Recession in Canada is officially over

I listened to two economists today at separate presentations. Who was it who said ten minutes spent with an economist is ten minutes wasted? Well, Don Drummond was certainly not one of those economists. He told the TD Bank audience - the recession is over.

I also ran into Michael Graham who sent me his newsletter with its useful insights. Here is Michael's view on the recession this year.

We are going to be able to tell our children and grandchildren how we – and they – escaped the next Great Depression. But only after 12 to 18 harrowing, high-anxiety months morphed into the worst financial crisis since the 1930s. Although there wasn’t a 1929-style stock market collapse, an extremely painful accompanying bear market (the second within a decade) included innumerable downward plunges. Let there be no doubt, as well, that the Great Escape of 2009 came at a fearsome price for which our generation must take full responsibility.It’s not that depression scares are new. Neither are recessions or bear markets which come and go like the seasons, usually presaging healthy restoration and rebalancing. In fact, I think I can safely record that my business career now spans six recessions and ten bear markets, shortly (I hope) to be succeeded by a seventh recovery and an eleventh bull market. Instead, what was so different this time round was an unforeseen and highly-contagious worldwide banking crisis that threatened – and in many instances toppled - household names like dominos. In the process, previously- reckless banks, desperate not to risk their badly-impaired capital any further, wouldn’t even lend to one another. Talk about broken trust.

The universally respected Paul Volcker, former Federal Reserve chairman, couldn’t have summarized what happened more aptly: “I don’t remember any time, maybe even in the Great Depression, when things went down quite so far, quite so uniformly around the world.” Yes, it was a very narrow escape indeed.

Jacoline Loewen, private equity, Toronto

Is there redemption in deal making?

That question is front and center in light of the announcement this week that the Parallel Petroleum Corporation had agreed to be acquired by an affiliate of Apollo Management in a deal valued at $483 million, including the assumption or repayment of $351 million in debt.

The New York Times has an interesting article on this - summarized here:

Apollo has been painted as one of the chief private equity villains of the financial crisis. The firm earned this reputation by orchestrating an attempt by Hexion Specialty Chemicals, which Apollo controls, to escape its obligation to acquire Huntsman. Apollo succeeded in this attempt, but its reputation suffered both externally and possibly internally as its investors sweated the possibility of a big damages award. Parallel’s announcement clearly is a signal to the market that Apollo is not permanently exiled.

But this does not mean that targets will blindly trust private equity. Prior to the financial crisis, the private equity acquisition agreement typically included a reverse termination fee that allowed a suitor to walk for any reason by paying this amount. Targets granted this right because they relied on private equity’s reputation for completing deals. Parallel filed its own acquisition agreement on Tuesday with the Securities and Exchange Commission. Parallel is willing to deal with Apollo, but the agreement itself shows that there is little trust. Instead of relying on reputation, Parallel reverted back to contract terms to ensure that Apollo lived up to its promise. While some of this may be attributable to Parallel’s state and need for certainty, the Parallel deal is yet another sign that a new private equity deal model is developing.

First, the acquisition agreement in the Apollo/Parallel deal does not have a financing condition. This is normal. However, this deal is all equity-financed by Apollo, which is injecting $283.2 million. This means that in order to do the deal, Apollo is taking the credit risk for any new financing as well as refinancing Parallel’s $150 million senior notes. This is a sign of a return to normalcy in the markets, but it also reflects the lengths Apollo had to go to secure this deal.

Second, the equity commitment letter was not disclosed on Tuesday. It will be disclosed with the tender offer documents. (An aside: When is the S.E.C. going to force the disclosure of these documents with acquisition agreements?) But the merger agreement appears to state that Parallel has a right to specifically enforce it. That is, Parallel can sue to force Apollo to specifically perform its obligations under the equity commitment letter instead of paying monetary damages. This is also a sea change. Before the financial crisis, a target only had a right to sue the shell subsidiary acquiring it. The only exception I remember was in the Fortress/Penn National Gaming deal.

In such a scenario, if there was even a right of specific performance, a judgment was required first against the subsidiary, forcing it to sue the buyout firm to perform on the equity commitment letter. Then the subsidiary would somehow have to pursue a lawsuit against its owner. This was a high hurdle. But the private equity firms wanted to keep their liability remote and insisted on it. The Parallel deal and its different approach is another marker that the practice is not likely to continue.

Third, this is the second significant private equity deal in recent months (the Bankrate deal is the other one) in which there is not a reverse termination fee. In other words, the buyer cannot terminate the deal by simply paying a preset fee. Instead, the Parallel merger agreement requires specific performance. Parallel can sue to force the Apollo subsidiaries to perform their obligations, and since these are shells, Parallel can also bypass these subsidiaries to sue on the equity commitment letter to force the money to be provided.

As in other recent private equity agreements, including the Sum Total/KKR Accel agreement, this deal requires that Parallel first seek specific performance as a remedy. Only if specific performance is unavailable can Parallel seek monetary damages and specifically the benefit of the share premium, and only then after giving Apollo two more weeks to perform its obligations.

This is a nice benefit to Apollo. It essentially provides them a free pass on litigation — with a maximum cap of having to close the deal. Because of this, future targets may want to rethink this provision.

Because the Parallel deal is all equity-financed, it can be a tender offer, which means it can close 20 business days after the tender offer commences, as opposed to the two to three months necessary for a proxy contest.

Previously, the margin rules and need to market the debt financing had made it difficult to structure deals as tender offers instead of mergers. The margin rules, Regulations U and X, limit a lender’s ability to lend money on margin stock. “Margin stock” includes any publicly traded security (e.g., Parallel stock). A private equity firm that wants to do a debt-financed tender offer can get around this problem by structuring the deal to comply with these margin rules and limit the amount of its borrowing to 50 percent of the value of the collateral pledged to secure the loan (i.e., Parallel).

Historically, this was lower than a private equity firm is willing to go.

And the tender offer has tight conditions. If you look at Annex A to the acquisition agreement, these are the bare minimum conditions you see in a tender offer — no material adverse change, requirement of regulatory approvals, etc. There is nothing like the minimum cash or Ebitda conditions you often would see in private equity deals.

The Parallel and Bankrate deals show that a new private equity model is developing. Private equity is focusing on the low side range of middle-market deals and negotiating tight contracts with no financing out, specific performance, all equity financing and a guarantee enforceable by targets.

Vice Chancellor Stephen P. Lamb's opinion in Huntsman/Hexion and the private equity implosion appear to be having lasting impacts. Nonetheless, this all-equity model is not portable to larger deals, so it remains to be seen if the historical structure of private equity will shift if and when private equity ventures deeper into the deal pool.

Still, the fact that anyone is still willing to deal with Apollo means a lot for private equity generally and perhaps the short memory of Wall Street. It would also be interesting to know if Apollo had to pay a slight premium for its reputation risk. But that is hard if not impossible to determine. If true, though, it would show that markets are much more efficient than the day’s conventional wisdom.

Replicate the strategy of companies that triumphed slumps.

Have you noticed Harvard Business Review is simplifying its writing style and also adding fancy graphics to their cover?

There is still substance in their articles though and I particularly enjoyed Eric Janszen's newest contribution. Unfortunately, it is in my paid for subscription link so I can not link you, but here's a quick summary:

According to Eric Janszen, author of The Post -Catastrophe Economy, “the era of unbridled, debt-financed consumer spending is over”.

He explains that to attract today’s money-conscious consumers, companies need to replicate the strategy of companies that triumphed in previous economic slumps. As consumer debt declines for the first time in decades, the winning companies will be those that can manage without offering the no-money-down and low-interest deals. Messages that promote value over brand and “getting back to basics” marketing tactics will appeal to debt-averse consumers.

Does Private Equity need to re-look the people assets?

Does private equity need to re-look the way it treats the people asset?

This is one of the concerns I am increasingly hearing from business owners deciding whether to go the PE route.

I am preparing for a large strategy conference for an excellent company, and watched one of my favourite strategists, Gary Hamel, interview Eric Schmidt from Google.

At about 23 minutes in, Eric asks the audience if they are familiar with people from private equity and then comments that private equity is not interested in the assets of Google, the employees. He talks about how private equity is most interested in the cash flow.

"Yes," I thought, "Specialization of management of a business is required and many business owners really benefit from private equity's financial sophistication."

But Eric is giving an off-the-cuff, honest comment and he is an incredibly high level client/partner of private equity. This is like getting a focus group "AHA" from private equity's dream client. One thing I have learned is to listen - really listen - to these throw out lines because they contain the key to building competitive advantage.

Eric's comment should make all private equity people pause and consider. Imagine if your private equity organization made it their strategic focus? Imagine the competitive advantage you could build?

The "IT" I am talking about is the people.

Could you make that top priority in a way that would please Eric?

Talking about the strategic culture of a company made me recall McKinsey's recent report on private equity and my pod cast interview with Sacha Gaie. What sto0d out for me was how few private equity funds made the big profits and how many did very badly. These top achievers were not the big players either. I wonder now if these private equity teams were more tuned in to the culture and the people inside their partnered companies?

It all begins with the people and it all ends with the people.

Here's Gary and Eric:

Jacoline Loewen, author of Money Magnet.

US Consumer Debt

What private equity does for your business

At its recent CEO Roundtable, Loewen & Partners and the Richard Ivey School of Business recorded a podcast with Sacha Ghai, global private equity expert and the author of the McKinsey Private Equity Canada 2008 report. McKinsey's annual report is an overview of key forces affecting Canadian private equity markets. The report provides a perspective on the short and long term implications for PE players, following the economic downturn. Looking forward, PE firms will create value by focusing on attractive niche opportunities.

Listen to podcast: What Private Equity Does for Your Business -
Sacha Ghai, McKinsey & Company,
chats with Jacoline Loewen for the Financial Post Executive
Download Full Report (PDF 2.32MB)

Percent of PE by Deal Size

MID-MARKET PRIVATE EQUITY DEALS SURGE

In its analysis of private equity activity during the first six months of 2009, PitchBook Data, a private equity research firm, reveals that lower and middle-market companies continue to successfully attract PE investment. Through the first half of 2009, middle market deals accounted for 70% of all investments, more than at any time in the last six and half years.

The new emphasis on deals under $50M means more financing options for small and medium enterprise business owners.

Jacoline Loewen, Author of Money Magnet.

What you can learn from fishing

How often have you heard the story where an entrepreneur risks their business to get the big fish? Doug Trott, founder of PriceMetrix, is one of those owners and the big fish he landed happened to be one of the world’s largest diversified financial services companies - Morgan Stanley. Doug says, "We were convinced that we had a solid track record and the integrity of our product was such that Morgan Stanley would have the confidence to use our service."

However, the risk of the deal falling through was high, made even more so, given the raging financial crisis. "By the time we got into October last year, the market was tanking and then by mid-December there was talk that Morgan Stanley was going to go insolvent”, said Mr. Trott. Thankfully, the insolvency rumours were just that, and a deal was finally struck. In April 2009 PriceMetrix officially started delivery of services to Morgan Stanley. When it comes to fising, go for the big ones because you might just catch one.

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Learn more about PriceMetrix

Royal Bank's market scoop strategy worked

We have heard the market forecast from Ben Bernanke (who was nominated by President Obama to a second term as Chairman of the U.S. Federal Reserve). Bernancke's prediction is that the recession is over while the other sage of Wall Street, Nouriel Roubini, thinks we are headed for the double dipper recession model. One will be right and one will be wrong.

One indicator is to check out bank performance. Being in private equity, we hear which banks are lending on what terms to whom. Royal has been very smart to use this recession as a time to scoop up market share and get mediocre deals done. Customers remember that they were there in the tough times and are loyal back. TD was lending huge amounts to old, steady companies at great rates. National Bank takes on lots of deals that the others sniff at so we will see their performance over the next year or so. If there is a double dipper recession, that could be a problem for them

Here's more from ScotiaMcleod. Lynn Lewis sent me this by Gareth Watson, CFA

This morning as we heard from Royal Bank (RY), National Bank (NA) and TD Bank (TD). While I won't go into specifics for each bank, I will simply say that the earnings this morning were very good across the board. Royal in particular blew away the Street with strength in retail and wholesale. National Bank also exceeded expectations by having strong trading revenue again while TD Bank exceeded expectations by keeping credit in check. Coming into the quarter we knew that retail would be the wild card for the banks as wholesale strength was expected, and the results speak for themselves as retail operations have done well in a challenging operating environment (except for maybe CIBC). Capital levels are strong, if not too strong, and I hope this past quarter will finally put the dividend question to rest as earnings will support dividend payments going forward. Overall it should be a good day for the banks today and therefore possibly the TSX Index. However, I would caution that these banks have been running higher for a long time going into this quarter and that they were pricing in lofty expectations which have been met for the most part (except CIBC), so we don't think there's huge upside today as the market has probably already priced a lot of it in, but without a doubt the strength of the earnings this morning will give Royal, TD and National a good boost at the open.

What American private equity is really saying

I spent the weekend enjoying BBQs, watching fireworks with my family, including the in-laws (oh joy). Actually, I'm lucky in the in-law category as I enjoy them all but I did notice that my Private Equity Fund Manager brother-on-law who works in Boston, USA, looks ten years older than the last time he visited. When I asked him how the US markets were doing, I was expecting him to give a repeat of the media – recession over, blah, blah. Instead, I was disturbed to hear him say that he was seeing private companies going out of business at an alarming rate.

Apparently, banks are not lending money which is the same as the body deciding to stop creating blood. Then there is also the freeze in consumer spending which continues despite the government softly whispering to frightened horses, “It’s OK to go out and use those credit cards.”

My brother-in-law’s doom and gloom report from small business America does confirm reports I have heard from large family owned Canadian companies. One Canadian CFO reported that he had attended a conference in the US and was shocked to learn that American family owned companies, and we are talking blue chip companies, were getting money at 18% line of credit and they thought that was terrific.

This is the reason why Canadian private equity is looking south and doing more deals there than in Canada where banks are still lending at 3% to this particular family business.

When the small to mid-sized companies start closing down, this is a disaster. The bulk of jobs are in the SME market

The key is for government to focus some of their stimulus tax breaks and cash flow breaks on small business balance sheets. Here in Canada, the Ontario opposition leadership race looked at GST tax equalization but a better one would be to reduce tax on new equipment purchases. Any other suggestions?

Jacoline Loewen is the author of Money Magnet and consults to companies wanting private equity and growth strategy.