I have pretty much worked out in a traditional gym all my life, not an athlete in any specific sport but more of your average gym rat.  I have also been involved in martial arts for many years, studying various styles and learning the Zen part as well as the physicality of doing the moves and fighting.  About 3 months ago I decided, at the urging of a friend, to try out a workout regimen called Crossfit.  Crossfit has been around for some time and the concept of it is grounded in a logical, fundamental approach to maximize the efficiency at which your body (machine) operates.  My first time out, I thought this workout could not be any worse than my training sessions of past. WRONG!  I learned in the first 15 minutes that this was something completely different.  I was so overwhelmed by the nature and style of the Crossfit workout that I was literally comatose for the remainder of that day.  That was a 15 minute workout!!!!  Without boring you with the nuances of this type of training I want to impart what I have learned over the last three months of Crossfit training.  First, and most importantly, the mind gives up well before the body does.  The Navy Seals use this type of mental training to see how tough the soldiers are mentally, not just physically.  Second, is that human nature generally has people taking the path of least resistance.  Third, under tremendous physical duress is where we make mental breakthroughs.  Last, but certainly not least, is needing someone to lead you through this process such as a great trainer, coach or mentor.  In this particular case, my coach is Justin Flynn, owner of Orange Coast Crossfit in Costa Mesa California. He applies a deft hand and gets people to have these breakthroughs.  For him, it is definitely ductus exemplo.

So why my diatribe on Crossfit, when this is a financial blog?  America, as the leading economic driving nation in the world, needs to lead by example.  This financial malaise is not just ours but the entire world economy’s. Unfortunately, the American economic engine is broken, albeit temporarily, and some hard decisions need to be made.  Are we making the right decisions, or will it alleviate the pain currently only to come back and severely hamper our economy later?  The financial alchemists in Washington and the Federal Reserve are working overtime trying to figure out the best path to bring the US back online.  The problem with large scale fixes and massive capital injections into the economy, is that the fix is now but the consequences are severe.  The United States’ GDP (Gross Domestic Product) has just had two of the worst quarters since the recession of 1982 and still looks to be contracting. 

I could spout tons of financial statistics to make whatever case I wanted to make but the real underlying reason that the US economy is in bad shape is the small business owners are being neglected at best and abused at worst.  Small business in this country is a lynchpin that keeps the economic engine humming along and when credit and liquidity are pulled almost overnight from these business owners, the effect will be a continuous erosion of GDP and, more importantly, a tax base.  California is a prime example of this eroding tax base.  The “Governator” came into office with the mandate to make California a strong state by reducing the red tape and onerous tax burdens being hefted upon the small business owner.  Fast forward 2 years and California’s taxes are at an all time high and the state is in real threat of filing for bankruptcy protection.

Overall, the US financial system is very delicate at this juncture with the dollar still at historical lows and the price of oil moving increasingly higher.  We desperately need to kick start the US economic engine.  Let’s face it, the last 9 months have been the most challenging times in recent history from Wall Street to Main Street.  The meltdown has affected all of us in some form or fashion.  In times like these, when stress and fear rule the day we have to look upon ourselves to have a breakthrough  If we need to make some hard decisions to get through these turbulent times, then that is what needs to be done.  Everyone is a sphere of influence so we all have the ability to lead by example.  My Crossfit mentor, Justin, is a perfect example of a never quit attitude both as a trainer and a small business owner.  Caution, not fear, is the word of these times and we should all try to lead by example.

What are the unintended consequences of this current market upheaval for the financial sector?  The most glaring one follows the first law of thermodynamics (and I paraphrase) which portends that nothing is ever created or destroyed but merely shifts forms.  The shift I am alluding to is the movement of talent and deals at these former large tier investment banking firms to new firms, or to more aggressive mid tier boutique investment banks or specialty M&A houses. 

This shift takes time, which is probably a contributing reason for the lack of IPO’s, PIPE transactions or any other type of liquidity events for the private equity/VC market. 

Need proof? According to Price Waterhouse Coopers (PWC) the VC activity for the first quarter is down to levels not seen since 1997.  VC and private equity funds have to consider the types of deals and companies they are willing to invest in based primarily on the extended holding time.  The only current exit for a privately backed company is through an M&A transaction and those deals will be done at increasingly smaller multiples as this is a buyers’ market.  The events of the past 12 months have really made professional investors and funds alike re-examine their investment model, pricing and exit strategies.  The unintended consequence of these events are a boon to M&A boutiques that concentrate on buyside representation or that have top tier clients looking for bolt on acquisitions. 

The market needs time to readjust to the new landscape in the capital markets.  Deals will be under much heavier scrutiny from all sides, the accountants, VC’s, private equity groups, valuation firms, investment banks etc.  This shift in due diligence on transactions will be significant.  There will be a natural growth of service providers bringing additional transparency to the “deal” business.  A true and needed unintended consequence.

I needed to understand better this new market and how it is growing, changing and establishing itself in the traditional investment world.  Kevin Jones of Social Capital Markets and a partner at Good Fund was kind enough to spend a little time discussing some of the topics so that I could glean some insight into this investment style.

AP: What signs can you point to that show the trend is growing?
KJ: Many more new social venture funds are being started, in the U.S. and in Europe, many of them focusing on sub-Saharan Africa or India. Microfinance is expanding beyond just tiny loans to the poor into sectors like education, water and micro-insurance. The pioneers of social finance are maturing, coming up with sophisticated financial vehicles like bonds for renewal energy in the developing world, while major multi-billion dollar funds are moving to related areas like sustainable forestry in response to investor demand.
 
AP: What do you think is the potential within this category?
KJ: I think this category, using the market for both financial return and social and environmental impact, has the potential to complement philanthropy and government intervention as a potent force addressing global challenges at scale.

AP: Can you offer some examples of successful impact investors?
KJ: I think the Acumen Fund has been successful, as has New Schools Venture Fund, and New Profit. Good Capital has good results; Aureous in the UK, one of the oldest social venture funds has outstanding results as does Calvert Social Investment Foundation. Equilibrium Capital is doing amazing things up in Oregon.

AP: Who are the leaders in the space on the entrepreneur side?
KJ: On the entrepreneur side I’d put Better World Books, New Leaf Paper, E&CO and Root Capital as the leaders.

AP: How does the recession impact this market?
KJ: Though everyone has less money, this sector has actually increased in relative strength, as I see it emerging. Investing and realizing what happens with your dollars, what your real impact is in the world makes more sense to more people now. With the spectacular collapse of a market totally focused on greed, impact investing is emerging as a strong new alternative.

AP: There are many specific funds that are religion oriented or based on the laws of Sharia that have mandates for what they can and cannot invest in.  Does impact investing have a given mandate or is it more of a theme?
KJ: It does not have a mandate, though people sometimes have religious reasons for impact investing. Secularists do it, atheists who care do it. It is simply the combination of seeking both financial return as well as positive environmental and social impact from that investment.

AP: Would LOHAS (Lifestyle of Health and Sustainability) be considered impact investing?
KJ: No, LOHAS is about lifestyles, not about economic justice. Your yoga mat is not particularly socially conscious. As it evolves to think about more than the yuppie self-conscious consumer – and more toward the people who make the oils, the coffee, the crafts - LOHAS will touch on and can overlap with impact investing.

AP: Are there any Sovereign Wealth Funds currently deploying capital into impact investing?
KJ: Yes, there is one in Dubai called Legatum.

AP: Most importantly what is the main driver for this type of investment style - is it profit or social good?
KJ: It is a blend. Sometimes it can be impact leading with return trailing; sometimes it is return leading with impact trailing.  It combines philanthropic elements and motivations with financial and investing rigor, due diligence and engagement with portfolio companies, etc. It is not binary. It’s a “category buster” at the highest level – a movement that’s clearly emerging as an asset class.

Some industries within the social investing category are LED lighting, organic/natural food companies, water treatment, sustainable energy.  Impact investing really looks at how an investment into a company changes people’s lives specifically as it relates to helping poorer nations and their population achieve a higher quality of life.  This can be through empowering citizens of that country to start small business, through micro finance solutions to enabling technologies that speed the process of business development.

In other news, GMAC is receiving another $7 billion infusion.  Why haven’t they provided any plan of reorganization or how they plan to stem the shortfall?  The “corporate welfare system” is in full force by the current administration.  I believe our administration does not know how to fix it but they believe throwing additional capital at the problem will solve it temporarily, which is the path of least resistance.  Remember people, this is your money and your future debt.  Where is the accountability?

A little hope is coming from a few IPO candidates that are garnering interest from Wall Street and the institutional markets.  Solar Winds and Opentable are bright spots in an otherwise dearth market for IPO capital.  Does this mark a return of IPO’s?  Probably not, but it is encouraging that an appetite is starting to emerge.  Depending on how these IPO’s fare in the open market they could be the oil that primes the pump.  We will have to wait and see.

Yes, two positive notes in a row!  John Paulson (not Henry,) the hedge fund manager that not only called the top and the ensuing melt down, but also put billions of dollars on those convictions, is now coming out and saying that it is time to set up a real estate fund.  It will be opportunistic and look at both residential and commercial investments.  So far this guy has played the market just right.  Is he the new oracle?

We all know the Obama political machine will soon run out of steam and we, the loyal taxpaying citizenry, will enviably hear these words.  “We, as a nation, need to come together and all do our part and tighten the belt to get us through this crisis.  We will all emerge stronger and a better country for this sacrifice.”  Oh believe you me, these words are coming.  To my readers, when this occurs please tell the worldwide web that you heard it here first.

We go into this Memorial Day weekend trying to forget all the bad news and just relax and enjoy what is left of the American dream.  If this crisis has done one thing, it has certainly put a spotlight on the glaring inconsistencies of government and how they regulate.  It is either lassaiz faire or it is socialistic.  Can’t there be a happy medium?  I believe the country should actually hire a head hunter similar to the way top tier Fortune 50 companies do it and bring a CEO, not a politician.  Oh, and did I mention a flat or Vat tax so that the most inefficient tax collecting system/agency on the planet can be nullified?  Plus I believe it would save at least 20% of the rain forests over the next 10 years (there has to be a green angle.)

Markets are concerned by this governmental interference as they believe if these current changes take place it will open the door to increased government meddling and thus rewriting additional rules.  Once you start the slide down the slope of government intervention you invariably open the door to additional “tinkering” which will add risk premiums and, worse, could drive foreign and domestic capital to other foreign markets. 

As a side note I have read and recommend to all my readers to pick up a copy of this book, “When Giants Fall; An Economic Roadmap for the End of the American Era”.  I do not care if you are a democrat or republican, liberal or conservative this book should be read as a matter of perspective.  Michael Panzer uses history as a basis for the points he makes in the book.  History is just that, history. It is how one can learn and get perspective from it that makes it empowering.  I will warn you that this book does not paint a pretty picture but I find it important to read a drastic point of view supported by facts and history so that it can be used as a reference point.

For instance, Manhattan, regarded as the safest and most valuable real estate in the world is currently seeing commercial vacancy rates over 12% and experts believe that will go to 19% by the end of this year!  That is not a crack in the dam, that is a complete hole. The second largest real estate shopping center owner, General Growth Properties, just filed for Bankruptcy protection.  That is another serious white elephant.  The markets continue to shrug off this bad news because we “choose” to focus on the positive things.  What is positive?  Did I fall asleep for 2 years and wake up and now the recovery is happening?  No, the fact that the markets, the administration and now the public are looking on the bright side is doing nothing but setting up the economy and the markets for another confidence shattering reality check to investors and Main Street.  Read the full article here.

Caveat Emptor…

George Washington, our founding president, of the United States died in 1799 from the common influenza virus or related symptoms of the flu.  The doctors of the day used Calomel, a mercury based product that caused the body to forcefully regurgitate its contents, and bloodletting.  Both of these methods, standard at the time, were used to treat the symptoms of the illness hoping the illness would be expunged and that the body would recover.  Well, in this instance, according to modern doctors, the treatment actually caused the death of the patient, our first president.  How could this analogy possibly relate to what is currently happening in the market?   Here goes my attempt to pull it all together. Read and observe.

The current market situation is similar to a doctor treating the patient’s symptoms but not addressing the underlying cause or illness.  It is truly the case of the treatment could eventually kill you.  The question is; are we sacrificing our country’s long term viability with short term fixes to the immediate economic issues?  I believe the answer is yes.  Don’t get me wrong – I believe that we have to address the current issues somehow, but we are going down a path towards socialism, evidenced by the government’s quasi control of the banking system, a clear redistribution of wealth through the administration’s tax system, and implementing monetary policies that have historically destroyed the value of a country’s currency.   Alarms should be going off in a rational person’s head; this has nothing to do with a person’s politics but moreover his sensibility and common sense.  We are a debtor nation with an outstanding balance, including contingent liabilities, of approximately $10 trillion (not billion).  If the US was an individual who went to the bank to get a loan the bank would literally laugh them right out into the street. 

More specifically, the markets basically reduce the value of the currency of over-leveraged countries. This is not unlike a bank that charges a higher interest rate to a higher risk borrower. Ever ask yourself what happens to the economies of countries that the world feels it can’t trust to pay them back? I can tell you this is no joking matter. We clearly need to weigh the pros and cons of short term economic fixes to the long term viability of the patient, the United States of America.

Anything that the administration does today will not ultimately show effect until at least 9+ months from now and I am being very aggressive on that time frame as it is usually a much longer period of time.  This economic conundrum is being made even worse ostensibly by the administration’s belief that government can cure the people’s ills - or wait - was that Stalin?  Obama has had a hearty task set upon him and he is utilizing all necessary powers to quell a very turbulent market and economy, but we collectively must not lose site sight of the fact that we are a capitalist society.  Governments are traditionally lousy at running businesses and typically exacerbate the problem. What needs to happen is more diligent oversight on the markets, starting with common sense, but also let traditional market forces run their respective course.  You see – I believe that our system, albeit flawed, is fundamentally efficient, if you screw up, you go broke.  Stronger players step in and take your market share. By letting the politicians step in front of the natural process, we run the risk of re-enacting Japan for the last 20 years, extending the malaise many years longer than if we just flushed the system. The underlying cause of this debacle, as stated in a previous post, is really the political process itself.  The outright failure by elected officials to stand up and say “the emperor has no clothes” was absent during this derivative fueled run up in the markets, real estate and commodities.  There is no accountability and that is what needs to fundamentally change so we can avert a disaster of this proportion in the future.

The cure being applied to fix the symptoms of the patient (US economy) today may end up killing the patient or at the very least put us on a firm path toward socialism.

This market rally even has some pundits calling a bottom to the market saying that we’ve had capitulation.  They claim the banking sector is sufficiently de-leveraged and that we could see a base building before we start to steadily rise.  All I can say to that is, “what information do they have, who are they talking to and what is in their morning coffee?”  This is a painful journey that does not correct itself in an instant but rather grinds itself out over time.  I am as happy as the next person that my 401k and portfolio have clawed back to dismal from utter carnage, but I am also aware that this current rally is not sustainable.  What do I base this on?  Corporate defaults are at an all time high, as evidenced by the massive amounts of capital flowing into DIP (Debtor in Possession) financings, a poor turn-out for the government’s public to private investment program, a looming commercial real estate melt-down, and GM’s potential bankruptcy filing. In fact,  I could go on and on, but you get the picture.

Here is the point of this post.  Be careful, be aware and most of all, be prudent.  Nothing has fundamentally changed in the market so these rally’s are nothing more than large institutional players shifting their portfolio’s around, allowing them different industry sector exposure.  The Dow in the high 6,000’s wanted a reason to go up and thus it looked for any good news it could to extrapolate it into higher stock prices.  I do not believe we have hit bottom yet.  This is a very emotional market with all sides trying to play a guessing game as to how the daily onslaught of news will be digested by the street, so caution should really prevail.