In the aftermath of THE coming-out party of late June (we refer to the Blackstone IPO rather than Paris Hilton’s perp walk), a client of ours weighed in – with some astute sarcasm – on the shift to a New World of risk: The Old one had supposedly ended a week earlier when the Blackstone IPO placed an unfathomable $30 billion-plus value on the world’s hottest private equity investor (a crescendo of growing exuberance and activity among hedge funds, private equity, real estate and other leveraged investors). But the New World seemed to offer a slap in the face to the year’s biggest IPO, which met the reality of increasingly skittish financing markets that finally blinked in the face of additional subprime mortgage distress, a tsunami wave of future debt deals to digest, and suddenly higher interest rates. We concur that important changes are afoot, although our response to the client noted our own comments from a year ago when we sensed the beginnings of a shift in risk attitudes. As we said at the time (following a particularly nasty decline in many international markets):

…We are encouraged…that the reappearance of risk in the broad investment environment will remind investors there is rarely a free lunch (July 2006).

Interestingly, the Emerging Market meltdown of a year ago was short-lived, and even the evaporation of $9 billion Amaranth Advisors a few months later proved to be little more than a blip. But with the subprime market’s seizure in February, it has become difficult to ignore the rumblings underneath various financial structures that were built to withstand merely the occasional breeze (and certainly not a harsh wind). With more examples of hedge funds on life support and debt offerings facing tougher renegotiations, the change in mood is easy to spot. But we have been well-prepared for these changes, and while the S&P 500 is up more than 20% over the past year, our equity portfolios have generally performed even better with our emphasis on stronger, better capitalized and more dominant businesses. We have argued for some time that this broad investment opportunity offered satisfactory upside while protecting our clients from the market’s dangerous disregard for risk, and we are therefore pleased to see the results so far. We can, however, imagine stronger headwinds – today’s modestly higher interest rates increasingly highlight the risks of leverage and illiquidity – and so we believe our basic portfolio positioning should continue to serve our clients well.

The current state of affairs should not be surprising to anyone with a sense of the history of credit cycles. Low interest rates, ample credit, frustrations with the equity market of 2000-2002, plus pension plan sponsors stretching for higher returns conspired to encourage the broad availability of more leveraged, illiquid structures. With memories of major financial distress fading into history, it’s been easy for investors to talk themselves into chasing returns rather than thinking about what could go wrong. Investment capital has overwhelmed the hedge fund, private equity and real estate markets to a degree most could never imagine. The commercial real estate market, in particular, has shown signs of overheating as giant deals seem to defy traditional economics. Some recent transactions showed a remarkable lack of pricing discipline among the bidders given that financing costs in some cases exceeded the current return on the target properties! Before the recent rise in interest rates, it was difficult to recall any previous period where commercial real estate yielded so little (“cap rates” of 3-4%) yet appealed to so many. To the buyers, these deals seem to reflect an unwavering belief in a long economic boom, persistent low interest rates and uninterrupted access to capital. Thanks, but no thanks.

The rush of capital into hedge funds and private equity funds uncovers a similar faith in the stability and infinite generosity of financial markets. We’ve discussed the underbelly of hedge fund structures previously (LTCM, Amaranth), and private equity represents another timely example of a neat idea taken to absurd extremes. Private equity firms offer a tempting model: the chance to acquire and better manage a stable business (with leverage added) shielded from the gaze of impatient Wall Street analysts and public market regulators, thereby generating high returns for patient investors. With an appealing track record and easy credit markets, the ability to do deals has exploded ($1.2 trillion in available capital since 2004). To say that we’re skeptical that all this money can generate acceptable returns over the coming years – after fees that seem to defy basic economics – would be a great understatement. For private equity managers to earn their keep, the funds must invest in larger deals, in a more competitive environment, and use more leverage. This has led, the data¹ show, to higher prices paid for acquisitions (the average transaction is now priced at 9.5x EBITDA, about 50% higher than seen 5-7 years ago) and greater leverage (interest coverage ratios now average below 2x, a slimmer margin of safety than witnessed since the LBO boom of two decades ago).

Equally troublesome is the illiquidity and lack of transparency these structures create. Ironically, the recent public offering of buyout funds illuminates practices that would have otherwise remained hidden to most of us. One publicly traded firm, KKR Private Equity Investors (KPE), offered a few gems in its first quarter report. First, KPE invested in other KKR buyout funds rather than wait for new companies to buy. This feature, supplemented by additional borrowings following its 2006 IPO, maximizes KPE’s ability to deploy its capital rapidly – and earn management fees – without having to bother to wait for actual takeover deals to be signed or completed. Furthermore, nearly all of the gain in Net Asset Value reported during most recent quarter came from writing up the unrealized value of many of its investments, a process we believe may rely more on judgment than hard fact. Like its Blackstone counterpart so far, KPE stock has languished, reflecting perhaps a realization by public investors of the slope of the playing field, as well as some skepticism that announced gains might at some point reverse should financial market conditions become less friendly.

As patient investors ourselves, we certainly note the similarity in philosophy between ourselves and private equity investors. But today, it seems the frenzied acquisition activity, more aggressive use of leverage, as well as the public offering of the management companies themselves has as much to do with the management compensation structure of these businesses as it does with the basic “blocking and tackling” that has been the hallmark of private equity’s historical successes. Ample and cheap capital has allowed for some very large and complex transactions, and many of the early deals in this cycle will undoubtedly generate high returns. There are clearly some very bright, aggressive folks leading many private equity funds. But it’s also probable that compliant credit markets in recent years have made even the mediocre appear to be geniuses.

The credit markets have certainly facilitated many of the excesses. To be fair, while it’s easy to criticize the easy credit available for complex collaterized structures beneath teetering hedge funds, or “covenant-lite” leveraged buyouts with flexible repayment options, the fact remains that defaults have been very low in recent years (just 0.8% of high-yield bonds defaulted last year), and demand for such paper has stayed strong. After all, the US economy remains on a positive trajectory and ample liquidity has served to limit the impact of any credit distress. But the recent rise in long-term interest rates (the highest level in five years), hiccups in the subprime and hedge fund markets, as well as a mammoth supply of new debt issues have emboldened lenders to ask more questions. Not only are providers of credit starting to demand more yield to compensate for basic credit risk, but debt covenants are tightening and optional payment structures are tougher to find. The return of some discipline to the credit markets is, in our opinion, long overdue. We hope it is not too late.

The powerful “compression” we’ve discussed for some time in the equity market has concurrently had an equally important impact on the credit markets. Because of few defaults and ample liquidity, credit spreads have been very tight, and there has been little additional compensation offered for bearing substantially more risk. But it’s very likely that as the credit markets focus increasingly on risk rather than return, spreads should begin to widen. And because credit is essentially the lifeblood of the financial system, the ripples will be felt widely. Even though the broad economy remains on decent footing, the effect of higher credit costs will weigh down the expected returns for the marginal buyout or debt collateralization. Structures that rely solely on ample and cheap credit may become less stable. Deals may be delayed, renegotiated or cancelled. And while the broad level of interest rates may rise or fall, we believe risk will once again play an important role in the pricing of credit.

It’s reasonable to wonder whether the overall equity market can prosper if we are indeed in a New World. With markets becoming increasingly correlated in recent decades, the odds would seem to be low that equity investors would be spared if credit availability evaporates or if long-term rates rise significantly. The counter-argument, however, deserves consideration. First, investors fled US equities following 2001 in a fruitless search for higher returns in housing and other alternative assets. Yet the data show a respectable 10.6% annualized return for the S&P 500 for the past five years, and some of that money might be lured back following disappointment elsewhere. Second, with mounting questions in the credit markets – as well as adjacent areas such as real estate, hedge funds and private equity – US equities might be viewed by some as the “safe” asset class. As we’ve previously pointed out, balance sheets and cash flow dynamics are exceptionally robust, and combined strong buyback and dividend activity has recently provided investors with current returns above 5% on average.

Although the market environment continues to adjust to the events of the past year, we believe our investment posture warrants little adjustment. Our focus on fundamentally strong, dominant businesses trading at attractive discounts to intrinsic value has paid off in the early stages of the evolution we’ve discussed. With risk considerations likely to play an even greater role in the future, we feel confident our current positioning continues to take advantage of a large market opportunity while avoiding the sleeplessness that would come from owning highly levered or illiquid structures in the midst of a turning credit cycle. Although the discount to intrinsic value for our portfolios has diminished in recent quarters – performance has outpaced value growth – the absolute returns from current levels remain meaningful.

Edward S. Loeb
quarterlynews@harrisassoc.com

¹The Deal, “Paying the Price for Paying the Price”, June 2007