接下来怎么办？

Memo to:

Oaktree Clients

From:

Howard Marks

Re:

Now What?

My memos mostly try to explain what’s been going on in the financial arena and how things got that way. With three published this past summer plus December’s review of the lessons of 2007, I’ve done a lot of that. Hopefully they were helpful. Given what I consider to be the importance of the current situation, I have decided to venture beyond the familiar ground and into an area where I’m on shakier footing: the future. Before doing so, however, I can’t resist the temptation to recap how we got here.

Boom

U

There’s a process through which bullish excesses set the stage for bearish corrections. It’s known as “boom/bust,” a label that succinctly describes the last few years and, I think, the next few. 

In 2001-02, heavy borrowing to overbuild optical fiber capacity led the telecommunications industry to the brink of financial collapse. This came to a head around the time that scandals were unearthed at Enron, WorldCom, Adelphia, Tyco and Global Crossing. This combination of events – set against the backdrop of a sluggish economy and some very negative geo-political events – led to a widespread crisis of confidence regarding corporate financial statements, corporate managements and corporate debt. The environment was quite bleak.



The Fed took interest rates as low as 1% to offset the negative effects of these events and others. Because of this – and with U.S. equities having fallen for three consecutive years for the first time since the Great Depression – many investors concluded that their return aspirations couldn’t be met in traditional investments. Pressure for higher returns had the effect of increasing the acceptance of alternative investments, hedge funds, emerging market securities, leverage and financial innovation . . . in the process, suppressing customary risk aversion.



Leverage and risk taking became the dominant features of the financial landscape, facilitated by a “global wall of liquidity.” The low promised return on most investments, the pressure for more and the availability of low-cost capital all combined to make leveraged structures the flavor of the day.



Importantly, much of the growth in leverage took place free of regulatory oversight. In the past, the creation of debt was limited by margin requirements, Fed regulations, bank capital requirements and bankers’ prudence. But under the new order, an

2008 Oaktree Capital Management, L.P.

All Rights Reserved

explosion of non-bank lending rendered the traditional restraints impotent, with unregulated hedge funds and derivative traders doing what financial institutions wouldn’t or couldn’t. And when traditional providers of capital did participate, competition to lend caused them to join in the trend to “covenant-lite,” “PIK/toggle” and other loosey-goosey structures. 

Financial innovation enjoyed enormous popularity. The application of leverage, securitization and tranching permitted debt backed by assets such as mortgages to be created and sold around the world. This process, it was said, enabled just the right level of risk and return to be delivered to each investor.



Financial sector participants and observers concluded that the world had been made a less risky place by disintermediation (in which banks sold off loans rather than hold them), adroit central bank management and developments that made debt more borrower-friendly. In many cases, this sense of reduced risk encouraged individuals to assume correspondingly more risk.



Because the structured products were so new, sophisticated and opaque, high ratings would be needed if they were to gain acceptance. Wall Street’s persuasiveness, combined with the rating agencies’ susceptibility, caused the needed ratings to be assigned. Thus the final element was in place for the financial innovations to gain widespread popularity.



Among the innovations, collateralized debt obligations, or CDOs, deserve particular mention. CDO originators would issue tranches of debt with varying levels of priority regarding the cash flows from debt portfolios assembled with the proceeds. In many cases, the portfolios consisted heavily of residential mortgage-backed securities, each comprised of large numbers of mortgages, often subprime. I find it inconceivable that buyers of CDO debt really understood the riskiness of the tranched debt of leveraged pools of tranched mortgage securities underlaid by thousands of anonymous loans. But solid ratings made the debt highly salable.



With vast sums available for high-fee investment products, managers’ incentives favored the rapid amassing and deploying of large pools of capital. The usual effect of such a process is to drive up asset prices, drive down prospective returns and narrow investors’ margin of safety. It was no different this time.



Due to widespread prosperity, large amounts of capital flowing into the mortgage market, and the flowering of the American dream of home ownership (and of wealth therefrom), rapid home price appreciation became a prominent feature of this period. Price gains further inflamed the people’s hopes, and behavior regarding residential real estate grew increasingly speculative.



Thanks to the combination of the wealth effect from home appreciation, the ability to borrow liberally against increased home equity, and strong competition among financial institutions to provide credit, consumer spending grew faster than

2008 Oaktree Capital Management, L.P.

2

All Rights Reserved

consumer incomes, propelling the economy ahead but rendering households increasingly leveraged. As this process moved onward, it depended on a continued supply of the underlying ingredients: confidence, liquidity, leverage, risk tolerance and acceptance of untested structures. The resulting “virtuous circle” was described in glowing terms just as its perpetuation was growing increasingly unlikely.

Bust It took five years or so for the bullish background described above to be established in full. As usual, far less time was required for the excesses to be exposed and the process of their unwinding to begin. The air always goes out of the balloon a lot faster than it went in. Regular readers know that if there’s one thing I believe in, perhaps more strongly than anything else, it’s the fact that cycles will prevail and excesses will correct. For the bullish phase described above to hold sway, the environment had to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. A lot of this has happened. Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction. But most of the time there is a spark that starts the swing from bullish to bearish. This time it came in the world of subprime mortgages. Subprime mortgages (as if there’s a person alive who doesn’t know) are loans made to people whose credit scores fall below the “prime” standards that government-sponsored agencies Fannie Mae and Freddie Mac require of the loans they buy. In the last few years, as part of the rosy process described above, subprime mortgages were issued in rapidly increasing numbers. They were often placed by independent mortgage originators paid for volume rather than credit quality; through salesmanship that caused excessive amounts to be borrowed; for the purchase of highly appreciated homes; with temporarily low “teaser” interest rates; in structures that reduced or delayed principal repayment; and without requiring borrowers to document the incomes they claimed. Of course, with the clarity that comes with hindsight, everyone now sees that these elements constituted breeding grounds for trouble. Anyway, here’s how things went: 

In late 2006 and early 2007, defaults among subprime mortgages began to rise. But as is usually the case with the first crack in the financial dam, this attracted little attention and was generally described as an “isolated development.”

2008 Oaktree Capital Management, L.P.

3

All Rights Reserved



By July 2007, however, the defaults became serious and could no longer be ignored. This precipitated wholesale downgradings of CDO debt securities.



The defaults and downgrades led to price declines. This caused leveraged investment entities that held CDO debt to receive margin calls and capital withdrawals. When they went to the market to sell the debt to raise cash, they found either that it couldn’t be sold or that the bids were way below fair value. When some investors announced significant losses, the mark-to-model approach often used for pricing was questioned and then rejected in favor of market prices.



In times of crisis, you sell what you can sell, not what you want to sell. Many of the entities that held CDO debt also held leveraged loans (the new term for bank loans, since most banks no longer hold on to loans for long). Thus, when they couldn’t get fair prices for CDO debt, they sold leveraged loans, putting their prices under pressure as well. And when the creation of new Collateralized Loan Obligations slowed to a trickle, the decline in demand from CLOs removed an important prop from loan prices.



Some leveraged entities that couldn’t sell enough CDO debt (or other holdings) at fair prices suspended withdrawals. In extreme cases, they melted down and investors lost everything. In sum, entities that had borrowed short to invest in longer-term, potentially illiquid assets fell victim to their funding mismatch. The precariousness of this position is easy to overlook when all is going well, asset prices are firm and capital is freely available. But it regularly leads to ruin when financial crises take hold.



With these developments, psychology turned from positive to negative overnight. Lenders became more nervous, requiring repayments, raising lending standards and refusing to roll over maturing loans. In particular, there was a dramatic contraction in the market for commercial paper backed by assets (rather than by promises from creditworthy firms).



Among other things, the investment banks found their balance sheets clogged with debt for buyouts that they had promised to place (“bridge loans”) before the music stopped, and the debt became unsalable on the agreed terms. This cut into their ability to make new loans. Discount sales were talked of, and funds were formed to buy up the loans.



Central banks stepped in to calm the waters. The European bank injected significant capital. The Fed cut short-term rates. The Bank of England guaranteed deposits at Northern Rock, a building society (S&L), and extended emergency loans. And so the panic eased. The reaction seemed to be “boy, I’m glad that’s over.” But the calm lasted only from early September to mid-October.

2008 Oaktree Capital Management, L.P.

4

All Rights Reserved



CDO downgrades continued, price declines deepened, and financial institutions began to report third-quarter losses on mortgage-related holdings. These occurred around the world, but they were concentrated in U.S. commercial and investment banks. There was some surprise when it turned out that, despite disintermediation, banks still had ended up holding the bag. Also surprising was the fact that new and unheard-of types of (usually bank-controlled) off-balance-sheet entities – structured investment vehicles (“SIVs”) and conduits – were among the big losers. Because some couldn’t renew their asset-backed financing, their debts had to be taken onto the banks’ balance sheets (to avoid holding fire sales in order to repay lenders), bringing the supposedly alchemical process of disintermediation full circle.



Banks warned of fourth-quarter losses, people wondered whether the warnings were sufficient, executives lost jobs, and suppliers of credit became even more restrictive. Due to the combined effect of losing equity to writedowns and having to take SIV debt onto balance sheets, there was talk of bank equity capital becoming inadequate. Citigroup found it appropriate to sell convertible equity to Abu Dhabi with an 11% starting dividend, and others like UBS and Merrill Lynch followed suit.



Mortgage lending ground to a near halt, even for “prime” borrowers. Homebuilders and housing-related retailers issued profit warnings. Inventories of unsold homes swelled. A few money market funds threatened to “break the buck” and had to be rescued. Towns in Norway that had bought CDO debt neared insolvency. Florida’s pooled fund for localities had to suspend withdrawals. Mono-line insurers that had guaranteed mortgage-related securities came under pressure, casting doubt on the safety of municipal bonds they had insured. The “isolated development” had sprouted surprising and widespread repercussions.

In just four months – from mid-July to mid-November – we saw the development of a full-fledged credit crunch, with that term regularly appearing in the headlines. Whereas anyone could get money for any purpose a year earlier, now deserving borrowers had a tough time securing funds. And there you have it: five pages devoted to the past in a memo about the future.

Clouds on the Horizon

U

U

The Fed and other central banks have taken strong action to lower the cost of credit and inject reserves into the system. And in the last month or so, things went quiet. But with everyone back from the holidays, events are likely to heat up again. Clearly things have just begun to be sorted out in the financial sector. Year-end pricing of mortgage-related securities may bring further writedowns. Auditors may view low prices as more defensible than high ones, and avoiding legal risk can influence their decisions. Conservative auditors will do battle with bank managements desirous of maintaining equity reserves and financial flexibility. On the other hand, there may be a

2008 Oaktree Capital Management, L.P.

5

All Rights Reserved

wish on the part of managements – especially new ones – to clear the decks by marking down or selling off problem assets. All of this may result in bigger losses in the short run. There’s still some mystery about whether mortgage losses will pop up in new places. For example, relatively little has been reported by insurance companies and pension funds. We also thought Asian institutions were big buyers of CDO paper over the past year or two, yet nothing’s been heard from them to date. Fundamentals are really bad in the housing sector: Record home price declines. High levels of foreclosure, and neighborhoods where for-sale signs are everywhere. Swollen inventories of unsold homes. Mortgage interest rate resets that are likely to add further to the above. Very low sale volumes (meaning sellers haven’t adjusted to reality in terms of the prices it’ll take to tempt buyers). Financing and refinancing difficult to obtain. People unable to buy homes because they can’t sell the ones they own. What will happen to mortgage defaults? It’s hard to say how bad it’ll get. Anyone who bought a home in 2005-07 and borrowed a high percentage of the cost is likely to be “upside-down” – that is, to owe more on the mortgage than the house is worth. Will these people keep on making mortgage payments? And what will happen as interest rates reset from teaser to market? Will borrowers be able to afford the increased payments? Will they stop paying on car loans and credit cards to make the mortgage payment? Or are the former more essential for survival in the short run?

Implications for the Broader Economy

U

Everyone wants to know whether there’s a recession ahead. They’re even asking me . . . someone who certainly doesn’t know. I don’t think about it much. First of all, thinking isn’t going to produce a useful answer. People have opinions, and while they may be considered opinions, I wouldn’t bet on whether they’ll be right. Most people say the probability is about 40-50%, which I think is their way of saying they don’t know but they feel it’s not unlikely. A recession is a technical matter: two consecutive quarters of negative real growth. Sure, recessions are bad, but if there isn’t a recession, that doesn’t mean everything’s okay. What matters to us is whether the economy will or won’t be sluggish. It is generally believed that highly leveraged companies run into trouble and defaults rise significantly when economic growth falls below 2% per annum. Several things suggest that in the months and perhaps a year or two ahead, economic growth will be less than vibrant. Many are related to the consumer. The housing situation described above particularly bodes ill.

2008 Oaktree Capital Management, L.P.

6

All Rights Reserved

 



Rising mortgage payments are likely to hinder consumer spending. It’s hard to believe consumer psychology will be positive. With home prices well below the levels of a year or two ago, the “wealth effect” will be negative. Feeling poorer is likely to discourage consumer spending. So is negative news about the economy, and the receipt of much larger bills for gasoline and heating. The combination of rising home prices and generous capital markets in the past permitted home equity to be withdrawn and spent. Neither of those is likely to be a positive in the near future.

Consumer spending is the engine of the U.S. economy’s growth. I just don’t see it staying strong. I heard the other day that we should applaud consumers’ “resilience”: their willingness to spend even when incomes and news are negative. Personally, I find it frightening. Eventually there’ll be a day of reckoning for spending growth which isn’t supported by income growth – that is, for dissaving. The second element with a negative prognosis is capital availability. Banks’ losses on mortgage-related securities have eaten into both (a) the capital they need to support their lending and (b) their appetite for risk. Less credit is available to hedge funds and private equity funds. Fewer CDOs and CLOs will be formed in the near future, so they won’t be able to provide debt capital as aggressively as they did in the past. Just as leverage and willingness to bear risk were the twin engines of the recent boom, so their reduction is likely to cause things to slow. Third, business expansion is unlikely to contribute to growth. Already-slow holiday spending, employment growth and orders for durables are unlikely to encourage businesses to expand production, build inventories or create jobs. The announcement of corporations’ fourth quarter results in a month or so will give us a hint regarding direction. The main offset to concern about a slowdown comes from overseas. In the past, a recession in the U.S. was sure to have effects worldwide. Now, it seems possible that developing economies such as those of China and India will see enough demand from elsewhere – including domestic demand – to avoid importing our slowdown. The most optimistic case holds that foreign demand might avert a recession in the U.S. Such demand could be buttressed by the softness of the dollar, which makes our goods very attractive to buyers spending foreign currencies. We’ll see. As usual, there are optimists and pessimists. The optimists see enough strength to offset the effect of the mortgage losses. The pessimists think a massive contraction in the prices of assets – mostly homes – implies a calamitous contraction that can only be averted through massive government action (if at all). We won’t bet on which is right, but we believe the economy – and thus business – will be less vibrant in the period ahead than it has been.

2008 Oaktree Capital Management, L.P.

7

All Rights Reserved

The Fed’s Dilemma

U

Investors are hoping the Fed will ride to the rescue with rate cuts and capital injections that bolster the economy. It did so in September, allowing sentiment to improve and debt prices to recover for a while, and again in December. The markets rejoice when the Fed cuts rates (all but the bond market, which worries that rekindled inflation will push up interest rates, which will push down bond prices). Personally, I think a rate cut sends a mixed message. It implies help is on the way, but it makes me wonder about the peril that made the Fed take the step. It’s like the guy who goes to the doctor and sees him pull out a gigantic hypodermic. Nice to know he’s getting treatment, but isn’t the condition worrisome? Along those lines, the Fed’s 50 basis point cut on September 14, which exceeded most expectations, caused breakingviews.com to run the headline “Does Ben [Bernanke] know something we don’t?” Around November 27, investors concluded they could count on a significant rate cut, causing the Dow to move up 546 points in just the next two days. Surely they think lower rates will stimulate the economy and help offset the credit crunch. But here are the counters: 

Will making money cheaper cause financial institutions to borrow and lend, or people to borrow and spend? Can a rate cut offset the frightening aspects of declining creditworthiness? Low interest costs provide scant compensation when loans go unpaid. Thus the Fed can offer cheap money, but it can’t make people borrow it, spend it or risk it. The phrase for that problem is “pushing on a string.” It’s a big part of the reason why Japanese economic growth has never been successfully restarted. For this reason, some observers are suggesting that Washington add fiscal stimulus (tax cuts and spending increases) to the Fed’s monetary policy. In this way, consumers’ reticence can be offset by direct government spending.



Will fear of rising inflation deter the Fed from stimulative action? In general, central bankers view their primary job as keeping inflation from accelerating as the economy grows. Avoiding slowdowns is usually secondary. Prices are moving up sharply in food and fuel, and the overall rate of inflation has broken out from the low levels of the past decade. This may limit the Fed’s freedom to stimulate the economy and risk a reheating. And I hear some worry about a return to the “stagflation” of the 1970s, in which inflation roared ahead but economic growth couldn’t gain traction.



What will lower rates do to the willingness of foreigners to hold dollar reserves? We need foreigners to hold dollar-denominated securities. They’re the swing buyers of billions of dollars of Treasury securities each year. If they won’t do so, who’ll finance our fiscal and trade deficits? If investing at U.S. interest rates is seen as implying too great an opportunity cost, a spreading conclusion that dollar holdings are unattractive will put us in quite a financing pickle. Of course, this worry will be

2008 Oaktree Capital Management, L.P.

8

All Rights Reserved

ameliorated if there’s widespread rate cutting among the central banks of the developed world. 

Finally, the Fed has to think about moral hazard. Yes, the Fed wants to prevent financial catastrophes and widespread resulting pain. But at the same time, it doesn’t want to give risk takers the impression that they can count on the central bank to make them whole, and thus encourage greater adventurousness in the future. The Fed will have to balance its reluctance to rescue sophisticated speculators against its desire to protect “innocent bystanders.”

I’m sure the Fed will take strong steps to keep the credit crunch from becoming as bad as it otherwise might. But there are limits on its freedom to take action and its ability to save the day.

Averting Fire Sales Many of the full-blown crises I’ve seen have been caused (or exacerbated) by the following process, which eventually ends in something commonly called a fire sale:      

take on short-term capital, invest it in longer-term or illiquid assets, experience price declines and writedowns that eliminate your resolve to hold, unsettle your suppliers of capital and/or jeopardize your capital adequacy, receive a margin call or capital withdrawal notice, need to raise cash on a day of market chaos, and be forced to sell into an inhospitable market regardless of price.

In the distressed debt funds that we organized in 1990 and 2002, both times of chaos in financial markets, we earned net IRRs in the 30s and 40s. If you think about it, those IRRs have to be described as aberrant. No one should be able to earn returns like those without significant leverage. And yet we did. Like all active investors, we try to buy things for less than they’re worth. The above results suggest we were aided in those funds by people who were willing to sell things far below their worth. Why would they do so? Often because of the fire sale process described above. Not surprisingly, our financial leaders are attempting to short-circuit this process. Mortgage defaults are real and widespread and will produce losses for holders of related securities. Eventually those losses will have to be recognized and dealt with. But I think several of the actions we’re seeing are aimed at avoiding exaggerated, panicked fire sales:    

injections of liquidity, mortgage reset holiday, taking SIVs (and their debt) onto balance sheets, and proposing a Super-SIV (which now seems to be history).

2008 Oaktree Capital Management, L.P.

9

All Rights Reserved

But we need to recognize that in addition to potentially enriching buyers of distressed assets, fire sales clear problems from balance sheets and speed solutions. They bring pain and chaos, but they also move things ahead. One of the reasons for Japan’s lingering malaise may be that it denied its bad-debt problems for too long, allowing sluggishness to dominate the economy. The questions in the U.S. and Europe will be what’s being done and whether it will work. I looked at the Super-SIV particularly quizzically. Its avowed purpose was to prevent fire sales on the part of SIVs that had financed debt purchases with asset-backed commercial paper that couldn’t be rolled over. So financial institutions would fund an entity that would buy assets rather than require their sale in the open market, where they would bring lower prices. But that’s perverting economics! Let’s see: “We’ll buy something for 90 rather than see it come to a frozen market where it might bring 70. Yes, we’ll buy it now even though we might have gotten a chance later to buy it for less.” That just shouldn’t happen, and now it appears it won’t, as the Super-SIV mission has been scrubbed.

A Word on the Monoline Insurers

U

I usually emphasize discussion of macro developments, but at this time there’s a micro story that very much deserves telling. Over the last two decades, a few companies developed the business of insuring municipal bonds. Since this was their only business, they’re called monoline insurers. Because of the extremely low historic frequency of defaults on munis, a relatively small amount of capital was enough to allow MBIA, Ambac and a handful of smaller companies to guarantee the payments on $2 trillion of municipal bonds. In the last few years, rather than be left behind as old fogeys, these companies “got modern” like almost everyone else: in addition to munis, they began to insure leveraged entities such as CDOs. And like everyone else, the actuarial calculations they used to determine how much debt they could afford to insure and the premiums they should charge were based on default experience from a brief period that shouldn’t have been extrapolated. Thus, like so many others, they took on propositions that have trashed their balance sheets, with grave implications for their basic business. Here’s where it gets interesting. Many muni buyers either want or are required to hold only AAA-rated bonds. And many munis gained their AAA ratings not because the issuers were eminently creditworthy, but because they were insured by companies with AAA ratings. But several of the insurers have landed on the credit rating agencies’ watchlists for downgrades, given the possibly unknowable risks they assumed. If they lose their AAA ratings – and thus the bonds they insured do so as well – will there be a rush of muni holders to the exit? A fire sale at which buyers are scarce? One or more of the insurers may need injections of equity capital to bolster their reserves. But what price will investors pay for their stock? (Warburg Pincus committed to invest

2008 Oaktree Capital Management, L.P.

10

All Rights Reserved

in MBIA about a month ago, when the stock was at $31, and today it’s less than half that). And if the potential CDO losses are so great that a monoline insurer’s net worth may be negative on an expected value basis, would anyone put in equity capital when the first of it basically will go to cover creditors? Certainly the monolines’ future has been complicated by Warren Buffett’s decision to compete by forming a new company that’s not burdened by a CDO legacy. A relatively minor sideshow, but one very much worth watching. And one which illustrates the potential of “isolated developments” to have surprisingly widespread ramifications.

The Shoe That Hasn’t Dropped

U

Amid all the chaos, one area has been unaffected thus far: corporate creditworthiness. Defaults on high yield bonds and non-investment-grade loans are usually the site of most of the pain in this area, and to date there have been almost none. Defaults among high yield bonds have averaged 4.2% over the last 20+ years and reached double digits in 1990-91 and 2001-02, giving us huge opportunities to buy depressed assets. In contrast, over the last year or two defaults have been near 25-year lows . . . and practically zero. Oaktree’s high yield bond portfolios are in their 47th month without a default. Will default rates on high yield bonds reach or exceed the historic average? And how will the new asset class of leveraged loans weather its first test? First, with a slower economy, there’s every reason to believe creditworthiness will decline and defaults will rise. It’s just hard to believe that the incidence of default will be unaffected if the economic environment turns less salutary. Second, over the last few years we’ve seen a highly elevated level of buyout activity, with deals priced at increasing multiples of cash flow and financed with rising proportions of debt. Better companies can support higher debt levels, and some of the buyouts have been of top companies. But we feel that prices and leverage ratios have been high in the absolute, and that competition to buy companies in a heated environment made buyout funds stretch on purchase price. Some of the assumptions underlying these deals undoubtedly will prove to have been overly optimistic, and eventually we’ll have the opportunity to buy debt in those deals at discounts. Non-performing debt related to leveraged buyouts gave us great buying opportunities when the LBOs of the 1980s cratered in 1990. Chastened providers of capital cut back their lending in the 1990s, and thus buyouts didn’t contribute to the 2002 debt crisis. But we expect unsuccessful buyouts to be a primary source of distressed opportunities in the next go-round. Given the high volume of non-investment-grade debt issuance recently, even a moderate rate of default implies a heavy supply of distressed debt, contributing to the perception of a credit meltdown.

2008 Oaktree Capital Management, L.P.

11

All Rights Reserved

Third, lots of potential defaults will be delayed or prevented because recent issuance has emphasized issuer-friendly debt. Default occurs when an interest payment isn’t made or a debt covenant (non-cash financial requirement) is breached. But in some recent issues, the borrowers obtained the right to pay interest for a while in the form of additional debt (“toggle” bonds, because the borrower can throw the switch), and in some there were few if any maintenance covenants (“covenant-lite” debt). Some borrowers also arranged for standby credit facilities, giving them further financial flexibility in tough times. Fewer tripwires – fewer defaults. These features will delay defaults but won’t necessarily preclude them. It all depends on what happens in the period between the day the default otherwise would have occurred and the day the music has to be faced. Maybe there’ll be fewer defaults. Maybe bigger ones. And anyway, there’s lots of “normal” (non-issuerfriendly) debt outstanding, especially in connection with small- and mid-size buyouts. In addition, it’s not as if debt became more borrower-friendly without there being a response. Financial engineers, who decide what risks can be taken on the basis of what’s likely, don’t see risk decline and leave it at that. They tend to build back the risk so as to fully utilize their “risk budget.” So I imagine people said, “Debt has become easier to bear; let’s take on more of it.” Which is safer: a company with a moderate amount of demanding debt, or one which has been highly levered with debt that’s less burdensome? The answer is that you can’t tell without knowing how things will unfold. You certainly can’t say the latter company is less risky than the former. Buyouts in Europe have been at least as aggressive as in the U.S. and on average have been associated with less solid companies. In addition, Europe has never seen a fullfledged debt crisis, and the first one could be traumatic. Thus we expect numerous defaults and lots of discounted debt there. On the other hand, Asia hasn’t yet been the site of many highly leveraged buyouts, so high levels of defaults and distress don’t figure into our expectations for Asia. Maybe next cycle, after some aggressive buyouts have taken place there. Looking ahead, private equity will be subject to crosscurrents. The less accommodating capital markets will have a number of effects:     

Buyout funds will find it harder to finance acquisitions, especially large ones. Similarly, a lot of existing buyout debt won’t be refinanceable on the same terms in the new environment. The speed and ease of recaps will be reduced, rendering quick withdrawals of equity capital at ultra-high IRRs much less likely. It will be harder for funds to achieve profitable exits, as would-be buyers from private equity funds won’t find it as easy to finance purchases or pay high prices, and IPOs will be an uncertain route to realizations. But these same factors will also affect the competition to invest, meaning private equity funds’ purchase prices in the future will likely be lower than they otherwise would have been.

2008 Oaktree Capital Management, L.P.

12

All Rights Reserved

Finally, underperforming companies will crop up in private equity portfolios, and the need for turnarounds and restructurings will take up time and pull down returns. In many ways, the private equity industry may have to operate as it did in an earlier era, when funds were smaller, the volume of transactions was more moderate, both purchase and sale prices were lower, holding periods were longer, and IRRs were lower (but perhaps more meaningful in terms of times-capital-returned). Funds will have to make money the way they used to, with more emphasis on buying cheap and adding value and less on financial engineering and quick flips. Large funds formed within the last 12-18 months may find themselves uninvested for a while, and thus in high-fee limbo.

*

*

*

It’s worth remembering that the boom of the last few years arose in the financial sector, not the “real world.” Economies grew around the world – as did corporate profits – but there was no economic boom other than in developing nations. It was optimism, risk tolerance, innovation, liquidity, leverage, credulity and the race to compete that reached multi-generational highs. Thus the ramifications will be (actually, have been) felt first and most strongly in the financial sector. The question is how far they’ll spread from there. Undoubtedly, credit will be harder to obtain. Economic growth will slow: the question is whether it will remain slightly positive or go negative, satisfying the requirement for the label “recession.” Regardless, positive thinking and thus risk taking are likely to be diminished. All I can say for sure is that the world will be less rosy in financial terms, and results are likely to be less positive than they otherwise would have been. That can be enough to make highly leveraged transactions falter. I’ve said many times that for each period there’s a mistake waiting to be made. Sometimes it’s buying too much, and sometimes it’s buying too little. Sometimes it’s being too aggressive, and sometimes it’s not being aggressive enough. Which it is depends on the combination of the going-in opportunities and the environment that unfolds. What mistake is on offer today? How aggressive should one be? Although the extent of the coming softness has yet to be fully defined, I feel we’re in the second or third inning. (For readers who aren’t followers of baseball, that means the standard nineinning game has barely begun.) I recently read a piece asserting that we’re still singing the national anthem before the start of a game destined to go beyond nine innings, but I find it hard to engage in such extreme thinking. The damage has begun to be felt and the correction has begun to take place.

2008 Oaktree Capital Management, L.P.

13

All Rights Reserved

Nevertheless, I do think we’re in the early going: the pain of price declines hasn’t been felt in full (other than perhaps in the mortgage sector), and it’s too soon to be aggressive. Things are somewhat cheaper (e.g., yield spreads on high yield bonds went from all-time lows in June to “normal” in November) but not yet on the bargain counter. Thus, I’d recommend that clients begin to explore possible areas for investment, identify competent managers and take modest action. But still cautiously, and committing a fraction of their reserves. “Don’t try to catch a falling knife.” That bit of purported wisdom is being heard a lot nowadays. Like other adages, it can be entirely appropriate in some instances, while in others it’s nothing but an excuse for failing to think independently. Yes, it can be dangerous to jump in after the first price decline. But it’s unprofessional to hang back and refuse to buy when asset prices have fallen greatly, just because it’s less scary to “wait for the dust to settle.” It’s not easy to tell the difference, but that’s our job. We’ve made a lot of money catching falling knives in the last two decades. Certainly we’ll never let that old saw deter us from taking action when our analysis tells us there are bargains to be had. In the period leading up to the current crisis, investors acted like they were loaded down with too much cash and desperate to put it to work. To do so, they ventured into uncharted waters and unknowingly accepted high risks in investments providing lessthan-commensurate compensation. With too much money chasing too few deals, the bargaining power was in the hands of the takers of capital. They used it to their advantage, making deals that were good for them but bad for the suppliers of capital. In the period ahead, cash will be king, and those able and willing to provide it will be holding the cards. This is yet another of the standard cyclical reversals, and it will afford bargain hunters a much better time than they had in 2003-07. Some of those who came to the rescue of troubled financial firms in 2007 may have jumped in too soon. There’s a fair chance they didn’t allow maximum pain to be felt before acting, (although the prices they paid eventually may turn out to have been attractive). I’d mostly let things drop in the period just ahead. My view of cycles tells me the correction of past excesses will give us great opportunities to invest over the next year or two.

January 10, 2008

2008 Oaktree Capital Management, L.P.

14

All Rights Reserved