Living in a Low Growth World

Posted by John Slater on May 16, 2013

Michael Drury, Chief Economist, McVean Trading and Investments LLC – Reprinted with Author’s Permission

Perhaps the question we are asked most frequently is when things will get back to normal, meaning in most investors’ eyes the way they were before Lehman.  Unfortunately, our answer is “That bird has flown” and we are now dealing with, and will continue to deal with for many years, a very different environment.  The mainstay of that difference is a lack of trust between those that have money to invest and those that want to use it for risky undertakings, and, in particular, a lack of trust in the banking system that used to intermediate between these two groups.  The result is a glut of savings available to “safe” investments driving risk-free yields to very low levels.  However, the central banks, by buying bonds and manipulating long term interest rates lower, are introducing a significant risk of capital loss into even “risk-free” assets.  Investors are both moving and driven out the risk and yield curves, and returns on riskier investments are falling.  The decline in returns at the precise time many investors want to start spending investment income has pushed up prices for proven existing income flows.  Meanwhile, a combination of distrust and a reduced pool of money that will wait long periods before income is produced have generated fewer green-field investments in physical plant and equipment, resulting in a slower potential growth path for the economy.

We are neither monetarist nor Keynesian, but rather institutionalist and a storyteller.  We see the current situation as the culmination of a long path where growing reliance on banks and the central bank to maintain economic growth has run aground.  Both re-establishing trust and balance in the old system or building a new one will take time – likely many years and at least one more economic shakeout to test the results.  In the meantime, we expect sub-standard economic growth, low inflation, low interest rates, growing concentration in market power, and rising government intervention in the form of higher taxes and regulation.  This is not a unique situation; it existed in the early 1900s before the Federal Reserve was created and in the 1930 when the Federal Reserve was far too timid.  Now, despite aggressive Fed intervention, QE lacks traction.  This is not the 1970s.  A smaller banking system means less nominal growth, and a more nearly zero-sums world.  We expect in time, some capital will be destroyed – particularly by ill-fated investments while reaching for yield – and eventually the traditional balance between savings and investment (and interest rates) will return to “normal”.  However, that day is still far away in our view, and the date of the next shakeout is in between now and then.

The Minsky Moment in Banking

Once upon a time, long ago and far away, banks use to operate by taking in deposits at 3% and lending them out at 6% and going home at 3PM.  The Federal Reserve regulated this system by requiring that banks hold a certain amount of reserves against their deposits to reduce the risk of a bank run.  They also required a bank to hold a minimum amount of capital in case their investments went bad.  Banks that wanted to make more loans than they had deposits depended on correspondent bank relationships where banks with limited loan opportunities would make deposits in other banks with better opportunities.  The correspondent relationships increased the efficiency of the banks by allowing diversification and directing deposits toward the best yielding investments.

In time, banks discovered ways to reduce their required reserves and increase the amount of deposits that were generating returns – but, at increased risk to the system from runs.  Repurchase agreements (repos) were used to reclassify deposits from high reserve categories to low or no reserve categories.  The interest rate on the repurchase agreement was a function of the potential earnings on the freed reserves.  Banks with limited investment opportunities could now lend their un-borrowed deposits, or excess reserves, to banks with greater opportunities.  The interest charged for lending these funds overnight was the federal funds rate.  This development led the Federal Reserve to move from using reserve requirements as their preferred tool for controlling growth in the money supply to managing the federal funds rate.  The Fed actively participated in the federal funds market in competition with banks, selling repos backed by reserves created with a stroke of the pen if they wanted interest rates to fall and buying up excess reserves via reverse repos if it wanted to raise rates.

In this new world, the Federal Reserve targeted an interest rate, and allowed the market to determine the level of reserves (and hence the money supply) that were consistent with that rate.  An expansion of loans, which raised money supply, naturally could generate either higher real growth or higher inflation depending on the actual scarcity of labor and capital.  If inflation rose, the Fed throttled back the economy by raising interest rates.  If growth faltered, it lowered interest rates by creating new reserves with a stroke of the pen to incentivize new lending.  Unused reserves earned nothing, so the banks always had an incentive to maximize lending or circulate excess reserves via the federal funds market to earn a positive rate.

Under the new system, deposits found their highest use because any lender anywhere in the US could make a loan – even if they had no deposits – as they could always borrow excess reserves in the federal funds market.  In effect, every bank was a correspondent bank to every other bank.  However, it also meant that the most aggressive banks – those most willing to put their capital at risk – dominated the system.  Due to the advantages of diversification, this tended to favor big banks.  They could bid aggressively for the potentially most lucrative loans knowing they could get funding in the federal funds market.  Moreover, since the Fed was targeting an interest rate, if banks bid up the federal funds rate as they sought to expand their lending, the Fed would increase the supply of reserves to keep the federal funds rate at the target.  Thus, the most optimistic lenders ultimately determined the growth in money supply, generating real economic growth if they were right and inflation (from more money chasing the same number of goods and services) if they were wrong.  The Fed would step in to reduce lending at the end of the cycle after over optimism pushed up actual or expected inflation.

The secret to the long running success of this system was that money supply (the Fed focused on M2) never fell during these corrections.  A slowdown in the rate of growth was enough to rein in economic activity and cause inflation to recede.  With money supply always larger than before, there was always someone in the system who could buy up the best of the bad investments of the overly aggressive lenders – funded at lower prices funded at lower interest rates, so with less risk.  That is, strong hands that could withstand short term declines in returns or hits to capital benefitted by picking up the pieces of viable projects after a bust.  Again, this tended to favor big banks with deep capital pools.

The Minsky moment arrived in the banking system when the most aggressive lenders realized they did not have to hold the loans they made on their balance sheets at all.  They could package up the loans and sell them to investors in the asset backed securities market – which is to say, the non-bank market.  The most aggressive lenders were effectively mortgage brokers, who had no skin in the game.  Often these were smaller banks trying to become bigger banks via fee income rather than return on assets.  In any case, the fact that the loans were placed outside the banking system meant that an expansion in lending did not result in the Federal Reserve creating new reserves and increasing the money supply.  Money attracted to these asset backed securities was competed away from other viable investments – reducing the pool available for plant and equipment — resulting in slower real economic growth and so subdued CPI (as opposed to asset) inflation despite aggressive lending.  The trouble began when non-bank entities important to the banking system (like Bear Stearns, and later AIG and Lehman) foundered under the capital losses from these over aggressive investments.  It was no longer the responsibility of the Fed to bail them out, but the much less practiced Treasury – and we all know how that went.

Living in a Low Growth World

In the aftermath of Lehman, confidence in the system has been shattered and the game has changed.  The Federal Reserve has pumped reserves into the system, but with risk adjusted rates of return below zero banks would rather take 16 basis points for holding them than lend them out.  These excess reserves, created with the stroke of a pen, have been used to buy bonds — which has allowed the Federal Government to increase spending via the safety net and avoid a 1930s style feedback loop from falling employment.  Other nations have gone the austerity route with the outcomes one would have expected based on historical precedent.  Money supply has expanded since Lehman, but as the growth in excess reserves is effectively electronic vault cash, there has been a sharp reduction in velocity – that is, a decrease in the efficient operation of the banking system.

A return to normality depends not on increasing the banking systems reserves, but rather on increasing its capital.  Bankers are reticent to lend because they remain uncertain about the viability of their existing capital base and would rather stay in the status quo than take on new risk.  The FDIC, in its infinite wisdom, has made it difficult to create a de novo bank, so little new capital is entering the system.  Rather, banking functions are moving into the non-banking sector.  This puts the economy in an environment like under the Gold standard, when investors compete in a zero sums game.  For over thirty years, the Federal Reserve effectively has been allowing the money supply to increase in anticipation of investments successful results– and reining in lending when excessive activity threatens to become inflationary.  An expanding nominal economic pie – even before bank funded investments generated output – provided the liquidity to bid up prices for labor and capital without requiring a decline somewhere else.  The competition was for growing market share in a growing pie.  In a low growth world, weak firms are more likely to see revenues decline and face margin squeezes.  Already cautious banks will naturally want borrowers to have more skin in the game, making it tough for small businesses – while the bigger firms have better access to capital pools at risk-taking non-bank lenders.

The post-Lehman period, like after the Panic of 1893 and the Great Crash is a period where the populous wants greater regulation of the laissez-faire investment environment that led to economic calamity.  In both the early 1900s and 1930s, when money supply growth was limited, governments attempted to balance the deficits created by the crisis by raising taxes – particularly on the wealthy – and so reduced saving (read capital) in precisely the group that might have picked up the pieces once resource prices had fallen during the correction.  Sound familiar?  We expect that higher taxes will continue to erode capital, but that it is during the next downturn the true correction of excess savings will occur – especially from losses among investors that are reaching for yield now.  Note, the ultimate solution that generated a return to higher interest rates after the early 1900s and 1930s were capital destruction during WWI and WWII.  Hopefully, this time it will simply take bad economic policies elsewhere (austerity in Europe, inflation targeting in Japan) to destroy enough of their capital that global balance is returned.  Low interest rates will not last forever, but history suggests the workout takes a very long time.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus Investment Banking LLC or Focus Securities, LLC.

Winds of Change: Banking

Posted by John Slater on May 8, 2013

John Mason – Originally Published at Seeking Alpha – Reprinted with Authors Permission

“Another Executive Leaves JPMorgan…” reads the headline of the business section in the New York Times. The question is, what is going on at JPMorgan Chase (JPM)?

The timing of this last leaving is raising questions. The latest major departure is Frank Bisignano, the co-chief operating officer. The questions are about the status of Jamie Dimon, Chairman and Chief Executive Officer of JPMorgan, the “persistent executive turnover,” and the up-coming board meeting where a debate is raging about whether or not Mr. Dimon should hold both top positions.

To me, there are two reasons for the recent departure events. First, Mr. Dimon is in control and he does not like what has happened inside JPMorgan over the past two years or so, with “the London Whale” and other events that have tarnished the “bravo” image of Mr. Dimon and his bank. The activity going on inside the bank remind me of a “turnaround” operation!’

But, there is a second reason for the things that are going on. Mr. Dimon is moving JPMorgan into the future.

If this is true, then this whole effort is to move JPMorgan into the future in the face of the “hostile” regulatory environment that exists, in the face of the changes that information technology are forcing on the banking industry, and the changing nature of the financial industry.

If I were Mr. Dimon, my feeling would be that the current regulatory environment “sucks”!

Being John Mason, my feeing is that the current regulatory environment “sucks”!

In either case, the basic feeling is that I really don’t want to run a bank. I want to run something different.

Second, whatever is being done in the financial industry, the future of commercial banking…of finance in general…is information technology. Finance is nothing more than information. Ultimately, finance is nothing more than 0s and 1s. Thus, whatever you call a financial institution in the future it will just be another name for a information processing organization.

And, if we are dealing in information technology, as Fred Tomczyk, CEO of TD Ameritrade was quoted as saying about the discount brokerage business, “…it’s a scale business. It takes a lot to compete in terms of investments and technology and marketing. There are only one or two-maybe-transactions left.”

If you have an account at TD Ameritrade why do you need a commercial bank?

Third, there is the changing nature of the financial industry. You look at the largest seven “commercial banks” in the United States in terms of revenues and you find in number five position, Morgan Stanley and in number six, Goldman Sachs Group, and in number seven, American Express.

In addition to that the total assets in the commercial banking sector are less than half the total “banking” assets in the United States. Total “banking” assets in the United States, according to the Federal Reserve System consists of those institutions that take deposits and are monitored and regulated and then there is the “shadow” banking system that does not take deposits and are not monitored and regulated to any degree.

What is the difference? All financial institutions are “intermediaries”. They receive funds from “savers” and lend the funds to “borrowers. But, the “savers” do not need to be depositors. The “savers” could be anyone providing the financial institution with funds to lend. The crucial thing is that the “credit intermediaries” have the ability to earn a sufficient spread on the difference between the interest rate they pay the “savers” and the interest rate they charge the “borrowers.”

These “intermediaries” can also buy assets, trade in assets and hedge assets and so on and so forth and earn fees rather than interest. And, there are other things these “intermediaries” can do to earn income. In these areas they don’t really need deposits.

And, officials at the Federal Reserve claim that perhaps most of what the investment bank-like institutions do…that is, Morgan Stanley and the Goldman Sachs Group…is really “shadow banking” and not commercial banking.

One can, therefore, really question whether most of what JPMorgan Chase does is commercial banking. David Reilly in the Wall Street Journal tells us that JPMorgan’s “total net loans of $708 billion at the end of the first quarter equaled less than a third of total assets of $2.4 trillion. Trading Assets and securities holdings were slightly more than its loan book. And its derivatives holding are the largest of any U. S. bank.”

He goes on: “Meanwhile the banks trading operations are a significant driver of profit. In the first quarter, JPMorgan’s corporate and investment bank produced net income of $2.6 billion. That was equal to 40% of overall profit and slightly exceeded the income generated by the bank’s consumer and community banking business.”

Why do I really want to be a commercial bank? Much of the deposit business is just a headache and it is so costly…think of all those branches out there…with hardly any customers ever in them.

The new chief operating officer, Matt Zames, was co-chief operating officer with Mr. Bisignano. But, Mr. Zames is coming from the fixed-income area. His background? He worked for a hedge fund, Long Term Capital Management.

Maybe JPMorgan Chase is thinking less of being a “commercial” bank and moving more and more of its business into the “shadow” area. This would be consistent with talk now being heard in Congress. Congressmen are apparently concerned that these too-big-to-fail institutions like JPMorgan should not have their non-depository business protected with deposit insurance. In essence, these too-big-to-fail institutions should be split into “real” commercial banks with deposits, and “shadow” banks or institutions that do not need deposit insurance.

As organizations like JPMorgan Chase earn more and more of their income from corporate and investment banking operations, asset management and corporate/private equity sources, why should they want to keep the consumer and community banking areas? If we are getting enough earnings from these other sources, let’s just “spin-off” the banking “stuff”.

I would bet that of the top twenty so-called commercial banks in the country in terms of assets, more than half the revenue of these financial institutions comes from “shadow banking” sources.

So, maybe Jamie Dimon is moving on. Maybe Jamie Dimon is trying to create a financial institution that will be a part of the future, not one that tries to hang onto the past. I believe that Jamie Dimon is smart enough to do this and brazen enough to carry it off.

Therefore, the current level of activity is showing us who is in charge. The future needs new ideas and in many cases new people to achieve that future. So JPMorgan is working through a turnaround and it is becoming more and more technology based, and is moving more and more into the “shadow.” If this is the case, I am much more hopeful for the performance of JPMorgan in the future than I have been recently.

Editor’s Note:  This is the first of a series addressing the implications of profound changes underway in both the domestic and global economies.  Future business success will require entrepreneurs to foresee the impacts of these changes and steer their firms accordingly.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus LLC or Focus Securities, LLC.

Winds of Change: Energy

Posted by John Slater on May 6, 2013

John Mason – Originally Published at Seeking Alpha – Reprinted with Authors Permission

In my last post I wrote about all the economic re-structuring that is taking place. Even though economic growth remains relatively tepid, changes are taking place in the economy that are going to dominate the future when the economy fully adjusts.

Maybe one of the reasons that the economy is growing so slowly is that the economy is going through a transition phase, like in the 1930s, where resources have to be re-allocated and re-structured in order for the economy to take off once again.

That is, resources are mis-located now relative to what is happening in the economy. For the economy to pick up its full head of steam, resources have to be re-aligned to fit what the economy is evolving into…not what it was. Economic policies that attempt to put resources…especially labor…back into the jobs they historically held…just doesn’t work!

Therefore, as I mentioned in the previous post, this re-structuring is creating tremendous opportunities for investment. But, one has to change ones perspective…and not focus on what was. This is why I found the recent article on the future of energy by Clifford Krauss in the New York Times so refreshing. The title to the article, to me, says it all, “By 2023, A Changed World in Energy.”

“If you could close your eyes for just a moment like Rip Van Winkle, and blink them open in 2023, you might see a very different energy world.

Electric cars may be popular. Solar energy could be cheap enough that millions of households and businesses deploy solar panels to generate their power needs. Fossil fuels will probably still dominate, but most trucks and many trains could run on natural gas rather than more polluting diesel. And the United States could be a major oil exporter.”

And, the miraculous change: “a country on the path to becoming energy independent, a hopelessly quixotic quest only a decade ago. Newly prolific oil fields in North Dakota and Texas are expanding domestic production to levels not seen in a generation. The United States has suddenly become a net exporter of gasoline and diesel fuel. And it is looking for new markets for natural gas as well: new drilling technologies have allowed domestic production to soar over the last five years, causing a glut and price slump.”

Krauss quotes energy expert Daniel Yergin, “When it comes to energy, the rule of the game is to expect the unexpected. So much effort is going into research, development and innovation all across the energy spectrum, 10 years from now we may well see the next game changer.”

All this, to me, spells opportunity. I don’t have space to go through all the possible changes that Krauss writes about in his article. They are mind-boggling. The point is that there are so many things going on in the energy field that it is hard to know exactly what the future is going to look like.

In terms of macroeconomic impacts, however, there are several things that look to be pretty clear. First, the demand for energy in the United States is growing, but rather slowly. The output of energy in the United States is exploding. Think of the implications this has for the US economy. Think about how this will change spending patterns.

In the rest of the world…demand is going to be expanding very rapidly. And, what do analysts see?

The International Energy Agency has recently published its World Energy Outlook, which included the prediction that “the United States will overtake Saudi Arabia and Russia as the world’s top oil producer by 2017, and North America will become a net exporter by around 2030. As imports of oil and other energy sources declines and exports increase, the United States balance of payments becomes a major contributor to economic growth, not a drain.

The world is going through a period of transition. Resources are being re-allocated. The primary resource, human capital, is going to have to go through a major re-structuring in the process. Education and training will have to be adjusted to meet the needs of the future.

One sees more and more studies on how the American work force is bifurcating between the more educated and the less educated. Floyd Norris discuses this bifurcation in his recent article “Wage Disparity Continues to Grow.” Those with educations are doing much better than those with less education. And, the median income continues to remain roughly constant. However, the lower end of the income spectrum continues to fall behind.

How can you have a better situation for the creation of opportunities? It appears as if everything seems to be moving in the right direction in the United States in terms of energy and energy resources. And, the financial resources are finding their way into these areas enhancing research and development. The expansion in this area creates all the right incentives for innovation.

So where do you find the opportunities?

In the natural gas area? In biofuels? Conversion of power plants from coal to combustible gas coming from converted coal? Electric cars? Changing cars and trucks and trains from oil and diesel oil to liquefied natural gas? A growth in renewable sources of energy coming from new and more efficient power generation where solar energy panels and wind conversion innovations make much greater contributions. And so on and so forth.

This is where I show my long-term optimism relative to my short-run pessimism. Unfortunately, I see the world bogged-down with its emphasis on short-run solutions. To me, these short-run solutions slow down the transition and help to postpone the arrival of the new structure. By focusing just on short-run solutions the world actually hurts those less educated because it prevents them from adapting to the new reality.

In all of this, however, there is great opportunity. However, we must focus on what is needed in the future and not what will help us retain the past. This is also were smart investing will help us to achieve that future.

In economic re-structuring there are lots and lots of opportunities. Even in the area of human capital, why do we need to wait on the government? How many private universities have evolved in the last ten years? In many places community colleges are thriving. If there is still a gap…try and find out who is trying to fill the gap. If you can’t find anyone trying to fill the gap you see…why don’t you try and get something going?

The point is, there is something terrific going on in the energy space in the United State. Going even further, there is something terrific going on in quite a few areas in the United States. When major transitional movements that impact an economy periodically are creating momentum all sorts of good things are available. But don’t focus on what the industry was…look to where the sector is going. Look for what is happening…and invest in them!

Editor’s Note:  This is the first of a series addressing the implications of profound changes underway in both the domestic and global economies.  Future business success will require entrepreneurs to foresee the impacts of these changes and steer their firms accordingly.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus Investment Banking, LLC or Focus Securities, LLC.

The Winds of Change Are Blowing

Posted by John Slater on May 5, 2013

John Mason – Originally Published at Seeking Alpha – Reprinted with Author’s Permission

The world is changing. The world is changing because it must change. When the unemployment rate hits 27 percent, as it now stands in Spain, something more is going on than just a business cycle.

Unemployment is also above 27 percent in Greece. In Italy, the unemployment rate is close to 12 percent. In France, the unemployment rate is above 10 percent. The employment problems in these countries are not just cyclical, they are structural.

The same for the United States. Although the unemployment rate in the United States is under 8 percent, the startling figure concerning the U.S. labor market is that the labor participation rate has dropped below 64 percent, a figure not reached since the latter part of the 1970s when women were not as big a part of the workforce as they are now.

These structural forces are causing divisions between countries as the world tries to recover from the Great Recession and more. Angela Merkel, German Chancellor, “highlights eurozone divisions.” The unemployment rate in Germany is 5.4 percent.

But, as we know, the utilization of capital in the western world tends to be lower now, for this stage in the business cycle, that at any other time in the past fifty years. Western countries are not only not using the human capital that is available; it is not using the physical capital it possesses. The competitiveness of the eurozone is an issue that comes up over and over again.

Phillip Stephens writes in the Financial Times about The New Deal for Europe: More Reform, Less Austerity. “High unemployment in Europe is not just a reflection of recession. It often mirrors ossified labor markets that lock out young people and discourage investment and innovation.”

But he also goes on to talk about the problem in the pension area. Additionally, there is the education and training shortfall. The infrastructure is not up-to-date. And, then there is always the problem in many areas of Europe of political corruption and unworkable governmental bureaucracies.

The problem for politicians is that these are long-run problems; they are not problems that are going to be achieved in the near future. And, that is where the austerity issue also comes into play. Almost everyone seems to believe that government deficits must come down. However, trying to bring the deficits down in the short-run can just exacerbate the problem. Most countries in Europe that have attempted to reduce their budget deficits have found that due to the slower growth that results their budget deficits have actually increased.

So many politicians act according to the quote attributed to John Maynard Keynes: “In the long run we are all dead.” To the politicians, if they focus on the long run, they fail to get re-elected. Thus, the time horizon for a politician is the next election.

But, this is where money comes into play. Politicians also need money to get re-elected…and to live “the good life”. In some areas of Europe, getting money from constituents is just “business as usual.” So there are a lot of structural issues that must be dealt with and, in most cases, these issues do not have easy solutions.

These issues, however, will produce some kind of results — one way or another — because the world always moves into the future. Even the political corruption issues cannot continue to be ignored. For an insight into this issue check out the book review by Janet Maslin in the New York Times headlined, “Formatting a World With No Secrets,” which deals with the book “The New Digital Age.”

The important point is that these structural problems are going to have to be dealt with. Education and training are going to be done differently. How much can on-line courses help resolve the issue? Do we continue to need massive universities and public school systems to educate the masses? Are public and private pension systems on the verge of massive changes?

But, what about our financial system? If the commercial banking system of the United States, which at present provides about fifty percent of the credit to the US economy, becomes a smaller and smaller contributor, what is going to happen to the financial structure of the country?

What about the natural gas revolution that is taking place? How is this going to impact utilities, manufacturing firms, and the infrastructure? And, there are the changes taking place in the health system. The health system has constantly been a laggard in the use of information technology. This is changing rapidly and everything I read about this the “revolution” here is going to change how we are treated, how we benefit from the new associations being created in the health field, and, I am told, these changes are going to increase our ability to deal with sickness, old age, and quality of life.

The story can go on and on. This re-structuring is going to create a large number of investment opportunities. However, these opportunities are not going to be short-term opportunities. These opportunities are going to be of the longer-term type because they involve major changes in the way America, Europe, and the world, do business.

Editor’s Note:  This is the first of a series addressing the implications of profound changes underway in both the domestic and global economies.  Future business success will require entrepreneurs to foresee the impacts of these changes and steer their firms accordingly.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus LLC or Focus Securities, LLC.

Will 2013 See Record Valuations for Middle Market Business Sales?

Posted by John Slater on March 7, 2013

Business owners time their exits for many reasons: health, retirement planning, availability or lack of family successors, competition, technology change, and many more. Yet, overwhelmingly, the question we are most often asked as a financial advisor to entrepreneurial companies is: “What’s my business worth?”

All things being equal, a rational business owner will presumably choose to sell at a point of optimal value for his or her interest in the firm. For the reasons outlined below, we believe that the next eighteen months may see the highest pricing for good middle market companies in the thirty years I have been in the M&A advisory business.

Historically, the market for mergers and acquisitions is one of the most volatile on the globe. In our experience, the market is very cyclical with three to four years separating peaks and troughs and six or seven years to cover a full cycle. The last bull cycle for M&A peaked in 2006-2007 and the market trough was witnessed in 2009-2010. Moderate improvement was witnessed in 2011 and 2012, with Q4 2012 being particularly strong. 2012 was FOCUS’s best year since 2007.

Source: Barclays and Business Insider

2013 started with a bang with large announced deals for Dell, Heinz, and Virgin Media just to name a few. Many observers predict these are not isolated deals and 2013 will witness a resurgence in M&A activity. While the M&A market could be derailed by a major decline in the equity markets or further chaos in Washington, we believe the odds favor a strong market for sales of middle market companies through sometime in 2014. By then a correction will be overdue and the likelihood of a cyclical bear market in equities may become increasingly high. Generally, a serious decline in the stock markets leads to a precipitous fall in M&A activity.

The next 12 to18 months will almost certainly be a highly favorable period for business exits. If this proves to be a cyclical market top, the next favorable period for businesses owners wishing to sell may not come around before the 2020s. In 2020, today’s sixty-six-year-old baby boomer will be seventy-three and today’s fifty-eight-year-old will be sixty-five and studying Medicare options.

2012 Middle Market M&A Values Back to 2006-2007 Highs

In 2012, FOCUS witnessed a strong recovery in sell side M&A values, with seven closed sales and average pricing above seven times EBITDA. Several recently issued reports indicate our experience was consistent with the overall market. For example, GF Data Resources, which tracks middle market M&A values based on data provided by more than two hundred private equity firms, recently reported that for deals in the $10-250 million range:
“Valuations averaged 6.2x trailing twelve months/ adjusted EBITDA, the highest mark in five years. Among major business categories, health care services and technology set the pace, both with average valuation multiples in excess of 7x.”

We again are seeing heated bidding wars and multiples exceeding 10x for great companies in hot industries. One important driver for the valuation jump in the middle market is an increase in total leverage available from a range of 2.5 – 3.25 times cash flow immediately following the 2007/08 recession to a 2012 range of 4-4.75 times.

Companies with steady, highly predictable cash flow are seeing leverage multiples of up to 5 times cash flow and even more for companies with EBITDA over $20 million. As a result, sponsors were able to reduce their equity commitments from the fifty percent range typical in 2010-2011 to a range of 35-40 percent of total capital in 2102.

Financial Market Liquidity Could Drive Values to Historic Highs

With their various QE programs, the world’s central bankers have created a tremendous overhang in global financial markets. Individual investors have begun to grab for yield, pushing “junk” bond yields to levels formerly reserved for A rated credits. Thomson Reuters LPC reports that leveraged lending for private equity backed deals reached $70 billion in 2012, a hair’s breadth shy of the 2007 record of $71 billion.

Private equity funds are aggressively pushing to fund finance companies and other direct lenders that were previously off limits to all but a few specialists. PE firms’ limited partners are even creating their own direct lending teams to enhance their yields. There should be a great deal of leverage available to support PE M&A deals in 2013.

Bain and Company has recently predicted that global capital assets will grow to $900 trillion or approximately ten times predicted global GDP for 2020 of $90 trillion. The chart below predicts a financial market pyramid that most readers will find quite frightening.

Bain suggests that this capital overhang will result in more frequent bubbles forming in particular asset classes as wealth managers race toward particular sectors which they believe promise stronger than average yields. We expect middle market M&A is a likely sector to experience a rapid increase in asset allocation this year and this should be reflected in a move to record sales multiples for many companies over the next eighteen months.

In discussions with a number of wealth managers, we hear a consistent refrain: “Over the past decade the endowment funds that ventured early into alternative assets have achieved superior returns. We are recommending that our clients increase their allocations to alternative assets and particularly to private equity where the endowments have witnessed their best performance.”

This recently was confirmed in a study commissioned by Mergermarket in a report entitled Alternative Investments Outlook 2013: Limited Partner Survey. Based on interviews with 100 active private equity limited partner investors, the Mergermarket study reports: “According to the LPs interviewed, private equity has successfully rebounded from the crisis, and is positioned for a strong 2013.

Nearly half of respondents say that their PE investments have surpassed their expectations and, of those who plan to adjust their allocation to private equity within the next year, the overwhelming majority (95 percent) expect to increase the amount apportioned to the (private equity) asset class.”

Private equity funds have an overhang of $100 Billion of commitments that must be invested in 2013 or lost. Since fund management fee income is directly proportional to committed funds plus investments, failure to use this money would have very negative consequences for many PE groups. Thus many of these funds will find themselves under tremendous pressure to do deals, even if they find that doing so requires an increase in their valuation expectations.

The biggest wild card remains the banks, which have become more aggressive in their pricing, but have not yet returned to the wild days of the mid 2000s in terms of leverage and coverage ratios. Should they do so, “Katy bar the door,” we may be in for a wild ride indeed. Even without the banks, the major commitments being made to business development companies and PE firms to fund cash flow-based loan facilities and other growth capital funding may be sufficient to drive leverage multiples higher.

Should the PE firms react to the new influx of LP investments with an increase in equity allocations to their deal funding, the stage could be set for a lively auction market that pushes middle market purchase multiples to levels never before seen.

How Should Business Owners React?

Many middle market businesses that were hurt by the crash and 2007/08 recession now have three years of solid performance and growth under their belt. These are the types of results that private equity firms crave. The owner of such a firm who is ready to sell based on non-market factors should take action yesterday to get into the market.

There is room in the pipeline for now, but by mid-year we expect most of the players in the M&A market, from the investment bankers, the PE firms, and their lenders to the lawyers and accountants who drive much of the timing should be getting very busy. On the backside, the one thing we know about M&A cycles is that no matter how strong the market, once the tide recedes, it is often years until it rises again. Miss this window and you may have a very long wait for the next one.

Those owner’s whose ideal time frames are a bit longer, say three or four years out, should give serious consideration to sale today. If the current cycle resembles the past, the middle market M&A boom predicted here may likely peak between late 2013 and midyear 2014. By then, the Fed will likely have begun to tighten credit, resulting in a rise in interest rates, which normally makes leveraged deals far less attractive.

Another presidential election will be looming and the next change of power in America carries a great deal of risk for the capital markets. The equity collapse around the 2008 election had the effect of depressing the M&A market for an extended period. There is a real risk that there may be no three to four year window for business owners wishing to sell. If history repeats, the current favorable window could shut within one to two years at the outside and most likely not reopen until the 2020s.

Finally, for the business owner with a longer horizon, this market may present a unique opportunity for growth through judicious acquisitions. The 2020s promise to be an era when many of the technologies now taking root, including personal robotics, bio-engineering, nano-technologies, and artificial intelligence coalesce into a period of global prosperity unimaginable to most observers beaten down by the steady drumbeat of depressing news.

For those business owners who share that optimism, the current market presents an interesting dichotomy: while middle market companies with steady and increasing EBITDA in excess of $5 million are enjoying record valuations, many smaller firms still sell for much lower multiples. Many companies have found their capital bases depleted after several years of struggle and are handcuffed when it comes time to resume their growth.

Many of these firms will find it necessary to team with a larger, better-capitalized acquirer to reach their full potential. Thus, we are seeing a number of companies that have been on the sidelines for several years begin to open their purses to acquire smaller firms that fill in gaps in terms of product line, technology, personnel, or distribution chains.

The next 24 months should be interesting indeed. Whether they ultimately choose to sell or grow, business owners who ignore current trends in the M&A market are running a significant risk of missing opportunities that they may not see again for many years.

Coming M&A Boom Will Not Cure Real Economy’s Ills

Posted by John Slater on March 3, 2013

Authored by John Mason – Originally Published at Seeking Alpha – Reprinted with Authors Permission

Behind almost all of the economic problems we are now facing is the need for economic restructuring. The world needs to move on and politicians and others are fighting to keep things as they are.

To me, this is one of the reasons why the common liberal/Keynesian solution to our current difficulties is more government spending, more stimulus. The common refrain is to push things right back into where they were. Push people back into construction jobs; push workers back into the auto plants; and push the untrained into information technology. Unfortunately, the world has changed. We cannot keep trying to push people back into the jobs they once held, or, push people into jobs they have not been trained for.

Everyone is excited about the boom in mergers and acquisitions. I have been among those, like James Less, Vice Chairman of JPMorgan Chase & Co. who said, “The Goldilocks era of post-crisis M&A has never been an if, but a when.”

For two years or more, I have been writing that the larger, better off companies, the larger money managers, are just waiting for the right environment to begin the acquisition binge. In terms of high profile the Dell (DELL) deal kind of kicked things off.

In the past two weeks, there have been at least four major deals announced. These have included the Dell buyout; the Comcast (CMCSA)(CMCSK) acquisition of GE’s (GE) stake in NBC Universal; the acquisition of American Airlines (AAMRQ.PK) by US Air (LCC); the Berkshire (BRK.A)(BRK.B)/3G Capital acquisition of H. J. Heinz Co. (HNZ); and the Liberty Global (LBTYA)(LBTYK)(LBTYB) proposal to takeover Virgin Media, Inc. (VMED). Each deal is worth more than $10 billion.

But, note, these transactions will not necessarily add to economic growth … at least, not immediately. Big deals like these result restructuring, layoffs, plant consolidations, and so forth. These transactions transform industries, modernize them, and economize them.

To me, the key word here is “restructuring.” The world has changed. Consequently, the economic structure we have been working with needs to be re-structured!

We need to go through this restructuring in the United States. Right now, however, we are seeing this scenario play out in the eurozone. Europe continues to slump in the middle of cries to end the austerity. Fears abound that Silvio Berlusconi and his populist party may get elected in Italy and block needed but unpopular reforms that have been proposed by the current government. France is wavering in the face of negative economic growth. And the other countries in the periphery of Europe wallow in stagnation.

The recent figures, the growth rate in France was negative 0.3 percent; in Italy growth was negative 0.9 percent; in Spain growth was negative 0.7 percent; and even in Holland, growth was negative 0.2 percent.

The basic problem across the board is that the economies of these countries are just not competitive. And, further fiscal stimulation is not going to make them competitive. Fifty years or so of fiscal stimulation has gotten these countries where they are today. You cannot just keep putting economic resources back into the jobs that are not in existence any more.

Gillian Tett, in the Financial Times, quotes one large American investor, “The competitive problems in France are horrible and current policy is making this worse.” The same goes for Italy, Greece, and Spain … and others. Tett adds, “What worries many American investors are the long-term structural challenges that are sapping growth.” These American investors are looking toward Europe to find more attractive yields.

What is true of Europe is also true of the United States. After 50 years and more of government sponsored credit inflation, artificially stimulated economic expansion as a policy of the government, America needs to restructure. When under-employment runs around twenty percent or so, when capacity utilization in manufacturing peaks at 80.0 percent of capacity or less, and when real economic growth seems to run under 2.0 percent per year, something needs to change.

We cannot just “goose up” the economy over and over again with more and more credit expansion. Doing so just unbalances the economy leading to predictions like those of Bain and Company that in 2020 we may have a $90 trillion real economy, but we may also have created $900 trillion in financial assets to achieve this size. If this isn’t credit inflation, I don’t know what it is.

But just, “goosing up” the economy is not going to really reduce under-employment or raise capacity utilization in manufacturing. We have seen that over the past fifty years, credit inflation has just exacerbated these problems, not reduced them.

Restructuring is painful! That is why politicians can play off this pain to get elected … and re-elected. And, nothing sells better than “I will see that the government spends more money to put you back to work,” and “I will see that you get more credit to buy your own home, even if you are unemployed, because every American should own their own home! And, constructing more homes creates jobs!”

My view of the future is that this is not going to change! In my view this is the environment we are going to have to live within … and invest within. A world of badly needed restructuring.

Now, I need to be careful here because I also see an environment of inflation … credit inflation. But, not all credit inflation comes out in an increase in prices, at least those prices included in the consumer price index. The prices included here are flow prices; prices of groceries or clothes or rents on houses.

Credit inflation can occur in other ways that don’t impact these flow prices. For example, the price of houses is not included in the consumer price index. The price of commodities is not included in the consumer price index. The price of stocks is not included in the consumer price index.

Bubbles can occur in these “stock” prices. And, recent publications by Bain and Company, in the scenario discussed above, predict that “bubbles”  could occur more frequently going up to 2020 and also be more volatile. These “bubbles” may not necessarily be included in the consumer price index depending on what prices they impact.

Furthermore, we have seen that credit inflation can result in the pyramiding of financial assets. Securitization of mortgages, credit card debt, auto loans, and so forth result in one structure of finance building on another. Money market mutual funds, alternative financial firms, collateralized debt obligations build up a pyramid of finance with little or no impact on the economy or on the consumer price index.

How can all this finance take place with little or no impact on the consumer price index? Just look at the 1990s and the 2000s. And, then the financial collapse came.

With little or no change in attitudes in our politicians or in the electorate or in popular opinion I believe that it is highly likely that we will be in the world envisioned by Bain and Company — a world of credit inflation.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus LLC or Focus Securities, LLC.

Damn Those Shadow Banks!

Posted by John Slater on March 3, 2013

Authored by John Mason – Originally Published at Seeking Alpha – Reprinted with Authors Permission

What do we do about the shadow banks or, more politely, alternative finance sources? David Reilly brings us some of the regulatory dilemma in the Wall Street Journal, “Too Big to Fail Casts a Very Long Shadow.”

The question is, “Should the U. S. Government look to backstop even more of the financial system than it already does?” The financial system is expanding. The financial system has already expanded.

Reilly writes that “the shadow-banking system is estimated at between $10 trillion to about $24 million, depending upon the activities included.” According to Federal Reserve System, the commercial banking system holds a little more than $13 trillion in assets.

According to the Federal Deposit Insurance Corporation (FDIC), the total of all assets held by all FDIC insured institutions is a little more than $14 trillion. According to Gary Gorton, Yale economist, in his latest book, “Misunderstanding Financial Crises: Why We Don’t See Them Coming,” the shadow banking system totaled something around $10 trillion to $14 trillion in the summer of 2008, just before the financial crisis started.

In June, 2008, the assets of the commercial banking system totaled just over $11 trillion; assets in all FDIC insured institutions totaled just over $13 trillion. Alternative financial institutions are something to deal with. And, alternative financial institutions are attracting more and more attention.

The issue about shadow banking is one about systemic financial collapse. And, in other words, as Federal Reserve Governor Daniel Tarullo stated before the Senate Banking Committee last week, the regulation of this part of the financial system is the issue “we should be debating in the context of too big to fail.”

Reilly writes, “While banks have faced tighter oversight, the shadow banking market remains a source of potential instability. It is worth remembering that runs here, rather than traditional bank runs, were a cause of the crisis and led to seizures of credit markets.”

Gary Gorton, in the book mentioned above, describes this run in the financial system in 2008. So, according to Tarullo, and William Dudley, President of the Federal Reserve Bank of New York, we need to regulate alternative finance.

Dudley stated, in a speech earlier this month, that there are two ways to contain shadow banking. The first is “to curtail short-term, wholesale financing that takes place outside the regulated banking system.” The second “would be to expand backstops to such activities. In other words, give some of the protections open only to banks, such as access to the Fed’s discount window, to certain products or nonbank financial firms.”

Of course, this latter path would include more regulation and examination! I have written about this situation over and over again in the past four years or so.

What about more and more regulation? We have seen plenty of that since the financial crisis hit in the fall of 2008. And, of course, we have produced that monstrosity of a camel of a regulatory structure called Dodd-Frank. And, what has happened? Well, the first thing we have to remember about regulation is that regulation is designed to protect against the problems that used to exist in the financial system. Regulation is backward looking.

The consequence of this regulation? The biggest of the commercial banks have moved on. They have the expertise and the connection with the latest information technology to go where the regulations are not. In this world today with the information technology we have, the biggest organizations with the most talent on hand can find ways — new ways — to get around what the government and the regulators are trying to do.

What is it that these big organizations are doing? We don’t know yet — and won’t know until after-the-fact. We are going to regulate something we don’t know? Come on, get real! But, all these new regulations are paralyzing many small- and medium-sized banks. Regulatory costs have sky-rocketed and many of these small- and medium-sized banks don’t have the human capital to respond to them.

I have had the opportunity to move out into the community banking community and talk with some bankers. Those that I spoke with aren’t lending. What is the reason they are not lending? Well, for one, regulatory costs and examination oversight cause them to do only what they are absolutely sure they can do, and they really are not certain about this. Why lend within such an environment, especially if you have other problems within the bank to deal with?

So do we need regulation to extend to the shadow banking system? Remember, any regulations that are extended to the shadow banking system will only be backward looking. And, imposing the burden and costs of regulation, if the regulation is effective, to these institutions will raise expenses, make borrowing from these firms more expensive, and restrict credit extension in a pretty important segment of the credit market.

The other issue has to do with the ability to regulate these institutions. Shadow banks are not like small- and medium-sized commercial banks. They have not been regulated for years, they have younger, more talented, more sophisticated employees than do the small- and medium-sized commercial banks, and the companies are lighter and more mobile that these small- and medium-sized financial institutions.

What to do with alternative finance is an issue that is not going to go away. It is on the cutting edge of where finance is going in the future. As readers of this blog know, finance, to me, is just information, nothing more than 0′s and 1′s, and how do you control that. What is money in such a world? These are issues we will be dealing with more and more in the future.

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, timeliness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus LLC or Focus Securities, LLC.

Will a Superabundance of Capital Lead to an M&A Boom?

Posted by John Slater on February 17, 2013

Authored by John Mason

“Bain & Company, the consultancy, forecasts a ‘superabundance of capital’ between now and 2020. In a recent report it argued that markets would be distorted by surpluses in Asian and Middle Eastern countries and private investment funds.

“It estimates that the world’s financial assets will outbalance its domestic product by ten to one – it will have $900 trillion of financial assets compared with $90 trillion of GDP – by 2020. The result will be a ‘world that is structurally awash in capital’ chasing few opportunities.

“‘Capital superabundance will increase the frequency, intensity, size and longevity of asset bubbles. The propensity for bubbles to form will be magnified as yield-hungry investors race to put capital into assets that show the potential to generate superior returns,’ the report concludes.”

These words from John Gapper appeared over the weekend in the Financial Times of London.

The signs of this possibility, according to Gapper, are two: first, the presence of lots and lots of cash on the balance sheets of corporations, hedge funds, and other financial interests; and second, the apparent movement in the buyout and acquisition market that reflects a growing belief among international investors that the US economy is stabilizing, the eurozone crisis has reached its final stages, and that elsewhere in the world economic recovery continues and capital flows are increasing. Apparently with these events, the desire to take on more risk has risen.

I have written for three years or so about the build up of cash on the balance sheets of corporations. Companies that never had issued long-term debt before took advantage of exceedingly low interest rates to increase their cache of money. The basic reasoning behind this buildup was that these financially sound firms would “make a killing” as the United States economy began to grow faster and government regulatory policy came together.

The targets of these companies? The answer was … companies that were not so financially sound; companies that needed restructuring; and companies that needed new life and new capital.

The merger and acquisition binge never took place. The reasons given for why a massive boom in M&A never took was also two-fold: first, economic growth remained tepid, and uncertainty seemed to blanket the world as the regulatory stance of the Obama administration never became clear, as the European crisis worsened and grew longer and the economic health of the rest of the world, especially in China, India, and others, was unclear.

Corporate leaders were just not willing to commit. Better safe than sorry.

But, now this seems to have changed. The Federal Reserve System has pumped billions of dollars into the United States economy and is continuing to do so as we go to work each day. The Fed has promised that this will continue for an extended period of time and short-term interest rates will remain low for another year or more. We believe them.

The American economy is not growing robustly, but there seems to be sufficient confidence that the economy will not fall apart to warrant some belief that investors can extend themselves into riskier investments. European financial markets have been relatively stable now since early December as European officials seem to be working to knit something together, even though the pace of accomplishment remains extraordinarily slow. And, the rest of the world seems to have stabilized and seems to be heading in the right direction.

The confidence of international investors seems to be building as money has moved out of United States Treasury securities and German Bunds.

Furthermore, it finally appears as if money is finally flowing into the “deal” market. Of course, the eye catcher here was the $24.4 billion buyout deal struck by Michael Dell for Dell (DELL). This was followed by John Malone, of Liberty Global (LBTYA), who stated that he was buying Virgin Media (VMED). Then a group of private equity funds in England announced a deal with EE, the United Kingdom’s largest mobile phone operator. And, there is also the deal announced a little earlier to less press coverage of Dish Network (DISH) buying Clearwire (CLWR).

The year started off slowly, but now near the middle of February, the numbers are starting to look really good. Finance is good!

But, what about economic activity? Will all this financial activity help the real economy grow and help to reduce the unemployment rate?

Three years ago when I was writing about the corporate build up of cash and the possible “boom” in mergers and acquisitions that might follow as the confidence picked up and the uncertainty surrounding government regulation dropped away, I wrote that there was still one problem to consider. All this money going into “deals” was not immediately going into new innovation or into the purchase of new capital equipment. This money was going to be swirling around and around with little or no immediate impact on achieving faster economic growth.

Buyout deals, like the Dell deal and mergers and acquisitions usually result in company consolidations, corporate restructurings, downsizing and reductions in employment.

The immediate impact of these transactions is to “rationalize” the economy and make it more efficient. This “rationalization” and increase in efficiency does not immediately add to economic growth or to lower unemployment rates. If anything it can move things in the opposite way.

Yes, eventually these restructurings and so forth will be good for the economy. They will lead to greater worker productivity, more capital expenditures, and more innovation. But, these latter things will not take place immediately.

Gapper, in his Financial Times piece, closes with similar sentiments. He states that “such investors are not risking money on entrepreneurs through venture capital funds or buying stakes in untested companies in initial public offerings. They are choosing well-known enterprises on a firm footing and using their earnings to gain better returns than cash or government bonds.”

These activities may lead to better times, he states, but “at the moment, the wave of deal making contrasts oddly with sluggish economies and risk-averse banks.”

The scary part of this scenario is the possibility presented us by Bain Capital: “Capital superabundance will increase the frequency, intensity, size and longevity of asset bubbles.”

I have written a great deal about credit inflation in my posts. It seems to me that the Bain 2020 picture of a $900 trillion in financial assets compared with $90 trillion of GDP is the height of credit inflation. Even if we don’t get all the way to this result, a credit inflation of this degree makes the credit inflation of the 1961 to 2007 period look like an insignificant “bump in the road.”

All data and information provided on this site is for informational purposes only.  Capital Matters makes no representations as to accuracy, completeness, currentness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.  The thoughts opinions, information and data submitted by the authors is theirs alone and has not been approved or endorsed by Capital Matters, Focus LLC or Focus Securities, LLC.

Dell Deal: A Sign Of The Future?

Posted by John Slater on February 9, 2013

Authored by John Mason

Things are changing in the financial markets. Financial institutions are starting to make money again in mortgages. Money market funds are “flush with cash.” Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs) are staging a comeback.

And, now there is the $24 billion deal by Michael Dell to take his company private. The interpretation of this transaction that I am most interested in is the one being mentioned in almost all the stories coming out in the press: “This is the largest corporate privatization since the financial crisis and the largest tech buyout ever.”

I am not interested so much in whether or not Dell, Inc. (DELL) is eventually saved. What I am interested in is what is happening in finance. It appears as if money is being mobilized again.

Goodness knows, the Federal Reserve has done just about everything it can to push money out into the economy. Comedians have gotten serious about QE1 and QE2 and QE3 … and QEfinity!

It has only been in the past six months or so that there has been any evidence of funds creeping out of the commercial banking system into other parts of the economy. But now, evidence seems to be growing of money flowing into other parts of the economy. This latest transaction, the creation of a large buyout deal, with the growing possibility that others are thinking about more deals, or even mergers and acquisitions, is very encouraging.

Over the past couple of years, myself and others have wondered about all the cash being built up in the coffers of large corporations. It seemed as if these large organizations were piling up cash hoards in preparation for moving in on less well-off institutions and making deals while the getting was good and while interest rates were so low.

But, economic growth was tepid and there was a great deal of uncertainty, especially about the regulatory/political environment. Merger and acquisition business picked up a little but was totally disappointing to some, myself included, as the quantity and dollar volume of deals fell far below expectations.

The cash came in for some use in the latter part of 2012 as the government’s fiscal situation created an environment in which many companies either paid special dividends or engaged in stock buybacks. Now, however, something different seems to be in the air.

There seems to be a little more optimism in the air concerning the health of the economy. Economic growth is unlikely to accelerate much in the coming year, but consumer markets and housing markets seem to be picking up. Also, assuming more risk seems to be acceptable these days.

International investors seem to be moving out of their “safe havens”, U.S. Treasury securities and German sovereign debt, and moving into riskier investments. After a one-day respite, the 10-year U.S. Treasury bond was trading today to yield above 2.00 percent again. This yield was around 50 basis points higher than where the bond traded in July 2012. The 10-year German bond, which also fell yesterday, resumed its rise, closing at 1.66 percent today, where it was trading to yield around 1.30 percent in early December. These movements seem to me to be just the tip of the iceberg.

Michael Dell got a lot of attention over the past couple of weeks as he attempted to push this deal through. Some substantial players expressed interest. Microsoft put $2 billion into the deal and will get a board seat. Now, Michael Dell seems as if he has pulled it off. The fact that deal is happening and that this size of deal can be financed can only be encouraging to others. I believe more privatization deals will take place this year.

And, I believe that we will finally see business in the M&A market pickup. I have believed for the past two to three years that there are quite a few hungry, financially well-off corporations that are poised to move on some of their less-well off brethren. These healthy institutions have just been waiting for the right economic environment and a reduction in the uncertainty that has plagued the atmosphere.

In addition, these corporations have been waiting for others to begin to move, first, because seeing others move increases confidence, but also, because if others are moving, the well-off corporations cannot be criticized for making the acquisitions because of the fact that if they are wrong they always have the excuse that others were making acquisitions as well.

Federal Reserve officials must be happy in seeing these things happen. Although commercial banks, at least those banks smaller than the largest twenty-five or so, are not taking on much “new” business, the efforts of the central bank to push large amounts of money into the financial system as a whole finally seems to be having some positive effects.

Although these positive results may not be immediately speeding up economic growth, they can only be seen as favorable in the Fed’s efforts to restore the economy to a sounder footing. We have to see the financial system functioning well before we will see the economy becoming more robust.

A Wonderful Life for Community Banks?

Posted by John Slater on December 27, 2012

During the yearend holidays we reach out for the comfort of the familiar.  One of the best ways to do that is to revisit films with a seasonal focus such as White Christmas, Miracle on 34th Street and most particularly It’s a Wonderful Life.  Directed by Frank Capra and released December 20, 1946, the film, starring Jimmy Stewart and Donna Reed tells the story of a young man, George Bailey, who was plunged into a difficult and entirely unfair situation as a result of the actions of others beyond his control.  George is driven to a point of such deep despair that he is considering suicide.  He is saved by a guardian angel and the support of those for whom he has toiled unselfishly for years.  For decades the film has provided us with the assurance that, if we just do right by others, we will ultimately be redeemed.

Great film of course, but did you ever think about the underlying issues that forced George Bailey to consider jumping off a bridge?  Bailey begrudgingly inherited a community-oriented Building and Loan Association in the 1940’s when just before Christmas his Uncle lost over $8,000 on the way to make a deposit.  The regulators had just arrived at the Building and Loan and found the loss.  They promptly issued a warrant for George’s arrest.  Even though he was innocent George was so unwound by the actions of the regulators that he felt his life was at end.

Fast forward to 2012.  This time don’t look for a friendly angel to save a Jimmy Stewart style hero.  On December 4, 2009 the FDIC seized Buckhead Band and sold its assets to State Bank and Trust Company of Macon, Georgia which also assumed the liabilities of the Buckhead Bank.  On December 3, 2012, just one day before the FDIC statute for claims would expire, the FDIC Receiver filed a lawsuit against the Board Members and Management of Buckhead Bank, seeking damages for gross negligence and in particular their failure to adhere to bank policies and safe and sound lending practices with regard to a large number of the bank’s loans, many of which funded commercial real estate (CRE) and property development transactions.

The FDIC’s claims could apply to many community banks faced with similar economic circumstances in the early 2000’s, which led up to the financial panic in 2008.  Many, if not most, community banks had:

• Significant exposure to real estate loans; both in residential and commercial.  Exacerbating this were loans for construction and land development.
• As a result of the sudden drop in real estate values beginning in 2007, the banks immediately suffered from drops in collateral value impairing those specific loans in real estate, not to mention many other small business loans placed in jeopardy by the real estate crash.
• Due to high levels of concentration as measured by asset classes compared to equity, the impaired assets put a dramatic strain on capital and the ability for those banks to absorb losses.
• The bank’s directors included a number of highly successful businessmen who had little direct knowledge of the bank’s portfolio, were busy managing their own businesses and who therefore depended on management to provide the data needed for proper asset management.

The FDIC appears to be claiming that the bank board had a responsibility to evaluate the quality of the bank’s portfolio on a fairly granular way and to take action to prevent the foreseeable risks entailed in the bank’s lending practices and portfolio concentrations.

Whether the Board or Management of Buckhead Bank failed to administer policies or assure that the bank engaged in safe and sound lending practices is a matter for the courts and we offer no special insight on that.  Rather, this article is intended to focus on the lessons current bank directors and officers should learn from this lawsuit.

The question for directors is whether they are at risk today for failing to take action to protect their banks from foreseeable issues down the road for which the FDIC might someday deem them grossly negligent for failing to address.  Some might suggest that the real question is why any busy businessman or professional with personal assets to protect would want to take the risks inherent in serving on a community bank board.  We’ve published a white paper suggesting that most banks under $1 billion in assets must either grow dramatically or merge with a larger bank in order to survive.  That means that for the directors of many small banks there is limited upside.

The Regulatory Future
The White House is visibly committed to take actions to increase regulation of the banking system.  While the emphasis to date has been on the large banks, the regulatory agencies have determined that the impact of Basel III and the Dodd-Frank Act will apply to all banks, large or small.  So what will the nature of those new regulations be?

• The old ratios defining capital adequacy will be revised upwards.  Anecdotally, the regulators are already suggesting the Risk Based Capital ratio will need to be around 12%.  This would mean that banks must achieve roughly a 20% increase in capital just to keep the portfolio they currently have.  However;
• The ratio could go higher if they have concentrations in real estate assets, especially those that are commercial and even more so, construction or land development.
• If community banks adopt a stress testing analysis they may be able to reduce the need for additional capital. (Note 1)   However, this will require much more work on the part of management and a good deal of expense for outside advisors brought in to assist in the process.
• Basel III will require a likely increase in banks’ core capital cushion taking it from 4% to 6%, a 50% increase.
• If a bank does not have access to capital to bring the ratios in line, it will have to shrink its assets into the capital ratios the regulators will demand putting further strains on equity returns and shareholder value.  If portfolio quality is less than pristine, the bank may not be in a position to dispose of sufficient assets at par.  The resulting losses could cause a further deterioration, leading to a death spiral for such banks.

What are the implications for community banks and their directors?
The number of community banks in the U. S. is going to shrink dramatically over the next few years.  The drivers are limited access to capital, increasingly unaffordable regulatory oversight and the inability of smaller banks to provide competitive returns on equity.  If a particular bank has a solid and growth competent management team as well as access to capital, it will have opportunities to acquire other banks that don’t have these resources in the next few years to hit that magic $1 billion assets mark.  However, if a bank does not have those attributes it will likely be forced to partner with a stronger bank, cede control and hopefully enable its shareholders to exchange their stock for that of a fast growing winner.

What are the risks for community banks that fail to address this situation proactively?
One option, which appears to be the alternative of choice today for many small banks, is to ignore the impending regulatory changes and bet that a rapidly growing economy in the next year or so will enable to them to escape the foreseeable industry changes.  For many banks with heavy concentration in CRE, demand for commercial real estate will also have to grow and show a long-term trend towards value stability.

However, nothing in the current environment would suggest the dramatic improvement in CRE valuations that will be needed to salvage many banks’ CRE portfolios.  CRE loan maturities began to peak in 2012, but the pressure from maturing loans will not be over for many banks until well into 2015.

And nothing in the current economic environment indicates a strengthening in loan demand sufficient to enable most small banks to address the dual pressures from higher capital requirements and deteriorating loan quality though the origination of new, highly profitable, high quality, loan assets.

With this as background, fast forward to 2015.  As a director of a small community bank, you have experienced the following.  Capital requirements have been raised and your bank has been unable to find new capital to meet the requirements.  As a result your bank is currently operating under a regulatory agreement issued in late 2013 requiring a reduction in real estate and other concentrations.  Worse, the brief, but sharp recession that began in the summer of 2014 led to a further decline in CRE collateral value of up to 30%, putting many formerly performing loans in jeopardy of default.  As you watch the regulators enter your bank’s front doors, your worst fears have been realized.

Now imagine that a new administration has come into power in 2017.  Riding on a wave of populist resentment, newly appointed regulators are out for blood.  And the first place they look is the boards of now defunct banks.  Their claim?  Directors of those banks were on notice that capital requirements were going to increase, but failed to take timely action.  Further, the directors knew or should have known that collateral values placed on many real estate assets securing the banks’ portfolios far overstated the saleable value of the real estate.  According to the complaints these directors were grossly negligent in failing to address this highly foreseeable situation.

It’s a Wonderful Life
Back to the movie: you will recall that George bails his thrift out of regulatory repercussions because of contributions from the clients he helped along the way.  In essence the community came to his defense with the funds he loaned them.  This is not likely going to happen to our community banks today.  And kind angels seem to be in pretty short supply.  However, an opportunity still exists for A Wonderful Life for community banks and their boards if they act now to head off the foreseeable consequences of the current situation through partnering with that bank down the road with a strong management team, access to capital and a stock destined for rapid growth as smart acquisitions begin to pay off in improved competitiveness and higher profits.

________________________________________________________

Note 1. “How Community Banks Can Fight Back Against Basel III” by Kamal Mustafa, Chairman and CEO of Invictus Consulting Group, LLC as published in the American Banker, November 26, 2012.

About the Authors

Focus LLC Managing Director, Bob Beard has more than twenty-five years experience as a senior manager and C-level executive in the asset based lending industry.  His experience includes serving as southeast regional underwriting manager for Heller Financial and as a senior executive with  Capital Business Credit.   For the past nine years he has assisted middle market borrowers with negotiating ABL financings.

Carl W. Raggio, III has been an executive in the banking world for over 30 years.  He is known for his turnaround experience in community banks, including the sale of three banks at values that doubled from the point of his entry.  These banks ranged in size from $300 million to over $1 billion in assets and had from 150 to 500 employees.  As a Managing Director of Focus LLC, a Washington, DC based investment banking firm that provides merger and acquisition and capital raising services to mid-sized private companies, Carl heads the firm’s Community Banking and Financing Institutions practice team.

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Capital Matters blog provides tools to provide business owners and business advisors with actionable information to help them understand how business growth can be financed. Financing sources included bank debt, common equity, preferred stock, growth equity financings, asset based loans, mezzanine financing, mezzanine debt, tranche B financing, corporate recapitalizations, venture capital investments, angel financings and initial public offerings (IPOs). It provides useful information for business owners, attorneys, accountants, investment bankers, and those in the middle market M&A business, including private equity groups, middle market investment bankers, corporate attorneys and business valuation experts. Capital Matters with John Slater provides business owners and their advisors with information about business sales, business acquisitions, mergers, acquisitions, business planning, middle market M&A transactions, growth capital financing, merger planning, selling a small business, financial reorganizations, strategic alliances, transaction due diligence, leveraged buyouts, mergers and acquisitions, goodwill in mergers and acquisitions, company mergers and strategic planning. The site will focus on the private equity industry and private equity groups as well as strategic acquirers. Site users are expected to include investment bankers, commercial bankers, corporate attorneys, business owners, business advisors, accountants, valuation professionals and M&A intermediaries. We also address Chapter XI Bankruptcy Sales, business turnarounds, financial distress, buying and selling businesses, writing business plans, due diligence checklists, goodwill in mergers and acquisitions, business mergers and acquisitions, going private transactions, financial reorganization, acquisitions and mergers, corporate mergers, buying and selling businesses, business valuation services, legal due diligence checklists, merger and acquisition checklists, investment banks, public companies going private, and corporate mergers and acquisitions. Topics of interest to our readers include due diligence, business valuation, acquisition checklist, mergers acquisitions planning, Chapter XI advice, restructuring and insolvency, business modelling, financially distressed corporate turnaround firms, turnaround corporate restructure, financial reorganization, distressed debt, bankruptcy chapter XI, turnaround consultant, chapter XI bankruptcy, chapter 11 bankruptcy, turnaround advisors, turnaround adviser. Our information is of interest with regard to international acquisitions of U. S. firms and well as domestic deals. International acquirers can learn about the United States M&A market. We will also provide articles with regard to mergers and acquisitions as well as M&A tutorials. The publisher, John Slater, has experience with business sales and acquisitions, mergers and M&A in Tennessee, Arkansas, Mississippi, Alabama, Louisiana, Georgia, Florida, North Carolina, Kentucky, Missouri, Texas, Oklahoma, South Carolina and West Virginia.