Vertical Pulse

Restructuring Wave On The Horizon?

Many restructuring and turnaround professionals are looking at the next six months to a year for the next wave of restructuring to hit corporate America. Some see Andrew Wilkinson’s move from Cadwalader Wickersham & Taft’s restructuring practice to Goldman Sachs as an indication that restructuring business is about to pick up. Corporate default rates which are around 1%, an extreme low, will only rise.

A Moody’s study found that between 2004 and 2006 the highest proportion of first time issuers had below-B ratings. This group of issuers will be entering a period in 2007 and 2008 when their default risk has historically been the highest because as evidence shows a company’s risk of default peaks in the third and fourth years after issuance.

The next wave of restructuring could be blamed on the private equity community because of the massive amounts of debt that companies take on to go private. Usually, leverage multiples of seven, eight, and nine times Ebitda are used to buyout a company. If liquidity dries up and bank lending terms tighten that could spell trouble for distressed companies.

The American Bankruptcy Institute and Daily Bankruptcy Review conducted a survey late last fall that found 70% of restructuring professionals believe U.S. corporate restructurings will increase in the next six months to a year. What could trigger such bad times? Forty-eight percent said it will be interest rates; 15% said homes prices; 13% said commodity prices; 7% said global competition; and 5% said the equity bear market.

Once companies do go bust turnaround and restructuring professionals will find it’s a whole new universe from previous restructuring eras in the 1980s and 2001. Bank lenders have sold off their exposure to risky companies in the secondary market where hedge funds, distressed debt, and high yield investors have gobbled up securities. Unproven intercreditor agreements will make bankruptcy court a battleground. Weak covenants will reveal companies bought-out in 2003 and 2004 were a bad deal. Because liquidation is always a last resort, there will be a great focus on write-offs, new funding and conversion.

These are some of the issues that are discussed at IncreMental Advantage’s conferences. For more information, please visit www.incrementaladvantage.com

Pension Plan Health

Hedge funds and buyout funds owe much of their recent success to their limited partners’ deep pockets. Corporate and public pensions are the typical LP that allocate anywhere from 5%, 10%, or more of their portfolio to private equity and hedge funds. It has been well documented in the media that pensions are facing tough liabilities and are increasingly looking to the alternative asset class to plug potential shortfalls.

Last month the State Street Corporation published a study that found about 80% of pension governing boards spent more than 10% of their time discussing alternative investments, which was a "substantial" increase over last year’s figures. Sixty-five percent of institutional investors interviewed said their hedge fund investment returns matched their expectations. The study also revealed that hedge fund programs comprise a larger share of institutional investors’ overall portfolio allocation. On the private equity side allocations remained stable from last year.

The alternative asset class no doubt helped corporate pension funds reach full funding for the first time this decade. CFO.com reported earlier this month that in 2006 pension plan assets’ growth came close to matching liabilities. Fund performance also beat expectations, gaining returns of 12.8% rather than the forecasted 8.4%. However, the beginning of 2007 has given some pension managers cause for concern.

"While the overall numbers were positive, the first quarter of 2007 points out an area of concern for pension managers: namely, significant funding ratio volatility due to interest rate swings, and plans’ over-reliance on equity market risk," said Aaron Meder, UBS Global Asset Management’s Head of Asset Liability Investment Solutions in the Americas. While a brief interruption in the equity market advance caused some of the funding ratio volatility, interest rates had a far bigger impact in the first quarter. For example, liabilities were down 2% in January as interest rates moved higher, but regained all and more of that decline, increasing by almost 4% in February as rates reversed course, an UBS study found.

While many plans are currently exposed to this risk, UBS found that alternative investment approaches can help better align assets and liabilities. "Plans can implement liability-driven strategies that may significantly reduce the uncertainty in their future pension contributions – often without reducing expected plan returns. The improvement in overall pension health in 2006 and the first quarter of 2007 provides many with an excellent opportunity to hedge some of their liability risk," said Meder.

These are some of the issues that are discussed at IncreMental Advantage’s conferences. For more information, please visit www.incrementaladvantage.com

Buyout Funds Raise Historic Level of Cash in Q1

The Dow Jones Private Equity Analyst recently reported that U.S. private equity shops have raised $44.3 billion among 68 funds in the first quarter of 2007. After a historic 2006 for private equity professionals there are no signs that 2007 will be any different. The first quarter’s $44 billion mark signals a 67% increase from the 46 funds that raised $26.6 billion in the first quarter of 2006.

The Private Equity Analyst study found that on top of the first quarter $44 billion about another 400 other funds are trying to raise another $130 billion – thanks to limited partners who are still flush with cash. The buyout funds represented $35.2 billion of the first quarter numbers while 22 venture capital funds represented $3.8 billion – down from the $4.4 billion raised by venture capital companies in the first quarter of 2006.

According to a MoneyTree Report put out by PricewaterhouseCoopers and the National Venture Capital Association, venture capital investing hit a five-year high in 2006 where $25.5 billion was allocated among 3,416 deals. "The year, which marked the highest level of investment since 2001, saw quarterly investment levels remain steady in the $5- to $6-billion dollar range, as the venture industry invested in the traditional technology and life sciences sectors and began a deliberate foray into the energy sector," the report states.

These are some of the issues that are discussed at IncreMental Advatage's conferences. For more information, please visit www.incrementaladvantage.com.

FAS 157 - Measuring Fair Value

One major concern institutional investors typically have is how hedge funds measures investments at fair value, especially for complex derivatives, private equity and mortgage servicing rights. Beginning Nov. 15 hedge funds will be obligated to issue financial statements to investors that will allow them to asses the information fund managers use to value certain assets. In 2006 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157), to do just this. FAS 157 creates a singular definition of fair value and establishes a more concrete framework for measuring fair value in generally accepted accounting principles.

Grant Thorton Financial Services Senior Manager Michael Patanella wrote in Hedge FundAdviser, a Grant Thorton quarterly newsletter, exactly what information will be used to measure fair value, which affects fair value measurements on related income and performance. Key to understanding FAS 157 value measurements are “inputs to valuation techniques,” which market participants use in pricing investments as well as assumptions about risk.

Two types of inputs Mr. Patanella writes about are “observable inputs,” which reflect the assumptions market participants would use in pricing investments based on market data obtained from sources independent of the reporting entity. “Unobservable inputs” reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing investments based on the best information available given the circumstances. The two types of inputs create a fair value hierarchy that makes it easy for CFOs to measure fair value at three levels.

Mr. Patanella explained FAS 157 will require reporting the following information:

• The fair value measurement at the reporting date
• The level within the fair value hierarchy in which the fair value measurements in their entirety fall, segregating fair value measurements using quoted prices in active markets for identical assets or liabilities, significant other observable inputs, and significant unobservable inputs.
• For fair value measurements using significant unobservable inputs, a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following: total gains or losses for the period, purchases, sales, issuances, settlements, and other factors.
• The amount of the total gains or losses for the period included in earnings that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains or losses are reported in the statement of income.
• In annual periods only, the valuation techniques used to measure fair value and a discussion of changes in valuation techniques, if any, during the period.

It is highly recommend for investors and hedge fund financiers to visit http://www.grantthornton.com/staticfiles/GTCom/files/Industries/FSandFI/Grant_Thonrton_Hedge_FundAdviser_Issue_2.pdf to learn more about FAS 157.

These are some of the issues that will be discussed at IncreMental Advantage's Mergers & Acquisitions Due Diligence Conferences. For more information, please visit www.incrementaladvantage.com.

Notes on Intellectual Property Valuation

Below are a few notes that I took from IncreMental Advantage's Intellectual Property Valuation Seminar which took place in New York City on March 28:

• The strength of the market that is addressed by the patent is an important driver of the value of the patent.
• According to ThinkFire, the highest prices can be achieved in selling patents when between 26-75 patents are sold together. There is resistance to paying a high price for a few patents ("We are not going to pay $3 million for 2 patents") and buyers believe that low value patents are bundled together when a large number of patents are sold simultaneously.
• Patent brokerage fees range from 1% to 10% of the expected licensing value.
• Licensees are resistant to paying high fees because it is they that take on the risk of commercializing the license.
• It is a good idea to shop patents to the competitor of a company that might be most interested in the patent. This is a good strategy to achieve higher values for your patents.
• Generally speaking, patents that have about 10 years of life remaining have the most value. It is better when the patents' priority dates is earlier than its issue date.
• Patents that promise to champion soon to emerge breaking technologies usually do not garner the highest prices.
• Most IP experts believe that there is little chance that researchers will demand significantly higher compensation packages even though their innovations may contribute hundreds of millions of dollars in revenue to their companies. However, in Germany, inventors' compensation is much more closely correlated to the commercial value of their research.
• The accounting for the development / acquisition of intangible assets is inconsistent: R&D is expensed. Software development for software companies is an asset. Buying R&D is an asset while developing R&D internally is expensed and is not considered an asset. No expenditures on intellectual capital--other than for research and development--is reported separately to investors. Thus, investors do not know about expenditures on IT, brand development or employee training. R&D expenditures are not defined. Companies can include costs for testing and maintenance in R&D as investors like to see high expenditures on IP.
• By not disclosing much information about the intangible assets resident at their companies, managers are plagued with Akerlof's Lemon Discount. The Lemon Discount means that investors will place a lower valuation on an asset or security when there is a lack of information.
• One practical nuance to citation analysis is to remove excessive self-citation. About 25% self-citation is acceptable.
• It is important to note that there is significant citation inflation. Ten years ago, the average patent had 8 references. Now, the average patent has 22 references. One reason for this citation analysis is that the Office of Patents and Trademarks is placing asterisks on patent applications for citations that are merely citations of interest. Applicants are also placing more citations on their applications to provide full disclosure.
• Pending patents in the form of continuation patents are extremely valuable because they can correct problems (perhaps in terms of prior art) associated with previously issued patents.

These are some of the issues that are regularly discussed at IncreMental Advantage's Intellectual Property Conference Series. To purchase the audio proceedings from the most recent Intellectual Property Valuation Seminar or to attend a future conference, contact Neomi Barazani at 609-919-1895 ext. 100 or neomi@incrementaladvantage.com.