This summer has been a crazy one for me and I have, as one friend wrote, "gone dark" since early June. So, as I begin to sprout prose again here, why not jump back in with a depressing post on the debt debacle & its impact on the our entrepreneurial world…
Over the past year, money has poured into the buyout world. Enabled by cheap debt, buyout firms have been taking companies private at a eye-popping rate. Many observers have noticed the comparison of this activity to the venture bubble of 1999-2000. Many pension fund managers have justified this insane ramp, stating that these companies are cash flow positive or that the public market is sizable or that “this time is different”. However, when you buy firms at 9-11x EBITDA and use significant leverage, everything will eventually end in tears.
Well, the punch bowl has formally been taken away this month. With the growing credit crisis spreading from the sub-prime debacle, banks have dramatically ratcheted back their lending terms and activity. The public markets, having continued their ascent driven by the ever-present buyout offers, are now growing more volatile. The failed UAL buyout triggered a dark period in the markets in the late 1980’s when I was on Wall Street and it looks like an encore performance is happening now with deals like Chrystler stalling. As Roach over at Pequot mentioned, brace yourself when the first major buyout deal files for Chapter 11.
Bill Gross, the Sage of the Debt world at Pimco, wrote in his Enough Is Enough article (worth the read):
"But the Blackstones, the KKRs, and the hedge funds of recent years also climbed to the top of the pile on the willing backs of fixed income lenders too meek and too passive to ask for a part of the action. Covenant-lite deals and low yields were accepted by money managers as if they were prisoners in an isolation ward looking forward to their daily gruel passed unemotionally three times a day through the cellblock window. "Here, take this" their investment banker jailers seemed to say, "and be glad that you’ve got at least something to eat!"…Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!
Investors are nervous that the sub-prime credit issues will spread to other credit sectors. They are asking if S&P/Moody’s missed the boat on assessing the sub-prime risk, then they probably have missed in the other sectors as well. Banks are balking at the terms proposed by recent large buyouts, despite some serious strong-arming tactics from the likes of KKR. And, debt origination is plummeting. Collateralized Debt Obligations (CDO’s) which peaked at $42B, have fallen to under $3B as bank credit groups retrench. Less mortgage credit and less buyout credit will impact both corporate revenue streams and market values.
So, what does this all mean:
1) increasing volatility in the public markets as investors try to figure out if changes represent the coming of Armageddon or a fantastic buying opportunity.
2) tighter credit guidelines and terms as banks and debt markets demand more return and more protection for the risks they are taking (yes, the laws of gravity are returning)
3) increasing difficulties in the buyout world as firms have to put more equity into deals while still paying higher EBITDA multiples due to competition. It will turn into a blood bath.
4) junk debt spreads will widen significantly as bankruptcies soar.
5) the IPO market will begin to soften again as the public markets try to figure things out. Quality companies will still go out but bankers will be increasingly selective.
6) later stage venture investors will begin to tighten terms.
This all said, should things go south, it will provide a strong opportunity for entrepreneurs who are disciplined. Venture capital and angel capital will be increasingly more cautious in backing new competitors into spaces. Should market conditions hit truly rocky times, weaker competitors will be pruned. This is why breakout companies such as Cisco often have their genesis or ascension coming out of difficult times. Focus on your core business and customer value proposition. Get to cash flow break even as quickly as possible. And, spend every penny as if it were your last. Buckle up for some interesting times. The markets may not necessarily go through major corrections, but investors are going to be reminded that there is risk associated with leverage, alternative asset classes and excessive liquidity.