eyeHappy 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

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