Changes in the credit environment brought on by this summer’s financial market turmoil will make it more difficult to make money through leveraged buyouts, according to Oxford Analytica.
Competition will increase and successful buyout funds are likely to focus on making real operational improvements in portfolio companies, rather than on quick transactions, Oxford says in a new analysis of the buyout market.
As a result of the crisis in the US subprime market, investors are now demanding higher risk premiums and tighter covenants on debt issues, Oxford says. “Currently, nearly 300 billion dollars of loans worldwide are assumed to be on banks’ balance sheets waiting for syndication. As long as these loans remain on the balance sheets, the banks are unlikely to finance larger new transactions.”
Assuming the global economy remains in reasonably good health and demand for buyout funds persists, Oxford says a number of changes are in store on the buyout front:
Longer holding periods and reduced returns. Lenders will reduce the amount of debt available for a transaction. With reduced debt levels, transaction prices are also expected to be lower. Funds owning portfolio companies will prefer to keep them for a longer period of time.
Reduced deal activity. Apart from other buyout funds, corporate and private sellers will also need some time to adjust their price expectations to the market. Transaction volumes, including secondary transactions, will decrease. Transactions of over 1 billion dollars are unlikely to get financed until banks have cleaned up their balance sheets.
Focus on operational improvements. Due to the slowed transaction market, buyout funds will focus their efforts on working with existing portfolio companies. In the past, a large part of funds’ returns was generated by favorable market conditions. Now, fund managers must demonstrate that they are able to generate premium returns in a normalized debt market.
Although the current credit crisis is likely to reduce returns of existing buyout funds, it should enable them to acquire companies at lower prices, Oxford says. Portfolio companies still benefit from a reasonably stable global economy and favorable pre-crisis debt agreements. Much will depend on how banks handle the backlog of loans on their balance sheets:
- Holding these loans to maturity would reduce future lending capacity and business opportunities.
- Renegotiated terms or selling at a discount would make the loans more attractive for investors but result in immediate losses. Currently, this seems the most likely alternative.
While eventual cuts in interest rates by central banks could lessen these losses, the crucial question is how long uncertainty will prevail in the credit market. If banks become unwilling to finance not only transactions but also necessary corporate investments, this could have significant negative effects on the broader economy.
The full report Buyout market is calming down is available for purchase.
Collateralized debt obligations backed by commercial real estate may not be quite as low-risk as their holders assume, according to CreditSights.
Following up its two-part analysis of potential risks in the commercial real estate market, CreditSights provides a helpful rundown of the CRE CDO market that highlights changes in the ways these instruments are funded.
CreditSights noted in Bubblenomics - Hunting for the Next Subprime in Commercial Real Estate (Part 1) and (Part 2) articles that total returns on commercial real estate holdings are set to hit an all-time record high this year in real terms. However, the turmoil in US residential real estate likely bodes ill for the US economy in general and commercial property in particular.
CreditSights says issuance of CRE CDOs has exploded in the past three years and now represents roughly 10% of all CDO issuance. A reason often cited for the success of CRE CDOs is that the rating agencies are excessively conservative in their estimates on property valuations when rating commercial mortgage-backed securities (CMBS), CreditSights says.
“Despite prices surging in recent years, the rating agencies tend to assign lower values to commercial property than the market, which reduces the proportion of the entire mortgage that can be funded by CMBS. This has forced property owners to look for other avenues to borrow additional money subordinate to the CMBS-eligible A-notes.”
CRE CDO ratings are also benefiting from a supposed diversification, since they hold a larger number of smaller-sized commercial property-related assets than CMBS, CreditSights says.
“But given that all the assets are in commercial real estate, which like residential property is no doubt more correlated now than it was 20 years ago in the last property collapse, the diversification might not equate to low correlation in defaults in the event of a commercial property downturn.
If commercial property conditions turn nasty then senior tranche investors who no doubt are under the impression that they are invested in low-risk or zero-risk assets may find that because the whole capital structure is backed by low quality real estate debt, even those senior tranches could be at risk.
CreditSights points out that roughly one quarter of all US commercial and multifamily residential lending - by value - is now provided by the capital markets via CMBS - $700 billion of the $3.1 trillion market. Ten years ago, just 7% was repackaged as CMBS.
CRE CDOs: A Diversified Collection of Low Quality Mortgage Debt? includes a history of the evolution of the commercial mortgage and a handy definition of terms.
Traditional “long-only” and alternative investment strategies are converging as alternative investments (such as hedge funds, private equity, real estate and structured instruments) have gained in popularity and influence. That is one of the conclusions of the sixth in an annual series of research reports produced jointly by KPMG International and CREATE-Research. The comprehensive 60-page report is based on input from over 200 investment managers, both long-only and alternative, including pension funds.
Convergence is occurring as managers have diversified into new strategies that are outside their normal sphere of expertise. According to the report there are three principal convergence trends:
- Between long-only and alternative investments; long-only managers adopting alternative techniques and vice-versa
- Between alternative investments – ‘product widening’. For example, private equity managers adopting hedge fund techniques and vice-versa
- Within asset classes – ‘product deepening’. For example, a UK real estate fund expanding its portfolio into Europe.
Convergence is neither universal nor unequivocal: within each sector, managers have fallen into three groups: purists, who have stuck to their core capabilities; pragmatists, who have diversified; and procrastinators, who have considered change without actions.
Managers want to run exciting products…while investors want something they can understand that delivers good results. Real estate, infrastructure and private equity are most favored by investors. This mismatch needs to be addressed.
Other findings of the report:
- Convergence between managers, the increasing complexity of financial instruments and a changing investor base are likely to drive up the demand for risk specialists who can stress test portfolios, do independent valuation and enhance overall transparency.
- The recent credit crisis will spark flight to quality favoring a new wave of customized structured finance products with principal protection and transparency as the main features.
- As a knock-on effect, third party administrators will grow rapidly by developing new skills and capabilities for new asset classes, driven in part by the institutionalization of alternative investments.
- The private equity industry will no longer be so private as governments and investors continue to demand more transparency, independent administration and new fee arrangements.
- Many hedge funds are absorbing the shock of the recent credit crisis through their contrarian strategies.
- Performance related fees are likely to become ever more popular as pension funds continue to force different fee structures for alpha and beta products.
- The demand for talent is outstripping supply in all corners of the market. This is likely to create retention difficulties and an increased inflationary pressure in the industry.
- The recent credit crisis is likely to slow down the pace of convergence between long-only and alternative investments as it takes its toll on managers in all sectors but it won’t reverse the thrust.
- The pace of convergence in future will rest on managers’ ability to deliver attractive returns, while ensuring that the nuts and bolts of operations are tight.
- Growth expectations for the next three years have fallen to average single digits for all asset classes in long-only and alternative investments.
- The investment industry will continue to consolidate with M&A activity occurring within and across all segments of the sector as organizational convergence mirrors product convergence.
The report Convergence and divergence: New forces shaping the investment universe is available for free download.
While brick & mortar retailers, from Wal-Mart to Circuit City, are experiencing tepid growth in their business, eCommerce players continued to experience strong growth in the third quarter.
According to web analytics provider comScore, revenues for non-travel related U.S. eCommerce grew by 23% in the third quarter, as compared to the same period in 2006. A total of $28.4 billion was spent on eCommerce sites in the quarter, as compared to $23 billion a year earlier.
The strongest online retail category was video games and accessories, which nearly tripled its revenues from the prior period, fueled by sales of the Nintendo Wii and Sony Playstation 3.
eCommerce purchases of video games, at 199% are growing at a faster clip than the overall video game hardware segment, which grew at 65% year-over-year for the month of September, following a 48% gain in August, according to NPD Group. Video game software growth was similarly lower, at 47% in September and 22% in August.
Other segments experiencing strong growth include consumer electronics, toys & hobbies and event tickets, each seeing more than 50% year-over-year growth in the quarter. As the music industry sees continued erosion in CD sales, many top performers have focused their efforts on generating revenue from concerts.
The growth in the toy category may have been the biggest surprise, coming on the heels of the well-publicized Mattel recalls. According to comScore Chairman Gian Fulgoni:
Despite the negative publicity of toy recalls, the third quarter saw robust growth for online toy sales. Given some of the uncertainty surrounding the holiday season, it’s possible that consumers were responding to fears of toy shortages and making their purchases early.
A new OECD study shows a trend away from direct public funding to stimulate innovation and toward providing tax breaks instead.
According to the OECD Science, Technology and Industry Scoreboard 2007, two thirds of the 30 OECD member countries offered businesses tax subsidies in 2006, up from 12 in 1995, and most have tended to make it more generous over the years.
Direct government funding financed an average of 7% of business R&D in 2005, down from 11% in 1995.
Spain, China, Mexico and Portugal provide the largest tax subsidies and make no distinction between large and small firms. Canada and the Netherlands on the whole continue to be more generous to small firms than large ones. Emerging economies, including Brazil, India, Singapore and South Africa, also offer a generous and competitive tax environment for businesses investing in R&D.
The type of tax subsidy available varies from country to country but includes an immediate write-off of current R&D spending, as well as tax relief or allowances against taxable income. International co-authorship of scientific publications tripled between 1995 and 2005. Cross-border co-operation on inventions nearly doubled as a share of total inventions worldwide between 1991-93 and 2001-03.
Foreign ownership of domestic patents increased by 50% between the early 1990s and the early 2000s. European Union countries interact most often with each other and are less globalized than the United States, while Japan and South Korea are less internationalized overall, the report finds.
In addition to new data on the rising investment in knowledge by emerging economies, this edition of the Scoreboard shows that:
- R&D spending in OECD countries has increased steadily in recent years although more slowly than during the second half of the 1990s.
- The number of business researchers has grown most rapidly in smaller OECD countries, such as New Zealand, Portugal, Spain, Iceland and Greece, where their number has grown by 10% a year over the past decade.
- The US and emerging economies, notably China, India, Israel and Singapore, focus their innovative efforts on high-technology industries, such as computers and pharmaceuticals, while continental Europe concentrates on medium-high-technology industries, such as automobiles and chemicals.
- The number of biotechnology patents has been falling since 2000 in most countries, after a sharp increase in the late 1990s, largely due to the more restrictive criteria applied by patent offices and the end of the wave of patenting that followed the decoding of the human genome.
- 80% of South Korean households have high-speed broadband access, the highest in the OECD. In 2005, Korea reported the highest surplus in the ICT goods trade balance, followed by Finland, Hungary and Japan.
A summary of the OECD Science, Technology and Industry Scoreboard 2007 can be downloaded free of charge. The full report is available for purchase.
As crude oil prices approach all-time highs even on an inflation-adjusted basis, analysts do not expect the impact on the world economy to be as severe as during the oil shocks of the 1970s and 1980s.
Crude prices need to reach about $100-$110 per barrel to be equal in real terms to the 1979 level. Even then the impact would be less due to rising purchasing power.
Adam Sieminski, chief energy economist at Deutsche Bank in Washington, said in the Financial Times that the current price increase, driven by demand, was different from the 1979 crisis. “That crisis was driven by a supply shortage and turmoil in the Middle East. That has wider implications on business and consumers’ psychology.”
G7 per capita income is now sufficient to buy 456 barrels of crude oil, well above the 320 to 350 barrels between 1980 and 1982. To bring G7 purchasing power down to this level would require oil prices rising to between $120-$130 a barrel.
Commonwealth Bank agrees in a free analysis of real oil prices, saying “the real bite on consumers is still short of the peak impact of the second oil shock in 1980.” Commonwealth declined to provide a figure for a comparable “real” oil price today. “While that calculation can be done, we’re skeptical that’s a good benchmark as the context is so different.”
The second oil shock was a garotte on supply contrived by producers just as central banks were about to put the boot into inflation. Now producers are still influential but the market is having a hard time keeping up with demand in strong global growth environment.
Econbrowser provides links to several papers dealing with the topic, mostly supporting the view that the economy’s increased flexibility and improvements in energy efficiency have reduced the potential impact of higher oil prices.
Meanwhile, speaking at a symposium on the “Economics and Geopolitics of Russian Energy” CERA’s Daniel Yergin advised that geopolitics and the financial markets were behind recent oil price hikes, not simply supply and demand, adding:.
Although publics and governments around the world are focused on prices, one of the most important factors in the world oil industry is the rapid rise in costs owing to shortages of people, equipment, and skills. The increased costs are leading to delays and postponements of oil and gas projects, which is affecting the timing of future supply.
On a more pessimistic note, the German Energy Watch Group claims that world oil production peaked in 2006 and is destined to decline sharply in the future.
The projection is at odds with the International Energy Agency “World Energy Outlook” forecast that shows production increasing significantly for many years. Energy Watch says the IEA forecast is based on assuming market forces and “business as usual” will boost production from estimated reserves to meet projected higher demand.
Energy Watch says its analysis “is based primarily on production data which can be observed more easily and are also more reliable. Historical discovery and production patterns allow to project future discoveries and – where peak production has already been reached – future production patterns.”
A new study concludes that increasing levels of ozone due to the growing use of fossil fuels will damage global vegetation, resulting in serious costs to the world’s economy.
The analysis by MIT and the Marine Biological Laboratory published in the November issue of Energy Policy, (subscription required) focuses on how three environmental changes (increases in temperature, carbon dioxide and ozone) associated with human activity will affect crops, pastures and forests.
The research shows that increases in temperature and in carbon dioxide may actually benefit vegetation, especially in northern temperate regions. However, those benefits may be more than offset by the detrimental effects of increases in ozone, notably on crops
The economic cost of the damage will be moderated by changes in land use and by agricultural trade, with some regions more able to adapt than others. But the overall economic consequences will be considerable.
If nothing is done, by 2100 the global value of crop production will fall by 10 to 12%.
The analysis uses the MIT Integrated Global Systems Model, which combines linked economic, climate and agricultural computer models to project emissions of greenhouse gases and ozone precursors based on human activity and natural systems.
Results for the impacts of climate change and rising carbon dioxide concentrations (assuming business as usual, with no emissions restrictions) brought few surprises. For example, the estimated carbon dioxide and temperature increases would benefit vegetation in much of the world.
Without emissions restrictions, growing fuel combustion worldwide will push global average ozone up 50% by 2100. That increase will have a disproportionately large impact on vegetation because ozone concentrations in many locations will rise above the critical level where adverse effects are observed in plants and ecosystems.
Without emissions restrictions, yields from forests and pastures are projected to decline slightly or even increase because of the climate and carbon dioxide effects. But crop yields fall by nearly 40% worldwide.
However, those yield losses do not translate directly into economic losses. According to the economic model, the world adapts by allocating more land to crops. That adaptation, however, comes at a cost. The use of additional resources brings a global economic loss of 10-12% of the total value of crop production.
Maybe it’s because its name is as opaque as the “structured investment vehicles” it is designed to rescue, but the “M-LEC” superconduit has been having a hard time garnering widespread support.
And when “the world’s greatest investor” Warren Buffett is critical, could that be the kiss of death for the fund designed to buy up some of the assets of struggling SIVs?
Quoted in the Financial Times, Buffet favors a more market-based solution: “I think there should be a requirement that before the securities are put into the new super-SIV, 10 % of the holdings should be sold into the market to people who are not associated [with the subprime problem. That way we can be sure that they are being put in at appropriate market prices . . . They should give the market the opportunity to price the super-SIV themselves so we can see what they are really worth.”
One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it.
Citigroup, Bank of America and JP Morgan Chase have committed more than $75 billion to M-LEC, the Master-Liquidity Enhancement Conduit.
In a useful free background paper The Great Commercial Paper Meltdown of 2007 Global Insights says the new M-LEC super-fund approach “is fraught with potential risks, especially in view of further downward pressure from the housing market, and associated deflation in the prices of mortgage-backed securities. “
The Treasury needs to closely coordinate the launching of these funds with the Federal Reserve, as monetary policy needs to be supportive—at least from a macro policy risk minimization perspective—as a necessary condition for success.
In The SIV SuperConduit-Not So Super, CreditSights points out that by buying only the most attractive assets that they can reasonably buy either at or close to par, M-LEC will effectively be diluting the credit quality of the SIVs’ remaining Asset-Backed Securities portfolios.
That will mean that SIVs will be even more exposed to erosion of credit quality in the remaining assets, which will likely be more concentrated in the more problematic sectors like RMBS and CMBS.
In a terse comment, Moody’s Investors’ Service said “We believe the creation of M-LEC will have a generally positive impact on the SIV sector and when monitoring our SIV ratings, Moody’s will take into account the potential impact of the initiative as well as the exposure of each vehicle to credit and liquidity risks.”
Noting that it does not expect M-LEC to have an impact on the ratings of US banks, Standard & Poors says the hope of M-LEC is that natural tension will establish a market price for less liquid securities.
S&P says if M-LEC vehicle is not adopted, the following scenarios are possible:
- The SIVs find sufficient funding on their own;
- The SIVs are able to liquidate enough assets to reach sustainable levels of funding;
- The SIV sponsors, most of which are large universal banks support the SIVs through the purchase of rolling SIV CP or the consolidation of the SIVs onto their own balance sheets; and
- The SIVs experience further negative pressure.
The Economist’s view is that it raises more questions than it answers:
Even those who support the fund admit that it is, at best, a temporary solution, buying time so SIVs can find other sources of finance or wind down gracefully. It may also provide breathing space in which to sort out deeper problems facing the market, such as the unstable structure and opacity of SIVs.
SeekingAlpha’s Roger Ehrenberg thinks “the real question is if the M-LEC has enough positives to make it worthwhile relative to the unknowns. As it introduces friction, it costs money to assemble for participating firms, especially those selling assets into the vehicle.”
Though it doesn’t directly solve any fundamental credit problems it does create a ready market for high-quality SIV assets, in size, that streamlines the operational process of generating liquidity relative to selling discrete assets to many, many buyers, he says. “And it does provide an opportunity for market conditions to improve, possibly enabling some of the currently distressed paper to recover.”
So net net, it might be worth a go.
There was a minor Internet dustup last week over a topic that most online users have never even heard of: “Twittering”.
Forrester analyst Peter Kim, in his report, Microblogging for Marketers, estimated that 6% of adult online users in the U.S. used micro-blogging platform Twitter at least monthly.
For those unfamiliar with the term, Microblogging is a fairly new technology that enables people to communicate with those in their social network via short posts, typically a sentence or two (maximum 140 characters) with a link. The most well known microblogging platform is called Twitter; others in the space include Pownce, still in limited beta, and Jaiku. Microblogging is much like SMS text messaging, though in a many-to-many environment.
After indicating that Twitter attracted approximately 447,000 unique visitors in August, the report stated that:
Six percent of online US adults use Twitter at least monthly or more frequently.
That figure jumped out at various bloggers, most notably Robert Scoble, a former Microsoft executive and publisher of the well-read Scobleizer blog. Using those figures, even assuming that 100% of Twitter users were U.S. adults, it would suggest that only 7.5 million American adults were online users. According to Scoble:
My data shows that the regular users are between 50,000 and 300,000, a high percentage of which are outside the United States. That doesn’t come anywhere close the numbers required for 6%. Keep in mind that Hotmail has 200 million users each month. Yahoo mail says they have about 250 million worldwide users.
Kim later responded in his blog that the source of the 6% number was an online survey conducted by Forrester, where 6% of respondents selected “monthly” or more frequently in response to the question “How frequently do you use… Twitter”?
Whatever the true number of online “Twitterers,” the larger question may be the original premise of the report – whether microblogging is an effective medium to reach an “affluent, well educated and early adopter audience”. As commenter Mickeleh notes, the flaw in that logic is that:
Most Twitterers won’t see anything you post. Twitter lets users create a channel of folks that they follow. If you’re not followed, you’re invisible.
While any market research is subject to challenge, forecasting data in this segment is a risky business. The blogosphere is ready to pounce on any potential data discrepancy, as Internet analyst Mary Meeker learned a few weeks ago, when a calculation error overstated her estimate of the impact of Google’s new YouTube overlay ads.
The Forrester report, Microblogging for Marketers, is available for purchase.
A new and exhaustive UN report on the state of the environment and the world’s resources makes for sobering reading.
The United Nations Environment Programme’s Global Environment Outlook 4, GEO-4, comes 20 years after the World Commission on Environment and Development (the Brundtland Commission) produced its seminal report, Our Common Future.
While there has been progress on some of the more straightforward problems for which solutions are proven, like the pollution of air and water, there remain what GEO-4’s authors call the persistent problems for which solutions are emerging - for example, climate change, deterioration of fisheries, and the extinction of species.
The report says the scale of the challenge is huge and without action humanity’s very existence is threatened.
Worldwide, greenhouse gas emissions, for example, some experts say, will need to fall by up to 50 per cent by 2050, compared with their 1990 levels – this is based on a threshold of a 2°C increase in the global mean temperature above pre-industrial levels, beyond which, some experts say, climate impacts become significantly more severe, and the threat of major, irreversible damage more plausible.
This implies emissions cuts of 60-80 per cent by 2050 in developed countries, and significant cuts for developing nations, should they accept emissions reduction commitments.
GEO-4 also warns that we are living far beyond our means. The human population is now so large that “the amount of resources needed to sustain it exceeds what is available.”
Humanity’s footprint [its environmental demand] is 21.9 hectares per person while the Earth’s biological capacity is, on average, only 15.7 ha/person…”.
The crisis includes not just climate change, extinction rates and hunger, but other problems driven by growing human numbers, the rising consumption of the rich and the desperation of the poor, the report says.
Examples are:
- Decline of fish stocks;
- Loss of fertile land through degradation;
- Unsustainable pressure on resources;
- Dwindling amount of fresh water available for humans and other creatures to share
- Risk that environmental damage could pass unknown points of no return.
GEO-4 says climate change is a “global priority”, demanding political will and leadership. Yet it finds “a remarkable lack of urgency”, and a “woefully inadequate” global response.
The report concludes that “while governments are expected to take the lead, other stakeholders are just as important to ensure success in achieving sustainable development. The need couldn’t be more urgent and the time couldn’t be more opportune, with our enhanced understanding of the challenges we face, to act now to safeguard our own survival and that of future generations.”
The report can be downloaded at no charge from the UNEP website.
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