I like to use common sense and human nature as the initial basis for this decision but I also like to back it up with fungible data.

I would love to hear from people whose rationale is the same as or different than mine.

I share all of these fears but California tends to be a very resilient economic force in the world.  So as the saying goes when times are good California is great and when times are bad California is terrible.  I want to understand how we got here and how we can get out of this.  I need to hear from people who fundamentally understand what has occurred and get their perspective on where California is going from here.  I wanted to interview people who make their living in deciding what happens next and who also have their own skin in the game.  What better place to start than a wealth manager and CA resident, David, who has done extremely well in navigating these treacherous waters.

-First a little of your background so the readers have an idea of what makes you tick.

I am a Senior VP and Wealth Advisor at one of the largest Wall Street brokerage houses.  I am a Certified Financial Planner, and have been in the business for ten years.  Prior to that, I ran a firm providing business management services to some of the most successful musical artists in the country.  I am passionate about politics, free market economics, and USC football.  I am on the board of the Lincoln Club of Orange County, and very involved with the Club for Growth. 

-How bad of shape is California in right now?

It is bad, very bad.  But it is not any worse than we should all have expected it to be (and frankly, not as bad as earlier this decade when Grey Davis was doing his best to ruin our state).  Governments routinely spend more than they bring in, but unlike the federal behemoth of Washington D.C., states can not print money, and states can not sell treasuries to foreign investors.  California faces an incomprehensible exodus of big and small businesses to outside, more business-friendly states (Texas, Colorado, Nevada, Arizona, Idaho, etc.).  We have the highest debt service in the country, rendering it nearly impossible to sell new debt, yet we face massive budget deficits, and a total lack of political will to cut where cutting is needed.

-Will it get worse before it gets better?

That depends on the phrase I used above, “political will”.  If Sacramento believes that the solution to this mess is higher taxes for high income earners, and more burdensome fees for job-creating businesses, then it will get far worse before it gets better.  And if the unions maintain their powerful strangle-hold on this state, it is impossible to see light at the end of the tunnel.  BUT, I sense a paradigm shift going on in the minds of voters.  And if voters get mad enough, Sacramento’s political will could very easily reverse.

-How high do you think unemployment will eventually get in California?

I believe the numbers will be skewed by the amount of business proprietors and workers who leave California.  Many currently unemployed people will find jobs, but will leave the state to do so.  Because our economy was so dependent upon real estate development, real estate construction, and real estate services (mortgage, brokerage, title, etc.), the numbers here are worse than most parts of the country.  However, there are abundant possibilities in technology in this state as well.  At the end of the day, California tends to have lower unemployment than the national average when unemployment is low, and higher unemployment when the national average is high.  I believe the national average will max out around 10-10.5%, and California will be somewhere around 12%.  We already see an impressive amount of re-training and career reinvention, though.  I have a lot of confidence in people’s ability to find work and create work when it is in their self-interest to do so.  Replacing private enterprise jobs with government jobs is horrible for productivity.

-Is the cause of this fiscal mess best blamed on the politicians in Sacramento or is that just the easy answer?

It is exactly 1/3 of the answer.  I blame the politicians in Sacramento for most of the problem, but the public employee unions to whom Sacramento seems enslaved deserve a lot of credit for our fiscal mess.  They have successfully negotiated countless pension agreements, compensation commitments, and benefits packages that are completely and totally untenable.  They do this with the weight of their own political lobby and dues paid by their members without representation.  The final 1/3 of the blame rests with the voters who have taken for granted that we can spend $60 billion per year on a very subpar public school system and not have to hold our elected officials accountable.  We have voted for every single bond measure we could if we liked what the bond would buy, but without any consideration of the cost of servicing the debt.  We need to be far tougher in the ballot box; that will force Sacramento to act tougher when they are in session.

-What are some potential catalysts that could turn the CA economy around, if any?

I believe a weakening of the power of the public employee unions will be a huge headstart.  I passionately commend school choice initiatives as a way of beginning that process.  Some spending discipline is a requirement, and that means electing officials who have the guts to say no to special interests, and even no to voters who are used to the state doing way, way too much.  Our economy will turn around when we allocate capital and resources where they are most efficiently used, and that place will never, ever be Sacramento!  Finally, business-friendly initiatives would be revolutionary at turning the economy around.  A reduction of corporate state income tax rates; a cease-fire on the capital gain tax; a lowering of the regulatory cost involved with hiring labor; I could go on and on and on.  Perhaps our next Governor will fly to Gov. Rick Perry’s office in Texas and say, “Governor, please tell me the top five things you have done, because I need to do them in California!!”  The problem us, Gov. Perry would never tell him – he is having far too much fun recruiting business away from us. 

-Philosophically, what are you telling your clients to do in this tenuous time?

As it pertains to California debt, my clients investing for tax-exempt income are improving the credit quality of the holdings, looking for better yield in the general obligation and essential services bonds that I feel face little possibility of default.  We are avoiding high yield bonds in local municipalities that have little or no financial back-up, and that could become “sacrifical lambs” in the state’s economic mess.  Outside of municipal bonds, I still find the “reflation” trade very attractive, and believe that the market lows of November 08’ and March 09’ created once-in-a-lifetime valuations for certain dividend-paying names.  I like the commodity story for now, and believe that one has to keep powder dry to profit from the volatility.  This is going to be a very interesting era, and as long as I avoid market indexing, I think I can make money right now.

-Last thoughts?

Investors need to be careful to pair the return they are trying to achieve with the risk they are willing to take.  Chasing yield, and forgetting that with higher yield comes higher risk, is a destructive habit.  As citizen-investors we need to be accountable for our own decisions, and hold our elected officials to more accountability as well.  California has the most extraordinary natural resources in the country, and is certainly the most desirable place to live in the country.  Politicians can only screw that up if we let them.

The economic force of California impacts the entire country.  The pain being experienced by Californians is unfortunately the hangover from the substantial run up in real estate both residential and commercial.  The demand was artificial fueled by institutions looking for yield and the perception of safety that the rating agencies gave to these investors.  Common sense gave way to greed and the mantra of outsourcing manufacturing anything tangible to India, China and Brazil was overwhelming.  The entire country is feeling it and paying for it but right now the state that felt the largest amount of euphoria during the good times is facing a painful economic lesson.  Unfortunately the ones to pay for it will be the residents.

Nothing Ventured, Nothing Gained

This current downturn - especially the contraction in personal and business liquidity - has been hard on everyone, no doubt, but, as with most trials in life, there have been a number of positives that have come from it.  Businesses are tightening up bloated overhead and maybe even (gasp) trimming corporate retreat budgets, focusing more on the things that matter most in generating long-term sustainable growth.  Consumers are more conscious of the credit card debt they carry.  They’re working a little harder on the job to make sure they’re not the next ones to pull a pink slip out of their inbox.  People are learning to be content with what they have while they pursue what they want, rather than be ruled by the culture of immediate gratification that says “go get what you want NOW, while you pursue the means to pay for it LATER.”  The former is much healthier, and a much more solid foundation on which to build future prosperity.  These are all positives.
 
However, one result of the downturn that is undermining a turnaround and inhibiting growth is the morphing of VCs (venture capitalists) into VCs (very cautious).  There is almost no “venture” in venture capital right now, and that means fewer “next generation” technologies are getting vital capital for early R&D, fewer high-energy, creative entrepreneurs are getting from prototype into production, fewer new and exciting brands are able to go from local distribution to regional/national, and so on.
 
According to the most recent National Venture Capital Association report on the state of the industry, venture capital investment in Q2 2009 was at mid-1990s levels, and this was up from Q1 levels.  The $6.9 billion invested in the first half of 2009 was essentially the same amount invested in 1996, the year of that seminal Internet event, the Netscape IPO.  First-time financing (companies receiving venture capital for the first time) dollars for the second quarter was reported at $678 million, which went into 141 companies, the lowest number of first-time deals since 1994.  Let’s think about that for a minute: fewer than three companies per state received first-time financing of less than $5 million each, enough to hire, say, 35 employees per company, or barely 5,000 new jobs created by this particular cog in the capitalist machine.
 
Cited among reasons for the fall-off is the lack of certain exit options such as an IPO, VCs conserving cash for existing portfolio companies, and dismal results leading to VC staff reductions which ultimately reduce the number of deals that can effectively managed and in turn make it necessary for VCs to invest in fewer companies.
 
In 1999, start-up entrepreneurs were getting $20 million in start-up capital based on an idea scribbled on a napkin at a bar.  This clearly was a case of VCs being too venturesome, and they paid the price.  $52 billion was invested by VCs that year.  With easy money - and lots of it - came extreme valuation inflation at all levels of the capital ecosystem, from start-ups to public companies.  (Note: just before the end one analyst pointed out that Amazon, in order to justify its then-current valuation, would have to grow at 100% for 20 consecutive years just to justify its price then).  The same VCs who wouldn’t invest $5 million in an idea at a $5 million pre-money valuation in 1996 were falling all over themselves to invest $20 million at a $50 million pre-money valuation for the same idea three years later.  And we all are painfully aware of the bubble, its pricking and the aftermath.
 
So there’s a valuation bubble where there is a fire hose of easy capital.  So what happens when there’s barely a trickle of capital?  The pendulum swings to the other (unhealthy) extreme and we see valuation compression and, worst for companies in need of capital, a smaller strike zone in terms of having a story that is on-target with a particular VC.  This time around in the down-cycle it appears that the strike zone has shrunk from top to bottom (size/stage) rather than corner to corner (industry/sector).  The effect is that once “venture capitalists” are now demanding meaningful market traction and growing revenues where they once needed only revenue; or multiple customers where they once needed only one “reference account;” or production level vs. prototype; or a complete management team vs. a charismatic CEO and a whiteboard.  In fairness to VCs they look out at the horizon right now and believe that they might not ever get a chance to raise more capital and they might be running their last fund.  They’re being Very Careful with the deals they invest in.
 
The net effect is that VC’s are stuck in a conundrum which is being conservative to a flaw, which could jeopardize their capital under management actually being redeemed and being aggressive in a time of no liquidity.  Angel investors haven’t been able to fill the gap and a lot of well-conceived business plans or even going concerns run by qualified and passionate entrepreneurs are going unfunded -the wealth creation process abandoned.  The venture capitalists are cautious because they need to see a trend in the markets improving for liquidity, they need to see a more balanced M&A market not just a buyers’ market and last but certainly not least they need to see the next BIG thing.  It may be “cloud computing”, it may be mobile services or it could be SaaS (Software as a Service).  There is no clear direction and the VCs are stricken with the old adage “paralysis by analysis.” 

As always, the numbers will improve and the pendulum will swing back towards the middle, but until then we need to keep the entrepreneurial spirit alive.

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…