just in in-tray
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NOTES FROM THE ROUND-THE-WORLD TRIP
Last week, my colleagues and I met with over 50 different professionals at 13 different firms to assess their observations and views of the market. Needless to say, they did not differ much from what I have been writing about for the past year or so.
? The economic outlook is likely to be the worst the world has seen since the 1970’s. It will definitely be worse than the 2001 recession, as that was very short, sharp and commercial led. This recession is being driven by both the consumer and massive over-leverage by both consumers and the financial community.
? While the US has led the downturn, both Europe and Asia will not escape unscathed. A large portion of mid-cap and family run businesses in Europe also highly leveraged their balance sheets in the past few years as did many consumers in purchasing their homes. Asia, as it is export driven, will also be affected. While most of Asia does not have a financial leverage issue (having learned from the Asia Crisis in 1998), they do have tremendous operational leverage, which will affect earnings much more than current analyst estimates expect.
? Different “mark-to-market” practices in Europe and US put the two regions in different stages of the economic downturn. The US has been forced to mark down much more quickly and severely than most of Europe. The question that is being debated is whether European financial institutions will finally be forced to have similar writedowns, or whether they will be able to “ride out the downturn” and never have to write things down severely. (this assumes a reasonably quick recovery by those that think they will not have to suffer similar writedowns). In either case, the downturn in Europe will emerge on a delayed basis relative to the US, and should start to show up in the coming months.
? There are some European banks that are still willing to lend, but they are few in number and are only willing to lend “smallish” amounts of US$100 million or less. Anything larger requires a “club deal,” which is increasing hard to put together.
? The US is in the beginning of the economic down cycle. That is, the US is probably one third of the way through the process on the debt and leverage side. There was almost complete unanimity that distressed assets will become more distressed, with many bankruptcies to come. The view was that there was no rush to jump in and buy and that the opportunities will still be there in 2009 and with much cheaper prices. In regards to real estate, the bottom may not occur until 2010 or even 2011 as some speculate.
? While distressed debt has widened to approximately 750 basis points, we can expect these securities to widen even further. In past recessions, these spreads have widened to levels of approximately 1200 to 1800 basis points over Treasuries.
? While residential real estate has already begun to plunge, softening is just beginning on the Commercial real estate side. Transactions were down 75% in the fourth quarter of 2007, as the prices bidders were willing to bid became much lower than the prices sellers were willing to sell their properties for. Cap rates for prime commercial buildings in the largest and most desirable cities have widened by 50 or so basis points to around 5.5%. However, cap rates in most other cities in the US are now closer to 8% or 9%, and the suburban areas of cities such as Washington DC and New York City have widened more substantially as well. Most saw that any overseas interest was in basically 5 or so cities – Boston, New York, Washington DC, Los Angeles and San Francisco. There was much less interest from Middle East buyers than one would expect. Most were sanguine about New York real estate, saying that there was not enough supply coming on to the market and that it would take substantial layoffs in order to push up vacancy rates substantially. On this point I disagree, as supposedly 40% of all office space is let by financial institutions and their related support industries. I think New York City will not escape and cap rates will widen and vacancies escalate on similar terms as the rest of the US.
? Longer term holders of US Commercial Buildings will not be sold and those owners will be willing to “ride it out.” However, those that bought in the last 18 months will soon be distressed sellers. Many of the recent purchases included short-term, 1 to 3 year bridge loans that will not be refinanced at existing Loan To Values nor at reasonably cheap interest rates. Most anyone who purchased EOP assets via Blackstone in the past year will have a hard time, as most were purchased at very low cap rates and with very little equity. One example would be a purchase in Los Angeles that was done with a loan of 90% LTV, with an interest-only loan that covered only 60% of the rent roll.
? Many of the Private Equity deals done in the past 18 months were done with incredibly high leverage. How much more leverage? In 2001, US Private Equity firms paid 6.1 EV/EBITDA for the average transaction with a total debt multiple of 4.1 times. In 2007, the purchase multiple was 9.8 times EV/EBITDA with a total debt multiple of 6.2 times! The numbers for Europe are similar. Oaktree also pointed out that the US has nearly US$2.5 Trillion of Low-Grade Debt outstanding, 65% higher than in 2001 and that Europe has US$732 Billion of Low-Grade Debt outstanding, almost 200% more than in 2001. They also pointed out that in many deals done in the past 18 months, the amount of debt on the firms that were bought out exceeded the total Economic Value (EV) prior to the takeout bid. All of these types of deals are extremely vulnerable to a downturn in the economy. Oaktree also noted that default rates were 10% or higher for high yield debt in both the 1990 and 2001 recessions. They see no reason why the rates shouldn’t be at least as high this time around. In fact, Howard Marks claims that this time will be a “once in a lifetime opportunity” to buy bankrupt and distressed companies.
? Those with lots of cash on hand to offer Mezzanine financing are in a prime position, basically able to pick and choose which firms to finance and on their own terms. For example, Goldman Sachs’ Mezzanine Fund has US$20 Billion to put to work. That means for the larger deals, they are the only player in town. The Fund is demanding (and getting) interest rates of 15+% with equity kickers and they are only financing those companies who they think have very strong businesses that have very little cyclicality in their revenue and cash flow streams. The interesting thing going forward will be to see whether Private Equity firms let certain investments go bankrupt, or whether they will attempt to buy back some of the discounted bank debt to recapitalize the investments at preferential terms. I suspect that the decision will be made on a case by case basis.
In sum, the dislocations are still at an early stage, and any attempt to bottom fish at this point in time would be extremely risky, as Joe Lewis’ $1 billion equity refinancing of Bear Stearns has proven. The downturn will last for quite a while, and while there will be some fantastic opportunities to purchase good companies at distressed prices, 2009 is probably the very earliest one should consider investing. The deleveraging of the financial system will continue for quite some time and no new lending by banks will be made available until their balance sheets are healed and/or recapitalized. This will also take time. Those with lots of cash and no debt today will be the ones who will be able to benefit over the next decade.
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