RISK PREMIUM ANALYSIS:

 BEST OR WORST OF TIMES FOR HEDGE FUNDS AND MONEY MANGERS?

For The Week Ended: October 17, 2008

BEARISH TREND REMAINS

This past week, the Dow Industrials managed to post a gain of 401 points, closing at 8,852.22 up nearly 4.75%, the biggest weekly percentage gain in over five years.  Stocks rose despite an array of negative economic news suggesting the U.S. is either already in or headed into a recession, despite the National Bureau of Economic Research’s (NBER) hesitancy to officially pronounce one.  Meanwhile, our Risk Premium Index coat hanger neck pattern is hardly indicative of a major reversal.  We expect the market to continue its bearish trading pattern well into 2009. However, bullish pops around presidential election time, the inauguration and New Years should be expected.

THAWING OUT THE CREDIT FREEZE: INDIAN SUMMER IT ISN’T

As we noted in our Risk Premium Newsletter last week, there is a real concern about the ability or willingness of banks to open their lending facilities to commercial and retail customers, borrowers who for the most part do not have the luxury of waiting for a bailout. Accordingly, until banks resume lending prospects for an economic recovery are likely to remain iffy at best.

NEW SOURCES OF CAPITAL: DON’T BANK ON THE BANKS

Not to despair. Funding is available for certain borrowers although we do not expect terms to be inexpensive or conventional – but it will be available.  Through the end of 2009 we expect U.S. corporations will have to roll over approximately $800 billion in maturing debt in what will be a very unaccommodating lending environment.  This estimate does not include new money needed for continuing operations or expansion. Traditional lending institutions may remain gun-shy in upcoming quarters and resist extending credit even to the highest quality borrowers, leaving a substantial portion of the market unattended.  And stock markets are not very hospitable places to raise money right now either. But for firms flush with cash, such as hedge funds and other financial entities, this could offer an outstanding opportunity to recoup many of the gains lost in the 2007 and 2008 equity and debt markets. 

HEDGE FUNDS & PRIVATE EQUITY INVESTORS: COMPETITIVE LENDERS

The corporate world continues to readjust to economic realities.  Ironically, it's the big-name players who epitomized the prosperity of the good years that may now act as the harbingers of change.  Many of the most celebrated names of the private equity boom are thought to have met their demise.  But think again.  It is starting to look as though private equity can grow in the wake of the credit crunch, filling a void which nervous traditional lenders are creating.  In the year through to July 25, 2008, private equity deals dropped more than 70% to U.S. $163.1billion.  But are the days of cheap debt gone and with it the leveraged buyouts that made up the private equity boom? Or will they be displaced be an even needier market?

A DOLLAR SAVED IS DOLLAR EARNED

Over the next five quarters, corporate America’s refinancing needs will approach $800 billion (see Table).  Historically, there would have been no urgency to permanently fund this debt in the capital market, with several companies having the option to secure credit from bank roll-over facilities.  Given the lack of liberal bank lending practices at this stage in the “credit freeze/thaw,” a certain number of heretofore good customers may find credit amenities unavailable, hence, these borrowers will need to seek out alternative lenders (...excluding the MAFIA, the next best source of funding would be Hedge Funds and Money Managers). Sovereign Wealth Funds, Private Equity Firms, Hedge Funds,  Money Managers, at least those left standing, and Debtor In Possession (DIPs) have greatly expanded investments opportunities not otherwise available.  Now that traditional institutions have displaced such loans due to their hyper-low risk tolerance  there will be substantial risk/reward opportunities opening up, some for as little as ¢25 on the dollar.   

FINDING A NEW SOURCE OF CAPITAL

For example, facing a patent cliff in 2011, Eli Lilly's latest innovative approach to R&D funding has potentially heralded a new trend in fund-raising. Lilly's latest move to secure R&D finance – from a hedge fund – could be replicated by its rivals and other corporations looking for money. Lilly, by the way, plans to use this non-traditional funding to speed up late-stage drug development times ahead of the 2011 patent cut-offs.

ATTRACTIVE RATES OF RETURN FOR ORPHAN BORROWERS ?

We estimate that five year Unsecured Debt could be priced anywhere between 10% and 13% (or as high as 19%) over the next 5 years, subject to terms and company market conditions. Many financial institutions may find these underlying corporate credit profiles unhealthy at this time, as they struggle to rebuild the health of their own portfolios, therefore these companies will be forced to turn to non-conventional sources, who will be in a position to dictate the terms and conditions to the lender’s maximum advantage (...otherwise they can get knee- capped).

THE RECESSION: EASIER TO PINPOINT AFTER NOVEMBER 4th

Economic data released this week are indicative of a recession as highlights of the negative weekly economic news show:

§  Housing starts fell to a 17-year low in September, with the annual rate reaching 817,000 starts representing a fall of 6.3%.

§  Retail sales lost 1.2% in September and 0.6% excluding autos.

§  Industrial production plunged to a 34-year low, falling 2.8% for the month.

§  Consumer prices and the CPI were flat and average weekly earnings were unchanged.

§  Business inventories rose 0.3% in August while sales slumped 1.8% and producer prices eased 0.4%.

§  General Motors remained under pressure to continue merger talks with Chrysler as well as find a buyer for its Hummer division.

§         The Industrial Risk Premium ended at 9.09% versus 9.53%

§         The Transportation Risk Premium decreased to 8.21% from 8.66%

§         The Utility Risk Premium decreased to 9.74% from 10.64% n

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