“Survival Integrations” – A Chapter yet to be Written -- January 15, 2008 (Also appearing in the MBA Tech NewsLink) -- Survivability and viability of operations will usher in a new wave of Financial and Mortgage M&A’s.
Let’s face it, the conditions of the financial and mortgage markets are deplorable. There is no apparent easy fix or wizard that can wave a wand to rescue the market from their needed unwindings and previous risky positions taken. The pain is severe and not contained to simply the risk-taking PE firms, hedge funds or investment bankers. The impact will be lasting as the duration of torment will be measured in years – not months. Nevertheless, there is still another chapter to be written surrounding the euphoric hangover of unbridled financial lending practices and complex, illiquid trading assets – “the forced or survival M&A.”
This type of “Shotgun” or “Survival” induced M&A transaction is not about growth, but viability of operations resulting from poor decision making, creating an inability to sustain required capital ratios and needed cash flows. Tantalizing tidbits have briefly appeared in the newspaper headlines in the last several months only to be denied or retracted by CEO’s who were professionally embarrassed or feared losing their existing positions. In essence, an internally reflective hostile takeover mindset is taking place among those fatally or significantly wounded by risk taking positions that have drained liquidity from their balance sheets – the terms will be most unpleasant for their survival.
Although before accepting this premise as a truism, we need to ask, what is compelling different with today’s markets which would force a survival merger? How will the liabilities of the past influence decision making in 2008 and beyond as politicians, legislative overseers, and the public become extraordinarily determined? What new adaptations and insights are market entrants or players utilizing to change the existing operational landscape?
Market Baseline and Dynamics
As part of any sound analysis, we need to place all the rampant figures, statements, and conjectures into a comprehensive framework. According to financial information recently mapped out by the Bank of England and reported in the Financial Times, the worldwide equity markets account for $51 trillion dollars in total valuation, whereas global bank deposits add another nearly $40 trillion. Government debt weighs in at $26 trillion and corporate bonds at $11 trillion -- with 91% of the latter being investment grade.
Furthermore, of the $11 trillion in asset back securities (ABS) approximately 66% of the ABS’s are related to the mortgage markets, and the remainder are underwritten by other consumer debt structures (e.g., credit cards, car loans, boats / RV’s). Additional decomposition reveals that of the $7.25 trillion of mortgage backed securities (MBS), 9.5% should be considered subprime and 8.2% Alt-A. Finally, the recent media attention on energy wealth driven Sovereign Wealth Funds (SWF’s) valuation approaches $4 trillion with some of the largest holders residing in the Middle East, Asia, and Europe.
Starting in earnest in June 2007, it has been the comprehension of the counter-party risks and structural interdependencies of market instruments that have rapidly contributed to the case for survival M&A transactions. The ensuing market uncertainty with a relatively “small” segment of the capital markets has led to a pervasive fear of not only disclosed losses, but those still lingering within structured investment vehicles (SIV’s) and the “off-balance sheet” operations.
A near immediate casualty of this market breaking point can be witnessed with the private equity (PE) organizations that until the rebalancing began, were enjoying the best historical year ever in terms of volume, profits, and respect. The fame of headlined mega-deals punctuated by highly visible IPO’s has since given way to contempt and mounting litigation. For markets, the loss of PE funds to fuel M&A and privatization deal flows has created a financial limbo for previously announced deals, while forcing any new deal to be smaller supported by higher yields. PE is not bust – it, like the markets will be forced to reinvent their models.
Despite the fact that this discussion of market rationale and implications alone could span numerous books, we need to mention one more important event that continues to influence executive decisions and spark regulatory interest and oversight—quality ratios concerning asset class tiers. These tiered based ratios are key for firms not only to determine the quality of investments and holdings, but also to secure new funding sources, pledging of assets for credit lines, growth, and of course as a barometer of financial health. It should be noted that in most of the prior downturns, these ratios were not impacted to the extent they were in 2007.
The takeaways – With funding sources severely reduced, the ability to finance improved profitability cannot be achieved using the operating models of the past -- arcane and over-capacity processes will accelerate the drain on resources hastening operational losses and forcing M&A events.
Enter the Non-Traditional Players
The global central banking and agency bailout risks and policy challenges continue to rise – a historical low dollar, banking rescues, commercial and personal bankruptcies, and credit trading and exchange markets that frequently require billions of dollars of injections just to function. The belief that the financial markets had superior elasticity and controls to weather the much-anticipated and isolated “sub-prime” correction, are now being proven inaccurate.
This ensuing void of leadership and direction has allowed “new” entrants into the markets touting their access to cash and commitment to the long-term. The new market players represent a lifeline for organizations with floundering operations and industry egos that until several months ago were “still dancing.” Yet, the opaqueness of their investment salvation as typified by the SWF’s is still being assessed under the scrutiny of nationalism and a regulatory requirement for unfettered transparency.
Additionally, there are well capitalized multi-nationals who currently have small finance and banking operations seeking major entry into the markets by resurrecting troubled operations – for example Virgin Money and Northern Rock. Lead by crack teams of experienced industry personnel supported by substantial investment firms, the new entrants are “leap-froging” their competitors using creativity and non-traditional guarantees. It is likely that others will be “forced” into the arrangement of the non-traditional organization as conditions worsen and as regulators and executives seek a “safe” way out of the chaos.
It may well be the audit firms that create the next impetus for survival M&A transactions. As worldwide standard boards wrestle with a standardized method to value complex and increasingly illiquid investment holdings, the impact of the updated audit guidance may spell disaster.
The downside implications may be far reaching as organizations that have not provided an objective and transparent assessment of these off-balance sheet instruments may find themselves in technical financial default across numerous covenants. The fear of these objective and public disclosures will create additional M&A events as management teams rush to secure viability for their operations and their livelihood.
The takeaways – With banking loan losses the highest in over 20 years, survival M&A’s will accelerate forcing established players into difficult terms and conditions while allowing nimble, well capitalized upstarts with experienced management teams to alter the competitive landscape.
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Facing the tipping point similar to debates surrounding Global Warming, financial and mortgage institutions will be permanently altered in 2008 – driven by new economic realities, regulators, politicians, technologies, investors, and global markets. The fragile stability witnessed in early fall 2007 has now given way to new concerns and corporate exposures – just look at the list of senior “resignations” in banks and investment organizations.
Change and sustainable innovation will come not at the point of a spear as some advocate, but as a mandate of global market customers that demand transparency and structural integrity. Or perchance, will the markets finally experience the fabled “decoupling” long promised as Asia and Europe continue to show signs of strength potentially pulling the US from the brink of disaster and isolating the fallout to a geographical region? As I said, we are entering a chapter that has yet to be written.
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