ThoughtStorm Strategic Capital - Thinking About Deals

How Bailout courses of action should affect your business model

This article from the 2001 Nobel laureate in economics is a concise and cogent description of the courses of action re: the bailout.

We're pleased to see that someone is talking about the need for quality due diligence and the potential risks of shoddy or slight investigations into value. We have pushed this message with our M&A acquiror and PE investor clients. They understand pretty readily once the costs are discussed.

Where we still find the most disbelief or unwillingness to accept the facts that diligence leads to estimates of value that support transactions that actually get executed is on the target/portfolio company side of things. Founders and CEOs find it difficult to explain how they will actually achieve the numbers in their projections; we often find that the fundamental business model is unexamined. By business model, we mean not the spreadsheet itself but the concept of the business, in terms of how efficiently a company uses its invested capital to produce revenue, how well it controls product costs as it converts revenue to gross income, how it controls operating expenses as it achieves EBITDA numbers, how it organizes its capital structure as reflected in EBT, and how it manages tax issues as reflected by Net Income, and finally how it balances reinvestment in the business and invested capital as we turn to a pure free cash flow (FCF) number.

We are building new tools and offerings to help companies at the board and senior management level think about their business model in the level of detail required to understand the implications of investor expectations. We focus on simplifying complexity to help direct management attention to the right links in the FCF value chain.

As we start presenting our ideas to the market, we'll announce more here.

Labels: due diligence, expectations, governance, performance

Monday, October 06, 2008 :: posted by Rick Colosimo @ 10:54 AM

Bailout: cause & effect

Larry Ribstein, who's a law professor and pretty focused on corporate governance generally, just described the bailout in some pretty straightforward terms.

WARNING: we are not typically focused on macroeconomics except in scenario planning. However, we see strong tendrils of the situation that are really about investor expectations, the efficiency of the market, and the quality of public disclosures.

Here is our brief description of the background of at least the current portion of the crisis (not the subprime problem itself, which is very different):

1. Banks have capital requirements so they won't be as likely to fail.

2. Part of bank capital is loans and portfolios of loans as well as fuzzier items, such as swaps and other derivatives.

3. The value of the fuzzier items concerned regulators, in part after seeing big drops in startup stock after the dotcom bust.

4. Regulators then required banks to carry those items at market value (just as they would for regularly traded securities) rather than book value. The purpose of this was to get some idea, as fuzzy as it may be, about the value of the assets that the banks wanted to use to fulfill their capital requirements.

5. Market values of CDOs (collateralized debt obligations) dropped as the estimates of subprime defaults differed from original estimates on which the price of the CDOs were set.

6. Banks reduced the value of the CDOs and other assets on their books according to the rules set by FASB for making those estimates when there isn't a regular market for assets (i.e., anything different than traditional stocks & bonds).

7. When the fuzzy assets were counted this way, the banks didn't meet the capital requirements. That led to banks raising a lot of capital at lower stock prices (Citi raised $10b(?), mostly from overseas), which obviously led their share prices lower.

8. Lower share prices & lower market values for the fuzzy assets & mark-to-market led to more capital raising, and so on.

The idea we've read in various places that mark-to-market by itself is somehow responsible for the underlying change in value of the assets is silly and violates causality. The assets in question are now so fuzzy that the market transactions I've read have imposed huge discounts, of 20-40%, on the assets. The real issue for the equity holders is being grumpy about the fact that they need new capital, which is coming in a discount, meaning dilution.

Ending mark-to-market would give everyone less information -- yeah, that's a *good* idea. Everyone, including the market, understands that it's hard to put values on fuzzy assets, and that risk is priced in accordingly. Now, if the regulators want to shift the capital requirements that are directly causing the need for sales of distressed assets and equity, that might make sense, but we recently just read a different item in the NYT on how similar reductions in capital requirements preceded the S&L bailout. Maybe that idea doesn't make sense after all. [NB: added text] Other alternatives proposed also focus on the capital requirements, but from the investment angle rather than the regulatory angle. No matter how you slice it, the capital requirement is the issue, not the valuation method of the capital per se.

What will happen, what indeed must happen in the end, is that these illiquid assets will end up in the hands of people who can afford to own illiquid assets. Illiquidity is kryptonite for banks, who had it bad enough back when they were taking in demand savings & checking deposits and making 5-year car loans and 30-year mortgages. Newer instruments seemed to improve things, and probably did, but changes in value seem to have been exponential rather than linear, at least over the small changes I've seen quoted, such as doubling the default rate on subprimes from 1.5% to 3%. While that could eliminate profits on thin margins, that shouldn't destroy more than 3% of the portfolio value if you owned all the mortgages and recovered ZERO from any default.

So that, to us, is one view of the situation.

Labels: disclosure, equity analysis, expectations

Wednesday, October 01, 2008 :: posted by Rick Colosimo @ 1:19 PM

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