October 2009


There is a growing belief – and it’s slowly being supported by market data – that the economy is improving. Traditionally, we would take this to mean that key indicators are accelerating; and, in some cases, such as manufacturing activity and worker productivity, they are. But the term “recovery” has also come to mean something akin to “not as bad as last time”; or, talking more like an economist, it’s become code for “a deceleration of the decline.”

So, whether we’re using lay language or professional parlance, we need to confront the fact that service sector activity, on which our economy is now largely based, continues to contract, and unemployment figures remain near historic highs. Both of these signposts should serve as a clear reminder that all is not well. And, despite professing that the current recession is “likely over,” Federal Reserve Chairman Ben Bernanke continues to urge caution with respect to the domestic economy.

If we move beyond the macro-indicators, there are also signs that a bottom in the transaction environment is imminent.

The most obvious key indicator is the public equity markets, where we have seen a very healthy recovery. The current bull market rally has driven the Dow Jones Industrial Average up 46%, the third-largest six-month rally in history. As a byproduct of the run-up, corporations have been able to pry open a new issuance window not seen in years. Further, credit spreads have tightened and issuance volumes of both investment grade and high yield debt will surpass 2008 figures. These have enabled corporations to access capital and much needed exits for financial investors, both of which are important to transaction velocity because liquidity drives the lifecycle.  In addition, CEO confidence, as measured by The Conference Board, surged in the second quarter into an “optimistic” reading. This means more views to the positive than to the negative. A favorable market outlook correlates strongly with corporate and financial buyer appetites.   Finally, there has been a spate of large deal announcements, driven primarily by large cap public companies seeking to capitalize on strategic synergies. These deals have changed the tone of the M&A market.

Based on available data, peak-to-trough contraction in M&A transaction volume has typically taken two years. The recessionary period of the late 1980s and the period at the outset of this century both conform to this pattern. As such, given that the current contraction began in late 2007, we would expect to see a bottom late this year. That said, we’ve seen improvements in market conditions, but we don’t believe circumstances are right for a quick return to normalcy for a number of reasons:

Sponsors on the Sidelines. While we have seen an increase in sponsor inquires regarding ongoing mandates, we have seen only a handful of term sheets and even fewer closed deals from this community. On the whole, the private equity industry is still struggling with problems within its existing portfolio. A lack of cheap debt capital to underwrite new deals has resulted in depressed sponsor-backed activity volumes. Year-to-date, global private equity activity is off over 66%, though.   The trailing four quarters have been slower than any four quarter period since the twelve months ended June 2002. Until sponsors are able to access cost-effective debt, total transaction volume will be muted.

Mezzanine Debt Not Solving the Last Mile Problem. Mezzanine debt was touted as the means through which leveraged buyouts were going to be effected when lenders scaled back on transaction leverage. It’s true that mezzanine fund-raising has reached unprecedented levels and subordinated debt has grown as a percentage of the deal capital structure, but company performance has declined significantly, rendering mezzanine of limited use for the buyout community. Further, lender return expectations have exceeded a level buyout professionals deem reasonable.  While mezzanine debt will be part of the solution during the recovery, company operating performance must improve in order for it to be accessed as intended.

Deal Velocity Absent in the Middle Market.  The composition of 2009 deal activity is heavily skewed toward transactions that are greater than $5 billion in value; but deal volume has dropped by approximately 23% in this segment. Even more telling, volume for deals involving companies valued at less than $1 billion (a traditional definition of the middle market) has fallen by over 50%. We’re seeing that most high-quality middle-market companies in the Pacific Northwest seem content to sit out the current market cycle. And deals that have gotten done, like RW Beck / SAIC, occurred at premium-market multiples that were justified by high levels of strategic value. The middle market makes up the largest percentage of transaction volume (33% in 2008); but until valuations improve, a true recovery in the transaction environment cannot be realized.

Strategic Buyers Continue to Show Caution.  While premiums paid for transactions in 2009 are well above the long-term historical average, this figure is skewed by a handful of large public deals. As an example, Dell offered a a 68% premium to the prior-day close to acquire technology services company Perot Systems. In reality, we are finding that strategic buyers are quite cautious with respect to tuck-in acquisitions. Most buyers views this as an opportune market to buy companies at cost-effective prices. But we don’t see these buyers stretching on valuation until operating results improve and financial buyers are able to provide a realistic alternative for sellers.

Ultimately, deal volume will return when the buyer’s ability to pay  and the seller’s expectations again converge. We now recognize that the market eroded so precipitously that a very large chasm was created; it’s also clear today that it will take time to build a solid and lasting bridge over that abyss. An improvement in the macro economy is definitely good for deal activity, but economic growth has to be reflected in the income statements of traditional middle market companies before we experience a return to normalized conditions.

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superzThe fall trade show season for the retail segment of the pet industry has come and gone.  From a macro perspective, the industry continues to thrive.   Not only is innovation accelerating, but the core themes around humanization, health and wellness and convenience remain relevant.   That said, things are not all sweetness and light.   Of greatest significance is the reality that the economic contraction is having an impact on the industry, maybe not in the most obvious ways.  Additionally, the H.H. Backer Pet Industry Trade Show was flat relative to SuperZoo, just two weeks prior.   In the balance of this post, I discuss the key observations from walking the floor in Las Vegas and my interpretation of front line accounts from those attending H.H. Backer.

Recession Resistant, But Not Proof

Anyone who pays attention to pet media has been inundated with articles touting the industry as a safe haven from the downturn in the economy.  While, technically speaking, the industry continues to grow, it is by no means moving along unscathed.   The show season provided ample evidence that the industry is feeling the pinch.   Notably in this regard, paid attendance was down across the two shows both in terms of buyers and exhibitors.   Many who normally exhibit at both shows chose one or the other, but not both.  Second, growth rates for most of the industry has slowed, in  the majority of cases significantly, though outliers still remain and in a world where “flat is the new up” any movement up and to the right should be commended.  Third, buyers (in the retailing sense as opposed to the M&A transaction sense) were clearly more cautious, many were there to browse and keep updated on the evolution of the merchandising mix,  but we saw a lot of “wait and see” from people in independent pet specialty who normally travel with their checkbook.

When one factors in that access to capital is currently quite limited, especially for small companies, these signs point towards consolidation in the industry.  Or at the very least a bifurcation of the market into leaders and laggards.  Cash flow generating businesses who can attract capital will drive growth through marketing spend, while those who cannot access funds will be challenged to allocation their limited resource base.

I’ll Take a Treat As Opposed to a Meal

While subtle it is notable; I felt the “presence” of the treat companies exceeded that of food companies at SuperZoo.  That is not to say there was an absence of food folks on the floor of the show.  In fact they were there in force, as always.   However, their participation was much less extravagant and a number of up-and-coming brands were absent.   Part of my conclusion is that there has been limited innovation among the major independent players, they are too busy duking it out  for shelf space.

The most notable innovator in my mind has been Merrick, which launched Whole Earth Farms.   Whole Earth is a premium natural line of dog food targeted to the value oriented consumer.  On one hand this makes complete sense to me, as consumers are forced to trade down, this product offers product attributes that are very appealing at an attractive price per pound.   Possibly of greater significance it may be attractive enough to pull up consumers who generally buy mass, but would prefer to feed their dogs natural.   With Pet Promise going away a healthy percentage of these customers are looking for a new home.  At the same time, I wonder if these two groups can live harmoniously.  Value orientated natural has not been highly successful in the human realm.  I offer Whole Foods 365 Everyday Value as Exhibit A.

I give runner up accolades on the food side to Mulligan Stew’s launch of their baked soft kibble and Honest Kitchen with their display of feathers signifying their move to free range chicken in their chicken based diets.  For the later, it made the point nicely.

At the same time we were more impressed with the evolution and innovation in treats, not only in terms of ingredients but also in terms or blurring the line between reward and core wellness.   At the show we saw an increasing number  (relative to the prior year) of treat companies promoting their offerings (or an offering) as “source verified”.    Further, numerous treat companies are marketing formulations with an ingredient count that only requires a few fingers.  Fruit and vegetable based treats are also on the rise.  Finally, many treat companies now have offerings that  promote general wellness or help alleviate specific issues experienced by companion animals — joint health, dental wellness, skin and coat support, digestive health.  Kudos to the likes of Zukes, Fruitables, Pegetables, Terrabone,  Petit Four Legs  (shameless plug) and a host of others.

LOHAS Movement A Foot in Pet

The lifestyle of health and sustainability movement continues to gain momentum within the pet industry.   Nearly every company I visited with that offered bedding and toys has a product incorporating some form of recycled material.   Sustainability has become more prominent in marketing, especially for companies where the link is less obvious.

Of greater significance is the proliferation of health related offerings.  Not only is the supplement space gaining in competitors, but sophistication from a product formulation and branding standpoint has also evolved.  New comers such as 3M and The Brampton Companies (which purchased Vet’s + Best) were just two of the more notable booths, coupled with industry incumbents Nutri-Vet, NaturVet, Ark Naturals, PetAg, and a handful of others.  Of the condition specific issues being addressed most prominently, dental health and weight management have joined hip and joint as the most commonly addressed.

Finally, there were a host of other target specific health solutions ranging from pet first aid kits to electronic emergency pet reference manuals to ear thermometers to therapeutic treadmills.   Most notable was Anti-Lick Strips from Nurtured Pets.  These all natural peel and stick bandages deter unwanted behavior and prevent small problems from becoming big problems.

Better Branding

A final note, packaging and associated branding in the pet industry has come a long way in the past 2 years.  This is consistent with my thesis that more companies have entered the market with traditional consumer packaged goods experience and who are looking at the industry as a business (the professional trumps the enthusiast).   It used to be that packaging was a source of competitive advantage.  Now, in some segments, sophisticated presentation is the bar for entry.  Anyone who knows Vets + Best pre-Brampton, can attest to what a makeover can do.   Other notable packaging came from the Get Naked line of health supplement from NPIC, Zupreem, Flexi, and Nutramax.  I expect more innovation next year as others refresh their image to keep up with their competitors.

/bryan

gekkoAndrew Lahde might not be a name you know well, but you should.  Lahde was the sole principal at Lahde Capital Management, a small California hedge fund that returned between 866% and 1000% (depending on who you believe) within a year betting on the decline of the sub-prime mortgage market.  And then he called it quits — at the peak of the market.   Ladhe tapped because he, well, hated his job.

Lahde, an MBA from the Anderson School at UCLA, honed his skill not at Goldman Sachs,  Morgan Stanley, or some big name hedge fund, but from the more modest platforms of Roth Capital, Gerard Klauer Mattison, Kayne Anderson Rudnick Investment Management and TD Waterhouse.

In November 2007, he called the forthcoming decline of the U.S. financial services industry, our domestic currency, and the global equity markets.  The problem was nobody knew who he was.  He had no platform.

So today we remember and salute Lahde by re-publishing his farewell missive, dated October 17, 2008, that someone called the “best thing written since Don Quixote. The letter address a broad range of topics, and I don’t support all of his positions, but it is worth the read, because it serves as a reminder of how disconnected we became from reality.

Enjoy.

/bryan

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list of those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they lookforward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don’t worry about my employees, they were always employed by Mr. Springer’s company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life – where I had to compete for spaces in universities and graduate schools, jobs and assets under management – with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won’t see it included in BP’s, “Feel good. We are working on sustainable solutions,” television commercials, nor is it mentioned in ADM’s similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant – marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other addictive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let’s stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say goodbye and good luck.

All the best,

Andrew Lahde”