Regardless of anyone thinks of the arrival of hedge funds in the private equity arena the sheer size and amount of capital available for private equity deals is transforming both private and public markets.

Source: Financial Times

Notwithstanding record levels of buyout activity in 2006, the amount of capital committed but uninvested has never been higher. This is a function of the frenetic fund raising by all the major private equity firms. Recently Morgan Stanley announced it would be raising $6Bln for private equity right behind Goldman Sachs’ $15Bln and Blackstone’s largest global buyout fund at $21Bln. Emerging Markets haven’t been spared with a record Russian fund ($1Bln) and the biggest Asian fund at $2.8Bln. The largest buyouts in history have also been announced recently with EOP setting to be the largest and Sainsbury set to be the largest European. Clearly, he buyout industry is soaring to new heights. 

“If one applies 5 times leverage to the $280Bln of uninvested buyout capital available you have “buying” power in excess $1.5 trillion. Given several announcements already in 2007 this buying power is likely to increase” states Jonathan Schneider of the Novator Credit Opportunities Fund.

Source: Financial Times

The strength of the LBO market is very well illustrated in the chart above. LBO activity has been steadily growing since 2001 and has leapt forward dramatically this year. “The coincidence of strong liquidity in the PE arena and the credit markets and a strong global economy have been the key factors in the record setting number of LBOs. It is instructive to observe the increase in the amount of leverage on the companies and the amount of equity being contributed by the private equity firms” claims Schneider and goes on to add “It is widely believed that PE firms are applying lower hurdle rates in their investment process. Certainly some of their financial risk is being ameliorated by “patient” capital structures which have very limited short/medium term amortization and relatively flexible loan covenants.”

“The importance of the PE asset class can hardly be exaggerated in these capital markets. It is helping to support the public equity markets, it is “policing” the management of public companies and it is driving unprecedented levels of credit market issuance” opines Schneider and concludes “looking at this market we are very wary of subordinated debt instruments and are focused on enterprises which have significant strategic value and/or meaningful contributions of equity capital by management. In the context of our proprietary deal flow we are seeing some attractive management buyout or “MBO” activity where successful, and wealthy, management teams are taking their middle-market companies private in the face of a neglectful stock market“.

Equity linked strategies are also affected. “To name a few, high ROEs, low borrowing costs, huge inflows in PE funds arena as well as the strong euro against both dollar and yen forcing companies to restructure, create a very favorable environment for corporate activity (especially LBO) and brings additional support to the equity market” claimed an allocator recently and went on to add “On the other hand, it increases the risks of being short single positions, especially in pair trades. A high equity risk premium also leads to limited dispersion and makes pair trading that much more difficult. Currently we no longer hold pure pair trading strategies and do not expect to add to these strategies before the environment dramatically changes”.

To circumvent this problem, some equity long/short managers have no shame implementing a negative view on a stock through the CDS market. Pierre Lagrange from GLG exposed a novel way of dealing with this problem at a recent conference. GLG didn’t like a company because of their decreasing top line and high provisions. This was partly reflected in the stock price though and with a low net debt to equity ratio and a low EBIT multiple, it was a prime candidate for a corporate event. Shorting the stock was simply too risky. By buying insurance in the credit markets using a CDS, GLG felt they could gain either way. If no bid materializes, spreads stay where they are, if there is a bid, the credit of the company (if it’s a LBO) or the buyer (if it’s a takeover) will be negatively affected and they gain on the spread. In any event, as the fundamentals continue to deteriorate spreads widen.

The past week has obviously been an emotional time in global markets. In the US on Tuesday, we saw 4 billion shares changing hands. This was record volume.

As most of us know all too well, the number of down shares relative to the number of up shares hit a recent record low. Basically, everything fell, and the advance/decline line thus contracted to 15%.

So what happened to trigger this sell-off? And, more importantly, what should we read in this brutal sell-off, and what do we know?

1– The Origins of the Sell-Off
Most of the market commentaries that we have read in the past few hours point to the Chinese tightening measures, and the large drops in the Shanghai and Shenzhen A share markets, as to the point of origin of the sell-off. Frankly, this strikes us as too clever by half. Indeed, the Chinese A share market remains a) small, b) mostly closed to foreign investors and c) was massively overbought after a 130%+ run in the previous twelve months. Putting it together, we have a tough time understanding why a –8% or so drop in Chinese shares, mostly owned by Chinese locals, should lead to a serious drawdown in the World’s most liquid and developed markets (US, UK, Japan etc…). The explanation has to lie elsewhere.

A) Markets are very overbought
As we highlight in our most recent Quarterly Strategy Chart Book, there is little doubt that equity markets around the world have had a tremendous run since the May-June sell-off. The World MSCI itself has basically been trading at a 30-day RSI of over 60 for the better part of the past three months. So the fact that markets are taking a breath should not surprise investors all that much.

B) Signs of Financial Stress Were Mounting?
In our Monday Daily Checking the Boxes Report, we wrote: “The story of increased stress among sub-prime lenders in the US is quickly gathering pace…. As a result of these developments, an index of credit-default swaps on 20 securities rated BBB- has dropped –30% since trading started on January 18th…. As insurance gets more expensive, shouldn’t we expect investors to start curtailing risk and head for higher quality assets?.... Combine these developments with the fact that a) risky assets in the past six months have had quite a run, b) oil seems to be breaking out on the upside and
c) central banks are in no mood to cut rates and we feel that we may have to rein in our very strong bullishness somewhat. Indeed, most of the liquidity growth of the past two years has come from the private sector multiplying the shrinking primary liquidity. Should this start to dry up, financial markets would find it more challenging to post the kind of returns they have done in recent months. As we write, credit spreads remain tight, real rates are low and volatility is weak (the VIX is still trading near all-time lows), and as long as this stays the case, markets will be fine. However, we fear that in the coming weeks, one of these variables could change.” Obviously, one of those variableshas now changed: volatility is no longer at record lows.

C) The Structure of the Markets is Changing?
The past forty eight hours have witnessed quite a change in sentiment across
almost all asset classes:

Interestingly, the Dow was down only around 100 points at noon on Wednesday; it then absolutely collapsed in the afternoon and, at its worst, had shed 546 points. This violent turnaround begs the question of whether the fact that we are currently approaching month-end could have anything to do with the sell-off? As an evergrowing amount of money is managed by hedge funds, whose monthly returns have to be stable and positive, could we start seeing more of these violent swings as we get close to the month-end valuation dates? It does feel as if a number of investors looked at the market yesterday and simultaneously decided: “let’s lock this year’s gains for now”….

2– Will We See A Repeat of May-June?
The last big market correction, which most of us remember all too painfully well,
occurred last May and June. Is this correction bound to be similar? Or should we
expect a different unfolding?

We believe that there are marked differences between the situation today and the situation last spring. Doing a quick T-Bar comparison, we find that the current sell off is very different to the June sell-off. Back then, the main fear was that central banks were falling behind the curve, that inflation was accelerating, that central banks would need to tighten aggressively. Instead, the question posed to investors by the markets in the past twenty-four hours is whether we are heading towards a big growth slowdown and a deflationary bust.

Undeniably, the biggest difference between today and the May-June period was that, last spring, bonds and equities fell simultaneously while commodities by and large rose. Today, equities and commodities seem to be weakening, and bonds are rallying sharply.

Undeniably, the market is asking investors to take a stance: those who believe in the possibility of a deflationary bust can buy overvalued bonds, whose real yields of approximately 2% (see our latest Quarterly Strategy Chart Book) offer little upside potential (except should the world experience a deflationary bust). Others who believe that the very strong earnings yields on equities is sustainable should stay put, since the difference between interest rates, and earnings yields, is even more attractive today than it was yesterday.

3– Are We Heading For a Deflationary Bust?
There is no doubt that a number of indicators are showing that growth is weakening. In Tuesday’s Five Corners, we highlighted that US leading indicators were set to move into negative territory (though note that they were negative in 1995 and that this turned out to be just a mid-cycle slowdown). Undeniably, US data has been quite weak of late, especially on the manufacturing side. Yesterday, the February Chicago PMI index came in at a lower-than-expected 47.9 (expected 50.0), the lowest reading since October 2002. More importantly, US fourth quarter GDP growth was revised down markedly to +2.2% YoY, compared to the earlier estimate of 3.5% YoY (though most of the downward revision in Q4 was accounted for by a drop in inventories). To top it off, US new home sales fell by -16.6% to an annual growth rate of 937,000 units, the biggest drop since 1994.

This slowdown message is further confirmed by the OECD leading indicators:

Though interestingly, our own global growth indicator, which admittedly is built
with a lot of market prices (cyclical shares outperformance, AU$, semi stocks, copper prices, aluminum…) has yet to roll over. And sure enough, up until 48
hours ago, the markets were not given much signs of concerns against an economic
slowdown.

As our readers know, we remain fairly sanguine about the prospects for global growth. And this optimism is mostly based on the fact that:

• Real rates remain far below the structural growth rate of our economies, thereby encouraging entrepreneurs to take risks.
• Spreads are still very tight (unlike in 2000), encouraging companies to either borrow to buy back stock, merge, or increase their capital spending.
• The factors of global growth which we highlighted in Into Capitalism’s GoldenAge and in Our Brave New World are still very much in place.

We thus do not believe that we are on the edge of a large deflationary bust. Instead, it seems that we are facing a good old-fashioned liquidity shakedown.

4– The Current Liquidity Shakedown
We know we use this analogy way too much… but we have yet to find a better one, so here it goes again: liquidity shakedowns are akin to dynamite fishing. When you throw a stick of TNT in the water, the little fish come up to the surface immediately after the explosion; meanwhile, it will take days for the sharks and the whales to pop up. By the same token, when liquidity contracts, the more marginal players get cut-off first and start to struggle; meanwhile, it can take months before the “whales” really start to hurt.

For example, in 2000, the “small fish” were the pets.com, Hikari Tsushin and other marginal Internet and mobile phone players which hit the wall as early as February and March 2000. It wasn’t until 2001 that the whales of Enron, MCI etc… really hit the wall.

Today, one could argue that with the US sub-prime lenders running into trouble, we are seeing the first “little fish” of a liquidity shakedown. Will there be bigger fish? Very possibly. For this reason, whenever we see “little fish” emerging, we tend to review our holdings carefully and make sure to avoid holding anyone, big or small, running negative cash-flows.

So where does this liquidity shakedown come from? Here, just like in the Anna- Nicole Smith-daughter saga, we find several potential fathers:

• Tightening by central banks: In recent weeks, central banks around the world have continued to tighten the screws. We saw rate hikes in the UK and Japan, as well as reserve requirement hikes in India and in China. Undeniably, and against what most people were expecting at the end of 2006, central banks remain on the war path.
• Rising Yen and the possibility of capital repatriation into Japan: It is interesting to note that, just as in May and June of last year, as the market hits an air pocket, the Yen rallies violently; it rallies especially strongly (around 2%) against the AU$ and the NZ$. As everyone knows, the Japanese investors have been exporting capital for years, and this has propped up international markets (see The Real Carry Trade Player - Mrs Watanabe). However, should the current Japanese rally prove less fickle than its predecessors (see A New Kind of Equity Rally in Japan), Japan’s constant flow of capital could be in the process of drying up.
• The US trade deficit is now improving: Earlier this week, in What if Growth Decouples from the US, we wrote: “The important question is not whether the US has a current account deficit (the world needs for the US to have one), but what the optimum current account deficit should be? And what happens when it is too small? Or too large…. Illustrating this point is the fact that, every significant improvement in the US trade balance has led to an international financial crisis. And this makes perfect sense: a smaller US trade deficit means that getting a hold of US$ is difficult; and when that happens, a marginal user of US$ somewhere around the world gets cut off…and goes belly up. If growth around the world today does decouple from a slowing US, and if as a consequence the US does start to export less US$ (a scenario which not only “feels right” but which is increasingly backed up by data), then investors should be careful to avoid all borrowers of US$ and negative cash flow assets”.
  
  
  
  

5– Putting It All Together: What We Think We Know
At this stage, there are only three things that we know for sure:

• Equity and risk assets around the world were very overbought and have now corrected a little.
• Real interest rates are much lower today than they were six weeks ago.
• Volatility has just increased markedly

What we think we know is that:

• Economic growth is slowing but it will not fall off a cliff, and we will not enter into a deflationary bust.
• The liquidity environment could be changing. Instead of having central banks withdrawing liquidity from the system and the private sector multiplying it rapidly, we could be moving towards a situation where the private sector’s ability to multiply money becomes constrained.

Putting it all together, this seems to us to be an environment in which high quality growth companies do quite well while cyclicals struggle. We realize that this is exactly the opposite of what has happened so far this year; but given the above, we have a hard time believing that the outperformance of steel, ship-building, materials etc… will continue unabated. The bond market is clearly telling us that the “inflationary boom” trades will not pan out; and we are inclined to listen.

We do not believe, however, that the overall upside trend in global equity markets is currently at risk. As we write the markets are trying to figure out whether the US, and the rest of the World, will enter into a deflationary bust. We won’t. And once the markets figure that out, the uptrend will restart. Finding this answer may, however, take a few weeks.

6– Conclusion: A Decision Tree
Whenever we get confused, we tend to draw up decision trees, as these tend to focus our thoughts in a remarkably clear manner.

Looking back at History, we found that big meltdowns and serious bear markets were typically preceded by at least two of the three following criteria: 1) serious rise in real interest rates, b) widening of quality spreads, c) increased volatility.

As we write, we have thus far only seen one of the three events taking place (the increase in volatility). So until we see either an increase in spreads, or an increase in real rates (and right now, it’s going the other way), we will be of the opinion that any brutal sell-off should be bought into.

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