Looking West (and South) Toward Tomorrow

Posted by John Slater on January 31, 2012

If the U. S. economy is to successfully navigate its current perilous course, attention must move from the baggage of the past to the opportunities and challenges of the future.  Nothing symbolizes that better than the comparison of Europe’s ongoing economic morass with China’s relentless growth.

Our friends at McVean Trading consistently produce one of the most insightful newsletters on global economic trends.  They’ve been generous to share their recent analysis reprinted below of the global trading shifts that have led to China’s current export dominance. We’ve reprinted the article in full below.  The article includes a interesting analysis of inflation trends in China, but the most important takeaway is that the Chinese surge is not an isolated event, but a continuum of trends that began almost forty years ago, first with Japan’s export boom, then with the Korean, Malaysian and Taiwanese Miracles and more recently with the strength of the Chinese manufacturing economy.  These are all part of a global movement to equalization of economic opportunity.

Far from dragging down the American economy, China’s boom is better viewed as the extension of trends that started more than 200 years ago when Samuel Slater (unfortunately no relation) memorized the technology developed in England for mechanization of the textile industry and brought it to the U. S.  Andrew Jackson gave Slater credit as being the Father of the American Industrial Revolution.  Of course today the shoe is on the other foot and he would more likely be branded as an intellectual property pirate.

Over time the seat of textile manufacturing moved from New England to the American South and eventually on to China.  It would be hard to argue that, over the longer term, New York or Boston has suffered as a result of the shift in their regional economies from strength in clothing and textile manufacturing to their current positions as global powerhouses in finance education and R&D.  To me the takeaway is that England, far from being weakened by the shift in manufacturing jobs to its former colony in the Americas, was able to cement its position as the superpower of its day.  It took advantage of these developments by investing heavily in the U. S. and continuing to build its dominance as the global trade leader of its era.  A quick spin around London circa 2012 certainly does not lead to the conclusion that the U. K. fell into irreversible decline because of America’s growing prosperity.

The U. S. is now in an analogous situation.  The rise of Asian manufacturing has certainly hurt many individual Americans, but overall the U. S. has been far more prosperous than it would have been without access to low cost imports.  In many of the more advanced technology industries, U. S. manufacturers have maintained their dominance, a feat that would not have been possible in the absence of access to lower cost “imported” labor.  With the current political focus on “protecting American jobs”, one of the most critical questions the country faces is whether we can maintain a consensus that enables the most innovative American firms to continue to access the global resources they will need to compete on a global basis.

We’re in the midst of the strongest economic boom the world has ever witnessed.  For clear evidence how pervasive this trend has become, take a look at the glittering new capital of Kazakhstan, one of the most remote corners of the world.  The National Geographic just published a great pictorial that you can download here.  We should not be threatened by the increasing prosperity of the world at large.  By taking advantage of this growth, the U. S. can continue its role as the world’s leader in technology and global trade with concomitant growth in per capita living standards for the American people and prosperity for its business community.

(The following is reprinted in full with the permission of the author)

Weekly Economic Update

Michael Drury                       Chief Economist

Taylor Somerville, CFA       Senior Economist

Vadim Sinitsyn               Associate Economist

Volume 62, Number 3                                                                                     January 20, 2012

China announced their GDP grew 8.9% over the four quarters of 2011, and at an 8.2% annual rate in the final quarter of the year. Nominal GDP grew 17.0% during the four quarters of 2011. As McVean Trading decomposes the data, implied inflation slowed sharply in the fourth quarter to a 5.6% annual rate from 9.1% in the third. Despite all the clamoring about food based retail inflation, the broader GDP deflator was up at a 7.4% annual rate in the second half of the year after a 7.3% annual rate in the first half. Inflation in 2010 was at a 6.6% annual rate – right in line with the average of the past eight years.

China’s high inflation rate remains a consequence of its managed foreign exchange rate policy, as it boosts money supply by buying dollars with newly created yuan to limit the rise in the value of its currency. The invisible hand is smarter, however, and pushes up prices in yuan to compensate. The need for money creation should ebb in 2012 due to a narrowing trade surplus, reduced inflows of foreign direct investment, and more hot money trying to move out of China than is coming in. Inflation has traditionally lagged behind growth in China as the authorities are slow to rein in lending. Continued restrictions on property may sustain the slowdown in inflation this year. A recent announcement indicated major banks will be allowed to increase loans 5%, but another announcement indicated the government wants a more even pattern of distribution through the year. Historically, almost 40% of loans are made in the first quarter – despite limited economic activity due to the New Year’s celebration. This year, the government wants 30%, so even if annual loan limits are expanded the first half may remain tough. This only adds to the concern sparked by Premier Wen’s recent speech warning about a difficult start to 2012 due to slow external demand. Bottom line, many indicators suggest rapidly slowing inflation at the start of the year in China, allowing for growing stimulus throughout the year as the Hu and Wen leadership transitions to the Xi and Li era starting in 2013.
Examining China’s Trade Gap

China’s shift to a consumer led economy has long been a dream of foreign marketers – mostly American — wanting to cash in on the vast new demand. However, the boom in Chinese exports has, in large part, been a response to foreigners – largely Asian – utilizing the country’s cheaper labor to maintain their share in America’s consumer markets. Japan first launched its mercantilist attack on American shores in the 1970s as soaring gasoline prices made cheaper cars (and everything else) a necessity to maintain lifestyle. However, as the yen began to appreciate rapidly in late 1985, Japan began to seek out cheaper labor across Asia. Over the next decade, South Korea, Thailand, Malaysia, Indonesia and others all saw rapid inflows of capital, which eventually culminated in the Asian crisis starting in Thailand in July 1997.

The third wave began in 2000, as Japan shifted its focus to China, rapidly increasing its exports to that nation as Chinese accession to the WTO opened the door to the world for its exports. It is noteworthy that Japan’s export numbers show a clear decrease in the share going directly to the US from 1986 to 1996 as they shifted production bases into Asia – but no change in their traffic to Europe. In the post-2000 phase, as Japanese production shifted into China, though most of the effect was to reduce share directly to America, exports directly to Europe fell by 7% as well reflecting the power of WTO access. Clearly, part of the shift in Japanese exports to China was due to that country’s rapid growth, but before 2004 (after China’s export share had already risen by 7%), China’s economy was still just $2 billion compared to $12 billion each in Europe and the US. Most of the shift had to be for re-export.

Moreover, the pattern is the same in South Korea and Taiwan, both Newly Industrialized Countries that benefitted from the second wave of Japanese exports to America. Starting in 2000, China’s share of South Korean exports explodes from 10% to 25% over the next decade. The share to America collapses from 21% to 10% — yet the shares going to Japan and Europe, both developed countries competing with the US for the same type of imports, decline far more slowly. Indeed, though Europe and the US had similar sized economies growing at about the same rate during this period, Europe’s share doesn’t fall until after 2008 – when the US recession (pre-Lehman) cause South Korea to refocus its exports. In Taiwan, we cannot break out the detail on Asia, but it is clear the Asian share came largely at the expense of the US and only slightly from Europe – and all of the decreased European share coming after China’s access to the WTO.

All of the analysis so far is based on Japanese, South Korean and Taiwanese data, but China and America’s own statistics confirm the trends. China’s trade surplus surged from less than 2% of their GDP in 2003 to almost 8% in 2007. It was still hovering around 7% of GDP in early 2009, just after Lehman (which collapsed imports), and their trade gap peaked at $312 billion. Since then, China’s trade gap has returned to just 2% of GDP, but given the much larger size of their economy, that now represents $157 billion. Though exports have grown at a 12% annual rate since 2007, imports have grown much faster 16% reflecting China’s faster domestic performance. At the peak in 2007, exports accounted for 35% of GDP with imports representing 28%. The best estimates at that time were that roughly one-third of imports were for domestic consumption (10% of GDP), thus the Chinese value added in exports amounted to 18% of GDP (36% of GDP export value – 18% of GDP import value). Assuming that imports for domestic consumption have remained at a steady 10% of GDP (and that is likely on the low side given the rapid growth in commodities demand), with exports now at 26% of GDP and imports at 24%, the value added would be just 12% of Chinese GDP. That would be roughly in line net exports from with the US and Europe.

Guangdong Province has always been China’s export powerhouse since it was set up as a special zone by Deng Xiaoping in 1978. In 2003, Guangdong accounted for 10% of Chinese GDP and 33% of exports. Its trade surplus of $22 billion was more than the surplus for the entire nation. The success of Deng’s export strategy caused other areas to compete with Guangdong, especially in the Yangtze River Delta in areas like Suzhou where Taiwanese electronics manufacturers concentrated. By the peak of the Chinese export boom in 2007, Guangdong accounted for just 40% of China’s trade surplus. However, since Lehman, the latecomers to the export boom across China have refocused on domestic production, aided by the record $1.4 trillion stimulus in early 2009. Still the country’s most export dependent region, Guangdong’s $126 billion trade surplus again accounts for most of the whole country’s total. Throughout this period, Guangdong’s exports have exceeded 60% of its GDP and re-exports over 20% of GDP. However, Guangdong has steadily shifted from low end manufacturers like toys, textiles and footwear to more advanced products like electronics and chemicals. Auto manufacturing is also a big growth industry, but primarily for domestic consumption (though exports of auto parts is a growing industry.) Bottom line, Guangdong’s story has long been different from the rest of China’s, but because it is where many foreign visitors spend their time it has distorted the world’s view of China.

Finally, the US statistics themselves show that China is primarily a replacement for the rest of Asia as an export base. As the Chinese share of the US import market has gone up, the share from Japan and the Newly Industrialized Countries has gone down. Over the past three years, as Chinese labor has started to become more expensive, the penetration from China has leveled off and the decline from Japan and the NICs has slowed or ended.
Looking at the wider picture of US exports, it is clear that what is selling in the US is not “Chinese,” but “cheaper”. Just as China has been replacing more expensive Japan, Eastern Europe and Latin America have been replacing Europe and Canada. US imports from the developed world have been dropping steadily over the past decade as lower cost labor from the newly freed communist countries and resurgent commodities producers has lifted the share of imports from the Emerging Markets. Some of this is due to increasing commodities prices, a byproduct of the rise of the Emerging Markets. However, the simpler reality is that flat to declining buying power for American workers has increased their appetite for lower cost imports to maintain their living standards – just as in the 1970s. The feedback loop is obvious as America continues to lose manufacturing jobs, and the bulk of new jobs are in services, where imports have a harder time competing.

So what is the next step in this inexorable process of the invisible hand shifting global production to the lowest cost producers? That depends on what you think about currencies and relative labor costs. The yen is still rising against the dollar, and even faster against the Euro now that its major competitor for finished products also has a banking system that is on the ropes. Even if the yen were to retreat from recent highs, we would expect Japan to continue shifting production into lower cost areas for some time. Although the Renminbi is now 22% higher versus the dollar than in 2005, it is still 11% cheaper relative to the yen. The shift into China should continue, but rising oil prices may shift some production to Mexico as proximity trumps currency. Meanwhile, a stronger US dollar, due to greater world insecurity, will not slow the pace of US manufacturing moving abroad or US consumers’ demand for imported goods. Both European and Japanese manufacturers are shifting some high value added products back to America. In Japan’s case, this is to take advantage of labor cost differentials in products that they cannot or will not shift into Asia (due to fear of intellectual property rights infringement or lack of sufficiently skilled labor.) For Europe, the shift may have more to do with supply line security, as they fear a Lehman type stop may be lurking. Regardless, the broader ongoing shift of global manufacturing to the Emerging Markets is likely to continue as those nations gain in sophistication of labor skills. Currencies matter, but productivity gains may matter more. While productivity growth has slowed in the developed world to roughly 2%, it is still bordering on double digits in China and other Emerging Markets as they simply adopt and adapt technologies that already exist in the developed markets.

From an American perspective, the best thing that can happen for jobs is a rapid rise in the value of Chinese/Emerging Markets labor, which makes it less desirable for developed countries to shift their production to them. China’s own demographics, with slower growth in its work age population, are a challenge – however, even more rapid growth in cheap labor from populous India, Indonesia, Turkey, Egypt etc., suggests that turning back the clock to American manufacturing dominance is unlikely. Rather than reclaiming old markets lost when our comparative advantage disappeared, the US needs to concentrate on winning the lion’s share of growing markets like health care and finance, where the world’s rapidly aging population spends more of their money. Indeed, US exports of energy, agriculture and natural resources are among our fastest growing industries as the growing Emerging Markets drive up prices, both because their own production costs of commodities are becoming more expensive, and because with rising incomes they are demanding more of these resources. Bottom line, China’s export boom was not an anomaly of mercantilist policy, but merely a concentrated example of the invisible hands ongoing process of leveling the playing field between the developed economies and Emerging Markets. We expect this process to continue at a rapid pace, whether China is the prime beneficiary or not. It will remain the key driver of international economic policy and trade – and commodities demand – for many years to come.

January Video Newsletter

Posted by John Slater on January 26, 2012

Will Business Owners Hit the Bid in 2012?

Posted by John Slater on January 24, 2012

Over the years one of the best indicators of M&A activity has been what I call the Free Lunch Index. I live in Memphis, normally not a hotbed of middle market M&A activity.  That’s why my practice is national in scope.  When banks or private equity groups do come to town looking for deals, I often get a call for lunch, breakfast or coffee.

Since the crash in 2008 it’s been fairly lonely out here and I pretty much buy my own lunches. Starting this month, however, I’ve seen a marked pickup in calls and lunch invitations.  The word appears to be out among both the private equity groups and the financial institutions that now is the time to get back into the market and they’re actually spending money to look for deals.

Our experience at Focus indicates that business sale interest has increased strongly since yearend. Apparently we are not alone.  Cyprium Partners, a leading mezzanine financing specialist, recently completed a survey of 175 investment-banking firms throughout the U. S.  Among their findings, 44% of respondents reported more assignments signed or in the market than at a comparable time in 2010.  56% reported that new business pitches were up and less than 10% of the firms reported lower activity.  Bottom line the M&A business is improving and that’s consistent with our belief that the overall economy will surprise to the upside.

It’s no secret that the U. S. private equity industry has been in a depression over the past three years.

Source: Pitchbook

Private equity deal flow showed great promise this time last year, but fell precipitously by the end of 2011.  Interestingly, according to Capital IQ, global aggregate annual deal flow in terms of number of transactions has been far more stable while dollar values have fluctuated widely.

Year                          # of  Transactions       $ Value of M&A (Trillions)

2007                               44,398                               $3.70

2008                               42,531                               $2.29

2009                               34,390                               $1.87

2010                               43,523                               $2.35

2011                               42,713                               $2.53

A pent up demand for business exits is driving transaction numbers, but in recent years most of our deals have been strategic in nature rather with only a few private equity buyers.  For years buyers, particularly in the private equity community, have told us they were waiting for business owners to “get more realistic” in their pricing expectations. That wait appears to have ended in 2011 and it was buyers, not sellers that blinked.

Private Equity Buyout Purchase Price Multiples (Deal Size/EBITDA)

Source: Pitchbook

That is consistent with our experience.  Buyers are paying historically high multiples for good companies.

Underlying all of these numbers is a single reality.  Private equity transactions, far more than strategic deals, are driven by the availability of financing.   From 2005 to early 2008 the M&A market thrived on the creation of massive amounts of debt in the Shadow Banking system.  Many billions of dollars of collateralized loan obligations (CLOs) and other off balance sheet funds were created to chase deals.  That game ended abruptly with the crash and has not come back.  Leverage is an absolute prerequisite for the private equity community; PEs cannot achieve their target yields with equity heavy balance sheet structures.  As a result the larger leverage driven deals have been few and far between.

There are some signs that the financing picture is changing.  2011 saw strong resurgence in both the high yield debt markets and middle market loan syndication activity.   Both markets fell off somewhat in the fourth quarter as traders evaluated the possibility of world financial markets again falling off the rails as a result of the European crisis, but there are signs that the corporate debt markets are rebounding.

As we have previously written, world monetary authorities appear committed to avoid this outcome at all costs and 2012 will likely see a binge of deficit monetization throughout both the western and the Asian economies.  The liquidity they are creating is beginning to show up in loan statistics and, increasingly we are hearing from bankers that they are anxious to make loans.  In contrast to prior years the word “good” does not always precede the word loans in those conversations.  Past experience says that such a shift in thinking will lead to a lowering of underwriting standards and a return to cash flow based lending by the banks.  When that happens “Katy bar the door” – we’ll be in for a wild ride indeed!

So what does this mean for business owners and for the markets? Without sellers there can’t be an M&A boom and for several years most owners have been hunkered down rebuilding their balance sheets and profitability.  They’ve been reluctant to come to market with their businesses for fear that multiples would be too low or that they would be measured against mediocre earnings.  For a number of reasons we believe that may change this year.

• Owners are getting older.  The last good time that Baby Boom owners had to exit was five years ago when many were in their early to mid fifties.  Now they are nearing sixty and the oldest are already at what used to be retirement age of 65.  If 2012 offers them an exit window, they have to consider the possibility that they’ll be in their late sixties or early seventies before another exit opportunity comes along.  At that point personal health and mortality begin to drive exits regardless of the economic situation.

• Strong valuations depend on both the availability and the cost of financing.  It appears that 2012 may be a Goldilocks year in which loan availability grows, but pricing stays low.  That’s a formula for lots of deals at great valuations.  Down the road we anticipate a strong increase in inflation.  You can get all the details on that in this article.  Should inflation take off, interest rates will inevitably follow, but potentially with a significant lag due to the monetization efforts of the Fed and the other global central banks.  The math is simple.  Once interest rates begin to rise the discount rates used in valuation models will increase and multiples will drop so there’s a premium for first movers.

• 2012 may be the last year in which U. S. business owners can take advantage of a low capital gains tax rate on exit.  My colleague Abe Garver recently published a great piece on this subject.  Abe’s bottom line suggests that failure to sell during 2012 will cost business owners heavily should they fail to sell this year.

“After the ball drops on December 31, 2012, the federal long-term  capital gains rate will literally skyrocket 66.7% in one second  from 15% to 25% (21.2% plus 3.8% Medicare tax from Obama’s health plan).

In other words if you have owned stock in a public or private held company for at least a year and you don’t sell it before January 1, 2013, the gain will immediately be worth 13.3% less after-tax.”

• The world still suffers from a serious debt overhang that must be worked off over time.  Our belief is that short-term efforts to address the debt are going to generate a significant rise in inflation and a stronger than expected economy short term.  As we wrote recently our last experience with inflation in the U. S. did not end well.  Inflation and recession/depression are not mutually exclusive.  In such an environment many owners will find their companies under unexpected stress.  I recall a highly leveraged client in the early 1980s paying 21% interest on $5 million of debt incurred to carry inventory that was no longer selling.  The business survived, but it was not pretty.

• Globalization will lead to continued competitive stresses for many businesses, although the era of competition from ultra-cheap Asian labor may be coming to an end.  In many industries companies will find it increasingly difficult to compete on a domestic basis only and conclude that merger with a global competitor is the best solution.  We anticipate Indian buyers will return to the U. S. and European markets in force this year. Additionally the time is coming soon when Chinese buyers are freed to increase their purchases, particularly of U. S. based technology firms.

• The pace of automation/robotization is likely to increase in both the manufacturing and service industries.  This will put pressure on private firms in two ways.  Those that do not deploy the new technologies will fall behind and ultimately fail.  Those that do will find the process very expensive.  In addition to the direct capital costs incurred, major software systems changes are very disruptive and firms often pay a significant price in terms of short-term productivity while they struggle to adopt new business methods as well as the new technologies.  These costs are very difficult to finance and, for many firms, sale will be the best option.

If we are right and pressures are building for a significant increase in M&A activity, what does that mean for the markets? In our experience M&A booms are generally very good for equity markets.  Business sales free up capital that requires reinvestment.  This has a direct and immediate impact on equity markets as investors watch prices of publically traded targets jump and begin to look for other potential targets in which they can invest.  It also happens over time as sellers invest a portion of their sale proceeds in their public equity portfolios.  Additionally buyers are often able to leverage acquisition programs into a market perception of corporate momentum and increased value.  As this feeds upon itself, multiples expand with a symbiotic impact on the IPO market.  This was true in the early 1960s, the early to mid 1980s, the late 1990s and the mid 2000s.  Of course these episodes did not always end well and cycles are far more compressed now than in the past.

At this point everyone wants a party.  When it begins enjoy it while you can: the hangover will be a doozy.

Is 2012 More Like 1972 Than 1992?

Posted by John Slater on January 23, 2012

Newt Gingrich and Bill Clinton are quick to remind us that twenty years ago they lifted America from the depths of recession, initiating an unprecedented period of prosperity, jobs growth and balanced budgets. Sounds nice, but what if the America of today bears a closer relationship to 1972 than 1992?

In January 1972 America was a bit over a year past the recession of 1969-1970. We had spent much of the prior decade mired in increasingly unpopular wars that had placed a huge drain on the nation’s financial resources and we were headed toward a messy exit from our Asian adventure. The Democratic Party was so ideologically divided that it was preparing to nominate George McGovern as its presidential candidate and thus give a resounding second term victory to Richard Nixon. After hitting an all time high of just under 1000 in 1968, the Dow Jones Industrials had experienced a sharp drop during 1969-1970 recession, but had since rallied back to near its highs and was poised to continue to rise into the election season.

Source: Capital IQ

On the monetary front the U. S. had been engaged in a period of what we would now call quantitative easing, funding debts incurred in the Vietnam War through the printing of new money. M2 had grown 12% in 1971 and was poised to grow another 12% in 1972. As a result the U. S. was running a then unheard of balance of payments deficit and had been forced off the gold standard in August of 1971.

Subsequent events certainly did not turn out well for the U. S. While inflation remained comparatively mild in 1972 at 3.7% for the year, the rate of price growth jumped to 6% by the end of 1973 and 11% in 1974. The ensuing recession of 1973-1975 was comparable in severity for much of the U. S. to what we have experience so far in the “Great Recession”.

Further by building inflationary expectations into the system, the experience of the early 1970s set the stage for even greater inflationary damage later in the decade. On an inflation adjusted basis, stock market prices would continue to decline throughout the decade. Not until the shock treatment of the early 1980s was the Fed able to restore price stability and set the stage for two decades of growth and a twenty year bull market in the 1980s and 1990s.

Certainly there are significant differences between 2012 and 1972. By 1972 inflation had been building in the U. S. since the mid-1960s. Wage inflation was strong, running between seven and eight percent for much of 1972. On the other hand, the U. S. and the world at large had much lower levels of debt than we do today. Further, the inflation of the 1970s did not really take off until the oil shock of fall 1973.

Without a trigger it’s not all that likely that the U. S. will experience an inflationary shock. In fact the “smart money” continues to bet that we are on the verge of deflation, not inflation. Interest rates are at levels unheard of since the 1950s and the entire U. S. economy is dependent on borrowers continuing to enjoy low rates for “an extended period”. For the rest of this article, however, let’s think the unthinkable. Are you prepared to bet your entire economic future on the assumption that there will be no price shocks in the world over the next few years?

We’ve just published a piece suggesting that in 2012 we may witness a much stronger economy than is generally expected. Our thesis here is, should that occur, the U. S. may experience far more inflation than is currently anticipated.

(1) The U. S. and the world at large have witnessed an explosion of debt over the past three decades.

Source: Prometheus Market Insight

It’s difficult to envision a return to economic stability in the world without a significant reduction in debt levels in relation to income. The Boston Consulting Group recently published a very insightful analysis of Europe’s options for debt reduction. Certainly similar choices face other debtor nations including the U. S. as well. We’ll summarize the choices as

· Work hard to pay the debt back

· Default

· Inflate the debt away

I’m betting inflation is perceived as the least painful choice. As we wrote last week, it appears to us that the fix is already in. By continuing to fund massive federal deficits, the Fed is building the foundation for significant levels of inflation, absent aggressive action to pull back the liquidity just before things get out of hand. The only real question is when the inflation will start. This is an election year. What are the odds that the Fed would put on the brakes in time, were growth and inflation to explode just before the 2012 election?

(2) If you think that rapid money growth is a predominantly western phenomenon, look at the chart below courtesy of Dee Woo on Seeking Alpha. Where U. S. M2 grew from $5 Trillion to $9 Trillion from 2001-2010, Chinese M2 grew from $1.5 Trillion to $11.5 Trillion in the same period, even though the Chinese economy remains smaller that that of the U. S. Strong money growth continued in both China (13.6%) and the U. S. (9.6%) in 2011 Source: Seeking Alpha

(3) Price stability in the western world has depended on two significant factors: (A) the depressing impact of globalization on wage inflation in the western economies; and (B) increasing efficiency in the manufacturing, retail and service industries driven by the accelerating robotization of former human activities. While the latter is likely to continue unabated, the downward pressure on prices from globalization may have run its course. You may be surprised to learn as i was that reported U. S. inflation for 2011 was actually in excess of 3%.

So long as China remains tethered to the U. S. economy with its dollar peg, it would be misleading to analyze the U. S. market in isolation from China. Wages in China have been increasing rapidly. Inflation is increasing as well, averaging 3.6% on an annual basis for the four years ended October 30, 2011 and 5.6% for the latest twelve months, not far from the levels of inflation that sparked the Great Inflation of the 1970s in the U. S. A number of our clients have recently experience significant (20-60%) price increases coming out of China. Pressures to encourage domestic growth, reduce pollution and provide for a rapidly aging work force are growing in China. These will inexorably lead to increasing import costs in the West.

(4) We saw some respite in the latter part of 2011 in terms of commodity costs for energy, food and metals. Even so petroleum was at an all time high for the full year and prices do not show any signs of abating in 2012. Economic growth in the non-Western countries so far has come from a relatively low base in terms of per capita resource consumption. The law of compound numbers indicates that continued rapid growth in these economies means that they will take an increasingly larger share of world commodity outputs. That will provide an inflationary bias for the foreseeable future.

(5) While the data suggests that there is a good deal of excess capacity in the U. S. economy, past experience has shown that capacity can tighten more quickly that anticipated. We have seen signs with our clients of impending supply shortages in selected industries. Since 2008 a lot of plants have closed. Many employees have been laid off or retired. There are persistent reports of shortages in certain skillsets, particularly those requiring technical training, math, etc. Sure there is a huge overhang of unemployment at the lower end of the spectrum. 80% of the American workforce currently supports the most productive economy the world has ever seen. In that portion of the workforce, we are much closer to full employment than in the economy as a whole. Growth significantly above trend could easily spark significant wage increases in the higher skilled segment, even while the wages of unskilled workers remain stagnant. Remember that the bottom 20% of workers only command about 2-3% of national income. It’s the incomes of the 80% that have a material impact on production costs.

The implications of this prognosis, if it were to come about, are significant. The global capital structure is built around an assumption that inflation will remain benign. To the extent that leveraged institutions hold long-term debt instruments, inflation, were it to cause an increase in interest rates, could be as damaging to balance sheets as the mortgage crisis was in the prior decade. For borrowers the affordability of still high levels of personal and governmental debt depends on maintaining the relatively low interest payments dictated by the current low rate environment. That said inflation may feel good for a while if it coincides with a short-term growth spike. Enjoy it while you can.

Could 2012 Surprise to the Upside?

Posted by John Slater on January 22, 2012

In January we are trained to predict the likely course of the coming year and more often than not we get it wrong. This year virtually everyone has had the same prediction: “We’ll muddle along at around 2.5% growth unless something really bad happens and then all bets are off.” The outliers tend to focus on the possibility that we are heading for a recession based in part on the negative call from the Economic Cycle Research Institute (ECRI). Yet some of the economic data is not cooperating with the doomsayers and our observations in the real world are that business for many of our clients is not all that bad and is in fact improving.

What if the pessimists are wrong and 2012 turns out to be a far more positive year for the economy than many are predicting? While the jury is still out, the data continues to improve in terms of employment and consumer spending.

Credit to Hale Stewart who recently published this and a number of other charts supportive of a positive economic case on Seeking Alpha. What’s the chance he could turn out to be right? Ignoring for the moment all the could go wrongs, what’s the case for a far stronger 2012 than is currently being predicted?

1. Everyone wants things to get better. This is not trivial. After four years of depression, everyone longs for the good old days. 2012 is predicted to be the best year since 2007 for the travel industry. What happens if Americans who have been accumulating dry powder for the past four years suddenly loosen their purse strings?

2. The Fed is committed to a massive and continuing program of monetizing the massive deficits the federal government continues to run. As we wrote recently, this has created a huge overhang of reserves in the banking industry. Should the banks begin to use these reserves to support new credit creation the impact would be significant.

3. The banks may be doing exactly that. For the first time since the crash we can see positive movement in new bank credit creation.

Source: St. Louis Federal Reserve

In our investment banking practice we stay close to lender who can fund our client’s growth and provide the financing to make our M&A deals happen. For the first time in years, we are seeing evidence that some banks are getting serious about making commercial loans. Bank earnings were reported this week with varying results. While many banks are still suffering from the effects of the crash, a few, such as Wells Fargo, appear to be making real progress. It’s not hard to imagine that somewhere in America a bank CEO pulled his troops together this week to ask what could be done to put their institution on the positive side of that comparison. In response someone on his team may have actually suggested that banks used to make money by making loans. Multiplied across the economy, the impact could be significant.

4. This is an election year. With the exception of 2008, recent election years have generally been very good for the economy.

Source: www.econointersect.com; Seeking Alpha

5. Outside of the western economies, the world continues to boom. Many believe that China is at risk of a hard landing, but the likelihood that 2012 is the year for such a negative outcome is quite low. China is in the midst of a historic transfer of leadership. The Chinese government will do everything possible to assure that this transfer does not happen during a period of economic crisis. They have many tools, including trillions of dollars of currency reserves, they can use to keep the music playing and have shown a past willingness to do so. Ongoing growth is certainly not limited to China; even Africa shows promise of real economic progress. The U. S. economy will continue to benefit from this ongoing explosion of global growth.

6. Finally and closer to home we are seeing signs of a pickup in merger and acquisition activity. Our industry has been in a deep depression since 2007. While there has been plenty of money on the sidelines in private equity and strategic coffers, weak private company earnings and the dearth of bank leverage have kept the lid on the deals market. Recently our new activity pipeline has shown signs of increasing strongly and we’ve heard reports from a number of law firms that their securities and transaction teams were quite business in Q4 2011 with strong activity sustained into 2012.

The deals business is an important barometer of economic activity. Deals generate fee incomes to banks, law firms, accounting firms and investment bankers with a significant multiplier effect in local economies. Equally important private company exits free up a significant amount of investment capital and former owners who have liquefied their business have a relatively strong predilection to support new ventures as angel investors and to invest a meaningful portion of their new liquidity in equities.

2012 will provide us with plenty of surprises. We’re just contrarian enough to suggest that one of those surprises may be a much stronger economy than the consensus expects.

Is QE3 Already Underway?

Posted by John Slater on January 17, 2012

Much ink is being spilled on when/if the Fed will move to the next iteration of its quantitative easing program. That’s the wrong question. The Fed and the world’s other major monetary authorities have effectively been captured by national treasuries running historically high budgetary deficits and their chief function has become the funding of governmental expenditures that cannot or will not be funded through taxes. Continued pressure to monetize the debt is a foregone conclusion so long as the deficits continue at their current levels.

A year ago we explored Chairman Bernanke’s position that “QE II (the purchase of long term Treasury Bonds by the Federal Reserve) is not inflationary and has not created an explosion of the money supply.”

How could it be the case that rapid monetary expansion could be accomplished without an inflationary impact? Keynes, though much maligned and misused, provided a clear explanation for this one with his description of a “liquidity trap”. In normal credit environments new reserves added to the banking system are magically multiple through the working of fractional banking, creating a significant multiplier effect on business activity throughout the economy.

In a liquidity trap this no longer works; reserves just sit at the banks and the money multiplier sinks. That’s where we are today as recently outlined by Paul McCulley, Chairman of the Society of Fellows of the Global Interdependence Center and former PIMCO trader, in a recent CNBC interview. As a result the Fed has been able to create in excess of $1.5 Trillion of excess bank reserves since the 2008 crash

(Click to enlarge)

Looked at globally, the trend is even more dramatic.

(Click to enlarge)

Source: Zero Hedge

The size of the combined Federal Reserve, European Central Bank and Bank of Japan balance sheets has grown from a historical norm of approximately 12% of their respective GDPs to 24% of combined GDP since 2008 and now total in excess of $8 Trillion. Yet inflation is still relatively subdued globally and fear still abounds that we are headed for a round of deflation and severe recession.

In our last post on the subject we were inclined to give Bernanke the benefit of the doubt. He understood well the risks of the liquidity trap and was aggressively pursuing actions to prevent it from driving us deeper into a global depression. So what has happened since then? Certainly events to date have supported the view that the Fed’s actions in creating this massive amount of liquidity were necessary. Absent these actions the U. S. economy would almost certainly have fallen into a severe recession in 2011.

While we gave Bernanke a pass last year, we are less inclined to do so now. A new element has entered into the picture: the capture of the central banks by national treasuries desperate to fund unrelenting deficits throughout the world. The central banks are in effect printing massive amounts of currency to fund government deficits worldwide. They have enabled their governments to substitute debt monetization for taxation.

Looking at the recent course of U. S. deficit funding presented in the chart below, it is apparent that something very new occurred in 2011. From 2008 to 2010 the deficits were funded predominantly by U. S. households and overseas investors. This had the effect of neutralizing the inflationary impact of the deficits.

U. S. Deficit Funding (Source: Federal Reserve Flow of Funds Guide F.209 and Clear View Economics)

(Click to enlarge)

In 2011 the situation changed radically. During Q1, the Fed purchased treasury securities at twice the rate of new debt issuance while households liquidated their treasury holdings at a rapid rate. Q2 reflected a similar pattern, though not so extreme. The financial crisis in Europe provided a respite in Q3 as overseas investors flocked to dollar denominated assets, but the funding needs were so dramatic that the Fed continued to monetize debt even in a period of otherwise favorable flows.

A year ago, while defending quantitative easing as necessary to keep the economy on even keel, Bernanke assured the world that, were inflation to rear its ugly head, the Fed could raise interest rates “in fifteen minutes” if necessary. So far the dampening effect of the liquidity trap has made such action unnecessary.

Because of monetary capture it will become increasingly difficult for the Fed or its counterparts overseas to cut off the spigot when inflation threatens. With government debt levels in major nations worldwide at or approaching 100% of their domestic GDPs, a dramatic increase in interest rates would have a devastating impact on national budgets. In such an environment it is easy to imagine that the path of least resistance will be a tendency on the part of the central bankers to accept a higher level inflation as the smaller price to pay.

Inequality Debate Based on Bad Data

Posted by John Slater on December 19, 2011

America is stumbling toward one of the most important decisions it has made in decades: how to bring our financial accounts back to a sustainable balance.  Due to a lack of perspective on tax policy over time, the political decision makers and the media have accepted misleading data with regard to an assumed increase in inequality of income as the primary framework for the debate.

With tax receipts at historic lows and expenditures heading for the stratosphere, no rational observer doubts that this decision will entail a combination of both spending cuts and tax hikes.  Republican rhetoric aside, the real question on the tax side of the debate is how these tax increases will be structured.  I am increasingly concerned that Congress will make a huge mistake that will penalize the mid-sized businesses, i.e. growing companies with 50 to 500 employees, that serve as the backbone of American productivity and that are the only hope for domestic jobs growth.

Let’s start with a bit of history from my personal experience, first as a business and tax lawyer and for twenty-eight years as an investment banker serving entrepreneurial businesses in M&A and arranging business financings.  When I started in practice, essentially all substantial businesses with which we worked were structured as C Corporations.  A typical client might be a manufacturer with 100 plus employees, revenue of $10 million plus and pre-tax profits of $1-2 million.  The owner often took a surprisingly small salary, say $100-125,000, paid a small amount of personal expenses from the business and retained the rest of the company’s profits in the corporation.

As a result of changes in federal tax law and the parallel development of Limited Liability Corporations (LLCs), a major shift from C-Corporations to pass-through entities began in the middle 1980s.  To demonstrate how dramatic this shift has been, IRS data shows that pass through income (S-Corps, Partnerships, REITs  and regulated investment companies) increased from 1.5% of adjusted gross income in 1980 to 14.9% of adjusted gross income in 2008.  If we look only at S-Corps and Partnerships, which comprise the core of entrepreneurial America, from 1980 to 2008, these entities’ share of total AGI increased from less than 1% to 9.2% of income.  While not all of this income went to the top 1%, a substantial amount did.  If we look only at the ratio of S-Corp and Partnership income to top 1% income, the percentage share increased from 7.8% to 46%.

This shift has a dramatic impact on the perception of increasing income at the wealthiest levels of society.  To explain why this is the case, consider our example above of a typical entrepreneurial firm.  That same highly successful business that generated $10 million in revenues in 1984 and produced pretax profits of $1.5 million might today generate $25 million with pretax profits of $2.5 million, reflecting inflation and a decline in profit margins over the period.

But the impact on the income accounts has been dramatic.  Where the owner of the business reported $125,000 in personal income in 1984, in 2011 he will report $2.5 million in personal income because he converted the business from a C-Corp to a pass-through entity (S-Corp or LLC).  Most of his after-tax income will be ploughed back into the business, leaving him with a salary of perhaps $200,000.  So the business owner is actually worse off after inflation than he was thirty years ago in terms of spendable income, but the Occupy Wall Street placards scream that our business owner’s increase in reported personal income from $125,000 to $2.5 million proves that inequality in America has increased alarmingly.

The inequality debate is based on a seminal paper written by Thomas Piketty and Emmanual Saez.  This paper depends primarily on a documented shift in the percentage of reported income received by the top 1% of earners from 10% in 1980 to a peak of 23.5% in 2007.  Due to the recession, the top 1% share had dropped to 17% by 2009, around the same level as 1998.  Proponents of the inequality debate were quick to say that the income differential will rapidly return as the economy improves when, in fact, that income has merely been shifted from corporate to individual income tax returns

Piketty and Saez have generated a highly scholarly and in depth analysis of the shifts in income tax collections over time.  If you want to dig into the Piketty and Saez data for yourself, download it here.  I don’t fault their data so far as it goes.  Instead I take issue with the conclusions reached because the data is based on income tax receipts and the conclusions fail to take into account one of the most important shifts in American tax policy since World War II.  The Tax Reform Act of 1986 caused a major shift in business ownership from C-Corps to pass-through entities and this has skewed the data to make it appear that the top 1% of earners are receiving a larger share of incomes.

The magnitudes of the shift support my conclusion.  Pass-through income’s share of net business income reported for tax purposes increased from 4% to 73% of all business income from 1980 to 2008, while C-Corps’ share fell from 75% to 22%.  Piketty and Saez’s own data shows the share of what they define as entrepreneurial income (S-Corps and Partnerships) increased from 7.8% of incomes for the 1% in 1981 to 28.3% of top 1% incomes in 2008.  These changes are of a magnitude sufficient to explain a significant portion of the shift in incomes to the 1%.

My purpose in writing this is not to defend hedge fund billionaires or traders milking the government sponsored banks.  We have a real problem in this country.  Tens of millions are unemployed or underemployed and that is the most critical issue we face.  My problem with the current debate is that the controversy over the “1%” is likely to be used to punish the very people who can solve the problem, America’s entrepreneurs.  I don’t want to see that happen just because of a misreading of the income data.

Are Derivatives Accounting Rules Helping the Big Banks Overstate Their Earnings?

Posted by John Slater on November 21, 2011

Profits do not mean the same thing for the major banks as they do for ordinary businesses.  If you manufacture or distribute widgets, calculating your profit on a sale is pretty straightforward.  What did it cost to acquire or make the widget? What did you sell it for?  The difference is profit.  For a broker/dealer it works pretty much the same way.  What did the bond cost me?  What commissions did I pay?  The difference is profit.

Now consider the case of the major money center banks.  Thanks to the repeal of Glass Steagall they are in the position to act not only as a broker dealer, but also as a principal, holding the financial instruments they create in their long-term investment book.  During the heyday of the mortgage securitization boom, this permitted the banks to package bundles of mortgages into mortgage-backed securities (MBS), booking a hefty spread in the process.  The MBSs could then be repackaged as collateralized debt obligations (CDO) and the CDOs could then be re-repackaged an infinite number of times as synthetic CDOs thanks to the magic of credit default swaps.

At each step of the process the bank earned a hefty origination spread, the investment bankers, brokers, lawyers and a myriad of consultants and rating agencies made their commissions and fees and everyone was happy, at least as long as the securities could be pawned off to some Norwegian village north of the Artic Circle.  At some point the music stopped and the Norwegians went back to hunting reindeer, but not so the bankers.

Thanks to the repeal of Glass Steagall the banks were able to find new customers for the convoluted structures their well-oiled machines were churning out by the hundreds: they held them on their own books.  By booking the securities at “retail” this process enabled the banks to continue reporting record profits right up to the day when the world learned that the Emperor had no clothes.  Not only were the profits they had booked imaginary, so were many of the securities on which they had been based.

Thankfully that insanity is past us.  Or is it?  The securitization market may be closed, but the big banks are engaged in a bubble of even more epic proportions. Take a look at the chart below tracking the growth of the financial derivatives market.  The total notional derivatives exposure of the four largest derivatives market participants, JP Morgan, Goldman Sachs, Citibank and Bank of America, was $235 Trillion as of June 30, 2011.  We’ll refer to these as the TBTFs (too big to fails).  From the end of 2008 to June 30, 2011, a period of very sluggish economic growth, their notional derivative exposure was up 35%.

Derivative Notionals by Type of User

Insured U. S. Commercial Banks

Source:  Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities – Second Quarter 2011

We’ve written about derivatives before.  In articles we posted  April 7 and April 8 2009 we questioned whether the U. S. understood what it was really taking on by bailing out the largest Wall St. banks.  Obviously that risk has continued to grow at a very rapid rate since the bailout.

Besides the growth of this market at a rate far higher than underlying economic growth, the chart reveals something interesting:  almost all derivatives exposure is for trading accounts, with only nominal exposure to end user contracts.  In other words almost all of this activity amounts to casino gambling.  What’s not apparent from this chart is that there are only four players at this table.  From the end of 2008 to June 2011 the derivatives market share of the five largest players, the TBTFs plus HSBC (in a very distant fifth place with 1.2% of the market) grew from 93.7% to 96%.

You might ask what supports this growth?  During the first six months of 2011 the TBTF holding companies booked trading revenues from these activities of $37 billion – enough said.  The more interesting question is where did these revenues come from.  That’s where things get interesting. To make things a little easier to understand, let’s assume a simpler market where two parties decide to trade something basic, say apples and oranges.  Let’s assume for now that the prices of apples and oranges is fixed in the outside market so there is no inflationary profit to be made in the apple/orange market.   While one of the participants may outsmart the other and make a profit at his expense, the market wide profit in the apple/orange market must be zero.  Increase the number of market participants to four and there is still no way for all four market players to profit.  If someone wins someone else must lose.

At this point someone is ready to jump in and say derivatives are different, Slater just doesn’t understand the complexities of the market, or the accounting or whatever.  If so I may be in pretty good company.  It became painfully obvious after the 2008 crash that the CEOs of some the largest financial institutions in the world did not understand the accounting implications of the hundreds of billions of mortgage securities on their books.

So let’s consider how this might work in the world of derivatives.  First, let’s consider what a derivatives transaction entails.  At the end of the day these are insurance transactions.  You’re concerned that interest rates are going up.  I agree that at some point in the future, say five years out, I’ll cover the risk that rates will rise past a certain point.  If rates don’t rise, I pocket the insurance premium you paid me.  If they do rise, I will lose not only my insurance premium, but potentially a lot more, as happened to the banks with the credit default swaps in 2008.  That’s where notional risk comes in.  Potentially I’ve got a huge amount to lose if all my bets go wrong.  In theory the TBTFs could lose three to four times the world’s GDP.  That would be a tough margin call to meet.  But we’re assured that’s not something to worry about because all the exposures are covered by bets the players have made on the other side of the same trades.

Based on the apple/orange example, it’s hard to see how anyone makes money if the books are truly matched.  For every winner there must be a loser.  Yet we are told that the TBTFs made $37 billion writing derivatives contracts in the first half of 2011.  So how might that happen?  How could all the players in a market make money from trading?  One example is a rising market.  Gold prices have risen over six hundred percent over the past ten years.  In a market like that it’s pretty easy to imagine that everyone in the market was making money.  Of course everyone made money for a while trading tulip bulbs as well.

With derivatives its hard to imagine that there’s some sort of bull market driving the profitability of the traders.  So let’s consider another possibility.  Imagine the following fable. Giuseppe Borgia, is a trader at Banco Ponzi (BP), a fictional global bank that participates in the derivatives market.  It’s November and Giuseppe hasn’t had a particularly good year so he’s worried about his bonus.  Giuseppe calls his friend Henri at Groupe Pyramide (GP) and suggests a trade.  If Henri will buy a five year $1 billion swap from BP on the 10 year U. S. Treasury, BP will buy an identical contract from GP.  Since each bank uses a sophisticated risk analysis model that demonstrates that the risk based pricing of the contract predicts a profit of 3%, over the life of the agreement, each participant can book a profit of $30 million and Giuseppe and Henri can each enjoy a very fine Christmas indeed.

You might say “Wait! surely the accountants, or the due diligence people, or management, or the regulators will figure this out and prevent it from happening.”  If the market were as simple as my example, they would, but imagine that instead of Giuseppe and Henri, we are dealing with a highly complex market where hundreds of traders at four banks trade among each other every day.  Instead of a blatant fraud like the one in our example, we witness aggressive trading behavior where the participants think that they are working to outsmart the market and are well paid for doing so.  But at the end of the day the result in the same, thousands of contracts, each individually enabling the traders to book a profit under the accounting rules that govern their activities, but collectively generating the same result, a matched book of business that is priced on the participants accounting records to include the “profit” each player recorded when they put on the trade.

Of course the problem with such a market is that when the trades unwind someone must take a loss.  To offset these losses additional trades must be booked.  And for the market participants to continue to generate net profits the market must continue to grow, eventually at an exponential rate.  Since the profits are book profits, not cash, you might ask where the cash comes from to cover the bankers’ bonuses, $2500 dinners, town cars and other costs entailed in operating such an expensive operation.  In the absence of another candidate, the only mark still at the table would appear to be Uncle Sam, in the form of the FDIC and the Federal Reserve that serve as the liquidity sources of last resort for the TBTFs.

So let’s hope my little fable turns out to be just that.  Perhaps I just don’t understand the accounting.  Perhaps there are other players at the table and the bill is really being paid by Saudi Princes, hedge fund titans or Russian oligarchs.  If not it looks like the American taxpayer better get ready to pick up one more chit and this one is going to be a real doozy.

Preparing for an Asset-Based Financing

Posted by John Slater on November 20, 2011

Many businesses have recently faced a new reality when they are abandoned by their traditional commercial banks and are forced to search for non-traditional sources of capital. Commercial banks have tightened their credit standards dramatically over the last several years or have abandoned commercial lending entirely. For many middle market distributors, manufacturers and service firms, asset-based lending (“ABL”) may be the best alternative.   Such firms typically have plentiful working capital assets that have historically not been leveraged to their full potential.

The basic concepts of an asset based financing are simple.  Rather than rely on balance sheet ratios or the earning power of the business, the lender can advance funding based upon the expected net liquidation value of the available collateral, typically inventory and receivables.  In theory asset based lenders (sometimes call “hard money lenders”)  can provide funding to even the most troubled borrowers.  In fact debtor in possessions (“DIP”) loans in Chapter XI bankruptcy have been a stock in trade for a number of such lenders.

The reality of ABL financing turns out to be more complex.  Most ABLs do care about the financial condition of their borrowers and will expect to see historical cash flow performance that supports loan payment plus a comfortable cushion. The resulting financial package will often include a variety of constraints, many of which the borrower may not be aware of until the closing table:

• Restrictions on advances, dividends, and other related party transactions

• Restrictions on capital expenditures and leases

• Strictly constructed personal guarantees (including spousal)

• Tight financial covenants

• Requirements to maintain excess liquidity or deposits

• Reserves for technical collateral protection issues (landlord payments, payroll taxes, lender-perceived weaknesses in working capital collateral, etc.)

• Prohibitions on disposition of assets

• Prohibitions from entering alternative financial arrangements and acquisitions

• Surrender of cash management to the lender

Planning for the Transaction

It is extremely important that the borrower understand these issues in advance so that he can position his business and balance sheet to minimize the structural constraints of a typical asset-based transaction, while obtaining the maximum benefit of leveraging the collateral.  We have outlined below some of the key issues to consider when preparing to go to market for an asset-based loan.

Getting personal finances in order

While larger ABL deals may be non-recourse to the borrower’s shareholders, most ABL financings under $10 million will require very strict personal guarantees prohibiting the guarantor from significantly transferring assets to other parties, requiring spousal guarantees, and other restrictive requirements.  In addition, the lender will most likely restrict or totally prohibit advances and other payments to the business owners outside of pre-negotiated salary and bonus amounts.

The owners should establish reasonable compensation guidelines for themselves and senior management, obtaining proper board of director approval prior to taking the deal to market.  The business owners should assure that their approved compensation is satisfactory to maintain their lifestyle requirements, as increases in compensation will likely require lender approval.  This may be difficult to obtain absent evidence of substantial performance improvement in the business.

The owners should consult with counsel regarding setting up trusts, estate planning, and other tax-advantaged vehicles (profit-sharing plans, SEP plans, etc.) prior to entering into a financing.  The owners will likely need lender consent to establish these types of plans after their company has closed an asset-based transaction, particularly if corporate assets or securities are involved in the plans.

Ensure that personal assets are properly titled.  For example, if the owner has purchased her child a car, she might consider placing the car title in the child’s name.  If the owner shares or has inherited a second home with others, ensure the ownership interests are properly segregated to shield equity held by third parties from the personal guarantee of company debts.  Similarly if a spouse not directly involved in the business has separate assets through inheritance or otherwise, it may make sense to establish trusts to shield those assets from the lender’s grasp.  Many attorneys recommend LLC structures of secondary real estate holdings for a variety of reasons and such a structure could be advantageous in protecting third parties from corporate obligations.

Prepare a very detailed monthly financial plan and identify all significant cash needs in the near future

Being aware that the borrower may be restricted in its use of cash under an asset-based loan agreement.  Working capital asset levels almost always vary seasonally, so it is imperative that the potential capital structure from an asset-based financing is adequate.  The rule of thumb is the company probably won’t be able to negotiate any more liquidity from the lender than is provided for at the date of closing, and should plan accordingly. If the borrower has a major capital expenditure item or other non-recurring cash need, make it a part of the financing request.  Lenders are generally amenable to providing for specific growth items in the initial financing package, but once the relationship is turned over to account management, their job is to get the money back.

Understand both the approval process and the relationship management of prospective capital providers

If the borrower is used to dealing with a commercial bank, it most likely had one relationship manager who sourced the relationship, closed the transaction, and managed it going forward.  Each of these functions is segregated in asset-based lending.  The calling officers are compensated solely to bring in business.  Due diligence is handled by a team specific to new business underwriting.  Two groups handle account management:  collateral analysts monitoring the asset quality and account executives responsible for overall account management.  Additionally, an independent group or a separate bank generally performs cash management if the lender is a non-bank commercial finance company.  Insist on meeting account management personnel prior to closing. These are the people the company will be dealing with throughout the relationship.

Stress test the structure

Take the company’s business plan and stress test it for factors that might arise, including both negative shocks and positive growth scenarios.  Either may pose liquidity issues for the business.  These tests will verify if there is adequate liquidity to deal with volume drop offs, seasonal issues, vendor terms (both existing and prospective), cash flow timing, margin pressures, or product development cycles.  The lender will perform a similar exercise, but they certainly don’t have the detailed knowledge of what might or might not happen to the business that the owners and senior management will have.  With the information gained through the stress test process, the borrower can often negotiate structural flexibility on the front end to provide for predictable contingencies.

Clean up the books

Lenders will perform various standard due diligence tests on collateral; however, the borrower can go a long way in getting a satisfactory structure if it: (1) writes off stale accounts receivable; (2) segregates or disposes of obsolete inventory, (3) discloses and provides structures (e.g. credit insurance) to address customer concentration issues, and (4) asks customers for payments on overdue but collectible amounts prior to due diligence.  The advance rates and other terms in a loan proposal are the highest possible amounts.  Even in a normal due diligence process, expect net advance rates to be 5 to 10 percent lower than initially proposed.

Consider multiple lenders

Running lenders “parallel” is a time consuming and costly process for both senior management and the accounting staff, but if there are potential wide varieties of interpretation of various issues the lender will encounter, consider more than one lender in the process.

Be aware of intercreditor issues

If the company has subordinated debt, seller notes to a prior owner, or indebtedness to controlling shareholders or other investors, expect considerable negotiations between the senior lender and junior capital.  Sometimes it is best to start over and replace all tranches of the capital structure.  It is easier for parties coming in new to a situation to negotiate terms than to restructure existing agreements.  If there are third parties involved with whom the company has little or no influence, this could be a deal killer. It could be prudent to address intercreditor issues  before engaging lenders to perform due diligence.

Watch for hidden costs

The stated interest rate in an asset-based financing can often be misleading for the borrower.  Extra fees like maintenance fees, deposit float, audit fees, and up front closing costs can add 2 to 3 percent  to the total cost of the financing.  Prepayment penalties can be burdensome if the financing is only needed for a short-term.

Negotiating Strategies

Business owners who have not previously been involved in an ABL transaction may be tempted to treat the process as they would historically have addressed a bank loan application.  In the past obtaining a loan was a matter of advising a few bankers that the loan was up for renewal, letting the bankers buy lunch, giving a tour of the facility, sharing some financial statements and waiting for the proposals to come in.  Unfortunately that world now fits in the same museum as the rotary telephone and the teletype machine.  In today’s hyper-competitive financial markets, preparing to go to market for financing is every bit as serious an undertaking as preparing for major litigation.  In the sections below we have outlined some of the tactics we utilize to assist our clients in navigating these treacherous waters.

Preparing to Attack the Market

Step one is a comprehensive due diligence exercise designed to identify in advance all of the issues likely to be of concern to prospective lenders.  We work to identify both the strengths and weaknesses of the business and emphasize the strengths, while addressing (but not ignoring) the weaknesses. In the due diligence process it is also important to gain a good understanding of the goals, both business and personal, that the borrower hopes to achieve with the financing.  The end result of this process will be a comprehensive loan request and disclosure document that answers all critical questions prospective lenders will ask.  While this is most definitely a sales document, our view is that real issues must be addressed up front, not sugarcoated.  It will be far more expensive if the prospective lender learns of a material issue (e.g. a major lawsuit) than if it is addressed forthrightly early in the process.

Negotiating with Existing Capital Providers

Sometimes a firm’s existing lender may be the best prospect to continue providing financing for the company.  Perhaps the issue driving the need for refinancing can be as simple as restructuring the existing funding to fit the changing regulatory constraints of the incumbent lender.  Often, however, a transaction is driven by the existing lender’s decision that the loan should be moved.  In such a case it is critical for the borrower to buy sufficient time to explore the available options.  Inserting a third party intermediary into the process provides the lender with assurance that action is being taken that will achieve the lender’s ultimate goal of getting paid.  This removes some of the time pressures that can become intense in such situations.

Knowing the players

Each deal has its own personality and the lenders that will find a logistics outsourcing provider attractive may not be the same as those that will chase a healthcare services firm.  FOCUS understands the various institutional biases of the current lenders and can match those against the needs and issues of specific borrowers.  We also track new entrants to the marketplace.  These institutions tend to be the most aggressive, but also bring the risk of indecision and inconsistency as the institution itself experiences start up pains.

Negotiating perspective

Everything is negotiable to some extent.  There is a lot of give and take in the various structural requirements of an ABL deal.  Lenders are willing to soften their position on things like hard guarantees, intercreditor issues, and pricing if the borrower’s message and goals are communicated concisely, collateral is well-performing, and cash flows are easily understood.

Structuring

How the deal is structured is at least as important as pricing for most ABL financings.  Issues such as funding availability vis-à-vis inventory and receivables can be the difference between a doable deal and a non-starter.  These issues need to be addressed upfront when there is competitive pressure and the business development representatives of the lenders have maximum incentive to carry the ball on behalf of the prospective borrower.

Shaking out the pricing

We have an Every Dollar Counts philosophy.  It’s important to do a detailed analysis of each proposed structure to determine the comprehensive all-in cost over the life of the credit facility, taking into consideration the nuances of timing of cash receipts (e.g., if the borrower’s collections are weighted toward the end of the week, it will want float calculated on a calendar day basis, not business day), upfront costs versus recurring costs, and any other hidden costs of the financing (for example, a bank charging wire fees for intrabank transfers).

In summary, asset-based financing can be a superior and cost effective financing structure for many businesses, but ABL is a much different world than commercial banking.  Preparation is critical, negotiation is a must and knowledge and experience have a significant impact on the ultimate outcome.

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.

John Slater, Focus LLC Partner and Capital Financing Team Leader, has spent more than thirty-five years assisting private companies arrange debt and equity financings and  advising middle market firms on mergers and acquisitions.

Gear Up for the Refinancing Wall

Posted by John Slater on November 14, 2011

Remember the fall of 2009? We had just survived the worst financial crisis since the Great Depression and the stock market was enjoying the early stages of a very powerful bear market rally. We could all breathe a great sigh of relief. Of course a few party poopers were still around to remind us in articles like this one published by the Wharton School that a mountain of debt built up during the bubble years of 2006 and 2007 would need to be refinanced by the middle of the next decade. This debt, measured in the trillions of dollars, encompassed both commercial loans–many generated to support highly leveraged buyout financings–and commercial real estate funding.

Source: Ancala.com

No need to worry, 2012 was a long way in the future. Well that future is now and Wall Street is again teetering on the brink of panic. Many firms that survived the crash have seen their profits–if not their revenues–return to past highs. Large profitable corporations have successfully refinanced much of their debt with very low cost long term bonds. For much of 2010 and the first half of 2011, strong high yield and leveraged loan markets enabled even middle market firms to stabilize their debt with relatively low cost funding as well. So the question is, “Have we dodged the bullet?”

Unfortunately, two recent reports answer the question with a resounding NO. The Financial Times, in an article entitled “Door Slams Shut for Corporate Have-Nots,” describes a two tier world in which a few very strong companies like Apple Inc. have taken advantage of the recovery to build up tremendous hordes of cash. On the other hand, weaker firms remain overleveraged and at extreme risk in the event of another financial crisis or a material rise in interest rates.

To accentuate the depth of the problem, KPMG recently published an in depth study entitled “The Refinancing Wall,” estimating that corporate debt maturities from 2011-2015 total $5 Trillion worldwide and that LBO maturities from 2011-2016 total almost $1 Trillion. Add to this approximately $2.75 Trillion in commercial real estate maturities and a market experiencing strong worldwide competition for funds to finance government deficits. We can reasonably anticipate that there will not be enough chairs in the circle when the music stops.

What does this mean for the lower middle market? Traditionally, commercial banks have been the primary source of funding for firms under $100 million of revenue. Since the crash, many banks have been merged out of existence or have exited commercial lending. The commercial lending capacity that remains, including both human and capital resources, will be heavily focused on workouts and restructurings for the next two to three years and will not be available to assist smaller companies with financing, no matter how promising their opportunities for growth.

Now is the time to prepare for the day when you, as a business owner, excitedly call your friendly and fresh faced loan officer, “Alexandra Silvermore,” only to find that she has been replaced by “Gustaf Bonbrecker,” who was recently assigned to commercial lending following a four-year stint in special assets. So what are the alternatives for a sound, growing lower middle market manufacturer, distributor, or service firm?

1. Asset Based Lenders (ABL)have traditionally filled the void left when traditional commercial loans are no longer available or adequate for the needs of a growing company. ABL providers rely primarily on the liquidation value of their collateral to provide assurance against loan losses and are not overly focused on the borrower’s profitability.  In recent years ABL providers have become much stricter in underwriting the credit of their borrowers and in assuring the quality and value of their collateral. Additionally most ABL providers are not fond of fixed asset collateral such as equipment and real estate. Term loans collateralized with such assets are generally financeable by ABL providers only as a small percentage of a larger loan facility comprised primarily of inventory and receivables.  

   The cost of ABL financings in the current market ranges from highly competitive interest rates in a range of 2-3 percent over the London Interbank Offered Rate (Libor) for the strongest borrowers with larger financing requirements ($10-15 million and up) to all in costs, including interest and various fees, that can range into the high teens for overall financing costs and we have seen even higher rates charged to clients with great cash flow, but limited financing flexibility. Most ABL providers want to see a minimum funding need of $5 million plus, with leading players like PNC, Wells Fargo, and USBank targeting needs in the $15-125 million range. A few specialized lenders will provide funding down to the $2-3 million range, but price their offerings accordingly. For more details on the ABL market, read Bob Beard’s in depth coverage at www.capmatters.com. 

2. Mezzanine Lenders have traditionally filled the gap where asset based loans do not fill the entire need. The term mezzanine is derived from the positioning of these loans in a borrower’s capital structure between senior debt (frequently ABL) and equity. Mezzanine lenders generally look to the cash flows of a business as their primary source of repayment, though some mezzanine lenders will take second lien positions as well to enhance their potential for recovery in a bankruptcy. Mezzanine loans are traditionally structured with a five year term, interest only with a principal bullet at maturity. Current pay interest is generally in the range of 12-13 percent with additional yield in the form of payment in kind (PIK) interest of 2-3 percent.Depending on the credit quality, the size of the facility, and other factors, the mezzanine lender may or may not require equity warrants to enhance their yield. Generally in the lower middle market, mezzanine lenders target total annual returns ranging from the mid-teens to low 20 percent range. Larger facilities can be more competitive with targeted yields in the low teens. Several billion dollars of new mezzanine capital has been raised in the past twelve months, providing adequate liquidity for those borrowers for which this type of funding works.The most important constraint is that the mezzanine lenders generally are very rigorous in demanding that their borrowers have good histories of adequate cash flow to cover anticipated debt service. This can pose a challenge to firms hit by the down cycle in 2008-2009. Also, for lower middle market firms, this means that total leverage (senior and mezzanine) cannot exceed 3-3.5 times cash flow with outliers at either end of the range depending on credit quality, growth prospects, etc.

3. Tranche B or second lien financing developed in the late 1990s to meet a desire on the part of many borrowers to minimize equity dilution from mezzanine warrants. These structures often piggyback on the senior loan structure, but carry a full subordination to the senior. In the current market, such subordinated debt will typically carry a yield premium of 4-6 percent over senior debt. Tranche B loans were commonplace in the 2005-2007 timeframe as billions of hedge fund and CDO funding poured into the market. With the collapse of the shadow banking system in 2008, only a few of these funds remain active today and many of those that do are more focused on unitranche funding as described in item six below.

4. Growth Equity financing is increasing filling in gaps for quality firms for which senior debt plus mezzanine is not sufficient. Many mezzanine firms have recently included such financing as a standard part of their package, in some cases as well as to enhance the credit quality of the mezzanine piece. Growth equity usually takes the form of preferred or common stock (or a member’s interest with equivalent priority positions in pass through entities). The preferred stock will generally carry an expected dividend coupon, often with a PIK feature to minimize the cash flow impact. In general growth equity financiers are seeking annual returns ranging from the mid 20s to the mid to high 30s depending on perceived risk, opportunity for growth, etc.

5. A variety of governmental programs are in place for smaller companies to fill the needs served by growth equity as well as mezzanine financing. These include federally subsidized SBICs as well as a variety of state sponsored programs generally described under the category of business development companies. Financing structures and cost of funds are not dissimilar from the cost of commercial fundings, with federally mandated yields caps sometimes generating lower costs of funds than the commercially funded vehicles. Read more…

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