It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”  — Charles Dickens, A Tale of Two Cities.

I’ve been getting a lot of calls lately.  Some from family members (hi mom, hello uncle Danny), some from friends, and many from current clients and prospective clients.  Most of them are not calling to exchange pleasantries, for it appears these are not the times to look past the issues facing us all and bury our heads in the sand with fodder about sports, politics, and the state of our yards.   The questions usually get put to me as follows:

1) Is the decline of Western civilization as we know it upon us, or soon to be?

2) What does this mean for me (the person calling)/our engagement/my transaction?

3) What is the bailout and how will it impact the market?

4) Will you still have a job next week?

The placement of the last question in the hierarchy is how I know people do not want to exchange pleasantries. Rather than commit these answers to memory, I thought I might memorialize them here, in the blogesphere, so others could benefit from, or laugh at them, either today, or later.

Chicken Little

First, let me begin by saying that volatility is essential to financial markets and systems.  If prices do not fluctuate, there in fact is no market.  However, volatility can accelerate in times of uncertainty and price swings can be substantial.  It is not for the faint of heart.  That said, for everyone who is a seller there is a buyer on the other side.   One person’s loss is another person’s gain.  The market is therefore akin to a zero sum game.  This will not change.  The search for alpha, returns in excess of risk assumed, will continue, and vast amounts of wealth will be created in ways not previously contemplated and, potentially, by people who may not have not been otherwise positioned  to do so in the past.   Net net, all is not lost, and never will be, the game has just changed.  Who captures alpha going forward will be determined by who adapts best and most quickly.  The phoenix will again rise from the ashes.

The above is an obtuse way of saying “no, the sky is not falling” and “the sky has always been falling” at the same time.  It is simply a matter of the perspective from which you emanate.  But since most of you are not shorting the dollar and long gold, I can see why you might be predisposed to viewing things through the more negative lens.  I simply see it as a shifting in the opportunity set.  If you are one to embrace opportunity than, like me, you see large storm clouds on the horizon, but not ultimate demise.

Magic 8-Ball

As for those parties seeking a transaction, there is a significant re-pricing of risk going on in the capital markets.  Companies engaged in sales to strategic buyers should experience less impact to the extent that their buyer population is not experiencing capital constraints due to the need for debt capital or the lack of debt capital all together.  I expect smart buyers will try and compress valuations, but sophisticated bankers enjoy developing the analytics necessary to combat this sort of behavior.  Bankers will have to earn their fees, but transaction velocity will continue, albeit at a slower pace.  Foreign buyers will play an increasingly important role over the near and medium term time horizon assuming the dollar languishes as expected.

Shareholders seeking majority recapitalizations will likely face the most significant challenges in getting their deals done.  Ultimately, it will take some time for this market to re-plumb.   Absent the availability of debt capital, multiples must come down and/or return hurdles must decrease.  I don’t expect private equity folks to cede the later.  However, strong companies with no “need” to engage in a transaction are likely going to sit on the sidelines if valuations and terms and conditions deteriorate precipitously.  Seller subordinated financing will bridge the gap in certain markets and instances, but not all.  Expect funding contingencies in term sheets. Funds like Bertram Capital, who have dedicated debt funds, are well positioned.  Funds with limited partners who are licensed lenders with fresh capital to deploy, created by the “bailout” or otherwise, are also better situated.  How the messy middle gets resolved is as yet unknown.  Ultimately, I suspect sellers are going to have to reconcile themselves to lower purchase prices and more structured transactions.  The delevering of the U.S. financial system will leave a significant mark on the private equity landscape.

As for growth capital, there will be a significant re-pricing of risk in this market as well.  However, this populous tends to be comprised of companies that are long on growth and short on earnings.  Restated, they need money to remain viable.  Capital will remain available but venture investors will engage in a flight to quality seeking greater traction, larger preferences, and lower valuations.  Firms who do not recognize this paradigm and wait to go to market or who cannot reconcile valuation in the new world will peril.  There is a considerable amount of venture capital on the sidelines.  It will get invested, but investors will be patient and look for attractive risk return profiles.  First time entrepreneurs should proceed with caution, emphasizing cash conversation at the expense of growth potentially.  I expect a handful of bold entities who have the iron stomach to invest in early stage big opportunities that are pre-revenue will clean up if they are able to pick winners, as deals will be had in this arena at attractive prices.

Modern Use for a Bucket

The “bailout” that is being hotly debated in many corners, is, in my opinion, necessary to free up funds for lending and economic growth. Yes, those who created the problem, will in turn benefit from the plan, but the taxpayer burden, I suspect, will not be as far reaching as some pundits are predicting, assuming an auction system for the debt of these banks is in fact utilized to determine their value and forward ownership.  It will take years to wring out, but the alternative is to sit stagnant, allow things to work out organically.  The net result of this will be a prolonging of the problem and a halt to corporate formation and economic expansion.  I’ll take the devil I don’t know over the devil I know in this case.  We need to free up the lending markets to put money into business to finance growth, otherwise their will be none and the economy will further contract; it’s a vicious cycle.  We will face inflation as or easy money policy of the past 18 months comes home to roost.  An engine of growth will be necessary to get us out of the predicament.

In these matters I prefer to turn to others whose daily job is to understand the economy and its cycles.  I thought Bill Gross, Chief Investment Officer at PIMCO, a fixed income investment management firm, got it right in his Washington Post article.

Et Tu Brute?

As for me, I’m still employed and expect to be tomorrow, next week, next month, next year, etc., etc.  I was a few years early on my ejection from the world of Wall Street, but my direction was accurate, the prior system was unsustainable and I found that hard to ignore (the same reason I did not go into tech banking when I graduated from business school in 2000).  I’m lucky in that I work for a small firm, focused on a defined market that is provincial, and we face limited competition.  We are nimble and occasionally smart in our planning. In fact, I’d like to hire some of the great people who are being displaced for reasons not of their own making.

Yes, there will be tough times ahead, maybe very tough times, but I have always adhered to the strategy that you live within your means and you take precautions to ensure your future.  I’m one of those people who actually have an earthquake preparedness plan.  My grandparents lived through the Great Depression.  As a result, I never get too high or too low.  This will help me navigate the challenges ahead.  Your support will be welcome.

This weekend I will sit down, open up a nice bottle of wine and toast to the future, whatever it may bring.  I’m confident that we will work through our troubles and the system will be better for it.  I hope you all find your way as well.

/bryan

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