Vertical Pulse

The Tip Of The Iceberg

On Wednesday, Nouriel Roubini, economist and chairman of global economics service RGE Monitor, told CNBC that the sub-prime problems the two Bear Stearns hedge funds were experiencing was just "the tip of the iceberg." Indeed. Call me a sucker for media sensationalism, but I think the sub-prime mortgage malaise is going to claim a lot more victims before its done running its course through the globe’s financial arteries. The U.K. news site, Timesonline.co.uk, reported today that losses on sub-prime could be as high as $75 billion. To put things in perspective, that is 1.6% of the $12 trillion American economy.

Just late yesterday it was reported that London-based hedge fund Queen’s Walk Investment lost $91 million (€67.7m) for its investors in the year ending March 31 because of American sub-prime mortgage investments. Also, Caliber Global Investment Ltd., a London-listed fund that controlled almost $1 billion of mortgage assets, plans to sell all of its assets over the next year and return as much of it as possible to investors. The fund blamed its closing on "rising (mortgage) delinquencies," as reported by Marketwatch.com.

Many sub-prime mortgages have been packaged into collateralized debt obligations (CDO), which can be pools of bonds, loans, or in this case, mortgages. There are around 950,000 mortgage-backed securities in the United States and maybe 1% of them trade every day, Hedgeworld.com reported. "There are hundreds of billions of dollars of these securities, and they have not been priced for true market value … they have been priced [according] to a model … [based on] the ratings of credit ratings agencies which were wrong," said Mr. Roubini. Hedge funds also used computer-driven models to price the assets. However, as The Wall Street Journal points out, such computer models are prone to miss changes in market sentiment.

Some what like Caliber, Merrill Lynch tried to auction off the assets seized from one of the Bear Stearns hedge funds. As the The Daily Telegraph reported, the auction failed and revealed a dark secret about CDOs. The sale was called off after buyers took just $200 million of the $850 million mix. "The banks were not prepared to bid over 85% of face value for CDOs rated ‘A’ or better," said Charles Dumas, Merrill’s global strategist. "We hear buyers were lobbing bids at just 30%." Yikes! What is worrying everyone is that the auction price of the CDOs would have assigned to them a market value far below that at which they were carried on the funds’ books. This could send shock waves through the market and seriously affect investors who hold similar securities.

Hedge funds are known for buying the riskiest portions of CDOs, which are carved up into tranches and sold to investors, in the search for high yield. More hedge fund blowups, like the Bear Stearns funds, Queen’s Walk Investment, and Dillion Read Capital Management, are expected. Consider this disturbing sign: a recent research report by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. In 2008, even more surprises are in-store with nearly $700 billion ARMS to reset; of that three-fourths are sub-prime mortgages.

The resets will negatively affect those investors holding sub-prime securities because home values have been declining in the U.S. for about year now. The steepest decline has been experienced in the Northeast at about an 8.8% drop. That decline will make it more difficult for borrowers who fall behind to sell their homes for enough money to pay off the loan.

"The dicing up and securitization of debt is good for spreading risk but poor for identifying where the risk ends up," the Timesonline.co.uk reported.

The next 12 months should be interesting, and scary, for the hedge fund community.

These are some of the issues that will be discussed at IncreMental Advantage’s Oct. 16 Hedge Fund Due Diligence Conference in NYC. For more information please visit www.incrementaladvantage.com.

Pros Discuss New Relationship Between Lenders and Borrowers

I thought I would relay some of the highlights from IncreMental Advantage’s Structuring Private Equity Transactions conference last week. Working in reverse order, the final comments of the Dealing with Companies That Are Distressed panel, several panelists were reluctant to predict when the next wave of corporate restructuring would occur. "I thought it would have been here by now," remarked Homyar Choksi, managing director of LBC Credit Partners, Inc. "But, it’s around the corner." Considering the problems with sub-prime mortgages that have been packaged into CDO bonds, Mr. Choksi might be right.

Mary D’Souza, senior vice president of GE Capital Markets, Inc., said many leveraged deals may suffer if there is a rise in interest rates or a slowdown in the economy, or both, which would increase the corporate default rate. Panel moderator William Derrough, managing director of Jefferies & Co., Inc, predicted that at the end of 2009 restructuring professionals will be extremely busy conducting deals with struggling companies. "It will be so busy that we will be hiring unqualified people (to do deals)," he said.

During the roughly hour-long discussion panelists briefly explored the world of credit default swaps (CDS). CDS's are basically insurance contracts lenders purchase to protect against a borrower from defaulting. Some of the panelists were surprised at the little amount of equity buyers needed to enter into these types of credit derivatives contracts, which have a market-wide notional value of $34 trillion. In addition to CDS, panelists basically said the amount of leverage in other derivative contracts and deal structures appeared astounding. Leverage in some of the deals had an debt to equity ratio of 50 to 1 (one of the Bear Stearns hedge funds had a ratio of 10 to 1 and Long Term Capital Management had a ratio of 100 to 1).

Panelists also discussed today’s relationship between distressed companies and their lenders. In what has become a hot topic, the issue of loan-to-own practices, many such lenders can exercise convertible notes to take control of a company or have a serious say in the decision making process when that company defaults. Lenny Parkins, partner with Haynes and Boone LLP, said distressed companies sometimes lose their say in who gets to trade the company's debt. Such debt can trade quickly where it is easy for management to lose track of who owns it. Sometimes companies discover the identity of their new debt-holders when management looks to extend their forbearance provision (an agreement to delay debt payment).

Even in participation agreements (several lenders in one loan) a lender can sell their portion of the loan to someone else, such as a hedge fund, without the company ever knowing such a transaction took place. What gets tricky is sometimes the name of the debt-holder does not change name on paper and management does not find out until they look to extend a forbearance provision. Subsequntly, management gets caught off guard because the new lender has different goals than a typical bank. Plus, now company executives must forge a new relationship with the lenders, who may not be all that friendly.

Panelists also discussed the bygone era of when banks would stick it out with companies while they restructured their operations, finances, etc. They compared that to today’s relationship where banks will now sell that debt to hedge funds, high yield investors, or other similar players who are looking to get returns of 30% on their distressed investment. At one time banks were satisfied getting their loans repaid, now new types of lenders are looking for debt repayments and equity. "Now, the funds want more stock and deal with cash as the cheaper asset in a restructuring. It’s an amazing situation," Mr. Parkins said.

For more information about IncreMental Advantage's conferences please visit www.incrementaladvantage.com.

Wisdom of Compensating with Stock Options

During IncreMental Advantage's Structuring Private Equity Transactions Conference there was some debate about the merits of companies compensating their employees with stock options.

One the one hand, the advantages of compensating employees with stock include - cash is tight at small companies and lots of money can be made through exercising stock options at successful companies.

On the other hand, the disadvantages of compensating employees with stock options include:

• Rank and file employees are skeptical of the value of stocks that fluctuate significantly;
• Private equity investors believe that they are giving away too much value;
• Employees spend too much time monitoring the price of the stock; and,
• When the stock price falls, employees become discouraged.

These are some of the issues that are discussed at IncreMental Advantage's Mergers and Acquisitions Due Diligence and Private Equity Conferences.

Hedge Fund Due Diligence Pays

The hedge fund community is abuzz by the news that they are on pace to have the best year since 2003. The Greenwich Global Hedge Fund Index rose 2.18% last month to reach 6.84% year-to-date. According to one blog all 18 hedge fund strategies (except shorts) achieved double digit growth last month. Hurrah for the hedgies!

This type of good news usually gets investors’ attention – and money. However, despite all the cheer, potential investors should not rush into any decision of sinking money into a hedge fund, which are well known for their risk. The Hennessee Group reported that 5.1% of funds it tracked liquidated in 2006 because of dwindling trading opportunities, poor performance, career moves or other reasons. That year the ill-fated Amaranth Advisors lost investors a total of $6 billion because of weak trading controls.

Investors can’t afford to do their due diligence half heartedly. Clever investors have warned the investment community over and over that hedge funds’ widespread use of derivatives is endangering the financial system. Richard Bookstaber, who runs FrontPoint Partners and had first hand experience with the 1998 Long Term Capital Management meltdown, warned that the market will probably experience another stock market crash similar to 1987 or LTCM incident because of hedge funds’ use of leverage, derivatives, and/or financial engineering.

More than 1,000 hedge funds crashed in 2006 when half of those failures were due to operational problems. One study found that such operational problems included misappropriation of funds and fraud. Almost all of the instances of fraud and misrepresentation involved some form of deception regarding the value of assets held by the fund. With professional hedge fund sleuths saying they are finding red flags in about 10% of all due diligence probes, investors must be vigilant.

According to The Capco Institute Journal of Financial Transformation, many funds that have failed were due to resource/infrastructure problems where there was an inability to accurately price or risk the fund’s book. Other operational problems have stemmed from unauthorized trading or trading outside of the fund’s guidelines.

These will be some of the issues discussed at IncreMental Advantage’s October 16 Hedge Fund Due Diligence conference in NYC. For more information please go to www.incrementaladvantage.com.

Can A Tax Help Private Equity's Boom?

For years as the financial media has covered the private equity industry, whether it venture capitalists or their buyout cousins, we have heard numerous reasons why companies opted to go private. Access to funding, resources, operational expertise, expansion, the lure of riches, and so forth, were often the explanation. All of this is correct. However, I believe the media has missed another reason why some small cap companies decide to sell an ownership stake – the estate tax, or what is popularly known as the "death tax."

Some of you may immediately know what I am alluding to. For those of you who are a little baffled, let me explain. Family businesses that are valued around $650,000 or more will have to pay a steep tax to Uncle Sam when the owner looks to pass on the organization to a son, daughter, or other relative. A business valued at $2 million is required by tax law that the new family owner pay the government $500,000 in estate taxes – a large amount. The business may not generate anything close to that much profit per year. The choice is clear, either sell the assets, hire expensive lawyers and accountants to help pay off the tax bill, or sell a significant stake to a venture capitalist firm or buyout firm.

Why sell to a PE firm? Because then the small cap company is no longer owned by individuals who might die and is instead operated by a bunch of venture capitalists, which means the death tax will never disrupt the company. A family selling a large ownership piece of their business to a private equity firm because of the death tax may not be the central reason, but it figures largely into their decision making.

Aside from the private equity equation, when there was a recent political debate of whether to abolish the death tax I remember being surprised to see William Gates – father of Microsoft founder Bill Gates – supporting the estate tax. Also, even more confusing, shortly after George W. Bush (tried to get the death tax be abolished) took office, an ad appeared in the New York Times that was signed off by William Gates, George Soros, Rockefellers, Roosevelts, and Paul Newman – who all supported the death tax. Why would these wealthy men favor such a tax that impacts them the most?

Easy, the tax generates a lot of M&A business for them. For example, the estate tax only impacts small family-owned businesses, which seriously motivates them to sell to a large public company (not affected by the tax). I believe such a tax kills competition. What would have happened if Microsoft (at its inception) was acquired by IBM? Would have society benefited from its innovation? What would have happened to IBM and other company’s motivation to compete and invent, which undoubtedly benefits all of society?

Warren Buffet, who is known as a skilled investor at acquiring undervalued businesses, is a huge advocate of the death tax. He no doubt benefits from the death tax as businesses, such as the Buffalo News, decide to sell because the family owners have few options (Buffet purchased the publication for $32.5 million).

Seems like tax cuts are not always in the interest of big business.

Demand for Gold in China and India

Mainland China purchased 31% more gold in the first quarter of 2007--almost 90 metric tons--compared to the first quarter of 2006. Demand in India soared even more dramatically--up 50%, or 211 metric tons, in the first quarter of 2007 versus the first quarter of 2006.

These are some of the issues that are discussed at IncreMental Advantage's Metals and Mining Conferences. More information is available at www.incrementaladvantage.com.

Man Group Looks To Expand Into Distressed Investing

The Man Group, a $60 billion hedge fund, announced today that the organization plans to expand its investments in distressed companies. Analysts for some time have been forecasting a market downturn will send a lot of highly leveraged companies into bankruptcy. Hedge funds, private equity firms, distressed security investors, activist investors, and others are preparing themselves to pick up the pieces during the next wave of corporate restructuring.

The Man Group is preparing to go public on the NYSE in September, the same month IncreMental Advantage will be holding its "Profiting from Corporate Restructurings" conference in New York City. The conference will be geared for a slew of investors that employ distressed security investment strategies. The aim will be to teach investors what the new landscape in corporate restructuring will look like and how they can come out financially ahead. I personally spent time talking with bankruptcy and restructuring attorneys throughout Manhattan to get a feel for what the scene will look like in bankruptcy court.

"We are looking for people in distressed," Man Group Chief Executive Peter Clarke told Reuters. "We view distressed as an area where we’re planning to grow." FiNTAG, a popular blog that covers the hedge fund industry by hedge fund operators, had one of its writers comment that his or her distressed fund has seen a large number of subscriptions, forcing the group’s managers to close it. "Interestingly my distressed fund managers are the light and soul of the party and are getting very excited indeed," the FiNTAG blogger wrote.

For more information about IncreMental Advantage’s Profiting from Corporate Restructuring conference contact Neomi Brazen at neomi@incrementaladvantage.com or at www.incrementaladvantage.com.

Intelligently Acquiring Fine Art and Collectibles

Appreciation of fine art and purchasing fine art in a financially sound manner are not mutually exclusive. Art collectors who conduct due diligence into a work of art’s provenance, authenticity and chain of ownership are not practicing infidelity against their favorite artist, they are practicing sound judgment. Connoisseurs of art and collectibles have every right to take financial considerations into account when making high-ticket purchases. Don’t let anyone tell you that exercising these rights is uncouth.

Maintaining a collection of fine art or collectibles is often highly rewarding. As many of these rewards are non-monetary, they cannot be measured with standard profit/loss analysis. However, some of the concerns associated with collecting art are that art is extremely expensive as are the transportation and insurance costs, art does not easily lead to diversification, commissions are extremely steep and capital gains taxes incurred when selling art often substantially exceed those incurred when selling securities. Moreover, while a bevy of regulators scrutinize every other class of investable assets, there are no regulators monitoring the purchasing and selling of art or collectibles.

We have designed a unique seminar that will arm you with the knowledge to make informed decisions about acquiring and disposing of fine art and collectibles. This seminar will:

• Acquaint you with the structure of the fine art industry and the relationships among the players.
• Enable you to better evaluate a work’s authenticity and provenance.
• Help you select art advisors.
• Educate you about the fees galleries and auctions charge.
• Provide you with insight into legal and insurance issues related to collecting art.
• Grant you with insight into creative ways to finance your collection.
• Give you pointers on selling works of art in ways designed to minimize your tax burden.

Further information about this conference is available at www.incrementaladvantage.com or by contacting Neomi Barazani at neomi@incrementaladvantage.com or 609-919-1895 ext. 100.

Searching for Copper

There was an interesting article in a recent issue of The Wall Street Journal about mining companies exploring for metals such as gold, silver and copper in increasingly remote and dangerous parts of the world. Partly because of China's insatiable demand for copper, mining companies are exploring for copper in places as inhospitable to business as Afghanistan and the Congo. (China's copper imports surged nearly 50% over the past year.) While these regions have almost no infrastructure (and expect that western mining companies build a great deal of infrastructure as a condition of doing business in these countries) and plenty of strife, they often offer rich veins of metals. For instance, in some areas, the Congolese copper is so close to the surface that it spills out onto the ground and is visible from satellite imagery.

These are some of the issues that will be discussed at IncreMental Advantage's Metals and Mining Investment Conferences. Further information is available by contacting Neomi Brazen at Neomi@incrementaladvantage.com or at www.incrementaladvantage.com.