Much has been written about the negative impacts of the subprime mess and the knock-on credit crisis. But what about the flip-side; who stands to gain from general economic and capital markets uncertainty?
I'll tell you - those who have balance sheet capacity and abundant liquidity to pick up bargains while others are suffering. Where capital was once incomprehensibly cheap and available it is now both dear and scarce. And this about-face took less than six months to unfold. Quite simply, capital is no longer a commodity.
I was speaking to a friend who is a senior member of an advisory team within a finance company that goes head-to-head against the Wall Street investment banks every day of the week. And they generally do pretty well, leveraging the capacity and appetite to book risk on deals where they are advisers. But things have gotten much better for them as of late, since so many of the investment banks are dealing with their own credit crises and have become far more reluctant to underwrite deals and incur syndication risk. This is but one small example of a firm that is capitalizing upon the adverse conditions in the credit (and now equity) markets.
When it comes to the credit crisis almost all roads run through the largest banks and investment banks. They packaged up, retained and sold (and some actually got into the origination end of) mortgage risk; were underwriters of massive amounts of leveraged loans; and provided incremental leverage and liquidity to hedge funds.
And if they had only been middlemen in the process, that would have been ok. But they weren't, and these banks held mortgage securities, retained loans and existing financing commitments that are burning holes in their balance sheets, causing them to both pull in their lending horns while aggressively bringing in new sources of capital. The traffic cop of transactional credit creation is currently on holiday. So given this, who is out there to capitalize on the increasing cheapness of both the debt and equity markets?
Consider the possibilities for these types of firms:
- Private equity firms: The leaders are generally awash in liquidity and have patient investors, indicating a vast opportunity set. And while their ability to lever acquisitions has dropped precipitously, the decline in purchase prices will help to dampen the effect of more equity-heavy capital structures on returns. Will returns reach the heights of the mid-2000s? Likely not in the near term. But these firms have the resources and experience to create value in both U.S. and overseas markets, and will have plenty of opportunities to deploy massive amounts of capital to capture the bargains that will inevitably emerge from today's market crisis.
- Hedge funds: While jittery and highly correlated markets are generally not good for stat arbs and other quantitatively-oriented investors, value-driven long/short equity and even-driven managers should do pretty well. In the global market sell-off value should once again rear its head, giving excellent stock-pickers with intermediate time horizons fertile ground to build an attractive portfolio and to watch it pay off over time. Event managers should also see some pretty interesting opportunities as corporations look to increase focus and efficiency and build liquidity by jettisoning non-core assets. Further, a number of larger companies which have underperformed will come under pressure to restructure either by selling or spinning off operations. In each of these circumstances, both value and event managers should see a range of attractive opportunities in a depressed and uncertain market.
- Corporations: Some will have the chance to be opportunistic while others will not. Companies like Berkshire Hathaway (NYSE:BRK.A) and Microsoft (NASDAQ:MSFT), with rock-solid balance sheets and tens of billions in liquidity can pretty much pick and choose their spots. Perhaps start new businesses to take advantage of others' problems (like BRK entering the municipal bond insurance business), or maybe pick up some valuable assets that have gotten much cheaper as of late (like MSFT's bid for YHOO). The point is, those with liquidity will have lots of options while those who are heavily levered and capital constrained will be focused more on staying afloat than on picking up the valuable entrails of some other firm's rotted carcass.
- Banks and Investment Banks: Like corporations, there will be a massive skew between those who can pro-actively take advantage of market bargains and those who will be focused on rebuilding and repairing damaged businesses. For example, Citigroup (NYSE:C), Merrill Lynch (MER) and UBS (NYSE:UBS) geared up to raise capital, skinny down the organizations and re-focus on core businesses. Breadth hurt as management complexity and greed masked building problems in risky businesses. Consider Goldman Sachs (NYSE:GS) and JP Morgan Chase (NYSE:JPM): capital is sufficient, need to optimize headcount given current market conditions and to remain nimble and aware as bargains arise from both trading and investment perspectives. Further, they continue to have the ability to use balance sheet to support deals, though not as freely as in the past as existing LBO commitments weigh on capital availability.
- Venture Capital: This should be a golden opportunity for the highly liquid venture capital industry. Early-stage opportunities remain abundant, while later-stage venture capital will become increasingly attractive as alternative financing sources dry up. They, like the private equity firms, raised money when times were good. That was smart. But difficult times should bring possibly even more opportunities to the best firms.
Notwithstanding the challenging markets, it is important to remember that not everyone will suffer. Capital formation will continue apace, but capital allocation will be far more disciplined than it has been over the past three years.