Turning Owners into Partners

We closed a deal last week that we had been working on for 5-6 months and many peope have asked how we found a good company to invest in during these difficult times when no owners want to be sellers and few high quality opportunities exist.

To begin with, this environoment should not be a surprise to anyone in the deal business, particularly given that the financial system locked up in September 2008 and has yet to recover despite some promising signs. At Navigation Capital, therefore, when we were doing our Plan for 2009 we decided that we would have to identify categories that we found attractive and actively pursue an investment in them. This represented a material change in strategy from the generally opportunistic approach that equity investors take of trying to identify companies that are available for sale, either through the investment banker community or through personal contacts. Instead of sellers, we decided to find partners.

To do this we identified 4 catagories where we would look for attactive investment opportunities: Interactive Media, Intelligent Infrastructure, Government Contracting, and Commercial Banking. We have signed NDA's or LOI's in all four and expect to close several more this year. We have also added a fifth category recently, green contract manufacturing.

To give you a sense of our thought processes and approach, let's use Interactive Media as an example, since this transaction will be announced this week. First, why IM? By observing our own portfolio companies dissatisfaction with their ability to be sure that their advertising spend was hitting the demographic that they wanted to attract and their frustration with their ability to measure their effectiveness in doing so, and by hearing the same thing from friends that run companies, we concluded that traditional advertising agencies were at risk of losing their customers to digital solutions. Not today, but over time.

Second, we looked at the data. Advertising spend was way down in every segment but, importantly, IM was not down as much. Increasing share in a declining market, but one that should rebound with the overall economy. Secular trend concealed by a short term cycle!

Third, we looked at the industry. A small number of truly significant big companies whose revenues were plummeting, and a large number of small companies whose revenues were under stress, but who were picking up market share. Potential future buyers if we could put a meaningful company together that was big enough to appeal to the large companies when their revenues recovered only to realize that they had lost market share. Finally, we needed a company. But at least we were focused and had the key dimensions. Today, little is secret, so compiling lists and identifying key executives only required the application of time and intelligence to a task (i.e., work).

But why would anyone take in capital today when valuations are low and operating performance is hard? We have investments in about 15 companies and none of them are for sale, so why would we expect another business owner to come to any different conclusion than we have? We don't. In thinking about our own situation we realized however that our ambitious and aggressive companies and their CEO's had changed their perspective at the end of last year from "hunkering down" and "getting through" difficult times to capitalizing on the opportunity to expand their business through acquisition of weakened competitors and more rapid organic growth They were coming to us for the necessary investment capital, so why wouldn't other owners who do not have immediate access to expansion capital not have the same need? They do, and long story short(er), we needed to find one in the IM space with the vision to see that need , the ability to plan the work and work the plan, and the sophistication to realize that a smaller piece of a much bigger pie is not only worth more but it is also more fun to bake and ultimately tastes better. By providing the necessary growth capital we become their partner.

Doing Well in Difficult Times

My apologies, but the title is a teaser. In reality, very few honest, hardworking people do well in difficult times. Problems, both personal and professional, seem to abound when times are tough and its easy to get discouraged and think that there is nothing you can do, that the situation is just too overwhelming.

When I feel this way, I recall the words of General Hal Moore, U.S. Army, who led troops in one of the defining battles of the Viet Nam war where he was outnumbered 10 to 1 by the best prepared force the North Vietnamese ever fielded in battle. He chronicles this in his book, "We were Soldiers Once....and Young". The book was made into a movie of the same name and then- Colonel Moore was played by Mel Gibson.

The lesson that General Moore draws from the almost impossible situation that he faced is: "No matter how desperate the situation, there is always one more thing you can do to increase your odds of success.". He repeats it in the youtube video shown below.

http://www.pokerleadership.com/video_leadership_hal_moore.html

What do I take away from this? Success is measured in small steps and each matters. Our own actions, everyday, can improve our situation. Looking for a job? Call one more person. Difficult business issue? Figure out one action you can take to improve the situation, and then think of another.

Equally importantly, this attitude doesn't have to be limited to you own personal situation. Want to make a difference in the world? You don't have to wait till you are elected President. Every positive action that you take increases the amount of good in the world. Serve dinner to a homeless person, deliver Meals on Wheels. Every time you do there is one less hungry person in the world, and over a lifetime this adds up. My friends are probably tired of hearing me say that if you walk two miles a day its equivalent (in caloric burn) to running 28 marathons a year. You can do enormous good by making a little bit of difference every day. If a group of people committed to success in whatever they are pursuing make this commitment, there is no limit to what they can achieve. You may not do well in difficult times, but you can do a lot of good.

It Doesn't Have To Be This Hard

Solving our economic problems? Big task. So let's start at the beginning. When I began my career at Fuqua Industries the CEO there told me there were two things you needed to know to be an effective planner: where you are and where you want to go. If you can figure those two out the rest came down to effective execution on your plan. Execution is the hard part, but without a good plan, there is nothing against which to test your actions and measure your progress.


So where are we? Without getting too analytical, the economy's in a tailspin, caused in large part by a financial system in disarray. Conventional wisdom (which is often right) is that easy credit, particularly to the subprime housing market, has caused a rash of defaults which, when multipled by leverage at 30:1, has caused our banks to become insolvent and stop lending. Lack of credit causes consumers to stop buying and businesses to contract, increasing unemployment and causing equity values to plummet. At the same time, earnings contract and the otherwise "performing" loans on bank balance sheets become troubled, further eroding a bank's ability to lend. Vicious circle, and if our portfolio of about 20 middle market companies is indicative, just at it's beginning. Most of our companies had good economic performance in 2008, but saw a decline in December and further (severe) contraction in January, 2009. If not corrected, this financially-induced tailspin becomes a real world death spiral.


Unprecedented situation? No easy answers? I don't agree. In the early 1990's we had very similar conditions. Credit markets were in turmoil, Citicorp (again) was technically insolvent, no one was lending, bank balance sheets were in disarray. Maybe the problem wasn't as big, but it was very similiar. How was this problem solved? Citicorp turned undervalued assets into cash and raised money from a Saudi prince. The institution I was soon to join, Mellon Financial Corporation, took another tack, setting up the nation's first "Good bank, bad bank".


How did it work? Actually, very simple. First the "troubled" assets were put in a new "bad bank", they were valued and a well known investment bank (Drexel Burnham) underwrote a bond which was sold to the public. Ultimately, the assets were sold, the bond was paid, and the investors made money. Which left an undercapitalized "good bank". Private equity investors (Warburg Pincus) recapitalized this bank, which allowed it, free of bad loans and with adequate capital, to begin lending again. The stock price went from around $3 to about $90, so everyone was happy.


If it's this easy, why not try it again? Well, that was actually the stated purpose of TARP, the $700 billion "Troubled Asset Relief Plan" that we hurried through Congress 4 months ago. Results to date: haven't spent the money and what we did spend didn't go for "troubled asset relief". Instead, the big banks sucked up the equity and, at the urging of the Treasury Department and the Federal Reserve, constrained their lending even further. Should we be surprised that it didn't work and the real economy is now getting crushed?


So what do we do? How about "working the plan"? Get the troubled assets off the banks' balance sheets and recapitalize the "good" banks. Can it be done? Sure, the problem is bigger than the 1990's, but the Federal government is bigger than Drexel Burnham who, incidentally, put up no money and suffered no losses in the process. Billions of private equity (compared to Warburg Pincus's $250 million) is sitting on the sidelines waiting for the government to take the first step.


If this is the plan, then let's focus on executing it. This is the hard part, but at least we can test our actions and measure our progess. For example, does a trillion dollar stimulus package make sense? Maybe it helps in other ways, but stimulating consumer demand doesn't solve our core problem. How about nationalizing a bank or two? Avoids the Lehman phenomenon but just moves bad assets on to the government's books indefinitely. Treats the short term pain but not the underlying disease. Mortgage relief? Focuses on a small part of the problem that, even if solved completely, does nothing to ameliorate the bigger issue.


So where does that leave us? I'm optimistic for several reasons. First, I think we have a lot of bright guys in charge and focusing on the real problem. I'm a little disappointed that there has been no articulation of the long term plan and no holding Congress accountable for its enthusiastic spending, but I think that's coming. Americans need to know there is a plan and that it will work. Second, if you believe in the business cycle, there are mechanisms inbedded in it that causes things to improve when excesses are wrung out. Govenment can encourage this and ease some of the pain along the way, but even if it does nothing the system self-corrects. Finally, and most importantly, this problem exists within a support system (the credit markets) which facilitate commerce, but does not have it roots in our productive core, which until recently has continued to perform well. If we can solve this secondary problem, our primary activity of manufacturing an unparalled quality and quantity of goods and services for worldwide consumption will be well positioned to lead an economic recovery.

Why Wachovia Deserved to Die

When Wells Fargo completed its purchase of Wachovia last week, many of us familiar with what we considered to be its irrational and even immoral practices gave a collective sigh of relief.  But its behavior is indicative of the mess we have created in trying to solve our current economic problems, caused, in large part, by bank behavior similar to that of Wachovia's.

One example should suffice, with the caveat that it is told from my perspective and my observations are only that, my observations.  Last Friday one of Knoxville TN's most prominent companies, Imagepoint, Inc. shut down and 450 people were let go, some without even being reimbursed for the expenses they had incurred on the company's behalf, because Wachovia had "bounced" the checks they were given.  The bank's consultants are in the process of liquidating the company's assets.  Imagepoint had been a fixture in Knoxville for fifty years. It had been profitable, with one exception, for as long as anyone associated with the company could remember.  It was the largest manufacturer and installer of outdoor signage, with BP, McDonalds, GM, and, ironically, Wachovia, among its largest customers.  The one exception to its long history of profitability was 2008 when, in response to the difficulty some of its customers were having with their own businesses, it restructured its own, moving from three plants to one and refocusing its business, successfully, on other market segments.  In the process, it became marginally unprofitable, losing about $1 million in ongoing earnings on sales of about $145 million.

By comparison, in the early 1980's, I was managing a company banking with SunTrust (then Trust Company of GA) and faced an economic downturn of similar proportions, which took a company that had a long history of profitable operations to a slight loss.  Our loan was one of the largest SunTrust (and probably the largest)  had on its books.  Jimmy Williams was the senior account manager and met regularly with our management team.  It was a difficult situation, but SunTrust stuck with us, understood our situation, didn't shut us down (which they had every right to do) and in 1983 the company was sold, SunTrust was paid in full, and the owners made enough money to found a firm, River Capital, that continues today to make investments in small companies around the SE with the intent to see them grow  and prosper.

Contrast this with Wachovia's behavior.  ImagePoint was one of its smallest corporate customers (certainly relative to its size).  Last week it had a revolver loan balance of slightly more than $5 million (against over $30 million of collateral).  More importantly, it had an offer on the table from a reputable group to acquire the company.  In full disclosure, the offer was from Navigation Capital, a firm I helped found after previously helping to found River Capital and Mellon Ventures.  Having completed over 150 investments totaling over $2 billion, I doubt Wachovia had any concern about our willingness or ability to do such a deal. Additionally, I was on the Board of ImagePoint, although not an investor in it.

Let's look at the key dimensions of the deal.  Navigation (and others) offered to put in $10 million of equity and $3 million in a standby debt facility, to be used if necessary to further support Wachovia's loan, which at that time was about $11 million on the revolver.  None of the money was going anywhere other than into the company.  The major shareholder, the company's CEO, was getting nothing and losing his job after running the company successfully for 35 years.  His sole motivation was to preserve the company, perpetuate the management team he had built, and save the agony that has been inflicted upon the 450 employees and 100's of suppliers and customers it served.  The other lenders to the company were exchanging $24 million in debt for a 10% ownership stake in the revitalized company.  In return for $13 million of new money supporting their loan, and all these other sacrifices, what did we ask Wachovia for?  Only that it support the company by continuing to lend it money as it had over the life of its relationship.

Wachovia's reaction:  In short,we met with them on a Friday in December for 45 minutes and they never contacted us again. No negotiation, no discusssion.  Instead, the following Sunday they bounced the checks the company had issued thinking it had $6.5 million in available funds, thereby putting employees, suppliers and customers on notice that the company was in trouble, even as it was considering a sale.  Did they have the right to do this?  Probably.  Was it unconscionable and, from my perspective, even immoral?  You decide.  Did anyone at Wachovia give even a moment's thought to the agony they were inflicting on thousands of people, including the families of those affected?  I doubt it.  I think they just checked with their lawyer to see if they would avoid any retribution for their reprehensible behavior.  Our conclusion, we needed a bank to be a partner with us in this transaction and Wachovia is no longer a bank.  My own reaction: I'm reminded of the refrain from one of the more obscure Rolling Stone's songs, Dead Flowers:  "Send me dead flowers in the morning, and I won't forget to put roses on your grave.".  May the remaining corpses at Wachovia rest in peace (RIP).

So, forget ImagePoint for a moment, why did this happen?  How did we go from a SunTrust understanding a company's problems and working through them, to a Wachovia (now Wells Fargo) that exerts maximum legal leverage at a time a company is most vulnerable to put it out of business?  Isn't this exactly what TARP was put in place to prevent from happening to our nation's homeowners and corporate infrastructure?  Wasn't this $700 billion meant to save jobs, not reward crushing them?  Sadly, as administered, the answer is "no".  Instead of buying troubled assets  and freeing banks to make more loans, we instead invested in their equity and encouraged them to "get rid" of their troubled loans.  End result, Wachovia's behavior.  Sadly, Wachovia is not the exception.  Other well known banks exhibit similar behavior.  A few examples, leaving names unnamed to protect the ongoing relationship I have with some of them.  A large, multi-national bank with no loan balance and no obligation to lend a company any more money ever, blocks the payment with the company's own cash of the interest owed to another lender, putting the company at risk of foreclosure despite its ability to pay.  More jobs lost, who cares?  Not the bank, it is improving its capital ratio, using our taxpayer money.  One of our companies, performing well and in full compliance with all its loan covenants, wants to spend a small amount of the cash on its balance sheet to set up a joint venture with another company (read "new jobs'), and is blocked by its lender.

Finally, I'm not asserting that these (and many other) banks are acting irrationally.  Just the opposite; they are responding to the incentives our policymakers put in front of them. Previously, as illustrated by the SunTrust example, bankers saw themselves as partners with businesses in their communities to help them grow and prosper, create jobs, and build an economy that would allow the bank itself to thrive.  It didn't require billions of taxpayers' dollars to get them to do so, they saw it as their role in a just and humane society whose long-term success contributed to their own.  Now that we are spending billions on solving their self-inflicted problems, can't we expect and incent our bankers to recognize a situation where, like SunTrust, they can preserve a company, save some jobs, and prosper at the same time?  "Yes we can." 

Leadership 101

Observing the leadership qualities of our present and future political leaders causes me to reflect on what I learned in the USMC almost 40 years ago(!). Three principles stand out:

You can't lead from the rear. A leader has to be out front, so he can set the direction for the rest of the troops. In Vietnam, a platoon commander generally was in about the third position when on patrol, out of a platoon of up to 30. Otherwise, he couldn't see the terrain and decide which way to go. So too in setting policy.

Plan the work and work the plan. Sometimes stated as: a simple plan, well executed, is superior to a more complex plan that is poorly executed. Remember the panic surrounding TARP ("troubled asset relief program") in mid-September? We had to enact a $700 million program over the weekend or the country would not survive. Where are we now? Three months later we have spent half the money, have no idea where it was spent or how effective it has been, and not bought a single "troubled asset". No planning, poor execution.

Empower the troops. Leaders set the direction, recruit the best people, empower them to accomplish their mission, and hold them accountable. Enough said.

Why (not) Barack?

So, the question I keep getting asked is: "How can an old, white, southern business guy vote for Barack Obama for President?" Well, I don't expect everyone to think like me, but I would expect that everyone who does would come to the same conclusion, and that is "How could you vote for anyone else?".

To begin with, we only had two choices. Would I have preferred Reagan in his prime, certainly, but you only get to pick from between those nominated. As a private equity investor, I spend my time (and investors' money) picking leaders to run the companies we invest in. What traits do I look for? Someone who collects all the facts at their disposal, analyzes them in a deliberate way that leads to a logical conclusion, develops a strategy around these conclusions, reflects the strategy in a plan, hires and motivates the best people to implement the plan, and continuously monitors performance and makes the necessary adjustments to stay on or regain course.

Does this sound like McCain or Obama? McCain ran as the Republican nominee, so he bore the responsibility of defending or denying the policies of the incumbent. He did neither, nor did he give any indication that he was even considering developing a strategy to deal with the nation's most pressing issues. Part of this was due to the fact that we have no clearly articulated foreign or domestic policy. Part was due to the fact that McCain just doesn't think from a strategic perspective. He simply reacts tactically. Sometimes his tactics are good (let's give him the credit he claims for the "surge"), more often they are poorly thought through like, for example, his $300 million mortgage buyout plan.

This nation is not going to prosper in the 21st century if it does not develop an economic strategy that allows us to retain/regain our competitive advantage. For a fuller explanation of what this would entail, see Michael Porter's cover story in Business Week (November 10, http://www.businessweek.com/magazine/content/08_45/b4107038217112.htm). Obama's campaign began to address these issues. He didn't answer them, but at least he acknowledged them. McCain's campaign focused mostly on character issues.

Similarly, this nation is not going to win the very real War on Terror without the cooperation of the rest of the world, most of which characterizes the U.S. as arrogant and a bully. Again, McCain's approach is mostly tactical ("Win in Iraq and then look for the next terrorist stronghold and win there."). I think most would concede that Obama has a broader world view than this which is probably where the next phase of the War on Terror is going to be fought.

On a more practical basis, my conclusion is that one of the reasons our nation has no coherent foreign or domestic policies is because the current President never articulated any and Harry Reid and Nancy Pelosi filled the void with their partisan approaches. Insert McCain into this equation and nothing changes. Ironically, if you don't like the policies of Reid/Pelosi, Obama is probably your one hope of controlling them, as was just evidenced on the Lieberman reappointment.

Finally, I think it is ironic that the major objection my peers have to Obama, and in many instances their principal reason for voting against him, is the likelihood that he will raise taxes. These are people who are part of the investor class that just lost $9 trillion(!) in the stock market because, in part, of the poor regulation of our credit markets and our unguided response to its decline. How does this loss compare to the proposed 5% increase in capital gains, which with losses of this magnitude is purely theoretical. The CEO of Goldman Sachs just agreed to a 99% reduction in his total compensation from last year, and the auto company chiefs have offered to work for $1 per year. How does a 2 1/2% increase in the ordinary income tax rate compare to this?

So, in summary, which candidate offered the better hope of a thought through and well executed strategy for dealing with our 21st century opportunities? I concluded Obama. Is there a risk? Sure, just like there was a risk to the Giants of going with a rookie quarterback like Eli Manning a few years ago. But at least there is a chance of success. The alternative is going with a veteran, who you are certain will never solve the team's problems. To me, easy choice. Larry