The Silly Season Again-Are We in For Another Bubble?
This article was published in March, 2007 by Steven R. Gerbsman and Robert Tillman.
Please read, enjoy and “be prepared”.
Here are some trends that are presently being observed in the market:
Valuations and Leverage
According to Venture Source, the median venture capital pre-money valuation in Q1 2005 was $15 million, the highest it has been since 2001. In Q3 2006, it is up 20%-40% from 2005. It is a good bet that it will be higher yet in Q4 2006. Although these deals have not reached the $21 million level of 1999 or the $23 million level of 2000, they are getting there. The market is also seeing valuations paid by private equity investors now in the 10X to 12X trailing EBITDA range. Strategic buyers are having a hard time competing at these price levels and Private Equity and Hedge Funds are flush with CASH.
The market is also observing that banks are financing new deals in the 7X to 7.5X trailing EBITDA range. This high level of debt financing is what allows the private equity firms to pay 10X to 12X trailing EBITDA. In many instances, the private equity firms approach a deal with the expectation that they will be able to refinance within a year and then pull out all or a substantial part of their equity investment. Clearly, a deal financed in this way must continue to show substantial EBITDA growth in order for such leverage to be repaid. Such highly leveraged deals are extremely vulnerable to any EBITDA downturn.
As professional turnaround and restructuring people, Gerbsman Partners talks regularly to investors, i.e. lenders, hedge funds, private equity firms and venture capital firms. We also are in contact with most of the top bankruptcy attorneys around the United States and with many investment bankers. The general consensus is that there is a very large amount of cash chasing a limited number of quality deals. Almost every deal of any significant size is professionally shopped by an investment banker, resulting in a highly competitive auction situation and high valuations.
We are also observing that most bank and investment firms are reporting few problems in their portfolios. Bankruptcy attorneys business have been slow. Certainly, most of the 2000 Bubble deals have been cleaned or sold or have died. Nevertheless, we feel that investment firms are simply covering up their problems using the large amounts of cash currently available. Many investment firms are in the process of raising new funds and are thus reluctant to face up to the problems represented by their “living dead” portfolio companies. Even with “healthy” companies, rapid growth often masks underlying structural problems.
Owing to increasingly globalized competition, there is little ability for businesses in many sectors to raise prices. In fact, prices in certain areas, particularly electronics and telecommunications services continue to fall in real terms. As such, we are observing cost pressure on businesses in the following areas.
Interest rate increases will likely continue and there has been a more than 2X rise in energy prices over the past two years, with oil hovering now around $50 – $60 a barrel. Since this rise in energy prices appears to be driven by higher consumption in both China and India, it is likely to be a long-term trend. The effect of this long-term energy price rise is still percolating through the economy.
Health care costs are increasing, which is felt by businesses as the cost of health insurance is also increasing. Part of these increases are owing to an aging population, workman’s compensation and liability insurance costs. We are also observing wage escalations, built in commercial real estate lease rent escalations, an increase in water prices, particularly in the Western United States. There is increasing evidence that we are in the end stages of a residential real estate bubble and currently in a soft nationwide soft real estate market. Consumer leverage is up substantially, in large part because of the real estate price increases and the cost of energy and in many instances, the consumer has spent at an unsustainable level by cashing in on the equity value of their homes and short term re-financings are coming due.
Other major uncertainties that we are observing are, the potential for a major terrorist attack in the United States using some form of nuclear weapon, the potential for a major global influenza epidemic on the scale of that of 1918, the potential destabilizing effects of the huge increase in hedge funds and in all forms of derivative contracts. (For the clearest explanation of derivatives and their consequences, see pages 12-14 of Warren Buffet’s 2002 Letter to the Berkshire Hathaway shareholders, an increasing trade deficit and a major ongoing budget deficit).
Increasing business and consumer leverage makes the overall economy vulnerable to any sort of shock. That shock can come from one of the sources we have cited or from ones that we have not yet seen. We are not certain what it will be or when it will come.
Market prices often continue to rise even when everyone “knows better”. For example, Sir Isaac Netwon, the Master of the Mint and likely the smartest man in England at the time of the famous South Sea Bubble foresaw a stock market crash and sold out his holding for a profit of 7,000 pounds. When the market continued to rise, he bought back in and subsequently lost 20,000 pounds. (This was at the time that the annual wage for a skilled craftsman was about 30 pounds). People who invest on the greater fool theory often find themselves looking at the greater fool in the mirror.
Based on the above, we strongly suggest that all equity and debt providers review all their all their portfolio companies and take aggressive steps immediately to address and weaknesses. We also trust that all financing groups seek to maintain pricing discipline in their investments. Based on the reality of 1999 and 2000 era funds, it is far better to miss a deal than to overpay.
About Gerbsman Partners
Gerbsman Partners focuses on maximizing enterprise value for stakeholders and shareholders in under-performing, under-capitalized and under-valued companies and their Intellectual Property. In the past 60 months, Gerbsman Partners has been involved in maximizing value for 79 technology, medical device, life science, digital marketing/social commerce and solar companies and their Intellectual Property and has restructured/terminated over $810 million of real estate executory contracts and equipment lease/sub-debt obligations. Since inception, Gerbsman Partners has been involved in over $ 2.3 billion of financings, restructurings and M&A transactions.
Gerbsman Partners has offices and strategic alliances in San Francisco, New York, Boston, Orange County, VA/DC, Europe and Israel.