Vertical Pulse

Djibouti and Eritrea Set Off Tinderbox

According to a story in The New York Times today, two small African nations - Djibouti and Eritrea - are staged to battle along a disputed border. The opposing forces are within feet or inches of one another. Within the length of a rifle barrel according to the story. To most observers, the contested area is nothing more than desolate sand. However, hostilities there (at the mouth of the Red Sea) could imperil some of the busiest shipping lanes in the world.

This is a very good current day example of how small sparks could produce dramatically disproportionate ramifications far from the site of the crisis. For other similar examples of how marginal events can reshape world affairs and history, read The Power of Incremental Advantage: How Incremental Improvements Produce Dramatically Disproportionate Results.

Blackstone Shakes Off Credit Crunch For A Day

Don't tell Blackstone there is a credit crunch on. Today The Wall Street Journal reports that Performance Food Group Co. agreed to be acquired by an affiliate of the Blackstone Group and Wellspring Capital Management in a deal valued at about $1.3 billion. Performance Food will continue to look for better bids over the next 50 days.

At a time when raising debt is very expensive, Blackstone and Wellspring offered shareholders $34.50 in cash for each outstanding share they hold, a 43% premium to Thursday's closing price of $24.19. The combined efforts between Blackstone and Wellspring, via their affiliate, are perhaps why the two were able to navigate the troubled debt markets.

Performance Food will be merged with Blackstone's VISTAR Corporation, a Denver-based food distributor, which the private equity firm took a controlling stake in sometime in July 2007 for $421 million. Blackstone also owns other companies in the food business, including Pinnacle Foods ($2.27 billion), United Biscuits ($3.19 billion), Tragus (£2.71 billion), and Orangina SAS ($2.30 billion).

Evercore Group L.L.C. is acting as financial advisor and Bass, Berry & Sims PLC is acting as legal advisor to Performance Food. Wachovia, Goldman Sachs, and Credit Suisse are acting as financial advisors and Simpson Thacher & Bartlett LLP is acting as legal advisor to Blackstone and Wellspring.

144a Securities Boom

Washington regulators have come up with another way to marginalize the ordinary retail investor by precluding them from participating in some of the more lucrative equity and bond markets. Under present market conditions people may scoff at the notion of investing in the stock or bond market, but no matter how the media plays it up with scenarios of dooms-day recessions, it is only temporary. A bull market will return one day. But JoeSixpack and his IRA or 401K may miss some of the better performing companies that go "semipublic" when the markets return to their glory of just even a few months ago.

Securities & Exchange Commission Rule 144a allows companies to raise capital without having to comply with certain regulations (some of them stupid, i.e., Sarbanes-Oxley). The downside for us simple folk is the securities can be sold only to sophisticated investors, such as hedge funds and investment advisers, who have to have a required minimum of $100 million under management.

"Through the first nine months of 2007 companies raised $300 billion in 144a equity, compared with $215 billion for public markets," reports Forbes, which ran a story on the 144a rule in its Jan. 7 edition. Most of these deals were done by companies that were already public, but there is a provision in the rule that allows for PIPO (Pre-Initial Public Offering). Forbes also found that two years before the useless Sarbox legislation went into effect in 2002, there were only two PIPO deals. Since then there have been 83, raising an average $282 million.

To learn more about 144a securities the Forbes story and SEC link are good places to start. In the coming months the semipublic sector will be getting assistance from Nasdaq, which will supply price information to buyers and sellers of 144a shares.

Commodity Prices Continue Surge

Huckabee wins Iowa and my faith in the GOP as the vanguard of limited government and fiscal restraint has been destroyed. The only one talking any kind of sense in economic terms is Ron Paul. But the average voter has no idea about monetary policy and therefore can't make heads or tails of what the populist Libertarian/Republican is talking about. Come to think about it, the lack of understanding about free market economics among voters is appalling.

Commodity prices know no bounds. Oil briefly hit the century mark twice in this new year. Fuel oil per gallon has increased from 0.97 cents in Nov. 1997 to $3.17 in Nov. 2007. Time to go long on oil, gold, wheat, raw materials, and short everything else.

"Since 2001 the dollar price of oil and gold have run in almost perfect tandem. The gold price has risen 239% since 2001, while the oil price has risen 267%. This means that if the dollar had remained 'as good as gold' since 2001, oil today would be selling at about $30 a barrel, not $99. Gold has traditionally been a rough proxy for the price level, so the decline of the dollar against gold and oil suggests a U.S. monetary that is supplying too many dollars," a Wall Street Journal editorial states.

The price of wheat and soybeans increased 3.4% and 2.8%, respectively, which follows a 75% increase in their price in 2007. I know demand has grown in India and China causing these commodities to rise in price, but that goes only so far. Such increases also follow the fall in value of the dollar very closely.

I am no monetary expert, but it appears the Nixon Administration's decision to take the dollar off the gold standard on Aug. 15, 1971 based on run-away inflation seems flawed. An expensive war in Vietnam, government spending, and bad Fed policy led to inflation. It seems that Ron Paul understands this based on his campaign planks of ending military adventurism, reducing government by 60% to 70%, and abolishing the Federal Reserve System. Too bad he won't be president.

The day Nixon switched to a floating currency Ron Paul was quoted in the Texas Monthly saying, "After that day, all money would be political money rather than money of real value. I was astounded." Soon after Mr. Paul decided to run for Congress.

On related matter, Ron Rimkus of BB&T Asset Management was on Bloomberg this morning arguing that the U.S. economy was already in a recession. He added to his argument that job numbers would catch up with this reality soon and that part of the blame should be placed on the Fed for acting to slowly to the credit crisis.

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

My Worry For 2008

My New Years Eve bubble-induced hangover did not help me forget the many worries I have for 2008. High oil prices (record $100 today), talk of recession, a return of populist politics, housing market crash, a weak dollar, a credit crunch, social unrest in Pakistan (Middle East region in general), and other issues have me walking on egg shells.

However, with the exception of social unrest and recession, the most important concern I have for 2008 is inflation. "A change in inflation expectations [could] send the Federal Reserve into a severe monetary policy tightening campaign that would take the U.S. economy into a recessionary path," wrote Wells Fargo Senior Economist Eugenio Aleman.

That comment came on the heels of Mr. Aleman's analysis that the ongoing credit crunch should bring U.S. economic growth back within a trajectory of a mature economcy - not an emerging market's rate of growth. Also, the negative savings rate and current account deficit would not weigh on the economy like in the past.

Patience Is A Virtue

The much talked about era of distressed funds has yet to arrive. Don't get too impatient. Many analysts  expect a slowdown in corporate profits over the next 12 months, which means debt-laden companies could struggle and eventually become crippled by a slowdown in the global economy.

"A net 60 percent of fund managers now expects corporate profits to deteriorate in the next 12 months — the most pessimistic response in almost a decade — while a net 62 percent expects the global economy to weaken," a Wednesday Merrill Lynch press release states. If this prognosis is correct, distressed debt funds and vulture investors will shine in late 2008 and throughout 2009.

"Investors' love affair with emerging markets continues despite a sharp rise in the number of fund managers expecting a slowdown in China's economic growth. A net 25 percent of respondents expect the Chinese economy to weaken in 2008. Only 4 percent in took this view in November," Merrill analysts found.

I would imagine distressed debt managers will wait for bond valuation to come more in line with market conditions. The Merrill poll found that a net 13% think equities are undervalued while a net 43% believe bonds are overvalued.

These are some of the issues that are discussed at IncreMental Advantage's conferences. For more information please click here.

Commercial Loans Experience Delinquency Uptick

According to the November edition of Real Estate Forum, "CMBS delinquencies continued to climb for the second straight quarter ... [which] jumped 16.2%, with $1.9 billion in loans being late, up from nearly $1.7 billion during the second quarter. Of the overdue paper, loans originated in 2005 and 2006 saw the biggest hike."

The delinquency rates will only increase as commercial mortgage-backed securities reach their peak default period in the next three to four years. Of all types of commercial activity, retail delinquencies continued to rise the most. "At the end of the third quarter, the amount of retail property-backed loans delinquent was $408.8 million, a 56% increase from Q2 and a 90% increase since March," the article continued. Of course, the hardest hit retail loans were in areas where home values have fallen the most.

If CMBS continue to be delinquent and then later default, expect investors to get jittery about valuing these assets during uncertain economic times. However, at the same time, patient investors can scoop up these securities at a discount. Consider today's news in The Wall Street Journal that sales of all retailers excluding auto and parts dealers surged in November by 1.8%; economists expected a 0.7% increase. May be the economy won't slip into a recession after all.

These are some of the issues that will be discussed at IncreMental Advantage's March 25 & 26 real estate conference. For more information, please visit www.incrementaladvantage.com.

CDO Doom

The bad news continues for collateralized debt obligations. According to the Financial Times' Alphaville, "As of December 3, 33 CDOs have reported events of default to S&P." One CDO, named Adams Square I, was liquidated recently at less than 25% of par value. The FT is reporting that note holders received nothing. "AAA notes? Nothing. Not a penny."

"Proceeds from the Adams Square I liquidation weren’t even sufficient to cover the termination payments to the CDS counterparty (Adams Square is, or was, a hybrid CDO, containing straightforward ABS and also CDS on ABS). Unable to meet its CDS payments, Adams Square had to draw down the balance from the super-senior swap counterparty. Thus there was no money left to pay the actual owners of the CDO - the bondholders. Adams Square, which was arranged by Credit Suisse, had 79 per cent of its total RMBS collateral downgraded by the rating agencies in October," Alphaville reporter Sam Jones writes.

E*Trade's portfolio of ABS was valued at 27 cents on the dollar by rescue hedge fund Citadel. More and more information is hitting the street of CDOs and mortgage backed securities from liquidation events and sales, which will give everyone an idea of these securities values. Doesn't look good.

Rick Bookstaber writes about "mark to value versus mark to liquidity during market crises" issues that gets at the heart of most these issues. Its a good read and worth your time.

Also worth reading is Brian Wesbury's editorial in today's Wall Street Journal where he explores how a "desire for government intervention to fix problems that grown adults have created for themselves is dangerous." He focuses on government's handling of the sub-prime mortgage mess, which to say is probably more politically, than economically, motivated.

LBOs To Mirror Sub-Prime Sorrow?

For the last few months this blog's authors have stated deep concerns about the good possibility of a downturn in the LBO market in the near future. What everyone has seen in the tumbling housing market, and subsequently in the mortgage-backed securities meltdown, could be replicated in the leveraged buyout debt market. The Wall Street Journal and Barron's ran stories this week about how paper tied to businesses buried under LBO debt is selling at steep discounts in light of an economic slowdown or recession.

"Many LBO-linked senior loans are trading for as low as 90 cents on the dollar," the Journal reports. This does not bode well for private equity fund investors who may see their returns dry up in the coming months as portfolio companies struggle just to pay off interest on their debt. For instance, Apollo-owned Realogy, its "annual cash flow, which topped $1 billion in 2005, could drop to $700 million this year, meaning the company is barely covering its interest costs of $650 million. Next year could be even worse," reports Barron's.

The Journal's punch line: "Of course, private-equity firms have the luxury of waiting out bad markets, and the terms of their debt packages were excessively forgiving. It's a long stretch to say that overpaying for a company leads to bankruptcy. But it can destroy the lifeblood of the private-equity industry: returns. 'Their returns are less likely to be double digit,' said Jake Newman, a media analyst at research firm CreditSights Ltd. 'They won't be able to get out [of investments] as soon as they want. And there will be some that fail.'"

Some of the currently souring LBO deals both publications report on include:

• Univision's first-lien paper is trading at 91.6 cents of par
• Freescale Semiconductor's term loan is changing hands at 93.2 cents
• Realogy's 10 1/2% senior unsecured notes due in 2014 trade around 75 cents on the dollar and yield 17%, while the 12 1/2% subordinated notes due in 2015 trade for 62 and yield 23%. They were issued at about 98
• Linens 'n Things' debt now trades at about 55 cents on the dollar
• Swift Transportation 12 1/2% bonds were fetching just 52 cents on the dollar last week, for a 26% yield to maturity
• Bonds issued by Columbia Sussex (which acquired casino operator Aztar) were trading last week at 68 cents on the dollar, to yield 17%
• Claire's Stores subordinated 10 1/2% bonds of 2017 trade for 62, for a 19% yield
• Dollar General's subordinated 11 7/8% debt due in 2017 has fallen to about 80 from par of 100 when it was sold in late June, and now yields 16%.

For vulture funds and some hedge funds, I'm sure they will be making unusually small loans to ailing private businesses, who are desperate for cash infusions, in order to monitor their financial health. When the timing is right, these funds will swoop in and pick apart the carcasses.

Back In The Red

It appears that our January hedge fund strategies conference will be held in a nick-of-time. November results for hedge funds bare out troubled times for the hedgies that should persist for awhile. The Wall Street Journal reported today that "average returns look likely to be back in negative territory for the first time since August, judging by the performance of listed closed-end funds. More worrying, those average returns conceal big dispersions not just between strategies but within strategies, with performances varying from as much as 10% down to 5% up, according to prime brokers."

When I was reviewing some of the hedge fund indexes a month or so ago, I noticed that some hedge fund strategies vary by a 15% difference. Quite a gap. Such volatility does not bode well for the industry, considering investors are sold on the idea that hedge fund managers maintain risk-adjusted returns in their strategies. "That will worry prime brokers, too. Most include material-adverse-change clauses in their contracts allowing them to withdraw financing -- and, if necessary, seize assets -- from funds that suffer major drawdowns," the Journal reports.

Speaking of brokerages, major banks have a lot to worry about too obviously from the ongoing debt market problems. Peter Hahn, a fellow at the Sir John Cass Business School in London, wrote an interesting editorial in the Journal's commentary section today, partly blaming weak bank boards for the current mess. It's worth the time to read.

"But November's figures are likely to trigger some soul-searching by investors, who will now have had several months to see how funds perform under pressure. Weak performers are likely to be jettisoned. Given that most hedge-fund investment these days is locked up for three months, the bulk of redemptions won't take place until the first quarter of next year. That could be when the credit crunch catches up with hedge funds," the article states.

For more information about IncreMental Advantage's Jan. 22 hedge fund strategies conference, please visit www.incrementaladvantage.com.