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.

J

Market Turbulence

The current market turbulence triggered a 7%+ decline in the S&P 500 over the last few weeks. The Euro markets fell even more. The impact of this turbulence will be minor if it passes quickly. I believe, however, it may be more long lasting than many perma bulls allege. I do not think this is 2008 version 2.0. Nonetheless, the turbulence may have some legs - economic basis. Consider the following:

1)     Weak Global Growth: World Bank cut the global growth rate.

2)     Continued Deflation Fears: This is especially true in Europe. The reason underlying is the Debt Deflation hypothesis first outlined by Irving Fisher following the 1930s Great Depression. Just as in the 1930s, consumer balance sheets were devastated by the 2008-2010 Great Recession. Consumer asset values, primarily their homes, fell below their liabilities. Consumers curtailed purchases to pay down debt and repair their balance sheets. The consumption drop and the resultant drop in the velocity of money take years to play out. Reinhart and Rogoff estimate it takes 7+ years from the end of the financial crisis to get back to normal. Thus, we about mid way thru the cycle.

3)     Europe: Is a basket case with a lack of political will to address underlying structural reforms.

4)     Emerging Markets: Impacted by commodity price declines.

5)     China: Affected by declining end markets for their exports.

6)     United States: Is the tallest midget in the room for now.

7)     Ebola: The quintessential Black Swan. No one saw this coming and no one knows how this will end. Nature throws curve balls like this every now and then just to remind us who is really in charge.

8)     VIX: The rise in the volatility index signals a potential downward shift in investor risk appetite.

So what are the possible implications of the above malaise on the M&A market, which heretofore experienced a strong rebound? If the volatility continues, deals could be pulled, delayed or canceled. Consider the following:

1)     Buyers: Become hesitant because you cannot project a price. The standard 30% premium over market is difficult to apply because the price to which you apply it against keeps changing. Whatever price you use could be even lower next week. Also, for deals using stock, a drop in the buyer’s stock price makes the deal more expensive regarding EPS dilution.

2)     Sellers: Are reluctant to sell when their market price is falling. Most sellers tend to anchor on their stock’s 52 week high. They believe the price could recover if they wait it out. This may be a long wait as one of the factors underlying equity prices, a strong IPO alternative, has shut down. Investors find it difficult to price IPOs when prices are so volatile.

3)     Hostile Takeovers-Activism: Could increase as a rising market no longer exists to cover over operating problems.

4)     Private Equity: The current M&A growth has been largely driven by strategic corporate acquirers. Private equity has been relatively quiet despite having substantial drop powder. As corporations drop out of the game PE firms may find less competition.

5)     Documentation: See the increased use of risk shifting clauses in Sale and Purchase Agreement and financing commitments.

6)     Cost of Capital: The Ten Year Treasury has fallen during the turbulence by over 30 BP to just over 2.2% as investors seek a safe haven. Rather than lowering the cost of capital as many pundits believe, the cost of capital may have actually increased. Consider:

a.     Debt Spreads: Have surged to their highest levels in over a year. Debt availability for the edge of the envelope 6X+ FD deals is also being tested as investors withdraw funds from high yield bond funds

b.     Equity Risk Premium (ERP): The ERP is usually calculated by taking the S&P 500 earnings to price ratio and subtracting the real 10 year rate, which is essentially 0 now. The 7% drop in the S&P means, if it holds and changes investor expectations, then ERP has also increased.

What are we to do? First, do not panic as this too shall pass. The factors supporting increased M&A still remain largely intact. The key is to remain solvent, liquid and to paraphrase President Obama - don’t do stupid stuff. Next, remain ready to move quickly as opportunities appear and conditions improve. A bull market makes us appear like geniuses. It doesn’t take a genius to recognize that volatility and deals do not mix well. So as your airline captain would say - ladies and gentlemen please fasten your safety belts we are experiencing some turbulence.

J