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.

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.



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”

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.


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.


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

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

No Quick Fix

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

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

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

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

Plan, Monitor and Re-plan

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

Understand Source and Uses

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

Seek Counsel

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

Consider Creative Alternatives for Liquidity

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

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