Even though Tony’s call for the attendees to go out a tell the people about the benefits of covenant-lite and PIK toggle debt was a joke but he did put up a valiant PR/charm offensive to try to defend these kinds of financing.  Basically, his argument amounted to an argument about the damage done to companies by debt holders through a company into a bankruptcy and getting DIP financing.  James argued that in most cases a liquidation of a struggling sponsored owned company is not the right move.  By having more flexibility to not trip covenants and toggle to interest payments tacked onto principle allows companies to continue to operate, not fire employees, and fix themselves.  He downplayed the damage that this kind of debt does to senior debt holders.  It is alright if James doesn’t have a problem with the senior debt holders taking a bath but he should not complain when the senior debt holders and senior subordinate debt holders do not want to give him aggressive terms.  James may also just be wrong when he makes the statement that defaults are low and will stay low because of loose covenants.  It may just be the case that because of covenant-lite and PIK toggle features of recent LBO related debt there will be fewer warning signs since covenants will not get tripped and once the companies do go into default they will be more badly damaged before the restructuring specialists and distressed investors get their hands on them.  Basically, PE firms may get more rope to hand themselves with if they can take senior debt holders for a ride longer because of covenant lite and PIK toggle features on the debt that finances their portfolio companies.  

Richard Shinder, a director in Goldman Sachs’ Special Situations Group, made basically these arguments which James disagreed with in Q&A.  There are plenty of banks and distressed investors that are staffing up right now for a major ramp up of defaults so obviously not everyone agrees with James.  Shinder coming over from Avenue Capital in and of itself serves as an example of Goldman Sachs staffing up for the start of a distressed explosion.  A representative of S&P at the conference said that their worst case scenario put defaults at 8.9% in 2008.  Other panelists at the conference thought that the debt markets were pricing in a 10-15% default rate in 2008.  In fact, no one was as rosy on where defaults would be than James but what did we expect him to say.  James attributes the lack of defaults in the face of a slowing economy to the covenant-lite debt terms portfolio companies received in the boom times.  James said that, "Covenant-lite debt structures are not only private equity’s interest, they’re in everyone’s interest … The only one you might argue is not better off is the senior secured. By keeping the company intact, the private equity owners are able to fix the problems, and by preserving the employees, the customers and the business society at large benefits."

Here are some interesting quotes from Shinder courtesy of The Deal:

"There are important factors affecting the marketplace. Even in deals that weren’t covenant-lite, the covenants were looser in general … What that will mean through this cycle is that those early warning signs that you had in prior cycles won’t be there anymore."

"Because you will have not had the intervention from turnaround advisers, businesses will be presented to [distressed investors] in a different state … because the opportunities to save the patient will have been missed. They’ll be more badly damaged from an operational point of view because there was no earlier intervention."

Also, let The Prince just point out that James really misrepresented his firm’s activities when he said that they were conservative users of leverage.   Blackstone was one of the most aggressive users of leverage and demanded the most concessions on covenants during the boom.  Almost any banker who worked opposite Blackstone during the boom will confirm this.  Just look at Freescale.  Who cares what the comps are trading at, 8.5 turns of leverage on a technology company is absurd.  Keep in mind that cash flows from this kind of company are way more variable than the industrial/manufacturing companies that PE firms have bought for years with successful results.  Please also believe The Prince when he says that if Blackstone and its partners could have got 10 turns of leverage from their lenders they would have taken it.  Blackstone, like other big buyout shops, does try to improve operations but lots of their returns do come from leverage.  James said something like only 10% of Blackstone’s PE fund returns in the past came from leverage.  That figure is immediately suspect and clearly misleading.  How would one even go about coming up with such a number?  How would you calculate it or determine which parts of a return are attributable to leverage, multiple expansion, or operating improvements?

Tony James was quite smug on the performance of Blackstone’s portfolio.  He defended the buyout of Freescale by saying that the acquisition was done at 8.5x EBITDA when the comps were trading at 12x.  He also said that outside of cell phone chip sale weakness related to Motorola’s weakness Freescale had gain share in all other markets.  He had a reason to be smug about Blackstone’s EOP deal.  That deal is rumored to have been an almost immediate success because of the great prices that pieces of the portfolio were sold for.  James was also smug when he talked about Blackstone saw opportunities to take advantage of many companies/individuals that bought EOP properties from Blackstone with short-term debt and no cannot roll the debt into long-term financing.  Wow Tony, so nice of you to lend them a hand.  With any luck you will get a chance to rip the faces off of the buyers of EOP properties from you once more.

The Prince must be allowed one ending digression on the smugness of Tony James and Blackstone.  I think the Epicurean Dealmaker sums up the ethos of Blackstone conveyed by their annual report quite well in his latest post, Bubble Land.  Here is an excerpt that The Prince found particularly funny but true:

Second, what kind of self-image do these images of Blackstone’s personnel convey? That they are so fucking powerful they use the streets of Manhattan for a conference room? That New York City itself is merely a vaguely fake-looking background to the important issues BX deals with every day? That BX functions in a surreal bubble devoid of all other human presence? That the Executive Committee likes to reenact scenes from Reservoir Dogs?

Third, what’s with the black cover? A sort of reverse Beatles White Album? An evocation of the all-powerful monolith from 2001: A Space Odyssey? A sympathetic black armband for pathetic unitholders who have lost somewhere between 35 and 50% of their investment value in BX shares since the IPO? Or just a "We’re so powerful and important we don’t need to put anything on our annual report cover" fuck-you?

And last but not least—although I admit the connection to semiotics or symbolism is tenuous at best—what the hell is with Steve Schwarzman’s suit? I mean, the guy is a fucking billionaire, and he looks like he’s wearing something The Men’s Wearhouse custom-made for MC Hammer. I haven’t seen pants that baggy below 116th Street since 1988.

Get a fucking tailor, man.

(Oh, and next time, hire someone who actually knows what they’re doing to design your annual report.)

Click here for the bios of the speakers and a schedule of the events.  The Prince has been really looking forward to this conference for the past few weeks and the featured speakers and the panels should offer some really great color on the state of the private capital investing world and the acquisition debt markets that finance PE investing. 

The Prince is especially interested in hearing the interview with Ken Moelis (click here for The Prince’s coverage of a previous interview with Moelis).  The panel with Alan Jones from Morgan Stanley and John Eydenberg from Duetsche Bank should also be really interesting.  The panel moderated by The Deal’s senior writer, Vipal Monga, will examine how financing will change as a result of the recent credit crisis.  The Prince often wonders how private equity firms will continue to bring in assets if their returns continue to decline and financing gets less aggressive.  Someone will benefit from changes that come about as a result of the recent crisis and The Prince is looking forward to hearing the professionals on this panel make some predictions.  The Prince will be writing about how the various industry leaders perceive the private equity environment during and after the conference. 

The story of Old Lane reminds the Prince of one maxim that should now be abundantly true.  Investment banks should not be in the business of buying hedge funds.  If they must own hedge funds to accomplish other goals, like talent retention, they should create such funds organically.  Investment banks should grow hedge funds organically if they must grow them at all and not go out and buy them.  The risks inherent in a purchase such as failure to properly align incentives using compensation and key person or human capital risks combined with high valuations makes any purchase of a hedge fund by an investment bank a value destroying endeavor.

First, we have the failure to align incentives in a large hedge fund once an investment bank makes a purchase.  Structuring compensation to reward and retain employees at a hedge fund is the most important decision a portfolio manager/CEO makes at a hedge fund.  They must pay their people enough to retain them and also give their employees compensation in forms that will encourage them to stay and not leave for other funds or to start their own funds.  Once this compensation structuring is taken out of the hands of the portfolio manager, who is the main owner, and the new owner, i.e. the investment bank, has a say this tough decision becomes nearly impossible to get right.  The best talent will realize that since a large asset gatherer like Old Lane owned by Citigroup is highly risk averse there will be less opportunity for the talent to take risks.  If the talent feels like they are not able to take risks that present attractive opportunities for the fund (and their own personal compensation as a result) because losses that could materially change the performance of the fund could result they will realize that their risk taking expertise can be better rewarded at other firms.  There is absolutely no way that investment banks can properly maintain incentives in the hedge funds they buy to retain talent and adequately reward talent.

Second, what are the assets that hedge funds such as Old Lane use to generate earnings?  Ultimately, a hedge fund’s assets are the people it employees and the expertise they bring to bear on the investing done by the fund.  When an investment bank buys a fund they are exposing themselves to human capital and key person risks that must be taken into account. What if the main portfolio manager tries to leave the fund or worse, just stops working very hard because he or she has already cashed out in the sale?  What if the portfolio manager’s top subordinates and their groups leave?  It is just impossible for an investment bank to protect their investment when their assets can be walking out the door or dramatically lowering their productivity because incentive structures based on compensation are misaligned.  These first two points about why investment banks should not buy hedge funds are inextricably link and the two points affect each other. 

Yet, these two points alone do not make a complete case for why investment banks should not buy hedge funds.  These first two points only take into account serious risks that should dramatically impact the valuation that a bank is willing to pay to acquire a hedge fund.  So if banks take into account these two major risks to the value of the hedge funds they are buying we should see low valuations, right?  Wrong.  The valuations paid for hedge funds paid by investment banks have been off the charts and they are downright ridiculous when taken in-light of the two points above made about risks to the value of a hedge fund bought by an investment bank.

Which brings us to The Prince’s final point.  The valuations given to hedge funds by investment banks are simply too high.  They are too high in light of the two aforementioned risk points—they are also too high because the banks are not making reasonable assumptions about the future of these funds.  What do I mean by "reasonable assumptions about the future of these funds"?  There are a number of assumptions that they are making which are crazy.  First, they are not adequately factoring in the risk of redemptions if the fund has a bad year or under performs. This risk, which is not that unlikely, basically makes the asset the bank bought worth nothing.  They are also not taking into account the fact that as a general rule of thumb, the larger a fund the lower its returns will be.  Larger funds simply do not have as many profitable ideas to put money into.  They have trouble deploying all their capital into their best ideas and often invest capital in ideas that will not generate Alpha. 

Returns to investors do decline when funds grow in size, any savvy investor in hedge funds will tell you this.  In fact some institutional investors in hedge funds will not invest in large funds because they do not think they provide enough value for their fees.  The larger a fund gets the more it becomes an asset gatherer trying to make gains on management fees and earn market returns so that its capital does not get redeemed.  The larger a fund gets the more risk averse its behavior becomes because it has a lot more to loose on the management fee side if it gets aggressive, shows a loss, and then gets a large chunk of its AUM redeemed.  So in light of these facts investment banks, in their valuations of hedge fund partnerships, are probably assuming that returns to investors will be better than they are likely to be in reality.  Considering all the points in this paragraph banks should be a lot more conservative when they predict the returns that a hedge fund will earn for its investors.  Being more conservative in this estimate will lead to lower projections of revenues from management fees which will impact valuation.  The Prince also believes that investment banks are probably not properly estimating compensation expenses.  Many investment banks may believe that they can cut compensation expense and still retain talent once they buy these hedge fund partnerships.  That belief is pure fantasy.  Investment banks should pay low valuations for hedge fund partnerships for no other reason than the cash flows from such partnerships are going to unpredictable.  This just comes with the territory of a business where most of your variability in earnings comes from an incentive fee pegged to performance and your capital can be redeemed subject to the lock-up and quarterly redemption schedule.

To demonstrate the points made above the Prince did a quick and dirty analysis of the acquisition of Old Lane by Citigroup.  The assumptions and ranges are based on the Prince’s experience in Prime Brokerage.  Obviously there are many things that are not absolutely correct here like the fact that the management fee is paid each quarter not in a lump sum by the investors.  I am also assuming that Old Lane has an incentive fee of 20% and a management fee of 1.5% which may actually be high given the size of the fund.  The Prince is also assuming that at the time of Citigroup’s purchase Old Lane had $3bn in assets under management.  The fund launched with $2bn and it is difficult to tell what its size was when Citigroup acquired it, but pegging it at $3bn is generous.  The analysis below is meant to push the envelope in an effort to justify the valuation given to Old Lane by Citigroup.

As you can see the price looks absolutely ridiculous for the kind of business that is prone to the kinds of risks and unpredictable cash flows outlined above.  The analysis also assumes no hurdle rate which would make the analysis make Citigroup look even worse.  Furthermore, it assumes that operating expenses like office leases, infrastructure etc. will run at only 1% of AUM which is probably low considering that Old Lane has a few hundred employees and offices on multiple continents.  The 20% incentive fee may even be high since it is almost a given that to raise the initial $2bn in AUM Pandit and company had to grant fee breaks to investors willing to write big checks on day one.  The 50% of revenues going to employee compensation may also be too low.  While this is a good assumption to make at investment banks when it comes to estimating employee compensation expense, it probably does not approximate hedge fund employee compensation expense which is probably a higher percentage.

Some may say well, Citigroup must have been expecting the fund to return more than 10% on average or grow in size to justify the multiple paid.  This expectation, if Citigroup held it, is foolish for many of the reasons listed above.  These reasons include the fact that investment returns usually decline as fund size increases and the unpredictability of investment returns which leads to unpredictable earnings for the hedge fund.  Let’s cut them a break and look at the valuation if Citigroup expected Old Lane to run at an AUM of $4.5bn and earn 10% each year. 

24x earnings is still a crazy sum to pay considering the unlikelihood that these assumptions will play out.  Old Lane did reach a peak AUM of 4.5bn before getting all its outside money redeemed and it never earned anything near a 10% per year return.  Now Citigroup is faced with the fact that it paid $800mn for something that is worth close to nothing, and will be worth nothing once all the talent leaves Old Lane’s sinking ship.  Yet, Citigroup is not the only bank that is giving crazy valuations to hedge funds when they buy them.  Morgan Stanley and others have also played in this water.  Some, like UBS, have even got burned (take a look at UBS’s write downs related to internal hedge fund Dillion Reed’s credit exposure).  It is time for investment banks to stop buying hedge fund partnerships.  Because of all the argument in this post, buying these things is unlikely to create value for a bank.  The risks are too great and the returns are to small or too unpredictable to compensate.

Pandit and his top lieutenant, John Havens, were admired and respected in Morgan Stanley’s institutional securities division.  Yet, selling this firm to Citigroup at $800mm then assuming posts at Citigroup looks like the height of blind self-enrichment.  In a phrase, "where’d you go wrong sons."  The only problem with this view is that someone at Citigroup was dumb enough in the first place to pay $800mm for Old Lane.  Thus giving us yet another example for why investment banks have no business purchasing hedge funds. 

Daniel Primack at PE Hub discovered on Friday that J.P Morgan is leading the lenders.  He also got the opinion from the sponsors that the process to get committed financing was made easier by ConvaTec’s high cash flow and lack of cyclicality.  A few months ago you could make those arguments until you were blue in the face and not get committed financing.  The banks must believe that the leveraged loan markets improvement is here to stay if they are handing out this much debt at terms that a sponsor could accept.  It is also interesting to note that ConvaTec was probably shopped around by its advisors as an LBO candidate and Avista and Nordic probably won a competitive bidding process.  Look out strategics, the PE sharks may soon be back in the water.

2) Epicurean Dealmaker - "Not Safe for Work"

Ed: "Like: did Al Gore really invent the internet? Does the "Prince of Wall Street" still have a job offer in Financial Sponsors at a "bulge bracket" bank? And, is it true that Equity Private and Dan Loeb plan to use a mixture of shredded 10-Qs and portfolio company business plans as confetti at their upcoming wedding scheduled for a secret location off the Dalmatian Coast? We may never know the answers, Dear Readers, but certain questions are worth asking anyway, no?"

Answer: ED, You better f**ckin believe that The Prince still has a job.

The Prince would also love to see more banter between EP and ED, but he’s not sure if this is going to get that going.

3) Information Arbitrage - "The KKR/SUNW Deal Telegraphed Today’s PE Environment"

Much better argument and analysis than the Prince put forward about private equity’s style drift.  Here Ehrenberg mainly focuses on the perverse decision making that comes about, like PE shops taking public equity stakes, PIPE stakes, or convertible stakes in public companies, when funds are too large and financing for LBOs is absent.

4) Naked Capitalism - "Hubris, Denial, and the Financial Services Culture"

Takeaways with a smile from the Milken Conference.

5) Dollar may have fallen too far relative to the Euro, according to the futures market.

The conditions seem right to go contrarian and short financials.  These firms are going to raise more capital as the recession worsens and losses related to the U.S. mortgage crisis grow.  The sector is also likely to see more dividend cuts and lower returns as a result of deleveraging.  Morgan Stanley analysts Betsy Graseck, Cheryl Pate and Justin Kwong came out with a similiar assessment of the sector in a research note on Monday.  The analysts also said that the credit markets problem are leading to a situation that is worse than the recessionary environment of 1990 and 1991.

Given the continued disarray in the credit market and the other headwinds faced by the sector, like a U.S. recession and deteriorating consumer credit performance, the recent rise in financial stocks may be premature.  Financial stocks in the S&P 500 are up more than 15% since their lows in mid-March when Bear Stearns got saved.  The difficulties in the credit markets are not even half over and fixing these markets will take even longer.  There are still lots of risks to financial firms.  The prince believes that credit deterioration will accelerate and banks will dilute earnings by raising more equity capital.  With all the aforementioned risks to the downside The Prince thinks it makes sense to short financials.  As the Prince has written earlier, an easy way to sell short financials is by buying SKF.

Disclosure: The Prince owns no positions long or short in financial firms or related ETFs composed of financial firms.

The demand increases may slow soon if the U.S. economy continues to slow and drags the rest of the world down with it.  Furthermore, the high price of oil and gasoline may lead some businesses and consumers to switch to substitutes like natural gas or electricity for their energy needs that were previously met by oil.  Higher prices may also lead to less demand from consumers as they make decisions about energy use which conserve energy such as driving less.  So the rise in oil/gasoline prices may ultimately serve to decreases in demand if it induces conservation or substitution.

Given this rudimentary analysis, the Prince looked on with disgust as Hilary Clinton and John McCain lined up to endorse a plan to suspend the federal excise tax on gasoline for the summer travel season.  How do they plan to make-up for the tax shortfall that will be created by cutting the 18.4 cent per gallon tax?  You guessed it, by introducing legislation to impose a "windfall profits "tax on oil companies.  The Prince puts "windfall profits" in quotes, unlike the New York Times, because The Prince thinks that framing oil company profits as "windfall profits" is misleading.  What does "windfall profits" even mean?  Does it mean undeserved, unexpected, higher than normal and/or ill-gotten?  The Prince really has no idea what this phrase means.  As far as The Prince is concerned it is nothing more than a label trotted out by politicians to vilify the oil industry to appease ignorant voters.

It has been awhile since the Prince has seen such a transparent attempt to pander to voters by proposing legislation that is stupid and inequitable.  Let’s go to wonderland for a second.  "Look at me! I am on the side of the working man who weeps when he has to fill up his truck with $4,00 gas.  I am going to take ill-gotten gains from the big bad oil companies and give them to the working man by dropping the excise tax."  Let’s just throw the shareholders of these terrible oil companies under the bus.  Doing that will definitely lead to the kind of investment in extraction and refining that we need to increase supply.  Right.  Does this sound as crazy to you as it does to the Prince? 

Let’s go back to the real world for a real statement from the McCain campaign as quoted by the New York Times.  “It’s clear Barack Obama’s not strong enough to provide immediate relief at the pump, and it shows he doesn’t understand our economy or have the ability to deliver for hard-working Americans,” said Tucker Bounds, a McCain aide. “Senator Obama’s arguments against John McCain’s gas tax holiday are complete fiction, and the reality is that he used to support a gas tax holiday before he was running for president.”  Really, he doesn’t understand the economy?  Any middle school economist could tell you that this plan is stupid and does nothing to lower the long-term demand for oil or encourage more investment to bring on more supply.  Statements like the one made by Mssr. Bounds absolutely disgust The Prince and give him no confidence in his representatives ability to make decisions based on reason.

"Gas tax holiday" there is another phrase that does not make sense.  It makes this legislation sound like a sweet deal for everyone like a free trip to the Hawaii or something.  Anyone who sat down and took a look at the history of boom followed by over investment then bust in the energy sector would never argue for a "Gas Tax Holiday" financed by a "windfall profit" tax.  The truth is profit desert has nothing to do with this question.  Oil companies have to have incentives to make investments in bringing more supply online.  They will only make the investments if they think they will get the returns on this investment.  The government changing the game by taking profits from the oil companies when times are good and not giving the companies any help when the industry is over-invested should give oil company investors fits.  The oil companies’ shareholders deserve the return on the investments their companies made.  Politicians should not have the authority to take from these shareholders who took the risk and give this to consumers who want cheaper gas.

This proposed legislation is so obviously political and it does nothing to solve the problem of high oil and gas problems.  In fact, in choosing to impose a windfall profits tax on oil companies the legislation makes it less likely that supply will be increased in the future and offers decreases incentives to conserve energy.  Removing this excise tax may make sense as a way to stimulate spending on non-energy purchases.  Yet, it’s purpose clearly is just to appeal politically to consumers who want short term savings on gas and are not looking at the long-term implications of this savings.  Politicians should be looking at the long-term costs of this legislation.  While the Prince is an independent and does not support Obama, Mssr. Obama does get it right by opposing this legislation.  It takes courage to take this stand considering how damaging it may be politically.  Mssr. Obama makes the decision for the right reasons too.  While he doesn’t argue that the industry should be protected from a "windfall profit" tax, he does firmly argue that the plan would save consumers little and do nothing to curtail oil consumption and imports.  Let’s get back to reasonable energy policy and not these politicized concessions that offer short-term political gains but no real long-term solution to the problems we face in the energy sector.

Here is an excerpt:

"When the music of financial-services contraction stops, there will be a lot of investment bankers without seats. Merrill Lynch alone recently said it would lay off another 2,900 people, on top of the 1,100 jobs already eliminated this year. The total number of eliminated banking jobs is likely to dwarf the 90,000 over the two years following the Internet bust of 2000.

For many of these bankers, getting fired could be the best thing that ever happened to them.
Rainer Maria Rilke, in "Letters to a Young Poet," offers some words of wisdom that the newly jobless would do well to consider: "This most of all: ask yourself in the stillest hour of your night: must I write?" Rilke warned of the hardships of his chosen craft, arguing that if the poet could even imagine living without writing, he would be better off doing so.

This kind of profound introspection is rarely undertaken by those young professionals who march off to investment banking careers based more on what is expected of them than on any deep commitment to the field. They should take a moment to ask themselves: Must I bank?

Such introspection, even if it comes late in life, can lead to greater fulfillment than scrambling for the next best investment banking job that might still be available. I wrote in my last book that the opportunity to really pause and face a world where the next step has not been preordained can be a profoundly cathartic learning experience. Judging from the emails I received after the last bust, many may have benefited from doing just that."

The Prince agrees with everything that Knee argues in this article.  Anyone considering a career in banking should read this article. It also offers a framework for how those who have been laid off should think about their situation.  It may actually end up being the best thing that ever happened to them, even if it feels like the end of the world right now.

Foreign sovereign wealth funds have put large amounts of money to work in the U.S. but mainly in the financial sector.  Yet, foreign strategic buyers have been larger overlooked in the speculation about who the new acquisitors would be in the M&A market.  Adam Reinebach, a recent article blog post at Mergers Unleashed, gives some reasons why the environment for cross-border M&A led by foreign strategics is strong:

"At least on paper, the conditions for foreign buyers interested in U.S. targets couldn’t be more auspicious. The dollar is weak, M&A financing is harder to come by for financial sponsors, and many strategic buyers in the States are hard-pressed to make acquisitions at a time when earnings targets are being missed."

He also, lays out some of the negatives that may prevent foreign strategics from getting deals done in the United States:

"I would guess that most companies would ultimately be willing to sell to a foreign buyer if the price is right and they feel the asset is being left in good hands. But for smaller companies, in particular, the concept of selling to a buyer in Europe or Asia can still be unnerving…These fears, however unfounded they may be, are only reinforced by all the talk about sovereign wealth funds invading American soil. That’s a topic for another column, but I’m guessing most readers of this column would agree that much of the mainstream commentary and press (i.e., the recent 60 Minutes interview with China’s SWF chief) has been negative and perhaps short-sided."

While The Prince mainly agrees with Reinebach about the environment that should encourage a cross-border M&A boom, It is worth noting that there is strong argument that European strategics may also fall victim to the same paralyzing effects that U.S. strategics have been hit with.  Given how connected the U.S. and foreign economies are, many foreign strategics have begun or will begin to see slowing earnings as consumer demand in the U.S. falls and U.S. consumers continue to default on consumer credit products.  Furthermore, foreign strategic buyers may see the turmoil in the U.S. credit markets and the slowing U.S. economy as reasons why a purchase in the U.S. at levels that satisfy U.S. sellers with unadjusted expectations may be imprudent.  In fact, the more we consider this topic, to more we see that by-and-large the considerations that are keeping U.S. strategics on the sidelines of M&A and the same considerations that will probably keep foreign strategics out of the U.S. M&A market.

Remember KKR closed the acquisition of Boots over a year ago.  The banks aborted the sale in July after offering discounts on the debt of below 90% of par.  For the most toxic issuance things have not improved much.  For example, this month Goldman Sachs sold $500 million of debt financing the buyout of Chrysler for as little as 63% of par.  Aggressive pricing has allowed banks to cut what was $237bn in unsold leveraged loans on their balance sheets to $95bn, according to Standard & Poor’s.   Could this recent improvement in leveraged loan pricing be indicative of the start of a reopening of the market to new issuance?  

Sounds like fighting words to the Prince.  The Prince has stayed on the sidelines on the Clear Channel dispute until this point.  The buyout firms’ quick rejection of the arbitration offer from the syndicate of banks prove once again the Prince’s earlier argument (Wall Street’s Short Memory on Private Equity) about how much leverage sponsors have when it comes to negotiations on committed financings.  If a group of financial sponsors wants to get get a deal done then they have very few incentives to give concessions to the banks that committed financing.  The fact is the banks and the private equity firms are essentially engaged in a continuous multi-decision game and have relationships that negotiations will test.  However, given the short memory of Wall Street, it is unlikely that any buyout firm will see real repercussions in the future if it forces the banks to honor their commitments.  Provided the private equity firm has capital in the future to invest The Prince guarantees that there will be bankers willing to forget the past to get a deal done.  Any banker threatening in committed financing negotiations to not be as aggressive next time on terms or not show a sponsor a company first is probably full of it.  The sponsors know this.   

Let’s briefly review. The Clear Channel deal has been in the pipeline forever.  Since July of this summer the banks began to drag their heals and push back.  However, even before this point, the sponsors underwent a rather embarrassing battle with shareholders over what was a fair price.  This $26bn buyout secured roughly $19bn in bank loans and high yield debt from the syndicate of investment banks led by Citigroup.  The banks would have earned nearly $400m on the financing but the shutdown of the leveraged loan market this summer made syndicating the debt at a net profit impossible.  This deal was supposed to close months ago and would have closed a few week had the banks not put their foot down on a specific term that was a deal killer for the sponsors.  The sponsors quickly filed suit in New York and Texas with Clear Channel joining the Texas suit.  The banks petitioned to have the case moved to New York.  Today the banks said they were prepared to submit to the decision of an independent arbitrator and believed that the matter could be resolved within six weeks (see the text of the offer).  The buyout firms quickly refused the offer.  "We are ready to complete the deal to buy Clear Channel on terms consistent with the binding commitments the banks made nearly a year ago, and provided all the documentation needed to execute the funding, but the banks refused to sign," the private equity firms said.

This kind of reminds the Prince of when Merck tried a few cases to try to set a precedent for how large the settlement would have to be over Vioxx.  The banks are going in to this one hoping they can set a precedent which will allow them to wiggle out of other committed financings in this environment or at least limit the pain.  The thought process is something like there is a speeding truck heading towards us and its hood says BCE.

It is probably a good thing for the industry that the Clear Channel suit brought by the sponsors against the banks will go to court.  Hopefully, it will be tried in New York.  Having this case go to court will set a precedent for how the industry and the courts should treat committed financings.  In an ideal world the case would be argued and decided before other massive buyouts, like BCE, go through.  The financial sponsors have a better case in the Clear Channel suit and The Prince knows they are going to win if this suit goes to trial.  However, the decision will be more important as a precedent for future negotiations.  This is probably one of the most important cases in quite some time in terms of its potential to remake the relationship between the sponsors and the investment banks.  The reputations of all the parties involved in this case are on the line but the banks have the most to lose and the sponsors have the most to gain.  The private equity firms didn’t blink in this negotiation and it will make future negotiations much easier for sponsors as a whole when they win.  The hearing this Thursday in New York should be interesting. 

A few weeks ago Ken Moelis, former Drexel, DLJ, UBS rainmaking banker, was interviewed on Bloomberg about the leveraged loan market and the changes he expects to see at investment banks.  Few people are as well placed as Ken Moelis to make such forecasts and his commentary is fascinating.  He also answers questions about his new boutique, Moelis & Company, and its phenomenal recent performance.  He also throws some criticism at UBS, his former employer.  He criticizes the financial conglomerate model because lines of authority and decision making are difficult to discern.  The Prince knows that this news is slightly outdated but he does not think many people saw this interview.

Here is a link to the video that aired on April 9, 2008

On investment banking in general:

"Investment banking is an incredible business.  A very unique business in which you empower some very smart people to take unusual risks.  Almost no other business in the world allows you to empower people on a day-to-day basis to take risks."

On the leveraged loan market in response to John Mack’s rosy picture:

"To give John Mack his due, maybe we are in the 9th inning, but that means they shut the game down.  What you are really asking is when does the next game start and I think we may be in the 9th inning of the last game and we might have to wait a year before baseball season actually starts again.  Because there is no more backlog being created and there are no more commitments out there and so yeah we may be ending the crisis point in leverage credit but the floodgates will not open again for a long-time.  I think it takes a long time for these cycles to reappear; people learn lessons, boards of directors, risk managers.  It will happen again but it will probably be five to six year before we get anything like what we at 9 months ago."  

On private equity’s edge in the boom:

"There was a real arbitrage, I believe, going on between the public equity market, which was being pretty irrational, and the private finance market.  What really happened was the security that was being under priced was leverage.  It was being given away in too large size at too low rates.  And what a lot of the private equity firms were really doing, I’m not sure they thought about it this way, but they were using the arbitrage of cheap credit which allowed them to actually pay 25-30-40% more than public equity markets.  Because what we are finding out is the debt was giving them that ability by pricing themselves too low or too aggressively." 

On Moelis and Company’s edge and the M&A market without LBOs:

"First of all, let me defend us [Moelis and Company], because you said we don’t have a balance sheet and I was joking.  I think we now have the strongest balance sheet on Wall Street given what is going on.  I‘m not sure that anyone has what you would call a balance sheet anymore from the old definition.  The interesting part is that M&A, I think is going to be down but nothing like what were feeling like in New York because of the finanacial panic that we are seeing here.  The rest of the country is really not experiencing quite the same pressure that the financial are and I think you are seeing strategic deals come back.  We just put a company up for sale this week and we did get 20 bids from financial sponsors.  So I think if you have good product people will find a way to finance it and purchase these companies."

On the investment banking business:

"We are going down, we will be down 30 to maybe even 50 percent in the short run and I think the street got staffed up to support what was a slight bubble in M&A.  I do think that people will have to downsize but it will be a healthy market.  Remember, if we went back just to 2005, we sort of had a very big spike in volumes in 06 and 07.  So if you go back to 05, we may have to go back to staffing levels of 05.  It’s not the end of the world…Look, I think across the board you are going to see these firms have to reduce by anywhere from 30 to 35 percent of headcount.  A lot of the financial products are going to go down more than M&A, some of the actual leverage lending itself and mortgage products and I do think you are going to see a significant retrenchment on Wall Street."

On relationship investment banking:

"What we are really doing out there, that is leading to our success, is that we’re going back to relationship investment banking.  I think that there was a lot of distraction here put on leverage and how much you could lend people and at what rates and I really think the CEOs and these companies want long-term relationships.  People who are willing to say no to them when you should say no and will know that they will still be involved with that company 3, 4, 5 years from now when they might do a transaction.  And I think that Wall Street really has to get back to that and we hope we are leading the charge in that direction."

Sounds like a page out of the Accidental Investment Banker or Goldman Sachs: Culture of Success.

On how Wall Street firms will survive a private equity fee diet:

"Well I think the good ones are going to manage back to remember who their client relationships were.  I think they are going to have to go back out, remember that their client is a relationship not a counterparty, and I think they are going to have to remember that about their own people too.  I think some of these firms have gotten used to moving paper around in size and forgot that the people within their own organizations are the true assets.  We used to say that the assets went up and down in the elevators at these investment banks but now the assets are piled up in CDOs and warehouse facilities and that’s the problem.  So I think you are going to see the firms go back to relationships with their own employees, the ones who do it right, I’m not sure that everyone will get there as quick as they should, and we might actually see some deconglomeration of these financial institutions." 

Given the first quarter M&A numbers all of what Moelis describes lays out sounds correct.  In the first quarter M&A activity by volume was down 22% to $861 billion globally versus Q12007.  U.S. activity was down 28%, to $318 billion, reflecting lack of credit for acquisitions and the related hiatus of financial sponsors.  Also consider that Yahoo-Microsoft at $45bn and Phillip Morris’ divesture by Altria at $111bn make up 50% of U.S. M&A thus far.  M&A fees are also down 28% globally in Q12008 versus Q12007. 

The recent wave of layoffs have predominately been in departments that are close to the credit crisis, i.e. structured product groups and leveraged finance product groups.  While some layoffs have occurred within investment banking division with deal volumes dropping more layoffs will be coming.  Certainly product groups like leveraged finance have already been cut and will continue to be cut but even coverage groups will be trimmed.  Many banks are even beginning to reexamine their M&A groups, normally considered the safest and most prestigious groups within most investment bank.  The investment banking divisions at major banks are going to be facing significant headwinds over this year and possibly even through 2009.  While these headwinds will certainly lead to some restructuring of the divisions, The Prince agrees with Moelis, that some downsizing will take place. 

However, those predicting cuts similar to those that occurred in 2002 in the wake of slow M&A from 2001 to 2004 will probably be wrong.  Moelis is right on point when he says we are going back to 2005 staffing levels.  Much of the headcount that was focused on financial sponsor transactions will be directed towards the middle market, deals with foreign buyers, and hostile transactions.  This makes sense considering that DB, GS, and MS all have their global M&A group heads based out of Europe now. 

If you are curious about what Moelis and Company is up to check out this great article from Dealmaker (free subscription required).

Amazingly, the goal of both the government and banks is to jump-start corporate lending and funding for consumers.  If that was the aim of Federal Reserve they sure have been pursuing the wrong policies recently.  The Federal Reserve has a similar program but the British approach would allow banks to park mortgage loans with the central bank for an entire year, or possibly more. The Fed’s effort allows banks to exchange mortgages for government bonds for 28 days with additional restrictions.  The European Central Bank recently began lending against mortgages for periods as long as six months. 

Under the terms of the pact with the banks, the Bank of England will swap as much as £50 billion in government bonds for securities backed by mortgages and some credit-card debt.  It is rather surprising to the Prince that in a small country where the public is very watchful of government spending the BOE is able to take such actions.  Taking these rotten assets into the public’s ownership amounts to just handing cash out to banks.  Although I am sure the calls for similar program will soon mount in the U.S. The Prince seriously doubts that such a massive swap of rotten assets for good assets would ever get past U.S. politicians or be cheap enough to bring to fruition.  From the scare details out at this point it seems clear that the BOE’s asset swap plan will cost taxpayers millions if not billions, it just won’t be apparent to the public for a few years.  However, if the medicine works, and it might work despite the doubter, the United Kingdom’s taxpayers will be getting a good deal given their high level of consumer indebtedness. (According to the WSJ total household mortgage debt in Britain at the end of 2007 stood at about £1.19 trillion — or about 84% of the country’s gross domestic product, compared with 75% of GDP in the U.S.  British banks also got a big chunk of the money they needed to make those mortgage loans from financial markets, rather than customer deposits: As of mid-2007, they counted on markets for nearly half their funding.) 

The United Kingdom is taking drastic measures to get credit flowing to businesses and consumers again.  The Prince is not holding his breath. 

Treasury Chief Alistair Darling plans to make an announcement on the plan Monday, the Prince will check back in on this one then.

The prince doubts that Goldman does risk management better than other firms or they have a secret edge.  Yes, they were right last spring and summer when others were wrong but that may be nothing more than a great call not an active choice to reign in risk.  Yet, nothing about a large short various tranches of the ABX trade necessarily screams that they have a risk management edge over other firms. Maybe the prince is way off base but he would love to hear from anyone who can answer his questions with anything more than pointing to Goldman’s recent performance.   Other firms may have had risk management processes just as good or even better than Goldman but were on the wrong side of this one.  Also, the prince is operating under the assumption that risk managers move from firm to firm.  How would Goldman be able to maintain an edge in risk management with its people moving to its competitors continuously.  The revolving door at top wall street firms for talented and/or lucky individuals makes it difficult to keep any advantage a secret for long.

Anecdotally, if you really want a glimpse into Goldman’s risk management or the culture of risk management they eschew ask Gary Cohn, current GS President and COO, about his famous aluminum trade. That position made his name at the firm when he made millions for the bank right around the time of the IPO.  I think you will hear a story that doesn’t display Goldman’s risk management in a positive light.  A highly concentrated position that was trying to corner the world aluminum market in London was deeply in the red.  Cohn refused to listen to his superiors and risk officers who told him to close the position.  After avoiding disaster by bluffing his way out of proposed higher rental rates on aluminum storage by his landlord in London, the aluminum market began to respond to a lack of supply and his position skyrocketed.  He was rewarded, his legend grew, and he advanced up the firm. 

Sounds like the risk management team at Goldman really reigned him in. Hmmm.  Goldman got to show strong profits right around the time of the IPO which were materially increased by the out-performance of Cohn’s proprietary position that the risk managers and senior firm leaders had insisted he close because it was large, deeply in the red, and had it went public would have portrayed Goldman in a negative light right as it became a publicly traded company.  Albeit this is just an antidote and things have become more sophisticated in risk management since that time.  However, it is a good example of where the risk management process was wrong and disregarded, the eventual outcome looked great, and no one focused on why the risk managers had been wrong.  Had the trade been a huge failure then the risk management process would have drawn critics amongst the first investors in Goldman Sachs at their first earnings meetings after becoming a public company.

Goldman and all the other banks still have balance sheet problems and their earnings power has been greatly diminished, as the Prince has pointed out in recent posts.  If we want to continue to judge Goldman’s risk management by the performance of the firm then the press may be crying foul if Goldman struggles comparatively in the year ahead as a result of not delevering like its competitors in this volatile environment.  Maybe the press a year from now will be touting some other firms risk management practices based on outcome based evidence only.  The Prince thinks it is highly likely.

Also, stay tuned this week as the prince deconstructs fortunes special on how to fix wall street. Not only does the piece convey a naïve understanding of the crisis and Wall Street in general but in Fortune’s rush to dumb down the crisis for the average Joe they get a number of facts and practices just flat wrong. The Prince can’t wait to tackle the Fortune coverage and talk about Nassem "The Dream" this week.  I will also lay off Goldman for awhile a lay some grief on some other firms, but Goldman has been taking such a different course than its competitors lately that it demands the Prince’s comment.

Just take a look at the chart above from Thomson.  Private Equity firms, once a major driver of worldwide mergers and acquisitions, are largely on the sidelines.  During the opening quarter of 2008 they announced just US$81.3 billion in deals.  The volume of financial sponsor-backed transactions reached its lowest levels since the third quarter of 2005. The impact of the credit crunch was particularly evident for large-cap targets as only one transaction over $5 billion was announced since July compared to 32 deals over $5 billion announced during the first seven months of the 2007. As a result, financial sponsors accounted for just 11% of announced transactions during the first quarter of 2008 compared to 22% during the first three months of 2007.  Wall Street is certainly feeling the pain from the private equity industry’s fee paying hiatus but the larger story is what the private equity firms have been up to while the LBO game has been shutdown.

To begin, private equity firms have been bringing all sorts of new activities under their umbrellas.  Many have started hedge funds or bought hedge funds to brand with their names.  An example that has been hugely successful is TPG-Axon, which is run by Dinakar Singh, former head of principal strategies at Goldman Sachs.  The fund launched with $5bn in 2005 and now has assets over $8.9bn since returns have been great and new money has flowed in.  TPG owns a minority stake in TPG-Axon’s management company and is an investor in the funds managed by TPG-Axon.  For another example, let’s consider Blackstone’s fund of hedge funds which is now one of the largest of its kind in the industry.  Furthermore, many larger buyout firms like Blackstone have started to provide advisory serve and begun to look more like investment banks.  Many PE firms have also launched venture funds or smaller private equity funds to invest earlier in growth companies.  They have also notably started leveraged loan funds to buy the debt that is created by LBOs.  KKR Financial and Carlyle’s now defunct fund stand-out in this category.  The story of private equity funds diversifying into other business areas has been ongoing for the last 3 to 5 years.   However, the first story has been going on for the past few years.  Two major events this week should give investors in private equity funds pause.

First, we had the $7bn capital infusion into Washington Mutual in the form of direct sale of equity securities.  TPG led the group doing the financing in exchange for a minority stake in the company and a board seat.  TPG Capital anchored an investment group comprised of WaMu’s top institutional investors to provide the $7bn.  TPG will buy $2bn worth of newly issued securities in WAMU.  WaMu’s board of directors intends to appoint TPG Founding Partner David Bonderman to the board. In addition, Larry Kellner, chairman and chief executive officer of Continental Airlines and former executive vice president and chief financial officer of American Savings Bank, will become a board observer at TPG’s request.  Keep in mind that Mssr. Bonderman was on WaMu’s board a few years ago and it did not cost him a $2bn investment.  For those of you who do not know, Bonderman is a founder and principal of TPG and TPG Asia (formerly Newbridge Capital).  Before founding TPG in 1992, Bonderman was Chief Operating Officer of the Robert M. Bass Group, Inc. in Fort Worth.

Now, private equity firms holding minority public equity stakes is nothing new.  Yet normally these stakes come about as a result of LBOs.  For example, if a PE shop LBO’s a company and then they take it public then they usually retain large portion of the shares.  Overtime they sell off these shares to realize the gains or losses on their LBO.  In some cases the PE firm may hold the shares even longer if they believe the shares will appreciate more in value.  However, the TPG investment is at the beginning of the investment process and not a result of a past LBO by TPG.  This should worry investors in private equity firms considering such minority investments because then what value does a private equity firm add over a mutual fund or hedge fund.  If their true alpha generating activities and their comparative advantage is in taking companies private using leverage, improving them, and then selling them why should we expect their minority investments to work.  Furthermore, why would investors in TPG Capital, want to allow this investment style drift brought on by taking minority public equity investments when they already have managers doing public minority investing that probably charge less the TPG and do not lock up their money for the 5 to 7 years that TPG does.  Even the most successful marquee hedge funds have lock-ups less than three years.  Given the liquidity problem and the lack of a comparative advantage brought on by TPG Capital or any private equity firm making minority public equity investments investors in such firms must consider if they should stay put in these funds.

Second, several private equity companies take on some $12 billion of Citigroup’s debt portfolio.  Apollo Group, TPG, and Blackstone Group are the buyers in the Citigroup case.  This portfolio was entirely composed of leveraged loans.  This action certainly clears some of the leveraged loan logjam.  So the private equity firms stepping in to buy this debt may stimulate other buyers to enter the market and clear the pipeline so new debt can possibly begin to be issued for LBOs.  From this perspective the investment makes sense.  Furthermore, if the private equity firms did credit work during the bidding for the companies that are referenced by this debt they may actually know a lot about these companies that may make these investments very good.  During 2007 we saw private equity firms that lost sellside auctions step in to buy the debt of LBOs because they believed that the company would perform well and they had already invested time in understanding the credit of the company being bought out.  So clearly on two levels buying this debt portfolio may be a strategically sound move and possibly a good investment. 

However, this action by the PE firms may still prove to be a risky business for firms and their investor.  Private equity investors are used to getting percentage returns in the late teens and would be disappointed if investment in debt delivered returns that were considerably lower.  Now returns in PE have been falling for years as a result of competition but holding this debt to maturity would further drop returns.  This drop in returns may cause some large investors in PE to reconsider the size of their allocations to private equity.  In fact, just the investment style drift brought on by buying this LBO debt may make investors concerned because most of these investors already have managers running hedge funds or bond funds that invest in this kind of credit.  These funds probably have better talent, knowledge, and experience investing in this kind of debt that the PE shops currently have.  Private equity firms purchasing leveraged loan debt may be strategically sound and could be lucrative but it raises all sorts of questions for investors about if PE firms are qualified to do such purchases.  Furthermore, investors will begin to wonder why they are paying PE firms high fees to do these purchases when other firms they have invested in already do them with more skill.  The danger is that private equity firms use money from their buyout funds to buy what they consider to be mispriced debt when investors in those funds have bought in on the basis that they would be exposing themselves to equity.  The return profile on debt is very different to that on private equity investments and the private equity guys may think they have sufficient credit experience when they don’t.

One more thing.  Citigroup is planning to sell its package for an average price slightly below 90 cents on the dollar, according to people briefed on the deal.   Average market prices for leveraged loans are now around 90 cents on the dollar, versus a low of 86 cents in early February, according to data from Standard & Poor’s Leveraged Commentary & Data.  The private equity firms are saying that they are going to finance this purchase with debt and equity.  Raising more debt to buy this debt raises all sorts of questions but it is significant.  Unfortunately, The Prince does not have the time to fully discuss the implications of this.  One quick comment though.  The action will raise the returns the PE firms can earn buying this debt but it also raises the risk of investing in these assets since the price of the loans could continue to fall.  Leverage combined with a volatile and declining leverage loan market would be really toxic for these PE firms holding this debt that used to be owned by Citigroup. 

In summary, all this recent investment style drift for private equity firms is nothing new.  However, the drift has certainly increased and spread into new kinds of investments.  The nature of these new kinds of investments should make investors in private equity firms concerned and suggests they should revaluate their investments in private equity firms.  Furthermore, The Prince believes that as a result of all this investment style drift private equity returns will continue to drop which may make cause investors to pull some of their money out of private equity.  It is just difficult to see how private equity firms have the expertise to move into these new investment styles and why they should continue to lock up money longer and take larger fees if they are going to be making these new investments that other managers already specialize in.

Corrections and Clarifications: This post was originally published on April 10, 2008.  Since that time a few factual inaccuracies have come to the Prince’s attention and he wishes to correct them and clarify some other points.  All of changes relate to the paragraph on private equity firms starting hedge funds.  The Prince mistakenly listed TPG-Axon’s AUM as $11bn when it was listed by Reuters as $8.9bn on January 8, 2008.  Dinakar Singh previous position was more specifically head of principal strategies at Goldman Sachs.  Furthermore, the Prince mistakenly said that "the hedge fund [TPG-Axon] uses TPG’s infrastructure, office space, etc.".  It has been brought to the Prince’s attention that this is not true.  TPG is a large minority investor in TPG-Axon funds and does own a minority position in the management company.  The aforementioned corrections and clarifications have been made to the article above.  Even though TPG is only a minority investor and is a distinct legal entity from TPG-Axon, the use of TPG’s brand and the their large initial investment in TPG-Axon’s funds at launch, are seen as a vote of confidence in the TPG-Axon.  These two actions by TPG made it easier for TPG-Axon to raise capital initially.

In more recent buyouts that are under pressure the banks have started to make MAC arguments in committed financing negotiations with sponsors.  This time the banks are using the MAC’s against the sponsors and not in the interest of the sponsors.  While, the Prince is not aware of a MAC being officially invoked in any recent busted buyouts, he certainly believes that banks are using MACs in contract negotiations as a threat and a bargaining chip.

Given the power that these clauses have to break up buyouts, absolve sponsors of paying breakup fees, and get banks off the hook from committed financings among other things, we should not be surprised that these clauses are and will be getting more attention.

A material adverse effects clause is a provision in M&A agreements that allows a party to walk away from a deal if a counterparty has suffered a so-called "MAE" as defined in the document.   "The last nine or 10 months feel like one big MAE," said Faiza Saeed, a partner at the venerable M&A law firm, Cravath, Swaine & Moore LLP in New York (quote courtesy of The Deal).  "Pointing to one case where the interpretation of an MAE clause was central to a dispute, she noted that the one in the Finish Line Inc.-Genesco Inc. agreement was fairly standard in carving out a number of potential occurrences from the definition of MAE.  "Definitions tend to be repeated from deal to deal without a lot of thought," said Saeed, who also noted that the complexity of MAE clauses often baffles clients as well as judges. "We’ve gone back and looked at these definitions and asked if anyone understands them."

Clearly the language of what a MAC and an MAE needs to be carefully considered.  For example, consider the MAC in the merger agreement for SLM Corp’s acquisitions by J.C. Flowers.   That agreement stated that Flowers could walk from the deal if SLM suffered a decline worse than that of other companies in its industry, but the agreement was ambiguous on a critical issue.  Should the court compare SLM to the whole of financial services?  Should it just compare it to student lenders?  Clearly SLM is an example where the drafting of the MAC and MAE could of been done better and The Prince does not believe that this is an isolated incident.

Given the power that MACs hold it is clear to the Prince that many attorneys will have to rethink how they draft such clauses and how they define an MAE in the future.  Furthermore, sponsors, banks, and sellers would all be wise to approach the drafting and inclusion MACs with a bit more caution and attention than in the past.

There was much hand wringing and scowling in congress when sovereign wealth funds descended upon struggling U.S. financial firms with cash to mend tattered balance sheets.  Many congressman made arguments reminiscent of arguments made against Japanese investments in U.S. real estate in the 1980s.  Some of these arguments even referenced the U.S. trade deficit with China and decried the purchase of U.S. assets, specifically U.S. government securities, by the Chinese.  While these arguments by congressman display a profound ignorance of basic economics and the incentives which face the Chinese and other foreign investors in the U.S. assets including U.S. government debt, they all have an underlying xenophobic tone and/or expression of suspicious thought.  The Prince could go on for days thanking foreign investors for bailing out U.S. financial firms, subsidizing the insane borrowing of the U.S. consumer and government, and artificially keeping the dollar stronger than it should be.  Would not that be an amazing sight to see a congressman offering such thanks and praise to the other countries on which the U.S. relies.  Yet, we will never see this happen because the truth which The Prince perceives is not popular and this post will probably also not be widely popular.  In fact this post may make many people uncomfortable just like the leading photo The Prince choose for this piece.  The disdain and complaining about foreign investments in the U.S. is not limited to the federal government and certainly reaches down into state governments, as my following example will illustrate.

There is one recent story, brought to The Prince’s attention by The Deal’s Dealscape blog, which really makes the Prince question the wisdom and intentions of lawmakers in this country when it comes to dealing with the financial industry.  Basically, there is a bill in the California legislature right now that could effectively pull the two largest U.S. pension funds, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, out of their private equity investments.  The bill is called Responsible Private Equity Investment Act of 2008 bill (AB 1967) and it restricts the two big state pension funds from investing in private equity funds that have sold stakes to sovereign wealth funds.  The bill establishes a group of tests that most private equity funds will fail.  For example, the fund’s country must be a signatory of five of the United Nation’s six human rights treaties.  CalSTRS has already said that is the bill passes it will have to cease investing in private equity, which is its best performing asset class.  CalPERS has been quiet on the bill.  Not surprisingly the bill is co-sponsored by Service Employees Union International (SEUI), a union that is a huge critic of PE (witness the attack on Rubenstein at the Wharton conference).

This bill has huge implications if passed.  We are talking about the top tier firms being excluded because they have sold stakes to foreign investors.  Firms like Apollo, Blackstone, and Carlyle would be sidelined.  So will the bill pass?  AB 1967 has only one sponsor in the legislature, Democrat Alberto Torrico.  He is a former assistant majority whip, meaning he knows the ropes in the legislature.  The Prince is not interested in handicapping the chances that the bill passes because the just the fact it has been proposed raises serious ethical issues.  Not to mention that fact that like the drive for Socially Responsible Investing, this bill would probably lower returns at both pension funds and thus harm all the pensioners within those funds.  What are we really afraid of when it comes to foreign investors?  Why do legislators not talk about the secret dirty reasons that make them uncomfortable about foreign investments.  These reasons are all too poorly hidden by such legislators’ rhetoric and actions.

Whenever our representatives ( don’t think many of The Prince’s readers have a problem with foreign investments) decry foreign investments in the U.S. they hide behind arguments like SRI, the human rights record of the company, national security concerns, etc.  Maybe they should take a good hard look at what intuitively makes us uncomfortable about foreign investments in the U.S.  They may realize that our real motives for protectionist actions and angry rhetoric is nothing more than racism.  They may find out that they don’t like what they see or believe.  Maybe the lawmakers who pass laws like the one being considered in California are nothing more than a dressed up 21st Century group of nativist when it comes to dealing with foreign investors.  The Prince leaves it to his loyal subjects to decide.

This morning in the New York Times, Andrew Ross Sorkin draws attention to the the fact that the Fed was calling the shots behind the Bear Stearns "bailout."  This point was obvious last week.  Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout."  It was pretty obvious the Fed was pulling the strings from the beginning.  Just take a look at the original $30bn backstop (now $29bn with JP Morgan on the hook for first losses of $1bn on risk derived from illiquid BS assets).  By meddling in the Bear Stearns mess again the Fed has entered a quagmire of competing interests.  The parties it must politically handle are Bear Stearns’ shareholders, J.P. Morgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.  To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world.  However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BS could only seek Chapter 7 with the trustee being SPIC).  Were the actions the Fed took in the "national economic interest" of the U.S.?  It does not matter much to The Prince—what is done is done, and its implications are enormous.  

After reading Mssr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle.  It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JP Morgan’s bid.  These actions clearly favor the argument that the Fed preferred the first bid, as Mssr. Sorkin points out.  The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business."  But why is this problematic? 

Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc.  Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward.  The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important.  Please allow The Prince to illustrate some of the most problematic implications.

First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates.  This is a landmark event in American monetary and economic policy.  The Fed as a lending last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.  The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear.  At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now.  While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.

Let’s analyze the situation more closely.  The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed.  Remember BS is regulated by the SEC.  The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates.  The Fed has taken these steps because of its concerns over counterparty risk.  That is the worry that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy.  This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).

We will soon learn that the Fed has learned its lesson when it comes to counterparty risk.  Such risk will have to be managed much better by banking regulators around the globe.   This will bring an end to the free-wheeling days of fixed income derivatives.  The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks.  More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker dealers themselves.  Fixed income derivatives are likely to go the way of other securities markets.  This means they will be non-levered hedging and speculation tools.  Leveraging through derivatives will probably end with an order from the regulators against such actions.

Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction.  The financing of $29bn is almost equity type financing.  It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by $1bn cushion of first loss collateral from JP Morgan.  What would happen if a broker deal is going down and there is no other broker dealer to buy the company like JPM?  This BS deal better work or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.

Third, the days are gone when an independent investment bank could have a large trading book.  The Fed will ensure that if it is required to bailout such institutions, not having regulatory of capital jurisdiction over such entities would be wholly unacceptable.  The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace.  Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.  Under this new regulatory system Goldman Sachs, with its large trading book, is no longer the model investment banking and JP Morgan now assumes that title.  JP Morgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime.  As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.

To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution, that is a player in the capital markets, is a good buy now that we are living in an era free of moral hazard.  If a company is big enough, there is no credit risk with the Fed waiting there with a bailout.  So go forth and sell protection on LEH, GS, and MS CDS at these levels.  Also go out and buy Agency credit risk.  It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community.  If BS is too big to fail and the Fed has to provide $30bn in effective equity in a bailout then what large financial institution is a credit or a counterparty risk?  That is all my loyal subjects.

Blue Blood & Mutiny: The Fight for the Soul of Morgan Stanley by Patricia Beard is one of the best pieces of business history The Prince has read in the last two years.  Combine this book with the tome that is House of Morgan and you will possess a pretty firm grasp of Morgan Stanley’s roots.  The book was especially interesting to the Prince because he had met many of the characters.  He even learned some interesting facts about some of them.  This is a wonderful book filled with characters so interesting it is hard to believe this is nonfiction.  After dispensing with some early firm history, the book follows the battle that a group of Advisory Directors of Morgan Stanley staged against Phil Purcell to save the culture at Morgan Stanley.  It resulted in the triumphant return of John Mack to the