A Picture is Worth...

Yesterday's WSJ had this terrific exhibit regarding the US debt markets. I think the most telling figure in this exhibit is that the junk bond market has suffered less than that for bank loans. Somehow individual and institutional investors have become comfortable with unsecured, blue sky bonds while bankers shy away from secured, cash flow loans.

Overhyped not Oversubscribed

There is lots of talk about all of the recent fiscal and monetary stimulus eventually causing an episode of massive inflation but so far nothing. Aggregate demand must exceed supply for inflation to occur. The drop in Consumption, which accounts for 70% of GDP, has been so severe that the fiscal stimulus has been left inadequate to fill that gap. As for the monetary leg of all this stimulus, it has mostly been much to do about nothing. With the exception of mortgage lending, very little of the new money supply is making it into the economy. Here are two statistics that sum it all up. The Fed's balance sheet has increased $1 trillion dollars since pre-crisis (mostly via the purchases of MBS, Federal Agency Debt and Direct Bank Loan assets) levels. The US banks on the other hand have amassed $1 trillion dollars of excess reserves; about $1 trillion dollars more than they had a year ago. Get the picture. When the Fed begins to unload (sell) all of its assets next year, they will soak up a lot of excess money supply. If the banks and their affiliates are the buyers, the monetary stimulus will have made a round trip without ever stopping at main street. The stimulus that never was.

The banks are making great on all this cheap money and for those few small businesses that are receiving credit; they are beneficiaries too. Much of the discussion and questions at today's Senate hearing with Ben Bernanke related to why banks are not lending to small business more. It was clear that no one really knew for sure but that, the answer is different for each and every bank. The only certainties offered by Mr. Bernanke is that the banks credit requirements are tougher and that, on the aggregate, the credit quality of businesses have suffered since the pre-crisis days. These two things are certainly reasonable and explain a large portion of the gap between money supply and money being supplied but they do not explain all of it. There is an element of human behavior and market friction that keeps otherwise good loans from being made. Asymmetric information or lack of information prevents the right decision from being made. This element is always present but the level of fear and aversion to risk ensure that bankers error to the side of not making the loan. For companies that are at or near the margin, it is extremely important that they instill confidence in their banker by having a well organized plan and having the ability to articulate their vision in the language of bankers - numbers. Bankers want to lend and it is their business to do so but for the moment, they are too nervous.

Public Knowledge

Continuing on my theme of the value of debt restructuring and recapitalization, I wanted to make note of a recent transaction by the public telecommunications company Knology. Knology recently closed on a credit facility amendment that extended the term of its facility by two years and increased its unused revolver by 40%. The result: it's market cap (market value of its equity) increased approximately 35+%. All this, even though the interest rate was increased by more than a full percentage. Ohh but wait, the new terms allow for dividends and stock re-purchases; read recapitalization. The market run-up is an endorsement for the value of longer-term debt and flexible terms (money security) over lower rates (money expense).

While the typical small business is not managing their balance sheet for the public markets, there is a lesson to be learned here. If a company's current bank has increased their credit line review frequency to quarterly and the LOC is at risk despite positive financial performance; the equity value is being squeezed. If a small company can find another lender willing to extend longer-term loans conventionally or via an SBA program, management could add significant value to the equity of the company just by restructuring the debt even in the face of higher rates. This is no easy task these days but not impossible.

Market Confirmation

In my previous blog I advocated small businesses and even individuals using debt to fund investments or even build a cash reserve for the potential double dip recession on the premise that money is extremely cheap and since its being subsidized by YOU; be sure to get your slice. Seems other folks agree with this view. According to Dealogic, for the first 9 months of 2009, of all debt issued by non financial companies, only 9 of the 100 largest bond deals globally and only 6 of the 100 biggest US deals, were for expansion, capital expenditures, investments or project finance, while 65 of the top 100 US deals were for refinancing or working capital. When companies issue debt, they tell investors why they're doing it in the prospectus they file. Most of these companies explanations suggest they are hoarding cash or repairing finances. Many also listed "acquisitions" as a use. When companies borrow debt without an immediate opportunity for a return on investment that exceeds the cost of capital, it is a good sign they either fear things could get worse (and capital will dry up) or they believe debt is so cheap that it is better to get your hands on it while it last and figure out what to do with it later.

Your Slice of Stimulus

For most individuals and small businesses, the easiest way to benefit from the stimulus efforts is to borrow. Whether it be refinancing a home mortgage or applying for a SBA loan, their has never been a better time to access cheap debt. 30 year fixed rate mortgages are under 5% and SBA loan fees, which can be 2-3% of the principal amount have been waived until years-end. The absence of fees and increase of federal guarantees to 90% LTV through the end of this year makes the 7(a) and 504 programs very attractive sources of financing. 504 loans can be 20-year amortizations with rates below 5.5%.

The Fed's balance sheet has grown well over a trillion dollars over the past year in an effort to stabilize credit markets and keep capital accessible. The Fed owns $692B of mortgage back securities and represents over 70% of this market's activity. Fed activity combined with huge inflows of private money into short-term bond funds continues to keep rates down. If there is inflation anywhere, it exists in fixed income assets. Money market funds yield near zero, high yield bond spreads are below pre-Lehman levels and some Bond ETF's are trading at up to 5% premiums to their Net Asset Values. Is there an asset bubble in debt securities? Low yields means high prices for debt. To borrow is to sell debt and there is never a better time to sell than when buyers are paying too much. Best of all, if the critics of the Fed are correct and we suffer from rampant inflation and higher taxes, your debt obligation balance declines in real terms without doing a thing and the interest tax deduction becomes more valuable.

Of course, don't borrow just for the sake of borrowing, but small business owners with solid investment or growth opportunities should not pass them by on the assumption that no one is lending. The SBA loan volume in its most recent financial quarter was up 18% from the previous year and nearly as high as 2007 quarterly levels. Again, this market is supported by the Fed's TALF buying whose balance has risen from $6B in April 2009 t0 $42B at the end of September. Sure, lending standards have tightened and reporting requirements have risen, but if a small business has good financial management and planning and a compelling business case, the lending markets are open. If the Fed buying activity winds down and SBA fee waivers are not extended, this window of opportunity may close.

The Twighlight Zone

This weekend marked the 50th anniversary of the show, The Twilight Zone. For those of you who have seen an episode or two, you know that the magic of the show was that you could never really be sure of what was reality and what wasn't. And the answers didn't come at the close of the show, either. During a NPR story about the show's anniversary this past Friday, the guest remarked, "what The Twilight Zone was doing was providing this extraordinary timely, and I think prophetic, transition between the kind of secure era of the Eisenhower period and what would become known as the 60's, when we would completely challenge everything that we normally thought was true and solid and established." Feel familiar? As I heard these words, I immediately thought of today's economic uncertainty.

Forget for a moment the guiding ideological differences in past administrations; since the 1980's, there has been a familiar mix of monetary and fiscal policy used to control inflation, exit recessions and guide the economy. Combine that with American ingenuity and the entrepreneurial spirit (and lots of easy credit - it turns out) and you always had confidence things would get back on trend whenever we hit bumps in the road. This time feels different, more uncertain.

Long-term, I'm optimistic but for now, the September jobs report points to the only certainty I can find. Employment is going to be slow to rebound and when it does, it will be accompanied by a wage & benefit reset for many American workers. While a reset would be good for getting back to full employment, understanding what that and less credit means to US consumption and GDP feels like passing through the Twilight Zone.

Trickle Down Liquidity

Well, one day after my last post, consumers tried to prove me wrong and surprised everyone with their strength in the retail sales report. I am still not convinced that the market isn't a little ahead of itself. That said, I should make it clear that I recognize the difference between the economy and the "market". The economy is on the mend and who am I to argue with the Fed. The market on the other hand has lost communication with ground control and has gone right past mend to "plaid". The S&P is up 60% from March lows and is trading at over 19 times estimated 2009 earnings. I am still calling for a pull back before year's end.

In a more relevant note to potential clients, the spread on High Yield, Investment Grade and Libor over treasuries continues to shrink which signals improved liquidity in the debt markets. Corporate bond sales are at a 6-month high. These improvements in credit will trickle down to your local banks and then to small and medium sized businesses. Improved liquidity combined with SBA fee waivers through year end should have small businesses evaluating their capital structure and determining if they need more capital or should refinance existing loans. A wave of commercial real estate defaults, a shadow inventory of foreclosed homes, and a winding down of government liquidity programs could reverse recent credit improvements.

Old World Indicators

I wish I knew where markets were headed this fall. Doesn't everyone? For a clue, I consulted my favorite leading economic indicator, the Baltic Dry Index. I like it because it is global in nature and related to the demand for the raw materials that economies consume. Mostly, I like it because it is old, its roots trace back to the Virginia & Baltick Coffee House in London in 1744, and yet still very relevant (perhaps more so due to global markets being more interlinked). Old and getting better with age; some of life's better things share this trait. According to the BDI and recent correlation, the S&P 500 is due for a pull back.

The S&P 500 is itself a leading indicator of economic activity and is one of the ten components of the The Conference Board's Leading Economic Index but when it is the stock market that you wish to forecast, you need an indicator that is sans S&P500 and is out in front historically. For at least recent history, the BDI has been leading the S&P500 by about three months. This would have suggested a fall in the S&P500 at the beginning of September. Obviously, it hasn't happened. The cash for clunkers program and similar ones in European countries have been a temporary positive boost to economies and perhaps a reason for the sustained levels of the stock market, but with those programs done and the China stimulus effect fading, the markets will be looking for the next engine of growth to sustain valuations. I wouldn't bet on consumers to pick up the slack despite recent improvements in their expectations. It will be up to the US stimulus package to finally kick in but so far its impact seems to have saved jobs (i.e. maintain government payrolls) rather than drive growth. I think we'll see more of the latter this fall but I am not so sure it will be enough to support current levels.

There certainly are other positive indicators to cite but it is recent events like the FDIC closing of Corus Bank due to soured commercial real estate loans combined with the lack of a convincing driver of economic growth for the near term that has me bearish on the fourth quarter. I would not begin to make recommendations on what to do with your stock portfolio; I am no good at that. But, I would advise companies in need of capital to find it quickly. Liquidity has returned to debt markets and the spread of high yield bonds over Treasurys has returned to levels not seen since last year. For now, decent companies seem able to issue debt and equity at reasonable terms as investors began to get comfortable with risk again. Depending on the increasing rate of commercial real estate loan defaults and the FDIC's decisions to wind down certain credit support programs this fall, we could see credit tighten again in the near term. If that happens, we'll see the S&P 500 take a dip. Having the cash to bridge the gap and seize investment opportunities will be key to survival and growth for many small companies. With that in mind, I think the market risk is to the downside for this fall. I hope I am wrong.

Knowing Where to Look

Beating up on the inefficiencies of government has become sport these days but I am continually impressed with the amount and quality of free data and information available on city, county, state and federal web-sites. Judging by my clients response, they are no less pleased with what I have been able to find while researching government databases for the purposes of building business plans or just framing the size of opportunity for new markets. Through a combination of web and human interface, I have found most government institutions to be an excellent source of valuable information.

Most recently, I had a prospective client tell me they were looking to expand and had located a property suited to their needs. It was not listed for sale so I suggested they let me do some poking around. In no time, I had gathered the target property's current owner, contact information, when the property last sold and the price paid. I also provided the dollar amount of debt used to acquire the property and from which bank it was borrowed and if there had been any subsequent foreclosure filings made on the property or owner. The client was curious, "where do you find all this information?" It's just good government and knowing where to look for it.

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I am the principal and founder of Gear Up Finance, a Tulsa, Oklahoma based Acquisitions and Corporate Finance advisory firm. I have been servicing a number of clients during the past 3 years and I am starting this blog in anticipation of my pending website launch. Stay tuned for links to the site and more detailed information about Gear Up Finance.

I am an independent financial advisor and my clients are as varied as the projects that I have performed for them. Of all my services offered, my specialty has been performing comprehensive due diligence and acquisition advisory services to clients seeking to buy (non-start-up) private companies with less than $50 million in annual revenue. During this time a recent trend has become clear; buyers of small private companies do not want to pay more than 5 times EBITDA (Earnings before interest, taxes, depreciation & amortization) for even the best run and performing businesses. I have seen acquisition enterprise valuation multiples range from 2 - 3x EBITDA for lesser quality companies and if EBITDA is negative, prepare for a haircut. There are exceptions to be sure, particularly when the target company has extraordinary growth potential, but since buyers can currently buy shares of excellent public companies with enterprise valuations around 5.5x EBITDA, it's a buyers market. (Private companies can be valued at a 30% discount to their public peers, all things equal, due to the lack of liquidity)

Owners of private companies who want to cash out should consider other liquidity alternatives such as recapitalization rather than selling their company. In today's tight credit markets you need to make sure you are properly prepared to engage several lenders. We can help. Gear Up Finance can help your company develop a professional financial management process and then prepare and circulate a bank book and presentation that will have lenders competing to extend your company credit. Give us a call for a free consultation - (918) 231-4571.