Monday, August 31, 2015

What the F@#$&&* Just Happened (Again)?

The financial markets had a wild ride over the past week with many investors having CTJM (come to Jesus moments). Things seem to be settling down (I hope). Nonetheless, episodes like this can have some lingering effects-especially in the VC and M&A deal markets.
Consider the following:

1)     Volatility Index (VIX): had been hovering in a narrow band of 10-15 before August suddenly spiked to over 40.This is below the record 80 during the financial crisis but still significant. Remember, the Russian, Asian and Greek crises had similar spikes and we all know how much fun those were. Usually, an unexpected event (e.g. Chinese devaluation?) inconsistent with investors’ views causes them to reassess their portfolio risk profile. They recognize their new profile now exceeds their risk appetite. They attempt to rebalance their portfolios (de-risk) all at the same time triggering a panic flight to quality.
2)     S&P 500: fell from 2090 to 1870 between 8/14 and 8/24 or 11% (exceeding the 10% definition of a “correction”) within 10days before recovering somewhat. Again mild compared to the big one in 2008 when it fell over 50%, but not too shabby. Also, some investors experienced dreaded margins calls-the mother of all CTJM.
3)     Equity Risk Premium the ERP reflects a market price of risk. I favor a forward implied ERP v the academic historical premium of 5-6%. Damodaran calculates the ERP jumped by over 70 bps or 12% from 5.9% to 6.6%.
4)     Credit Spreads:  widened based on the increase in the BBB-treasury spread.

Now let’s think thru some possible implications of these developments:

1)     IPOs: likely to be delayed as most investment bankers/ underwriters are reluctant to price and bring deals to market when the VIX exceeds 20 and stays there; as they demand a higher return/lower pricing for perceived increased risk. This could have ripple effects on so-called “private IPO” late stage follow-on capital raising rounds. May even trigger a down financing round in which the capital is raised at a lower value than in previous rounds. This could break the VC culture of optimism (AKA culture of denial) and impact VC pricing/valuation momentum.
2)     M&A: pending deals may have some trouble closing. This is reflected in widening arb spreads. Furthermore pricing new deals becomes more complicated. What base should buyer’s use to base their premium? Most seller’s anchor on their 52 week high and may resist offers based on current lower prices. Buyer confidence may decline leading to postponed deals. Finally, banks and credit markets in general may tighten credit terms.
3)     Hedge and Activist Funds: many suffered some significant losses and may be reluctant to initiate new takeover contests.
4)     WACC: increased ERP and credit spreads will increase WACC affecting stock prices and future investments.

The sky is not falling, but clearly something happened. You can choose to ignore and see the downturn as a buying opportunity. Others may want to pause and reassess the market and their strategies before proceeding. In any event the effects will ripple thru the deal and financing markets with possible more shoes to drop. So keep your seat belts fastened.


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