Wednesday, January 27, 2010

Is uncertainty the new paradigm?

I would like to dedicate the first entry to my professor, Ed Altman, the Max L. Heine Professor of Finance at the Leonard N. Stern School of Business at NYU and Director of Research in Credit and Debt markets. Dr. Altman is an expert in the fields of corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis.

To Dr. Altman I owe a solid understanding of corporate and municipal bonds and primarily an insight into what it means to be a leader and professional of the highest caliber and standards.

“The New Paradigm for Private Equity” was the inaugural annual conference in a series organized by Alvarez & Marsal, a leader among global professional services firms today and originally founded as a restructuring boutique in New York City. For this conference that took place on January 21st, Alvarez & Marsal collaborated with the Stern School of Business and placed Ed Altman at its helm as the co-chair and one of the two keynote speakers, the second one being Wilbur L. Ross, WL Ross & Co. and Invesco Private Capital.

Both Dr. Altman and Mr. Ross maintained that the New Paradigm is actually not so new or surprising but rather a resurgence of trends that mark a distinct phase of evolution within private equity. The point was proven eloquently and convincingly with two different methodological approaches:

Dr. Altman presented his rigorous analysis of the market and, specifically, the default rate of corporate bonds and how these can be studied to predict an impending credit bubble. His five discrete approaches (the Macroeconomic Model, the Mortality Rate Model, the Market Based Model, the Recovery Rate Model, and the Distressed Debt Market Size Estimate) confirmed events that today everyone recognizes in retrospect. For example, Dr. Altman proved that historically, default rates of corporate bonds rise for two years before a recession. While his predictions for corporate defaults are in agreement with those announced by the big rating agencies, the point worth noting here is that a thorough study of market conditions gives early warning signs. These can be used as techniques to assess the sustainability of market trends, avoid credit bubbles, and assist investors understand the true financial profile of companies as well as identify opportunities for investing.

The evolving nature of private equity was confirmed in the second keynote address, in which Mr. Ross presented a list of seven “new” paradigms for private equity drawn from his own long career in the field:

#1 Washington is the new Wall Street; #2 By necessity, there is a proliferation of private public partnerships; #3 The FDIC framework cannot protect failing banks, which is leading to an extreme reduction in the number of existing banks in the US—not such a bad thing, after all; #4 Private Equity firms are becoming the new tax revenue targets; #5 The terms of financial engineering in private equity are changing rapidly. The gap between the top 25% and low 25% of distressed firms is widening. #6 It will take years to repair the economy while the slow recovery will affect turnarounds, the success of which will be more the result of the micro aspects of the business rather than the macro conditions of the economy; #7 There will be more capital available for distressed investing in private equity.

The remainder of the conference was organized in three panels:

Panel 1, Distressed Investing for Control (Moderator: Mark Patterson, MatlinPatterson Global Advisors LLC; Panelists: Kipp DeVeer, Ares Management; Angus C. Littlejohn, Jr., Littlejohn & Co., LLC; Michael Psaros, KPS Capital Partners, LP; Jason New, The Blackstone Group)

The volume of defaults in the last two years has substantially increased the scale of supply of distressed companies and, therefore, has impacted the breadth of management expertise needed in distressed investing. Screening of distressed companies has become more complex as well. This has led investors to a greater degree of specialization and conservatism. The panelists represented investors who are in distressed investing for the long run, and not for the quick trading of distressed companies in which hedge funds are usually interested. Consequently, the relationship between the private equity sponsor and distressed company management is very important and becomes tighter in difficult times. Therefore, conservatism, management, and execution are the key characteristics of the panelists’ approach to investing. In addition, these three are their tools for success in creating value for the management and the sponsors, which is, they asserted, the definition of private equity: value creation for the stakeholders.

Panel 2, Private Equity Investment in the Banking Sector (Moderator: Steve D. Goldstein, Alvarez & Marsal; Panelists: P. Olivier Sarkozy, The Carlyle Group; Mark K. Gormely, Lee Equity Partners LLC; Max Holmes, Plainfield Asset Management LLC; Fred D. Price, Sandler O’Neill + Partners, L. P.)

Compared to the clearly operations-driven first panel, this panel on banking left the audience trying to decipher aphorisms on banks and “their notoriously weak management teams.” Having said that, Steve Goldstein did an excellent job setting up the discussion and introducing banking as a new area of distressed investing, a perfect follow up to Mr. Ross’s keynote speech in which he had admitted to favoring investing in regional banks of relatively small size ($5 to $8 billion market cap). This panel’s negative overview of American banking is based on: the government’s involvement in subsidizing the real estate market and, consequently, in creating an unsustainable economy; the weak management teams that still remain in place; the restrictive legal framework that does not allow private equity sponsors to hold a seat on the board in any of the banks they partially own. In fact, a private investor holding anywhere between 15% and 24.99% will be called to sign a passivity agreement; one holding anything above 25% and up to 49% will be called to sign a bank holding agreement. Both agreements are designed to strip private investors from power in any management issues (i.e. no voting power on the bank’s board) despite the capital they may have poured in.

Panel 3, Portfolio Company Management—Picking the Right Horse for the Course (Moderator: Jeff Feinberg, Alvarez & Marsal; Panelists: Joseph R. Edwards, First Reserve Corporation; Kevin Haines, Protostar Partners, LLC; Dean B. Nelson, KKR Capstone; Bill Sullivn, Apax Partners LLP)

The uniqueness of this last panel derived from its own composition: all four panelists are specialists within a particular industry, except for Mr. Haines, whose firm, Protostar Partners LLC has a unique approach to investing since it is one of the very few firms who buy entire portfolios of companies. This approach confirms a point made earlier, namely that private equity firms today have a need for breadth of expertise. In contrast, the other three firms have found their respective market niches in which they know all the players. This makes it easier for them to distinguish who is a good fit for their team, usually a professional who combines deep knowledge in the specific field combined with finance experience. Still, they all agreed that private equity creates an intrusive relationship that affects or even completely erases existing management. Regardless, the sponsor-management relationship can work successfully when it is based on: commitment from both parties; courage to make the necessary difficult decisions for the company; and conviction that this relationship can indeed bring results.

Regulatory uncertainty may very well be a sign of the times but the main takeaway from the January 21st conference was Tony Alvarez’s II (Co-CEO Alvarez & Marsal) three-prong assertion on private equity’s new paradigm: #1 One cannot take anything for granted when liquidity capacity is unpredictable; #2 One should ask a lot of questions, especially when the goal is to assess a partner and his/her suitability; #3 Teams need a leader and one needs to be ready to pick one and move on with the task at hand. Considering that Tony Alvarez II transformed the small boutique firm he co-founded to a global service organization that operates in 16 nations, I would certainly follow his lead.


  1. A very informative synopsis on the current state of private equity and a very useful insight as we are studying the industry. Thank you

  2. Thanks so much for your useful and perceptive comments about the Private Equity Conference held at Stern on January 21, 2010. Good luck on future additions of your blog.

    Professor Ed Altman (1/31/10)