Lehman Brothers Aftermath

Intelligent Investing Panel
The Upside Of Lehman
Alexandra Zendrian, 09.17.09, 06:00 PM EDT
The anniversary of Lehman's collapse has people reflecting on how the world has changed. One lesson: visit your financial advisor and diversify.

The one year anniversary of Lehman Brothers' demise has been commemorated in many different ways. Some have mourned how it led to the subsequent implosion of the stock market. Others have debated whether saving it would have changed anything. Yet a handful of investors and advisers have used Lehman's collapse as an opportunity to learn and even profit.

"I believe that when we look back on this period, years from now, we will say it had a positive impact on our economy and the American people as a whole," says Lynn Phillips-Gaines, a financial planner at Raymond James Financial ( RJF - news - people ). One lesson investors had to realize, she says, is that there is no such thing as absolute safety, and people need to find ways to make their investments as safe as possible. Phillips-Gaines also notes that many more clients are coming to her office to discuss their asset allocation and financial goals. She's going through what she calls the "financial fire drill" with them to determine exit strategies and ways to protect them from some of the risks out there before something goes wrong.

She's also noticing a lot of small businesses expanding and looking into opportunities because of the business slowdown. When talking to some of these small business, she says, "The common thread through these conversations is, 'If we hadn't slowed down, we would never have thought about these opportunities staring (us) in the face.'" Firms have been able to pick up top talent that was left on the Street by firms that needed to cut back. And companies that "saved for a rainy day" had the cash available to transform their business in this downturn as others were scrambling to stay afloat.

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Brian Hamburger, founder of Hamburger law firm, has noticed people paying a lot more attention to smaller firms, especially smaller financial firms. Previously, if you weren't one of the "big name" firms, such as Bank of America ( BAC - news - people ), Morgan Stanley ( MS - news - people ) or Goldman Sachs ( GS - news - people ), few people would send business your way. Since Lehman's fall, investors want more personalized investment advice and a relationship with the person who is providing it. Other investors are noticing that they don't need the emotional help that comes from a financial adviser, so they're purchasing a structured product and investing for themselves instead, he says.
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Because many investors had too much risk in their portfolios when the markets went south, they are now gauging what their risk tolerance should be in the future. Matt Rubin, director of investment strategy at Neuberger Berman, suggests that investors use the fixed income portion of their portfolio for stability first and getting an income second. He recommends master limited partnerships, which is a type of exchange-traded fund, for high net worth clients. These securities combine the tax benefits of a limited partnership but have more liquidity because they're traded on an exchange. Investors can also use a mutual fund-like vehicle to buy a fixed income portfolio.

Investors also need to learn to diversify their investments, says Greg Ghodsi, senior vice president at Raymond James. "Our clients sustained some losses, but they were minimized by moving assets to high-quality municipal bonds," he says. Investors can look into the following municipal bond exchange-traded funds: PowerShares Insured National Muni Bond ( PZA - news - people ) and iShares S&P National Municipal Bond Fund ( MUB - news - people ).

Another lesson learned from the financial crisis, and the Bernie Madoff Ponzi scheme a few months later, is that investors need to "trust but verify," says Mike Boyle, senior vice president of portfolio management at Advisors Asset Management. He also suggests that investors should have more than one financial adviser to be exposed to more information and have ways to gauge the information coming from them. Having more than two advisers wouldn't be cost effective, Boyle says.

Investors need to think more critically than ever, says Ray Sclafani, founder of ClientWise, an executive coaching firm. From 2003 to 2008, assets mostly rose, so people got used to seeing more money in their pockets and not having to actively monitor the market. Since the world has changed, Sclafani suggests that investors need guides more than they need financial advisers because they need someone to empower them to make the right decisions, people who know what those right decisions are for each person. He says financial advisers often have their set asset allocation and ways of managing a portfolio that aren't personalized.

Charlie Green, chief executive officer at Trusted Advisor Associates, thinks the issue of trust hasn't been learned yet. Many Wall Street financial advisers and traders conduct their business around transactions rather than relationships, he says, which leads to selfishness and more emphasis placed on the bonus received for trades than the potential cost of that trade. To change this mindset, Green would like to see business schools reevaluate encouraging competition when they teach business strategy. Competition has been elevated to a point that can be detrimental, he says. Corporations should also be re-engineered so that parts of the company can be measured and possibly broken up more easily.

There are some lessons that we haven't yet learned from the financial meltdown though. Jim Sarni, managing principal of Payden & Rygel Investment Management, is discouraged by the continued repacking of mortgage-backed securities. (See "Invest In ... Mortgage-Backed Securities?")

These loans aren't performing as well as their credit ratings would have dictated, he says. His hope for a year from now is that Standard & Poor's, Moody's ( MCO - news - people ) and other ratings agencies will do better with their corporate default rates forecasts. (See "Playing The Ratings Game.") Without correct ratings in this area, the recovery will be prolonged, Sarni says. He also hopes that we will tamper our global, insatiable demand for yields, which has put us in compromising positions.

It's a New Day

Forbes: It's officially a year ago that the markets had what is almost certainly their worst month ever, with the S&P 500 dropping like a stone, Lehman Brothers going out of business and volatility skyrocketing. Truly the stock market, at least numerically, hasn't recovered since. What are your thoughts as you reflect on this anniversary? What do you think about going forward when it comes to financial planning? What should be learned from this anniversary?

Lynn Phillips-Gaines: Now a question I can sink my teeth into. This morning I told my husband "I am soooo thankful that it is not September 2008." I only thought the early '80s and 1987 were painful. And for anyone paying attention, it was profoundly scary.

I believe that when we look back on this period, years from now, we will say it had a positive impact on our economy and the American people as a whole. The big take home for many of my clients (and the public in general) was that there truly is no such thing as absolute safety. Our system was built on people taking risk and being rewarded for taking risk. I think complacency set in to some degree. It seems the farther away we get from understanding as a people how a dollar is made, the more we abused the system. Boomer parents who never said "no" to fulfilling their kids' every whim have finally grown a spine and are giving their kids a chance to learn. People are saving. People are looking at their spending for non-essentials. People are "shopping in their own closets" so to speak. Yes, it is hurting the rebound because the consumer isn't spending as much, but we are building a better platform for the next recovery.

People are paying attention.

The small businesses I work with are saying, "Well, we are not going to make money the way we always have, so what now?" In fact, the common thread through these conversations is, "If we hadn't have slowed down, we would never have thought about these opportunities staring me in the face ... We would have been too busy to pursue them." At once, you can sense the enthusiasm and apprehension as they take this entrepreneurial risk. And it excites me to watch from the sidelines. I see them using the business principles to build the next generation business and re-tool themselves, and I can tell that they will be successful.

One firm in particular used the slow times of the last nine months going through a disciplined process of defining "who they want to be when they grow up" and then purging offerings that were no longer viable. They have rewritten their business plan and incorporated a massive change in focus. And interestingly, they were able to take their pick of highly desirable professionals from which to build their businesses going forward. And the new folks were happy to have not only a job, but also to have a say in helping to craft the business going further. I will say, the reason this firm had the luxury of doing this is because the owner had the foresight to set aside cash reserves during the good times to fund a downturn. This firm is in a cyclical business and she knew that downturns are inevitable.

And because the spigot of easy financing is not available, they are not likely to continue funding the old way of doing business that is no longer valid. This supports my thesis that in adversity and pain is when good things emerge. As much as Nietzsche's Twilight of the Idols 1888 quote has become a cliché, I believe it to be appropriate here "What does not kill me makes me stronger." A good metaphor is the medical advancements made during wartimes on the battlefields.

GregGhodsi: This recession/depression will have a generational change on society. All of the advice our parents/grandparents gave us finally makes sense. "Don't borrow more than you can afford." "Save for a rainy day." Et cetera.

Who could have imagined long-standing firms would disappear? What this has reminded us is many firms managed their capital well and should be the new leaders of our economy.

Investors have also learned to diversify your investments. Our clients have sustained some losses, but they were minimized by moving assets to high-quality municipal bonds.

Forbes: Let's be more specific. Which are the firms that you believe managed their capital well, and should be the new leaders of the economy? And which firms are simply being propped up by the government?

Phillips-Gaines: In my practice, I don't actually make these calls myself, so I am not able to make specific names for the new leaders of the economy.

As far as the changes we have made in our financial planning, it has been as Greg mentioned, a return to those mundane things which may not have been so important in the past. We are revisiting each client's investment policy statement. We are testing time horizons and cash reserves amounts. We are looking at the reality of where people stand as far as their retirement dates and if they need to work longer. We also were making sure we were tax-harvesting for losses going forward.

And we are waiting to see what happens with health care and taxes going forward. We are also being very careful with cash in anticipation of higher interest rates farther down the road. And cash flow is king now. I never have been a big user of guaranteed withdrawal benefits from annuities, but I can tell you they are/will play a role going forward.

One thing that has changed, we don't have trouble getting our clients to come in and allow us to review their overall financial plan. In good times, they don't feel the need, and it can be frustrating, because it is during those times that you must do the financial fire drill, making sure you have all your contingencies covered, not after the fact.

Ghodsi: Let's compare this to an individuals' portfolio. It is OK to buy single-digit stocks but employ some risk management; don't overweight if the trade goes bad, don't use more leverage than you can afford. The banks (old leaders) forgot these simple diversification rules in the name of growth. The banks that followed these rules should be the leaders as we move forward. In my opinion, investors will reward the good stewards of shareholders' money.

Small Business Loan Project

Marquette’s small business loan fund projection upbeat
by Mark Anderson Staff Writer

Tom Jenkins is CEO of Marquette Capital Partners, which is opening its second fund aimed at providing loans to small- and medium-sized businesses (Photo: Paula Keller)
Tom Jenkins is CEO of Marquette Capital Partners, which is opening its second fund aimed at providing loans to small- and medium-sized businesses (Photo: Paula Keller)
More: Marquette Capital Partners: local portfolio
Here’s one of those green-shoots stories possibly indicating that the capital markets and their customers are coming back – albeit very slowly, and with the continuing help of the federal government.

Marquette Capital Partners’ CEO Tom Jenkins says his group expects to raise $50 million to $100 million by second quarter 2010 for its second fund aimed at providing loans to small- to mid-sized businesses. And the Marquette Capital Fund II will bring even more powder than that to the market – it’s organized as a Small Business Investment Company (SBIC), enabling it to borrow low-cost money through the U.S. Small Business Administration. That should boost its lending pool as much as three times higher.

Jenkins hopes to close the first deal for that new fund by year end, and although the volume of deals coming across his desk is still meager, he says activity is growing in a niche that’s been one of Marquette’s specialties: closely held, often family-owned companies looking to grow in a bear market.

“There are still healthy companies that need capital for positive reasons,” Jenkins said. “They’re seeing weak competitors that they’d like to buy.” In fact, the majority of activity in Marquette’s initial $80 million SBIC fund, launched in 2004, is focused on acquisitions now.

“We’ve spent a lot of time on revenue generation, and earnings are starting to pick up at those companies (Marquette holds 21 companies in its portfolio). Now, we’re looking hard at acquisitions that make sense.”

Those buys will be financed with the initial fund’s final 15 percent, a cache that Marquette reserved for add-on acquisitions.

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That demand – and the company’s time-tested model – is driving interest in its second fund, too, Jenkins said. He expects almost 80 percent of Marquette II’s dollars to come from investors in the first fund – a group of about 20 wealthy families and a dozen financial institutions, mostly from the upper Midwest, who contributed about 65 percent of Marquette I. Marquette Financial Group, the holding company owned by the Carl Pohlad family and Marquette’s parent, invested the remaining 35 percent.

Performance is a key reason those investors are coming back. Marquette predicted returns of 18-20 percent on a five-year investment model, and in the three exits they’ve negotiated so far “we’ve exceeded those goals on each sale,” Jenkins said.

The group also created a portfolio of companies that’s been resilient through the recession’s buffeting.

“We’ve done some restructuring, but our original capital structures are holding up pretty well,” with no bankruptcies or losses so far, he said.

The fund’s managers deserve credit for that record, according to Holly Huels, senior vice president with Capital for Business, a St. Louis-based investment fund. Huels’ firm was an investor in Marquette I and an investing partner in two of Marquette’s portfolio projects, and she said their success is the result of old-fashioned investment virtues.

“They’re very disciplined in their evaluation of companies and their due diligence, but they also stick with the company. A lot of people put capital in and move on to the next investment. Marquette keeps paying attention, working with management, and that’s helped them and their investors.”

Timing provides another advantage for Marquette and the rest of the SBIC industry right now, said Dileep Rao, a lecturer at the Carlson School of Management and a veteran venture capital investor and adviser.

“The debacle of the last year [in the capital markets and the economy] created an opportunity for SBICs,” Rao said. “Banks that were generous in their lending criteria in the past are very much more conservative now,” forcing deal sponsors to find new sources to fill the new financing gaps.

With pension funds still cautious and equity investors having a hard time putting a reliable value on small companies, ventures like Marquette get more attention, Rao said: “SBIC’s are a source of funding that’s available, and as a result, they’re seeing more and more of the available deals.”

That market demand, as well as some easing in the licensing process, is swelling the ranks of SBICs, according to Brett Palmer, a spokesman for the National Association of Small Business Investment Companies (NASBIC) in Washington, D.C. SBIC applications had dropped to just six during 2008 – a historic low – but license approvals are already up to 11 in 2009, and an additional 25 are in the pipeline for 2010.

But new applicants still face close to a year-long licensing process, said Huels, this year’s NASBIC chair. That leaves in place a significant barrier to entry for new companies, and benefits already-licensed SBICs such as Marquette.

Jenkins’ team, like most currently licensed SBICs, delivers much of its capital in the form of subordinated debt, either to closely held companies that are expanding, or to help pay for takeovers. It often structures some equity investment into those deals in the form or warrants or direct stock investments, and it also shops for takeover partnerships where it can play a larger equity role.

But Jenkins said Marquette’s penchant for financing growing, closely held companies will probably dominate its new portfolio for awhile.

That’s in part because strong, closely held businesses are going to find good acquisition opportunities in this market. Many of those companies will feel edgy about teaming up with conventional private equity investors, though, Jenkins said.

“Private equity funds usually want to take a great deal of control, so most closely held businesses don’t want to talk to them,” he said. But Jenkins’ team – many of them bankers who’ve worked together in Pohlad-owned businesses for 20 years or more – can make deals that keep borrowers happy and the investment group in a strong fiduciary position.

“We can be the perfect solution. We’ve all learned how to structure securities in a way that doesn’t threaten [management’s] control.”

Marquette II enjoys a couple more benefits, thanks to rule changes enacted as part of the federal stimulus legislation passed in February.

SBICs are now able to invest greater sums in single investments, and they’re also able to borrow greater amounts from the SBA. That capability will probably double Marquette’s average investment in companies from $4 million to $8 million, giving it the ability to provide more comprehensive financing for its clients right through to Marquette’s exit.

The larger, more efficient fund also means Marquette’s staff roster will grow. Jenkins intends to open an office in Los Angeles this year, joining its Minneapolis headquarters and an office in Chicago. And he’ll add employees, too – growing from seven to 12 people.

And that gives them one more distinction: they’re one of the rare financial services companies that’s hiring.