Friday, November 09, 2007

Where Have All the Deals Gone? and Star Wars Thinking

There is an interesting dichotomy that exists in capital markets. Not so many months ago, pre-August, there was a widespread perception that we were running out of stocks. Private equity interests were gobbling up anything that had a reasonably steady cash flow. Such companies were easily leveraged by the accommodating banks and investment bankers. Needless to say, the music stopped in the takeover waltz (as all of us can see, Chuck Prince has stopped dancing) In one of the more memorable and now infamous quotes that have come out of this capital market era, Chuck told the FT:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Despite the fact that liquidity had a major hiccup, and deal cancellations have been fairly rampant, U.S. private equity firms are still dancing. They have bested last year's record of $258 billion and have passed the $263 billion mark with a month and a half to spare, according to Dow Jones' Private Equity Analyst.The majority of the capital, just over $200 billion has gone to leveraged buyout shops.

I think this is an important factor to bear in mind. Certainly, every time markets go sour, similar behavior occurs. Fear leads us to truncate our investment horizons, long-term growth is set aside, growth forecasts are reduced, earnings multiples are brought down, required rates of return are brought up. Prices collapse.

But what is different this time is that there is more private equity firepower than ever that is ostensibly on the sidelines for now. Buyouts will continue to occur but will require greater equity funding and less leverage. Returns on equity driven by leverage may well be less than historical returns but perhaps prices to effect a takeover may well be less demanding.

The world has changed as financial institutions are taking hits from CDOs. But it ain't entirely over. At The Deal's M&A conference this week, Leon Black observed, "there's no question that this summer the world changed for private equity" as the credit markets that allowed "private equity to go from being 3% of the M&A market to 35% in 2007 shut down for doing highly leveraged deals." "The ability of private equity and acquisitive strategic buyers to innovate in terms of financing is almost unlimited."

One other observation re innovation in capital markets. Equity capital markets issuance globally totaled $445 billion over the first six months of 2007 on 3,000 deals, the highest dollar volume since the record set in 2000. As some of you may recall, this wasn't exactly a precursor for positive markets for the next two years. Much of the capital raise has occurred in Asia and emerging markets. In the third quarter, a total of 248 IPOs raised $46.8 billion world-wide in the quarter, up from 179 that raised $40.71 billion in the same period last year.

But outside of public equity lives the PIPE market, private investment in public equity, a market that has historically been viewed as a last-ditch source of financing. Historically, small cash-starved tech or healthcare companies that couldn't secure more conventional debt financing utilized this market. According to financial research company Sagient Research Systems, the PIPE market hit historic highs in the third quarter of 2007, with $38.8 billion, or 996 transactions, 33% greater than the volume of PIPE transactions through the same period in 2006.

Private placements such as PIPEs can be done at lower cost than traditional equity deals. Because such deals are sold to accredited or institutional investors, the securities do not require registration with the SEC. Consequently, a great deal of time and expense can be saved. As banks try to value their existing loan and structured portfolios, PIPEs are finding a way to infuse capital into deals.

Credit problems remain a thorny issue for capital markets. But market innovations are more available than ever. Nasty markets will put prices into the gun sights of some of these participants. Prices can be silly and exaggerated at either end of the spectrum, both way too expensive and way too cheap. Technicians may worry about falling knives but decent businesses that have been hacked by fearful sellers may create great buying opportunities.

Consider yesterday's Restoration Hardware news. A private equity company is doing a buyout at 2.5 times Wednesday's price! Though this business has struggled in the retailing slump, obviously there still appears to be some franchise value that many investors missed.

As an investor, don't rely on the short-term trends in a stock to tell you what it is worth. Earnings surprises, earnings revisions represent noise. We cannot guess the unknowable future. We are far better equipped to understand the present and what it means for the future. Use market weakness to rethink your analysis. But analyze rather than rationalize...hang onto your companies that have enduring competitive advantage and great returns on invested capital. Stick with ROIC and dismiss growth for now. A high return on invested capital is the signpost of a great franchise. Ensure that cash flow generation is there, don't rely on earnings and especially earnings forecasts.

Remember that an equity represents a long-term claim on assets. Yet most analysts base their opinion on next year's or maybe two years of forecasts.
That's not how anyone should value a stock.

There is a great line from Obi Kenobi in Star Wars that comes to mind, "Who is more foolish? The fool or the fool who follows him?"

Stay calm, relaxed and aware. There's lots of fat pitches coming our way.

Disclaimer: I, my family, and friends do not have a current position in any securities mentioned in this post.


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