Sep 19, 2014, 12:38 AM ETConference Presentation, Panel, Fireside Chat

Asia Summit 2014 - U.S. Capital Markets: Smooth Sailing, but in What Direction?

Panel Composition: The discussion features John Sokoloff (Managing Partner, LGP/Leonard Green Partners), Samir Jain (Chief Economist, American Realty Capital), and Tom Fink (CEO, Babson Capital).
Global Events Influencing Sentiment:
- Federal Reserve: The Fed released a new "dot plot" suggesting rates may rise sooner than market pricing indicates, potentially 1 to 1.5 hikes ahead.
- UK Referendum: The Scottish independence vote caused a rally in the British pound.
- IPOs: Alibaba's IPO was priced at $68 at the high end.
- Consumer Tech: The new iPhone launch and automotive sales hitting a record 17 million units in 2014 are noted as economic drivers.
Market Valuation Concerns:
- The US stock market is up over 50% in the past two years, driven significantly by higher margin rates rather than top-line growth.
- John Sokoloff warns that the current credit environment (7–8x cash flow at 5% pre-tax rates) is unsustainable and historically inverted compared to the 1989 era (5x EBITDA at 10–12%).
- Samir Jain notes the US economy is in a mid-cycle expansion with lower volatility (VIX in 10–15 range) compared to the previous year's political and fiscal gridlock risks.

Credit Environment Evolution:
- Borrowing terms have shifted from covenants-protected bank loans to floating-rate debt with minimal lender dialogue (e.g., second lien loans requiring only interest payments).
- Sokoloff states that while the credit boom has fueled returns, the industry is currently "borrowing every nickel" while terms remain favorable.
Deal Flow & Underwriting Standards:
- Babson Capital's approval rate for deals has dropped from 75% (3 out of 4) in 2009 to approximately 25% (1 in 4) currently.
- Sokoloff anticipates a "massive tidal wave" of exits in the private equity sector, with exits running roughly 2:1 over capital deployed in the past 18 months.
Strategic Pivots for 2015:
- Dividend Recapitalizations: Managers are utilizing re-leveraging to extract capital early, reducing transaction risk before holding periods extend.
- Secondary Market Acquisitions: There is a growing trend of buying assets from other private equity firms ("stuck assets") rather than buying from founders, as some firms sell their best companies prematurely to raise new funds.
- Focus on Disruption: Investors are targeting "disruptors" and "market share stealers" in mundane sectors (e.g., food distribution, healthcare) to find growth rates exceeding GDP.

Real Estate (Samir Jain):
- Interest Rate Sensitivity: Real estate valuations are not inversely correlated with rates if the increase is driven by economic growth, inflation, or replacement costs; it is only negative if driven by mis-signaling.
- High-Yield Strategy: Opportunities exist in senior secured middle-market loans to corporates and sector-specific net lease properties where financing costs are low relative to high cap rates.
- Niche Growth: Strong performance anticipated in storage, industrial distribution, hospitality, and grocery-anchored retail.
- Private vs. Public REITs: Private/off-market REITs are preferred for their ability to manage entry/exit timing, avoid market volatility, and access illiquidity premiums.
Fixed Income & Alternatives:
- Redefining Fixed Income: Jain advocates for "durable income" proxies (infrastructure, timber, agriculture, cell towers) to unlock returns beyond interest rates and credit spreads.
- Hedge Fund Strategy: Long-short strategies with a long bias are identified as favorable.
- Credit Cycle Positioning: Tom Fink warns that while corporate balance sheets are strong, a sudden spike in rates could cause a liquidity reaction similar to past dislocations.

Capital Market Maturity:
- John Sokoloff characterizes Asia as a "time warp" to the late 1980s US, where bank lending dominates (70–80%) compared to the US (approx. 20%), indicating a massive opportunity for institutional credit and high-yield bonds.
- Markets in Australia and Hong Kong are more advanced, but many Asian capital markets lack the rule of law, accurate books/records, and title security prevalent in the US.
Investment Risks & Opportunities:
- Policy Risk: The primary deterrent for US private equity firms is government intervention and the ability of authorities to change rules mid-transaction.
- Consumer Demand: There is a "unquenchable thirst" for American brands (e.g., Whole Foods, Shake Shack, J.Crew) across the region, despite China's demographic challenges.
- Capital Flows: Approximately 25% of LGP's capital and a significant portion of Babson Capital's third-party money originate from Asian institutional investors (sovereign wealth funds, pension funds, banks).
- Investment Horizon: Investors are cautioned against short-term thinking; the Asian market development is expected to be a multi-decade tidal wave despite near-term friction.

Valuation Pressure: The primary concern for private equity is the price paid for assets; managers worry they may not be able to exit at the same multiples in 7–8 years if the market normalizes.
Interest Rate Risks:
- A rapid increase in rates could freeze credit markets or force defaults, though current corporate liquidity is deemed sufficient to withstand moderate hikes.
- Tom Fink suggests that focusing solely on the "interest rate story" may cause investors to miss broader value opportunities.
Market Correction Prediction:
- Sokoloff predicts that when the market does turn, it will likely come down "quickly and violently," creating a buying opportunity for those who survived the downturn.
- He argues that the current market rally driven by a "no other place to put money" mentality is unsustainable.
Long-Term View: All panelists emphasize the need for fundamental analysis over short-term market timing, focusing on sustainable business models and the ability to weather economic cycles.