Michael Jackson
June 26, 2009

We are deeply saddened by yesterday's tragic news about Michael Jackson. Over the last year, I have had the opportunity to know and work with this gentle and talented man. We were pleased to help support his return to public life through our acquisition of Neverland Ranch.

His legacy as the most profound and influential entertainer of our time will live on through his children, his iconic and timeless artistic contributions, and in the hearts and minds of his tens of millions of fans around the world.

Of course, Neverland itself is now a mythical sanctuary to Michael and we are doing our best to accommodate the throngs of global press and fans arriving there to express their grief.

Our thoughts and prayers are with his family.

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It's About the Vault, Not the Gold
June 23, 2009
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In the past 90 days, the dark clouds of fear shared by all have transformed into a dawn of hope and rebirth for many. Stock prices are up 30 percent; US emerging markets bourses are up 35 percent; oil and most commodities are up significantly; credit spreads have narrowed; and the dollar has fallen. Many pundits have called the bottom, and the fear of global Armageddon has passed.

Unfortunately, we have been unable to find the same euphoria in the fundamentals. The market has simply discounted the continued deterioration and looked through to the surety of a global recovery in 2010 to 2011. This perception is undoubtedly further influenced by near zero interest rates, Fed liquidity programs, and Fed purchases of agency bonds. (PLEASE MR. PRESIDENT, DON'T STOP NOW).

Simultaneously, public sector debt is exponentially rising and credit availability to both corporate and individual consumers is negligible. Unemployment is close to 12 percent and our $1.5 trillion a year deficit seems like an anniversary gift for the next decade. The only way to fund these deficits is to increase income taxes, add a VAT tax, and allow the dollar to cycle lower.

On the horizon we sense rising oil prices (over $100/barrel, which is really bizarre), increased taxes, continued deleveraging ($7 trillion in the financial sector alone), increased unemployment, rising government bond yields, low GDP growth, continued schizophrenia between inflation and deflation, over-estimated and under-performing corporate earnings and cash flows, and more recycling of financial institutions, especially in Europe.

The "V" day recovery, a celebration of the passing of global Armageddon, may turn into the "W" (for wake) day recovery that embodies a different kind of "V" – volatility.

In the midst of banging my head against the walls of this intellectual Rubik's Cube, a friend's son who is in his senior year of university, called and asked to interview me for a class project. Since it was the most uplifting call of my week and I assumed he had been sent to voicemail by those great men to whom the question should have been directed, I couldn't refuse. The topic was "What is the key to greatness?" I told him my persona at the moment more reflected "What is the key to survival?" but I would be happy to lend a hand.

We began with my usual college preparatory headline that greatness is a way of life, not an event, and is borne by developing a couple of precise disciplines or "clubs in the bag." Thereafter, with practice and dedication you can expand from a driver and a putter to fill out the complement of other clubs that you will need along the course. Knowing how to use them is the first task and then learning when to use them is the next. Then I told myself, this is proficiency, not greatness. This search for the answer became even more compelling to me as I sought a diversion to the inescapable changing circumstances and information overload clogging our thoughts everyday.

I felt as though my response was thin and sounding more like a Jim Carrey sequel to Napoleon Hill's "Think and Grow Rich" than the real thing. I started to grasp for a true common denominator of greatness amongst those individuals in whom I have sensed greatness. Great people have all mastered their trade or passion, whatever it is, but what makes them great is something else, something more than being good at what they do. Greatness seems to come to those that focus on "not the quarry but the chase, not the trophy but the race." Greatness is the container in which you find commitment, dedication, loyalty, trust, integrity, tenacity, and courage. In most instances it is filled with humility, patience, passion, perseverance, and selflessness. But still my response felt prepackaged and shallow.

I was still caught in a mental tornado that was obliterating the real answer. As the tempest raged on my brain shifted gears and I began to reflect upon my recent European tour. While there I noticed a new trend. The smartest investors in the world were becoming increasingly frustrated while attempting to attribute performance to alpha managers or swaying beta in confused markets and they longed to return to neutral and regroup. They were shifting to gold as their investment of choice. This, anecdotally, caused a run on vault space in most Swiss Banks. Investors could easily find gold to buy, but a trustworthy bank to house it, that granted exclusive entry access to only the depositor, was a different story. Then it hit me – I was focusing on the characteristics of greatness (gold) when greatness was actually found in the walls of the vault. The vault was the scarcity, not the gold. Its safety and security took centuries to establish, it wasn't earned over an occasional good trade. It was earned through good times and bad, through utilization and neglect, over the trials and tribulations of a multitude of cycles. What good was liquidity if you couldn't access it or retrieve it in the midst of a storm of illiquidity?

Investment greatness today may be found in simply fortifying the vault, not in increasing the gold bullion that lies within. Preservation vs. propagation is the play of the day. It took private equity twenty years to design, build, and maintain its vaults. Even though there will be good and bad trades emanating from within, they are still the best safeguards of outsized returns in the market place. Private equity has outperformed all other asset classes on almost every metric over a 10- and 15-year historical perspective. Without question, 2008 and 2009 were plagued with struggle and underperformance; however, the people and their skill set are the same and have consistently delivered outperforming value for the last two decades. Although current circumstances have encouraged us to re-think aspects of the business model – GP and LP relationships and, most amazingly, the increasingly confusing LP to LP relationship –private equity is here to stay.

We will take a look at a re-think of the model, but first let's examine the backdrop for where we find ourselves today.

Current State of Play
We are constantly learning to listen to our instincts more than the "noise" and those instincts are telegraphing the opposite message of what the rhetoric around us seems to be chanting.

• Markets are frenetic and tremendously volatile! Short-term deflation and long-term inflation.
• Businesses everywhere are struggling for market share, margin, and revenues. Trying to estimate next quarter's revenues and earnings has become much more of an art than a science, as outlooks continue to deteriorate. Every day, management teams are releasing reduced revenue and EBITDA guidance. Management teams' inability to predict the top line has led them to major cost cutting programs in attempts to alleviate the pain and give them hope at having a better than awful bottom line.
• Value is impossible to determine and as illusory as the liquidity that drives its determination. In this type of a cycle, firms must defend and reposition balance sheets, bolstering cash and limiting debt, but there is no premium for acquiring private assets. In a deflationary environment everyone fears that the value of any asset purchased today will be less tomorrow. Any leverage applied to that type of acquisition may make it an unforgiveable mistake. Current distress has been felt mostly at the financial instrument and intermediary levels. The true agony at the asset level will now start its ugly march.
• Corporate restructurings are being conducted in the "Octagon." There are few clear rules in an ever-changing landscape coupled with hundreds of constituencies with varying desires and objectives. Relationships no longer matter and the counterparties are at war with each other. The deleveraging process will be painful for all, especially institutions who find themselves as investors on all sides of these transactions.
• Hedge funds have dramatically changed the "debt restructuring game." They are avaricious buyers of all forms of corporate and high-yield debt and have created massive returns by buying credit default swaps (CDS), a type of insurance against default. Pragmatic lenders who hedged their economic exposure through CDS can often make higher returns from CDS payouts, which are exponentially levered, rather than from out-of-court restructuring plans. This adds to the lack of transparency in this sector.
• Hedge funds have also added to the opaqueness in the debt markets. With low volumes, they can buy/sell a bond and short that position on an exchange. Consequently, they can avail themselves of the "mark to market" indexing of a particular exchange by themselves being the re-pricing force. This further adds to the lack of transparency in this sector.
• Unemployment is a mortal wound. We cannot believe in a recovery until this trend reverses itself which currently appears far off.
• We have our financial systems on life support and will not see the reality of their long-term viability until we pull the plug. My fear is that the government will be intimidated to pull the plug too soon. Banks are in a race to repay TARP funds and all recently resurrected companies now want out of governmental domination. The key to assured survival is actually the opposite – stay on life support. Not just until we are walking, but until we can run the Boston Marathon. The fear of inflation, on the other hand, is a problem that can be handled by shortening the race to a 5k.
• In spite of the tremendous short-term deflationary pressures, the long-term outlook must be inflation, which it appears to be a long way down the road. The US deficit is about $1.5 trillion annually (10 percent of GDP). Our federal government net debt to GDP ratio is now 45 percent. Continued deleveraging, re-regulation and unemployment will keep the government deficits at this level just to stay at 1 percent GDP growth. As our GDP ratio climbs towards 100 percent, debt will become harder to sell in the light of ratings pressure and mid and long term interest rates and security will be challenged. As Pete Peterson has articulately noted, if you add Medicare, Medicaid and Social Security to these deficits that need to be covered you quickly get to $60 trillion or 400 percent of GDP. Sovereign funds and foreign governments cannot lap up the deficit. The Fed will have to keep stepping in and buying treasuries and agency bonds. Inflation could descend on us in spades.
• The World Bank continues to dampen its views on the global economy, saying the recession will be more profound than previously expected and warns that the flight of capital from developing nations will balloon unemployment.
• This is the era of unprecedented opportunities in the arbitrage of real estate debt.
• Monetary defaults and unfunded maturities in commercial real estate will start to rear their ugly heads and continue through 2012. Our best guess is that if most tradable commercial real estate were marked to market in the USA which carried debt with maturities between now and 2012 that another $750 billion to $1.5 trillion deleveraging will take place. Add to this the bullet refinancing in corporate debt and high yield to refinance at 50 percent levels of current market values and there could be an additional $3 trillion.
• Real estate is for trading, not for holding.
• Severe liquidity restraints have caused banks to tighten lending standards and the shadow banking system such as CMBS, CDOs and hedge funds have all but been shut down on new lending. Approximately 80 percent of lending came from these sources in prior years. As the $1.5 trillion of refi demand looms over the horizon from 2009 to 2013, where will this tremendous source of capital come from?
• The only "V" we are witnessing is volatility. The continued lack of confidence in most markets, coupled with normally occurring unforeseen events, is keeping the markets frenetic. We anticipate a "WW" recovery and a deleveraging cycle which may last up to 30 months.
• Private equity investments are plagued by managers and investors trying to figure out the complexity of liquidity, capital call and distribution predictability, harvesting and safeguarding current investments and limited partner's needs while properly seizing new opportunities. The model will need more "infinite life" capital and alignment of GP and LP interests.
• LPs come in all shapes and sizes. Sovereign Wealth Funds, Public Pension Funds, Corporate Pension Funds, College Endowments, Fund of Funds, and Family office. What they are all realizing is that their various LP interests and concerns are different and varied. However, the current structure of advisory committees and LP approvals are a hindrance. More flexible and directed structures which allow a specific LP class to have greater or less participation in various aspects of the business will be a topic of future discussion.
• Commodity prices of oil, energy, and minerals will continue to soar causing patches of global instability.
• US taxes will increase exponentially in parody with increased US deficits. This will spur outsourcing and relocation and further frustrate unemployment.
• Deleveraging will continue at a massive pace and as a consequence so will deflation. The trillions of dollars of deleveraging remaining to get to stabilized debt to GDP ratios will not happen in rapid fashion. It will take 24-30 months to reach a stage of balance and during this time period there will be massive deflationary pressures and continued volatility, especially in the debt markets. It will be difficult to value the residual on most credits going forward and the market will cry for more transparency. With trepidation amongst the general market to become involved in this arena, it will in turn be the greatest opportunity to take advantage of the dislocation created by the lack of demand.
• Amazingly enough, as institutions are undergoing a wave of illiquidity, the current liquidity lies within households, which are increasing their savings.

Lessons from the Past
Today is a tale of two cities. On one hand, the fight for value on legacy investments continues and solutions are difficult and time consuming. On the other hand, it is in these cyclical downturns in which we have historically made our best and most profitable acquisitions. What have we learned from past crises:

• Relationships - When I think back to the defining moments, the great strides have all been around relationships. Those relationships are built by laying long lines and testing them. They are not constructed in easy times but are earned under fire. Their quality is based on clear expectations of what we want from each other and what the reliability factor is. It is not defined by return. It is defined by judgment, experience, wisdom, and character. In the past, relationships were the proprietary determinant of competition. Sourcing, financing, operating and exits were all done amongst groups that had faith and confidence in each other. If there was a problem, we all sat down and fixed it. In the last decade, relationships gave way to complex instruments created by anonymous entities and auctions conducted without regard to important but non-economic factors. We are all now paying the price of not having paved relationships rather than transactions. Aligned and clearly communicated expectations of those with whom we do business provide the foundation of trust which is the ultimate insurance policy to success.
• Leverage – We have learned that leverage adds dramatically to scale but minimally to yield. Private equity returns over 10 years are about 16 percent levered and 11 percent unlevered. Real estate returns over 15 years are about 8 percent levered and close to 7 percent unlevered. The utilization of leverage for us simply gave us more buying capacity not necessarily higher risk adjusted returns. Consequently, it is much better to utilize higher amounts of equity and less scale to reduce risk over any specific spectrum. The use of aggressive leverage, even if available, is a mortal wound in a deflationary cycle.
• Liquidity – Liquidity is definitely a premium, even within a private equity structure. The concept that endowments and pension funds need not pay for a liquidity premium is true only when they don't need liquidity. A balance in an overall portfolio or private equity fund needs to have a liquidity toggle for a portion of the fund. The "side pocketing" of assets by hedge funds which frustrated the redemption procedure for investors has made all investors a bit more concerned about ultimate exits, even in private equity. We cannot buy debt portfolios highlighting a near-term trade only to become long-term investors to maturity when the trade doesn't materialize.
• Infinite life vs. finite life – Sequential funds are a problem for investor and manager: Multiple funds, multiple conflicts, multiple managerial issues and a focus on a transaction as opposed to building a business. We need to begin the transition to an infinite life business model and LP alignment within the GP itself. This needs to include more flexible co-investment structures and streamlined governance.
• Make quicker decisions with fewer mistakes – Our best results have always been in the middle of a crisis. To see these opportunities the team must be clear minded, in shape, focused, and equipped with the proper tools. My job is simple - supply the team with those resources, mixed with vision and adaptability. This is a market where the playbook became outdated as soon as we took the field. The ability to make quick, well-informed decisions, while making the least amount of mistakes along the way, is the fastest road to relevance.
• Communicate, Communicate, Communicate – The more information passed between GP and LP, the more trust is instilled. Listen and accept valid criticism and amend the model and process where appropriate.
• Ready, Fire, Aim – These moments require bold and decisive leadership and we cannot afford to be paralyzed by analysis and consensus. Adaptation and experimentation are essential, and both GPs and LPs need to prove they are trustworthy.
• Terminate hubris and promote humility.
• Tell the bad news first and clearly and then get on with life – Take write-downs soon and accurately and move on.
• Start early on fixing the model. A fee structure based on committed capital, invested capital, or costs must be reconciled to a new reality. Scale, scope, and liquidity must all be revisited. The business model will change. Those who adapt will flourish, those who don't will vanish.

What is Needed Now?
It seems to me that there are two clearly defined windows of opportunity to access the "deleveraging of real estate" in the United States.

Distressed Debt
We need to provide ourselves with the proper tools to access a long and continuing strain of real estate delevering and take full advantage of the intervening events in the debt and real estate markets. However, it will take awhile for equity values to reflect attractive pricing and fundamentals to appear promising on the horizon. The first window of opportunity will lie within the real estate distressed debt arena. The recycling of NPLs, sub-performing and partially-performing loans is a time consuming business of singles and doubles with minimal volatility. CRE loans from commercial banks and various traunches of CMBS debt will provide additional opportunities especially for those which had been storied and sequestered.
These investments will provide short-term gains, some interim cash flow, greater amounts of liquidity, and require value-added techniques and specialized troops, as opposed to financial engineering. There will be a moment for accelerated real estate equity acquisitions at scalable levels, but it is most likely not now.

Banks
There has probably never been a better moment for a well-run, conservative bank with a clean balance sheet to make attractive real estate loans. Equity capital in a bank is about 6 - 8 percent which is the best and safest leverage available in the market place. Real estate values themselves will continue to drop to double decade lows, margins will be the highest due to non availability of refinancing options, debt service coverage will be the highest and most conservative, and the quality of the properties to be selected can be the most discriminating.
Private equity is searching for ways to participate in the rebuilding of the banking sector through acquisition of troubled banks which are in resolution by the FDIC or the OCC and participation in Bank Holding Company structures. As more banks become subject to regulatory receivership and resolution, private equity will find an artful way to be the financial concierge to health of these institutions. Additionally, new banks and mortgage originators are a safer and more logical first inning investment vehicle for a long and burdensome real estate restructuring cycle.

Conclusion
Private equity will clearly redefine itself and amend its model to better fit its customer base. There will be winners and losers. Greatness will come by expanding and readying the vault. If greatness doesn't find us, we will find it.

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