TREES INVESTMENT COUNSEL VIEWPOINT (Q2 2007) 

Is it as good as it gets? Markets are booming and economies are buoyant across the globe - in the United States, Europe, Asia, Latin America, you name it.  With a few notable exceptions, things are good...very good.

The Dow Jones Industrial Average and the Standard and Poor's 500 are at record highs despite the subprime debacle and a weak housing market.  Oil prices above $70 are having no market impact, although the upshot of higher energy prices has reared its ugly head in the form of inflation.  Just look at the price of a gallon of milk at the supermarket!

As we discussed in our last Viewpoint, there are some major forces including a less cyclical world economy and an abundance of liquidity that appear to be propelling markets and could continue to do so for some time.  But as we extend the period of market prosperity (we reemphasize that we have not had a 10% correction since 2002), it is natural to look for pitfalls.  What could go wrong?

Outside of the risk of a terrorist event or significant natural disaster (both of which could cause mayhem), the beginning of a credit tightening cycle is underway.  Where the spigots were flowing wildly just a few months ago, banks are being more discerning in their lending and are increasing the price of risk (widening spreads), as well as tightening debt covenants.  Notably a few private equity deals have encountered trouble with financing over the past few months, and the liquidity of subprime debt has been curtailed, forcing a few hedge funds to shutter.  As underlying interest rates increase and spreads widen, it is more expensive for hedge funds and private equity funds to borrow money to leverage their investments.  Leverage has been the linchpin of their inflated returns.

Interestingly, the alternative investments category (private equity, hedge funds, real estate, etc.) is flush with cash, making it more competitive than ever for available deals.  Supply and demand theory suggests that greater competition results in higher prices and valuations paid for deals, which is exactly what has happened.  At the same time, with tightening credit and higher rates, it is going to be more difficult to hit the elevated rates of return that firms have been posting over the past five years of cheap credit.  Unbelievably, it has been observed that some real estate deals have been done at negative "cap rates", whereby the financing rates have exceeded the current return on the purchased properties.  These dealmakers are clearly counting on continued economic prosperity to generate positive returns.

Finally, private equity managers are no dummies.  With Blackstone and KKR as public entities and a long line looking to follow in their footsteps, one has to wonder, is it a market peak? Private equity firms are notoriously some of the most closed lipped about their investments and the inner workings of their business models - going public is the antithesis to these stalwart principles.  Moreover, PE managers are some of the best paid professionals in the world.  Why would firms open themselves up to the scrutiny of the public markets if they did not see an end to the ballyhoo? We can't think of a reason.  Can you?

  
July 18, 2007