strength make them daunting opponents. Large pet specialty will take share among the most attractive demographic and thrive amidst the chaos among big box players. Their ability to educate buyers and offer patrons a favorable service experience situates them to be long term partners of both customers and the most compelling pet related brands. They will also take share from contracting boutiques hit be financial hardship.

Second, in bad times value trumps luxury.  The downturn in the U.S. economy has eroded the balance sheets of mainstream consumers. While companion animals will continue to a growing part of our society, consumers will become more fickle as it relates to spending on their pets. Product (excluding consumables) and service providers must give pet owners a compelling value proposition if they expect to experience continued growth. This change is expected to be lasting.

Third, consumers want to know what they are paying for.  In the food arena, efficacy is going to become important, a concept which many have taken at face value.  The market has become saturated with better-for-you pet food brands whose differentiation has become hard to appreciate. Supply chain control and organic are no longer differentiators. As distribution opportunities contract, due to contraction in the boutique market, and funding dries up, solutions that can demonstrate high degrees of efficacy will prevail. Customers will begin to demand results for their incremental dollar.

Finally, pet health will come in to focus as owners make difficult choices with their limited free cash flow.  Pet related health care is even more inefficient than its human corollary. Relations between veterinarians and their customers is strained by the high cost of service and medications and the limited proliferation of pet insurance. Further, compliance rates on even basic pet medications are sub-standard. Solutions will arrive that deliver compelling value throughout the pet health care supply chain, driving operating and cost savings at the clinic level, compliance rates among drug applications and ultimately satisfaction for pets and their owners.

Net net, I expect the balance of 2009 to be challenging but good for pet related industries.   Notably, I believe we will see additional pet related equity deals as investors seek to put capital to work in sectors that continue to grow.  As the debt market improves, leveraged buyouts of some of growing bell weathers of the industry (a la FURminator) begin to come in to play, assuming valuation expectations have come down due to market realities.   One would also expect public pet companies to seek to buy growth in a effort to fuel their lagging equity prices.  This could kick of a consolidation phase in the middle market, but I’m not overly optimistic.

As always, you can contact me for a complete version of our market presentation.

/bryan

 

When Will It End?

We Ask the Lenders—But Nobody Knows for Sure

It has long been our view that the economic recovery will begin when some liquidity returns to the lending markets. Businesses rely on the ability to borrow cost-effective capital to underwrite their daily operations, and debt is an essential cog in leveraged transactions; purchase price multiples rely on it.

With debt generally unavailable, the transaction and capital markets have dried up. On a micro-level, many companies we talk to are currently unable to pursue compelling opportunities because of a lack of credit that that would have been available a year ago. Other firms are facing tougher “survival mode” decisions in which cash is squeezed from any and every available source.

We don’t anticipate a rapid return to normalcy, but we are seeing signs that the market is making incremental gains.
High-yield issuance volume has remained robust; premium-quality second lien deals are starting to find interested buyers; the Federal Reserve’s intervention at the long end of the yield curve has diminished the opportunity for banks to buy loans on the secondary market at yields more attractive than those on new issuances; and The Toxic-Asset Relief Plan will also better position major lending institutions to recapitalize their balance sheets and begin new originations.

Unfortunately, these macro viewpoints are not much help to companies that need to make tactical decisions on how to fund their operations. In an effort to deliver better actionable information, Cascadia decided to go directly to the source and ask lenders what they’re up to, how the world has changed and, most importantly, when they think the market will improve.

As you might expect, some lenders were reluctant to make predictions or disclose information due to the fluctuating condition of the market and their business. Others were only willing to speak to us on an anonymous basis. Both of these factors are telling and, in our mind, do nothing to diminish the value of the content in the attached.

Read on for greater insight and—as always—let me know what you think.

/bryan

When Will It End?

 

The Sound of Silence

It’s been a while since I posted about the current state of our economy, its prospects for recovery and how that is impacting the transaction environment.   It hasn’t been for lack of interest, but rather the pace of play with the dynamics changing at an alarmingly fast rate.   Further, with the recent market up tick, I have been enjoying the sound of silence.

As the market was shedding hundreds of basis points daily between late January and early March, a number of educated parties with whom I have regular contact were search for flavor of the moment remedies to advocate on behalf of, sometimes with true relentless vigor.  The most consistent was the call to nationalize the banking system, based on the Swedish model for de-levering financial institutions.    Never mind that that the parallels between the two systems don’t match up well — at all (let alone that neither political party wants to be responsible for wiping out shareholders completely, a symptom of the myopia brought on by our political system), it was sensible that people wanted to see a quick shift in the paradigm in order to stem the flow of red on their brokerage statements.  Unfortunately, it is just not that simple given the gravity and scope of what we are facing.

While I do not believe the fundamentals of our situation have changed more than at the margins, I do see signs that things are beginning to improve, maybe only for the interim.  Most significantly is that we have broken the negative media cycle that the sky is falling and we are all going to be crushed under its weight.   News stories from sources who stood to benefit from undermining the stability of our financial system appear to have tapered off, or at the very least people have begun to tune enough of it out to limits its implications.   The sad part is that what turned the tide was a leaked memo from Citibank with really no corroborative substance.   In place of constant negativity we have begun the fine art of finger pointing, pouncing on issues of fairness as opposed to issues of fundamentals.   The stupidity of AIG paying bonuses and people taking them is just that — stupidity.  If we were facing certain demise I don’t think it would dominant the headlines and be the source of job security questions around the Secretary of the Treasury.

Beyond our changing media pH, there are most tangible signs of life.  Most significantly, in my view, and largely unnoticed by most is that a number of second-lien deals are drawing interest from buyers.   While the tranches are small, relatively speaking (hundreds of millions of dollars), the willingness of lenders to stand behind the asset based lenders/senior secured is significant.   Second lien deals tend to have longer maturities and lighter covenant packages  in return for healthy economics.   The ability of a company to trade out of expiring term debt and in to a longer maturity instrument is favorable under these conditions.   Combined with continuing robust high yield issuances and you have yourself the makes of the base of a debt market in absence of air ball or cash flow loans.

Assuming you don’t read the Gold Sheets or have access to a GE finance professional to feed you all the latest loan data, there were other, more overt signposts that one might view as favorable.    Unexpectedly, February new home sales rose (4.7%), the first uptick since July 2008, as did durable goods orders (3.4%).   I take less comfort from the former, as it likely reflects the builder community liquidating inventory to free up cash to enable them to start projects whose permit limits would otherwise be lost.   These are distressed or quasi-distressed sales, based on the percentage decline in price (-18%).  Further, favorable evidence of improvement can be seen in the narrowing spread to LIBOR, the taming of the VIX index and the stability of energy prices.  It is worth noting that, you can pin some of the tail on the donkey due to overly cautious economic forecasting on behalf of a community which has been much maligned recently for its overly optimistic viewpoint.

Lastly, we continue to see a solid flow of opportunity from our little slice of investment banking.   While deals that would be characterized as “b” or “c” deals are not getting done,  many very well situated companies are looking to see how they may in fact get ahead by using this down cycle as a buying opportunity.  Equity players are eager to see good deal flow and multiples have not fallen significantly due to the flight to quality.

Dead cat bounce?  I don’t think so.  More like a bear market rally which will fizzle around 8,000.  The gains made from 6,600 back to the 7,500 level were not based on any tangible data, but rather hope.   The market had become way oversold and therefore the slightest bit of favorable sentiment sent the market soaring.   What a difference a few months makes.   The last time we saw Tim Geithner make a major policy announcement, the market sank like a stone.  Upon the unveiling on the Toxic-Asset Plan it soared.   Expect the market to tread water here until we get more consistent solid economic news as opposed to mere drops in the bucket.   Weak GDP data and corporate earnings should keep a ceiling on any rally.   A spike in energy prices would also be  a very big deterrent.  Then again, the leading edge is always the most hard to call.

/bryan

 

A Survival Guide for Family Owned Middle Market Companies

On February 10, 2009, Secretary of the Treasury Timothy Geithner announced the new administration’s plan for stabilizing the U.S. financial system.  The following day, Congress agreed to a compromise on the pending economic stimulus bill aimed at providing consumers with both economic relief and opportunity.  When the cost of both programs is added to the capital committed to date for the financial bailout, the total bill being assumed by the U.S. government and its tax payers climbs to $9.7 trillion (including the Federal Reserves loans and guarantees).

Despite calls for political leaders to come together to help our nation avoid an economic “catastrophe,” as President Obama characterized it, the political tenor in Washington has been disappointing, providing Americans with little comfort that anything will be done quickly or correctly.  We have little assurance that these programs, both individually and cumulatively, will stem the decline.  The Federal Reserve and our political leaders lack true historical parallels and are working from a playbook that is being written and re-written on the fly.  In addition, lawmakers seem intent on presenting their voters with pork barrel projects and punishing people for past transgressions rather than focusing on the core mission of the programs and the timeliness of their implementation.

No Quick Fix

While we agree that quick action is imperative – especially as jobs continue to be shed and production continues to fall – we must not be naive about the consequences of our actions.  There is no quick fix and there are substantive pitfalls inherent in the path our leaders have chosen.  For example, based on historical precedent, the endless printing of money will result in downstream inflation and protectionist approaches to trade that have historically undermined our long-term industrial competitiveness.  Unfortunately, our political system encourages short-term myopia at the expense of improvement in future generations’ standards of living.

Even with all this negativity, we take comfort from the resistance that has been shown by the Dow Jones Industrial Average.  It would have been our expectation that the endless barrage of bad news and a general lack of faith in our government’s path thus far would have driven us well below the November 2008 lows. Further, we note the recent re-test has largely been caused by the financial sector, as only two of 10 S&P 500 sectors are negative since November 2008. A decline of this nature, which lacks market breadth, to historical lows, does not preclude the creation of a firm bottom.  That said, if industry breadth expands we will have to revisit our thesis.

Notably, the number of 52-week lows has diminished significantly since last November.  Further, corporate debt issuances also continue to improve as spreads narrow, though these offerings have largely been confined to large cap market leaders who are offering investors a compelling risk-reward tradeoff.  In January, issuances more than doubled the previous record for the same month.

As the prospects for a turnaround in 2009 fade to black, we offer family-owned middle-market companies the following advice for managing through the recession:

Plan, Monitor and Re-plan

While most organizations engage in an annual budgeting exercise, those that utilize scenario planning are the exception, not the rule.  Given the economic environment, we would encourage companies to revisit their financial plan on a monthly, if not weekly, basis.  While creating accurate projections in turbulent times can be challenging, updating your view on forward financial performance is essential to identifying capital needs (size and timing) and eliminating waste.  Further, it will help identify when it is prudent to pursue hiring and growth opportunities.

Understand Source and Uses

Substantial business value is often lost when companies require capital on an expedited basis.  Lacking flexibility and options, the cost of short term debt and equity solutions can be exorbitant and put personal finances at risk, let alone the future of the business.   Avoiding these scenarios requires a company to understand at a very granular level how it creates cash flow and where it consumes resources, and what flexibility it has on either axis.  Economic contraction will elongate receivable and payable cycles and change the terms on inventory purchasing.  A well-run company will engage in frequent dialogue with parties throughout its supply chain in order to determine how the flow of cash is changing.  If there are downstream needs, they must be identified and aggressively dealt with, and will often require difficult decisions.  Companies that are proactive in the management of their capital needs stand the best chance of weathering the storm.

Seek Counsel

These are unprecedented times, but you need not navigate them alone. Most family-owned businesses value their privacy, especially when it comes to financial matters.  While we understand and appreciate this view, a company does not necessarily need to disclose all critical information about its operations in order to benefit from valuable insight from third parties.  Similarly situated business executives, lawyers, accountants, family planners and commercial and investment bankers can all be great sources of ideas and information.  These parties are situated on the front lines of deal activity and capital formation.  We are seeing smart, well-run family business seek our counsel and those of our partners, and many of these companies are trying to understand how they can take advantage of this downturn.  If you have ever considered instituting a board of directors and advisory board, now would be an ideal time to surround yourself with people who will give you candid and actionable advice.

Consider Creative Alternatives for Liquidity

While a number of traditional liquidity avenues are closed or are offering low valuations to owners, viable options do exist for creating owner liquidity in the current environment.  Mezzanine debt continues to be an avenue for companies generating at least $3 million of EBITDA.  We are also seeing a limited number of leveraged buyouts and take-private transactions being consummated at attractive valuations utilizing debt from Canadian financial institutions, who seem to be lending more liberally.  Finally, we expect ESOPs to make a strong comeback as the valuation of contributed equity is based more on technical parameters as opposed to recently observed market multiples.  Both private equity and debt alternatives remain available to underwrite ESOPs.

There is no panacea for our economic ailments, but family-owned middle-market companies can take steps to ensure their long-term future. Doing this, however, means embracing a more open and proactive approach. Companies that adopt prudent and decisive action will be poised to prosper when a recovery takes hold.

/bryan

 

Coping With Economic Realities

Last in the series I had been working, which you can download it here.

The contraction of the U.S. economy has resulted in upheaval in the middle market transaction environment. Both private equity and strategic buyers are facing challenges in getting deals done. That said, we believe the popular press has gone too far in their characterizations in an effort to remain relevant.

While we see 2009 as a challenging year at best, opportunities remain available to attract capital and achieve liquidity for shareholders. The capital markets are not closed and M&A is not dead. That’s not to say that everyone will enjoy the same alternatives.

In the final piece of our three part series, we provide insight into the deals that will get done in 2009 and how companies can best situate themselves to take advantage of those opportunities. In short, this is an availability of capital market, not a cost of capital market.

/bryan jaffe

 

Big Players, Big Games, Big Plays

It is Super Bowl week for the National Football League.  It is also Super Bowl week for the market in my opinion.   In addition to a slew of earnings releases from market bellwethers in the pipeline, we will get economic news providing us some indication of just how bad 4Q08 was.   We know it was bad.   Retail data has been revealed, write downs have been announced and expectations have been slashed.   However, if it turns out to be worse than expected it will roil the markets and provide the television pundits plenty of fodder in which to claim that we are all going to go personally bankrupt, at least financially.  If we some how find a way to meet or exceed consensus estimates and market psychology does not pull us down much below the November 2008 lows, AND we end the week at 8000+, I expect that we will have established a bottom.  Small consolation, but you have to take what you can get right now.

Now to tie up a few loose ends:

TARPooned

Why are banks not lending?  This is the question my mother asks me on a weekly basis.  The good news, for me, is that she is not alone in asking me this question.  The bad news is that people don’t like my answer.   The reason, in my view, is that while TARP did neutralize the balance sheets of a handful of banks, it did nothing to remove the associated plutonium.   As such, when then portfolio companies of these lenders go Southern Hemisphere on their covenants, it sends the balance sheets back out of the alignment.  Further, as more companies are expected to experience financial distress, lending ratios will get further sideways.

In order to remedy this situation, the system is going to need a lot more money or a mechanism to move these bad assets of the balance sheets or to nationalize the banking industry.   This is probably the most difficult decisions to make, because there is no good answer.  Nationalizing the banking industry would basically put an end to the free market economy and market based capitalism as we know it.   Creating a liquidating asset management company like a Resolution Trust Corporation seems to make more sense on its face.  However, it creates a litany of questions that are vexing regarding pricing (face value, market to market) and who keeps gains and absorbs after the fact losses.  Clearly this would become a political issue resulting in the realization of the lowest cost denominator solution.  When is doubt print more money right?

That is FAScinating

Not really, unless you dig accounting issues, but I wanted to stick with the theme.

In November 2007, the Financial Accounting Standards (”FAS”) Board (”FASB”) issued Rule 157 (”FAS 157″).   FAS 157 dealt with the fair value measurement standard for assets whose value was, wait for it, hard to measure.  In developing FAS 157, FASB said it considered the need for increased consistency and comparability in fair-value measurements and for expanded disclosures about such measurements.  FAS 157 defines “fair value” as the price that the asset or liability would achieve in an orderly market transaction between informed participants at the measurement date.   I’ll spare you the rest of the accounting detail.

When FAS 157 was issued there was a litany of articles about how it was going to “rock the financial services industry to the core” or some such other derivative statement (most these “gloom and doomers” failed to recognize Goldman Sachs had been using mark-to-market accounting for years).   That didn’t quite happen, at least not at the time.  However, in light of the financial crisis many people are pointing at FAS 157 as the cause of unnecessary pain, as it has forced banks to market their assets to market in very troubling financial conditions.  Many of those who are complaining the loudest are private equity personalities, people who don’t like FAS 157 to begin with.  Historically, private equity firms would hold their investments at cost for at least a year unless a subsequent transaction justified marking it up or down.  They were negatively impacted, in their view, by FAS 157 as it would expose to the rest of the world, or at least to limited partners, their missteps.  Woe is me.

Well it turns out woe will be quite large.  This morning we learned that Thomas H. Lee partners wrote down $524 million worth of assets in order to comply with FAS 157.   With $8.1 billion under management, this is a healthy sum for a firm that is considered one of the oldest and most successful in the business.   I expect we are going to learn of significant write-downs across the industry.   On the plus side, this will give outsiders some insight into their valuation assumptions and view of the future, which will help inform companies as they consider their options for funding operations and achieving liquidity.

Paychecked

Okay, so I could not keep the streak going.

As expected, New Seasons Markets lost in their bid to not comply with the subpoena they received pursuant to the Federal Trade Commissions antitrust exploration regarding Whole Foods and Wild Oats.   However, New Seasons was able to come to an agreement with Whole Foods to limit its disclosure in certain areas so as to reduce the cost of compliance and limit the risk the company was taking in turning over sensitive information.   Through this process it also came to light that another company also sought a legal solution, but it is unclear who it was and what outcome their case has met.

/bryan

 

Leap Year, Literally

Happy new year to you all.  I hope you all had a safe and happy holiday season.  As the new year dawns, the general tendency is to fade in to prediction mode about what the upcoming year might hold on whatever front.  I’m not a great long range forecaster, and I have the equity portfolio that proves such.  Where I excel is in reading the next 3 – 5 moves in the game.   Summarizing the view from the trenches if you will.   I’m good at the middle game but far from being a grand master, able to see 10 – 12 moves forward.  However, what I am fairly confident in, is if I could warp the time space continuum, I would fast forward to 2010 and forget about 2009.   Unfortunately, I can’t do that, nor can I hold my tongue long enough to avoid making a few predictions, so here we go:

Hangover Not Cured

The economy is in the tank, and it is accelerating, not improving.  We just don’t know it yet because the Federal Reserve does not give us the numbers in a timely manner, but we should be able to infer it from the anemic retail and job reports, forecast slashing and weak earnings we are seeing.   ADP was nice enough to tell us that 693,000 jobs were lost in December, and the Federal Reserve was kind enough to make a series of ambiguous statements that they economy is in fact on life support, but without numbers people tend to shield their candle from the wind and tell themselves it will be alright.

It’s time to recognize that it is not alright and act accordingly.  Third quarter 2008 GDP contracted at an annual rate of 0.5% and politicians flocked to capital hill screaming bailout.  What will they say when they find out 4Q08 GDP shrank by over 5%+?  If this comes to be realized, and I think it will, I suspect this will be very damaging to consumer psychology.  If the consumer goes south, then we could push unprecedented levels on the contraction front.  People who are predicting a 2H09 recovery and talking about how the tea leaves are looking favorable for a cyclic rally to kickoff in April or May of this year appear to be living in an alternate reality.   Consumers psychology will not turn that quickly and their balance sheets will need to be rebuilt.  While I do not like to think or say it, I do not anticipate we will begin to see the light at the end of this recession tunnel until 2010, and that might be slightly optimistic.

The Dark Ages

As anticipated, transaction volume plummeted in 2008.   M&A volume was down a third for the year and 44% for 4Q08.  Domestic LBO volume was down 84% for the year, falling off a cliff in 4Q to $4.8 billion.   Global LBO volume was off 71%.  Almost all of the fourth quarter deal volume occurred in October, meaning that post-Lehman Brothers, all you could hear were crickets.   Wall Street should have taken the quarter off, to get a head start on taking 2009 off.

Part of the reason deal volume fell so precipitously was the lack of availability of debt capital.  Goldman Sachs and Morgan Stanley converted to commercial banks, not at their request, and banks then went in to “hoard capital” mode and have not come out of the turtle position.   Deal related debt fell to 4.9x EBITDA from the prior year period of 6.2x for deals with greater than $50 million of EBITDA and to 4.5x  from 5.6x for deals below this EBITDA threshold.

If there was a silver lining, price compression was not seen at the levels that were anticipated.  In fact deals with greater than $50 million in EBITDA cleared at a whopping 9.5x, the second highest observation ever recorded by S&P.  What this means is the quality bar was high and only the best deals got done.  With company toplines falling 20% – 40%, I expect prices to compress throughout 2009.

For the coming year transaction volume will be drive two factors burning strategic rationale or need.  Need will be driven not by buyers, but by sellers.  Properties will come to market as a result of having lost their debt facility, driven by shareholders that need liquidity and general financial distress.  Not a rosy picture.  I believe 1H2009 deal volume will be the worst ever with 1Q09 struggling to best 4Q08.   Smart companies with liquidity cushions will hunker down and ride this wave out, as opposed to going to market.  The best positioned will seek to snap up the best distressed properties for cents on the dollar and benefit as such at exit.  Further evidence of the “rich get richer” theory.

Ice is Not Fluid

Maybe the rate limiting factor to both economic improvement and improved transaction velocity will be achieving some viscosity in the debt capital markets.   Based on what we have seen TARP has done little if anything to meaningfully free of new capital to buy company side risk.   Fortune-500 companies continue to have unprecedented levels of cash on their balance sheets to insulate them from liquidity crises.  The cannot free up this capital until they can borrow.   Their bonds continue to yield mid-double digit returns in many cases.   The proposed Obama backed stimulus plan has done little to create a sense of stability in the market.  Lenders who told us to call them back in 1Q09 are now saying, call us in 2Q09, prompting us to coin the phrase “second quarter is the new first quarter”.

As some point someone is going to have to start lending at more cost effective levels than the long end of the yield curve is currently commanding or GDP will fall to unprecedented depths.   I do see this happening in 2009, the lending environment improving that is, either as a result of the government intervening by buying long term corporates, thereby driving yields down, or restricting the usage of funds proportioned in the bailout to certain activities including new originations.

Yes, 2009 will be bad.  Unprecedented levels of pain will be experienced by our nation and workforce.  There will be huge dislocation in the white collar industries, other than health care.  I hope for the best for all of us.  Live within your means, keep your senses about you, don’t follow faddish trading strategies when you do not understand the underlying market dynamics and find opportunities to celebrate the small victories in 2009.  For some, fortunes will be lost and for others made.  That who re-write the rules are more likely to fall into that later category.

/bryan

 

Private Equity Views From the Trenches (Part 2)

In early November I published excerpts from a piece I was doing regarding the future of private equity and how it will adapt in this current market. You can now download the published article here.

/bryan

 

Antitrust as a Business Strategy

I’ve had a love hate relationship with Whole Foods Markets, Inc.  I love what they provide for me, but I hate the crowds and the customer experience.   In my household we refer to it as “Whole Paycheck”.   I was lucky, in a sense, when I lived in New York, the first Whole Foods  went in just a few blocks from my apartment, providing a working guy an oasis of healthy food options, that stood in marked contrast to everything I could procure within a 10 block radius of my doorstep.   I moved to Seattle and, thankfully, Whole Foods was just a few exits up the freeway, and I was able to conveniently procure my produce, protein and staples that served as the basis of our healthy lifestyle.

I first learned about Whole Foods when I was a traveling management consultant at Price Waterhouse (pre-merger with Coopers & Lybrand).   Back in the early days of Fast Company (circa 1996), the magazine featured an article on the company (article here) calling it the future of democratic capitalism — decentralized team based work environment, financial transparency, and consensus hiring.  At the time, I thought it was interesting model (multi-functional teams were all the rage in the reeingeering world), completely counter cultural within the grocery industry, but I was fairly out of tune with the natural foods movement at the time.

As I graduated from consulting to investment banking, my proximity to Whole Foods became closer,  and not only as a consumer.   Perry Odak, who was a Gordian Group, LLC (my previous employer) relationship, from the Ben & Jerry’s deal, had been brought in to turnaround Wild Oats Markets, Inc., the second largest organic market chain in the country.  While we were never engaged, to my knowledge, we were routinely bouncing ideas off of Perry and providing him valuation insights.  It was clear that an M&A exit was in their future.  I spent more time understanding the industry and business model and walking the isles of Whole Foods.  By then I was pretty much living in the prepared foods section.

While Whole Foods enjoyed a healthy run, driven by expansion of the store footprint, accelerating consumer sentiment around natural and organic foods, and the strong economic environment, the run began to lose steam in late 2006.   With the stock trading at $65/share in November 2006, the company announced results which included a projected slowing of their growth rate.   Comps were off, margin compression was evident, and square footage ramp was below expectations.  The era of 20%+ annual growth for Whole Foods had sunseted many believed.  Applying more conservation price-to-earnings assumptions yielded implied stock prices nearly 50% the prevailing share price.  By January, the stock was trading at $43/share, or better than expected according to analysts.

In February 2007, the inevitable happened, Whole Foods offered to purchase Wild Oats via a tender offer for would turn out to be approximately $752 million ($586 million if you net out the stores sold to Smart & Final post close).  If you can’t build it any more, than buy it.  Given Wild Oats historical operating challenges and Whole Foods  execution acumen, it was thought that considerable value enhancement could and would occur.  Whole Foods has a strong track record of turning around under performing natural foods retailers, and  it appeared there were significant opportunity for both overhead cost savings and store-level productivity gains to be had at Wild Oats owned stores.   The analyst community believed the merger will be a significant earnings driver for Whole Foods over the next several years.

A funny thing happened on the way to the alter however — the Federal Trade Commission  (FTC) filed a lawsuit to block the proposed acquisition, taking a very narrow view of the antitrust market, given that nearly every grocery store now sells organic and natural products.  This had negative implications for the stock, as uncertainty now was a compounding factor on top of eroding performance in the core business caused by cannibalization, competition and price reductions.   At the very least management would be distracted and integration delayed.

Whole Foods did not sit on its hands and wait for the FTC to mess with its future.  Instead they took their case to court and received a preliminary injunction against the FTC, setting the stage for an imminent closing.  In the background, it came to light that Whole Foods CEO John Mackey had been posting negative comments  under an anagram of his wife’s name (Rahodeb, when unscrambled would be Deborah) about Wild Oats and glowing comments about his own organization on the Yahoo! Finance message board for seven years, referring to himself in the third person.  Additionally emails from Whole Foods executives expressing their disdain for Wild Oats and their desires to “crush them at any cost” came to light.   That notwithstanding, on August 27, 2007 the deal was finalized and the merger effected.

Case closed? Not so fast.

After closing the deal with Wild Oats, Whole Foods stock price continued to erode.  Earnings misses followed by failed integration milestones blurred in to an economic crisis where consumers were trading down and, ultimately, suspension of the dividend.   Facing both a confidence crisis and a liquidity crunch, Whole Foods took a $425 million investment from Leonard Green & Partners (LGP) through their Green Equity Partners Fund.   While very successful, LGP is not known for paying peak market multiples.

Then things started to get very strange…

On July 29th,  a three-judge panel ruled that a district court judge had erred when he refused to grant an FTC request for an injunction to block the merger of Whole Foods and Wild Oats.  On November 21st, Whole Foods lost a decision to have that ruling reviewed by a larger panel of judges.   Despite the fact that most Wild Oats stores have been closed or absorbed, the FTC is now moving to have the merger invalidated.  A hearing on the merger is scheduled for February 2009.  Whole Foods has launched a new suit, claiming their right to due process has been violated.

In an effort to make a compelling case that Whole Foods is not a monopoly they have subpoenaed the records of 93 competitors in the natural food space (note: the number quoted in the popular press is 96, but in a recent court motion, the number was stated as 93).  Their inquiry focuses on 29 markets in what is terms are the “premium organic retailing space”.   Parties were given until November 4th, 2008 to respond. Financial records, weekly sales figures, marketing plans, store opening schedule, inventory reports, and more.  Most of these entities are in fact private, making these records proprietary.  Amazingly, 50 of 93 entities have complied in whole or in part without a peep.  The squeaky wheel in the machine is New Seasons Markets, a nine store chain of natural markets located in Portland, Oregon.

New Seasons CEO Brian Rhoter naturally took issue with the subpoena and is taking his case to court.  In his blog Rhoter points out not only the burden complying with the order is having on his business financially, but also, aptly,  that the FTC motion does not, in his mind, provide for adequate protection of its information or remedies upon breach.  Basically, Rhoter is saying we don’t have a dog in this fight, so why are we unnecessarily being burdened and our business information being put at risk.   The fact that Whole Foods had fronted the argument that none of their employees would see the data, and then went to court to get it sent to their Austin headquarters, raises eyebrows.

While I feel for New Seasons and side with Rhoter on this issue, my sense is that Whole Foods will prevail in court.   Antitrust does not work without competitive information and Whole Foods is following the common protocol, at least at a high level.  What boggles my mind is that others being impacted by this legal morass are not lining up behind Rhoter, at least in an attempt to greatly narrow the scope.   And what of the 42 odd companies (sans New Seasons) who have made no production in this case?  What action is Whole Foods going to take against them?  It is possible if New Seasons would have quietly ignored the subpoena that they might be better off in the short run.  After all I don’t think Whole Foods has the necessary runway to successful compel “groupo 42″ to produce and then internalize that response and incorporate it by February.

I can’t also help but let my mind wander, to the actions of Mackey and the emails of key employees that painted a win at all costs culture within the corporate center, and wonder if secretly Whole Foods is loving this part of the process.  Essentially this is antitrust as a business strategy.  I’m not saying that anything Whole Foods is not above board or that they have any intention of misusing anyone’s information, but the reality is you can’t see this information and then wipe the slate clean of it when making decisions.  Sure, pursuant to the protective order, key executives would never see this data but there are a cadre of individuals who will and invariably there will be data leakage, there always is.  Further, this case is central to the future of Whole Foods, its executives and board have to be exposed to  some of the information in order to make decisions on legal strategy.  Even if data reaches them in summary form, or at a high level, it is information they would otherwise not  have had access to in absence of this case.  This only leads me to be more sympathetic to Rhoter, as it points to a lack or organization among independent organic retailers.  If only they had known they would need their own lobby.

The last great example of a company that used antitrust as a business strategy was Gemstar-TV Guide International.   The fate of that entity and its executives was not so favorable.  That said, I value Whole Foods role in the market and I hope it prevails in its case against the FTC.  A break-up of the company would do more harm than good.   Organic food retail is a highly competitive market place once you consider how much of the product can be obtained in  mainstream supermarkets and club warehouses.  However, I wish Whole Foods approach to business was more indicative of its role as senior statesmen for the industry and consistent with what we might view as its mission.

/bryan