Thomas H. Lee's Sperling Says Markets Are `Choking' on Buyouts
By Jason Kelly and Charles Stein
July 27 (Bloomberg) -- Private-equity takeovers of companies such as Dollar General Corp. and Alliance Boots Plc have piled on more debt than investors are willing to tolerate, Thomas H. Lee Partners LP Co-President Scott Sperling said.
``There are five or six transactions that the market is still choking on,'' Sperling said in an interview today. ``All of those that have been difficult to finance, that may have been a catalyst to what we're seeing.''
Kohlberg Kravis Roberts & Co., the New York-based firm behind the Alliance and Dollar General bids, failed this week to find financing for its buyout of Alliance, the U.K.'s biggest pharmacy chain. That's reflective of a larger repudiation of leveraged buyouts by debt investors demanding to be compensated better for the risks of the loans and bonds.
``We're going to see a pause here,'' Sperling, whose firm is based in Boston, said. ``The folks in our industry are going to sit back and wait for whatever reasonable readjustment there will be.''
About two-thirds of the price tag in the typical leveraged buyout is paid with borrowed money, with the balance coming from cash the takeover firm has raised. Private-equity firms have announced $692.7 billion in transactions so far this year, almost equaling last year's total of $701.5 billion, according to data compiled by Bloomberg.
Buyout firms including KKR are relying on their investment banks to provide loans to finance the deals or reworking the terms of the debt to make them more palatable to investors.
Concern about how private-equity firms will obtain funding is affecting deals that have yet to be completed. Cadbury Schweppes Plc, the world's largest candy maker, said today it plans to delay the sale of its U.S. beverage unit because of the ``extreme volatility'' in the debt markets.
Two buyout groups, one including TPG Inc. in Fort Worth, Texas, and the other New York-based Blackstone Group LP, have expressed interest in the drinks unit, according to people with knowledge of the bidding.
Saturday, July 28, 2007
Friday, July 27, 2007
LBO Financing faces increasing challenge
Chrysler, Boots Financing Woes Dim `Golden Era' for Buyouts
By Edward Evans and Jason Kelly
July 26 (Bloomberg) -- The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.
Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt.
LBO firms, which announced an unprecedented $690.4 billion of takeovers this year, need to raise $300 billion of debt to fund purchases, according to data compiled by Bear Stearns Cos. That's going to get harder because investors, hit by losses on subprime mortgages, are shunning riskier bonds and loans.
``You're going to see more broken deals,'' billionaire investor Wilbur Ross said in an interview yesterday in New York. ``If the investment banks continue to get hung up, their appetite for risk is going to go down. That'll be a big change.''
Sales still in negotiations are being affected. Cadbury Schweppes Plc, the London-based maker of Dairy Milk chocolate, may get less than the $15 billion sought for its U.S. beverage unit as two buyout groups bidding for the division struggle to arrange funding, people with knowledge of the talks said yesterday.
It may also mean lower fees for Wall Street firms. Deutsche Bank, Germany's biggest bank, JPMorgan, the third-largest in the U.S., Credit Suisse Group, Switzerland's second-biggest bank, and New York-based Goldman Sachs Group Inc., the world's most profitable investment bank, took the biggest share of the $8.4 billion in fees paid by LBO firms in the first half, according to data compiled by Freeman & Co. and Thomson Financial in New York.
`Ugly' Scenario
``You've got an ugly short-term scenario,'' said Marek Gumienny, managing director at London-based buyout firm Candover Investments Plc, in a telephone interview yesterday. ``There will be pressure from credit committees at banks to reprice, restructure and offload this stuff.''
KKR has announced $136 billion of leveraged buyouts this year. Buyers typically fund LBOs with debt backed by the target's assets. They pay off the borrowing using cash flow and profit by selling the company three to five years later.
Kravis, who helped create the LBO business in 1976 with his cousin George Roberts, needs to raise money to pay for credit- card-payment processor First Data Corp. of Greenwood Village, Colorado, and Harman International Industries Inc., the Washington-based maker of Harman Kardon speakers.
Gross, Dimon
Since Kravis, 63, made his ``golden era'' comment in a speech to Canada's Venture Capital & Private Equity Association, almost 40 bond and loan sales have been canceled or restructured. Record defaults on U.S. subprime mortgages triggered the flight from below-investment-grade debt.
Bill Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, said on July 24 that lenders are ``frozen'' and ``absolutely nothing is moving.'' Jamie Dimon, chief executive officer of New York-based JPMorgan, described the drop in demand last week as ``a little freeze.''
Frankfurt-based Deutsche Bank, which is leading the financing for KKR's takeover of Nottingham, England-based pharmacy chain Alliance Boots, failed to sell 5 billion pounds ($10 billion) of senior loans to fund Europe's biggest LBO, two people with direct knowledge of the negotiations said yesterday. Chrysler, the U.S. unit of Stuttgart, Germany-based DaimlerChrysler AG, postponed the $10 billion sale of loans for its buyout by New York-based Cerberus Capital Management LLC, according to investors briefed on the decision.
Banks' Expense
``LBO financing has got much more expensive,'' said Willem Sels, a credit strategist at Dresdner Kleinwort Ltd. in London.
While terms of the Chrysler and Alliance Boots takeovers may have to change, both will still be completed. The banks funding the sales, rather than the buyout firms, have committed to covering most of the extra cost.
``Too many people have forgotten that underwriting is underwriting: you're on risk,'' Candover's Gumienny said. ``Some banks may not be in a position to do deals at the moment until they've reduced their credit or feel they can syndicate very easily. They're not going to be rushing out, throwing money at things.''
The private-equity firms aren't low on cash themselves. Pension funds, university endowments and wealthy individuals poured a record $210 billion into buyout funds last year, according to data compiled by London-based research firm Private Equity Intelligence Ltd.
`Huge Pipeline'
While mergers and acquisitions may slow, private-equity firms and their banks won't abandon LBOs unless the broader economy stumbles, said Warren Hellman, co-founder of San Francisco-based buyout firm Hellman & Friedman LLC.
``If there's a turn in the economy, a lot of stuff, the mega-stuff that's been done is going to start to look troubled,'' Hellman, a former president of New York-based Lehman Brothers Holdings Inc., said in an interview in San Francisco. ``That's the most concerning thing.''
The slide will be gradual, rather than an implosion that kills almost every LBO, said Mitchell Cohen, a managing director at Hellman & Friedman.
``It will be a little bit awkward for the next couple of months when this huge pipeline of stuff works its way through,'' Cohen said in an interview.
By Edward Evans and Jason Kelly
July 26 (Bloomberg) -- The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.
Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt.
LBO firms, which announced an unprecedented $690.4 billion of takeovers this year, need to raise $300 billion of debt to fund purchases, according to data compiled by Bear Stearns Cos. That's going to get harder because investors, hit by losses on subprime mortgages, are shunning riskier bonds and loans.
``You're going to see more broken deals,'' billionaire investor Wilbur Ross said in an interview yesterday in New York. ``If the investment banks continue to get hung up, their appetite for risk is going to go down. That'll be a big change.''
Sales still in negotiations are being affected. Cadbury Schweppes Plc, the London-based maker of Dairy Milk chocolate, may get less than the $15 billion sought for its U.S. beverage unit as two buyout groups bidding for the division struggle to arrange funding, people with knowledge of the talks said yesterday.
It may also mean lower fees for Wall Street firms. Deutsche Bank, Germany's biggest bank, JPMorgan, the third-largest in the U.S., Credit Suisse Group, Switzerland's second-biggest bank, and New York-based Goldman Sachs Group Inc., the world's most profitable investment bank, took the biggest share of the $8.4 billion in fees paid by LBO firms in the first half, according to data compiled by Freeman & Co. and Thomson Financial in New York.
`Ugly' Scenario
``You've got an ugly short-term scenario,'' said Marek Gumienny, managing director at London-based buyout firm Candover Investments Plc, in a telephone interview yesterday. ``There will be pressure from credit committees at banks to reprice, restructure and offload this stuff.''
KKR has announced $136 billion of leveraged buyouts this year. Buyers typically fund LBOs with debt backed by the target's assets. They pay off the borrowing using cash flow and profit by selling the company three to five years later.
Kravis, who helped create the LBO business in 1976 with his cousin George Roberts, needs to raise money to pay for credit- card-payment processor First Data Corp. of Greenwood Village, Colorado, and Harman International Industries Inc., the Washington-based maker of Harman Kardon speakers.
Gross, Dimon
Since Kravis, 63, made his ``golden era'' comment in a speech to Canada's Venture Capital & Private Equity Association, almost 40 bond and loan sales have been canceled or restructured. Record defaults on U.S. subprime mortgages triggered the flight from below-investment-grade debt.
Bill Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, said on July 24 that lenders are ``frozen'' and ``absolutely nothing is moving.'' Jamie Dimon, chief executive officer of New York-based JPMorgan, described the drop in demand last week as ``a little freeze.''
Frankfurt-based Deutsche Bank, which is leading the financing for KKR's takeover of Nottingham, England-based pharmacy chain Alliance Boots, failed to sell 5 billion pounds ($10 billion) of senior loans to fund Europe's biggest LBO, two people with direct knowledge of the negotiations said yesterday. Chrysler, the U.S. unit of Stuttgart, Germany-based DaimlerChrysler AG, postponed the $10 billion sale of loans for its buyout by New York-based Cerberus Capital Management LLC, according to investors briefed on the decision.
Banks' Expense
``LBO financing has got much more expensive,'' said Willem Sels, a credit strategist at Dresdner Kleinwort Ltd. in London.
While terms of the Chrysler and Alliance Boots takeovers may have to change, both will still be completed. The banks funding the sales, rather than the buyout firms, have committed to covering most of the extra cost.
``Too many people have forgotten that underwriting is underwriting: you're on risk,'' Candover's Gumienny said. ``Some banks may not be in a position to do deals at the moment until they've reduced their credit or feel they can syndicate very easily. They're not going to be rushing out, throwing money at things.''
The private-equity firms aren't low on cash themselves. Pension funds, university endowments and wealthy individuals poured a record $210 billion into buyout funds last year, according to data compiled by London-based research firm Private Equity Intelligence Ltd.
`Huge Pipeline'
While mergers and acquisitions may slow, private-equity firms and their banks won't abandon LBOs unless the broader economy stumbles, said Warren Hellman, co-founder of San Francisco-based buyout firm Hellman & Friedman LLC.
``If there's a turn in the economy, a lot of stuff, the mega-stuff that's been done is going to start to look troubled,'' Hellman, a former president of New York-based Lehman Brothers Holdings Inc., said in an interview in San Francisco. ``That's the most concerning thing.''
The slide will be gradual, rather than an implosion that kills almost every LBO, said Mitchell Cohen, a managing director at Hellman & Friedman.
``It will be a little bit awkward for the next couple of months when this huge pipeline of stuff works its way through,'' Cohen said in an interview.
Allco Finance in BIMBO of Allco Equity
Allco Finance Buys Management Control of Allco Equity (Update2)
By Robert Fenner
July 26 (Bloomberg) -- Allco Finance Group Ltd., an Australian manager of energy, aviation and property assets, took control of Allco Equity Partners Ltd. after agreeing to buy out Chief Executive Officer Peter Yates and director Greg Woolley.
Woolley and Yates agreed to sell shares to Allco Finance, lifting its interest in Melbourne-based Allco Equity to 12.5 percent, the companies said in a statement today. Allco Finance also acquired options that may raise its stake to 35 percent, according to the statement.
Allco Finance will also move to 100 percent ownership of the company that manages Allco Equity, from 39 percent, after buying the stakes held by Yates and Woolley. The price paid for the shares and buying out management wasn't disclosed, with the options exercisable at A$5 a share.
Shares in Allco Equity rose 17 cents, or 4 percent, to A$4.39 at the 4:10 p.m. close of trading in Sydney, giving the company a market value of A$438 million ($389 million). Stock of Sydney-based Allco Finance fell 38 cents, or 3.5 percent, to A$10.49.
Marcus Derwin will replace Yates as CEO of Allco Equity.
Allco Finance and Allco Equity were part of a bidding group led by Macquarie Bank Ltd. that failed to take over Qantas Airways Ltd. this year.
Allco Finance is opening an office in Milan as it seeks more investments in Europe. The firm agreed in March to buy $200 million of wind energy assets in Germany and France, and may look to bundle these into a new investment fund. On June 13, it agreed to buy 50 percent of Italy's Industria Petroli Meridionale Srl.
By Robert Fenner
July 26 (Bloomberg) -- Allco Finance Group Ltd., an Australian manager of energy, aviation and property assets, took control of Allco Equity Partners Ltd. after agreeing to buy out Chief Executive Officer Peter Yates and director Greg Woolley.
Woolley and Yates agreed to sell shares to Allco Finance, lifting its interest in Melbourne-based Allco Equity to 12.5 percent, the companies said in a statement today. Allco Finance also acquired options that may raise its stake to 35 percent, according to the statement.
Allco Finance will also move to 100 percent ownership of the company that manages Allco Equity, from 39 percent, after buying the stakes held by Yates and Woolley. The price paid for the shares and buying out management wasn't disclosed, with the options exercisable at A$5 a share.
Shares in Allco Equity rose 17 cents, or 4 percent, to A$4.39 at the 4:10 p.m. close of trading in Sydney, giving the company a market value of A$438 million ($389 million). Stock of Sydney-based Allco Finance fell 38 cents, or 3.5 percent, to A$10.49.
Marcus Derwin will replace Yates as CEO of Allco Equity.
Allco Finance and Allco Equity were part of a bidding group led by Macquarie Bank Ltd. that failed to take over Qantas Airways Ltd. this year.
Allco Finance is opening an office in Milan as it seeks more investments in Europe. The firm agreed in March to buy $200 million of wind energy assets in Germany and France, and may look to bundle these into a new investment fund. On June 13, it agreed to buy 50 percent of Italy's Industria Petroli Meridionale Srl.
Thursday, July 26, 2007
Some comments on credit hedging strategies and portfolio management
Hedge Fund Strategies for the Asian Credit Markets
MSuvir A. Mukhi , Income Partners Asset Management
Outlook for the Asian Credit Market in 2004
We expect the positive macroeconomic background in Asia to persist in 2004. Our base case is for growth to pick-up in G3 economies (US, Euroland and Japan), leading to a coordinated global recovery. Asia will benefit from a pick-up in exports to these markets. Additionally, growing domestic demand and stronger inter-regional trade, driven by China, will add further impetus to growth. Thus we still expect the environment to be credit friendly in 2004.
The positive macro environment will enable corporates to continue strengthening their financial profiles. Sovereigns too will benefit from stronger growth, which should lead to improving fiscal profiles. Thus, we would expect the positive rating trend seen in the past three years (see chart) to continue in to 2004.
Another positive aspect of the Asian credit market is the healthy and growing supply. Gross issuance of Asian eurobonds was a record US$30 billion in 2003, up from US$20 billion in 2002. It is expected that 2004 supply will marginally exceed that of 2003.
The healthy levels of new issuance help ensure that breadth is maintained in the market and that market prices are reflective of credit fundamentals. Among the new supply expected are first time issuers, which generally offer diversification benefits and greater relative value. Given the amount of liquidity in the system, we believe the new supply should be met with adequate demand.
Another major consideration when assessing the outlook for Asian credits in 2004 is the political calendar. As detailed in the following table, eight Asian countries will be holding elections. While we expect most elections to be held peacefully and result in minimal economic policy changes, it is always the unexpected which haunts the market. Elections always contain room for surprises, which could add to volatility in Asian credit markets.
Finally, investors in Asian credits will likely have to deal with rising US Treasury yields. Hence duration management will become an increasingly important consideration.
Performance of Asian Credit Hedge Fund
The Asian Credit Hedge Fund (ACHF), which was launched in February 2002, has performed well since inception. The fund returned 14.1% in the Feb-Dec 2002 period, and 12.5% in 2003.
The following table compares the fund's returns to returns of JP Morgan's Asian Credit Index (JACI) and Merrill Lynch's US Treasury Index.
As can be seen, the ACHF has performed well in different credit and interest rate environments. Another point to note is ACHF's lower volatility. In the combined 23 months, ACHF's standard deviation (0.6%) was significantly lower than that of the JACI and the ML UST index. Similarly ACHF demonstrated a lower number of down months and a higher Sharpe Ratio - indicating better risk-adjusted returns.
ACHF's Strategy for 2004
In our opinion, ACHF's multiple-strategies and hedging techniques are well suited for the above-described environment, where we are likely to witness rising yields, potentially increased volatility and more selective spread compression. The following strategies are expected to enable us to achieve double-digit returns in 2004 with limited monthly volatility.
A. Core Credit Selection
The core of ACHF's strategy is to long / trade a core portfolio of credits, which are expected to demonstrate improving credit fundamentals and/or offer significant relative value opportunities.
This will include a diversified portfolio of bonds, loans, perpetuals and convertible securities. In addition, the portfolio will normally include 15-20% in special situation investments, which are usually characterised by deep discounts and exceptionally high return potential. The fund is not constrained by currency, rating, structure or tenor of any investment, as unwanted risks can be hedged away.
The ability to invest in multiple asset classes improves the fund's investment options, enables us to seek the best value, and helps generate returns in different market environments. For example, yield curves of different currencies do not necessarily move in tandem. Similarly returns of special situation investments, convertible bond and high-grade bonds are not necessarily correlated.
Given our positive macro views, we expect higher-yield and special situation investments to outperform this year. Hence these areas will be the focus of our credit portfolios, especially given that they are less correlated to US Treasury movements. We also expect convertibles will benefit from stronger equity markets. Rather than taking outright equity risk we will focus on balanced convertibles offering yield with some equity upside.
The core credit portfolio, described above, is augmented by the following strategies aimed at enhancing returns and reducing volatility.
B. Interest Rate Hedging
ACHF dynamically manages its interest rate exposure through the use of US Treasury futures, options and swaps. This enables us to protect the portfolio's returns against adverse movements in government bond yields.
The fund has a successful track record of managing interest rate volatility. For example, in 2003, Merrill Lynch's US Treasury Index recorded a negative return in five months out of 12 months. By contrast, the fund was able to generate positive returns in four out of these five months. The only exception was July 2003, when the Treasury index dropped 4.24%, and ACHF fell by 0.70%.
C. Credit and Macro-risk Hedging
ACHF also uses credit default swaps to manage overall country exposures and macro risks. For example, we may have favourable credit opinions on certain corporate credits in the Philippines, but we may be cautious on the country's macro-economic and/or political situation. In this case we may long the corporate credit and short the sovereign component by buying CDS protection on the sovereign. Similar strategies are also used to manage overall net country exposure on a portfolio basis.
The fund also invests in various currency, commodity and equity options as long-term sleeping hedges against potential market surprises. These hedges are unlikely to ever come in-to-the money. However, we believe they offer the portfolio protection in the event of unexpected situations. We limit the annual cost these hedges to just about 1% to 1.5% of the fund's NAV.
MSuvir A. Mukhi , Income Partners Asset Management
Outlook for the Asian Credit Market in 2004
We expect the positive macroeconomic background in Asia to persist in 2004. Our base case is for growth to pick-up in G3 economies (US, Euroland and Japan), leading to a coordinated global recovery. Asia will benefit from a pick-up in exports to these markets. Additionally, growing domestic demand and stronger inter-regional trade, driven by China, will add further impetus to growth. Thus we still expect the environment to be credit friendly in 2004.
The positive macro environment will enable corporates to continue strengthening their financial profiles. Sovereigns too will benefit from stronger growth, which should lead to improving fiscal profiles. Thus, we would expect the positive rating trend seen in the past three years (see chart) to continue in to 2004.
Another positive aspect of the Asian credit market is the healthy and growing supply. Gross issuance of Asian eurobonds was a record US$30 billion in 2003, up from US$20 billion in 2002. It is expected that 2004 supply will marginally exceed that of 2003.
The healthy levels of new issuance help ensure that breadth is maintained in the market and that market prices are reflective of credit fundamentals. Among the new supply expected are first time issuers, which generally offer diversification benefits and greater relative value. Given the amount of liquidity in the system, we believe the new supply should be met with adequate demand.
Another major consideration when assessing the outlook for Asian credits in 2004 is the political calendar. As detailed in the following table, eight Asian countries will be holding elections. While we expect most elections to be held peacefully and result in minimal economic policy changes, it is always the unexpected which haunts the market. Elections always contain room for surprises, which could add to volatility in Asian credit markets.
Finally, investors in Asian credits will likely have to deal with rising US Treasury yields. Hence duration management will become an increasingly important consideration.
Performance of Asian Credit Hedge Fund
The Asian Credit Hedge Fund (ACHF), which was launched in February 2002, has performed well since inception. The fund returned 14.1% in the Feb-Dec 2002 period, and 12.5% in 2003.
The following table compares the fund's returns to returns of JP Morgan's Asian Credit Index (JACI) and Merrill Lynch's US Treasury Index.
As can be seen, the ACHF has performed well in different credit and interest rate environments. Another point to note is ACHF's lower volatility. In the combined 23 months, ACHF's standard deviation (0.6%) was significantly lower than that of the JACI and the ML UST index. Similarly ACHF demonstrated a lower number of down months and a higher Sharpe Ratio - indicating better risk-adjusted returns.
ACHF's Strategy for 2004
In our opinion, ACHF's multiple-strategies and hedging techniques are well suited for the above-described environment, where we are likely to witness rising yields, potentially increased volatility and more selective spread compression. The following strategies are expected to enable us to achieve double-digit returns in 2004 with limited monthly volatility.
A. Core Credit Selection
The core of ACHF's strategy is to long / trade a core portfolio of credits, which are expected to demonstrate improving credit fundamentals and/or offer significant relative value opportunities.
This will include a diversified portfolio of bonds, loans, perpetuals and convertible securities. In addition, the portfolio will normally include 15-20% in special situation investments, which are usually characterised by deep discounts and exceptionally high return potential. The fund is not constrained by currency, rating, structure or tenor of any investment, as unwanted risks can be hedged away.
The ability to invest in multiple asset classes improves the fund's investment options, enables us to seek the best value, and helps generate returns in different market environments. For example, yield curves of different currencies do not necessarily move in tandem. Similarly returns of special situation investments, convertible bond and high-grade bonds are not necessarily correlated.
Given our positive macro views, we expect higher-yield and special situation investments to outperform this year. Hence these areas will be the focus of our credit portfolios, especially given that they are less correlated to US Treasury movements. We also expect convertibles will benefit from stronger equity markets. Rather than taking outright equity risk we will focus on balanced convertibles offering yield with some equity upside.
The core credit portfolio, described above, is augmented by the following strategies aimed at enhancing returns and reducing volatility.
B. Interest Rate Hedging
ACHF dynamically manages its interest rate exposure through the use of US Treasury futures, options and swaps. This enables us to protect the portfolio's returns against adverse movements in government bond yields.
The fund has a successful track record of managing interest rate volatility. For example, in 2003, Merrill Lynch's US Treasury Index recorded a negative return in five months out of 12 months. By contrast, the fund was able to generate positive returns in four out of these five months. The only exception was July 2003, when the Treasury index dropped 4.24%, and ACHF fell by 0.70%.
C. Credit and Macro-risk Hedging
ACHF also uses credit default swaps to manage overall country exposures and macro risks. For example, we may have favourable credit opinions on certain corporate credits in the Philippines, but we may be cautious on the country's macro-economic and/or political situation. In this case we may long the corporate credit and short the sovereign component by buying CDS protection on the sovereign. Similar strategies are also used to manage overall net country exposure on a portfolio basis.
The fund also invests in various currency, commodity and equity options as long-term sleeping hedges against potential market surprises. These hedges are unlikely to ever come in-to-the money. However, we believe they offer the portfolio protection in the event of unexpected situations. We limit the annual cost these hedges to just about 1% to 1.5% of the fund's NAV.
Wednesday, July 25, 2007
A good article explaining differences between ratings models
RATING OF CDO TRANCHES: THE CATWALK OF MODELS
By Vinod Kothari
Full article found at: http://www.vinodkothari.com/cdoratingmodels.htm
The CDO business is reaching out to banks, investors and high net worth individuals all over the World. Investment banks and CDO structurers from London, Paris, New York, Singapore or Sydney would put together a CDO of roughly 100 obligors, achieve some kind of a model-driven diversification, achieve a convenient first loss piece of x% that is sufficiently rewarded by the inherent arbitrage earnings of the CDO, and lo, the CDO is in the market. If it is a single tranche transaction, as most CDOs today are, you don't need to wait until all the tranches are sold off, as just one tranche is enough to successfully sell the CDO in the market.
Inherently, all the CDOs are cast in a model - unlike the portfolio of a usual balance sheet transaction, CDO portfolios are completely synthetic. "Synthetic" is close to "unreal", that is, the portfolio is completely virtual. It is constructed not by actually originating credits, but simply by synthetically selling protection on the target names. Therefore, the idea of a synthetic CDO is that of calendar beauty - it is perfect in every respect. It is an idealized portfolio where everything is only as much as you would love to have. This idealized perfection is attained to fit into rating agency models that compute the expected losses of the CDOs, and therefore, in a not very discrete way, it is the rating agency models that have been instrumental in the spurt of CDOs in the market.
Briefly, the extent of credit enhancement at any tranche level of a CDO is such as to reduce the probability of the defaults exceeding the level of subordination to an equivalent of the probability of losses at that tranche level. For instance, if Moody's idealized probability of default for a Baa2 piece is 1.58%, there must be such credit enhancement (meaning subordination) at the BBB piece level that the probability of wiping out the same is reduced to 1.58%.
Each rating agency has its own model to work out this probability distribution.
Arguably, the most transparent of the rating methodologies has been the Moody's binomial expansion technique (BET). The binomial expansion method comes from probability distributions where there is a definite number of outcomes of an event. For example, if we are tossing a fair coin, there is 50% chance of getting a head, and 50% of getting a tail. If we toss it 50 times, what is the probability of getting n heads, say, 7 heads? This is given by the binomial distribution. One may mathematically compute the probability using a formula, or find it on Excel with function binomdist.
When we have n number of harmomised obligors in a pool, there is a probability, for every one of these obligors, that the obligor may be in a state of default or state of performance. Therefore, there are two possible outcomes per obligor, and the probability of default of each of the obligors is given by the estimated probability. That probability of default per obligor may itself be drawn from several sources - such as historical probabilities implied by the rating transition histories, or prevailing cash market spreads, or structural study of each obligor based on financial data, such as in Merton model.
If n number of obligors default, and there is a loss (1-recovery rate) per obligor of x amount, then the total amount of loss of the CDO is nx. As long as nx is not more than the subordination at the tranche level, there is no default as for the tranche. So, the magic of the model lies in computing the probability of nx exceeding the level of subordination.
The critical inputs that go into estimating the probability of the losses exceeding the level of subordination for the tranche are:
Probability of default of each obligor
The notional value each obligor - in synthetic transactions, the notional value per obligor is harmonized
The recovery rate, which is reciprocal of the loss per obligor
The inter-obligor correlation, that is, the degree to which losses of one obligor will be associated with losses in other obligors too.
Moody's single binomial methodThe simplest of approaches is the Moody's single binomial expansion. This is by far the most simple approach. It reconstructs the actual CDO portfolio into an idealized portfolio that completely zeroes out the correlation in the pool. This is done by computing the diversity score of the portfolio. The diversity score having been computed, it is as if there are as many obligors in the pool as indicated by the diversity score. For example, if in a portfolio of 100 obligors of $ 10 million each (notional of $ 1 billion), the diversity score is 45, we assume as if there are 45 obligors in the pool with a notional of $ 1000/45 million. All the obligors have no correlation, and have the same probability of default.
Now, we know from the binomial distribution the probability of n number of defaults out of 45, from which we may compute the probability that losses will exceed a particular level. The cumulative probability for say, 5 defaults out of 45 will indicate the probability that the losses will be limited to the loss of 5 obligors, and the tail risk is that the probability that the loss will exceed 5 obligors.
Moody's multiple binomial methodLater, Moody's came out with its multiple binomial method. Here, it is still the binomial method, but with the pool broken into several subsets with different probabilities of defaults for each sub set. This method marked an improvisation, as, instead of assuming the probabilities of default of each obligor in the harmonized pool to be the same, the multiple binomial method allows for different probabilities per subset.
The multiple binomial method reflected the tail risk inherent in the CDO as the higher probabilities of default inherent in lower-rated obligors were not being adequately considered in the single binomial method. The tail risk of the sub-sets was more than that of the whole.
Moody's correlated binomial methodRecently, the rating agency came out with a correlated binomial methodology. A special report of August 10, 2004 (Moody's Correlated Binomial Default Distribution) explains the method. Unlike the earlier assumption where, the diversity score having been computed, the correlation in the pool was taken to be zero, this model allows for a correlation to be present even after computation of the diversity score. The new method is obviously triggered by one of the most dreaded problems in CDOs - fat tails. "Fat tail" implies a more than nominal probability of losses at the far end of the distribution - that is, high degree of probability of several defaults in the pool.
The diversity score itself has been adjusted after taking into account the correlation, that is to say, the correlated diversity is higher than the independent diversity score.
S&P's CDO Evaluator approachStandard and Poor's CDO Evaluator is based on a Monte Carlo simulation approach. As for the user, most of the underlying computations take place inside the "gray box". The required inputs the issuer's ID, par amount, industry classification, and S&P rating for the issuer. Internally, S& P assumes correlations - 30% intra industry.
Fitch VECTOR model:Fitch, on the other hand, uses a different sector-by-sector correlation on its Vector model. Fitch model is also based internally on Monte Carlo simulation. The default rates come from a new CDO Default Matrix (giving asset default rates by rating and maturity), which is based on historical bond default rates and can be modified to take account of "softer" default definitions when used for rating synthetic CDOs. Pairwise asset correlations, similar to what's done by Moody's, are based on estimates of cross- and intra-industry, and geographical correlations of equity returns. As a result, Fitch will assign an internal and external correlation for each of the 25 industry sectors used. In the past, Fitch did not explicitly model correlations, but applied penalties for high obligor, industry and country concentrations in CDO collateral pools.
The model riskIntuitively, it would not be difficult to understand that correlation is the key million-dollar input in estimating the expected loss probability at any tranche level. As we move up the correlation assumption, the loss distribution curve shifts its peak to the left, and the tail at the right hand becomes fatter and fatter. In case of CDOs, it is the tail that moves the dog - therefore, the real risk is the risk of fat tails.
Inherently, there are several risks still not being captured by the rating agency models. First, the probability of defaults of obligors are being mapped along the historical probabilities of given ratings. There is a huge difference between the historical probabilities of default, and those implied by the cash market spreads, and this difference becomes more acute for lower rated obligors. The intuitive argument for this widening difference is that the market tends to exaggerate the risks of default of lower rated obligors. While computing probabilities of default, the rating agencies are still influenced by the historical ratings.
Besides this, the credit spreads in the market for obligors of the same rating may be widely different. Motivated by arbitrage considerations, a CDO structurer may choose obligors on the upper fringes of credit spreads though with a given rating.
The CDO business is booming - structurers are adding inputs like interest rate swaps, equity default swaps, etc., in a bid to provide higher spreads to investors. Investors have looked at CDOs as not a part of a hard core investment pool but like a bit of venturesome portfolio allocated to provide a yield-kicker. In this environment of spread-peddling, it is likely that some one would like to play smarter than the investment bank next door, and this would lead to a race of outsmarting. The casualty may be that the rating agency models may be overexploited, which might eventually lead to a loss of credibility of the ratings information.
By Vinod Kothari
Full article found at: http://www.vinodkothari.com/cdoratingmodels.htm
The CDO business is reaching out to banks, investors and high net worth individuals all over the World. Investment banks and CDO structurers from London, Paris, New York, Singapore or Sydney would put together a CDO of roughly 100 obligors, achieve some kind of a model-driven diversification, achieve a convenient first loss piece of x% that is sufficiently rewarded by the inherent arbitrage earnings of the CDO, and lo, the CDO is in the market. If it is a single tranche transaction, as most CDOs today are, you don't need to wait until all the tranches are sold off, as just one tranche is enough to successfully sell the CDO in the market.
Inherently, all the CDOs are cast in a model - unlike the portfolio of a usual balance sheet transaction, CDO portfolios are completely synthetic. "Synthetic" is close to "unreal", that is, the portfolio is completely virtual. It is constructed not by actually originating credits, but simply by synthetically selling protection on the target names. Therefore, the idea of a synthetic CDO is that of calendar beauty - it is perfect in every respect. It is an idealized portfolio where everything is only as much as you would love to have. This idealized perfection is attained to fit into rating agency models that compute the expected losses of the CDOs, and therefore, in a not very discrete way, it is the rating agency models that have been instrumental in the spurt of CDOs in the market.
Briefly, the extent of credit enhancement at any tranche level of a CDO is such as to reduce the probability of the defaults exceeding the level of subordination to an equivalent of the probability of losses at that tranche level. For instance, if Moody's idealized probability of default for a Baa2 piece is 1.58%, there must be such credit enhancement (meaning subordination) at the BBB piece level that the probability of wiping out the same is reduced to 1.58%.
Each rating agency has its own model to work out this probability distribution.
Arguably, the most transparent of the rating methodologies has been the Moody's binomial expansion technique (BET). The binomial expansion method comes from probability distributions where there is a definite number of outcomes of an event. For example, if we are tossing a fair coin, there is 50% chance of getting a head, and 50% of getting a tail. If we toss it 50 times, what is the probability of getting n heads, say, 7 heads? This is given by the binomial distribution. One may mathematically compute the probability using a formula, or find it on Excel with function binomdist.
When we have n number of harmomised obligors in a pool, there is a probability, for every one of these obligors, that the obligor may be in a state of default or state of performance. Therefore, there are two possible outcomes per obligor, and the probability of default of each of the obligors is given by the estimated probability. That probability of default per obligor may itself be drawn from several sources - such as historical probabilities implied by the rating transition histories, or prevailing cash market spreads, or structural study of each obligor based on financial data, such as in Merton model.
If n number of obligors default, and there is a loss (1-recovery rate) per obligor of x amount, then the total amount of loss of the CDO is nx. As long as nx is not more than the subordination at the tranche level, there is no default as for the tranche. So, the magic of the model lies in computing the probability of nx exceeding the level of subordination.
The critical inputs that go into estimating the probability of the losses exceeding the level of subordination for the tranche are:
Probability of default of each obligor
The notional value each obligor - in synthetic transactions, the notional value per obligor is harmonized
The recovery rate, which is reciprocal of the loss per obligor
The inter-obligor correlation, that is, the degree to which losses of one obligor will be associated with losses in other obligors too.
Moody's single binomial methodThe simplest of approaches is the Moody's single binomial expansion. This is by far the most simple approach. It reconstructs the actual CDO portfolio into an idealized portfolio that completely zeroes out the correlation in the pool. This is done by computing the diversity score of the portfolio. The diversity score having been computed, it is as if there are as many obligors in the pool as indicated by the diversity score. For example, if in a portfolio of 100 obligors of $ 10 million each (notional of $ 1 billion), the diversity score is 45, we assume as if there are 45 obligors in the pool with a notional of $ 1000/45 million. All the obligors have no correlation, and have the same probability of default.
Now, we know from the binomial distribution the probability of n number of defaults out of 45, from which we may compute the probability that losses will exceed a particular level. The cumulative probability for say, 5 defaults out of 45 will indicate the probability that the losses will be limited to the loss of 5 obligors, and the tail risk is that the probability that the loss will exceed 5 obligors.
Moody's multiple binomial methodLater, Moody's came out with its multiple binomial method. Here, it is still the binomial method, but with the pool broken into several subsets with different probabilities of defaults for each sub set. This method marked an improvisation, as, instead of assuming the probabilities of default of each obligor in the harmonized pool to be the same, the multiple binomial method allows for different probabilities per subset.
The multiple binomial method reflected the tail risk inherent in the CDO as the higher probabilities of default inherent in lower-rated obligors were not being adequately considered in the single binomial method. The tail risk of the sub-sets was more than that of the whole.
Moody's correlated binomial methodRecently, the rating agency came out with a correlated binomial methodology. A special report of August 10, 2004 (Moody's Correlated Binomial Default Distribution) explains the method. Unlike the earlier assumption where, the diversity score having been computed, the correlation in the pool was taken to be zero, this model allows for a correlation to be present even after computation of the diversity score. The new method is obviously triggered by one of the most dreaded problems in CDOs - fat tails. "Fat tail" implies a more than nominal probability of losses at the far end of the distribution - that is, high degree of probability of several defaults in the pool.
The diversity score itself has been adjusted after taking into account the correlation, that is to say, the correlated diversity is higher than the independent diversity score.
S&P's CDO Evaluator approachStandard and Poor's CDO Evaluator is based on a Monte Carlo simulation approach. As for the user, most of the underlying computations take place inside the "gray box". The required inputs the issuer's ID, par amount, industry classification, and S&P rating for the issuer. Internally, S& P assumes correlations - 30% intra industry.
Fitch VECTOR model:Fitch, on the other hand, uses a different sector-by-sector correlation on its Vector model. Fitch model is also based internally on Monte Carlo simulation. The default rates come from a new CDO Default Matrix (giving asset default rates by rating and maturity), which is based on historical bond default rates and can be modified to take account of "softer" default definitions when used for rating synthetic CDOs. Pairwise asset correlations, similar to what's done by Moody's, are based on estimates of cross- and intra-industry, and geographical correlations of equity returns. As a result, Fitch will assign an internal and external correlation for each of the 25 industry sectors used. In the past, Fitch did not explicitly model correlations, but applied penalties for high obligor, industry and country concentrations in CDO collateral pools.
The model riskIntuitively, it would not be difficult to understand that correlation is the key million-dollar input in estimating the expected loss probability at any tranche level. As we move up the correlation assumption, the loss distribution curve shifts its peak to the left, and the tail at the right hand becomes fatter and fatter. In case of CDOs, it is the tail that moves the dog - therefore, the real risk is the risk of fat tails.
Inherently, there are several risks still not being captured by the rating agency models. First, the probability of defaults of obligors are being mapped along the historical probabilities of given ratings. There is a huge difference between the historical probabilities of default, and those implied by the cash market spreads, and this difference becomes more acute for lower rated obligors. The intuitive argument for this widening difference is that the market tends to exaggerate the risks of default of lower rated obligors. While computing probabilities of default, the rating agencies are still influenced by the historical ratings.
Besides this, the credit spreads in the market for obligors of the same rating may be widely different. Motivated by arbitrage considerations, a CDO structurer may choose obligors on the upper fringes of credit spreads though with a given rating.
The CDO business is booming - structurers are adding inputs like interest rate swaps, equity default swaps, etc., in a bid to provide higher spreads to investors. Investors have looked at CDOs as not a part of a hard core investment pool but like a bit of venturesome portfolio allocated to provide a yield-kicker. In this environment of spread-peddling, it is likely that some one would like to play smarter than the investment bank next door, and this would lead to a race of outsmarting. The casualty may be that the rating agency models may be overexploited, which might eventually lead to a loss of credibility of the ratings information.
CDO/CLO sales slowing down, LBOs becoming more difficult?
KKR, Homeowners Face Funding Drain as CDO Sales Slow (Update2)
By Neil Unmack and Kabir Chibber
July 24 (Bloomberg) -- The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.
Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said.
Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.
``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.''
Investors are demanding yields 15 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 5.5 percentage points in February, according to data compiled by JPMorgan.
Deals Pulled
The shakeout is leading firms from Maxim Capital Management in New York to Paris-based Axa Investment Managers to delay or scrap planned CDO sales.
Maxim began buying mortgage bonds for a new CDO after completing its second deal in March. Chief Investment Officer Doug Jones in New York said he slowed the purchases, having acquired only a third of the assets planned, partly because the bank underwriting the deal grew concerned it could lose money as volatility increased. He declined to name the underwriter.
``We don't want to get too far along and create something that's not sellable,'' said Jones, who manages $4 billion of CDOs.
Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.
New Warehouses
``There are just very few, if any, bankers opening new warehouses,'' said Finkel.
Axa, which manages 4.7 billion euros ($6.5 billion) of high- yield loans, abandoned plans to sell a collateralized loan obligation, a type of CDO that's mostly backed by corporate loans. High-yield, or junk, securities are rated below Baa3 by Moody's Investors Service and BBB- at S&P.
``CLOs are not that appropriate an instrument to offer investors given the current credit cycle,'' said Nathalie Savey, Axa's head of leveraged finance in Paris. ``There is so much uncertainty regarding spreads.''
The slowdown comes as private equity firms such as Kravis' Kohlberg Kravis Roberts & Co. and Blackstone Group LP, both based in New York, need to borrow at least $300 billion in coming months to finance acquisitions, according to Baring Asset Management in London.
Buyout groups rely on CDOs for 60 percent of the loans to finance U.S. acquisitions, according to JPMorgan.
More Bailouts?
``CLOs have been instrumental in funding the surge in LBOs and pushing down loan spreads,'' said Gunnar Stangl, the Frankfurt-based head of index and bond strategy at Dresdner Kleinwort, a unit of Allianz SE, Europe's biggest insurer. ``They provide constant institutional demand for leveraged loans.''
CDOs also financed growth in lending to home owners with poor credit or high debt, known as subprime mortgages. About $50 billion of home loan debt rated BBB and BBB- went into CDOs in 2006, almost the same as the total sales of mortgage backed securities with identical ratings, Citigroup Inc. analysts estimated in a report in April.
``For the last 18 months the majority of subprime ABS was bought by another securitization vehicle that issued further bonds,'' the Citigroup analysts said.
The five biggest managers of U.S. CDOs include New York-based Bear Stearns and Zurich-based Credit Suisse Group, according to S&P. Their annual fees range between 0.04 percentage points to 0.75 percentage points of the amount of underlying collateral, depending on the type of the CDO and its performance.
Merrill Leads
New York-based Merrill Lynch & Co., the world's third-largest investment bank by market value, is the biggest underwriter of CDOs, selling $55 billion last year, said a report this month by Charlotte, North Carolina-based Bank of America Corp., which cited Dealogic Holdings Plc data.
Citigroup of New York is the biggest underwriter of CLOs, managing $16.6 billion of sales, and the second-largest bank underwriter of CDOs. Bank of America Securities LLC, Wachovia Corp. of Charlotte and Goldman Sachs Group Inc. in New York are the next-biggest CDO underwriters.
On top of management fees, banks underwriting CDO sales charge underwriting fees as high as 1.75 percent, compared with an average of 0.4 percent for selling regular investment-grade bonds, according to data compiled by Bloomberg. Banks collected $8.6 billion underwriting CDOs last year, according to a report last month by JPMorgan analyst Kian Abouhossein in London. They took in another $3.8 billion from related trading, investing and other activities, the report said.
Drexel Creation
Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Sales of the securities surged to $503 billion last year from $84 billion five years ago, according to Morgan Stanley. Sales reached $251 billion in the first quarter, the Bank for International Settlements in Basel said last month.
CDOs pool assets ranging from investment-grade asset-backed debt to high-yield loans, and repackage them into bonds. The securities are split into portions with ratings as high as AAA to no ratings, known as the equity portion.
Any losses on the underlying collateral are first assigned to the equity portion of a CDO. These are mainly bought by hedge funds, banks, pension funds and managers of the CDOs, according to a JPMorgan report last week. In return for the higher risk, buyers received annual returns as high as 98 percent, according to a report this month by Morgan Stanley, citing Moody's data. The median return for CLOs was 8.55 percent, based on securities that have been liquidated, Morgan Stanley said.
Steering Clear
At the opposite end, insurers, banks and other CDOs tend to buy the less risky portions with AAA credit ratings that pay 23 basis points to 150 basis points more than benchmark interbank lending rates, according to Morgan Stanley. Governments selling AAA bonds typically pay interest at the interbank rate or less.
Buyers of the least risky portion of a CDO underwritten by Credit Suisse this month were offered annual interest 22 basis points above benchmark rates. The CDO, called Avoca CLO VIII Ltd., managed by Avoca Capital in Dublin, pooled 508 million euros of high-yield loans. About 69 percent of the deal was rated AAA. A basis point is 0.01 percentage point.
Investors are steering clear of new CDOs following the Bear Stearns debacle. Ralph Cioffi, the 22-year Bear Stearns veteran who managed the two money-losing hedge funds, tried to minimize risk by buying the top-rated portions of CDOs.
`Unprecedented Declines'
The funds were wiped out by ``unprecedented declines'' in the value of AA and AAA rated securities, Bear Stearns wrote to clients last week. The losses triggered a selloff across credit markets because of concerns that a fire sale of CDOs would mean losses for holders of even the least risky debt and that fewer sales of new CDOs would reduce demand for bonds and loans.
``If the experts are getting it wrong that says something,'' said Kevin Lyne-Smith, who helps oversee $100 billion as managing director at Julius Baer Holding AG's private banking division in Zurich.
Even with the widening in CDO spreads, the funding cost remains at around the average over the past five years for deals backed by leveraged loans. Defaults by speculative-grade companies slid to a 25-year low of 1.12 percent worldwide in June, Standard & Poor's said.
Weathering Disruptions
CDOs were booming until the Bear Stearns funds collapsed. New funded deals are up 31 percent this year to $315 billion, according to JPMorgan.
Sales of U.S. funded CDOs, which include only CDOs sold to investors as bonds, were $6.1 billion in the U.S. this month, down from $36.7 billion for all of June, according to JPMorgan.
Deals are still being completed. London-based Elgin Capital, a fund manager co-founded by Michael Clancy, who formerly helped run Merrill Lynch's credit trading operation, sold 400 million euros of CLOs in July. BNP Paribas SA, based in Paris, underwrote the sale, offering yields for the BB-rated portion at 425 basis points over interbank rates, less than the spread of 480 basis points on similarly rated securities it sold in May 2006.
The CDO market has weathered disruptions in the past. In 2002, bond defaults by telecommunications companies including WorldCom Inc., now Ashburn, Virginia-based MCI Inc., caused junk- bond CDO sales to drop by 19 percent from the previous year as rating companies downgraded the securities. In 2003, CDO sales increased 18 percent to $99 billion, according to Morgan Stanley data.
Better Terms
M&G Plc, the fund-management arm of London-based insurer Prudential Plc, is considering a new CLO fund when the market stabilizes.
``We don't know when it will come back, but it should,'' said Dagmar Kent Kershaw, who helps manage 6.5 billion euros of CDOs at M&G. ``We believe now is a good time to get into the market, as some of these assets are cheaper than they have been for a while and offer excess value to the savvy investor.''
Frankfurt-based Deutsche Bank AG is leading banks attempting to sell 9 billion pounds ($18.5 billion) of loans to finance KKR's 11.1 billion-pound takeover of U.K. pharmacy chain Alliance Boots Plc with billionaire Stefano Pessina. KKR partner Dominic Murphy in London declined to comment.
``Before, you could structure an aggressive loan, and knew that a CLO would buy it,'' says Miguel Ramos Fuentenebro, managing partner at Washington Square Investment Management in London. ``Now you can't be so sure.''
Cerberus Capital Management LP, based in New York, increased the interest margins on $12 billion of loans to finance its buyout of Chrysler in Auburn Hills, Michigan, to 300 basis points over Libor for five years on the biggest portion of the debt, up from the 275 basis points it initially proposed.
``It's dangerous to call the end of a market, but there are concerns,'' said Jeroen Van den Broek, credit strategist at ING Groep NV in Amsterdam. ``Private equity firms are going to have to pay up. The cost of debt is significantly higher than it was two years ago.''
By Neil Unmack and Kabir Chibber
July 24 (Bloomberg) -- The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.
Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said.
Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.
``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.''
Investors are demanding yields 15 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 5.5 percentage points in February, according to data compiled by JPMorgan.
Deals Pulled
The shakeout is leading firms from Maxim Capital Management in New York to Paris-based Axa Investment Managers to delay or scrap planned CDO sales.
Maxim began buying mortgage bonds for a new CDO after completing its second deal in March. Chief Investment Officer Doug Jones in New York said he slowed the purchases, having acquired only a third of the assets planned, partly because the bank underwriting the deal grew concerned it could lose money as volatility increased. He declined to name the underwriter.
``We don't want to get too far along and create something that's not sellable,'' said Jones, who manages $4 billion of CDOs.
Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.
New Warehouses
``There are just very few, if any, bankers opening new warehouses,'' said Finkel.
Axa, which manages 4.7 billion euros ($6.5 billion) of high- yield loans, abandoned plans to sell a collateralized loan obligation, a type of CDO that's mostly backed by corporate loans. High-yield, or junk, securities are rated below Baa3 by Moody's Investors Service and BBB- at S&P.
``CLOs are not that appropriate an instrument to offer investors given the current credit cycle,'' said Nathalie Savey, Axa's head of leveraged finance in Paris. ``There is so much uncertainty regarding spreads.''
The slowdown comes as private equity firms such as Kravis' Kohlberg Kravis Roberts & Co. and Blackstone Group LP, both based in New York, need to borrow at least $300 billion in coming months to finance acquisitions, according to Baring Asset Management in London.
Buyout groups rely on CDOs for 60 percent of the loans to finance U.S. acquisitions, according to JPMorgan.
More Bailouts?
``CLOs have been instrumental in funding the surge in LBOs and pushing down loan spreads,'' said Gunnar Stangl, the Frankfurt-based head of index and bond strategy at Dresdner Kleinwort, a unit of Allianz SE, Europe's biggest insurer. ``They provide constant institutional demand for leveraged loans.''
CDOs also financed growth in lending to home owners with poor credit or high debt, known as subprime mortgages. About $50 billion of home loan debt rated BBB and BBB- went into CDOs in 2006, almost the same as the total sales of mortgage backed securities with identical ratings, Citigroup Inc. analysts estimated in a report in April.
``For the last 18 months the majority of subprime ABS was bought by another securitization vehicle that issued further bonds,'' the Citigroup analysts said.
The five biggest managers of U.S. CDOs include New York-based Bear Stearns and Zurich-based Credit Suisse Group, according to S&P. Their annual fees range between 0.04 percentage points to 0.75 percentage points of the amount of underlying collateral, depending on the type of the CDO and its performance.
Merrill Leads
New York-based Merrill Lynch & Co., the world's third-largest investment bank by market value, is the biggest underwriter of CDOs, selling $55 billion last year, said a report this month by Charlotte, North Carolina-based Bank of America Corp., which cited Dealogic Holdings Plc data.
Citigroup of New York is the biggest underwriter of CLOs, managing $16.6 billion of sales, and the second-largest bank underwriter of CDOs. Bank of America Securities LLC, Wachovia Corp. of Charlotte and Goldman Sachs Group Inc. in New York are the next-biggest CDO underwriters.
On top of management fees, banks underwriting CDO sales charge underwriting fees as high as 1.75 percent, compared with an average of 0.4 percent for selling regular investment-grade bonds, according to data compiled by Bloomberg. Banks collected $8.6 billion underwriting CDOs last year, according to a report last month by JPMorgan analyst Kian Abouhossein in London. They took in another $3.8 billion from related trading, investing and other activities, the report said.
Drexel Creation
Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Sales of the securities surged to $503 billion last year from $84 billion five years ago, according to Morgan Stanley. Sales reached $251 billion in the first quarter, the Bank for International Settlements in Basel said last month.
CDOs pool assets ranging from investment-grade asset-backed debt to high-yield loans, and repackage them into bonds. The securities are split into portions with ratings as high as AAA to no ratings, known as the equity portion.
Any losses on the underlying collateral are first assigned to the equity portion of a CDO. These are mainly bought by hedge funds, banks, pension funds and managers of the CDOs, according to a JPMorgan report last week. In return for the higher risk, buyers received annual returns as high as 98 percent, according to a report this month by Morgan Stanley, citing Moody's data. The median return for CLOs was 8.55 percent, based on securities that have been liquidated, Morgan Stanley said.
Steering Clear
At the opposite end, insurers, banks and other CDOs tend to buy the less risky portions with AAA credit ratings that pay 23 basis points to 150 basis points more than benchmark interbank lending rates, according to Morgan Stanley. Governments selling AAA bonds typically pay interest at the interbank rate or less.
Buyers of the least risky portion of a CDO underwritten by Credit Suisse this month were offered annual interest 22 basis points above benchmark rates. The CDO, called Avoca CLO VIII Ltd., managed by Avoca Capital in Dublin, pooled 508 million euros of high-yield loans. About 69 percent of the deal was rated AAA. A basis point is 0.01 percentage point.
Investors are steering clear of new CDOs following the Bear Stearns debacle. Ralph Cioffi, the 22-year Bear Stearns veteran who managed the two money-losing hedge funds, tried to minimize risk by buying the top-rated portions of CDOs.
`Unprecedented Declines'
The funds were wiped out by ``unprecedented declines'' in the value of AA and AAA rated securities, Bear Stearns wrote to clients last week. The losses triggered a selloff across credit markets because of concerns that a fire sale of CDOs would mean losses for holders of even the least risky debt and that fewer sales of new CDOs would reduce demand for bonds and loans.
``If the experts are getting it wrong that says something,'' said Kevin Lyne-Smith, who helps oversee $100 billion as managing director at Julius Baer Holding AG's private banking division in Zurich.
Even with the widening in CDO spreads, the funding cost remains at around the average over the past five years for deals backed by leveraged loans. Defaults by speculative-grade companies slid to a 25-year low of 1.12 percent worldwide in June, Standard & Poor's said.
Weathering Disruptions
CDOs were booming until the Bear Stearns funds collapsed. New funded deals are up 31 percent this year to $315 billion, according to JPMorgan.
Sales of U.S. funded CDOs, which include only CDOs sold to investors as bonds, were $6.1 billion in the U.S. this month, down from $36.7 billion for all of June, according to JPMorgan.
Deals are still being completed. London-based Elgin Capital, a fund manager co-founded by Michael Clancy, who formerly helped run Merrill Lynch's credit trading operation, sold 400 million euros of CLOs in July. BNP Paribas SA, based in Paris, underwrote the sale, offering yields for the BB-rated portion at 425 basis points over interbank rates, less than the spread of 480 basis points on similarly rated securities it sold in May 2006.
The CDO market has weathered disruptions in the past. In 2002, bond defaults by telecommunications companies including WorldCom Inc., now Ashburn, Virginia-based MCI Inc., caused junk- bond CDO sales to drop by 19 percent from the previous year as rating companies downgraded the securities. In 2003, CDO sales increased 18 percent to $99 billion, according to Morgan Stanley data.
Better Terms
M&G Plc, the fund-management arm of London-based insurer Prudential Plc, is considering a new CLO fund when the market stabilizes.
``We don't know when it will come back, but it should,'' said Dagmar Kent Kershaw, who helps manage 6.5 billion euros of CDOs at M&G. ``We believe now is a good time to get into the market, as some of these assets are cheaper than they have been for a while and offer excess value to the savvy investor.''
Frankfurt-based Deutsche Bank AG is leading banks attempting to sell 9 billion pounds ($18.5 billion) of loans to finance KKR's 11.1 billion-pound takeover of U.K. pharmacy chain Alliance Boots Plc with billionaire Stefano Pessina. KKR partner Dominic Murphy in London declined to comment.
``Before, you could structure an aggressive loan, and knew that a CLO would buy it,'' says Miguel Ramos Fuentenebro, managing partner at Washington Square Investment Management in London. ``Now you can't be so sure.''
Cerberus Capital Management LP, based in New York, increased the interest margins on $12 billion of loans to finance its buyout of Chrysler in Auburn Hills, Michigan, to 300 basis points over Libor for five years on the biggest portion of the debt, up from the 275 basis points it initially proposed.
``It's dangerous to call the end of a market, but there are concerns,'' said Jeroen Van den Broek, credit strategist at ING Groep NV in Amsterdam. ``Private equity firms are going to have to pay up. The cost of debt is significantly higher than it was two years ago.''
Monday, July 23, 2007
Bidders emerge for Singapore IPPs
Marubeni, Keppel, Sembcorp to Bid on Temasek Units, Bankers Say
By Denise Kee
July 23 (Bloomberg) -- Marubeni Corp., Keppel Corp. and Sembcorp Industries Ltd. plan to bid for the electric utilities being sold by Temasek Holdings Pte, Singapore's government-owned investment company, three bankers with knowledge of the deal said.
Singapore-based Keppel and Sembcorp, the world's biggest oil-rig builders, this month contacted lenders to provide financing and advice, said the bankers, who declined to be identified because the talks are private. The units, Power Senoko Ltd., Power Seraya Ltd. and Tuas Power Ltd., may be valued about S$2.5 billion ($1.7 billion) each and sold in stages over the next two years, they said.
Temasek, which said June 19 it is selling the businesses, wants to tap rising demand for power assets as economic expansion boosts energy use. The utilities account for 90 percent of Singapore's generation capacity and may attract investors in the Asia-Pacific region, where $53.5 billion of acquisitions involving energy companies have been announced this year.
Temasek ``will benefit from bullish investor sentiment in infrastructure assets,'' said Leslie Phang, who oversees $1 billion at Commonwealth Private Bank in Singapore. ``Buyers would snap it up in a jiff because historical profit growth of the three power companies supports the valuation.''
Seraya's net income rose 11 percent to S$130 million in 2006, according to the company's annual report. Senoko's profit gained about 12 percent to S$133.3 million, while Tuas Power had net income of S$104 million as sales surged 27 percent to S$1.7 billion, annual reports show.
`Natural Fit'
``As a key player in Singapore's energy market, greater involvement in the local generation companies would seem a natural fit with our core business,'' Sembcorp said in an e- mailed response to questions. ``The decision to sell the generation companies has just been announced, and we are evaluating our options.''
Keppel and Sembcorp are seeking commitments from lenders to lock them in exclusive relationships because competition for funding will intensify as the sale progresses, the bankers said.
``We are keen to evaluate the opportunities that Temasek's divestment of power plants present,'' Ong Tiong Guan, managing director of Keppel's infrastructure arm, Keppel Energy Pte, said in an e-mail. ``If it makes commercial sense, we will participate in them.''
Marubeni spokesman Daigo Noguchi declined to comment on whether it will bid.
CLP-Mitsubishi Venture
OneEnergy Ltd., a joint venture between CLP holdings Ltd. and Mitsubishi Corp., plans to request proposals this week to appoint a financial adviser, the three bankers said.
CLP Holdings ``has previously indicated that Singapore is a market CLP is interested in,'' said Carl Kitchen, public affairs manager at the company, which owns half of OneEnergy. ``But regarding the specific assets, it's too early to comment on whether CLP is bidding.''
Temasek plans to release relevant information to potential bidders and the sale process could start in September, said Wong Kim Yin, managing director for investments at the company. Temasek said in its June 19 statement that the sale will be completed by end-2008 or early 2009. Morgan Stanley and Credit Suisse Group are advising Temasek on the sale.
Singapore generates 80 percent of its electricity from natural gas imported from Malaysia and Indonesia. Blackouts in the city-state in November 2003 and June 2004 were caused by disruptions in gas supply from Indonesia, according to Energy Market Authority, the government regulator.
Gas Supply
``The biggest risk is, however, the potential supply disruption of gas from Indonesia and Malaysia,'' Commonwealth Private Bank's Phang said, and ``rising commodity costs may put a dent on profitability.''
Singapore plans to invest S$1 billion in a liquefied natural gas terminal by 2012 to meet one-third of the country's gas demand. The facility will provide an alternative supply source.
Seraya and Tuas were set up in 1995, and have generation capacity of 3,100 megawatts and 2,670 megawatts, respectively. Senoko has a capacity of 3,300 megawatts, according to Temasek's June 19 statement.
Temasek was incorporated in 1974 and manages S$129 billion of assets in various industries including telecommunications, financial services and real estates.
By Denise Kee
July 23 (Bloomberg) -- Marubeni Corp., Keppel Corp. and Sembcorp Industries Ltd. plan to bid for the electric utilities being sold by Temasek Holdings Pte, Singapore's government-owned investment company, three bankers with knowledge of the deal said.
Singapore-based Keppel and Sembcorp, the world's biggest oil-rig builders, this month contacted lenders to provide financing and advice, said the bankers, who declined to be identified because the talks are private. The units, Power Senoko Ltd., Power Seraya Ltd. and Tuas Power Ltd., may be valued about S$2.5 billion ($1.7 billion) each and sold in stages over the next two years, they said.
Temasek, which said June 19 it is selling the businesses, wants to tap rising demand for power assets as economic expansion boosts energy use. The utilities account for 90 percent of Singapore's generation capacity and may attract investors in the Asia-Pacific region, where $53.5 billion of acquisitions involving energy companies have been announced this year.
Temasek ``will benefit from bullish investor sentiment in infrastructure assets,'' said Leslie Phang, who oversees $1 billion at Commonwealth Private Bank in Singapore. ``Buyers would snap it up in a jiff because historical profit growth of the three power companies supports the valuation.''
Seraya's net income rose 11 percent to S$130 million in 2006, according to the company's annual report. Senoko's profit gained about 12 percent to S$133.3 million, while Tuas Power had net income of S$104 million as sales surged 27 percent to S$1.7 billion, annual reports show.
`Natural Fit'
``As a key player in Singapore's energy market, greater involvement in the local generation companies would seem a natural fit with our core business,'' Sembcorp said in an e- mailed response to questions. ``The decision to sell the generation companies has just been announced, and we are evaluating our options.''
Keppel and Sembcorp are seeking commitments from lenders to lock them in exclusive relationships because competition for funding will intensify as the sale progresses, the bankers said.
``We are keen to evaluate the opportunities that Temasek's divestment of power plants present,'' Ong Tiong Guan, managing director of Keppel's infrastructure arm, Keppel Energy Pte, said in an e-mail. ``If it makes commercial sense, we will participate in them.''
Marubeni spokesman Daigo Noguchi declined to comment on whether it will bid.
CLP-Mitsubishi Venture
OneEnergy Ltd., a joint venture between CLP holdings Ltd. and Mitsubishi Corp., plans to request proposals this week to appoint a financial adviser, the three bankers said.
CLP Holdings ``has previously indicated that Singapore is a market CLP is interested in,'' said Carl Kitchen, public affairs manager at the company, which owns half of OneEnergy. ``But regarding the specific assets, it's too early to comment on whether CLP is bidding.''
Temasek plans to release relevant information to potential bidders and the sale process could start in September, said Wong Kim Yin, managing director for investments at the company. Temasek said in its June 19 statement that the sale will be completed by end-2008 or early 2009. Morgan Stanley and Credit Suisse Group are advising Temasek on the sale.
Singapore generates 80 percent of its electricity from natural gas imported from Malaysia and Indonesia. Blackouts in the city-state in November 2003 and June 2004 were caused by disruptions in gas supply from Indonesia, according to Energy Market Authority, the government regulator.
Gas Supply
``The biggest risk is, however, the potential supply disruption of gas from Indonesia and Malaysia,'' Commonwealth Private Bank's Phang said, and ``rising commodity costs may put a dent on profitability.''
Singapore plans to invest S$1 billion in a liquefied natural gas terminal by 2012 to meet one-third of the country's gas demand. The facility will provide an alternative supply source.
Seraya and Tuas were set up in 1995, and have generation capacity of 3,100 megawatts and 2,670 megawatts, respectively. Senoko has a capacity of 3,300 megawatts, according to Temasek's June 19 statement.
Temasek was incorporated in 1974 and manages S$129 billion of assets in various industries including telecommunications, financial services and real estates.
Friday, July 20, 2007
JPMorgan's Jamie Dimon on leveraged buyout loans, and equity bridge loans
"I'm not going to give you specific numbers...because I don't think we disclosed those nor have I seen anyone disclose them. There are loans, and there are bridges, and I want to separate that. The loans are much more secured and senior, et cetera than the bridges...We're involved in a couple, and that's life. That's the world we live in, and we think the loans themselves are good, so we obviously are going to pay a lot of attention to it. If you look at the business, we have our share of ongoing loans, and on the other hand do think there is some deals I have seen out there which are not good. I am not going to mention the names, but we aren't involved in the ones we...think are not good.
Everything you underwrite you do thinking you may own it one day, and so if a lot of the stuff we have out there ends up on our balance sheet, we're still okay. We won't like it, but we'll be okay. We may have to put up some reserves against it, and I should also point out and I will not go into equity bridges other than to say like our private equity positions on our balance sheet, not in the investment bank are $6 billion. That's now under 10% of our equity, so it is really conservative, and the bridge equity stuff would change that number but not dramatically in terms of the company's balance sheet, we're not particularly worried about it. I think equity bridges are a terrible idea. I think they're a bad -- I think they're a bad financial policy. I don't think they're good for the banks. I don't think they're good for the private equity guys, so I hope they go the way of the dinosaur because they're basically a one-sided put on our balance sheet. I also think the street is topped up on them. There is only so much you can do and feel comfortable with. It is kind of silly to take that downside risk and have none of the upside potential."
Everything you underwrite you do thinking you may own it one day, and so if a lot of the stuff we have out there ends up on our balance sheet, we're still okay. We won't like it, but we'll be okay. We may have to put up some reserves against it, and I should also point out and I will not go into equity bridges other than to say like our private equity positions on our balance sheet, not in the investment bank are $6 billion. That's now under 10% of our equity, so it is really conservative, and the bridge equity stuff would change that number but not dramatically in terms of the company's balance sheet, we're not particularly worried about it. I think equity bridges are a terrible idea. I think they're a bad -- I think they're a bad financial policy. I don't think they're good for the banks. I don't think they're good for the private equity guys, so I hope they go the way of the dinosaur because they're basically a one-sided put on our balance sheet. I also think the street is topped up on them. There is only so much you can do and feel comfortable with. It is kind of silly to take that downside risk and have none of the upside potential."
Guilt by association? Rise in interest rates and credit delinquencies
Basis Capital Suffered Subprime Losses in February (Update1)
By Laura Cochrane
July 19 (Bloomberg) -- Basis Capital Fund Management Ltd., an Australian hedge fund caught up in the rout in U.S. subprime mortgages, suffered losses as early as February.
In a letter sent to investors July 6, Basis Capital said its investments in collateralized debt obligations, or CDOs, had been tarnished by ``guilt by association.'' Less than a week later, the Sydney-based hedge fund, which had assets of $1 billion in May, said its two funds lost 9 percent and 14 percent last month. Withdrawals from the funds have been frozen and some margin calls have been missed, research firm Zenith Investment Partners Ltd. said in an e-mailed note today.
Basis Capital is the first Australian hedge fund to report losses from the shakeout in the U.S. subprime market. Most of the pain may be borne by individuals, who are allowed to invest in Australian hedge funds, unlike in the U.S. where the largely unregulated pools of capital are off limits to retail investors.
``There will be a flow on in the marketplace surrounding the problems experienced by Basis and its investors, but it's too early to say exactly how that will pan out,'' said Bill Entwistle, chief investment officer at Absolute Capital in Sydney, who invests in the rated portions of CDOs.
Most of investors would have been attracted by Basis Capital's high ratings and returns, he said.
The Aust-Rim Opportunity Fund returned almost 12 percent on average the past five years and the Yield Alpha Fund averaged a 15.5 percent return, according to reports by Zenith Investment Partners available on Basis Capital's Web site earlier today.
Both funds had five-star ratings from Standard & Poor's. The ratings were suspended yesterday.
June Losses
The Yield Fund lost 14 percent in June, and the its Aust-Rim Opportunity Fund declined 9 percent, Basis Capital said July 12.
Some of Basis Capital's lenders are seeking to sell the fund's assets, Zenith said, citing a disclosure notice from the hedge fund. A sale at ``distressed'' prices could cut the net asset value of units in the Yield Fund to below 50 percent of the level as at May 31, the notice said.
``This latest information is obviously very concerning,'' Melbourne-based Zenith, which rates investment funds, said today. ``This could lead to significant losses to investors in the Yield Fund, which in turn will also adversely affect the Aust-Rim Fund.''
Delinquencies on U.S. subprime mortgages -- home loans to people with poor or meager credit -- surged to a 10-year high this year on rising borrowing costs. CDOs based on these loans have plunged in value and caused loses at hedge funds worldwide. Sales of CDOs rose fivefold to $503 billion last year compared with 2003.
`Fund of the Year'
Bear Stearns Cos., the fifth-largest U.S. securities firm, yesterday told investors in its two failed hedge funds they'll get little if any money back after ``unprecedented declines'' in the value of securities used to bet on subprime mortgages.
Basis Capital, founded by Steve Howell and Stuart Fowler in 1999, invests in the most risky portion of CDOs, the so-called equity tranche, which is first in line for any losses as borrowers fall short on mortgage payments. Investors in the equity portion aim to generate returns of more than 10 percent.
Howell, a former director of Asia-Pacific trading at American Express Bank in Singapore, and Fowler, a former Salomon Smith Barney trader, worked together at County NatWest. Basis Capital was named `Fund of the Year' at the 2005 AsiaHedge awards and Macquarie Bank Ltd.'s Skilled Manager of the Year in 2004.
Basis Capital is in talks with creditors after banks seized and began to sell off its investments, the Financial Times reported today.
Calls to Basis Capital's office today were referred to the marketing department, which didn't immediately return messages.
Hedge Fund Regulation
In Australia, all hedge funds have to be licensed by the Australian Securities and Investments Commission, allowing them to sell to retail investors. Australian investors, mostly individuals, have A$675 million invested in the two funds, the Financial Review said today.
To sell to retail investors in the U.S., a hedge fund would have to register with the Securities and Exchange Commission, a move most shun to avoid scrutiny.
A spokeswoman for the Australian securities regulator declined to say whether it was investigating Basis Capital.
By Laura Cochrane
July 19 (Bloomberg) -- Basis Capital Fund Management Ltd., an Australian hedge fund caught up in the rout in U.S. subprime mortgages, suffered losses as early as February.
In a letter sent to investors July 6, Basis Capital said its investments in collateralized debt obligations, or CDOs, had been tarnished by ``guilt by association.'' Less than a week later, the Sydney-based hedge fund, which had assets of $1 billion in May, said its two funds lost 9 percent and 14 percent last month. Withdrawals from the funds have been frozen and some margin calls have been missed, research firm Zenith Investment Partners Ltd. said in an e-mailed note today.
Basis Capital is the first Australian hedge fund to report losses from the shakeout in the U.S. subprime market. Most of the pain may be borne by individuals, who are allowed to invest in Australian hedge funds, unlike in the U.S. where the largely unregulated pools of capital are off limits to retail investors.
``There will be a flow on in the marketplace surrounding the problems experienced by Basis and its investors, but it's too early to say exactly how that will pan out,'' said Bill Entwistle, chief investment officer at Absolute Capital in Sydney, who invests in the rated portions of CDOs.
Most of investors would have been attracted by Basis Capital's high ratings and returns, he said.
The Aust-Rim Opportunity Fund returned almost 12 percent on average the past five years and the Yield Alpha Fund averaged a 15.5 percent return, according to reports by Zenith Investment Partners available on Basis Capital's Web site earlier today.
Both funds had five-star ratings from Standard & Poor's. The ratings were suspended yesterday.
June Losses
The Yield Fund lost 14 percent in June, and the its Aust-Rim Opportunity Fund declined 9 percent, Basis Capital said July 12.
Some of Basis Capital's lenders are seeking to sell the fund's assets, Zenith said, citing a disclosure notice from the hedge fund. A sale at ``distressed'' prices could cut the net asset value of units in the Yield Fund to below 50 percent of the level as at May 31, the notice said.
``This latest information is obviously very concerning,'' Melbourne-based Zenith, which rates investment funds, said today. ``This could lead to significant losses to investors in the Yield Fund, which in turn will also adversely affect the Aust-Rim Fund.''
Delinquencies on U.S. subprime mortgages -- home loans to people with poor or meager credit -- surged to a 10-year high this year on rising borrowing costs. CDOs based on these loans have plunged in value and caused loses at hedge funds worldwide. Sales of CDOs rose fivefold to $503 billion last year compared with 2003.
`Fund of the Year'
Bear Stearns Cos., the fifth-largest U.S. securities firm, yesterday told investors in its two failed hedge funds they'll get little if any money back after ``unprecedented declines'' in the value of securities used to bet on subprime mortgages.
Basis Capital, founded by Steve Howell and Stuart Fowler in 1999, invests in the most risky portion of CDOs, the so-called equity tranche, which is first in line for any losses as borrowers fall short on mortgage payments. Investors in the equity portion aim to generate returns of more than 10 percent.
Howell, a former director of Asia-Pacific trading at American Express Bank in Singapore, and Fowler, a former Salomon Smith Barney trader, worked together at County NatWest. Basis Capital was named `Fund of the Year' at the 2005 AsiaHedge awards and Macquarie Bank Ltd.'s Skilled Manager of the Year in 2004.
Basis Capital is in talks with creditors after banks seized and began to sell off its investments, the Financial Times reported today.
Calls to Basis Capital's office today were referred to the marketing department, which didn't immediately return messages.
Hedge Fund Regulation
In Australia, all hedge funds have to be licensed by the Australian Securities and Investments Commission, allowing them to sell to retail investors. Australian investors, mostly individuals, have A$675 million invested in the two funds, the Financial Review said today.
To sell to retail investors in the U.S., a hedge fund would have to register with the Securities and Exchange Commission, a move most shun to avoid scrutiny.
A spokeswoman for the Australian securities regulator declined to say whether it was investigating Basis Capital.
Tuesday, July 17, 2007
Another bearish article on the credit cycle
Goldman, JPMorgan Stuck With Debt They Can't Sell to Investors
By Caroline Salas and Miles Weiss
July 17 (Bloomberg) -- Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.
The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.
Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100 billion LBO, are now paying for their overconfidence. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record $8.4 billion in fees during the first half of 2007, according to Brad Hintz, the former chief financial officer at New York-based Lehman Brothers Holdings Inc.
``The private equity firms, being very tough negotiators, are unlikely to let the banks off the hook,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. ``They'll say that's your problem and that's why we're paying you: To take risk.''
As the market began to turn sour last month, Goldman Sachs, Citigroup Inc., Lehman and Wachovia Corp. had to buy $725 million of bonds that Goodlettsville, Tennessee-based Dollar General Corp. was selling to finance Kohlberg Kravis Roberts & Co. purchase of the company for $6.9 billion. All of the securities firms are based in New York, except Wachovia, which is located in Charlotte, North Carolina.
Bonds Tumble
Those bonds are probably worth 94 cents on the dollar, or $43.5 million less than when they were sold on June 28, according to Justin Monteith, an analyst at high-yield research firm KDP Investment Advisors in Montpelier, Vermont. KKR completed the acquisition of Dollar General on July 9.
Bear Stearns Cos. strategists estimate that about $290 billion of deals still need to get funded, including those of Greenwood Village, Colorado-based credit-card processor First Data Corp. and energy company TXU Corp. of Dallas.
The question is ``how much yield are the brokerage firms going to have to eat,'' said Hintz, who is now an analyst at Sanford C. Bernstein & Co. in New York. ``What they've committed to is not current trading rates in the market. If I have a problem it doesn't mean I can't place the problem, but it's going to cause a mark-to-market loss.''
Record Sales
Acquisitions by private equity firms such as New York's KKR and Blackstone Group LP helped push sales of high-yield bonds and loans worldwide up more than 70 percent during the first half of the year to a record $708 billion, according to data compiled by Bloomberg. High-yield, or junk, bonds are those rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The investment banking fees generated by LBOs in the first half amounted to almost two-thirds of the $12.8 billion paid by LBO firms to Wall Street in 2006, data compiled by Freeman & Co. and Thomson Financial show. In the race to win deals, the five largest U.S. investment banks more than tripled their lending commitments to non-investment grade borrowers during the past year to $174 billion, according to their regulatory filings.
KKR co-founder Henry Kravis in May called it the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia. The extra yield investors demanded to own junk bonds rather than Treasuries shrank to a record low of 2.41 percentage points in June from the peak of more than 10 percentage points in 2002, according to index data from New York-based Merrill Lynch & Co.
No Escape
For loans rated four or five levels below investment grade, the spread over the London interbank offered rate shrank to 2.12 percentage points in February from more than 4 percentage points in 2003. It has since widened to 2.72 percentage points.
Some bankers even speculated that $100 billion LBO was possible, a scenario that is now ``definitely'' off the table, said Stephen Antczak, high-yield strategist at UBS AG in Stamford, Connecticut. Wall Street's confidence in its ability to finance just about any deal led buyout firms to remove clauses in their purchase agreements that would allow them to back out if their banks couldn't come up with the financing.
Just three of the 40 biggest pending LBOs have an escape clause that lets the buyer back out if funding can't be arranged, said Mike Belin, U.S. head of equity derivatives strategy at Deutsche Bank AG in New York. A couple of years ago, a majority of deals included a financing contingency, Belin said, based on his research.
``If you were a credit officer or a risk manager who said `No' to virtually anything over the last few years you were wrong,'' Hintz said. ``So did they take it too far? Well, yeah. But that's part of any cycle. The issue is did they take it too far and is it going to hurt their earnings.''
Market Cracks
The market for high-yield bonds and junk-rated, or leveraged loans began to crack in June as concerns that LBOs were becoming too risky coincided with a slump in the market for subprime mortgages that caused the near-collapse of two Bear Stearns hedge funds.
Junk bonds lost 1.61 percent last month, the most since March 2005 when General Motors Corp. forecast its biggest quarterly loss since 1992 and the debt lost 2.73 percent, according to Merrill Lynch.
Investors refused to buy bonds to finance purchases of companies including Dollar General and ServiceMaster Co., forcing bankers to either buy the bonds themselves or extend a loan to make up for the securities that weren't sold.
In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.
Lending Commitments
Citigroup, the biggest U.S. bank, reported that its securities and banking division recorded an expense of $286 million in the first quarter to increase loan-loss reserves to account for higher commitments to leveraged transactions and an increase in the average length of loans.
Lehman reported on July 10 that its commitments for ``contingent acquisition facilities'' more than doubled in the quarter ended May 31 to $43.9 billion, exceeding its stock market capitalization of $39.1 billion. Lehman said its commitments contain ``flexible pricing features'' that allow it to charge more if market conditions deteriorate.
Goldman Sachs more than doubled its lending commitments to non-investment grade borrowers to $71.5 billion in the year ended May 31.
Citigroup spokeswoman Danielle Romero-Apsilos, Lehman spokeswoman Tasha Pelio and Goldman Sachs spokesman Michael Duvally, either declined to comment or didn't return phone calls.
ServiceMaster Bonds
JPMorgan failed to sell $1.15 billion of bonds for Memphis, Tennessee-based ServiceMaster on July 3. The banks provided ServiceMaster, the maker of TruGreen and Terminix lawn-care products, with a bridge loan to make up for the failed bond sale. ServiceMaster is being bought by private equity firm Clayton Dubilier & Rice Inc. for $4.7 billion.
KKR and New York-based Clayton Dubilier this month completed their $7.1 billion purchase of Columbia, Maryland- based US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, even though junk bond investors refused to buy $1.55 billion of bonds and $3.37 billion of loans to finance the deal, according to estimates from New York-based Bear Stearns.
Deutsche Bank led the bond offering, which included $1 billion of ``toggle'' bonds that would have allowed US Foodservice to pay interest in either cash or additional debt. KKR and Clayton Dubilier relied on loans to complete the deal, according to S&P's Leveraged Commentary and Data unit.
`Beyond Our Risk'
``Many of these things are beyond our risk desires,'' said Bruce Monrad, who manages $1.5 billion of high-yield bonds at Northeast Investment Management Inc. in Boston.
JPMorgan spokesman Adam Castellani, Deutsche bank spokesman Scott Helfman and Morgan Stanley spokeswoman Jennifer Sala either declined to comment or didn't return calls. All the banks are based in New York, except Deutsche Bank, which is in Frankfurt.
Banks can always sell the debt if demand increases. Meanwhile, they may have to report a loss from the decline in value of their holdings, a process known as marking to market.
Banks could also lose money should they have to offer discounts on loans in order to syndicate the deals, said Tanya Azarchs, a banking industry analyst at New York-based S&P.
``I don't think it's going to cause banks to fail or even lead to downgrades,'' Azarchs said. ``But I do think there will be a little indigestion and lower earnings.''
The biggest concern is ``hung deals,'' where a lender is left holding a large loan to a single borrower, said Azarchs. ``Those traditionally in all the prior credit cycles have caused the greatest amount of grief for the large syndicating banks,'' Azarchs said.
`Burning Bed'
In 1989, First Boston Corp., now part of Credit Suisse, made a bridge loan for a buyout of Ohio Mattress Co., the predecessor to Sealy Corp. The junk bond market collapsed before First Boston could refinance the loan, and the securities firm ended up owning a big stake in the bedding manufacturer.
The deal became known as ``Burning Bed.''
``The thing about this business is memories are two seconds long,'' said James Schell, a private equity attorney in the New York office of Skadden, Arps, Slate, Meagher & Flom LLP.
Banks led by Citigroup committed to extend $37.2 billion in credit to fund the purchase of TXU by a group that included KKR, Fort Worth, Texas-based TPG Inc. and Goldman Sachs's private equity group. The financing will comprise $25.9 billion of term loans and $11.3 billion in an unsecured bridge loan.
First Data
Credit Suisse, based in Zurich, is leading banks in the U.S. that have agreed to provide KKR with $16 billion of loans for its $26.1 billion takeover of First Data. The plans include an $8 billion bond sale, which is scheduled for August or September, according to Bank of America Corp.
For firms such as KKR or Blackstone, both based in New York, the tighter credit environment may make their acquisitions less profitable and even change the way they go after future targets. Mark Semer, a spokesman for KKR, declined to comment.
``The underwriters are going to be forced to provide bridge loans and it's getting pretty ugly, but Wall Street deserves to get smacked around a little,'' said William Featherston, managing director in high-yield at J. Giordano Securities LLC in Stamford, Connecticut. ``It's been easy for so long.''
By Caroline Salas and Miles Weiss
July 17 (Bloomberg) -- Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.
The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.
Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100 billion LBO, are now paying for their overconfidence. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record $8.4 billion in fees during the first half of 2007, according to Brad Hintz, the former chief financial officer at New York-based Lehman Brothers Holdings Inc.
``The private equity firms, being very tough negotiators, are unlikely to let the banks off the hook,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. ``They'll say that's your problem and that's why we're paying you: To take risk.''
As the market began to turn sour last month, Goldman Sachs, Citigroup Inc., Lehman and Wachovia Corp. had to buy $725 million of bonds that Goodlettsville, Tennessee-based Dollar General Corp. was selling to finance Kohlberg Kravis Roberts & Co. purchase of the company for $6.9 billion. All of the securities firms are based in New York, except Wachovia, which is located in Charlotte, North Carolina.
Bonds Tumble
Those bonds are probably worth 94 cents on the dollar, or $43.5 million less than when they were sold on June 28, according to Justin Monteith, an analyst at high-yield research firm KDP Investment Advisors in Montpelier, Vermont. KKR completed the acquisition of Dollar General on July 9.
Bear Stearns Cos. strategists estimate that about $290 billion of deals still need to get funded, including those of Greenwood Village, Colorado-based credit-card processor First Data Corp. and energy company TXU Corp. of Dallas.
The question is ``how much yield are the brokerage firms going to have to eat,'' said Hintz, who is now an analyst at Sanford C. Bernstein & Co. in New York. ``What they've committed to is not current trading rates in the market. If I have a problem it doesn't mean I can't place the problem, but it's going to cause a mark-to-market loss.''
Record Sales
Acquisitions by private equity firms such as New York's KKR and Blackstone Group LP helped push sales of high-yield bonds and loans worldwide up more than 70 percent during the first half of the year to a record $708 billion, according to data compiled by Bloomberg. High-yield, or junk, bonds are those rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The investment banking fees generated by LBOs in the first half amounted to almost two-thirds of the $12.8 billion paid by LBO firms to Wall Street in 2006, data compiled by Freeman & Co. and Thomson Financial show. In the race to win deals, the five largest U.S. investment banks more than tripled their lending commitments to non-investment grade borrowers during the past year to $174 billion, according to their regulatory filings.
KKR co-founder Henry Kravis in May called it the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia. The extra yield investors demanded to own junk bonds rather than Treasuries shrank to a record low of 2.41 percentage points in June from the peak of more than 10 percentage points in 2002, according to index data from New York-based Merrill Lynch & Co.
No Escape
For loans rated four or five levels below investment grade, the spread over the London interbank offered rate shrank to 2.12 percentage points in February from more than 4 percentage points in 2003. It has since widened to 2.72 percentage points.
Some bankers even speculated that $100 billion LBO was possible, a scenario that is now ``definitely'' off the table, said Stephen Antczak, high-yield strategist at UBS AG in Stamford, Connecticut. Wall Street's confidence in its ability to finance just about any deal led buyout firms to remove clauses in their purchase agreements that would allow them to back out if their banks couldn't come up with the financing.
Just three of the 40 biggest pending LBOs have an escape clause that lets the buyer back out if funding can't be arranged, said Mike Belin, U.S. head of equity derivatives strategy at Deutsche Bank AG in New York. A couple of years ago, a majority of deals included a financing contingency, Belin said, based on his research.
``If you were a credit officer or a risk manager who said `No' to virtually anything over the last few years you were wrong,'' Hintz said. ``So did they take it too far? Well, yeah. But that's part of any cycle. The issue is did they take it too far and is it going to hurt their earnings.''
Market Cracks
The market for high-yield bonds and junk-rated, or leveraged loans began to crack in June as concerns that LBOs were becoming too risky coincided with a slump in the market for subprime mortgages that caused the near-collapse of two Bear Stearns hedge funds.
Junk bonds lost 1.61 percent last month, the most since March 2005 when General Motors Corp. forecast its biggest quarterly loss since 1992 and the debt lost 2.73 percent, according to Merrill Lynch.
Investors refused to buy bonds to finance purchases of companies including Dollar General and ServiceMaster Co., forcing bankers to either buy the bonds themselves or extend a loan to make up for the securities that weren't sold.
In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.
Lending Commitments
Citigroup, the biggest U.S. bank, reported that its securities and banking division recorded an expense of $286 million in the first quarter to increase loan-loss reserves to account for higher commitments to leveraged transactions and an increase in the average length of loans.
Lehman reported on July 10 that its commitments for ``contingent acquisition facilities'' more than doubled in the quarter ended May 31 to $43.9 billion, exceeding its stock market capitalization of $39.1 billion. Lehman said its commitments contain ``flexible pricing features'' that allow it to charge more if market conditions deteriorate.
Goldman Sachs more than doubled its lending commitments to non-investment grade borrowers to $71.5 billion in the year ended May 31.
Citigroup spokeswoman Danielle Romero-Apsilos, Lehman spokeswoman Tasha Pelio and Goldman Sachs spokesman Michael Duvally, either declined to comment or didn't return phone calls.
ServiceMaster Bonds
JPMorgan failed to sell $1.15 billion of bonds for Memphis, Tennessee-based ServiceMaster on July 3. The banks provided ServiceMaster, the maker of TruGreen and Terminix lawn-care products, with a bridge loan to make up for the failed bond sale. ServiceMaster is being bought by private equity firm Clayton Dubilier & Rice Inc. for $4.7 billion.
KKR and New York-based Clayton Dubilier this month completed their $7.1 billion purchase of Columbia, Maryland- based US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, even though junk bond investors refused to buy $1.55 billion of bonds and $3.37 billion of loans to finance the deal, according to estimates from New York-based Bear Stearns.
Deutsche Bank led the bond offering, which included $1 billion of ``toggle'' bonds that would have allowed US Foodservice to pay interest in either cash or additional debt. KKR and Clayton Dubilier relied on loans to complete the deal, according to S&P's Leveraged Commentary and Data unit.
`Beyond Our Risk'
``Many of these things are beyond our risk desires,'' said Bruce Monrad, who manages $1.5 billion of high-yield bonds at Northeast Investment Management Inc. in Boston.
JPMorgan spokesman Adam Castellani, Deutsche bank spokesman Scott Helfman and Morgan Stanley spokeswoman Jennifer Sala either declined to comment or didn't return calls. All the banks are based in New York, except Deutsche Bank, which is in Frankfurt.
Banks can always sell the debt if demand increases. Meanwhile, they may have to report a loss from the decline in value of their holdings, a process known as marking to market.
Banks could also lose money should they have to offer discounts on loans in order to syndicate the deals, said Tanya Azarchs, a banking industry analyst at New York-based S&P.
``I don't think it's going to cause banks to fail or even lead to downgrades,'' Azarchs said. ``But I do think there will be a little indigestion and lower earnings.''
The biggest concern is ``hung deals,'' where a lender is left holding a large loan to a single borrower, said Azarchs. ``Those traditionally in all the prior credit cycles have caused the greatest amount of grief for the large syndicating banks,'' Azarchs said.
`Burning Bed'
In 1989, First Boston Corp., now part of Credit Suisse, made a bridge loan for a buyout of Ohio Mattress Co., the predecessor to Sealy Corp. The junk bond market collapsed before First Boston could refinance the loan, and the securities firm ended up owning a big stake in the bedding manufacturer.
The deal became known as ``Burning Bed.''
``The thing about this business is memories are two seconds long,'' said James Schell, a private equity attorney in the New York office of Skadden, Arps, Slate, Meagher & Flom LLP.
Banks led by Citigroup committed to extend $37.2 billion in credit to fund the purchase of TXU by a group that included KKR, Fort Worth, Texas-based TPG Inc. and Goldman Sachs's private equity group. The financing will comprise $25.9 billion of term loans and $11.3 billion in an unsecured bridge loan.
First Data
Credit Suisse, based in Zurich, is leading banks in the U.S. that have agreed to provide KKR with $16 billion of loans for its $26.1 billion takeover of First Data. The plans include an $8 billion bond sale, which is scheduled for August or September, according to Bank of America Corp.
For firms such as KKR or Blackstone, both based in New York, the tighter credit environment may make their acquisitions less profitable and even change the way they go after future targets. Mark Semer, a spokesman for KKR, declined to comment.
``The underwriters are going to be forced to provide bridge loans and it's getting pretty ugly, but Wall Street deserves to get smacked around a little,'' said William Featherston, managing director in high-yield at J. Giordano Securities LLC in Stamford, Connecticut. ``It's been easy for so long.''
A hint that credit spreads are widening?
Derivatives Banks Concerned by Hedge Fund Leverage, Fitch Says
By Hamish Risk
July 17 (Bloomberg) -- Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.
Hedge funds' influence on credit derivatives and debt markets has continued to grow at a ``dramatic pace,'' Fitch said in today's report. The funds are responsible for 60 percent of all trading in credit-default swaps and about 33 percent of collateralized debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.
U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns in New York earlier this month was forced to provide $1.6 billion for one of two hedge funds that made wrong-way bets on subprime debt. The firm declined to bail out lenders to the other fund, which borrowed more money against its investors' capital to take bigger risks.
In a market slump, large transactions financed with borrowed money may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' Fitch analysts led by Ian Linnell in London wrote in the report for the 2006 survey.
Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started conducting the survey in 2003, the ratings company said.
Counterparty Concentration
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, from 86 percent in the previous year, Fitch said.
``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.
Contracts based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single- name credit-default swaps last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest maker of luxury cars.
After GM, contracts based on Brazilian government debt were the second-busiest in terms of the amount traded.
Banks and hedge funds say it's cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.
In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.
A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.
By Hamish Risk
July 17 (Bloomberg) -- Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.
Hedge funds' influence on credit derivatives and debt markets has continued to grow at a ``dramatic pace,'' Fitch said in today's report. The funds are responsible for 60 percent of all trading in credit-default swaps and about 33 percent of collateralized debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.
U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns in New York earlier this month was forced to provide $1.6 billion for one of two hedge funds that made wrong-way bets on subprime debt. The firm declined to bail out lenders to the other fund, which borrowed more money against its investors' capital to take bigger risks.
In a market slump, large transactions financed with borrowed money may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' Fitch analysts led by Ian Linnell in London wrote in the report for the 2006 survey.
Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started conducting the survey in 2003, the ratings company said.
Counterparty Concentration
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, from 86 percent in the previous year, Fitch said.
``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.
Contracts based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single- name credit-default swaps last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest maker of luxury cars.
After GM, contracts based on Brazilian government debt were the second-busiest in terms of the amount traded.
Banks and hedge funds say it's cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.
In a credit-default swap, the buyer pays an annual premium to guard against a borrower's failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices typically decline when creditworthiness improves, and rise when it worsens.
A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.
CDS shows Lend Lease risks buyout, says Bloomberg
Lend Lease Buyout Risk Rises, Credit Defaults Swaps Show
By Laura Cochrane
July 17 (Bloomberg) -- Lend Lease Corp., Australia's biggest property developer, may be the target of a leveraged buyout, according to traders betting on the creditworthiness of companies.
Speculation that private equity firms are poised to bid has increased the risk of holding Lend Lease debt to the highest since August 2005. Credit-default swaps are financial instruments based on corporate bonds and loans used to speculate on a company's ability to repay debt.
Buyout firms could buy Lend Lease to break it up, selling businesses including Actus Lend Lease in the U.S. and Bluewater shopping centers in the U.K., said Brent Mitchell, an analyst at Shaw Stockbroking Ltd. A total of $76.7 billion of takeovers have been announced in Australia this year, up from $44.8 billion at the same time last year, according to data compiled by Bloomberg.
``If you took it over there are a couple of quick sales you could do to recoup a lot of what you paid for it,'' Melbourne- based Mitchell said. ``The Actus U.S. military housing business has been fairly successful with a 25 percent market share and they also have a number of high profile U.K. contracts.''
Credit-default swaps based on $10 million of Lend Lease bonds gained 20 percent in the past month to $61,000 at 2 p.m. in Sydney, Bloomberg data shows. This is the highest since Aug. 15, 2005. An increase in the five-year contracts indicates deteriorating credit quality.
Chief Executive Officer Greg Clarke told the Australian Financial Review that Lend Lease hasn't ``had an approach for years,'' the newspaper reported yesterday.
Lend Lease declined to comment today.
Leveraged Buyouts
Private-equity firms have flocked to Australia, which last year scrapped a 30 percent capital gains tax for overseas investors, with the total value of announced takeovers by such firms rising to $15.6 billion from $3.7 billion at the same time last year. Still, interest may wane because of rising borrowing costs after the value of U.S. subprime-mortgage debt plunged.
Pacific Equity Partners and Permira Holdings Ltd. quit a buyout group for Coles Group Ltd., Australia's second-largest retailer, last month and yesterday Kohlberg Kravis Roberts & Co. abandoned a planned debt sale for a Dutch retailer.
Lend Lease is ``under-geared,'' Mitchell said, so buyout firms wouldn't have to borrow as much to take over the company, reducing the chances that rising costs would deter firms from pursuing a deal.
Buyout firms use a combination of their own funds and debt to pay for acquisitions. They seek to expand companies or improve performance before typically selling them within five years to other funds or investors.
Bond Risk
Credit-default swaps were conceived to protect bondholders against default. They pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
Investors have increasingly turned to the derivatives as cheaper and easier investments than bonds, making the market one of the best gauges of changes in credit quality.
Leveraged buyouts are perceived as bad for bondholders because private-equity firms typically use the company they are acquiring to borrow the money needed to finance the deal.
Lend Lease's debt has the lowest investment-grade ranking of BBB- by Standard & Poor's and Baa3 by Moody's Investors Service. The company has A$1.4 billion ($1.2 billion) of bonds outstanding, Bloomberg data show.
Lend Lease has a market capitalization of A$7.4 billion. The shares fell 1 cent to A$18.54 at 3:35 p.m. in Sydney.
By Laura Cochrane
July 17 (Bloomberg) -- Lend Lease Corp., Australia's biggest property developer, may be the target of a leveraged buyout, according to traders betting on the creditworthiness of companies.
Speculation that private equity firms are poised to bid has increased the risk of holding Lend Lease debt to the highest since August 2005. Credit-default swaps are financial instruments based on corporate bonds and loans used to speculate on a company's ability to repay debt.
Buyout firms could buy Lend Lease to break it up, selling businesses including Actus Lend Lease in the U.S. and Bluewater shopping centers in the U.K., said Brent Mitchell, an analyst at Shaw Stockbroking Ltd. A total of $76.7 billion of takeovers have been announced in Australia this year, up from $44.8 billion at the same time last year, according to data compiled by Bloomberg.
``If you took it over there are a couple of quick sales you could do to recoup a lot of what you paid for it,'' Melbourne- based Mitchell said. ``The Actus U.S. military housing business has been fairly successful with a 25 percent market share and they also have a number of high profile U.K. contracts.''
Credit-default swaps based on $10 million of Lend Lease bonds gained 20 percent in the past month to $61,000 at 2 p.m. in Sydney, Bloomberg data shows. This is the highest since Aug. 15, 2005. An increase in the five-year contracts indicates deteriorating credit quality.
Chief Executive Officer Greg Clarke told the Australian Financial Review that Lend Lease hasn't ``had an approach for years,'' the newspaper reported yesterday.
Lend Lease declined to comment today.
Leveraged Buyouts
Private-equity firms have flocked to Australia, which last year scrapped a 30 percent capital gains tax for overseas investors, with the total value of announced takeovers by such firms rising to $15.6 billion from $3.7 billion at the same time last year. Still, interest may wane because of rising borrowing costs after the value of U.S. subprime-mortgage debt plunged.
Pacific Equity Partners and Permira Holdings Ltd. quit a buyout group for Coles Group Ltd., Australia's second-largest retailer, last month and yesterday Kohlberg Kravis Roberts & Co. abandoned a planned debt sale for a Dutch retailer.
Lend Lease is ``under-geared,'' Mitchell said, so buyout firms wouldn't have to borrow as much to take over the company, reducing the chances that rising costs would deter firms from pursuing a deal.
Buyout firms use a combination of their own funds and debt to pay for acquisitions. They seek to expand companies or improve performance before typically selling them within five years to other funds or investors.
Bond Risk
Credit-default swaps were conceived to protect bondholders against default. They pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
Investors have increasingly turned to the derivatives as cheaper and easier investments than bonds, making the market one of the best gauges of changes in credit quality.
Leveraged buyouts are perceived as bad for bondholders because private-equity firms typically use the company they are acquiring to borrow the money needed to finance the deal.
Lend Lease's debt has the lowest investment-grade ranking of BBB- by Standard & Poor's and Baa3 by Moody's Investors Service. The company has A$1.4 billion ($1.2 billion) of bonds outstanding, Bloomberg data show.
Lend Lease has a market capitalization of A$7.4 billion. The shares fell 1 cent to A$18.54 at 3:35 p.m. in Sydney.
Sunday, July 15, 2007
Can Wall Street be trusted to value risky CDOs?
Can Wall Street be trusted to value risky CDOs?
Sat Jul 14, 2007 9:33AM EDT
By Neil Shah - Analysis
NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.
With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.
The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.
"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."
Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.
Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."
Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."
Recent troubles at hedge funds run by Bear Stearns (BSC.N: Quote, Profile, Research), Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.
"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."
Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.
UNREALISTIC ASSUMPTIONS
While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.
Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.
This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets.
Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.
"I find it troubling that the rating agencies are only now publicly recognizing this," Rosner said.
The potential for self-serving pricing by hedge funds is a "serious concern," MIT's Lo said. "There needs to be more independence in pricing and valuation."
Bear Stearns on May 15 said that the riskier of its two hedge funds was down 6.5 percent for April, but then revised that figure to down almost 19 percent a few weeks later.
A logical choice for independent CDO pricing might be rating agencies, but this may be difficult in practice, Lo said.
"If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for developing those models will very quickly be hired by the hedge funds," Lo said.
The ratings agencies are themselves facing mounting complaints that they have been too slow and opaque in their tackling of the subprime crisis. Some say the agencies ignore key credit risks and cash in by doling out top-notch ratings to subprime-related CDOs.
In the wake of troubles at Bear's hedge funds, the chairman of the House Financial Services Committee said on Wednesday that he would hold a hearing on the role of credit-rating agencies in the fall.
S&P spokesman Adam Tempkin said the agency is very transparent. "We make all of our technical papers completely available to anybody that wants them. They explain every aspect of the models we use."
Noel Kirnon, senior managing director at Moody's, said, "The performance of our ratings overall suggest we're doing a pretty good job."
"The ratings aren't the output of a model," said Fitch managing director Kevin Kendra. "Ratings are the output of a credit committee."
BLAME IT ON THE INVESTORS
But many say investors in lightly regulated hedge funds or risky CDO securities knew what they were doing.
"Nobody made anybody else put their money into a hedge fund," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.
Fear of a broad-based selloff in CDOs may also be overblown since some bondholders would be loathe to sell at fire-sale prices and also because any sudden sales would bring in other hedge funds hungry for bargains.
"Not all hedge funds are crying today," said Arturo Cifuentes, managing director at R.W. Pressprich and former global head of CDO research at Wachovia. "For some hedge funds, this is a great opportunity."
Sat Jul 14, 2007 9:33AM EDT
By Neil Shah - Analysis
NEW YORK (Reuters) - The complex models that Wall Street uses to analyze risky investments in subprime mortgages may be as suspect as some of the securities themselves.
With a surge in defaults on subprime home loans jolting credit rating agencies and two Bear Stearns hedge funds in recent weeks, some fear that these models may overlook swift market downturns or corrupt loan data. That could spell further turmoil for credit markets.
The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors.
"These models end up breaking down rather dramatically during abnormal times," said Andrew Lo, a finance professor at Massachusetts Institute of Technology. "And, of course, those are exactly the times that we should and need to worry about."
Ratings companies like Moody's Investors Service use computer models to help predict losses on thinly traded debt investments called collateralized debt obligations, or CDOs, that are often tied to pools of high-risk home loans. The models help the agencies determine what rating a security merits.
Because securities in the $1 trillion CDO market trade infrequently, it is difficult for hedge funds and other investors to mark their values to recent sale prices, called "marking to market."
Hedge funds instead use mathematical models of their own to estimate and report the value of their CDO holdings to investors -- a practice known as "marking to model."
Recent troubles at hedge funds run by Bear Stearns (BSC.N: Quote, Profile, Research), Braddock Financial Corp. and United Capital Markets have highlighted the problems inherent in that approach. Even so, fund managers are resisting market views on the value of subprime assets and continuing to "mark to model," claiming declines represent short-term volatility.
"'Mark to model' is a joke," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm. "What you need to do now is vet the underlying collateral" in CDOs instead of just modeling, which wasn't done earlier, she said. "It's grubby, roll-up-your-sleeves kind of work."
Some hedge funds may now have to report losses on CDOs, while pension funds and insurance companies may dump other securities if these are dropped by raters to "junk" status.
UNREALISTIC ASSUMPTIONS
While models may be necessary to analyze investments of such complexity and have worked well under normal conditions, they may break down quickly in times of crisis, MIT's Lo said.
Many popular hedge fund models ignore the possibility of a sudden withdrawal of liquidity, while ratings agencies may make overly abstract or unrealistic modeling assumptions and rely on the quality of the data assembled by Wall Street banks.
This week, Moody's and its rivals Standard & Poor's and Fitch Ratings slashed ratings on billions of subprime-related bonds, including CDOs, rattling global financial markets.
Josh Rosner, managing director at investment research firm Graham Fisher & Co., points to a recent S&P statement that the loan performance data it uses has called into question the accuracy of some of the data initially provided to them.
"I find it troubling that the rating agencies are only now publicly recognizing this," Rosner said.
The potential for self-serving pricing by hedge funds is a "serious concern," MIT's Lo said. "There needs to be more independence in pricing and valuation."
Bear Stearns on May 15 said that the riskier of its two hedge funds was down 6.5 percent for April, but then revised that figure to down almost 19 percent a few weeks later.
A logical choice for independent CDO pricing might be rating agencies, but this may be difficult in practice, Lo said.
"If the ratings agency ends up coming up with a really, really good pricing model, the individual responsible for developing those models will very quickly be hired by the hedge funds," Lo said.
The ratings agencies are themselves facing mounting complaints that they have been too slow and opaque in their tackling of the subprime crisis. Some say the agencies ignore key credit risks and cash in by doling out top-notch ratings to subprime-related CDOs.
In the wake of troubles at Bear's hedge funds, the chairman of the House Financial Services Committee said on Wednesday that he would hold a hearing on the role of credit-rating agencies in the fall.
S&P spokesman Adam Tempkin said the agency is very transparent. "We make all of our technical papers completely available to anybody that wants them. They explain every aspect of the models we use."
Noel Kirnon, senior managing director at Moody's, said, "The performance of our ratings overall suggest we're doing a pretty good job."
"The ratings aren't the output of a model," said Fitch managing director Kevin Kendra. "Ratings are the output of a credit committee."
BLAME IT ON THE INVESTORS
But many say investors in lightly regulated hedge funds or risky CDO securities knew what they were doing.
"Nobody made anybody else put their money into a hedge fund," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.
Fear of a broad-based selloff in CDOs may also be overblown since some bondholders would be loathe to sell at fire-sale prices and also because any sudden sales would bring in other hedge funds hungry for bargains.
"Not all hedge funds are crying today," said Arturo Cifuentes, managing director at R.W. Pressprich and former global head of CDO research at Wachovia. "For some hedge funds, this is a great opportunity."
Tougher lenders in Asia (ex-Japan perhaps)
Private equity ambitions curbed by lenders in Asia
Fri Jul 13, 2007 7:35AM EDT
By Alison Tudor - Analysis
TOKYO (Reuters) - Private equity firms eyeing jumbo acquisitions in Asia are facing more demanding terms from their lenders, but fierce competition among banks for new business means the region's buyout boom is unlikely to be derailed.
A tougher stance from lenders could make takeovers -- particularly massive ones -- more expensive and more difficult for buyout funds, which prefer to pay for companies using a little of their own equity and a lot of debt.
Deal-hungry private equity firms that have had their way with banks during the buyout boom may now be forced to pay higher interest rates on the debt, or use less debt in bigger, riskier deals, making mega deals harder to structure and potentially reducing their returns.
"This is the first sign that the pendulum may be swinging back the other way - investors have linked arms and pushed back," said Tim Donahue, head of leveraged finance Asia Pacific at JP Morgan, where he helps private equity funds raise debt for deals.
Debt providers have become more risk averse following a global spike in credit costs caused by rising defaults in U.S. mortgage-related bonds, another highly-leveraged product.
Bankers estimate credit spreads for Asian buyouts have widened by about 20-30 basis points in the last few weeks, equivalent to a couple of million dollars of extra cost on a billion-dollar deal. If credit spreads continue to widen, clinching bigger deals will get even tougher.
"Until recently we'd push as hard as we could to get more debt, but now credit committees at banks will play more of a watchdog role, which is healthy for the market," said one manager of a private equity firm in Australia, the biggest buyout market in Asia so far in 2007.
U.S. private equity firm TPG cited credit market volatility as a reason for recently pulling out of bidding for Australian retailer Coles. Financial sources said higher credit costs may have been the final straw after a protracted bidding war with another retailer, Wesfarmers
Private equity firms announced $22 billion worth of deals in Asia-Pacific excluding Japan in the first half of this year, another record for the industry, according to data provider Thomson Financial.
Loan volume for LBOs across the Asia Pacific hit $15.8 billion in the first half of 2007, already above the 2006 total of $13.4 billion and up from $3 billion in 2004, according to Reuters unit Basis Point, which tracks acquisition finance.
Defaults are near record lows in Asia Pacific, but ratings agency Moody's said the benign environment has turned mildly negative, with debt-laden buyouts a major factor.
A STEP TOO FAR?
Asia's loan market is dominated by banks hungry for new business and with a sea of capital to lend, which ensures there will be plenty of appetite to fund most buyouts -- even if terms are tougher.
But the loose lending terms that buyout firms have been able to demand on massive deals, including so-called "covenant lite" structures that lack traditional protection offered to buyers of the debt, are expected to be harder to come by.
A barometer of funds' ability to raise debt in the region will be TPG's $1.4 billion acquisition of Singapore's United Test and Assembly Center (UTAC). Banks that funded the deal with the less-stringent terms may have a harder time syndicating the loan to other buyers.
Lenders have begun asking for a few covenants to be put back on loans and for higher spreads on the biggest deals, which could make buyouts more expensive and less profitable.
"While inconvenient, that's not a deal-breaker," said another private equity fund manager based in Australia.
Buyouts in Asia are smaller than in the West, where the push-back from debt lenders is greatest, and leverage in the region is lower, which means any backlash should be less severe.
Debt multiples on Asian deals average about 5-6 times earnings before interest, tax, depreciation and amortization (EBITDA), far below the 9-11 times on some recent U.S. deals.
And with fewer assets for sale, Asia lacks the glut of deals seen in the west, although deal sizes in the region are creeping higher. Last year private equity firms announced 15 buyouts over $1 billion across the Asia Pacific, up from three in 2003, Thomson Financial said.
A small but growing band of institutions that buy the more risky parts of Asian buyout debt, such as hedge funds and managers of pools of loans such as collateralized loan obligations, are stepping up the pressure on private equity.
But for now, deals continue to flow.
"There is push back on deals that are structured 'lite', but if a deal is reasonably structured, well protected and at an appropriate leverage multiple then it will get done," said Farhan Faruqui, head of global loans Asia Pacific for Citigroup.
Fri Jul 13, 2007 7:35AM EDT
By Alison Tudor - Analysis
TOKYO (Reuters) - Private equity firms eyeing jumbo acquisitions in Asia are facing more demanding terms from their lenders, but fierce competition among banks for new business means the region's buyout boom is unlikely to be derailed.
A tougher stance from lenders could make takeovers -- particularly massive ones -- more expensive and more difficult for buyout funds, which prefer to pay for companies using a little of their own equity and a lot of debt.
Deal-hungry private equity firms that have had their way with banks during the buyout boom may now be forced to pay higher interest rates on the debt, or use less debt in bigger, riskier deals, making mega deals harder to structure and potentially reducing their returns.
"This is the first sign that the pendulum may be swinging back the other way - investors have linked arms and pushed back," said Tim Donahue, head of leveraged finance Asia Pacific at JP Morgan, where he helps private equity funds raise debt for deals.
Debt providers have become more risk averse following a global spike in credit costs caused by rising defaults in U.S. mortgage-related bonds, another highly-leveraged product.
Bankers estimate credit spreads for Asian buyouts have widened by about 20-30 basis points in the last few weeks, equivalent to a couple of million dollars of extra cost on a billion-dollar deal. If credit spreads continue to widen, clinching bigger deals will get even tougher.
"Until recently we'd push as hard as we could to get more debt, but now credit committees at banks will play more of a watchdog role, which is healthy for the market," said one manager of a private equity firm in Australia, the biggest buyout market in Asia so far in 2007.
U.S. private equity firm TPG cited credit market volatility as a reason for recently pulling out of bidding for Australian retailer Coles. Financial sources said higher credit costs may have been the final straw after a protracted bidding war with another retailer, Wesfarmers
Private equity firms announced $22 billion worth of deals in Asia-Pacific excluding Japan in the first half of this year, another record for the industry, according to data provider Thomson Financial.
Loan volume for LBOs across the Asia Pacific hit $15.8 billion in the first half of 2007, already above the 2006 total of $13.4 billion and up from $3 billion in 2004, according to Reuters unit Basis Point, which tracks acquisition finance.
Defaults are near record lows in Asia Pacific, but ratings agency Moody's said the benign environment has turned mildly negative, with debt-laden buyouts a major factor.
A STEP TOO FAR?
Asia's loan market is dominated by banks hungry for new business and with a sea of capital to lend, which ensures there will be plenty of appetite to fund most buyouts -- even if terms are tougher.
But the loose lending terms that buyout firms have been able to demand on massive deals, including so-called "covenant lite" structures that lack traditional protection offered to buyers of the debt, are expected to be harder to come by.
A barometer of funds' ability to raise debt in the region will be TPG's $1.4 billion acquisition of Singapore's United Test and Assembly Center (UTAC). Banks that funded the deal with the less-stringent terms may have a harder time syndicating the loan to other buyers.
Lenders have begun asking for a few covenants to be put back on loans and for higher spreads on the biggest deals, which could make buyouts more expensive and less profitable.
"While inconvenient, that's not a deal-breaker," said another private equity fund manager based in Australia.
Buyouts in Asia are smaller than in the West, where the push-back from debt lenders is greatest, and leverage in the region is lower, which means any backlash should be less severe.
Debt multiples on Asian deals average about 5-6 times earnings before interest, tax, depreciation and amortization (EBITDA), far below the 9-11 times on some recent U.S. deals.
And with fewer assets for sale, Asia lacks the glut of deals seen in the west, although deal sizes in the region are creeping higher. Last year private equity firms announced 15 buyouts over $1 billion across the Asia Pacific, up from three in 2003, Thomson Financial said.
A small but growing band of institutions that buy the more risky parts of Asian buyout debt, such as hedge funds and managers of pools of loans such as collateralized loan obligations, are stepping up the pressure on private equity.
But for now, deals continue to flow.
"There is push back on deals that are structured 'lite', but if a deal is reasonably structured, well protected and at an appropriate leverage multiple then it will get done," said Farhan Faruqui, head of global loans Asia Pacific for Citigroup.
Private Equity Glossary
Taken from Tuck School of Business at Dartmouth
http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html
"A" round — a financing event whereby venture capitalists become involved in a fast-growth company that was previously financed by founders and/or angels.
Accredited investor — a person or legal entity, such as a company or trust fund, that meets certain net worth and income qualifications and is considered to be sufficiently sophisticated to make investment decisions in complex situations. Regulation D of the Securities Act of 1933 exempts accredited investors from protection under the Securities Act. Typical qualifications for a person are: $1 million net worth and annual income exceeding $200,000 individually or $300,000 with a spouse. Directors and executive officers are considered to be accredited investors.
After-tax operating income — see Net operating income after taxes.
Airball — a loan whose value exceeds the value of the collateral.
Alpha — a term derived from statistics and finance theory that is used to describe the return produced by a fund manager in excess of the return of a benchmark index. Manager returns and benchmark returns are measured net of the risk-free rate. In addition, manager returns are adjusted for the risk of the manager's portfolio relative to the risk of the benchmark index. Alpha is a proxy for manager skill.
Alternative asset class — a class of investments that includes private equity, real estate, and oil and gas, but excludes publicly traded securities. Pension plans, college endowments, and other relatively large institutional investors typically allocate a certain percentage of their investments to alternative assets with an objective to diversify their portfolios.
Angel — a wealthy individual that invests in companies in relatively early stages of development. Usually angels invest less than $1 million per startup. The typical angel-financed startup is in concept or product development phase.
Anti-dilution — a contract clause that protects an investor from a substantial reduction in percentage ownership in a company due to the issuance by the company of additional shares to other entities. The mechanism for making adjustments is called a Ratchet.
"B" round — a financing event whereby professional investors such as venture capitalists are sufficiently interested in a company to provide additional funds after the "A" round of financing. Subsequent rounds are called "C", "D", and so on.
Balloon payment — a relatively large principal payment due at a specific time as required by a lender.
Basis point ("bp") — one one-hundredth (1/100) of a percentage unit. For example, 50 basis points equals one half of one percent. Banks quote variable loan rates in terms of an index plus a margin and the margin is often described in basis points, such as LIBOR plus 400 basis points (or, as the experts say, "beeps").
Best efforts offering — a commitment by a syndicate of investment banks to use best efforts to ensure the sale to investors of a company's offering of securities. In a best efforts offering, the syndicate avoids any firm commitment for a specific number of shares or bonds.
Beta — a measure of volatility of a public stock relative to an index or a composite of all stocks in a market or geographical region. A beta of more than one indicates the stock has higher volatility than the index (or composite) and a beta of one indicates volatility equivalent to the index (or composite). For example, the price of a stock with a beta of 1.5 will change by 1.5% if the index value changes by 1%. Typically, the S&P500 index is used in calculating the beta of a stock.
Beta Product — a product that is being tested by potential customers prior to being formally launched into the marketplace.
Blow-out round — see Cram-down round
Blue sky — regulations in individual states regarding the sale of securities and mutual funds. These laws are intended to protect investors from purposely fraudulent transactions.
Board of directors — a group of individuals, typically composed of managers, investors, and experts, which have a fiduciary responsibility for the well being and proper guidance of a corporation. The board is elected by the shareholders.
Boat anchor — a person, project or activity that hinders the growth of a company.
Book — see Private placement memorandum
Book runner — the lead bank that manages the transaction process for an equity or debt financing, including documentation, syndication, pricing, allocation and closing.
Book value — the book value of a company is the value of the common stock (total assets minus liabilities minus preferred stock minus intangible assets). The book value of an asset of a company is typically based on its original cost minus accumulated depreciation.
Bootstrapping — the actions of a startup to minimize expenses and build cash flow, thereby reducing or eliminating the need for outside investors.
Bp — see Basis point.
Bridge financing — temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders. In venture capital, a bridge is usually a short term note (6 to 12 months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note to preferred stock at a price that is a 20% discount from the price of the preferred stock in the next financing round. See Wipeout bridge and Hamburger Helper bridge.
Broad-based weighted average ratchet — a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to a weighed average of investor A's price and investor B's price. A broad-based ratchet uses all common stock outstanding on a fully diluted basis (including all convertible securities, warrants and options) in the denominator of the formula for determining the new weighted average price. See Narrow-based weighted average ratchet.
Bullet payment — a payment of all principal due at a time specified by a bank or a bond issuer.
Burn rate — the rate at which a startup with little or no revenue uses cash savings to cover expenses. Usually expressed on a monthly or weekly basis.
Business Development Company (BDC) — a publicly traded company that invests in private companies and is required by law to provide meaningful support and assistance to its portfolio companies.
Business plan — a document that describes a new concept for a business opportunity. A business plan typically includes the following sections: executive summary, market need, solution, technology, competition, marketing, management, operations and financials.
Buyout — a sector of the private equity industry. Also, the purchase of a controlling interest of a company by an outside investor (in a leveraged buyout) or a management team (in a management buyout).
Buy-sell agreement — a contract that sets forth the conditions under which a shareholder must first offer his or her shares for sale to the other shareholders before being allowed to sell to entities outside the company.
C corporation — an ownership structure that allows any number of individuals or companies to own shares. A C corporation is a stand-alone legal entity, so it offers some protection to its owners, managers and investors from liability resulting from its actions.
Call date — when a bond issuer has the right to retire part or all of a bond issuance at a specific price.
Call premium — the premium above par value that an issuer is willing to pay as part of the redemption of a bond issue prior to maturity.
Call price — the price an issuer agrees to pay to bondholders to redeem all or part of a bond issuance.
Call protection — a provision in the terms of a bond specifying the period of time during which the bond cannot be called by the issuer.
Capital Asset Pricing Model (CAPM) — a method of estimating the cost of equity capital of a company. The cost of equity capital is equal to the return of a risk-free investment plus a premium that reflects the risk of the company's equity.
Capital call — when a private equity fund manager (usually a "general partner" in a partnership) requests that an investor in the fund (a "limited partner") provide additional capital. Usually a limited partner will agree to a maximum investment amount and the general partner will make a series of capital calls over time to the limited partner as opportunities arise to finance startups and buyouts.
Capital gap — the difficulty faced by entrepreneurs trying to raise between $2 million and $5 million. Friends, family and angel investors are typically good sources for financing rounds of less than $2 million, while many venture capital funds have become so large that they are only interested in investing amounts greater than $5 million.
Capitalization table — a table showing the owners of a company's shares and their ownership percentages as well as the debt holders. It also lists the forms of ownership, such as common stock, preferred stock, warrants, options, senior debt, and subordinated debt.
Capital gains — a tax classification of investment earnings resulting from the purchase and sale of assets. Typically, an investor prefers that investment earnings be classified as long term capital gains (held for a year or longer), which are taxed at a lower rate than ordinary income.
Capital stock — a description of stock that applies when there is only one class of shares. This class is known as common stock.
Capped participating preferred stock — preferred stock whose participating feature is limited so that an investor cannot receive more than a specified amount. See Participating preferred
Carried interest — a share in the profits of a private equity fund. Typically, a fund must return the capital given to it by limited partners plus any preferential rate of return before the general partner can share in the profits of the fund. The general partner will then receive a 20% carried interest, although some successful firms receive 25%-30%. Also known as "carry" or "promote."
Catch-up — a clause in the agreement between the general partner and the limited partners of a private equity fund. Once the limited partners have received a certain portion of their expected return, the general partner can then receive a majority of profits until the previously agreed upon profit split is reached.
Change of control bonus — a bonus of cash or stock given by private equity investors to members of a management group if they successfully negotiate a sale of the company for a price greater than a specified amount.
Clawback — a clause in the agreement between the general partner and the limited partners of a private equity fund. The clawback gives limited partners the right to reclaim a portion of disbursements to a general partner for profitable investments based on significant losses from later investments in a portfolio.
Closing — the conclusion of a financing round whereby all necessary legal documents are signed and capital has been transferred.
Club deal — see Co-investment.
Co-investment — either a) the right of a limited partner to invest with a general partner in portfolio companies, or b) the act of investing by two or more entities in the same target company (also known as a Club deal).
Collateral — hard assets of the borrower, such as real estate or equipment, for which a lender has a legal interest until a loan obligation is fully paid off.
Commitment — an obligation, typically the maximum amount that a limited partner agrees to invest in a fund.
Common stock — a type of security representing ownership rights in a company. Usually, company founders, management and employees own common stock while investors own preferred stock. In the event of a liquidation of the company, the claims of secured and unsecured creditors, bondholders and preferred stockholders take precedence over common stockholders. See Preferred stock
Comparable — a publicly traded company with similar characteristics to a private company that is being valued. For example, a telecommunications equipment manufacturer whose market value is 2 times revenues can be used to estimate the value of a similar and relatively new company with a new product in the same industry. See Liquidity discount
Control — the authority of an individual or entity that owns more than 50% of equity in a company or owns the largest block of shares compared to other shareholders.
Consolidation — see Rollup
Conversion — the right of an investor or lender to force a company to replace the investor's preferred shares or the lender's debt with common shares at a preset conversion ratio. A conversion feature was first used in railroad bonds in the 1800s.
Convertible debt — a loan which allows the lender to exchange the debt for common shares in a company at a preset conversion ratio.
Convertible preferred stock — a type of stock that gives an owner the right to convert to common shares of stock. Usually, preferred stock has certain rights that common stock doesn't have, such as decision-making management control, a promised return on investment (dividend), or senior priority in receiving proceeds from a sale or liquidation of the company. Typically, convertible preferred stock automatically converts to common stock if the company makes an initial public offering (IPO). Convertible preferred is the most common tool for private equity funds to invest in companies.
Convertible security — a security that gives its owner the right to exchange the security for common shares in a company at a preset conversion ratio. The security is typically preferred stock, warrants or debt.
Co-sale right — a contractual right of an investor to sell some of the investor's stock along with the founder's or majority shareholder's stock if either the founder or majority shareholder elects to sell stock to a third-party. Also known as Tag-along right.
Cost of capital — see Weighted average cost of capital
Cost of revenue — the expenses generated by the core operations of a company.
Covenant — a legal promise to do or not do a certain thing. For example, in a financing arrangement, company management may agree to a negative covenant, whereby it promises not to incur additional debt. The penalties for violation of a covenant may vary from repairing the mistake to losing control of the company.
Coverage ratio — describes a company's ability to pay debt from cash flow or profits. Typical measures are EBITDA/Interest, (EBITDA minus Capital Expenditures)/Interest, and EBIT/Interest.
Cram down round — a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the startup company to significantly reduce ("dilute") the ownership percentage of previous investors.
Cumulative dividends — the owner of preferred stock with cumulative dividends has the right to receive accrued (previously unpaid) dividends in full before dividends are paid to any other classes of stock.
Current ratio — the ratio of current assets to current liabilities.
Data room — a specific location where potential buyers / investors can review confidential information about a target company. This information may include detailed financial statements, client contracts, intellectual property, property leases, and compensation agreements.
Deal flow — a measure of the number of potential investments that a fund reviews in any given period.
Debt service — the ratio of a loan payment amount to available cash flow earned during a specific period. Typically lenders insist that a company maintain a certain debt service ratio or else risk penalties such as having to pay off the loan immediately.
Default — a company's failure to comply with the terms and conditions of a financing arrangement.
Defined benefit plan — a company retirement plan in which both the employee and the employer contribute to the plan. Typically the plan is based on the employee's salary and number of years worked. Fixed benefits are outlined when the employee retires. The employer bears the investment risk and is committed to providing the benefits to the employee. Defined benefit plan managers can invest in private equity funds.
Defined contribution plan — a company retirement plan in which the employee elects to contribute some portion of his or her salary into a retirement plan, such as a 401(k) or 403(b). With this type of plan, the employee bears the investment risk. The benefits depend solely on the amount of money made from investing the employee's contributions. Defined contribution plan capital cannot be invested in private equity funds.
Demand rights — a type of registration right. Demand rights give an investor the right to force a startup to register its shares with the SEC and prepare for a public sale of stock (IPO).
Dilution — the reduction in the ownership percentage of current investors, founders and employees caused by the issuance of new shares to new investors.
Dilution protection — see Anti-dilution and Ratchet
Direct costs — see Cost of revenue
Disbursement — an investment by a fund in a company.
Discount rate — the interest rate used to determine the present value of a series of future cash flows.
Discounted cash flow (DCF) — a valuation methodology whereby the present value of all future cash flows expected from a company is calculated.
Distressed debt — the bonds of a company that is either in or approaching bankruptcy. Some private equity funds specialize in purchasing such debt at deep discounts with the expectation of exerting influence in the restructuring of the company and then selling the debt once the company has meaningfully recovered.
Distribution — the transfer of cash or securities to a limited partner resulting from the sale, liquidation or IPO of one or more portfolio companies in which a general partner chose to invest.
Dividends — regular payments made by a company to the owners of certain securities. Typically, dividends are paid quarterly, by approval of the board of directors, to owners of preferred stock.
Down round — a round of financing whereby the valuation of the company is lower than the value determined by investors in an earlier round.
Drag-along rights — the contractual right of an investor in a company to force all other investors to agree to a specific action, such as the sale of the company.
Drawdown schedule — an estimate of the gradual transfer of committed investment funds from the limited partners of a private equity fund to the general partners.
Drive-by VC — a venture capitalist that only appears during board meetings of a portfolio company and rarely offers advice to management.
Due diligence — the investigatory process performed by investors to assess the viability of a potential investment and the accuracy of the information provided by the target company.
Dutch auction — a method of conducting an IPO whereby newly issued shares of stock are committed to the highest bidder, then, if any shares remain, to the next highest bidder, and so on until all the shares are committed. Note that the price per share paid by all buyers is the price commitment of the buyer of the last share.
Early stage — the state of a company after the seed (formation) stage but before middle stage (generating revenues). Typically, a company in early stage will have a core management team and a proven concept or product, but no positive cash flow.
Earnings before interest and taxes (EBIT) — a measurement of the operating profit of a company. One possible valuation methodology is based on a comparison of private and public companies' value as a multiple of EBIT.
Earnings before interest, taxes, depreciation and amortization (EBITDA) — a measurement of the cash flow of a company. One possible valuation methodology is based on a comparison of private and public companies' value as a multiple of EBITDA.
Earn out — an arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such as revenue or net income.
Elevator pitch — a concise presentation, lasting only a few minutes (an elevator ride), by an entrepreneur to a potential investor about an investment opportunity.
Employee Stock Ownership Program (ESOP) — a plan established by a company to reserve shares for long-term incentive compensation for employees.
Enterprise value (EV) — the sum of the market values of the common stock and long term debt of a company, minus cash.
Entrepreneur — an individual who starts his or her own business.
Entrepreneurship — the application of innovative leadership to limited resources in order to create exceptional value.
Equity — the ownership structure of a company represented by common shares, preferred shares or unit interests. Equity=Assets-Liabilities.
ESOP — see Employee Stock Ownership Program.
Evergreen fund — a fund that reinvests its profits in order to ensure the availability of capital for future investments.
Exit strategy — the plan for generating profits for owners and investors of a company. Typically, the options are to merge, be acquired or make an initial public offering (IPO). An alternative is to recapitalize (releverage the company and then pay dividends to shareholders).
Expansion stage — the stage of a company characterized by a complete management team and a substantial increase in revenues.
Fairness opinion — a letter issued by an investment bank that charges a fee to assess the fairness of a negotiated price for a merger or acquisition.
Firm commitment — a commitment by a syndicate of investment banks to purchase all the shares available for sale in a public offering of a company. The shares will then be resold to investors by the syndicate.
Flipping — the act of selling shares immediately after an initial public offering. Investment banks that underwrite new stock issues attempt to allocate shares to new investors that indicate they will retain the shares for several months. Often management and venture investors are prohibited from selling IPO shares until a "lock-up period" (usually 6 to 12 months) has expired.
Founder — a person who participates in the creation of a company. Typically, founders manage the company until it has enough capital to hire professional managers.
Founders stock — nominally priced common stock issued to founders, officers, employees, directors, and consultants.
Free cash flow to equity (FCFE) — the cash flow available after operating expenses, interest payments on debt, taxes, net principal repayments, preferred stock dividends, reinvestment needs and changes in working capital. In a discounted cash flow model to determine the value of the equity of a firm using FCFE, the discount rate used is the cost of equity.
Free cash flow to the firm (FCFF) — the operating cash flow available after operating expenses, taxes, reinvestment needs and changes in working capital, but before any interest payments on debt are made. In a discounted cash flow model to determine the enterprise value of a firm using FCFF, the discount rate used is the weighted average cost of capital (WACC).
First refusal — the right of a privately owned company to purchase any shares that employees would like to sell.
Friends & family financing — capital provided by the friends and family of founders of an early-stage company. Founders should be careful not to create an ownership structure that may hinder the participation of professional investors once the company begins to achieve success.
Full ratchet — an anti-dilution protection mechanism whereby the price per share of the preferred stock of investor A is adjusted downward due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to match the price of investor B's preferred stock. Usually as a result of the implementation of a ratchet, company management and employees who own a fixed amount of common shares suffer significant dilution. See Narrow-based weighted average ratchet and Broad-based weighted average ratchet
Fully diluted basis — a methodology for calculating any per share ratios whereby the denominator is the total number of shares issued by the company on the assumption that all warrants and options are exercised and preferred stock.
Fund-of-funds — a fund created to invest in private equity funds. Typically, individual investors and relatively small institutional investors participate in a fund-of-funds to minimize their portfolio management efforts.
Gatekeepers — intermediaries which endowments, pension funds and other institutional investors use as advisors regarding private equity investments.
General partner (GP) — a class of partner in a partnership. The general partner retains liability for the actions of the partnership. In the private equity world, the GP is the fund manager while the limited partners (LPs) are the institutional and high net worth investors in the partnership. The GP earns a management fee and a percentage of profits (see Carried interest).
GP — see General partner.
Going-private transaction — when a public company chooses to pay off all public investors, delist from all stock exchanges, and become owned by management, employees, and select private investors.
Golden handcuffs — financial incentives that discourage founders and / or important employees from leaving a company before a predetermined date or important milestone.
Grossing up — an adjustment of an option pool for management and employees of a company which increases the number of shares available over time. This usually occurs after a financing round whereby one or more investors receive a relatively large percentage of the company. Without a grossing up, managers and employees would suffer the financial and emotional consequences of dilution, thereby potentially affecting the overall performance of the company.
Growth stage — the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service. Also known as "middle stage."
Hamburger helper — a colorful label for a traditional bridge loan that includes the right of the bridge lender to convert the note to preferred stock at a price that is a 20% discount from the price of the preferred stock in the next financing round.
Hart-Scott-Rodino Act — a law requiring entities that acquire certain amounts of stock or assets of a company to inform the Federal Trade Commission and the Department of Justice and to observe a waiting period before completing the transaction.
Harvest — to generate cash or stock from the sale or IPO of companies in a private equity portfolio of investments
Hedge fund — an investment fund that has the ability to use leverage, take short positions in securities, or use a variety of derivative instruments in order to achieve a return that is relatively less correlated to the performance of typical indices (such as the S&P 500) than traditional long-only funds. Hedge fund managers are typically compensated based on assets under management as well as fund performance.
High yield debt — debt issued via public offering or public placement (Rule 144A) that is rated below investment grade by S&P or Moody's. This means that the debt is rated below the top four rating categories (i.e. S&P BB+, Moody's Ba2 or below). The lower rating is indicative of higher risk of default, and therefore the debt carries a higher coupon or yield than investment grade debt. Also referred to as Junk bonds or Sub-investment grade debt.
Hockey stick — the general shape and form of a chart showing revenue, customers, cash, or some other financial or operational measure that increases dramatically at some point in the future. Entrepreneurs often develop business plans with hockey stick charts to impress potential investors.
Holding period — amount of time an investment remains in a portfolio.
Hot issue — stock in an initial public offering that is in high demand.
Hot money — capital from investors that have no tolerance for lack of results by the investment manager and move quickly to withdraw at the first sign of trouble.
Hurdle rate — a minimum rate of return required before an investor will make an investment.
Incorporation — the process by which a business receives a state charter, allowing it to become a corporation. Many corporations choose Delaware because its laws are business-friendly and up to date.
Incubator — a company or facility designed to host startup companies. Incubators help startups grow while controlling costs by offering networks of contacts and shared backoffice resources.
Indenture — the terms and conditions between a bond issuer and bond buyers.
Initial public offering (IPO) — the first offering of stock by a company to the public. New public offerings must be registered with the Securities and Exchange Commission. An IPO is one of the methods that a startup that has achieved significant success can use to raise additional capital for further growth. See Qualified IPO.
In-kind distribution — a distribution to limited partners of a private equity fund that is in the form of publicly traded shares rather than cash.
Inside round — a round of financing in which the investors are the same investors as the previous round. An inside round raises liability issues since the valuation of the company has no third party verification in the form of an outside investor. In addition, the terms of the inside round may be considered self-dealing if they are onerous to any set of shareholders or if the investors give themselves additional preferential rights.
Institutional investor — professional entities that invest capital on behalf of companies or individuals. Examples are: pension plans, insurance companies and university endowments.
Intellectural property — knowledge, techniques, writings and images that are intangible but often protected by law via patents, copyrights, and trademarks.
Interest coverage ratio — earnings before interest and taxes (EBIT) divided by interest expense. This is a key ratio used by lenders to assess the ability of a company to produce sufficient cash to pay its debt obligation.
Internal rate of return (IRR) — the interest rate at which a certain amount of capital today would have to be invested in order to grow to a specific value at a specific time in the future.
Investment thesis / Investment philosophy — the fundamental ideas which determine the types of investments that an investment fund will choose in order to achieve its financial goals.
IPO — see Initial public offering
IRR — see Internal rate of return
Issuer — the company that chooses to distribute a portion of its stock to the public.
J curve — a concept that during the first few years of a private equity fund, cash flow or returns are negative due
Junior debt — a loan that has a lower priority than a senior loan in case of a liquidation of the asset or borrowing company. Also known as "subordinated debt".
Junk bond — see High Yield Debt.
Later stage — the state of a company that has proven its concept, achieved significant revenues compared to its competition, and is approaching cash flow break even or positive net income. Typically, a later stage company is about 6 to 12 months away from a liquidity event such as an IPO or buyout. The rate of return for venture capitalists that invest in later stage, less risky ventures is lower than in earlier stage ventures.
LBO — see Leveraged buyout
Lead investor — the venture capital investor that makes the largest investment in a financing round and manages the documentation and closing of that round. The lead investor sets the price per share of the financing round, thereby determining the valuation of the company.
Letter of intent — a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as a "Term Sheet".
Leverage — the use of debt to acquire assets, build operations and increase revenues. By using debt, a company is attempting to achieve results faster than if it only used its cash available from pre-leverage operations. The risk is that the increase in assets and revenues does not generate sufficient net income and cash flow to pay the interest costs of the debt.
Leveraged recapitalization —the reorganization of a company's capital structure resulting in more debt added to the balance sheet. Private equity funds can recapitalize a portfolio company and then direct the company to issue a one-time dividend to equity investors. This is often done when the company is performing well financially and the debt markets are expanding.
Leveraged buyout (LBO) — the purchase of a company or a business unit of a company by an outside investor using mostly borrowed capital.
Leverage ratios — measurements of a company's debt as a multiple of cash flow. Typical leverage ratios include Total Debt / EBITDA, Total Debt / (EBITDA minus Capital Expenditures), and Seniore Debt / EBITDA.
L.I.B.O.R — see The London Interbank Offered Rate.
License — a contract in which a patent owner grants to a company the right to make, use or sell an invention under certain circumstances and for compensation.
Limited liability company (LLC) — an ownership structure designed to limit the founders' losses to the amount of their investment. An LLC does not pay taxes, rather its owners pay taxes on their proportion of the LLC profits at their individual tax rates.
Limited partnership — a legal entity composed of a general partner and various limited partners. The general partner manages the investments and is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original investment. The general partner receives a management fee and a percentage of profits (see Carried interest), while the limited partners receive income, capital gains and tax benefits.
Limited partner (LP) — an investor in a limited partnership. The general partner is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original investment. The limited partner receives income, capital gains and tax benefits.
Liquidation — the selling off of all assets of a company prior to the complete cessation of operations. Corporations that choose to liquidate declare Chapter 7 bankruptcy. In a liquidation, the claims of secured and unsecured creditors, bondholders and preferred stockholders take precedence over common stockholders.
Liquidation preference — the contractual right of an investor to priority in receiving the proceeds from the liquidation of a company. For example, a venture capital investor with a "2x liquidation preference" has the right to receive two times its original investment upon liquidation.
Liquidity discount — a decrease in the value of a private company compared to the value of a similar but publicly traded company. Since an investor in a private company cannot readily sell his or her investment, the shares in the private company must be valued less than a comparable public company.
Liquidity event — a transaction whereby owners of a significant portion of the shares of a private company sell their shares in exchange for cash or shares in another, usually larger company. For example, an IPO is a liquidity event.
Lock-up agreement — investors, management and employees often agree not to sell their shares for a specific time period after an IPO, usually 6 to 12 months. By avoiding large sales of its stock, the company has time to build interest among potential buyers of its shares.
London Interbank Offered Rate (L.I.B.O.R.) — the average rate charged by large banks in London for loans to each other. LIBOR is a relatively volatile rate and is typically quoted in maturities of one month, three months, six months and one year.
LP — see Limited partner
.
Management buyout (MBO) — a leveraged buyout controlled by the members of the management team of a company or a division.
Management fee — a fee charged to the limited partners in a fund by the general partner. Management fees in a private equity fund typically range from 0.75% to 3% of capital under management, depending on the type and size of fund.
Management rights — the rights often required by a venture capitalist as part of the agreement to invest in a company. The venture capitalist has the right to consult with management on key operational issues, attend board meetings and review information about the company's financial situation.
Market capitalization — the value of a publicly traded company as determined by multiplying the number of shares outstanding by the current price per share.
MBO — see Management buyout
Mezzanine — a layer of financing that has intermediate priority (seniority) in the capital structure of a company. For example, mezzanine debt has lower priority than senior debt but usually has a higher interest rate and often includes warrants. In venture capital, a mezzanine round is generally the round of financing that is designed to help a company have enough resources to reach an IPO.
Middle stage — the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service. Also known as "growth stage."
Milestones — a valuation methodology that compares public and private companies in terms of a ratio of value to an operations figure such as revenue or net income. For example, if several publicly traded computer hardware companies are valued at approximately 2 times revenues, then it is reasonable to assume that a startup computer hardware company that is growing fast has the potential to achieve a valuation of 2 times its revenues. Before the startup issues its IPO, it will likely be valued at less than 2 times revenue because of the lack of liquidity of its shares. See Liquidity discount.
Multiples — operational or financial goals of a company that are often used to determine whether a company will receive additional financing or whether management will receive additional compensation.
Narrow-based weighted average ratchet — a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to a weighed average of investor A's price and investor B's price. A narrow-based ratchet uses only common stock outstanding in the denominator of the formula for determining the new weighed average price.
NDA — see Non-disclosure agreement.
Net operating income (NOI) — a measure of cash flow that excludes the effects of financing decisions. NOI is calculated as earnings before interest and taxes multiplied by one minus the tax rate. Also known as profit after taxes (NOPAT).
No-shop clause — a section of an agreement to purchase a company whereby the seller agrees not to market the company to other potential buyers for a specific time period.
Non-compete — an agreement often signed by employees and management whereby they agree not to work for competitor companies or form a new competitor company within a certain time period after termination of employment.
Non-cumulative dividends — dividends that are payable to owners of preferred stock at a specific point in time only if there is sufficient cash flow available after all company expenses have been paid. If cash flow is insufficient, the owners of the preferred stock will not receive the dividends owed for that time period and will have to wait until the board of directors declares another set of dividends.
Non-interference — an agreement often signed by employees and management whereby they agree not to interfere with the company's relationships with employees, clients, suppliers, and subcontractors within a certain time period after termination of employment.
Non-solicitation — an agreement often signed by employees and management whereby they agree not to solicit other employees of the company regarding job opportunities.
Non-disclosure agreement (NDA) — an agreement issued by entrepreneurs to protect the privacy of their ideas when disclosing those ideas to third parties.
Offering memorandum — a legal document that provides details of an investment to potential investors. See Private placement memorandum.
OID — see Original issue discount.
Operating cash flow — the cash flow produced from the operation of a business, not from investing activities (such as selling assets) or financing activities (such as issuing debt). Calculated as net operating income (NOI) plus depreciation.
Optics — the way a concept is presented. Sometimes entrepreneurs' presentations are strong on optics but weak in content.
Options — see Stock options.
Option pool — a group of options set aside for long term, phased compensation to management and employees.
Original issue discount (OID) — a discount from par value of a bond or debt-like instrument. In structuring a private equity transaction, the use of a preferred stock with liquidation preference or other clauses that guarantee a fixed payment in the future can potentially create adverse tax consequences. The IRS views this cash flow stream as, in essence, a zero coupon bond upon which tax payments are due yearly based on "phantom income" imputed from the difference between the original investment and "guaranteed" eventual payout. Although complex, the solution is to include enough clauses in the investment agreements to create the possibility of a material change in the cash flows of owners of the preferred stock under different scenarios of events such as a buyout, dissolution or IPO.
Orphan — a startup company that does not have a venture capitalist as an investor.
Outstanding shares — the total amount of common shares of a company, not including treasury stock, convertible preferred stock, warrants, and options.
Oversubscription — when demand exceeds supply for shares of an IPO or a private placement.
Pay to play — a clause in a financing agreement whereby any investor that does not participate in a future round agrees to suffer significant dilution compared to other investors. The most onerous version of "pay to play" is automatic conversion to common shares, which in essence ends any preferential rights of an investor, such as the right to influence key management decisions.
Pari passu — a legal term referring to the equal treatment of two or more parties in an agreement. For example, a venture capitalists may agree to have registration rights that are pari passu with the other investors in a financing round.
Participating dividends — the right of holders of certain preferred stock to receive dividends and participate in additional distributions of cash, stock or other assets.
Participating preferred stock — a unit of ownership composed of preferred stock and common stock. The preferred stock entitles the owner to receive a predetermined sum of cash (usually the original investment plus accrued dividends) if the company is sold or has an IPO. The common stock represents additional continued ownership in the company. Participating preferred stock has been characterized as "having your cake and eating it too."
Patent — a legal right to sue any person or company that attempts to use, manufacture or sell the patented product or process.
PEIGG — acronym for Private equity Industry Guidelines Group, an ad hoc group of individuals and firms involved in the private equity industry for the purpose of establishing valuation and reporting guidelines.
PE ratio — see Price earnings ratio.
Piggyback rights — rights of an investor to have his or her shares included in a registration of a startup's shares in preparation for an IPO.
PIPEs — see Private investment in public equities.
Placement agent — a company that specializes in finding institutional investors that are willing and able to invest in a private equity fund. Sometimes a private equity fund will hire a placement agent so the fund partners can focus on making and managing investments in companies rather than on raising capital.
Portfolio company — a company that has received an investment from a private equity fund.
Post-money valuation — the valuation of a company including the capital provided by the current round of financing. For example, a venture capitalist may invest $5 million in a company valued at $2 million "pre-money" (before the investment was made). As a result, the startup will have a post-money valuation of $7 million.
Preemptive rights — the rights of shareholders to maintain their percentage ownership of a company by buying shares sold by the company in the future financing rounds.
PPM — see Private placement memorandum.
Preference — seniority, usually with respect to dividends and proceeds from a sale or dissolution of a company.
Preferred return — a minimum return per annum that must be generated for limited partners of a private equity fund before the general partner can begin receiving a percentage of profits from investments.
Preferred stock — a type of stock that has certain rights that common stock does not have. These special rights may include dividends, participation, liquidity preference, anti-dilution protection and veto provisions, among others. Private equity investors usually purchase preferred stock when they make investments in companies.
Pre-money valuation — the valuation of a company prior to the current round of financing. For example, a venture capitalist may invest $5 million in a company valued at $2 million pre-money. As a result, the startup will have a "post-money" valuation of $7 million.
Price earnings ratio (PE ratio) — the ratio of a public company's price per share and its net income after taxes on a per share basis.
Primary shares — shares sold by a corporation (not by individual shareholders).
Private equity — equity investments in nonpublic companies.
Private investment in public equities (PIPES) — investments by a private equity fund in a publicly traded company, usually at a discount.
Private placement — the sale of a security directly to a limited number of institutional and qualified individual investors. If structured correctly, a private placement avoids registration with the Securities and Exchange Commission.
Private placement memorandum (PPM) — a document explaining the details of an investment to potential investors. For example, a private equity fund will issue a PPM when it is raising capital from institutional investors. Also, a startup may issue a PPM when it needs growth capital. Also known as "Offering Memorandum."
Private securities — securities that are not registered with the Securities and Exchange Commission and do not trade on any exchanges. The price per share is negotiated between the buyer and the seller (the "issuer").
Promote — see Carried interest.
Prospectus — a formal document that gives sufficient detail about a business opportunity for a prospective investor to make a decision. A prospectus must disclose any material risks and be filed with the Securities and Exchange Commission.
Prudent man rule — a fundamental principle for professional money management which serves as a basis for the Prudent Investor Act. The principle is based on a statement by Judge Samuel Putnum in 1830: "Those with the responsibility to invest money for others should act with prudence, discretion, intelligence and regard for the safety of capital as well as income."
Purchase method — a merger accounting treatment whereby a buyer purchases the assets (and liability obligations) of a company at their market price and then records the difference between the purchase price and the book value of the assets as goodwill. This goodwill need not be amortized but must be valued annually and any decreases or increases in value must be reflected in the buyer's financial statements.
Qualified IPO — a public offering of securities valued at or above a total amount specified in a financing agreement. This amount is usually specified to be sufficiently large to guarantee that the IPO shares will trade in a major exchange (NASDAQ or New York Stock Exchange). Usually upon a qualified IPO preferred stock is forced to convert to common stock.
Quartile — one fourth of the data points in a data set. Often, private equity investors are measured by the results of their investments during a particular period of time. Institutional investors often prefer to invest in private equity funds that demonstrate consistent results over time, placing in the upper quartile of the investment results for all funds.
Ratchet — a mechanism to prevent dilution. An anti-dilution clause is a contract clause that protects an investor from a reduction in percentage ownership in a company due to the future issuance by the company of additional shares to other entities.
Realization ratio — the ratio of cumulative distributions to paid-in capital. The realization ratio is used as a measure of the distributions from investment results of a private equity partnership compared to the capital under management.
Recapitalization — the reorganization of a company's capital structure.
Red herring — a preliminary prospectus filed with the Securities and Exchange Commission and containing the details of an IPO offering. The name refers to the disclosure warning printed in red letters on the cover of each preliminary prospectus advising potential investors of the risks involved.
Redeemable preferred — preferred stock that can be redeemed by the owner (usually a venture capital investor) in exchange for a specific sum of money.
Redemption rights — the right of an investor to force the startup company to buy back the shares issued as a result of the investment. In effect, the investor has the right to take back his/her investment and may even negotiate a right to receive an additional sum in excess of the original investment.
Registration — the process whereby shares of a company are registered with the Securities and Exchange Commission under the Securities Act of 1933 in preparation for a sale of the shares to the public.
Registration rights — the rights of an investor in a startup regarding the registration of a portion of the startup's shares for sale to the public. Piggyback rights give the shareholders the right to have their shares included in a registration. Demand rights give the shareholders the option to force management to register the company's shares for a public offering. Often times registration rights are hotly negotiated among venture capitalists in multiple rounds of financing.
Regulation D — an SEC regulation that governs private placements. Private placements are investment offerings for institutional and accredited individual investors but not for the general public. There is an exception that 35 nonaccredited investors can participate.
Restricted shares — shares that cannot be traded in the public markets.
Return on investment (ROI) — the proceeds from an investment, during a specific time period, calculated as a percentage of the original investment. Also, net profit after taxes divided by average total assets.
Rights offering — an offering of stock to current shareholders that entitles them to purchase the new issue, usually at a discount.
Rights of co-sale with founders — a clause in venture capital investment agreements that allows the VC fund to sell shares at the same time that the founders of a startup chose to sell.
Right of first refusal — a contractual right to participate in a transaction. For example, a venture capitalist may participate in a first round of investment in a startup and request a right of first refusal in any following rounds of investment.
Road show — presentations made in several cities to potential investors and other interested parties. For example, a company will often make a road show to generate interest among institutional investors prior to its IPO.
ROI — see Return on investment.
Rollup — the purchase of relatively smaller companies in a sector by a rapidly growing company in the same sector. The strategy is to create economies of scale. For example, the movie theater industry underwent significant consolidation in the 1960s and 1970s.
Round — a financing event usually involving several private equity investors.
Royalties — payments made to patent or copyright owners in exchange for the use of their intellectual property.
Rule 144 — a rule of the Securities and Exchange Commission that specifies the conditions under which the holder of shares acquired in a private transaction may sell those shares in the public markets.
S corporation — an ownership structure that limits its number of owners to 100. An S corporation does not pay taxes, rather its owners pay taxes on their proportion of the corporation's profits at their individual tax rates.
Scalability — a characteristic of a new business concept that entails the growth of sales and revenues with a much slower growth of organizational complexity and expenses. Venture capitalists look for scalability in the startups they select to finance.
Scale-down — a schedule for phased decreases in management fees for general partners in a limited partnership as the fund reduces its investment activities toward the end of its term.
Scale-up — the process of a company growing quickly while maintaining operational and financial controls in place.
Search fund — a market for the sale of partnership interests in private equity funds. Sometimes limited partners chose to sell their interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown schedule. Certain investment companies specialize in buying these partnership interests at a discount.
SEC — see Securities and Exchange Commission.
Secondary market — a market for the sale of partnership interests in private equity funds. Sometimes limited partners chose to sell their interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown schedule. Certain investment companies specialize in buying these partnership interests at a discount.
Secondary shares — shares sold by a shareholder (not by the corporation).
Secured debt — debt that has seniority in case the borrowing company defaults or is dissolved and its assets sold to pay creditors.
Security — a document that represents an interest in a company. Shares of stock, notes and bonds are examples of securities.
Securities and Exchange Commission (SEC) — the regulatory body that enforces federal securities laws such as the Securities Act of 1933 and the Securities Exchange Act of 1934.
Seed capital — investment provided by angels, friends and family to the founders of a startup in seed stage.
Seed stage — the state of a company when it has just been incorporated and its founders are developing their product or service.
Senior debt — a loan that has a higher priority in case of a liquidation of the asset or company.
Seniority — higher priority.
Series A preferred stock — preferred stock issued by a fast growth company in exchange for capital from investors in the "A" round of financing. This preferred stock is usually convertible to common shares upon the IPO or sale of the company.
Sharpe-ratio — a method of calculating the risk-adjusted return of an investment. The Sharpe Ratio is calculated by subtracting the risk-free rate from the return on a specific investment for a time period (usually one year) and then dividing the resulting figure by the standard deviation of the historical (annual) returns for that investment. The higher the Sharpe Ratio, the better.
Small Business Investment Company (SBIC) — a company licensed by the Small Business Administration to receive government capital in the form of debt or equity in order to use in private equity investing.
Spin out — a division of an established company that becomes an independent entity.
Stock — a share of ownership in a corporation.
Stock option — a right to purchase or sell a share of stock at a specific price within a specific period of time. Stock purchase options are commonly used as long term incentive compensation for employees and management of fast growth companies.
Strategic investor — a relatively large corporation that agrees to invest in a young company in order to have access to a proprietary technology, product or service. By having this access, the corporation can potentially achieve its strategic goals.
Subordinated debt — a loan that has a lower priority than a senior loan in case of a liquidation of the asset or company. Also known as "junior debt".
Sweat equity — ownership of shares in a company resulting from work rather than investment of capital.
Syndicate — a group of investors that agree to participate in a round of funding for a company. Alternatively, a syndicate can refer to a group of investment banks that agree to participate in the sale of stock to the public as part of an IPO.
Syndication — the process of arranging a syndicate.
Tag-along right — the right of a minority investor to receive the same benefits as a majority investor. Usually applies to a sale of securities by investors. Also known as Co-sale right.
Takedown — a schedule of the transfer of capital in phases in order to complete a commitment of funds. Typically, a takedown is used by a general partner of a private equity fund to plan the transfer of capital from the limited partners.
Takeover — the transfer of control of a company.
Ten bagger — an investment that returns 10 times the initial capital.
Tender offer — an offer to public shareholders of a company to purchase their shares.
Term loan — a bank loan for a specific period of time, usually up to ten years in leveraged buyout structures.
Term sheet — a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as "Letter of Intent".
Trade secret — something that is not generally known, is kept in secrecy and gives its owners a competitive business advantage.
Tranche — a portion of a set of securities. Each tranche may have different rights or risk characteristics.
Turnaround — a process resulting in a substantial increase in a company's revenues, profits and reputation.
Two x — a statement referring to 2 times the original amount. For example, a preferred stock may have a "two x" liquidation preference, so in case of liquidation of the company, the preferred stock investor would receive twice his or her original investment.
Under water option — an option is said to be under water if the current fair market value of a stock is less than the option exercise price.
Underwriter — an investment bank that chooses to be responsible for the process of selling new securities to the public. An underwriter usually chooses to work with a syndicate of investment banks in order to maximize the distribution of the securities.
Unsecured debt — debt which does not have any priority in case of dissolution of the company and sale of its assets.
Venture capital — a segment of the private equity industry which focuses on investing in new companies with high growth rates.
Venture capital method — a valuation method whereby an estimate of the future value of a company is discounted by a certain interest rate and adjusted for future anticipated dilution in order to determine the current value. Usually, discount rates for the venture capital method are considerably higher than public stock return rates, representing the fact that venture capitalists must achieve significant returns on investment in order to compensate for the risks they take in funding unproven companies.
Vesting — a schedule by which employees gain ownership over time of a previously agreed upon amount of retirement funding or stock options.
Vintage — the year that a private equity fund stops accepting new investors and begins to make investments on behalf of those investors.
Voting rights — the rights of holders of preferred and common stock in a company to vote on certain acts affecting the company. These matters may include payment of dividends, issuance of a new class of stock, merger or liquidation.
Warrant — a security which gives the holder the right to purchase shares in a company at a pre-determined price. A warrant is a long term option, usually valid for several years or indefinitely. Typically, warrants are issued concurrently with preferred stocks or bonds in order to increase the appeal of the stocks or bonds to potential investors.
Washout round — a financing round whereby previous investors, the founders, and management suffer significant dilution. Usually as a result of a washout round, the new investor gains majority ownership and control of the company.
Weighted average cost of capital (WACC) — the average of the cost of equity and the after-tax cost of debt. This average is determined using weight factors based on the ratio of equity to debt plus equity and the ratio of debt to debt plus equity.
Weighted average ratchet — an anti-dilution protection mechanism whereby the conversion rate of preferred stock is adjusted in order to reduce an investor's loss due to an increase in the number of shares in a company. Without a ratchet, an investor would suffer from a dilution of his or her percentage ownership. Usually as a result of the implementation of a weighted average ratchet, company management and employees who own a fixed amount of common shares suffer significant dilution, but not as badly as in the case of a full ratchet.
Wipeout round — see Washout round.
Wipeout bridge — a short term financing that has onerous features whereby if the company does not secure additional long term financing within a certain time frame, the bridge investor gains ownership control of the company. See Bridge financing.
Write-down — a decrease in the reported value of an asset or a company.
Write-off — a decrease in the reported value of an asset or a company to zero.
Write-up — an increase in the reported value of an asset or a company.
Zombie — a company that has received capital from investors but has only generated sufficient revenues and cash flow to maintain its operations without significant growth. Typically, a venture capitalist has to make a difficult decision as to whether to kill off a zombie or continue to invest funds in the hopes that the zombie will become a winner.
http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html
"A" round — a financing event whereby venture capitalists become involved in a fast-growth company that was previously financed by founders and/or angels.
Accredited investor — a person or legal entity, such as a company or trust fund, that meets certain net worth and income qualifications and is considered to be sufficiently sophisticated to make investment decisions in complex situations. Regulation D of the Securities Act of 1933 exempts accredited investors from protection under the Securities Act. Typical qualifications for a person are: $1 million net worth and annual income exceeding $200,000 individually or $300,000 with a spouse. Directors and executive officers are considered to be accredited investors.
After-tax operating income — see Net operating income after taxes.
Airball — a loan whose value exceeds the value of the collateral.
Alpha — a term derived from statistics and finance theory that is used to describe the return produced by a fund manager in excess of the return of a benchmark index. Manager returns and benchmark returns are measured net of the risk-free rate. In addition, manager returns are adjusted for the risk of the manager's portfolio relative to the risk of the benchmark index. Alpha is a proxy for manager skill.
Alternative asset class — a class of investments that includes private equity, real estate, and oil and gas, but excludes publicly traded securities. Pension plans, college endowments, and other relatively large institutional investors typically allocate a certain percentage of their investments to alternative assets with an objective to diversify their portfolios.
Angel — a wealthy individual that invests in companies in relatively early stages of development. Usually angels invest less than $1 million per startup. The typical angel-financed startup is in concept or product development phase.
Anti-dilution — a contract clause that protects an investor from a substantial reduction in percentage ownership in a company due to the issuance by the company of additional shares to other entities. The mechanism for making adjustments is called a Ratchet.
"B" round — a financing event whereby professional investors such as venture capitalists are sufficiently interested in a company to provide additional funds after the "A" round of financing. Subsequent rounds are called "C", "D", and so on.
Balloon payment — a relatively large principal payment due at a specific time as required by a lender.
Basis point ("bp") — one one-hundredth (1/100) of a percentage unit. For example, 50 basis points equals one half of one percent. Banks quote variable loan rates in terms of an index plus a margin and the margin is often described in basis points, such as LIBOR plus 400 basis points (or, as the experts say, "beeps").
Best efforts offering — a commitment by a syndicate of investment banks to use best efforts to ensure the sale to investors of a company's offering of securities. In a best efforts offering, the syndicate avoids any firm commitment for a specific number of shares or bonds.
Beta — a measure of volatility of a public stock relative to an index or a composite of all stocks in a market or geographical region. A beta of more than one indicates the stock has higher volatility than the index (or composite) and a beta of one indicates volatility equivalent to the index (or composite). For example, the price of a stock with a beta of 1.5 will change by 1.5% if the index value changes by 1%. Typically, the S&P500 index is used in calculating the beta of a stock.
Beta Product — a product that is being tested by potential customers prior to being formally launched into the marketplace.
Blow-out round — see Cram-down round
Blue sky — regulations in individual states regarding the sale of securities and mutual funds. These laws are intended to protect investors from purposely fraudulent transactions.
Board of directors — a group of individuals, typically composed of managers, investors, and experts, which have a fiduciary responsibility for the well being and proper guidance of a corporation. The board is elected by the shareholders.
Boat anchor — a person, project or activity that hinders the growth of a company.
Book — see Private placement memorandum
Book runner — the lead bank that manages the transaction process for an equity or debt financing, including documentation, syndication, pricing, allocation and closing.
Book value — the book value of a company is the value of the common stock (total assets minus liabilities minus preferred stock minus intangible assets). The book value of an asset of a company is typically based on its original cost minus accumulated depreciation.
Bootstrapping — the actions of a startup to minimize expenses and build cash flow, thereby reducing or eliminating the need for outside investors.
Bp — see Basis point.
Bridge financing — temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders. In venture capital, a bridge is usually a short term note (6 to 12 months) that converts to preferred stock. Typically, the bridge lender has the right to convert the note to preferred stock at a price that is a 20% discount from the price of the preferred stock in the next financing round. See Wipeout bridge and Hamburger Helper bridge.
Broad-based weighted average ratchet — a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to a weighed average of investor A's price and investor B's price. A broad-based ratchet uses all common stock outstanding on a fully diluted basis (including all convertible securities, warrants and options) in the denominator of the formula for determining the new weighted average price. See Narrow-based weighted average ratchet.
Bullet payment — a payment of all principal due at a time specified by a bank or a bond issuer.
Burn rate — the rate at which a startup with little or no revenue uses cash savings to cover expenses. Usually expressed on a monthly or weekly basis.
Business Development Company (BDC) — a publicly traded company that invests in private companies and is required by law to provide meaningful support and assistance to its portfolio companies.
Business plan — a document that describes a new concept for a business opportunity. A business plan typically includes the following sections: executive summary, market need, solution, technology, competition, marketing, management, operations and financials.
Buyout — a sector of the private equity industry. Also, the purchase of a controlling interest of a company by an outside investor (in a leveraged buyout) or a management team (in a management buyout).
Buy-sell agreement — a contract that sets forth the conditions under which a shareholder must first offer his or her shares for sale to the other shareholders before being allowed to sell to entities outside the company.
C corporation — an ownership structure that allows any number of individuals or companies to own shares. A C corporation is a stand-alone legal entity, so it offers some protection to its owners, managers and investors from liability resulting from its actions.
Call date — when a bond issuer has the right to retire part or all of a bond issuance at a specific price.
Call premium — the premium above par value that an issuer is willing to pay as part of the redemption of a bond issue prior to maturity.
Call price — the price an issuer agrees to pay to bondholders to redeem all or part of a bond issuance.
Call protection — a provision in the terms of a bond specifying the period of time during which the bond cannot be called by the issuer.
Capital Asset Pricing Model (CAPM) — a method of estimating the cost of equity capital of a company. The cost of equity capital is equal to the return of a risk-free investment plus a premium that reflects the risk of the company's equity.
Capital call — when a private equity fund manager (usually a "general partner" in a partnership) requests that an investor in the fund (a "limited partner") provide additional capital. Usually a limited partner will agree to a maximum investment amount and the general partner will make a series of capital calls over time to the limited partner as opportunities arise to finance startups and buyouts.
Capital gap — the difficulty faced by entrepreneurs trying to raise between $2 million and $5 million. Friends, family and angel investors are typically good sources for financing rounds of less than $2 million, while many venture capital funds have become so large that they are only interested in investing amounts greater than $5 million.
Capitalization table — a table showing the owners of a company's shares and their ownership percentages as well as the debt holders. It also lists the forms of ownership, such as common stock, preferred stock, warrants, options, senior debt, and subordinated debt.
Capital gains — a tax classification of investment earnings resulting from the purchase and sale of assets. Typically, an investor prefers that investment earnings be classified as long term capital gains (held for a year or longer), which are taxed at a lower rate than ordinary income.
Capital stock — a description of stock that applies when there is only one class of shares. This class is known as common stock.
Capped participating preferred stock — preferred stock whose participating feature is limited so that an investor cannot receive more than a specified amount. See Participating preferred
Carried interest — a share in the profits of a private equity fund. Typically, a fund must return the capital given to it by limited partners plus any preferential rate of return before the general partner can share in the profits of the fund. The general partner will then receive a 20% carried interest, although some successful firms receive 25%-30%. Also known as "carry" or "promote."
Catch-up — a clause in the agreement between the general partner and the limited partners of a private equity fund. Once the limited partners have received a certain portion of their expected return, the general partner can then receive a majority of profits until the previously agreed upon profit split is reached.
Change of control bonus — a bonus of cash or stock given by private equity investors to members of a management group if they successfully negotiate a sale of the company for a price greater than a specified amount.
Clawback — a clause in the agreement between the general partner and the limited partners of a private equity fund. The clawback gives limited partners the right to reclaim a portion of disbursements to a general partner for profitable investments based on significant losses from later investments in a portfolio.
Closing — the conclusion of a financing round whereby all necessary legal documents are signed and capital has been transferred.
Club deal — see Co-investment.
Co-investment — either a) the right of a limited partner to invest with a general partner in portfolio companies, or b) the act of investing by two or more entities in the same target company (also known as a Club deal).
Collateral — hard assets of the borrower, such as real estate or equipment, for which a lender has a legal interest until a loan obligation is fully paid off.
Commitment — an obligation, typically the maximum amount that a limited partner agrees to invest in a fund.
Common stock — a type of security representing ownership rights in a company. Usually, company founders, management and employees own common stock while investors own preferred stock. In the event of a liquidation of the company, the claims of secured and unsecured creditors, bondholders and preferred stockholders take precedence over common stockholders. See Preferred stock
Comparable — a publicly traded company with similar characteristics to a private company that is being valued. For example, a telecommunications equipment manufacturer whose market value is 2 times revenues can be used to estimate the value of a similar and relatively new company with a new product in the same industry. See Liquidity discount
Control — the authority of an individual or entity that owns more than 50% of equity in a company or owns the largest block of shares compared to other shareholders.
Consolidation — see Rollup
Conversion — the right of an investor or lender to force a company to replace the investor's preferred shares or the lender's debt with common shares at a preset conversion ratio. A conversion feature was first used in railroad bonds in the 1800s.
Convertible debt — a loan which allows the lender to exchange the debt for common shares in a company at a preset conversion ratio.
Convertible preferred stock — a type of stock that gives an owner the right to convert to common shares of stock. Usually, preferred stock has certain rights that common stock doesn't have, such as decision-making management control, a promised return on investment (dividend), or senior priority in receiving proceeds from a sale or liquidation of the company. Typically, convertible preferred stock automatically converts to common stock if the company makes an initial public offering (IPO). Convertible preferred is the most common tool for private equity funds to invest in companies.
Convertible security — a security that gives its owner the right to exchange the security for common shares in a company at a preset conversion ratio. The security is typically preferred stock, warrants or debt.
Co-sale right — a contractual right of an investor to sell some of the investor's stock along with the founder's or majority shareholder's stock if either the founder or majority shareholder elects to sell stock to a third-party. Also known as Tag-along right.
Cost of capital — see Weighted average cost of capital
Cost of revenue — the expenses generated by the core operations of a company.
Covenant — a legal promise to do or not do a certain thing. For example, in a financing arrangement, company management may agree to a negative covenant, whereby it promises not to incur additional debt. The penalties for violation of a covenant may vary from repairing the mistake to losing control of the company.
Coverage ratio — describes a company's ability to pay debt from cash flow or profits. Typical measures are EBITDA/Interest, (EBITDA minus Capital Expenditures)/Interest, and EBIT/Interest.
Cram down round — a financing event upon which new investors with substantial capital are able to demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the startup company to significantly reduce ("dilute") the ownership percentage of previous investors.
Cumulative dividends — the owner of preferred stock with cumulative dividends has the right to receive accrued (previously unpaid) dividends in full before dividends are paid to any other classes of stock.
Current ratio — the ratio of current assets to current liabilities.
Data room — a specific location where potential buyers / investors can review confidential information about a target company. This information may include detailed financial statements, client contracts, intellectual property, property leases, and compensation agreements.
Deal flow — a measure of the number of potential investments that a fund reviews in any given period.
Debt service — the ratio of a loan payment amount to available cash flow earned during a specific period. Typically lenders insist that a company maintain a certain debt service ratio or else risk penalties such as having to pay off the loan immediately.
Default — a company's failure to comply with the terms and conditions of a financing arrangement.
Defined benefit plan — a company retirement plan in which both the employee and the employer contribute to the plan. Typically the plan is based on the employee's salary and number of years worked. Fixed benefits are outlined when the employee retires. The employer bears the investment risk and is committed to providing the benefits to the employee. Defined benefit plan managers can invest in private equity funds.
Defined contribution plan — a company retirement plan in which the employee elects to contribute some portion of his or her salary into a retirement plan, such as a 401(k) or 403(b). With this type of plan, the employee bears the investment risk. The benefits depend solely on the amount of money made from investing the employee's contributions. Defined contribution plan capital cannot be invested in private equity funds.
Demand rights — a type of registration right. Demand rights give an investor the right to force a startup to register its shares with the SEC and prepare for a public sale of stock (IPO).
Dilution — the reduction in the ownership percentage of current investors, founders and employees caused by the issuance of new shares to new investors.
Dilution protection — see Anti-dilution and Ratchet
Direct costs — see Cost of revenue
Disbursement — an investment by a fund in a company.
Discount rate — the interest rate used to determine the present value of a series of future cash flows.
Discounted cash flow (DCF) — a valuation methodology whereby the present value of all future cash flows expected from a company is calculated.
Distressed debt — the bonds of a company that is either in or approaching bankruptcy. Some private equity funds specialize in purchasing such debt at deep discounts with the expectation of exerting influence in the restructuring of the company and then selling the debt once the company has meaningfully recovered.
Distribution — the transfer of cash or securities to a limited partner resulting from the sale, liquidation or IPO of one or more portfolio companies in which a general partner chose to invest.
Dividends — regular payments made by a company to the owners of certain securities. Typically, dividends are paid quarterly, by approval of the board of directors, to owners of preferred stock.
Down round — a round of financing whereby the valuation of the company is lower than the value determined by investors in an earlier round.
Drag-along rights — the contractual right of an investor in a company to force all other investors to agree to a specific action, such as the sale of the company.
Drawdown schedule — an estimate of the gradual transfer of committed investment funds from the limited partners of a private equity fund to the general partners.
Drive-by VC — a venture capitalist that only appears during board meetings of a portfolio company and rarely offers advice to management.
Due diligence — the investigatory process performed by investors to assess the viability of a potential investment and the accuracy of the information provided by the target company.
Dutch auction — a method of conducting an IPO whereby newly issued shares of stock are committed to the highest bidder, then, if any shares remain, to the next highest bidder, and so on until all the shares are committed. Note that the price per share paid by all buyers is the price commitment of the buyer of the last share.
Early stage — the state of a company after the seed (formation) stage but before middle stage (generating revenues). Typically, a company in early stage will have a core management team and a proven concept or product, but no positive cash flow.
Earnings before interest and taxes (EBIT) — a measurement of the operating profit of a company. One possible valuation methodology is based on a comparison of private and public companies' value as a multiple of EBIT.
Earnings before interest, taxes, depreciation and amortization (EBITDA) — a measurement of the cash flow of a company. One possible valuation methodology is based on a comparison of private and public companies' value as a multiple of EBITDA.
Earn out — an arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such as revenue or net income.
Elevator pitch — a concise presentation, lasting only a few minutes (an elevator ride), by an entrepreneur to a potential investor about an investment opportunity.
Employee Stock Ownership Program (ESOP) — a plan established by a company to reserve shares for long-term incentive compensation for employees.
Enterprise value (EV) — the sum of the market values of the common stock and long term debt of a company, minus cash.
Entrepreneur — an individual who starts his or her own business.
Entrepreneurship — the application of innovative leadership to limited resources in order to create exceptional value.
Equity — the ownership structure of a company represented by common shares, preferred shares or unit interests. Equity=Assets-Liabilities.
ESOP — see Employee Stock Ownership Program.
Evergreen fund — a fund that reinvests its profits in order to ensure the availability of capital for future investments.
Exit strategy — the plan for generating profits for owners and investors of a company. Typically, the options are to merge, be acquired or make an initial public offering (IPO). An alternative is to recapitalize (releverage the company and then pay dividends to shareholders).
Expansion stage — the stage of a company characterized by a complete management team and a substantial increase in revenues.
Fairness opinion — a letter issued by an investment bank that charges a fee to assess the fairness of a negotiated price for a merger or acquisition.
Firm commitment — a commitment by a syndicate of investment banks to purchase all the shares available for sale in a public offering of a company. The shares will then be resold to investors by the syndicate.
Flipping — the act of selling shares immediately after an initial public offering. Investment banks that underwrite new stock issues attempt to allocate shares to new investors that indicate they will retain the shares for several months. Often management and venture investors are prohibited from selling IPO shares until a "lock-up period" (usually 6 to 12 months) has expired.
Founder — a person who participates in the creation of a company. Typically, founders manage the company until it has enough capital to hire professional managers.
Founders stock — nominally priced common stock issued to founders, officers, employees, directors, and consultants.
Free cash flow to equity (FCFE) — the cash flow available after operating expenses, interest payments on debt, taxes, net principal repayments, preferred stock dividends, reinvestment needs and changes in working capital. In a discounted cash flow model to determine the value of the equity of a firm using FCFE, the discount rate used is the cost of equity.
Free cash flow to the firm (FCFF) — the operating cash flow available after operating expenses, taxes, reinvestment needs and changes in working capital, but before any interest payments on debt are made. In a discounted cash flow model to determine the enterprise value of a firm using FCFF, the discount rate used is the weighted average cost of capital (WACC).
First refusal — the right of a privately owned company to purchase any shares that employees would like to sell.
Friends & family financing — capital provided by the friends and family of founders of an early-stage company. Founders should be careful not to create an ownership structure that may hinder the participation of professional investors once the company begins to achieve success.
Full ratchet — an anti-dilution protection mechanism whereby the price per share of the preferred stock of investor A is adjusted downward due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to match the price of investor B's preferred stock. Usually as a result of the implementation of a ratchet, company management and employees who own a fixed amount of common shares suffer significant dilution. See Narrow-based weighted average ratchet and Broad-based weighted average ratchet
Fully diluted basis — a methodology for calculating any per share ratios whereby the denominator is the total number of shares issued by the company on the assumption that all warrants and options are exercised and preferred stock.
Fund-of-funds — a fund created to invest in private equity funds. Typically, individual investors and relatively small institutional investors participate in a fund-of-funds to minimize their portfolio management efforts.
Gatekeepers — intermediaries which endowments, pension funds and other institutional investors use as advisors regarding private equity investments.
General partner (GP) — a class of partner in a partnership. The general partner retains liability for the actions of the partnership. In the private equity world, the GP is the fund manager while the limited partners (LPs) are the institutional and high net worth investors in the partnership. The GP earns a management fee and a percentage of profits (see Carried interest).
GP — see General partner.
Going-private transaction — when a public company chooses to pay off all public investors, delist from all stock exchanges, and become owned by management, employees, and select private investors.
Golden handcuffs — financial incentives that discourage founders and / or important employees from leaving a company before a predetermined date or important milestone.
Grossing up — an adjustment of an option pool for management and employees of a company which increases the number of shares available over time. This usually occurs after a financing round whereby one or more investors receive a relatively large percentage of the company. Without a grossing up, managers and employees would suffer the financial and emotional consequences of dilution, thereby potentially affecting the overall performance of the company.
Growth stage — the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service. Also known as "middle stage."
Hamburger helper — a colorful label for a traditional bridge loan that includes the right of the bridge lender to convert the note to preferred stock at a price that is a 20% discount from the price of the preferred stock in the next financing round.
Hart-Scott-Rodino Act — a law requiring entities that acquire certain amounts of stock or assets of a company to inform the Federal Trade Commission and the Department of Justice and to observe a waiting period before completing the transaction.
Harvest — to generate cash or stock from the sale or IPO of companies in a private equity portfolio of investments
Hedge fund — an investment fund that has the ability to use leverage, take short positions in securities, or use a variety of derivative instruments in order to achieve a return that is relatively less correlated to the performance of typical indices (such as the S&P 500) than traditional long-only funds. Hedge fund managers are typically compensated based on assets under management as well as fund performance.
High yield debt — debt issued via public offering or public placement (Rule 144A) that is rated below investment grade by S&P or Moody's. This means that the debt is rated below the top four rating categories (i.e. S&P BB+, Moody's Ba2 or below). The lower rating is indicative of higher risk of default, and therefore the debt carries a higher coupon or yield than investment grade debt. Also referred to as Junk bonds or Sub-investment grade debt.
Hockey stick — the general shape and form of a chart showing revenue, customers, cash, or some other financial or operational measure that increases dramatically at some point in the future. Entrepreneurs often develop business plans with hockey stick charts to impress potential investors.
Holding period — amount of time an investment remains in a portfolio.
Hot issue — stock in an initial public offering that is in high demand.
Hot money — capital from investors that have no tolerance for lack of results by the investment manager and move quickly to withdraw at the first sign of trouble.
Hurdle rate — a minimum rate of return required before an investor will make an investment.
Incorporation — the process by which a business receives a state charter, allowing it to become a corporation. Many corporations choose Delaware because its laws are business-friendly and up to date.
Incubator — a company or facility designed to host startup companies. Incubators help startups grow while controlling costs by offering networks of contacts and shared backoffice resources.
Indenture — the terms and conditions between a bond issuer and bond buyers.
Initial public offering (IPO) — the first offering of stock by a company to the public. New public offerings must be registered with the Securities and Exchange Commission. An IPO is one of the methods that a startup that has achieved significant success can use to raise additional capital for further growth. See Qualified IPO.
In-kind distribution — a distribution to limited partners of a private equity fund that is in the form of publicly traded shares rather than cash.
Inside round — a round of financing in which the investors are the same investors as the previous round. An inside round raises liability issues since the valuation of the company has no third party verification in the form of an outside investor. In addition, the terms of the inside round may be considered self-dealing if they are onerous to any set of shareholders or if the investors give themselves additional preferential rights.
Institutional investor — professional entities that invest capital on behalf of companies or individuals. Examples are: pension plans, insurance companies and university endowments.
Intellectural property — knowledge, techniques, writings and images that are intangible but often protected by law via patents, copyrights, and trademarks.
Interest coverage ratio — earnings before interest and taxes (EBIT) divided by interest expense. This is a key ratio used by lenders to assess the ability of a company to produce sufficient cash to pay its debt obligation.
Internal rate of return (IRR) — the interest rate at which a certain amount of capital today would have to be invested in order to grow to a specific value at a specific time in the future.
Investment thesis / Investment philosophy — the fundamental ideas which determine the types of investments that an investment fund will choose in order to achieve its financial goals.
IPO — see Initial public offering
IRR — see Internal rate of return
Issuer — the company that chooses to distribute a portion of its stock to the public.
J curve — a concept that during the first few years of a private equity fund, cash flow or returns are negative due
Junior debt — a loan that has a lower priority than a senior loan in case of a liquidation of the asset or borrowing company. Also known as "subordinated debt".
Junk bond — see High Yield Debt.
Later stage — the state of a company that has proven its concept, achieved significant revenues compared to its competition, and is approaching cash flow break even or positive net income. Typically, a later stage company is about 6 to 12 months away from a liquidity event such as an IPO or buyout. The rate of return for venture capitalists that invest in later stage, less risky ventures is lower than in earlier stage ventures.
LBO — see Leveraged buyout
Lead investor — the venture capital investor that makes the largest investment in a financing round and manages the documentation and closing of that round. The lead investor sets the price per share of the financing round, thereby determining the valuation of the company.
Letter of intent — a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as a "Term Sheet".
Leverage — the use of debt to acquire assets, build operations and increase revenues. By using debt, a company is attempting to achieve results faster than if it only used its cash available from pre-leverage operations. The risk is that the increase in assets and revenues does not generate sufficient net income and cash flow to pay the interest costs of the debt.
Leveraged recapitalization —the reorganization of a company's capital structure resulting in more debt added to the balance sheet. Private equity funds can recapitalize a portfolio company and then direct the company to issue a one-time dividend to equity investors. This is often done when the company is performing well financially and the debt markets are expanding.
Leveraged buyout (LBO) — the purchase of a company or a business unit of a company by an outside investor using mostly borrowed capital.
Leverage ratios — measurements of a company's debt as a multiple of cash flow. Typical leverage ratios include Total Debt / EBITDA, Total Debt / (EBITDA minus Capital Expenditures), and Seniore Debt / EBITDA.
L.I.B.O.R — see The London Interbank Offered Rate.
License — a contract in which a patent owner grants to a company the right to make, use or sell an invention under certain circumstances and for compensation.
Limited liability company (LLC) — an ownership structure designed to limit the founders' losses to the amount of their investment. An LLC does not pay taxes, rather its owners pay taxes on their proportion of the LLC profits at their individual tax rates.
Limited partnership — a legal entity composed of a general partner and various limited partners. The general partner manages the investments and is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original investment. The general partner receives a management fee and a percentage of profits (see Carried interest), while the limited partners receive income, capital gains and tax benefits.
Limited partner (LP) — an investor in a limited partnership. The general partner is liable for the actions of the partnership while the limited partners are generally protected from legal actions and any losses beyond their original investment. The limited partner receives income, capital gains and tax benefits.
Liquidation — the selling off of all assets of a company prior to the complete cessation of operations. Corporations that choose to liquidate declare Chapter 7 bankruptcy. In a liquidation, the claims of secured and unsecured creditors, bondholders and preferred stockholders take precedence over common stockholders.
Liquidation preference — the contractual right of an investor to priority in receiving the proceeds from the liquidation of a company. For example, a venture capital investor with a "2x liquidation preference" has the right to receive two times its original investment upon liquidation.
Liquidity discount — a decrease in the value of a private company compared to the value of a similar but publicly traded company. Since an investor in a private company cannot readily sell his or her investment, the shares in the private company must be valued less than a comparable public company.
Liquidity event — a transaction whereby owners of a significant portion of the shares of a private company sell their shares in exchange for cash or shares in another, usually larger company. For example, an IPO is a liquidity event.
Lock-up agreement — investors, management and employees often agree not to sell their shares for a specific time period after an IPO, usually 6 to 12 months. By avoiding large sales of its stock, the company has time to build interest among potential buyers of its shares.
London Interbank Offered Rate (L.I.B.O.R.) — the average rate charged by large banks in London for loans to each other. LIBOR is a relatively volatile rate and is typically quoted in maturities of one month, three months, six months and one year.
LP — see Limited partner
.
Management buyout (MBO) — a leveraged buyout controlled by the members of the management team of a company or a division.
Management fee — a fee charged to the limited partners in a fund by the general partner. Management fees in a private equity fund typically range from 0.75% to 3% of capital under management, depending on the type and size of fund.
Management rights — the rights often required by a venture capitalist as part of the agreement to invest in a company. The venture capitalist has the right to consult with management on key operational issues, attend board meetings and review information about the company's financial situation.
Market capitalization — the value of a publicly traded company as determined by multiplying the number of shares outstanding by the current price per share.
MBO — see Management buyout
Mezzanine — a layer of financing that has intermediate priority (seniority) in the capital structure of a company. For example, mezzanine debt has lower priority than senior debt but usually has a higher interest rate and often includes warrants. In venture capital, a mezzanine round is generally the round of financing that is designed to help a company have enough resources to reach an IPO.
Middle stage — the state of a company when it has received one or more rounds of financing and is generating revenue from its product or service. Also known as "growth stage."
Milestones — a valuation methodology that compares public and private companies in terms of a ratio of value to an operations figure such as revenue or net income. For example, if several publicly traded computer hardware companies are valued at approximately 2 times revenues, then it is reasonable to assume that a startup computer hardware company that is growing fast has the potential to achieve a valuation of 2 times its revenues. Before the startup issues its IPO, it will likely be valued at less than 2 times revenue because of the lack of liquidity of its shares. See Liquidity discount.
Multiples — operational or financial goals of a company that are often used to determine whether a company will receive additional financing or whether management will receive additional compensation.
Narrow-based weighted average ratchet — a type of anti-dilution mechanism. A weighted average ratchet adjusts downward the price per share of the preferred stock of investor A due to the issuance of new preferred shares to new investor B at a price lower than the price investor A originally received. Investor A's preferred stock is repriced to a weighed average of investor A's price and investor B's price. A narrow-based ratchet uses only common stock outstanding in the denominator of the formula for determining the new weighed average price.
NDA — see Non-disclosure agreement.
Net operating income (NOI) — a measure of cash flow that excludes the effects of financing decisions. NOI is calculated as earnings before interest and taxes multiplied by one minus the tax rate. Also known as profit after taxes (NOPAT).
No-shop clause — a section of an agreement to purchase a company whereby the seller agrees not to market the company to other potential buyers for a specific time period.
Non-compete — an agreement often signed by employees and management whereby they agree not to work for competitor companies or form a new competitor company within a certain time period after termination of employment.
Non-cumulative dividends — dividends that are payable to owners of preferred stock at a specific point in time only if there is sufficient cash flow available after all company expenses have been paid. If cash flow is insufficient, the owners of the preferred stock will not receive the dividends owed for that time period and will have to wait until the board of directors declares another set of dividends.
Non-interference — an agreement often signed by employees and management whereby they agree not to interfere with the company's relationships with employees, clients, suppliers, and subcontractors within a certain time period after termination of employment.
Non-solicitation — an agreement often signed by employees and management whereby they agree not to solicit other employees of the company regarding job opportunities.
Non-disclosure agreement (NDA) — an agreement issued by entrepreneurs to protect the privacy of their ideas when disclosing those ideas to third parties.
Offering memorandum — a legal document that provides details of an investment to potential investors. See Private placement memorandum.
OID — see Original issue discount.
Operating cash flow — the cash flow produced from the operation of a business, not from investing activities (such as selling assets) or financing activities (such as issuing debt). Calculated as net operating income (NOI) plus depreciation.
Optics — the way a concept is presented. Sometimes entrepreneurs' presentations are strong on optics but weak in content.
Options — see Stock options.
Option pool — a group of options set aside for long term, phased compensation to management and employees.
Original issue discount (OID) — a discount from par value of a bond or debt-like instrument. In structuring a private equity transaction, the use of a preferred stock with liquidation preference or other clauses that guarantee a fixed payment in the future can potentially create adverse tax consequences. The IRS views this cash flow stream as, in essence, a zero coupon bond upon which tax payments are due yearly based on "phantom income" imputed from the difference between the original investment and "guaranteed" eventual payout. Although complex, the solution is to include enough clauses in the investment agreements to create the possibility of a material change in the cash flows of owners of the preferred stock under different scenarios of events such as a buyout, dissolution or IPO.
Orphan — a startup company that does not have a venture capitalist as an investor.
Outstanding shares — the total amount of common shares of a company, not including treasury stock, convertible preferred stock, warrants, and options.
Oversubscription — when demand exceeds supply for shares of an IPO or a private placement.
Pay to play — a clause in a financing agreement whereby any investor that does not participate in a future round agrees to suffer significant dilution compared to other investors. The most onerous version of "pay to play" is automatic conversion to common shares, which in essence ends any preferential rights of an investor, such as the right to influence key management decisions.
Pari passu — a legal term referring to the equal treatment of two or more parties in an agreement. For example, a venture capitalists may agree to have registration rights that are pari passu with the other investors in a financing round.
Participating dividends — the right of holders of certain preferred stock to receive dividends and participate in additional distributions of cash, stock or other assets.
Participating preferred stock — a unit of ownership composed of preferred stock and common stock. The preferred stock entitles the owner to receive a predetermined sum of cash (usually the original investment plus accrued dividends) if the company is sold or has an IPO. The common stock represents additional continued ownership in the company. Participating preferred stock has been characterized as "having your cake and eating it too."
Patent — a legal right to sue any person or company that attempts to use, manufacture or sell the patented product or process.
PEIGG — acronym for Private equity Industry Guidelines Group, an ad hoc group of individuals and firms involved in the private equity industry for the purpose of establishing valuation and reporting guidelines.
PE ratio — see Price earnings ratio.
Piggyback rights — rights of an investor to have his or her shares included in a registration of a startup's shares in preparation for an IPO.
PIPEs — see Private investment in public equities.
Placement agent — a company that specializes in finding institutional investors that are willing and able to invest in a private equity fund. Sometimes a private equity fund will hire a placement agent so the fund partners can focus on making and managing investments in companies rather than on raising capital.
Portfolio company — a company that has received an investment from a private equity fund.
Post-money valuation — the valuation of a company including the capital provided by the current round of financing. For example, a venture capitalist may invest $5 million in a company valued at $2 million "pre-money" (before the investment was made). As a result, the startup will have a post-money valuation of $7 million.
Preemptive rights — the rights of shareholders to maintain their percentage ownership of a company by buying shares sold by the company in the future financing rounds.
PPM — see Private placement memorandum.
Preference — seniority, usually with respect to dividends and proceeds from a sale or dissolution of a company.
Preferred return — a minimum return per annum that must be generated for limited partners of a private equity fund before the general partner can begin receiving a percentage of profits from investments.
Preferred stock — a type of stock that has certain rights that common stock does not have. These special rights may include dividends, participation, liquidity preference, anti-dilution protection and veto provisions, among others. Private equity investors usually purchase preferred stock when they make investments in companies.
Pre-money valuation — the valuation of a company prior to the current round of financing. For example, a venture capitalist may invest $5 million in a company valued at $2 million pre-money. As a result, the startup will have a "post-money" valuation of $7 million.
Price earnings ratio (PE ratio) — the ratio of a public company's price per share and its net income after taxes on a per share basis.
Primary shares — shares sold by a corporation (not by individual shareholders).
Private equity — equity investments in nonpublic companies.
Private investment in public equities (PIPES) — investments by a private equity fund in a publicly traded company, usually at a discount.
Private placement — the sale of a security directly to a limited number of institutional and qualified individual investors. If structured correctly, a private placement avoids registration with the Securities and Exchange Commission.
Private placement memorandum (PPM) — a document explaining the details of an investment to potential investors. For example, a private equity fund will issue a PPM when it is raising capital from institutional investors. Also, a startup may issue a PPM when it needs growth capital. Also known as "Offering Memorandum."
Private securities — securities that are not registered with the Securities and Exchange Commission and do not trade on any exchanges. The price per share is negotiated between the buyer and the seller (the "issuer").
Promote — see Carried interest.
Prospectus — a formal document that gives sufficient detail about a business opportunity for a prospective investor to make a decision. A prospectus must disclose any material risks and be filed with the Securities and Exchange Commission.
Prudent man rule — a fundamental principle for professional money management which serves as a basis for the Prudent Investor Act. The principle is based on a statement by Judge Samuel Putnum in 1830: "Those with the responsibility to invest money for others should act with prudence, discretion, intelligence and regard for the safety of capital as well as income."
Purchase method — a merger accounting treatment whereby a buyer purchases the assets (and liability obligations) of a company at their market price and then records the difference between the purchase price and the book value of the assets as goodwill. This goodwill need not be amortized but must be valued annually and any decreases or increases in value must be reflected in the buyer's financial statements.
Qualified IPO — a public offering of securities valued at or above a total amount specified in a financing agreement. This amount is usually specified to be sufficiently large to guarantee that the IPO shares will trade in a major exchange (NASDAQ or New York Stock Exchange). Usually upon a qualified IPO preferred stock is forced to convert to common stock.
Quartile — one fourth of the data points in a data set. Often, private equity investors are measured by the results of their investments during a particular period of time. Institutional investors often prefer to invest in private equity funds that demonstrate consistent results over time, placing in the upper quartile of the investment results for all funds.
Ratchet — a mechanism to prevent dilution. An anti-dilution clause is a contract clause that protects an investor from a reduction in percentage ownership in a company due to the future issuance by the company of additional shares to other entities.
Realization ratio — the ratio of cumulative distributions to paid-in capital. The realization ratio is used as a measure of the distributions from investment results of a private equity partnership compared to the capital under management.
Recapitalization — the reorganization of a company's capital structure.
Red herring — a preliminary prospectus filed with the Securities and Exchange Commission and containing the details of an IPO offering. The name refers to the disclosure warning printed in red letters on the cover of each preliminary prospectus advising potential investors of the risks involved.
Redeemable preferred — preferred stock that can be redeemed by the owner (usually a venture capital investor) in exchange for a specific sum of money.
Redemption rights — the right of an investor to force the startup company to buy back the shares issued as a result of the investment. In effect, the investor has the right to take back his/her investment and may even negotiate a right to receive an additional sum in excess of the original investment.
Registration — the process whereby shares of a company are registered with the Securities and Exchange Commission under the Securities Act of 1933 in preparation for a sale of the shares to the public.
Registration rights — the rights of an investor in a startup regarding the registration of a portion of the startup's shares for sale to the public. Piggyback rights give the shareholders the right to have their shares included in a registration. Demand rights give the shareholders the option to force management to register the company's shares for a public offering. Often times registration rights are hotly negotiated among venture capitalists in multiple rounds of financing.
Regulation D — an SEC regulation that governs private placements. Private placements are investment offerings for institutional and accredited individual investors but not for the general public. There is an exception that 35 nonaccredited investors can participate.
Restricted shares — shares that cannot be traded in the public markets.
Return on investment (ROI) — the proceeds from an investment, during a specific time period, calculated as a percentage of the original investment. Also, net profit after taxes divided by average total assets.
Rights offering — an offering of stock to current shareholders that entitles them to purchase the new issue, usually at a discount.
Rights of co-sale with founders — a clause in venture capital investment agreements that allows the VC fund to sell shares at the same time that the founders of a startup chose to sell.
Right of first refusal — a contractual right to participate in a transaction. For example, a venture capitalist may participate in a first round of investment in a startup and request a right of first refusal in any following rounds of investment.
Road show — presentations made in several cities to potential investors and other interested parties. For example, a company will often make a road show to generate interest among institutional investors prior to its IPO.
ROI — see Return on investment.
Rollup — the purchase of relatively smaller companies in a sector by a rapidly growing company in the same sector. The strategy is to create economies of scale. For example, the movie theater industry underwent significant consolidation in the 1960s and 1970s.
Round — a financing event usually involving several private equity investors.
Royalties — payments made to patent or copyright owners in exchange for the use of their intellectual property.
Rule 144 — a rule of the Securities and Exchange Commission that specifies the conditions under which the holder of shares acquired in a private transaction may sell those shares in the public markets.
S corporation — an ownership structure that limits its number of owners to 100. An S corporation does not pay taxes, rather its owners pay taxes on their proportion of the corporation's profits at their individual tax rates.
Scalability — a characteristic of a new business concept that entails the growth of sales and revenues with a much slower growth of organizational complexity and expenses. Venture capitalists look for scalability in the startups they select to finance.
Scale-down — a schedule for phased decreases in management fees for general partners in a limited partnership as the fund reduces its investment activities toward the end of its term.
Scale-up — the process of a company growing quickly while maintaining operational and financial controls in place.
Search fund — a market for the sale of partnership interests in private equity funds. Sometimes limited partners chose to sell their interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown schedule. Certain investment companies specialize in buying these partnership interests at a discount.
SEC — see Securities and Exchange Commission.
Secondary market — a market for the sale of partnership interests in private equity funds. Sometimes limited partners chose to sell their interest in a partnership, typically to raise cash or because they cannot meet their obligation to invest more capital according to the takedown schedule. Certain investment companies specialize in buying these partnership interests at a discount.
Secondary shares — shares sold by a shareholder (not by the corporation).
Secured debt — debt that has seniority in case the borrowing company defaults or is dissolved and its assets sold to pay creditors.
Security — a document that represents an interest in a company. Shares of stock, notes and bonds are examples of securities.
Securities and Exchange Commission (SEC) — the regulatory body that enforces federal securities laws such as the Securities Act of 1933 and the Securities Exchange Act of 1934.
Seed capital — investment provided by angels, friends and family to the founders of a startup in seed stage.
Seed stage — the state of a company when it has just been incorporated and its founders are developing their product or service.
Senior debt — a loan that has a higher priority in case of a liquidation of the asset or company.
Seniority — higher priority.
Series A preferred stock — preferred stock issued by a fast growth company in exchange for capital from investors in the "A" round of financing. This preferred stock is usually convertible to common shares upon the IPO or sale of the company.
Sharpe-ratio — a method of calculating the risk-adjusted return of an investment. The Sharpe Ratio is calculated by subtracting the risk-free rate from the return on a specific investment for a time period (usually one year) and then dividing the resulting figure by the standard deviation of the historical (annual) returns for that investment. The higher the Sharpe Ratio, the better.
Small Business Investment Company (SBIC) — a company licensed by the Small Business Administration to receive government capital in the form of debt or equity in order to use in private equity investing.
Spin out — a division of an established company that becomes an independent entity.
Stock — a share of ownership in a corporation.
Stock option — a right to purchase or sell a share of stock at a specific price within a specific period of time. Stock purchase options are commonly used as long term incentive compensation for employees and management of fast growth companies.
Strategic investor — a relatively large corporation that agrees to invest in a young company in order to have access to a proprietary technology, product or service. By having this access, the corporation can potentially achieve its strategic goals.
Subordinated debt — a loan that has a lower priority than a senior loan in case of a liquidation of the asset or company. Also known as "junior debt".
Sweat equity — ownership of shares in a company resulting from work rather than investment of capital.
Syndicate — a group of investors that agree to participate in a round of funding for a company. Alternatively, a syndicate can refer to a group of investment banks that agree to participate in the sale of stock to the public as part of an IPO.
Syndication — the process of arranging a syndicate.
Tag-along right — the right of a minority investor to receive the same benefits as a majority investor. Usually applies to a sale of securities by investors. Also known as Co-sale right.
Takedown — a schedule of the transfer of capital in phases in order to complete a commitment of funds. Typically, a takedown is used by a general partner of a private equity fund to plan the transfer of capital from the limited partners.
Takeover — the transfer of control of a company.
Ten bagger — an investment that returns 10 times the initial capital.
Tender offer — an offer to public shareholders of a company to purchase their shares.
Term loan — a bank loan for a specific period of time, usually up to ten years in leveraged buyout structures.
Term sheet — a document confirming the intent of an investor to participate in a round of financing for a company. By signing this document, the subject company agrees to begin the legal and due diligence process prior to the closing of the transaction. Also known as "Letter of Intent".
Trade secret — something that is not generally known, is kept in secrecy and gives its owners a competitive business advantage.
Tranche — a portion of a set of securities. Each tranche may have different rights or risk characteristics.
Turnaround — a process resulting in a substantial increase in a company's revenues, profits and reputation.
Two x — a statement referring to 2 times the original amount. For example, a preferred stock may have a "two x" liquidation preference, so in case of liquidation of the company, the preferred stock investor would receive twice his or her original investment.
Under water option — an option is said to be under water if the current fair market value of a stock is less than the option exercise price.
Underwriter — an investment bank that chooses to be responsible for the process of selling new securities to the public. An underwriter usually chooses to work with a syndicate of investment banks in order to maximize the distribution of the securities.
Unsecured debt — debt which does not have any priority in case of dissolution of the company and sale of its assets.
Venture capital — a segment of the private equity industry which focuses on investing in new companies with high growth rates.
Venture capital method — a valuation method whereby an estimate of the future value of a company is discounted by a certain interest rate and adjusted for future anticipated dilution in order to determine the current value. Usually, discount rates for the venture capital method are considerably higher than public stock return rates, representing the fact that venture capitalists must achieve significant returns on investment in order to compensate for the risks they take in funding unproven companies.
Vesting — a schedule by which employees gain ownership over time of a previously agreed upon amount of retirement funding or stock options.
Vintage — the year that a private equity fund stops accepting new investors and begins to make investments on behalf of those investors.
Voting rights — the rights of holders of preferred and common stock in a company to vote on certain acts affecting the company. These matters may include payment of dividends, issuance of a new class of stock, merger or liquidation.
Warrant — a security which gives the holder the right to purchase shares in a company at a pre-determined price. A warrant is a long term option, usually valid for several years or indefinitely. Typically, warrants are issued concurrently with preferred stocks or bonds in order to increase the appeal of the stocks or bonds to potential investors.
Washout round — a financing round whereby previous investors, the founders, and management suffer significant dilution. Usually as a result of a washout round, the new investor gains majority ownership and control of the company.
Weighted average cost of capital (WACC) — the average of the cost of equity and the after-tax cost of debt. This average is determined using weight factors based on the ratio of equity to debt plus equity and the ratio of debt to debt plus equity.
Weighted average ratchet — an anti-dilution protection mechanism whereby the conversion rate of preferred stock is adjusted in order to reduce an investor's loss due to an increase in the number of shares in a company. Without a ratchet, an investor would suffer from a dilution of his or her percentage ownership. Usually as a result of the implementation of a weighted average ratchet, company management and employees who own a fixed amount of common shares suffer significant dilution, but not as badly as in the case of a full ratchet.
Wipeout round — see Washout round.
Wipeout bridge — a short term financing that has onerous features whereby if the company does not secure additional long term financing within a certain time frame, the bridge investor gains ownership control of the company. See Bridge financing.
Write-down — a decrease in the reported value of an asset or a company.
Write-off — a decrease in the reported value of an asset or a company to zero.
Write-up — an increase in the reported value of an asset or a company.
Zombie — a company that has received capital from investors but has only generated sufficient revenues and cash flow to maintain its operations without significant growth. Typically, a venture capitalist has to make a difficult decision as to whether to kill off a zombie or continue to invest funds in the hopes that the zombie will become a winner.
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