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Thursday, December 04, 2008

Some thoughts on the "Credit Crunch"

Recession and the credit Crunch

I have been trying to spin out technology from a govt. incubator in the N.E. of England, this has been a long and convoluted track, one which is precariously coming to a major nexus. The track has seen the business model morph from a major project , with debt finance in the teens of millions and matched equity financing , to the bare bones of a model which was built on a deck of cards that are crumbling away quickly. I am sure many of my readers have been there before, where a solid plan on the exterior is actually a convoluted network of supporting items and actions, if you miss or loose a couple of them the whole becomes very unstable( or role is to makes sure we have spare aces up our sleeves). This is normal for a start up but adding on top off that the financial institutions issues with the credit collapse, it makes it nearly impossible to raise debt financing , and the terms from your VC in general is like day light robbery, but what is a guy to do, if you have a project you need to have the resource. I look at it like "Oceans 13" You have a major deal to make loads of cash and have the time of your life executing the deal (For some sad folks it's the execution and not the pot of gold that we crave), you take your money to bank roll you, from where you can get it.

(I do need to take a minute here to say that there are some good guys out there, the guys I have worked with on this deal have been some of the best I have worked with (SIGMA VENTURES), there are a few others that I have come to respect both sides of the pond. )

So today's little gem comes from a favorite blog off mines "Pure VC" www.purevc.com it talks about "the depths and extent of the financial crisis we face today", you can stop here and now turn to your favorite fiction site, BBC, The Sun, The mirror, or let these guys educate you.

Deleveraging, Recapitalizations, & Margin Calls
People still don't seem to believe or comprehend the depths and extent of the financial crisis. Here is my brief explanation. We have been in an economy built on leverage and that leverage is coming down like a house of cards. Banks and financial companies were levered 40:1 loaning monies out that far exceeded the capacity for defaults. It started with residential mortgages and sent the financial world reeling as banks packaged these loans and sold them to others. Due to recent changes in accounting rules, banks were forced to value these assets "marked to market". Thus when the market froze and there was no liquidity to trade debt, valuations declined. We saw the collapse of some venerable investment banks such as Bear Stearns and Lehman Brothers as well as thrifts such as Washington Mutual and Indy Mac and mortgage titans Freddie Mac & Fannie Mae and Countrywide - the list goes on and on. We also saw the swallowing of Merrill Lynch and Wachovia, and the near crumbling of Citigroup. Even Goldman Sachs and Morgan Stanley have not been spared.
For those of you who believe that the financial companies will be coming back anytime soon, please think again. The market no longer values any business model that relies on leverage. In order to deleverage, companies must sell assets both good and bad. This compounds the problem as these assets are worth less and less. To make matters worse, the entire industry is in trouble and there are no buyers to take on leverage (the only buyer is the Federal Government). Anybody that acquires or merges with another insitution is simply asking for trouble. How can an overleveraged bank imagine that it can purchase another weaker overleveraged bank without weakening its position? It can't. Thus, it must go back and raise funds such as Bank of America did after its Merrill acquisition. Dividends will be cut completely. Massive amounts of equity will need to be raised. And when the federal money runs out we will be in trouble.
Thus the economy is in a massive recession and is shrinking because of deleveraging. If we were levered 40:1 and we are going back to 10:1 leverage then you can imagine our economy will shrink that same amount. If you don't understand what I am talking about, think about the size of the economy as measured by credit card transactions. Imagine if your bank suddenly froze your credit cards and you could not buy anything on credit and you had to use cash. Transactional volume would come to a halt because most people use credit to pay for just about everything. Unfortunately, a freezing and cutting of credit extended to consumers may actually happen. You can imagine what this will do to retailers. It looks like we are going back to the age where cold cash is king.
Essentially, we have had a recapitalization of the entire economy. The stock market has lost trillions of dollars as reflected by the haircuts of stock prices. Open up your 401k statement and you will see what I am talking about. 99% of the population does not understand what "recapitalization" means. In the private equity world, recapitalizations are the re-valuing and re-valuation of a company's worth. When you hear "recap" it typically refers to loss of valuation to the downside - think "massive shrinkage of company's value". Sometimes a recap is to the upside but that is what we would call a "dividend recap" meaning that we are taking out money from the company at the time of recapitalization. Anyways, the key theme in a recap is this - previous investors typically get washed out unless they "pay to play."
One final thought - the entire world has been put on a "margin call". How? Well, the market has told us that any business model using leverage is no longer desirable. Thus anybody with leverage is forced to close out its leverage down to either zero or something more reasonable. This is why it is a treacherous downward spiral - the only assets to sell are those that are devalued and those companies that are publicly traded are thus in a bad position. They have margin calls on them and must sell devalued assets that are losing more value everyday.
Do you still think that the next shoe to drop is not the commercial real estate industry? Or the consumer credit industry? The market thinks leverage is evil - any business models with leverage must adapt or become the next victim of market evoluion.

Have a great weekend

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