The Great Escape

There can be no more sobering illustrative example of these realities than today’s USA, where President Obama’s first budget unapologetically anticipated adding $10 trillion in deficits through 2017, led off by $1.5 trillion of excess spending this fiscal year. That’s a whopping 12% of GDP, or another thirteen-digit number to be added to a steeply-climbing national debt that already exceeds $11 trillion, or 70% of GDP.

A cartoon of Uncle Sam with upturned hat asking: “Brother, can you spare a trillion or two?” (Canadian Business - February 16) stays in my mind. There’s also the quip about the US becoming nothing more than a pension (and healthcare) plan with an army. Sadly, there could be a ring of truth to both.

If there is some accompanying comfort, it might be that the U.S. is not alone. Britain’s predicament, as I could realise at first hand, seems every bit as dire. The same is true for most other OECD members – and also for Canada. Though our fiscal position remains much stronger than most, there is widespread questioning of the federal government’s belief we can be back in balance by 2013. Regardless, this will take that much longer than the target recovery date if now-nationwide provincial deficits are also included. (STOP PRESS: Just extended to 2015 by Finance Minister Flaherty who has also revised this fiscal year’s budget deficit estimate to $55 billion from $50 billion.) Globally, add the transfer of the debts of troubled banks and others to a public sector launched on a well-intentioned and major supportive stimulus spending, and the burden of public debt becomes all the more formidable. Then add an extravagant era of private-sector debt overhanging almost all OECD economies, and you have an even more haunting spectre grippingly illustrated by an Economist front cover (June 13) of a baby chained to a massive ball of debt labelled “the biggest bill in history”.

The immediate risk emerges as disinflation, if not deflation, as wages shrink and energy prices fall from their peak levels of a year ago. I concede it may take years for these conflicting forces to play out, but I’m still troubled by the prospect of all that money chasing insufficient goods and services and our politicians succumbing to expediency. Agreed, raising taxes and cutting back on government spending are not usually the best way to win elections. (Not surprisingly, Gordon Brown and Stephen Harper are both apposed to such measures.) There are also finite limits to how much governments can borrow. Monetizing the deficits may sound the better solution, but this is simply a glorified word for inflating the system with cheapened money, thereby diminishing the burden of public debt.

Michael Graham, from his newsletter - The Great Escape

Jacoline Loewen

How the economists missed the biggest thing in their lives

"Why the heck did they not know?" is a common question at economic presentations these days. Today's guest blogger, Michael Graham, elaborates.

Recently, the Queen pointedly asked the brains of my alma mater, the London School of Economics, why they could not have foreseen the coming cataclysm. Weeks later Her Majesty received a lengthy reply that could have been best reduced to a simple “We don’t know”. On my latest trip to a deeply troubled Britain, I couldn’t help but notice an eye-catching headline in The Daily Telegraph. “The Fiscal Ruin of the Western World Beckons” was probably exaggerated. Nevertheless, there should be no doubt about the hole our world has dug itself into. Or the extent to which Mr. Volcker, now head of President Obama’s Economic Advisory Panel, and Ben Bernanke, the re-nominated Federal Reserve chairman, are going to have their work cut out for them. Everyone should want to wish them well.

Those free-market champions Ronald Reagan and Margaret Thatcher would certainly not approve of the bailouts, relief packages, loan guarantees and diverse other rescue measures provided financial institutions and auto manufacturers judged too big to be allowed to fail. The very successful “cash for clunkers” incentive only adds to what one critic has expressively likened to a bewildering alphabet soup.In the case of the U.S., estimated total government support now exceeds a staggering $10 trillion. That’s before the $1 trillion currently being proposed by the Obama Administration for healthcare. The pattern is similar in many other countries, most notably Britain. And also in Canada, which has swung dramatically into the red at both the national and provincial levels. Adam Smith, of Wealth of Nations fame and the father of modern-day free markets, would probably roll in his grave at the resulting interference with the invisible hand of his competitive world marketplace.

No doubt, government intervention on today’s scale must make it harder to keep participants in disciplinary line. As a result, daunting economic risks stand to become all the greater. Nevertheless, to quote Jeffrey Immelt, Chairman & CEO of General Electric, we have no choice but to accept that “the government has moved in next door and it ain’t leaving”.

There could be offsetting comfort in comedian Will Rogers’ homily that “the good thing about government is that we don’t get what we pay for”. But, like it or not, we have entered a prolonged government-private sector partnership of unknown consequences on a scale few would have ever imagined. It must be remembered, that government spending cannot prop up wounded economies indefinitely. Nor can pump-priming fiscal deficits be recipes for sustainable economic growth. Rising government debt also inhibits fiscal and central bank manoeuvrability. A trio like this can bring only short-term stimulus at best.

Web: grahamis.ca

Email: Michael@grahamis.ca

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.