Looking for an End to Deleveraging

Finally, a deal! The chairman of Lightyear Capital, Donald Marron, told me that we would know we have hit bottom when deals start to flow again. Yesterday's announcement that Novartis will acquire Nestle's holding in eye-care company Alcon for about $11 billion could be a harbinger of the tap opening, ever so gingerly.

Deals have been off the table (and falling off the table) for months as the financial system "deleverages." The question of late has been: Can we deleverage the economy without killing it?

One of New York's top fund-of-funds recently held a phone-in session with investors to bring them up to date on the financial situation. If it was meant to be calming, it should have been conducted in a foreign language. The message was: The economy is still so gummed up with bad credit that hedge funds are setting the price of, well, practically everything.

Here's how it works. The banks and investment banks (except for Goldman Sachs) are trying to reduce the debt on their balance sheets by selling loans and other securities. All the normal opportunities to offload such loans by bundling them and selling them through structured investment vehicles are dead. (For instance, new collateralized debt obligation issues this past quarter totaled $6.4 billion, versus $103.6 billion a year ago.) Banks would like to dump their shakiest assets, but there are no buyers. So they have to sell high-grade assets instead. The "next marginal buyers" for such assets are, mostly, hedge funds. However, hedge fund managers are also reducing the debt on their balance sheets, some through their own volition, and others due to margin calls from the banks that have put several funds out of business this year. Overall, the hedge fund industry has "deleveraged" in two of the past three months, paying off trillions, it is said, in debt.

Here's the messy part. To entice hedge funds to buy, the triple-A rated securities being sold by banks have to be priced to yield something between 8% and 12% — or in other words, a yield that would satisfy an aggressive hedge fund without adding any leverage. This trend has played out in some startling transactions. About three weeks ago, a large bank sold an $18 billion portfolio of "money good triple-A rated paper" to yield 9%, the effects of which apparently "rippled across the market." I bet it did.

Translated, that means that the perfectly sound top-grade debt of leading corporations and banks that was selling to yield perhaps 6% took a 33% haircut, granting the buyer a 9% yield. Welcome to the other side of the credit mountain.

On the deal side, little money has been available to finance takeovers, for essentially the same reason. As the banks reduce their debt, they have become exceedingly picky about making new loans. Loan provisions have tightened up (covenant lite has become covenant tight), and they are not willing to finance takeovers using historically high leverage. As a result, one private equity player says, deals that used to get done easily with eight times leverage are now being priced using borrowings of six or six-and-a-half times equity. That sets the bar a lot higher; fewer transactions can still make sense.

Consequently, it was likely that strategic buyers would emerge as the next round of bidders for corporate assets. These would-be purchasers were left behind in the great overleveraged takeover boom, outbid by private equity firms able to borrow gobs of money to finance otherwise unappealing deals. Today, though, they are the ones who still have money, and a rationale for getting transactions done.

That said, there is no lack of money available. Leveraged buyout firms reportedly raised $50 billion in new funds in the fall, and the hedge funds that are still healthy are said to be sitting on large amounts of cash as well. One major prime broker reported to clients that its equity hedge fund clients have average net exposure of only 28%, a level not seen since 2002. That compares with an average net exposure of 55% to 60% this time last year. Cash balances for many representative funds are up 100% so far this year.

There is money to invest, but at the moment, no reason to invest it. "Wait and see" has become "wait and prosper" as prices for nearly every kind of asset have declined and continue to fall. Hedge funds and others perceive an opportunity cost to investing today; they want to stay liquid.

How does this turn? It will be, partly, a matter of perception. Eventually a desirable asset will become the target of a bidding war, and the price will move up. Buyers who hesitate will eventually be penalized for doing so. Or assets will be sold for prices that are simply too tempting to resist. In the leveraged loan market, for example, the pricing today suggests default rates way above what is actually taking place, or is likely to take place. This anomaly may be explained in part by a shortage of liquidity in the marketplace. Dealers are not committing capital to the sector, as they are part of the deleveraging scenario, too.

Also, investors in hedge and private equity funds will eventually demand action. They will not be pleased to be paying fees to have their money invested in money market funds.

In the meantime, cash is king.

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