Dr. John Rutledgejrutledge@safanad.com

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Weather Map Investment Framework

Safanad Investment Approach• In science, temperature and pressure differentials produce two very

different types of change. Small differentials lead to smooth, gradual change. Extremely large differentials trigger sudden, violent change like hurricanes, earthquakes, and tsunamis that can permanently change the landscape. Likewise, in economics, price and return differentials drive economic and financial change that can be smooth and gradual or turbulent and chaotic, like the financial crisis.

Weather Map Investing• Identify forces that produce return differentials--economic storm

systems—that persist long enough to exploit for significant gains, and broken markets where non-price rationing restricts access to capital, creating opportunities for extraordinary investment returns. Carefully deploy capital in the path of these storm systems to capture extraordinary returns. Withdraw capital when storms have run their course and markets have returned to normal

Safanad Weather Map - 5 Major Storm Systems• Reflation: Unprecedented central bank QE measures have set up

pressures that will result in rising inflation, interest rates, and property prices in the US, UK, EU, and Japan. Reflation is the super-cell of storm systems. It will drive global capital markets for many years.

• Regulatory Fallout: Financial and healthcare regulation—two examples of collateral damage caused by the financial crisis--have permanently changed the way credit is allocated and medical services are delivered.

• EU debt Crisis: Banks are selling assets and restricting lending.• Abenomics: Printing money and the return of nationalism will

happen; structural reforms and the return of growth will not.• Geo-political Realignment: The financial crisis and 13 years of war in

the middle east have altered the size and influence of nations and are forcing a global political realignment that has heightened risk.

ReflationChina Growth

EU Debt

ReflationAbe-nomics

EU Debt Crisis

RegulatoryFallout Geo-Political

Realignment

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Summary

Economic and Financial Storm Systems

• Investors are struggling to make sense out of the two-speed economy. The production economy, measured by GDP and employment, continues to show anemic growth. In contrast, asset prices are booming. Both represent collateral damage from government actions taken during the global financial crisis. Our storm systems identify and exploit the extraordinary return gaps caused by these conditions. Each should lead to profound changes in asset prices. Each represents an opportunity to deploy capital at attractive returns.

• Reflation—Government expansion during the financial crisis has placed government debt on unsustainable paths in the U.S., Europe, and Japan. U.S. government debt in the hands of the public, for example—34% of GDP in 2000, 74% today—will be at banana republic levels (212-620% of GDP) within 75 years, according to recent CBO estimates. Political backlash, in the form of Dodd-Frank, has corrupted the once unquestioned commitment of the Fed and other central banks to stable prices, shifted their focus to labor markets, and led to the historically unprecedented $3 trillion money printing exercise now known as Quantitative Easing. The initial result is soaring asset prices. The ultimate result is higher inflation and interest rates.

• Regulatory Fallout refers to the related long-lasting collateral damage to institutions, the legal structure, and regulations caused by the global financial crisis. These changes have converted a temporary financial crisis into permanent changes in the way we run our lives and our businesses. ObamaCare is forcing changes in the way health care is delivered, pushing patients out of high cost hospitals and emergency rooms into lower-cost skilled nursing facilities, urgent-care centers, and home care. Dodd-Frank has buried small banks under a mountain of compliance costs and restricted the financial system’s capacity to make and securitize business and mortgage loans. Both have slowed growth, reinforcing the Fed’s commitment to zero interest rates. Both have created extraordinary investment opportunities.

• EU Debt Crisis has forced banks to sell assets and led to credit rationing for business and real estate finance.• Abenomics has turned Japanese policy on its head. The BOJ has vowed to increase inflation to 2% by the end of next year. Rising nationalism has led

to growing tensions with China.• Geo-political Realignment in the wake of the financial crisis is showing up in the headlines and may be the biggest long-term risk. Financial crisis

and 13 years of war have altered the size and influence of developed countries relative to emerging markets, the U.S. relative to China, and Russia relative to Europe as revealed by recent events in the Ukraine, Iraq, and rising tensions over territorial and mineral rights in the China Sea.

Investment Strategy

• Opportunities: Real estate; Orphaned middle market companies.• Risks: Global political conflict; Reaction to Fed tightening; Stock market correction as investors worry that valuations have gotten ahead of earnings

and revenue growth; Rising interest rates as people become aware of mounting inflation pressures; compressed exit values.

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1 in every 8 people in the world lives in a country at war (not counting Detroit, the Bronx, or East L.A.). Together, they account for 9% of oil production, 3.8% of FDI, 3% of GDP, 0.7% of market capitalization.

• Afghanistan• Democratic Republic of the Congo• Central African Republic• Colombia• Palestinian Territories• Iraq• Israel• Kenya• Libya• Mali• Nigeria• North Korea• Pakistan• Somalia• Sudan• Syria• Ukraine• Uganda• Yemen

Candidates for Inclusion/Hot Spots• Russia• China Sea

• China/Japan/South Korea/Vietnam/Philippines• Philippines

With few exceptions, military action and conflict are followed by rising stock prices over the next 2 years.(Charts courtesy of J.P. Morgan, Eye on the Market, July 21, 2014)

Geopolitical Conflict

Geo-Political Realignment has created a growing risk of conflict

Putin and Russia have captured the headlines.• The bear has woken up. After 25 years of silence, Russia is

aggressively asserting its intention to resume its position as a world power.

• Putin’s mission: re-arm Russia, re-assemble the Soviet bloc, and drive a wedge between Europe and China and the U.S.

• Unopposed Crimea takeover. Ukraine civil war. Overtures to China, Japan.

• US has no appetite to push back: 13 years of Gulf war fatigue, shrinking defense budgets.

• EU emasculated by weak economy, dependence on Russian gas.

• Even after MH17, US/EU sanctions have no teeth• Putin popularity in Russia growing

The bigger risk is in Asia.• Changing relative size and influence of U.S. and China is

forcing a global realignment of interests.• China aggressively seeking energy and mineral resources to

ensure stability at home.• Chinese investments in sub-Saharan Africa• Pipeline, gas supply deal with Russia• Dispute with Japan over Diaoyu/Senkaku islands. Frequent

near collisions of military aircraft.• Vietnam riots after CNOOC deployed drill rig in contested

waters.• Japan supplying gunboats to Vietnam.• Philippines military exercises with U.S.• Obama “pivot to the east”, puts US and China into

increasing conflict.• US arms sales to Japan encourage Abe’s growing nationalist

posture. Putin to visit Tokyo in September.

Increasing risks that an accidental event could trigger armed conflict.

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What’s Behind the Incredible Stock Market Gains?

The most remarkable thing about the rising stock market since April, 2009 has been its uniformity across time, geography, sector, capitalization, and style.

• S&P 500 cumulative total return 117.3%• 1 year, 3 year, and 5 year returns differ by less than 10 basis

points.• Although U.S. markets have outperformed global averages,

most major regions of the world have experienced increases. (Exceptions include China, Russia, and gold) Selected 3 year annual returns:

• 7.3% Global Dow• 9.1% Stoxx Europe 600• 15.9% Nikkei• 11.9% DJ Americas• 11.6% India

• Gains were broadly shared among sectors as well. 3 year compounded total returns include:

• 80.3% Healthcare• 71.3% Consumer Services• 52.0% Industrials• 49.6% Financials• 48.2% Technology

• Except for spikes during the January Crimea invasion and the recent downing of MH17 and Israeli/Palestinian fighting, volatility has fallen to historic lows.

• Stock and real estate prices have run ahead of output prices, resulting in PE’s rising to uncomfortable levels.

QE has been the driver behind rising asset prices• Bank reserves +30x from $85B to $3T. Monetary base 4x.• Over time banks convert reserves to loans, deposits.• Left in place this would eventually quadruple prices.• End of QE does not stop this process. Fed must extinguish the

reserves.• Recent evidence suggests they will not do so.

Regulatory Fallout: the 2 Speed Economy

Where’s the growth?• To date, QE has not produced the robust growth the Fed expected• Fed models have consistently overestimated real growth• The result is what a friend of mine calls a “plow horse” economy, a long, slow,

drawn-out recovery that never seems to get us back to full employment.• Fed estimates still show a 5.7% output gap, i.e., real GDP is $846B below capacity

and labor markets have a long way to go to reach full employment. That’s why they talk about the need for more stimulus and that’s one of the reasons they are not worried about inflation.

There are 2 reasons this is happening:• The first is simple. For many reasons, 5% of the population have dropped out of

the labor force. They are not coming back. Capacity output is 5% lower than it was before the financial crisis.

• Corollary: there is not as much slack as economists think there is. Labor markets are getting tight. Prices and wages are beginning to rise.

• The second reason is not simple. Dodd-Frank have buried banks under a mountain of regulations and compliance costs. Big banks can handle it. Small banks can’t. 50% of small banks have disappeared since 2007. The survivors are walking dead, unable to lend.

• As a result, the entire increase in business lending since the trough has come from big banks. Small bank loans are still at trough levels.

• Small banks lend to small businesses the historical source of all new jobs. and to local real estate projects. No loans equals slow job growth, weak consumer spending and the slow recovery.

• Big banks lend to big customers, especially to financial firms like private equity sponsors, hedge funds, and M&A. These firms buy assets, not tennis shoes so asset prices rise faster than sales, output, and profits.

• The result is slow profit growth (7.5% so far this quarter), rising P/E multiples, and companies hoarding cash instead of building new plants.

• Some reason for optimism: As companies increase sales, incremental profit margins (20%) are nearly double current reported margins.

• Sales and output will continue to increase slowly. And QE will flows through to higher prices for real and financial assets.

Investment Opportunity: Orphaned Middle Market Company Finance

The impact of Dodd-Frank on small banks has permanently reduced credit availability for middle market companies.

• Small banks are traditionally asset-based lenders, the primary source of small company working capital. They are disappearing. Big banks are not equipped to fill in the vacuum.

• Regional banks are traditional cash flow lenders to the middle market. Rising capital requirements and compliance costs are forcing them up-market, increasing EBITDA minimums from $5M to $20M.

There are a lot of middle market companies.• More than 400K companies with $25M-$100M sales• Based on recent PitchBook data, more than 7500 companies currently

owned by private equity firms. 60% have sales below $100M.• The middle market accounts for 75% of buyout activity

This suggests there should be a profitable opportunity to bring capital to the middle market.• The opportunity should exist at the primary level, delivering finance directly

to operating companies but only for loans too small to be easily traded in secondary markets. Hedge funds—the primary buyers of tradable loans, are awash in low cost capital. This is a lending opportunity for people willing to stay in small town Holiday Inns, not people looking at Bloomberg terminals.

• Debt and EBITDA multiples were consistent with this in the early years of the recovery but have since risen sharply. What’s going on?

Investment Opportunity: Orphaned Middle Market Company Finance

The orphaned middle market opportunity is visible in the pricing data. • Lower middle market companies (< $7.5M EBITDA) have tighter senior

debt and total debt limits and transact at significantly lower EBITDA multiples than larger companies.

• Money is expensive. Banks are quoting Libor + 3-4% but will not make loans. Non-bank lenders are lending at Libor + 4.5-6%. Second liens are available at 8-12% and sub-debt is available at 12-14%.

There is another change worth noting. Traditional large non-bank lenders are moving up-market too in response to the same pressures as banks. They are being replaced by Business Development Companies (BDC’s). Their strategy is to:

• Provide equity sponsors with a total capital solution, known as UnitTranche lending.

• Collect blended senior/sub-debt returns of 8-10%.• Leverage the returns using warehouse lines of credit to produce

attractive net returns (12-15%) for investors.

BDC returns are unlikely to be a permanent solution to the middle market financing needs. They are vulnerable to slowdowns that affect loan quality, availability of leverage financing, and rising interest rates. It is likely there will be a shake-out of lenders when rates rise followed by opportunities to deploy permanent capital at attractive returns.

Investment Opportunity: Real Estate Finance

The impact of regulations, compliance costs, and higher capital requirements has dried up availability of real estate financing as well.

• Banks of all sizes have fewer real estate loans today than they did in 2007.

• Quoted mortgage rates are very low but there is widespread credit rationing and no loans available at those rates unless they fall in line with specific government programs.

• As a result, 30% of homes sold last year were sold for 100% cash with no mortgage.

• This has triggered an exodus from owning to renting homes.

• In spite of this financing shortage, existing home sales prices have increased steadily at rates near stock market returns.

Investment Opportunity: Commercial Property

The dearth of real estate financing is visible in commercial property as well.

• Mortgage originations have are rising but still far short of pre-crisis levels and levels required to refinance existing mortgages.

• Massive Fed purchases of mortgaged-backed securities and declining delinquencies have narrowed spreads somewhat but failed to produce a robust CMBS market.

• The Fed’s zero interest rate policy and QE efforts have only resulted in a modest decline in cap rates.

• Commercial property prices have risen sharply, in line with equity prices, driven by improving operating fundamentals.

• Rising inflation and interest rates will lead to a significant increase in demand for commercial property to serve as an inflation hedge, which will mitigate a large part of any upward pressure on cap rates.

• There would appear to be attractive opportunities:• Mezzanine mortgage finance.• Acquiring and managing multi-family

properties.

Investment Strategy

Marketable Securities – Overweight• US relative to Japan, EU.• Stocks relative to bonds• Leveraged finance• Branded consumer product companies• Dollar relative to Euro, yen

Private Equity – Focus on• Lower middle market credit opportunity• Lower middle market equity opportunity• Healthcare, Education, Retail, Financial Services, and Residential remain relevant sectors

Real Estate• Multifamily• Healthcare• Education• Mezzanine commercial loans

Key Risks• Stock market correction due to worries about valuations, Fed policy, and geopolitical tensions.• Rising interest rates, refinancing risk, and exit multiples.

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