Simple Analysis is Never a Solution in Valuing Complex Derivative Securities

Valuing Complex Derivative SecuritiesValuing Complex Derivative Securities

Even though private equity fund managers are in the business of sourcing and investing daunting amounts of money into a variety of private companies, their mindset often resembles that of the businesses in which they invest. In their 2015 Annual US PE Fund breakdown, Pitchbook identified the average size of a PE firm in 2015 was $177,000,000. Assuming a pretty standard annual management fee of 2%, the fund manager of an average PE fund in 2015 “earned” $3,540,000 of revenue from management fees…and probably close to $0 in free cash flow. This is because they spend their revenue like most small businesses; on human resources, rent, travel & entertainment, infrastructure, capital formation with potential investors, and marketing to potential portfolio companies.

PE Fund managers typically don’t achieve “free cash flow” until they begin to harvest their portfolio company investments 5-10 years into their fund’s lifespan. On top of that, unlike most business owners, they typically don’t get to participate in the profits of their labor until their investors first recover a preferred annual return somewhere in the neighborhood of 8%. Said differently, on a $177,000,000 fund, they have to return $14,160,000 per year before they can participate in the incremental profits of the fund! For a $177,000,000 fund, that’s about $70 million over 5 years!

While the image of a “vulture” private equity firm descending upon the salt-of-the-earth family-run enterprise has become ingrained in pop culture and the political discourse, the fact is that the vast majority of private equity firms are run just like small businesses too. Entrepreneurs should keep this in mind the next time a Private Equity fund contacts them about a prospective growth investment or buy-out.


Tags: Valuing Complex Derivative Securities

Dr. Scott Hakala has extensive practical knowledge of finance, economics, statistics, and business valuation theory. His expertise includes: corporate finance, restructuring and cost of capital; the valuation of securities and business interests (transactions, mergers, acquisitions, fairness opinions); the valuation of intangible assets (patents, trademarks); analysis of publicly traded securities (insider trading studies, trading analyses, event analyses, materiality, damages in securities litigation); expert testimony and economic loss analyses (commercial litigation); wage and compensation determination (reasonable compensation studies, lost personal income, wrongful termination); transfer pricing; derivative securities (options pricing and valuation); and antitrust and industry structure, strategic pricing, marketing and cost allocation analyses.

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Are most Private Equity fund managers small business owners too?

Private Equity Fund Managers Small Business OwnersPrivate Equity Fund Managers Small Business Owners?

Even though private equity fund managers are in the business of sourcing and investing daunting amounts of money into a variety of private companies, their mindset often resembles that of the businesses in which they invest. In their 2015 Annual US PE Fund breakdown, Pitchbook identified the average size of a PE firm in 2015 was $177,000,000. Assuming a pretty standard annual management fee of 2%, the fund manager of an average PE fund in 2015 “earned” $3,540,000 of revenue from management fees…and probably close to $0 in free cash flow. This is because they spend their revenue like most small businesses; on human resources, rent, travel & entertainment, infrastructure, capital formation with potential investors, and marketing to potential portfolio companies.

PE Fund managers typically don’t achieve “free cash flow” until they begin to harvest their portfolio company investments 5-10 years into their fund’s lifespan. On top of that, unlike most business owners, they typically don’t get to participate in the profits of their labor until their investors first recover a preferred annual return somewhere in the neighborhood of 8%. Said differently, on a $177,000,000 fund, they have to return $14,160,000 per year before they can participate in the incremental profits of the fund! For a $177,000,000 fund, that’s about $70 million over 5 years!

While the image of a “vulture” private equity firm descending upon the salt-of-the-earth family-run enterprise has become ingrained in pop culture and the political discourse, the fact is that the vast majority of private equity firms are run just like small businesses too. Entrepreneurs should keep this in mind the next time a Private Equity fund contacts them about a prospective growth investment or buy-out.

Christopher C. Lucas, CFA, CPA

PRINCIPAL
clucas@valuescopeinc.com
Full Bio →

 

Next Commercial Credit Bust to be Softened by 2013 Leveraged Lending Guidance

Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.

Summary of 2015 Shared National Credit Review[1],[2]

In 2013, bank regulatory agencies (the “Regulators”) released the Interagency Guidance on Leveraged Lending (the “Guidance”) intended to curtail perceived excesses in bank lending practices. One of the most impactful elements of the Guidance was the rule that banks should not make “non-pass” loans. The Guidance defined “pass” loans as loans in which the borrower demonstrated the ability to repay all of its senior debt and one-half of its total debt in a five to seven year period.
The Guidance initially proved confusing and banks did not immediately adopt its recommendations to the Regulators’ satisfaction. After the Regulators criticized banks for non-compliance in the 2014 Shared National Credit Review (the 2014 “SNC Review”), banks appear to have gotten the message. After the 2015 SNC Review, Comptroller of the Currency Thomas Curry stated, “[T]he 2015 SNC Review found lower levels of leverage and improved repayment capacity in bank leveraged loan portfolios.”
Statistics compiled by the Loan Syndications and Trading Association shown in the charts below support the findings of the 2015 SNC Review.

Commercial Credit Bust

Footnotes

[1] Coffey, Meredith, “SNC: Banks Complying With LLG Rules… But SNC Suggests Rules Might Change”, November 2015; Loan Syndication and Trading Website at http://www.lsta.org/news-and-resources/news/1/snc-banks-complying-with-llg-rules-but-snc-suggests-rules-might-change

[2] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Shared National Credits Program 2015 Review, November, 2015 at http://www.occ.treas.gov/news-issuances/news-releases/2015/nr-ia-2015-149a.pdf

Christopher C. Lucas, CFA, CPA

PRINCIPAL
clucas@valuescopeinc.com
Full Bio →

 

Quarterly Economic Outlook: or when will bankruptcy attorneys get busy again?

Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.

Economic Outlook – Bankruptcy Attorneys

The current economic expansion is aging, but is likely to continue for several more quarters. The charts below provide insight into the economic outlook for the remaining duration of the current economic expansion.

Majority of Evidence – Signs of Stability

Economic Outlook - Bankruptcy Attorneys
Source: united states department of economic analysis at http://www. Bea. Gov/national/

The chart above illustrates our progress through the current business cycle and the length of the prior two cycles. The expansion in the 1990’s remains the longest in US history. The chart above indicates that real GDP growth for the four quarters ending June 2015 averaged a healthy 2.7%.

Economic Outlook - Bankruptcy Attorneys
Source: united states bureau of labor statistics at http://data. Bls. Gov/timeseries/lns14000000

Unemployment remains low (see chart above), while inflation remains under control (see chart below).

Economic Outlook - Bankruptcy Attorneys
Source: federal reserve bank of minneapolis at https://www. Minneapolisfed. Org/community/teaching-aids/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913; note that the fed has targeted a 2. 0% inflation rate in recent years

The strong US dollar, weak oil and commodity prices and weak global growth are the primary contributors to today’s low inflation rate. Low inflation has allowed the Federal Reserve (the “Fed”) to leave the fed funds rate close to 0% for seven years.

Economic Outlook - Bankruptcy Attorneys
Source: united states federal reserve board at http://www. Federalreserve. Gov/releases/h15/data. Htm

The chart below shows the Fed raised the fed funds rate to fight inflation before each of the last two recessions. In this chart, corporate earnings are a proxy for economic growth. The Fed has not begun the tightening cycle which precedes business contractions.

Economic Outlook - Bankruptcy Attorneys
Correlation between corporate earnings and fed funds rate

The yield curve remains a reliable predictor of the approach of the end of economic expansions.

Economic Outlook - Bankruptcy Attorneys
Source: m. G. J, “the imf urges the fed to delay a rate rise”, the economist, september 3, 2015

The yield curve represents the yield on US Treasury obligations of various maturities. The Fed raises short-term interest rates to reduce the current inflation rate. This effort consistently results in a circumstance where short-term rates rise to yields considered appropriate for long-term Treasury bonds in the final stages of economic expansions.

Minority of Evidence – Signs of Instability

The weak global economy has resulted in weak commodity prices, particularly weak oil prices.

Quarterly Economic Outlook: Or When Will Bankruptcy Attorneys Get Busy Again?
Source: us energy information administration at http://www. Eia. Gov/dnav/pet/pet_pri_spt_s1_d. Htm

The weakness in oil prices has caused corporate earnings weakness for the last three quarters.

Economic Outlook - Bankruptcy Attorneys
Source: standard & poors corporation https://us. Spindices. Com/search/? Query-s%26p+500+earnings&search=go&search=go – “index earnings”

In the manufacturing sector, growth has almost slowed to contraction.

Economic Outlook - Bankruptcy Attorneys
Source: national association of purchasing managers – manufacturers’ purchasing managers’ index

Energy sector weakness has a negative impact on companies that borrowed heavily when oil prices were expected to remain high.

Increasing distress in the energy sector has caused yields on syndicated loans to increase 100 basis points from May 2015.

Economic Outlook - Bankruptcy Attorneys
Source: yield on leveraged loan 100 index at http://www. Leveragedloan. Com

Similarly, more than $5.2 billion in funds have been removed from the loan market since mid-July.

Economic Outlook - Bankruptcy Attorneys
Source: funds flow from syndicated loan market at http://www. Leveragedloan. Com

Conclusion

Several quarters remain before bankruptcy attorneys return to high employment. However, weakness in specific sectors should provide an increased flow of near term bankruptcy activity.

Footnotes

[1] Source: United States Department of Economic Analysis at http://www.bea.gov/national/

[2] Source: United States Bureau of Labor Statistics at http://data.bls.gov/timeseries/LNS14000000

[3] Source: Federal Reserve Bank of Minneapolis at https://www.minneapolisfed.org/community/teaching-aids/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913; note that the Fed has targeted a 2.0% inflation rate in recent years

[4] Source: United States Federal Reserve Board at http://www.federalreserve.gov/releases/h15/data.htm

[5] Source: Standard & Poors Corporation at http://us.spindices.com/search/?query-S%26P+500+earnings&Search=GO&Search=GO – “Index Earnings” spreadsheet, Quarterly Data tab

[6] Source: United States Federal Reserve Board at http://www.federalreserve.gov/releases/h15

[7] Source: M.G.J, “The IMF Urges the Fed to delay a rate rise”, The Economist, September 3, 2015

[8] Ibid

[9] Source: US Energy Information Administration at http://www.eia.gov/dnav/pet/pet_pri_spt_s1_d.htm

[10] Source: Standard & Poors Corporation at http://us.spindices.com/search/?query-S%26P+500+earnings&Search=GO&Search=GO – “Index Earnings” spreadsheet, Quarterly Data tab

[11] Source: National Association of Purchasing Managers – Manufacturers’ Purchasing Managers’ Index

[12] Source: Kakouris, Rachelle, “Oil & Gas Cos Could See 40% Decline in Borrowing Base – Survey”, September 23, 2015 at www.leveragedloan.com/category/distressed-debt/

[13] Source: Yield on Leveraged Loan 100 Index at http://www.leveragedloan.com

[14] Source: Funds flow from syndicated loan market at http://www.leveragedloan.com

Christopher C. Lucas, CFA, CPA

PRINCIPAL
clucas@valuescopeinc.com
Full Bio →

 

Fed’s Dudley Says U.S. on Track for 2015 Interest-Rate Increase

Sept 2015 Interest Rate Increase

http://www.bloomberg.com/news/articles/2015-09-28/fed-s-dudley-says-u-s-on-track-for-2015-interest-rate-increase

Sept 2015 Interest Rate Increase“The economy is doing pretty well,” Dudley said Monday at an event hosted by the Wall Street Journal in New York. “My expectation is that we probably will raise interest rates later this year.”

Dudley said he expected growth in the second half will be a little bit weaker than in the first half, when the U.S. grew around 2.25 percent on an annualized basis.

Concern over the outlook for the world’s second-largest economy have roiled financial markets since China’s surprise currency devaluation on Aug. 11. Investors have reduced their bets the Fed would act at one of its two remaining FOMC meetings this year and saw a 40 percent probability of a move by the Dec. 15-16 FOMC, down from 49 percent on Sept. 21.

Christopher C. Lucas, CFA, CPA

PRINCIPAL
clucas@valuescopeinc.com
Full Bio →