They say there are two certainties in life, death and taxes.  That’s not entirely accurate since death comes at the end of life, but that is probably just quibbling.  Taxes are a certainty however, whether of not you choose to pay them.  If the 2012 presidential campaign has illuminated anything definitive to date, it is that not all income streams are equal from a tax standpoint; those who make the majority of their income through buying and selling investments (the Mitt Romney’s and Warren Buffet’s of the world) have much lower effective tax rates because their income is treated as capital gains instead of ordinary income — 15% versus 35% at the highest level.  Some form of equity is looming on the horizon.

In 1993, the Clinton Administration sought to tackle a $300 billion federal deficit through government spending cuts and increasing personal income taxes on top earners.  This resulted in a budget surplus in 1998, which grew to $230 billion by 2000. The surplus was a central discussion point in the 2000 presidential campaign.  George W. Bush suggested America was “owed a refund” and campaigned under a promise to lower taxes on the wealthy if elected.  The net result was the 2001 Economic Growth and Tax Relief Reconciliation Act and 2003 Growth Tax Relied Reconciliation Act, collectively referred to as the “Bush Tax Cuts”.

The Bush Tax Cuts lowered ordinary income tax rates 3%-5%, phased out the estate tax, reduced the marriage penalty, lowered rates on income from dividends and capital gains, and increased exemptions.   Critics argue over the long term impact of these changes, but two things are hard to dispute: a) the Bush Tax Cuts resulted in U.S. government losing billions of dollars of revenue over a 10 year period and b) keeping the cuts in place have become a central political platform for the Republican party.   While I am no political handicapper, the combination of a swelling U.S. deficit (and therefore the need for more revenue streams), the growing income gap between the wealthy and the middle class (as evidenced by the “Occupy” movement), and the clear improbability of the GOP winning both the White House and the Senate, mean the Bush Tax cuts are all but dead on the stroke of midnight December 31, 2012.

The implications of Cinderella leaving the ball are meaningful, as evidenced by the table below:

Estimated Changes Upon Expiration of Current Tax Program
2012 2013E % Increase
Ordinary Income 35% 43.4% 24%
Long-Term Capital Gains 15% 23.8% 59%
Qualified Dividends 15% 43.4% 189%
Estate and Gift 35% 55% 57%
Source: Moss Adams LLP Year-End Tax Planning Guide, November 2011

The question many are asking is whether these changes may light a fire under M&A for family owned businesses in 2012.   After all, if you own a business worth $100 million and  you sell in 2012 versus 2013 you save yourself at least 8.8%, but possibly much more if the”Buffet Rule” is enacted into law, which would put a minimum tax rate of 30% on all income streams if you make over $1 million annually.

History would tell us that taxes alone are not sufficient enough to push people towards transactions they would otherwise defer.  However, history has not seen this level of increase in the capital gains rate since the 1967 – 1972 period when rates increased 11.5%, but over a period of five years.  Here we are talking about 8.8% over night.  Further, the market has never enjoyed the levels of liquidity currently in the marketplace, from both strategic acquirors and private equity firms.  Excess liquidity tends to correlate with rising purchase prices.  Throw in a pinch of uncertainty regarding Europe over the next 24 months and you might have a convergence of circumstance strong enough to call some to action.

Despite the stars aligning only a subset of the market should be interested in this reality, and that would be companies on the larger end of the spectrum.  Yes, as enterprise value increases the impact of the capital gains rate changes increases, but more importantly so do transaction market multiples.  According to GF Data Resources, the spread between the multiples garnered by businesses worth greater than $50 million is a fully 2.0x in a leveraged buyout versus those with lower enterprise values.  The data shows that the “size premium”, so to speak, increased a full 1.0x in 2011.  Absent attractive purchase prices, people tend to sit on the sideline no matter how their tax bill changes from one year to the next.

Net net, I think 2012 will be a strong year for M&A because of the total market dynamics, but I don’t think taxes alone are going to stimulate a plethora of activity that would not otherwise be there on other merits.


I’m not a big fan of Las Vegas.  Generally speaking it’s too hot during the day and too cold at night for my enjoyment.  Further, as I have aged I’ve become less of a fan of noise and crowds and rooms without windows.  While you won’t find me hitting the strip on a personal vacation, I make an exception for SuperZoo, the “National Show for Pet Retailers”.

Of the major pet shows, SuperZoo is, in my opinion, the most valuable to attend for someone who surveys the industry.  Part of that charm is due to the shortcomings of the other major retail shows.  As an example, Global Pet, the largest pet show in the nation, is, well, as you might expect, big and dominated by the presence of the large industry players.  Sprinkled in between are a host of import companies and the mid-market is pushed into the corners of the room.  The booths of the innovators are usually quite crowded and getting an audience is pretty tough; product providers are there to do business after all.   In its defense, Global Pet has the best press room.  Further, the benefit of Global Pet is that is sets the tone for the year, even if you have to travel to Orlando.

In contrast, SuperZoo helps you see take a pulse on the state of the year.  The show provides a great sense of what retailers have done year-to-date and what they will be emphasizing for the holiday season.  Of significance, the show, because it is perceived as regional, is not dominated by the large multinational CPG players; the mid-market is well represented.  Further, it is much easier to get access to business owners and learn about the state of the industry company-by-company.   SuperZoo also has the best food (Lotus of Siam is my favorite), which is important in picking your tradeshow.  It also means that our bi-annual report publication date is just around the corner.

As I prepare for my fourth SuperZoo, I’m very interested in what I will see for a variety of reasons.   First, I’m interested to get a read on how the industry is doing in light of the broader economic climate.   Prior to the 2009 recession, the pet industry was viewed as “recession proof”.   While the industry thrived relative to other consumer facing franchises during financial downturn, the contraction did take some wind out of its sails and the message was recast as “recession resistent”.   In contrast to 2009, where the impact of reduced liquidity was so broad, we should be able to get a real read on how decoupled (or coupled) the pet industry is to the general economy.  Currently, we have stagnant GDP growth and high unemployment but also rising consumer incomes and improving individual balance sheets.  Notably, Petsmart (our pet industry public company proxy) posted strong 2Q2011 results with same-store-sales increasing 5%, comp transactions growing 2%, total sales increasing 7% and earnings growing 32%.   So is this a case where Petsmart is executing impeccably, or is the industry thriving against a relatively sanguine economic backdrop?  Conversations at SuperZoo should yield some insight.

Second, I’m interested in getting a better sense on the state of pet food, dog food in particular.   While any pet pundit would pursue this line of inquiry at anindustry show, I am now more interested than ever as I believe the market dynamics are changing.   Notably, the super premium category is seeing hyper-competition driven by big budget CPG acqusitions, large independents increasing sales and marketing spend (Blue Buffalo television commercials anyone?), and in-house brand launches for the largest independent pet retailers.   I see this environment as very challenging for a mid-market kibble manufacturer who does not have a meaningful angle of differentiation.  However, I also see this as a great time for food companies pushing alternative form factors (dehydrated, raw, freeze-dried) as all the kibble marketing messages now seem to blend together.   I’ll be looking to see if the recent equity raised by the upstarts in this niche translates into an increase presence at their booths.

Lastly, I remain interested in other opinions about pet e-commerce.   We’ve heard the party line from Petsmart in their 2Q earnings call, but I want to get it from the product providers perspective.   Of greatest interest is how their wholesale pricing is being impacted by what is clearly price competition in the industry.  Further, with the increase in proprietary product at the major pet retailers, I want to know if the mid-market pet players see the direct channel as their future, and if so how they are going to change their operating model.

If you are going to be in Vegas for the show.  Give me a shout, and hopefully we can meet up and chat.


Mezzanine debt, sometimes referred to as junior debt or subordinated debt, came into vogue during the “go-go” 1990s buyout boom.   The origins of mezzanine debt are rather cloudy, but the instrument was invented to allow private equity firms the ability to limit the amount of equity dollars they put at risk in a deal.   Once a purchase price was agreed and senior debt (bank financing secured against the assets of the company) was arranged, buyers would offer mezzanine debt funds the opportunity to get 15% – 20% return by taking an unsecured position ahead of the equity slug.   Interest rates on mezzanine debt was in the low teens with 66% – 75% of the interest being cash pay and the balance paid-in-kind interest (interest that accrues and is added to the principal and then paid when the debt is retired).  The balance of the targeted returns were achieved by issuing at-the-money or penny warrants to the debt provider.

Limited partners (pensions, endowments, and the like that make up the capital used by institutional funds) liked the mezzanine concept as it enabled them to get attractive risk adjusted returns, with the cash interest protecting them on the downside and the warrants juicing their returns on the back end.  In a strong bull market of rising tides, mezzanine funds did very well as default rates ran very low and equity returns exceeded expectations.  Many hedge funds got into the act by making similar investments in operating companies with a more risky profile.  These investments targeting slightly higher returns than institutional mezzanine.

Shortly after the Internet bubble burst, mezzanine debt, in its traditional form, went in to decline.  A flood of cheap bank debt made mezzanine less attractive to sponsors and the emergence of publicly traded Business Development Companies, offering one stop financings (senior debt, junior debt, and equity — often referred to as unitranche debt) , cut into mezzanines traditional markets.   Any gaps between purchase price multiples and bank availability was bridged through the emergence of second lien notes (debt that took a second position on fixed assets and real estate), which offered a lower cost of capital relative to mezzanine debt.   Traditional lenders, including second lien, were offering to cover as much as 95% of the purchase price, so there was no need to offer excess returns to anyone.  Between 2005 – 2007, mezzanine debt went in to hibernation.

By 2007, mezzanine began to make its comeback.   As purchase price multiples reached into the stratosphere mezzanine returned to filling its initial mission.  Any incremental dollar of debt meant an incremental $0.50 – $0.75 of purchase price.  Based on this improving demand function, mezzanine debt funds raised $15.7 billion in 2007.  In 2008, nearly 60 funds raised over $34 billion.  These funds were meant to fund the last mile on leveraged buyout transactions but then the music stopped.  By 1Q2009 the buyout market was bone dry.

Flush with capital, mezzanine debt providers were left to contemplate a “buyoutless” world.   In response to these changing circumstances funds separated into two camps — those determined to define their own identity (Camp I) and those intent to wait out the storm (Camp II).

While Camp II sat dormant, Camp I’s initial response was to seek to make stand alone mezzanine investments.  After all, mezzanine looked like a good tool to achieve short term liquidity relative to taking equity at depressed prices, if it was even available.   However, these funds were not well situated to do de novo deals, having historically relied on the diligence of their equity partners to get comfortable with a transaction.  As a result, targeted returns spiked and mezzanine debt became visually and economically unpalatable.   Lenders began targeting returns of 25% – 30% to compensate for their diligence risks (after all there was no equity to save them).   Many awesome deal stories followed.

However, as the buyout market has roared back to life, Camp I has shown that its evolution has staying power, while Camp II has returned to business as usual.   In fact Camp I is pitching itself as an alternative to institutional equity — faster, cheaper, without the governance hangover.  Notably, terms sheets from Camp I funds look much like those from the old public traded business development corporations, only without the senior debt.   Today a typical mezzanine term sheet will have a subordinated debt component, with cash and paid-in-kind interest and dollars allocated to an equity investment in lieu of warrants.   These mezzanine funds can stretch far on valuation because they have the downside protection of the coupon and no private equity partner to be beholden to.  The script has flipped.

As we enter into a period of uncertainty with respect to how this cycle will build and how long it will last, mezzanine debt players are better situated than their counterparts to take deal volume from other parts of the capital structure.   As a result, I expect to see standalone mezzanine debt volume grow dramatically through the balance of the year.


“Dozens of people spontaneously combust each year.  It’s just not really widely reported.”

— David St. Hubbins, Spinal Tap

During the period spanning 2H2008 to 1H2009, I enjoyed a steady stream of inbound calls from companies seeking debt.  About half of those calls were from people thinking that I had something to do with a bank that made loans; the balance were from businesses, large and small, seeking additional capital to fund their operations.   Most of them were beyond help, due to the state of their business and/or collateral.  However, a small handful were beyond help, not because they were bad credits, but because the national banking system achieved a level of gridlock not seen in my lifetime, or probably anyone’s for that matter.

The market panic caused a significant contraction in available debt.  Market prices for even high quality credits trading on the secondary market plummeted (30% – 40%); default rates spiked (a 400% increase to ~ 13% in December 2008); spreads widened materially (+400 BPS on Commercial Paper, one of the lowest risk financial investments); capital ratios increased (Tier 1 capital requirements for lenders increased from 4% in May 2009 “Stress Test” to 7% at Basel III); and bank numbers contracted (active cash flow lenders went from 154 in 2007 to 18; FDIC has closed approximately 300 banks as a result of the recession).   No wonder people could not get a loan.

The above should be no surprise to anyone who follows the financial news.  However, today, some 12 months removed from those panic induced calls, people look at me quizzically when I tell them that debt is in fact available.   The looks I receive are a cross between “what you talking about Willis?” and the glare my grandfather bestowed on me when he thought I was pulling his leg.   Yes, debt is available, but like spontaneous combustion it’s not really widely reported.

To be clear, a significant portion of the business ecosystem is still unable to access debt.  Asset based loans remain widely available, with lower advance rates, but there are a lack of lending institutions that write check sizes under $5 million.  For those banks that remain in this market, many of them continue to be saddled by under performing real estate portfolios and credit standards that are harder to crack then getting into the wine cellar in the presidential war bunker.   As such, loans for small business remain very hard to come by, and this will continue for some time.  However, debt for large middle market businesses is not only widely available, but the trend has turned silly as banks seek to invest (no loans no loan revenue) as much of their available capital with the highest quality credits.  Eventually, competition will drive these banks to begin moving down the size and quality stack until the lower echelons are again able to access cost effective debt capital.

One prime example of debt market health is the availability of leveraged dividends.  A leveraged dividend involves taking out debt to pay, as you might expect, a dividend.   In short, a significant percentage of capital is not remaining in the business, it’s going in to the pockets of shareholders (often times private equity funds) with the liability remaining at the corporation.   When leveraged dividends are widely available, it is the first sign of debt market excess.   Now consider that over $40 billion of leveraged dividend recaps have been declared in 2010, according to S&P.   These levels exceed 2005 totals and are competitive with 2006/2007 volumes, the base of the last market peak.  The shareholders of HCA, Dunkin’ Brands, Burlington Coat Factories, Ascend Learning, Getty Images, Pelican Products, and Petco have been the chief beneficiaries.   While many of these companies operate in attractive industries that are “recession resistant” (health care, education, pet retail), many of them are not owners of highly predictable recurring revenue streams that would put a lenders credit committee at total ease.

Likely a better measure is what I am seeing in the market as it relates to debt issuance.   Based my purview, the credit market remains bifurcated.  However, as a company’s trailing twelve months (“TTM”) Earnings Before Interest Taxes and Depreciation (“EBITDA”) approaches $10 million, it becomes much more widely available.  Further, in the last 6 months, we have seen a trickle down effect.  In 1Q10 the benchmark was $15 million in TTM EBITDA, while today it is in the +/- $8 million range and goes lower, albeit not much, for companies that are in non-cyclical industries and have predictable recurring revenue streams and performed well throughout the recession.  A caveat is that if EBITDA has spiked materially over the last twelve months, a three or four year average is applied to establish “baseline” EBITDA.   It also helps if the company is backed by a third party equity provider.

What is also notable is that bank hold sizes have gone down considerably.    What this means is I am seeing syndicate deals on transactions that we would traditionally see a lender signal source.    Companies seeking $100 million loans are ending up with 5 – 7 banks in their credit versus 1 – 2 pre-meltdown.  This means it is actually easier for $10+ million TTM EBITDA businesses at the lower end to get credit than at the higher end, as you don’t need to get the entire credit industry on board with your transaction.    I realize this is backwards, but welcome to the current credit market reality.

Finally, availability does not necessarily correlate to volume.    Currently, lenders are seeking a minimum of 40% of enterprise value be in the equity account.   Therefore a company that is valued at 6.0x TTM EBITDA can only get up to 3.5x leverage, and more likely 3.0x.   Thus, no meaningful EBITDA means no meaningful debt.

Net net, we are not in a flush lending environment by any means, due in part to government imposed capital requirements, but debt is available if you fit in the current sandbox.






Some 15 years ago (maybe more) I read “Diet For A New America”, the expose of America’s factory farms, written by John Robbins, the then heir to the Baskin-Robbins fortune.  The book opened both my eyes and mind with respect to the agriculture industry in the U.S.    While the book did little, at the time, to change my dietary habits, it was central to shaping my relationship with food, for the better, in the long run.    This blog post is unlikely to do much to actually change our circumstance in the short term, but, like Robbins,  I believe we need to begin with a recognition and acceptance of the problem; from there change can emanate over a realistic time horizon.   With that I offer up my plan for saving capitalism as we know it:

1.  Tort Reform – I suspect you are now scratching your head.   This plan begins here? Yes it does.   I  don’t purport to know who is telling to truth when Rep. Tom Price says the cost of unnecessary litigation taxes the health care system $650 billion annually or if this figure is only $56 billion as Harvard Public Health Professor Michelle Mello estimates, and in fact I don’t really care.  What I do know is your unhindered ability to bring a lawsuit drives up the cost of nearly everything.   More significantly, it undermines all sense of accountability in our society.   We have become a nation that expects something for nothing; our sense of entitlement is, for lack of a better word, gross.   Procedural limits and damage caps would not only reduce costs but it would change the way we view ourselves.   Tort reform would restore the concept of work ethic in America.  Consider it the end of the free lunch, with apologies to Harry Butler (you can Wikipedia that one).

2. Address Obesity – The cost of obesity to the American economy is huge — hundreds of billions of dollars.   However,  for me it is less about the direct cost to the health care system (again), and more about the indirect cost, which are borne by employers in the form of higher costs and lost worker productivity.  Let’s face it, the average American is going to have to work both harder and longer in the future to pay for our nations debt.    We can’t do that if society is unable to return to a reasonable health standard.   Further, the high cost of health care dissuades innovation and new company formation.   We will not solve obesity as its roots are genetic, but we can promote industry and incent individuals to address the problem.  Maybe if we, as a nation, can reduce our dependency on processed foods, it will provide a necessary injection to our domestic agriculture base let alone help us do our jobs better.  Productive workers are happy workers.

3. Term Limits/Return of the Welfare State – I have a political science minor, but I am no expert on government; I haven’t lived through enough political regimes to be credible.  However, our political system has clearly become a soap opera that is equal parts partisan politics and tomfoolery.   The net effect is we end up with policies that address the lowest common denominator.   Further, long standing incumbents in key positions of power act like they know what is in the best interest of the people who are telling them to do just the opposite.   Our life has been reduced to 90-days of negative campaign ads every other year.   We need new ideas and responsive political representatives in government.  Term limits favor meritocracy, encourage competition, reduce bureaucracy, and control the influence of interest groups.   However, term limits are not enough, we also need to return significant rights to our states.   We are no longer a homogenized population whose needs can be universally addressed by policies at the national level.  States are better situated to devise and implement policies that meet the needs of its residents.   By empowering people to deal with problems locally you build a sense of community.

4. Underwrite the New Manufacturing Economy – Currently, capital flows follow collateral and cost effective business models.   Without ties to a deep pocket, capital intensive businesses have little hope of getting off the ground.   Capital expenditure has become a “dirty word”.  However, the manufacturing base is a critical employer of our middle class population, and it is vanishing because of our adversity to invest in real assets.   Our need for instant gratification limits our growth.   Further, the current labyrinth of federal grants currently funding the manufacturing industry favors those who are well enough off to pay for lobbyist to influence policy development and employees to process the paperwork to garner it.  The rich are simply getting richer.  The poster child of the current regime is Tesla Motors, hardly a start-up manufacturing business but your tax dollars are paying to build their manufacturing facility and Tesla’s venture investors thank you.  We need real venture capital for fundamental manufacturing innovation and micro-lending to leverage the available equity investment.   Re-energize manufacturing and you begin to address America’s unemployment problem and restore our sense of self worth.

5. Reign in Consumer Credit – Let’s face it, we are a consumer driven economy and one that is prone to spending beyond our means, well beyond our means.    In fact, as a nation we have over $950 billion in credit card debt and  14% of disposable income goes to service that debt — just service it, not repay the principal.  The average household with credit card debt has a revolving balance of $15,788.  Credit card companies and consumer lending organizations help facilitate over indulgence by enabling people to borrow beyond levels that they can reasonably pay — zero down mortgages anyone?   Further, credit card fees and adjustable rate mortgages penalize low wage earners who do not have collateral or the track record to get the most cost effective credit or refinance.  Reign in credit and you increase accountability, you also reduce a regressive economic force in our society thereby narrowing the  wealth gap.   Cheap credit also creates asset bubbles which influence our economic cycle to the negative when they burst.  Finally, the fees that would no longer be going to pay for monthly interest charges could go to actually paying the backlog of unpaid taxes ($300 billion annually).  When you care about your country, you actually don’t mind paying your fair share for what it provides you.

If we boil this down my Rx for America comes down to restoring our nation’s pride.  Pride in yourself, your family, your role in your community, your role in society, and your ability to positively impact the economic system.   Pride that comes from doing an honest days work and receiving a fair and honest wage in return.  Pride from doing the right thing for society by accepting responsibility for your own health and actions.  Pride in paying your own freight.  Pride from the fact that your elected officials actually represent your interests.  From pride comes trust and from trust comes a sense of purpose that extends beyond the individual and to the collective.  Together we can move mountains.

Pie in the sky?  In totality yes, but saving our economic system a trillion dollars annually is not easy.  If you look at each of these issues in isolation, they are winnable battles.  Win them all and you save America.  And no I am not running for office.



I’ll readily admit that I don’t know much about inflation.  It’s hard for my generation to appreciate the concept since the majority of our wage earning years have been characterized by a general absence of an inflationary cycle.   Since I graduated from business school in 2000, inflation (as measured by the Consumer Price Index for all urban consumers (CPI-U)  has not breached 5%.   In fact, over the course of 2009, we experienced considerable deflation, with negative growth in the CPI-U for eight months of the year.

So why is it that I am holding inflation indexed bonds in my portfolio?  That is a good question.   The reason I went into TIPS six months ago, was my belief that inflation was inevitable.   The unprecedented amount of liquidity that has been injected by the U.S. government in an effort to stabilize and re-energize the economy requires it.   Or does it?

As a general rule, when excessive liquidity is injected into the market place with an rapidity it leads to an inflationary cycle.  The logic equation is that the recipients of that cash will find themselves with an excess inventory of funds and bid up the prices of goods and services.  The sellers of those goods and services find themselves cash rich and pass along the favor.  The declining value of the currency causes people to part with these excess funds as opposed to holding on to them.   As evidenced by the graphs below — M1 (the money supply) and a trade weight currency exchange index (DTWEXM) — these very conditions are in play right now.  The money supply expanded by more than $1.7 trillion in 2009, more money than is necessary for transaction purposes.

So why is it that we find ourselves with sustained low inflation despite excess liquidity?  Notably, the process of inflation is not precipitous, especially in a complex economy and during a period of economic decline.  It is not hard to fathom an entity, be it a person, business, fund, etc., holding excess liquidity (read: hoard cash) out of fear despite the erosion of value resulting from falling currency rates, because the alternatives are less attractive.   The media often refers to this as the “money on the sidelines”.   Despite a strong economic recovery as measured by the stock market, people remain fearful of future problems stemming from the bloated balance sheet of our economy, and, as a result, they continue to be more than happy to hold onto their monies, even if they are less precious tomorrow than today.    One only needs to look at consumer spending figures and read about wage stagnation to see evidence of this pattern of behavior.

Additionally, economic meddling exacerbates the realization of inflation by delaying capital outlays.  Bailouts of individuals and institutions mean they can postpone deleveraging events and calls on collateral.   Notably stimulus packages spread out spending over a longer time horizon which prolongs the effect.   Further, much of the current stimulus sits on bank balance sheets in the form of excess reserves — money that provides savers assurance that their collateral is safe.  Because this money is sitting idle, since banks are not lending, the drop in the velocity of money has offset the dramatic increase in the supply of funds.

Despite these realities, the conundrum will not last.  We are talking monetary physics here after all.   If one is to believe the great economist Milton Friedman, the peak effect of on economic growth of excess liquidity will be felt between 18 – 30 months after the rapid expansion of the money supply.  Further, the impact on consumer prices will then be felt a further 12 – 18 months downstream, meaning, in monetarist terms, the inevitable spike in inflation would occur sometime in late 2011.

Whether you subscribe to Freidman’s paradigm or not, it is easy to conclude that that when banks start to lend, the velocity of money will increase and inflation will follow as a result.  Since the recovery is expected to be slow and bumpy, it is not hard to envision that the velocity of money will remain low throughout 2010, keeping inflation in check until late 2011 at the earliest.   Further, high unemployment and excess production capacity will keep wage growth in check (not hard to imagine) further muting inflationary pressure.   Finally, if you believe Bernanke the government could, at its discretion, unwind the special lending programs, pull back the reserves and sell of the securities it has purchased, thereby avoiding the problem of monetary expansion all together.

However, in my opinion inflation will likely be realized sooner than Freidman would  have predicted.    Notably, the Fed cannot put the brakes on the program as contemplated without risking pushing us back into a recession.  This is highly political, so nothing will be done until it is clear that we are out of the woods.   As a result, the money will remain in the system allowing for velocity to increase sooner than anticipated.  Further, I expect there to be political pressure both from within and abroad for us to inflate our way out of our current deficit.   This would be achieved by the Fed allowing inflation to increase while holding interest rates low.  The net impact would be negative cost of borrowing on an inflation adjusted basis.  This would stimulate both borrowing and spending.  Further, wages would increase, which in turn would increase the tax base, thereby enabling the government to pay off its massive deficits.   This is too seductive a solution for politicos to keep their hands off, especially if the President’s approval ratings continue to dwindle.   However, this program is hard to enact in a periods of high unemployment, so the recipe is not ideal.

That all being said, it seems clear we are not headed for double digit inflation anytime soon.   Our current deflationary cycle is still in effect and the combination of other factors — falling commodity prices currency valuations, fear, low velocity of money, high unemployment, etc. — will insulate us from significant systemic shocks.  However, expect modest inflation to return in the medium term and be seen in markets were capacity is constrained first.


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.

poohIt’s hot, too hot for my liking.  I’m sleeping in my basement with my dogs, while my hometown enjoys a record heat wave.  While laying awake at night stewing in my own juices I began running through some old blog posts in my head and thought it might be worth revisiting the status of the financial markets.

Over the past three weeks, we have seen another unprecedented run in the DOW and S&P 500.   On July 10th, I began to ask myself if we were headed back into the abyss as the DOW seemed intent on testing the 8,000 barrier once again.   On its way there, it apparently got spooked and went the other direction, breaking through 9,000 with ease.   On a percentage basis, the DOW ran 12.6% from July 10th to July 31st.   This move is rather consistent with the way stocks behave during significant economic contractions, in that they are prone to high levels of volatility and can swing excessively.

To understand the reason why that is, we need to review what a stock price really is.  We know it is the discounted value of all the future earnings associated with that ownership instrument.   Those projected streams are subject to two main risks — macroeconomic risk and company execution (let’s exclude investor sentiment for the moment), to be revisited in another entry).  When stocks as a herd run down, the causation is usually macroeconomic uncertainty, as opposed to company specific factors.   Since the impact of macroeconomic conditions on forward earnings is a science lacking a high level of precision, corrections can be significant as clarity increases.   Said differently, as our financial system was melting down with great rapidity last winter you had an over correction to the downside as equity analysts predicted a massive impact of our structural problems on forward corporate earnings.   As second quarter (2009) earnings were released these past two weeks they came with a number of “positive surprises”.  However, these were not surprises at all in my estimation, but rather poor forecasting to begin with.   Coupled with some positives on the consumer confidence (consumer confidence index has doubled off the lows; new home sales increased 11% in June), treasury spreads have increased (spread between 10-year and 3-month increased nearly a full percentage point, meaning people were beginning to favor longer term instruments) , unemployment (job loss increased, but the pace of job loss slowed), economic growth (ISM manufacturing index topped 50, above which means growth) and banking system stability, the market ran quickly to its current position — aided of course by the media.

With that explanation behind us, we can no turn our attention to where does the DOW go from here.   The truth is, I don’t know, but my inkling is that we don’t have much room for upside right now.   My basic premise rests upon the reality that corporate earnings surprises were largely based on the realignment of costs with revenue opportunities; there was no real growth of the top line.  As such, we continue to contract, albeit at a slower rate.  Until we can truly rightsize consumer sentiment, we will struggle with generating real growth.

Further, there are significant structural hurdles.

  • Industrial Production.  Based on Federal Reserve disclosures, nearly one-third of our manufacturing capacity remains idle.   This is the lowest rate of production since the Fed started to record this data.  The last parallel we can find was 70.9% in December 1982.   The picture is just as bleak on a global level.  Such excess capacity cannot be rationalized quickly and is more likely to result in price based competition, which can only lead to further calamity.   On the plus side there appears to be very little inventory in the channel, as companies have moved aggressively to cut cost.  However, until trade and inventory credit loosens further, it will not rebound.
  • Tax Base.   Across the board the domestic economic system is facing an economic shortfall of catastrophic proportions.  The U.S. government has spent nearly $2.7 trillion this year, versus collections of $1.6 trillion.   In cumulative, state government deficits total $120 billion.   Forty nine states require balance budgets however. (Vermont is your holdout).  Personal income taxes have dropped by over 25%, with no quick path to renewal.   Yet, we somehow need to find ways to underwrite huge government programs and keep the lights on at the local level.  The imbalance is massive and budget gaps will result in further market disruption.
  • Consumer Sentiment.  As the consumer goes, so goes the economy given our asset lite service based model.   The problem is the consumer is underwater and expected to remain so for some time.   Jobless rates have reached double digits and it will take years for reabsorbtion.   Over 4 million Americans have been looking for work for more than six months, an unprecedented level.   Retails sales were down a further 5.1% in June versus a projected 4.5%.    We have yet to experience the wave of personal bankruptcies that will surely arrive as people walk away from their mortgages and face the music on their mountain of personal credit card debt.
  • Banks.  The banking system remains unhealthy, though the risks of a full scale collapse remains unlikely.   Deep skepticism with respect to real estate will result in regional and local market lending dislocation.   Rather than facing loan losses head on, banks are preferring to extend and pretend on the consumer level.   Without dependable credit consumers and businesses cannot grow.

Net net, it is not at all clear where growth is going to come from.   However, it is clear that we have found bottom, as evidenced by the slowing declines.  More than likely we are in for an extended period of sideways, with growth coming from stimulus and government programs (e.g., cash for clunkers, health care reform).     This will be jobless recovery with  companies surviving on lean diet of capital expenditures.   No one is forecasting robust growth.   In short I can’t see much upside.  Further, if this downturn has fundamentally changed consumer behavior, than the market will continue to shrink and stock prices will follow it down.


solar eThe 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.


simonIt’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.