But now the stock market’s on the mend. In my book, a 49% rally off the bottom for the S&P 500 qualifies as healing.

The economy’s showing signs of improvement. First-time jobless claims have dropped more than 15% since peaking in April.

As for the M&A market, well, it’s still suffering…

Through the second quarter, volume dropped 40.2% worldwide. Deals involving U.S. companies fared worse, dropping 57.5%, according to Thomson Reuters. And July marked the first month in over a decade when not a single deal worth $5 billion or more was announced.

But if you’re serious about investing, you need to know when the M&A market is on the upswing and should be tracking it religiously.

Why?

Because nothing causes stock prices to rise faster and further than an unsolicited takeover offer.

In fact, if we invest in a company before a deal is announced, we stand to pocket an average gain of 43.5% to 53.7%, according to the numbers crunchers at FactSet (NYSE:FDS) MergerStat. In a single day! No other investment strategy can boast the same lightning fast rewards.

Tracking M&A Market Activity With High Credit Spreads

If you’re looking for one number to predict a full-blown rebound in M&A market activity – and signal the best time to invest in takeover targets – try high-yield credit spreads. The spread is simply the difference in interest rates between junk bonds (the typical vehicle used to finance M&A) and comparable U.S. Treasuries.

• When the spread is high – above the historical average of 590 basis points – it means banks consider the risk of lending to suitors to be above average. In turn, they compensate for the higher risk by charging higher interest rates, thereby choking off M&A market activity by making financing too expensive.
• On other hand, when the spread is below the historical average, it means banks consider the risk of lending to be low. In turn, they charge lower interest rates, which encourages M&A activity as companies capitalize on the cheap financing to go on buying sprees.

Right now the spread stands at 857 basis points. At first blush that seems terrible, until you look at this chart.

http://www.investmentu.com/images/iu081209chart.gif

Following the collapse of Lehman Brothers, spreads hit a high of 2,180 basis points! So we’re actually down 61% from that level, with momentum squarely on our side.

As this trend continues, financing will become more affordable. In turn, I expect M&A market activity to come roaring back.

The markets remained littered with historic values. More importantly, there’s a mountain of cash waiting to be leveraged and put to work.

Private equity funds alone are sitting on $1.02 trillion in dry powder, according to London-based research house Preqin. Almost half of that – $472 billion – resides in buyout funds. If they don’t find it a home (i.e. – start buying companies), they’ll be forced to return it to investors.

How to Play The Imminent M&A Market Rebound

In previous columns on the takeover boom, I explained my strategy for uncovering the market’s most promising takeover targets and highlighted sectors and companies ripe for the picking.

However, if you’re looking for a more conservative way to play the imminent M&A market rebound, and the acquisitive nature of private equity funds, consider The Blackstone Group (NYSE: BX).

Here’s why…

• Private equity firms typically enjoy the best returns from investments made in a down market. And Blackstone’s sitting on a $26 billion cash pile to take advantage of all the bargains and practice its expertise in distressed investing, deal making and restructuring.
• Sure, other options exist to get exposure to the private equity space and the M&A market, namely Fortress Investment Group, LLC (NYSE: FIG) and Och-Ziff Capital Management Group (NYSE: OZM). But neither stack up to Blackstone in terms of experience, expertise or financial resources.
• Plus, by investing in Blackstone you get a portfolio of companies that are much healthier than the market. Roughly two-thirds of the companies will report positive or flat earnings, compared to just 35% for the S&P 500. And almost no debt is coming due until 2013, eliminating the refinancing risk plaguing countless other businesses.

Tack on an annual stock dividend of $1.20 (equivalent to an 8.4% yield) and this is a no brainer. You’ll get paid to wait for the M&A activity to rebound and the Buyout King to get back to buying.

Good investing,

Louis Basenese

Source: The M&A Market: When This Number Falls, Expect the Takeovers to Heat Up

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded.  The name “private equity”is the rechristened, kinder and more gentile label for what used to be known as leveraged buyouts, or LBOs. But make no mistake about it, while leverage may not be part of the name any more, it remains a big part of every private equity deal.

LBO firms, or “franchises”, as Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co. (KKR), likes to call his shop, acquire publicly traded operating companies. Then they streamline management and operations to increase profitability and hope to cash out through a merger, an outright sale of the company, or by taking the company public again through an initial public offering, or IPO.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

Generally, once a target is identified, an offer is made to buy a majority, or all of the stock of the company. The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. Except for the private equity firm’s initial equity investment, the target company is essentially buying itself.

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

The leveraged buyout business has been around for a long time and it has worked very well for investors and the private investment bankers who make an extravagant living with other people’s money. In fact, the business was so successful it eventually led to its now very problematic fork in the road. The problem facing private equity is that their leveraged deals were at one time in such great demand that it became too easy to borrow too much money.

The result was that they chased too many deals, paid too much for targets, paid themselves too many dividends and fees, and now their portfolio companies are straining and collapsing under the weight of too much debt.

Act I: The Two Big Mistakes that Made Leveraging Possible

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called  collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Since banks were able to sell off their leverage loans to investors they had plenty of recycled money to lend out again and again. Competition to lend out all that money put borrowers in an advantageous position, which they exploited.

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.

But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders.

Among other things, some borrowers demanded and got rights to:

• Increase debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) levels to 10:1.
• Freely substitute collateral.
• Have collateral “released” outright.
• Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
• Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
• Employ PIK toggles, sometimes called “extendibles.”

PIK toggles (think of a toggle switch which is used to turn something on or off) let the borrower can roll interest payments into principal and extend the maturity, instead of making twice yearly cash payments. If that sounds like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal, it’s because it is the exact same borrower covenant.

It’s like déjà vu all over again.

Act II: With No Leverage Private Equity Deals Fall Apart

Junk, junk and more junk. When the music stopped and the credit crisis began last August, money and credit evaporated. Only then did it bother leveraged loan investors that the private equity guys were leveraging their private companies to pay themselves huge dividends – enough in many cases to repay the entire initial cash equity investment used to underpin the leveraged buyout of their targets. And only then did they realize that all the debt heaped onto these companies was going to drag many of them into bankruptcy.

At that point, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans which were securitized and subject to mark-to-market accounting. And they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Also in the clutches of the three-headed-dog from Hades, Cerberus, is Chrysler LLC; Chrysler Financial, GMAC LLC (General Motors Acceptance Corporation) (GMA) – 51% owned by Cerberus – and Residential Capital LLC, a GMAC company. By most accounting standards, all of these companies are, if not already, close to insolvent.

GateHouse Media Inc. (OTC: GHS), 40% owned by Fortress Investment Group LLC (FIG), is at risk of debt default and may likely be headed for bankruptcy. Former Lazard Ltd. (LAZ) deputy chairman and  media honcho Steve Rattner’s Quadrangle Capital Partners may lose control of American Media Inc., publisher of The National Enquirer and Star magazine, as he battles with bondholders and may also lose portfolio company Alpha Media Group Inc., publisher of Maxim magazine. These few examples of failures are just the tip of the iceberg.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months.

It’s understandable that bankrupt target companies are suing. Mervyn’s, for example, filed a 57 page suit against its lead dog master Cerberus, alleging fraud among other charges. But what is not as easily understandable is that some other lawsuits have the potential to turn the game viciously against the private equity firms and all the major bank lenders. I’m not talking about the deals that got done; I’m talking about the deals that didn’t get done because private equity firms walked away or otherwise tried to dissolve pending deals.

Apollo Management asked a Delaware Court of Chancery to kill a transaction it had entered into to have one of its portfolio companies, Hexion Specialty Chemicals Inc., buy NYSE listed Huntsman Corp.(HUN) for $6.5 billion. Huntsman sued and won. The judge issued a ruling that Hexion “knowingly and intentionally” breached parts of the merger agreement and ordered the company to complete the deal. Not only is Apollo being forced to go through with the deal, the ruling allows Huntsman to seek damages from Apollo. Apollo is now suing the banks it had lined up to provide debt financing for the deal.

There are hundreds of billions of dollars of abandoned deals that may now be re-visited in courts around the country. The implication for private equity firms and banks is potentially staggering.

Here are a few of the larger failed deals that resulted from a lack of debt investor interest:

• Cerberus’ failed  deal for United Rentals Inc. (URI).
• The Blackstone Group LP’s (BX) failed deal for Alliance Data Systems Corp. (ADS).
• J.C. Flowers’ failed deal for SLM Corp. (SLM), also known as Sallie Mae.
• And Appaloosa Management in conjunction with Harbinger Capital Partners, Merrill Lynch & Co. Inc. (MER), Goldman Sachs Group Inc. (GS), and UBS Securities LLC’s failed financing of Delphi Corp. (OTC: DPHIQ) to take it out of bankruptcy, for which they are being sued for fraud and conspiracy to “derail” the bankruptcy plan; a serious situation because interfering with a bankruptcy is a federal crime.

The amount of leverage involved in private equity deals is a problem if banks aren’t eager, or able, to supply needed loans. But that alone isn’t scary. What is scary is the effort private equity firms are making to actually get into the banking business themselves.

Act III: Private Equity Seeks to Corrupt Banking System

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

The prospect is frightening.

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. In addition, the holding company is forced to serve as a “source of strength”, meaning its capital will be called upon to support its bank.

Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. The private equity firms are sitting on hundreds of billions of dollars of fresh money raised recently. While it may seem reasonable and expedient to allow private equity capital to be infused into ailing banks, any compromise of existing regulations would result in the creation of the mother of all moral hazard enablers.

There’s no doubt that if the recession is as deep and as long as feared,, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

Source: Overly Leveraged Private Equity Deals Add to Unemployment and Deepen Recession

On the other hand, threats of hurricanes in the Gulf of Mexico and geopolitical turmoil in Iraq, Turkey, Nigeria – and now the fireworks between Russia and Georgia – could spark a dramatic reversal in sentiment and renew fears of supply disruptions.

However, this week’s economic calendar contains the types of reports that will factor into the musings of Federal Reserve policymakers with regards to interest rates.

The report on the Consumer Price Index (CPI) for July – due out Thursday – gives economists another look into domestic price pressures, although the recent drop in energy prices will not yet be reflected in this data.  Then again, economists tend to focus only on so-called “core” inflation (which “excludes volatile food-and-energy prices,” anyway).

The July retail sales report gives us some additional insight into the consumer mindset, demonstrating that those tax rebates are virtually all gone. With gas prices on the decline, consumers should have a bit more available disposable income in the months ahead (though, again, the July numbers may not show any enhanced activity just yet).

Additional confirmation of the recent consumer cautiousness should come from the next round of earnings reports, which will feature reports from such retailers as Macy’s Inc. (M), J.C. Penney Co. Inc. (JCP), Nordstrom Inc. (JWN), and Wal-Mart Stores Inc. (WMT).  Should the gas trend continue, consumers could emerge from hibernation just in time for the holiday shopping season… wishful thinking?

Market Matters

Let the games begin. As host of the 2008 Summer Olympic Games, Mainland China takes center stage and gets the chance to show the rest of the world that it has arrived as a global player and an economic superpower. Of course, no event should be more apolitical than the Olympics.  That is, until China banned some participants for their support of Darfur.  And before U.S. President George W. Bush criticized China’s poor record of human rights on the eve of the games. And before China deported a few activists who were demonstrating against certain national policies. (Probably nothing that a few gold medals won’t cure.)

Speaking of having politics cross over into the economy: Last week, Democratic presidential candidate Barack Obama publicly lobbied for the sale of 70 million barrels of oil from the U.S. strategic reserve and also claimed to now support new offshore drilling (if his tire gauge idea fails to prove an effective policy).  As the presidential-election campaigns accelerate into the home stretch, investors can expect plenty of promises (and flip-flopping) from both sides of the aisle.  (How do you feel about those Bush tax cuts this week, Senator McCain?)

So just where are investors to turn these days?  Freddie Mac (FRE) and Fannie Mae (FNM) returned to the headlines last week, as both reported significant losses – far in excess of Wall Street expectations.  (Weren’t those analysts following the news?)  Likewise, insurance giant American International Group Inc. (AIG) reported its third consecutive quarterly loss as its mortgage portfolio remained deeply under water.  Citigroup Inc. (C), Merrill Lynch & Co. Inc. (MER) and UBS AG (UBS) each reached multi-billion settlements with the New York state attorney general over certain high-risk securities that the firms will buy back from affected investors. Outside of financials, Cisco Systems Inc. (CSCO) – the subject of a recent “Buy, Sell or Hold” feature in Money Morning – provided a boost to techs by announcing better-than-expected profits; likewise, The Procter & Gamble Co. (PG) proved that consumer companies could still thrive, despite surging commodity prices.

Institutional funds have garnered additional interest as of late as investors seek out non-traditional asset classes to help compensate for the challenges of the markets.  In July, Hedge Fund Research Inc. reported that the return on a basket of 60 funds designed to reflect the industry as a whole declined by about 3%, the worst monthly showing in six years.  Tutor Investment Corp. will be spinning off its Raptor fund at year-end after bad calls on the energy sector caused ongoing losses for the past two years.  Private equity firm, Fortress Investment Group LLC (FIG), reported a larger-than-expected quarterly loss and has seen its share price drop about 40% since its IPO in early 2007.  Bear in mind, not all hedge funds and non-traditional assets are created equal; plenty of “winners” have emerged lately.

Anyone remember when oil touched $147 a barrel on July 11?  Has the bubble officially burst?  Energy continued its downward spiral as oil fell below $117 barrel, its lowest level since early May.  Rising inventories eased supply/demand concerns and renewed strength in the dollar also helped support domestic securities (thanks to the European Central Bank – see below).  Equity market volatility remained as investors tried to weigh the negative Freddie/Fannie reports against the positive energy trend (and the inactivity of Federal Reserve policymakers with regards to interest rates – also see below). Stocks alternatively soared, plunged, and soared again as the major indexes moved considerably higher by end of last week.

Then there are the ongoing Beijing Summer Olympic Games (which opened Friday), a reminder that every investor should have a China investment strategy.

[Editor’s Note: Please click here to read the first part of our two-part research report -"Why Every Investor Should Have a China Investment Strategy." The second part of that report will appear later this week.]

Perhaps that jubilant Olympic spirit is contagious?  So let the games continue: “USA…USA…USA…!”

Economically Speaking

They came, they debated, they analyzed, and they left – with no action taken. The “they” we refer to here are the members of the Federal Open Market Committee (FOMC), the Federal Reserve policymakers responsible for setting interest rates.

With dueling economic dilemmas impacting the country (slow growth vs. inflation), Federal Reserve Chairman Ben S. Bernanke and his band of central bank policymakers chose to leave the benchmark Federal Funds rate unchanged at 2.00% at their policymaking meeting last week.

While most Fed-watchers still expect the next interest-rate move to be to the upside, some believe such an action is unlikely before the end of this year as reduced consumer activity continues to spark talks of recession.  The recent decline in commodity prices helped the Fed stay on the sidelines, given that inflationary pressures are slightly less than before (at least, for the time being).  The European Central Bank (ECB) and Bank of England both left their key rates unchanged as they also weigh ongoing economic concerns in their countries against continued price pressures.  They prompted a surge in the dollar and took additional pressure off of the Fed, as well.

On the retail front, same store sales in July were lackluster at best as consumer held off on back-to-school purchases and focused on necessities such as food and household goods. (Apparently, last year’s No. 2 pencils and lunchboxes still will work fine.

Even the afore-mentioned Wal-Mart’s sales came in slightly below expectations while mall chains – the Limited Brands Inc. (LTD) and The Gap Inc. (GPS) – and luxury retailers such as Saks Inc. (SKS) all struggled as consumers no longer had those tax rebates to spend.  Moving to housing, the Federal Deposit Insurance Corp. (FDIC) reported that just under 1% of all prime (not subprime) loans originated in early 2007 were at least 90 days delinquent, meaning that the mortgage crisis still has a ways to go before being resolved (and additional write-downs may be on the way).  The weekly jobless claims data showed that more unemployed folks are seeking government benefits than at any time since March 2002.

Weekly Economic Calendar

Source: Federal Reserve Policymakers Will Hold the Line on Interest Rates – At Least for Now

A typical hedge fund invests or goes long in stocks and other securities, and simultaneously bets against or shorts those overvalued securities. In theory, this means hedge funds are supposed to deliver an absolute return in all markets while protecting your capital. They’re also supposed to reduce your risk and hopefully, outpace stock benchmarks.

This strategy doesn’t come cheap. If you’re a hedge fund investor, you’re expected to fork over big bucks in management fees. And that’s not all. You could be subjected to 12-month lock-in periods (or more) and then hand over a 1% annual management fee and a slick 15% performance or incentive fee on new net profits. What a deal!

This pales in comparison to plain indexing or investing in active mutual funds, that don’t lock-in your capital and or charge obscene annual fees. Also, mutual funds rarely blow-up like some hedge funds…but hey, that’s not even worth mentioning right?

What Happened to Hedging?

Seriously, to be fair, hedge funds did protect investor capital in the last bear market from 2000 to 2002. So for two years, investors were satisfied with their hedge funds.

But, if you take a closer look, you’ll notice most so-called “hedge” funds simply failed to do that during the severe market dislocations in history. For example, most hedge funds lost a pile of dough during the fall of Long-Term Capital Management in August 1998, the aggressive rate hikes of 1994 and during the October crash of ‘87.

This is how hedge funds work. Hedge funds function properly and make money as long as there are a series of established trends in their respective sphere of trading. But once markets dive sharply, most hedge funds fall just as hard as everything else.

The Markets Have NOT Been Kind to Hedge Funds This Year

So far, 2008 has been one of the toughest years for global investors since 2002. As you might guess, the average hedge fund is losing money. In fact, some hedge fund categories are faring worse than the S&P 500 Index.

Go back a little farther and the hedge fund story just gets worse. Since 2007, a record number of hedge funds have either closed or collapsed. This market volatility has drawn the final curtain on some of the more inexperienced and highly leveraged operators.

According to the Credit Suisse Tremont Hedge Fund Index, those amazing Wall Street and London trading wizards are down an average 2.1% this year through March 31. Even worse, out of the 12 sub-indices that make up this database, only three are profitable.

The best-performing hedge fund sector this year is the short-selling category. That’s an obvious place to make money for any short-only focused hedge fund. But others, including distressed debt, event-driven, convertible arbitrage, and long/short equity are all suffering losses through March (latest data available).

So far in 2008, most hedge funds have failed to make the grade. Investor cash flows have tumbled more than 50% compared to 12 months ago as redemptions surge. Many investors have also grown concerned about prime-broker counterparty risk whereby investment banks like Bear Stearns conducted trading on behalf of large hedge funds.

Too Popular?

Back in the ‘80s and ‘90s, hedge fund managers only marketed these products to the super wealthy. But now, hedge funds are marketed to mainstream investors through publicly listed companies and retail hedge funds offshore. Pension funds, endowments and even sovereign wealth funds (SWFs) are climbing aboard hedge funds this decade for higher inflation-adjusted returns in this sluggish stock market environment.

Hedge funds grew so popular heading into the mid-2000s that several high-profile managers went public. Fortress Investment Group (FIG-NYSE) is no doubt one of the better hedge funds in the world. But even being one of the “better ones,” this hedge fund has still gotten slammed since going public in 2007 following a dismal first quarter as leveraged loans soured.

“Fortress” Doesn’t Live Up to its Name

Unfortunately, too many hedge funds fail to earn their stripes. They simply don’t deserve their fat 15% incentive fees. Many managers disguise themselves as long/short products. But in reality, they’re just glorified mutual funds that fail to properly hedge while levying huge fees.

Despite their ongoing issues, a small handful of hedge funds do belong in a large globally diversified portfolio. From a universe of more than 6,000 products, some are still worth your dollars. These managers have earned top performance accolades over the years, successfully protected investor capital and have a large portion of their net wealth invested in their funds.

But now, more than ever, you must conduct careful due diligence on any hedge fund product. Make sure you understand any potential hedge fund’s liquidity provisions, underlying leverage, lock-ups (if any) and the fund’s prime brokerage relationship.

Also, a true-blue hedge fund should be able to make money in most markets, including bear markets and crashes. Investors beware.

ERIC ROSEMAN, Investment Director