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. 

http://ycorpblog.com/2008/05/04/ok-so-now-what/

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.

He emphasized this by saying, “The capital required by the investment bank for future growth must be generated under its own steam. Surpluses from the wealth management business will be returned to shareholders through dividends or share buy-backs.”  He also said UBS will no longer try to be all things to all people within the investment banking business. 

Even if the above statement is true why would you ever state it publicly.  So much for the full-service investment bank marketing pitch.

The Prince does agree with one of his final comments.  “We did not question the integrated model enough. We used the strength of our balance sheet and compelling financing options for activities which should have been more expensive to finance based on their risk. We used our surplus cash flow from the wealth management business to promote organic growth in the investment bank. That was where we went wrong."  When you compete for business solely with your balance sheet this is what happens.  UBS won banking business, especially with sponsors, because they got aggressive on terms.  Now they have to pay the price.

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.

Now these demands, which are directed at investment banks for less leverage and more liquidity (more capital cushion), are very similar to the demands that regulators made on commercial banks following the stock market crash/great depression.  However, very little attention has been focused on how this is going to affect the organization of the investment banking industry or how it will affect profitability in the industry.  Bill Gross, famed bond investor and CIO of PIMCO, wrote on his company’s website in his April investment outlook that regulators will force investment banks to set aside more capital, "resulting in reduced profitability."  A report by analysts at Morgan Stanley and consulting firm Oliver Wyman predicts "longer term ROEs to fall as banks seek to de-lever and regulators ask banks to hold more cushion.”  Others have privately speculated that profitability will go down as measured by ROE but how this change in profitability induced by further regulation will effect the competitive positions of the various firms has not been directly addressed.

Allow the Prince to take a look at this.  In this article this morning from Bloomberg David Viniar, Goldman Sachs’ chief financial officer, was asked if he thought the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.”  He made this statement less than 48 hours after a government-backed deal rescued Bear Stearns.  The Prince disagrees, and in fact, the regulation that will come about to limit leverage and the liquidity of assets will impact Goldman more than its peers.  Despite Mssr. Viniar’s strong comments The Prince must believe that privately Goldman management is seriously worried about how their firms comparative advantage in proprietary trading may be taken away by regulators wanted to reign in risk at investment banks.  Like The Prince wrote in his earlier post, if Goldman’s edge over JP Morgan is removed by more regulation then the JP Morgan business model will reign supreme on Wall Street and firms that used to have big trading books like GS will be permanently handicapped.

Llyod Blankfein, CEO Goldman Sachs Group, Smug Contrarian or Arrogant Fool?

Before we pursue this commentary further the Prince needs to make clear to his readers how liquidity and leverage are inextricably linked when an investment bank tries to finance its balance sheet.  Keep in mind that most firms, except Goldman Sachs which increased its leverage, are reducing historically high leverage levels right now because of market volatility and uncertainty.  Now the Prince thinks Goldman Sachs increasing its leverage reeks of arrogance and will probably end poorly for them given the lack of confidence and volatility in the market place.  They do have more freedom to increase their leverage compared to their competitors, since Goldman can still borrow at 10 year duration at 2.41% over 10 year treasuries versus 3.02% over treasuries for Lehman.  Yet, just because they have the freedom to do it does not mean it is a good choice.  In fact the Prince thinks they will regret it but he has to grant that recently their contrarian stances have paid off.   On this move, however, their luck may run out.

Yet, back to the strong link between liquidity and leverage when financing an investment bank’s balance sheet.  Clearly regulators and to some extent ratings agencies will put pressure on banks to lower their leverage.  There are multiple ways for an investment bank to finance and most use a combination of long-term debt, short-term commercial paper, and repurchase agreements to finance their liabilities and lever up on the equity they have.  The better the bank is as a credit risk the more opportunity they will have to get longer term capital by issuing long-term bonds (like 10 years) or issuing short-term commercial paper.  The third kind of financing, repurchase agreements or repos (also remember the opposite reverse repos), is where Bear Stearns got crushed. 

In the case where no one will buy new issuance of commercial paper or more new issuance of long-term debt or the yield demanded just makes such paper too expensive for a bank to make the interest payments a bank must rely more and more on repos to finance their liabilities and leverage.  Goldman tends to borrow more short-term CP and long-term debt and not rely as heavily on overnight or short-term repos.  "Goldman is still AA rated and has a good image in the marketplace as shrewd risk takers, so the spreads they’re paying for 10-year money are a lot less than everybody else’s,” said CreditSights’ Hendler.  Goldman only finances 14.8% of its balance sheet with repos while Lehman finances about 27.2% of its balance sheet with repos.  For comparison, Bear Stearns used repos for 26.2% of its borrowing at the end of 2007.  The problem with the repo market is that you must rely on other broker dealers or other counterparties to trade with you.  When Bear could not tap the commercial paper or long-term debt markets, could not get an equity infusion, and its counterparties stopped doing repos with them they were inches from becoming insolvent.  Combine that with all the prime brokers saying at once they would not disintermediate trades done with Bear Stearns for derivative contracts like CDS. 

Now how much money you can borrow against your cash bond collateral in the repo market is directly proportional to the quality of the bond collateral you hold.  So in Bear Stearns case the CDO and MBS collateral they were trying to borrow against would not fetch as much money on loan as if they held government treasurys.  So banks that have AAA rated non-mortgage debt of long and short term maturities can actually get more leverage cheaper in the repo market using such debt as collateral in the repurchase agreement.  So in this case the better your assets they more you can lever up and the more liquid your collateral/financing. 

Now in Bear Stearn’s base they were holding illiquid mortgage securities that were falling in value or had no bid in the marketplace.  They were trying to borrow against this collateral but some banks would not take that mortgage debt as collateral to lend money in the repo market.  When no one would do repo with Bear with any kind of collateral the game was really up.  So in this case the banks that are left standing now will have as much liquidity and freedom of action to lever their balance sheets as the strength of the bonds they hold can provide serving as collateral in the repo market for cash on loan.  Yet, like the Prince said before, freedom of action with respect to leverage is not a reason in and of itself to actually put on more leverage given market conditions.

To summarize the Prince’s predications.  ROE will fall across Wall Street as regulators force banks to deliver.  Goldman Sachs will suffer more losses than peers in this volatile environment because of their contrarian move to increase leverage.  In the long term Goldman Sachs will be stripped of its proprietary trading advantage which is the central component of its business model by regulators wanting to lower risk in the investment banking world.  JP Morgan and other big balance sheet banks with small trading books will replace Goldman Sachs as the top investment banks.  Disagree with the Prince’s analysis or predication?  He grants an audience to any subjects that wish to question his commentary.  What him to tone down the negative comments on Goldman Sachs?  Tough.

Disclosure: The Prince currently owns SKF but has no other positions in broker dealers or other positions linked to broker dealers.

5 April 2008 - "Jeff Mayer, a former member of Bear’s five-person executive committee and a co-head of fixed income, was named vice chairman of J.P. Morgan’s investment bank, with a focus on global risk. J.P. Morgan also named Craig Overlander, the other fixed-income co-head, as a vice chairman to focus on global clients.

Mike Nierenberg, who ran global rates and foreign exchange at Bear, was named co-head of global securitized products with Bill King, who previously held the position alone at J.P. Morgan." - WSJ "J.P. Morgan Integrates Bear Senior Managers"

The Prince: Does anyone else see the irony/stupidity of giving the co-head of Bear’s fixed income division the job of focusing on global risk at JP Morgan?  Really?  Also, why is JP Morgan moving anyone from Bear’s securitized products to their own securitized products group.  Everyone at BS working in that group should be fired.  Just another example that on Wall Street people bounce back so fast it almost defies belief.

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