Kevin WilsonKevin WilsonKevin WilsonKevin WilsonZeus CapitalZeus Capital

WBS FORUMWBS FORUM 1313thth October 2008October 2008

Zeus Capital

Fear and Loathing in Financial ServicesFear and Loathing in Financial ServicesFear and Loathing in Financial ServicesFear and Loathing in Financial Services

A cautionary tale of the overA cautionary tale of the over--exuberanceexuberanceA cautionary tale of the overA cautionary tale of the over exuberance, exuberance, unrestrained greed and clueless regulation unrestrained greed and clueless regulation which brought us to our current positionwhich brought us to our current positionwhich brought us to our current position. which brought us to our current position.

Th f P i t E itTh f P i t E itThe consequences for Private Equity.The consequences for Private Equity.

Zeus Capital

Collateralised Loan Obligations Collateralised Loan Obligations for Beginnersfor Beginners

CLOs CLOs –– The Root ProblemThe Root Problem

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Rating DebtRating DebtRating DebtRating Debt

Rating agencies make a lot of money byRating agencies make a lot of money byRating agencies make a lot of money by Rating agencies make a lot of money by classifying debt according to its safety.classifying debt according to its safety.AAA is the best and safest debt so itAAA is the best and safest debt so itAAA is the best and safest debt so it AAA is the best and safest debt so it needs to pay less interest. It is very rare.needs to pay less interest. It is very rare.A d bt i j t littl i ki itA d bt i j t littl i ki itA debt is just a little riskier so it pays more A debt is just a little riskier so it pays more interest.interest.People relied on these ratings……..People relied on these ratings……..

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Building a CLOBuilding a CLOIn millions of £sIn millions of £s

£700m of “AAA” debt costing 6% a year£700m of “AAA” debt costing 6% a year£700m of AAA debt costing 6% a year£700m of AAA debt costing 6% a year

£200m of “A” debt costing 7% a year£200m of “A” debt costing 7% a year£200m of A debt costing 7% a year£200m of A debt costing 7% a year

Zeus Capital

Building a CLO Building a CLO In millions of £sIn millions of £s

£700m of “AAA” debt £700m of “AAA” debt We need to pay the We need to pay the costing 6% a yearcosting 6% a year£200m of “A” debt £200m of “A” debt costing 7% a yearcosting 7% a year

p yp yinterest on our debtinterest on our debt£700m at 6% = £42m£700m at 6% = £42m

costing 7% a yearcosting 7% a year£100m of equity from £100m of equity from investors seeking toinvestors seeking to

£200m at 7% = £14m£200m at 7% = £14m£56m£56m to be found to be found each yeareach year investors seeking to investors seeking to

make make You have now raised You have now raised

each yeareach yearWhat to invest the What to invest the £1000m in???£1000m in??? £1000m £1000m –– a billion a billion

poundspounds

£1000m in???£1000m in???

Zeus Capital

Building a CLO Building a CLO In millions of £sIn millions of £s

£700m of “AAA” debt £700m of “AAA” debt What to invest the What to invest the costing 6% a yearcosting 6% a year£200m of “A” debt £200m of “A” debt costing 7% a yearcosting 7% a year

£1000m in???£1000m in???Lets try 4000 Lets try 4000

t f £1/4t f £1/4 costing 7% a yearcosting 7% a year£100m of equity from £100m of equity from investors seeking toinvestors seeking to

mortgages of £1/4m mortgages of £1/4m each paying 8% a each paying 8% a yearyear investors seeking to investors seeking to

make make You have now raised You have now raised

yyThis makes This makes £80m£80m a a year in interest paid to year in interest paid to

£1000m £1000m –– a billion a billion poundspounds

usus

Zeus Capital

When CLOs workWhen CLOs workWhen CLOs workWhen CLOs work

Annual income from mortgages = £80mAnnual income from mortgages = £80mAnnual income from mortgages = £80mAnnual income from mortgages = £80mCost of paying interest on our debt = £56mCost of paying interest on our debt = £56m

S fitS fit £24£24So profit = So profit = £24m£24m

And this And this annualannual profit all belongs to the profit all belongs to the £100m of equity £100m of equity –– a great deal!a great deal!q yq y gg

Zeus Capital

When it goes wrong …….When it goes wrong …….When it goes wrong …….When it goes wrong …….

£700m of “AAA” debt£700m of “AAA” debt Lose 1 in 10Lose 1 in 10£700m of AAA debt £700m of AAA debt costing 6% a yearcosting 6% a year£200m of “A” debt £200m of “A” debt

Lose 1 in 10 Lose 1 in 10 mortgages and you mortgages and you lose £100m lose £100m

costing 7% a yearcosting 7% a year£100m of equity from £100m of equity from q yq yinvestors seeking to investors seeking to make a fortunemake a fortune

A memory!A memory!

Zeus Capital

When it goes wrong…….When it goes wrong…….When it goes wrong…….When it goes wrong…….

£700m of “AAA” debt£700m of “AAA” debt Lose 3 in 10Lose 3 in 10£700m of AAA debt £700m of AAA debt costing 6% a yearcosting 6% a year£200m of “A” debt £200m of “A” debt

Lose 3 in 10 Lose 3 in 10 mortgages and you mortgages and you lose £300m lose £300m

costing 7% a yearcosting 7% a year£100m of equity from £100m of equity from q yq yinvestors seeking to investors seeking to make a fortunemake a fortune

A memory!A memory!

Zeus Capital

Of course you need to find the Of course you need to find the mortgages……mortgages……

At first it was easy to find quite safeAt first it was easy to find quite safeAt first it was easy to find quite safe At first it was easy to find quite safe mortgages at three times salarymortgages at three times salaryThen when they ran out you had to takeThen when they ran out you had to takeThen when they ran out you had to take Then when they ran out you had to take four times salary four times salary A d th h ld lik bi lA d th h ld lik bi lAnd then anyone who would like a big loan And then anyone who would like a big loan pretty well regardless of their ability to pay pretty well regardless of their ability to pay

l t bl t b i t !i t !–– welcome to subwelcome to sub--prime mortgages!prime mortgages!

Zeus Capital

European Private Equity Funds formed 1980 to 2006. European Private Equity Funds formed 1980 to 2006. A li d N t P l d IRR i i ti t 31 DA li d N t P l d IRR i i ti t 31 DAnnualised Net Pooled IRR since inception to 31 Dec Annualised Net Pooled IRR since inception to 31 Dec

20062006Results refer to fund size not deal sizeResults refer to fund size not deal size

StageStage No of fundsNo of funds Pooled IRRPooled IRRAll ventureAll venture 677677 5.55.5Buyout Buyout €€00--250m250m 244244 12.012.0BB €€ 0000 1b1b 3838 20 020 0Buyout Buyout €€500m500m--1bn1bn 3838 20.020.0Buyout Buyout €€1bn +1bn + 3939 12.212.2All b tAll b t 368368 14 414 4All buyouts All buyouts 368368 14.414.4GeneralistGeneralist 9696 9.79.7All private equityAll private equity 1 1411 141 10 810 8

Zeus CapitalAll private equityAll private equity 1,1411,141 10.810.8

Source:Thomson Financial

The Continued Demise of the LBOThe Continued Demise of the LBO

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The Latest StoryThe Latest Story –– Bubble UpBubble UpThe Latest Story The Latest Story Bubble UpBubble UpLBO debt grew spectacularly on the back of structured LBO debt grew spectacularly on the back of structured finance products of every type (CLOs, CLO^2, CDS, SIVs, finance products of every type (CLOs, CLO^2, CDS, SIVs, Synthetic CLOs)Synthetic CLOs)Synthetic CLOs)Synthetic CLOs)Same structures AND same excesses as US subSame structures AND same excesses as US sub--prime prime debacledebacleEffects to mid 2007Effects to mid 2007Effects to mid 2007Effects to mid 2007

Ever increasing leverage for deals Ever increasing leverage for deals –– asset inflationasset inflationEver diminishing standardsEver diminishing standards

Vendor due diligenceVendor due diligenceVendor due diligenceVendor due diligenceProPro--forma EBITDAforma EBITDAWeaker banking docsWeaker banking docs

Private Equity moved to megafunds following high Private Equity moved to megafunds following high returns from the debt bubble.returns from the debt bubble.

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New WorldNew World –– post mid 2007post mid 2007New World New World post mid 2007post mid 2007Debt for deals very difficult to accessDebt for deals very difficult to accessyyBanks in trouble themselvesBanks in trouble themselves

Underwriting hurts!Underwriting hurts!Larger deals worst hitLarger deals worst hitHighly leveraged portfolio companies are obviously at Highly leveraged portfolio companies are obviously at riskriskriskrisk

Bankruptcy usually follows default not covenant Bankruptcy usually follows default not covenant breachbreach

AddAdd--ons difficultons difficultFunds difficult to deploy Funds difficult to deploy –– give backs?give backs?

Zeus CapitalAnd all with economies weaker and nervousAnd all with economies weaker and nervous

What Happened to the What Happened to the M k t ?M k t ?Markets?Markets?

Exchange 30 Jun 07 31 Dec 07P/E

Exchange 30-Jun-07 31-Dec-07

FTSE 350 14.48 12.62

ISEQ 14.69 10.07

DAX 14 52 13 64DAX 14.52 13.64

CAC 40 16.25 11.63

S&P Europe 350 14.63 12.49

AVERAGE DECLINE 19%

Zeus CapitalAVERAGE DECLINE 19%

Average Decline Average Decline -- June to Dec 2007June to Dec 2007gg£'m

Debt 60

Equity 40

Valued at cost @ 30 June '07 100

Decline in PEs @ 31 Dec '07 19%

Value at 31 Dec '07 81

Less: Debt (60)

Value of Equity at 31 Dec '07 21

Decline in Equity value 48%

Now a lot worse

Zeus CapitalDecline in Equity value 48%

So how did we get here?So how did we get here?So how did we get here?So how did we get here?

Two reasonsTwo reasonsTwo reasonsTwo reasonsGreed Greed

from the ‘rocket scientists’ creating derivativefrom the ‘rocket scientists’ creating derivativefrom the rocket scientists creating derivative from the rocket scientists creating derivative productsproductsTo individuals borrowing freely and investing in To individuals borrowing freely and investing in high risk productshigh risk products

ContagionContagionBrought about by deregulationBrought about by deregulationNot enough ‘sheepdogs’ in regulatory authoritiesNot enough ‘sheepdogs’ in regulatory authorities

Zeus Capital

Could we have seen it coming?Could we have seen it coming?Could we have seen it coming?Could we have seen it coming?

Money supplyMoney supplyMoney supplyMoney supplyRapid expansion also preceded 1987 crashRapid expansion also preceded 1987 crash

BankingBankingBankingBanking£650 billion ‘gap’ 2007/8 between retail deposits and £650 billion ‘gap’ 2007/8 between retail deposits and lendinglending-- funded by wholesale marketsfunded by wholesale markets

Inflation in asset pricesInflation in asset pricesUK housing sectorUK housing sector

The signs were thereThe signs were thereZeus Capital

The signs were thereThe signs were there

The consequences for Private The consequences for Private E i IE i IEquity IEquity I

ValuationsValuations areare under serious pressureunder serious pressureValuations Valuations areare under serious pressureunder serious pressureValuations with debt at discount?Valuations with debt at discount?V l ti i dj t d EBITDA ??V l ti i dj t d EBITDA ??Valuations using adjusted EBITDAs??Valuations using adjusted EBITDAs??Cash based multiples aboundCash based multiples abound

Much lower returns

Will be no recaps

Will be few secondary buy-outs

A cyclical downturn comes!

Zeus CapitalBut some cheap deals around

The consequences for Private The consequences for Private E i IIE i IIEquity IIEquity II

Bank borrowings difficult to secureBank borrowings difficult to secureggSo deals financed with more equity up frontSo deals financed with more equity up frontAnd refinanced quietly later to leverage returnsAnd refinanced quietly later to leverage returns

New funds difficult to launchNew funds difficult to launchNew funds difficult to launchNew funds difficult to launchSo go elsewhereSo go elsewhere-- sovereign wealth fundssovereign wealth fundsAlready equal to PE funds (£1 trillion)Already equal to PE funds (£1 trillion)Expected to treble in next 3/5 yearsExpected to treble in next 3/5 yearsExpected to treble in next 3/5 yearsExpected to treble in next 3/5 years

Banks will restructureBanks will restructureSome will die off altogetherSome will die off altogetherB h b f J S dB h b f J S dBeen here before e.g. Japan, SwedenBeen here before e.g. Japan, SwedenDebt will resurfaceDebt will resurface-- flight to qualityflight to qualityBond market may resurfaceBond market may resurface

Zeus CapitalWith special thanks to Jon Moulton