The Great Unwind and Its Impact, By Jim Zukin

May 1, 2009

www.HL.com U.S. 800.788.5300 Europe +44.20.7839.3355 China +86.10.8588.2300 Hong Kong +852.3551.2300 Japan +81.3.4577.6000

Los Angeles • New York • Chicago • San Francisco • Minneapolis • Washington, D.C. • Dallas • Atlanta • London • Paris • Frankfurt • Hong Kong • Tokyo • Beijing

The Great Unwind and its Impact

James Zukin祖金


1

The U.S. and the Roman Empire

Introduction

There are striking similarities between the current situation in the United States. and the factors that brought down the Roman Empire, including

declining moral values and political civility at home,

overconfident and overextended military in foreign lands, and

fiscal irresponsibility by the central government.

A metaphor for Wall Street is the Colosseum. In the Colosseum, Romans fought not just individual duels, but a much deeper battle for the heart and soul of the republic – and lost.

The Colosseum was symbolic of their obsession with wealth and material excesses, destroying its values and exposing its vulnerability, until eventually Rome was overrun by outsiders.

The difference between the United States and the Roman Empire is the innovation machine manned by millions of American entrepreneurs.

Source: Economist, David Walker


2

The Great Unwind

Financial complexity is at a tipping point.

Today the marginal utility of financial innovation may be negative.

Financial institutions established to manage risk, instead, have created risk.

The think tanks and universities of America did little.

have stood by as the crisis ravaged their endowments and destroyed the credibility of the market thesis,

the “market we trust” school of market idolatry has ended.

Market mistrust is increased by a dramatic rise in the number and size of Ponzi schemes that have grown from local to global and cumulatively will soon be crossing the $80,000,000,000 threshold.

A market without effective regulation is a “school for scoundrels”.

Taxes drive too many transactions. The Internal Revenue Code needs simplification and a focus on integrating a much more rules-based approach into the system of the major CPA firms, the banks, and other financial institutions.


3

On the Great Unwind

In 1980, bank indebtedness was equivalent to 21% of U.S. gross domestic product. In 2007 the figure was 116%.

In 2004, the Securities and Exchange Commission changed a rule and exempted the five largest investment banks from regulations that capped their debt-to-capital ratio at 12 to 1. Soon it approached 30 to 1.

Since first coined in February 2007, the credit market phenomenon known as the “Great Unwind” has had a profoundly disruptive effect on U.S. and international financial markets.

Disorderly trading and cascading forced selling—coupled with unprecedented levels of illiquidity—has placed the U.S. banking system into a cycle of distress.

As the Federal Reserve/Treasury/FDIC plan attempts to rescue the United States from this crisis, the banking system’s movement through the cycle will define the duration of the current recession.

Reasonable disclosure of investment bank and hedge fund model inputs and assumptions and marks would help to rebuild investor trust. Fundamental information on the assets being traded in illiquid markets including cash flow projections, credit/duration risk, prior sales, asset valuations and projections with base case and deep recession with increased tariffs case would be quite helpful. Supplemental information of markets utilized by others. The big four CPA firms can spearhead this to show the number of holders, range and median of marks on specific bonds, stocks or other financial assets.


4

Cycle of Distress

As the U.S. Federal Reserve’s balance sheet swelled from $900B to over $2T almost overnight, the United States, along with the rest of the G8, went “all-in” with unprecedented levels of government loans and guarantees in a historic effort to prevent the global financial system from failing.

+ Less Risk

- Greater Risk

+ Increasing Distress

Recovery or Obscurity

Stage 4

Market Exit of Bank to New Owners

New Credit Culture Implemented

Decline & Challenge

Stage 1

Problem Loans Emerge

Costs Rise

Governance Issue Emerge

Relief & Recuperation

Stage 3

Regulators Recapitalize the Banks

Non-Performing Loans Transferred to AMC

Best Management Practices Implemented

Crisis & Catastrophe

Stage 2

Regulatory Intervention as Bank Capital Shrinks

Most Lending Ceases

Many Non-Performing Loans

- Decreasing Distress

Cycle of Distress

2010

2009

2007

2008

Good News

We are here


5

The Valuation Issue

The U.S. Valuation Debate Continues

Accounting rule-makers have come under unprecedented pressure to ease their rules on “fair value accounting,” the practice of marking assets to market prices.

All of the major models and theories in broad use on Wall Street and in finance, such as the capital asset pricing model, Black-Scholes option pricing model, and modern financial theory in application, often produces miss pricing based on assumptions based on historical observations with a bias towards the upside.

Assumptions regarding volatility and duration that are overly optimistic (i.e., “compound optimism”) were routinely utilized.

Business schools need to rethink how they teach modern financial theory for the theory in application has serious flaws due to the estimation of variables.


6

The Valuation Issue (cont.)

The U.S. Valuation Debate Continues

An enduring area of option research is the fundamental financial model assumption that future returns will follow a log-normal distribution, the famous “bell shaped curve.” However, this assumption may overprice assets in today’s crisis driven market.

In analyzing the applicability of market inputs, it is important to look at market volatility. Forced selling is inconsistent with the concept of “freely and actively traded.”

The mark to market valuation information provided from qualified third parties is important information for investors. Its use in accounting sometimes creates inadvertent events of trading procyclicality causing downward pricing spirals.


7

Global Lessons: Conclusion

The Great Unwind Begins

The “Great Unwind” is now underway. As the financial sector grew to extraordinary size, it did so with great leverage.

The “Great Unwind” does not just describe the eventual liquidation and dismemberment of a generation of Wall Street creations, including the 30x leveraged investment bank business model that spawned these now distressed entities. It also has a note of optimism as the markets will eventually rewind in an orderly fashion under greater regulatory scrutiny.

The major long-term issue will be managing the inflationary effect and corruption potential of the massive expansion of government capital creation moving at full speed across the globe.


8

News From China

36 of the 100 firms anointed by the Boston Consulting Group in January 2009 are “contending for global leadership” are Chinese. No other country can boast so many.

China has become the world’s largest exporter of information and communications technology.

China’s banking system is awash with liquidity. Chinese bank lending surged by 21% in the year April ‘08 to January ’09, up 30% in March.

Some shovel-ready projects are already under-way. Transport infrastructure spending in December 2008 was already 61% higher than the year earlier.

China’s outbound M&A is booming, but only in natural resources.

Inbound private equity into China is down along with prices but FDI is still $6-$8 billion per month.

Source: Caijing


9

Challenges in China

“What to expect in the Year of the Ox”

Risk of doing business in China was a much higher cost of insuring Chinese receivable plus 30%

More anti-trust surprises

– Coca Cola and Mitsubishi Rayon

Chinese GAAP and obsolete inventory

The one knuckle rule; moving to international accounting standards

Into adverse selection – why are you in the deal?

Retrading

One bed, two dreams

Any deal with a book

If value rises post-agreement, approval may be withheld

In JV, pick the CFO

Learn Chinese, become Chinese

Create relationships based on mutual trust – creating the trust of obligation

Comrade Zukin “I am ready” – so is China

What are the limiting ingredients for China’s next leap?

Management and management training

Resource, Environmental and water supply issues including healthcare

Regulatory deal review may take 1-3 years, how to do it in 2-4 months


10

M&A Considerations for Chinese Buyers

Cross-border M&A transactions are often precedents for Chinese and U.S. companies, therefore, it is critical to address the additional complexities.

Pre-Closing Considerations Post-Closing Considerations

Language difference and cultural differencesTime zone differenceManaging U.S. and PRC deal teams Parent company objectivesLack of complete informationExpectation gapGreater detailed due diligenceConversion of financial statementsComplex tax structuresCash vs. stock considerationNew PRC M&A rules – 2 approvals

SOE’s can jump the cueU.S. regulatory approvals

SEC, HSR, CFIUS, as applicableExtended time frame to closing

Managing new management teamsKeeping employees motivatedReporting to new board of directorsMaintaining vendor relationshipsIntegrating operationsAchieving synergiesManaging cultural differencesCommunicating to publicDealing with the financial crisisPolitical dimension of partnering with the state (SOE JV’s)


11

Panda Bonds to the Rescue?

Amid a dearth of liquidity in global capital markets, sovereign Panda bonds are now on the agenda. They could redirect excess liquidity in the Chinese money system to a global financial system badly in need of capital, and it would raise China’s profile in international capital markets.

Should China allow foreign governments, particularly the United States, to issue renminbi bonds in the domestic market? China has seen only three domestic bonds by foreigners: two by the International Finance Corp in 2005 and 2006, and one by the Asia Development Bank in 2005.

China is also sitting on US$1.9T of foreign reserves. Currency risk has become a major concern.

The Panda bonds could siphon liquidity out of the mainland money supply, which has surged on consecutive record trade surpluses. That would save the government the expense of having to issue money-supply-sterilizing government bonds, which carry an interest cost.

Use of the instrument could also help develop the domestic capital market and help to establish the renminbi as a major currency in global finance. This could happen in a controlled manner over several years with tight coordination with NDRC, MOFCOM, PBOC and CSRC.

Source: Ifre.com


12

Dow Jones Industrials (2/1/2008 – 4/2/2009) - Datastream Asia Borrowing

(basis points)

0

100

200

300

400

500

600

700

800

900

Japan

Asia excluding Japan

July Sept Nov Jan Mar May July Sept Nov2007 2008 2008

Spreads on Credit Default Swaps Initial Public Offerings Volumes in China & Hong Kong

Source: Datastream

Sources: Bloomberg and IMF staff calculationsNotes: Measured by iTraxx Indices. Spreads are the annual amount that an entity seeking protection must pay, expressed as a percentage of the value of the debt being protected. A basis point is 1/100th of apercentage point.

Source: Dealogic

Source: Bond, equity and loan database of the IMF through Dealogic

4,000

6,000

8,000

10,000

12,000

14,000

Feb-08

Mar-08

Apr-08

May-08

Jul-08

Aug-08

Sep-08

Oct-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

0

1,000

2,000

3,000

4,000

5,000

DJ Industrials SHANGHAI SE COMPOSIT PriceClose

0

20

40

60

80

100

2003 04 05 06 07 08

Shanghai & Shenzen Hong Kong

(HK$B)

(billion dollars)

0

20

40

60

80

100Bond Equity Loan


13

Greater China M&A Quarterly Trend Asia-Pacific M&A Quarterly Trend

2009 YTD – By Value 2009 YTD – By Volume

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Q103

Q203

Q303

Q403

Q104

Q204

Q304

Q404

Q105

Q205

Q305

Q405

Q106

Q206

Q306

Q406

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Valu

e($

M)

0

50

100

150

200

250

300

350

400

Volu

me

ValueNumber of Deals

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

Q103

Q203

Q303

Q403

Q104

Q204

Q304

Q404

Q105

Q205

Q305

Q405

Q106

Q206

Q306

Q406

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Valu

e($

M)

0

100

200

300

400

500

600

700

800

900

1,000

Volu

me

ValueNumber of Deals

Financial Services17.6%

Real Estate4.1%

Business Services2.8%

Construction0.4%

Industrials & Chemicals

23.2%

Consumer12.6%

TMT5.9%

Energy, Mining & Utilities16.1%

Pharma, Medical & Biotech1.1%

Transport13.6%

Leisure2.5%

Financial Services8.1%

Real Estate7.3%

Business Services5.1%

Construction2.2%

Industrials & Chemicals

24.8%

Consumer18.9%

TMT13.1%

Energy, Mining & Utilities11.0%

Pharma, Medical & Biotech3.6%

Transport2.3%

Leisure3.6%

Source: Mergermarket Source: Mergermarket

Source: Mergermarket Source: Mergermarket


14

Altered M&A Market

Pre- June

2007

Massive global liquidityLiberal lending termsRecord M&A activity driven largely by private equity firms

Robust Environment

2H 2007 /

1H 2008

Global debt market dislocationMassive reduction in private equity activity and disappearance of large leveraged buyouts“Broken” deals with greater focus on MAC clauses and reverse break-up feesSignificantly reduced equity valuationsMiddle market M&A is resilient

Market Disruption

2H 2008

Failure of major financial institutions leads to near-evaporation of credit markets as interbank lending tightensRetreat in investor confidence leads to dramatic decline in equity capital marketsAreas of relative strength (middle market, cross-border) tested by credit market collapseConsolidation / equity infusions among financial institutions to strengthen capital positionsUnprecedented global coordination of government intervention in financial sector

Investor Confidence Crisis, Offset by

Government Intervention

2009

Outlook

“Mergers of necessity” likely to emerge as prevailing theme Capital constraints continue to limit M&A activity…but encourage attractive divestitures and sales by cash constrained companies looking to weather the stormEquity market volatility makes valuations difficult to determine…but depressed valuations make returns work, even on over-equitized dealsConditions point to a buyers' market, with capital rich companies as the key beneficiariesCreative financing structures, PIPEs and stock deals likely more prevalent

Uncertainty Amid Changed Landscape


15

Historical Context

After a sharp downturn from 2000-2002, M&A activity steadily increased from 2003-2007

Through June 2007, transaction levels rebounded to near all-time historical highs

The onset of the credit crunch, triggered by problems in the sub-prime market, has effectively shut down financing markets since the second half of 2007, causing agreed upon transactions to be unwound and the rate of new to deals to fall

The outlook for the remainder of 2009 reflects an altered M&A landscape, with a different set of drivers underpinning a more muted level of activity

M&A activity likely to consist primarily of defensive mergers, sales of non-core assets and industry restructuring plays

Opportunities triggered via sellers motivated by short-term liquidity needs, covenant default pressures and focus on core business

Historical Developments

1960s 1970s-1980s

Conglomerate Mergers,

DiversificationLBOs, Raiders,

Hostile Takeovers, Divestitures

Consolidation, Deregulation,

Megadeals

1990-2000

2000-2002

Credit Crunch/Mild Recession

2003-2005

Active M&AMarket/Pent-Up Demand

1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2007


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2005


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2007


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2005


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2007


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2005


1960s 1970s-1980s





Megadeals

1990-2000

2000-2002


2003-2007


Num

ber

of tr

ansa

ctio

ns


16

U.S. M&A Activity ($25MM-$500MM)*

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

January 795 664 500 508 684 729 754 921 919 486

February 863 595 456 494 609 576 696 782 768 425

March 978 588 504 568 709 688 819 817 709 522

April 744 596 554 552 664 676 779 752 743

May 894 653 567 516 612 637 860 957 666

June 893 600 494 554 666 705 855 927 797

July 782 610 538 595 649 672 808 809 871

August 801 537 504 487 657 722 796 845 640

September 779 359 489 622 627 735 848 815 688

October 775 536 544 653 593 702 809 945 592

November 635 464 440 519 587 691 741 786 510

December 697 469 479 656 672 647 833 736 588

Annual Total 9,636 6,671 6,069 6,724 7,729 8,180 9,598 10,092 8,491 1,433

Source: Thomson Reuters

* Includes undisclosed transactions


17

U.S. M&A Activity ($25MM-$1B)*

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

January 816 675 507 513 701 740 764 945 937 491

February 895 607 464 501 629 586 715 811 784 431

March 1,007 595 514 575 722 701 839 837 727 526

April 757 608 566 555 677 694 796 772 763

May 913 659 582 528 628 652 875 992 680

June 909 611 502 560 675 725 870 956 811

July 801 623 545 607 664 686 821 845 888

August 820 542 513 499 670 741 815 871 648

September 792 365 494 630 641 746 858 831 697

October 797 550 551 666 603 723 830 961 600

November 651 470 450 526 596 703 766 803 518

December 710 479 491 669 682 663 856 753 593

Annual Total 9,868 6,784 6,179 6,829 7,888 8,360 9,805 10,377 8,646 1,448

Source: Thomson Reuters* Includes undisclosed transactions


18

Global M&A Activity ($25MM-$500MM)*

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

January 2,042 1,849 1,534 1,587 1,731 1,901 1,923 2,454 2,408 1,717

February 2,229 1,728 1,315 1,266 1,546 1,506 1,707 2,061 2,146 1,630

March 2,481 1,823 1,440 1,542 1,845 1,952 2,130 2,357 2,074 1800

April 2,006 1,756 1,492 1,356 1,665 1,712 1,820 2,179 2,280

May 2,238 1,931 1,533 1,493 1,492 1,638 2,072 2,511 2,108

June 2,229 1,722 1,273 1,511 1,533 1,902 2,165 2,453 2,261

July 2,076 1,783 1,486 1,606 1,667 1,777 2,082 2,511 2,421

August 1,979 1,459 1,329 1,335 1,527 1,724 2,018 2,247 1,944

September 2,109 1,161 1,374 1,540 1,578 1,808 2,118 2,239 2,299

October 2,000 1,567 1,560 1,774 1,632 1,827 2,123 2,556 2,093

November 1,981 1,526 1,290 1,479 1,619 1,797 2,106 2,169 1,945

December 2,029 1,397 1,346 1,685 1,851 1,922 2,308 2,183 2,146

Annual Total 25,399 19,702 16,972 18,174 19,686 21,466 24,572 27,920 26,125 5,147




19

Global M&A Activity ($25MM-$1B)*

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

January 2,079 1,877 1,551 1,605 1,757 1,930 1,947 2,497 2,448 1,729

February 2,281 1,757 1,332 1,279 1,577 1,537 1,740 2,125 2,186 1,650

March 2,528 1,853 1,459 1,560 1,881 1,976 2,182 2,412 2,123 1,816

April 2,040 1,783 1,514 1,375 1,688 1,751 1,865 2,226 2,329

May 2,283 1,952 1,562 1,513 1,519 1,672 2,130 2,591 2,155

June 2,269 1,747 1,300 1,527 1,554 1,939 2,215 2,532 2,317

July 2,116 1,810 1,505 1,634 1,706 1,809 2,129 2,592 2,468

August 2,013 1,475 1,350 1,359 1,550 1,770 2,056 2,310 1,964

September 2,143 1,179 1,388 1,557 1,601 1,834 2,152 2,280 2,325

October 2,037 1,604 1,582 1,800 1,655 1,864 2,173 2,612 2,127

November 2,017 1,541 1,314 1,497 1,645 1,831 2,164 2,222 1,968

December 2,072 1,417 1,371 1,711 1,893 1,976 2,371 2,233 2,164

Annual Total 25,878 19,995 17,228 18,417 20,026 21,889 25,124 28,632 26,574 5,195




20

Disclaimer Statement

© 2009 Houlihan Lokey. All rights reserved. This material may not be reproduced in any format by any means or redistributed without the prior written consent of Houlihan Lokey.

Houlihan Lokey is a trade name for Houlihan, Lokey, Howard & Zukin, Inc. and its subsidiaries and affiliates which include: Houlihan Lokey Howard & Zukin Financial Advisors, Inc., a California corporation, a registered investment advisor, which provides investment advisory, fairness opinion, solvency opinion, valuation opinion, restructuring advisory and portfolio management services; Houlihan Lokey Howard & Zukin Capital, Inc., a California corporation, a registered broker-dealer and SIPC member firm, which provides investment banking, private placement, merger, acquisition and divestiture services; and Houlihan Lokey Howard & Zukin (Europe) Limited, a company incorporated in England which is authorized and regulated by the U.K. Financial Services Authority and Houlihan Lokey Howard & Zukin (China) Limited, a company incorporated in Hong Kong SAR which is licensed in Hong Kong by the Securities and Futures Commission, which provide investment banking, restructuring advisory, merger, acquisition and divestiture services, valuation opinion and private placement services and whichmay direct this communication within the European Economic Area and Hong Kong, respectively, to intended recipients including professional investors, high net worth companies or other institutional investors.

Houlihan Lokey gathers its data from sources it considers reliable; however, it does not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the authors at the timethis presentation was written, and this information is subject to change. Houlihan Lokey makes no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors regarding the subject securities and issuers and do not necessarily coincide with those of Houlihan Lokey. Officers, directors and partners in the Houlihan Lokey group of companies may have positions in the securities of the companies discussed. This presentation does not constitute advice or a recommendation, offer or solicitation with respect to the securities of any company discussed herein, is not intended to provide information upon which to base an investment decision, and should not be construed as such. Houlihan Lokey or its affiliates may from time to time provide investment banking or related services to these companies. Like all Houlihan Lokey employees, the authors of this presentation receive compensation that is affected by overall firm profitability.

Documents

The Great Unwind and Its Impact, By Jim Zukin