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Harry Newton's In Search of The Perfect Investment Technology Investor.

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9:00 AM EST, Thursday, September 11, 2008: Lest we forget. It was seven years ago this morning.

Diversification, continued: In the old days, private equity funds and leveraged buyout funds -- which are often the same -- routinely gave their investors 40% IRR a year. These days are not those days. As part of my brilliant diversification, I have money invested in a couple of these funds. My funds are run by brilliant managers, whom I thoroughly due-diligenced (new verb). All the managers had done brilliantly -- until I invested. I'm not entirely the King of the Declining Industries, also called every fund manager's worst enemy. But -- let's put it this way -- past performance is no guarantee of future performance.

Yesterday's mail brought a "Letter to Investors as of August 29, 2008" from one of the funds. This fund has been around several years. The investments it holds are theoretically now worth a miserable 4.6% more than what we paid. Muni bonds have done much better. What happened? The Letter to Investors begins thus:

A year has passed since the initial dislocation in the credit and capital markets sparked a global repricing of risk. The financial crisis that has ensued has continued to weigh on the health of financial institutions worldwide and has led to a severe reduction in the availability of credit. At the same time, further weakness in the housing market and inflationary pressures (particularly higher oil and food prices) have negatively impacted consumer spending. As a result, the U.S. And Europe have experienced an economic slowdown that is likely to continue well into the second half of the year.

As it relates to private equity, periods of market uncertainty are almost always accompanied by a slowdown in private equity activity. Indeed, extremely tight credit conditions have made financing new investments increasingly difficult. However, despite market conditions, we continue to see some activity, particularly in the small and middle-markets and in sectors such as energy and healthcare.

Since the magnitude and duration of the economic downturn, the pace of recovery, and subsequent economic activity are difficult to predict. ... Clearly with a softer economy and weaker stock market performance, valuations of certain portfolio companies have come under some pressure. ...

We believe what ultimately matters is how well the portfolio companies perform operationally over the long-term and what valuation we realize upon exit for these investments. To that end, we feel comfortable that the portfolio's diversification and, in many instances, significantly flexible capital structures -- many of which include long-tenored debt, substantial undrawn lines of credit, loose or no maintenance covenants and/or payment-in-kind toggle notes -- help provide the time and optionality for the portfolio to mature and navigate the currently weak economic environment.

I deliberately bolded those words because I thought them particularly important. What is bringing down companies today are inflexible capital structures -- some things to watch out for. I don't know what word "optionality" means, but I can guess.

High-interest loans are blossoming: With capital tight, funds and companies are turning to their shareholders for loans. Be wary. Remember you and I are not banks. These loans (and their conditions) are often presented on a "take or leave it" basis, often with balloon payouts many years hence. These days I prefer regular dividend checks and investments I can sell from one day to the next. Cash remains kings. I wish it paid a little more.

Yesterday's gamble. I've been pushing WaMu because my talented friend, Alan Fishman, is WaMu's new CEO. That hasn't stopped the market from beating up on the stock. It's down substantially since I recommended it. Personally, I saw it falling after my recommendation and didn't buy. The New York Times had a piece on WaMu this morning:

Washington Mutual Stock Falls on Investor Fears

As Wall Street scoured the financial industry Wednesday for the next weakest link after Lehman Brothers, it set its sights on a familiar target: Washington Mutual, the nation’s largest savings and loan.

Shares in the troubled lender, one of those hardest hit by the nation’s housing crisis, plunged 30 percent, falling below $3 for the first time since 1991. Investors grew increasingly nervous that, like Lehman, Washington Mutual is running out of time — and options — to save itself.

As losses from subprime mortgages and credit cards mount, investors are increasingly concerned that the troubled bank will be unable to raise fresh capital or find another institution to take it over. A new accounting rule that would force potential buyers to write down assets of target companies to current market value may also dissuade a would-be acquirer.

And with the Treasury Department’s bailout of Fannie Mae and Freddie Mac fresh in mind, even a decision over the weekend to replace the lender’s chairman of 18 years, Kerry K. Killinger, with Alan H. Fishman on Monday failed to dispel concerns that the worst is yet to come.

“This can only go on for so long,” said Christopher Whalen, a managing partner at Institutional Risk Analytics. “If this goes on until the end of the year, the bank is either going to have to be sold or recapitalized by the government. Those are the only choices.”

Inside Washington Mutual, executives were perplexed by what they saw as paranoia driving down the stock, according to people briefed on the situation.

The decision to hire Mr. Fishman, a veteran banker, had been seen as a way to clean up the mess left by Mr. Killinger after a series of deals that built Washington Mutual into a large but poorly managed lender. The bank had also reached an agreement with the government that effectively put it on probation. But Washington Mutual announced that its plans would not require it to raise capital or improve liquidity.

Even so, investors remain nervous about its financial health and believe the job may be too big for Mr. Fishman. Washington Mutual is in a precarious position because it has roughly $180 billion of mortgage-related loans, which could result in $9 billion to $14 billion in losses this year, said Jaime Peters, a Morningstar analyst. Losses in its big subprime credit card portfolio have ballooned.

“If loss rates continue to rise, WaMu could see charge-offs of 4 or 5 percent by the end of the year,” Mr. Whalen said. “Their entire capital could be wiped out.”

It has been 15 years since any bank larger than $10 billion in assets collapsed. The largest bank failure on record occurred in 1984 when Continental Illinois National Bank and Trust in Chicago ran into trouble, presaging the savings and loan crisis. Should Washington Mutual, with assets of $310 billion, find itself in a similar predicament, the Federal Deposit Insurance Corporation would take a crushing blow to its insurance fund.

In early March, JPMorgan Chase sent a letter to Washington Mutual, urging it to consider a deal quickly because the environment was becoming worse. Washington Mutual balked, preferring to remain independent. A month later, Mr. Killinger turned to TPG and several other private equity investors after it became clear that the bank needed capital. The deal allowed Mr. Killinger to keep his job, but many analysts said the bank would need another infusion.

Since then, the picture has only become more bleak. In the second quarter, Washington Mutual posted its biggest loss ever, which sent shares plummeting. Its stock price fell to just over $3 in mid-July, roughly 65 percent less than the $8.75-a-share price that TPG paid in its transaction.

The company also had its credit outlook cut by Standard & Poor’s, the ratings agency, this week because of its position in the housing market. The cost to insure the company’s debt rose to a record high Wednesday, another sign that investors are increasingly nervous about the company’s ability to pay back its loans. Washington Mutual has $44 billion of debt that falls due this year and $43 billion due between 2009 and 2014, Ms. Peters said.

If Washington Mutual needs to raise capital quickly, it will very likely find itself between a rock and a hard place, because credit markets have all but closed their doors to troubled banks.

TPG, the big private equity firm, agreed to pump in $7 billion in June and might be a logical choice to invest more. But with Washington Mutual’s stock trading at less than $3 a share, that investment has not turned out well so far. TPG has a track record of being patient. Still, it is unclear whether it would choose to double down on its bet or cut its losses.

Another possible plan would be for Washington Mutual to pursue a suitor. But there are few banks healthy enough, or willing, to strike such a big deal. JPMorgan Chase has long had its eye on Washington Mutual for its big retail branch network, which would give it a foothold on the California coast and add to its heft in the New York and Chicago markets. A JPMorgan spokesman declined to comment.

Even so, a change in the accounting rules, effective in December, make that extremely difficult. In the past, an acquiring bank would be able to record the value of the assets of the institution it bought as a portion of the value that it paid for them. Under the new rules, a bank must immediately mark them to where they could be sold, causing any acquirer to absorb a big hit to its capital. That would most likely force the buyer to raise fresh capital.

“The way that you do that normally is by making it up through earnings, but here you don’t have that luxury,” said Robert Willens, an independent accounting consultant.

As a result, some in the industry have started to wonder whether the government might have to step in. One option, similar to the approach taken with Fannie Mae and Freddie Mac, might be for the government to agree to buy shares issued by Washington Mutual. Some analysts said that would provide the capital to allow the bank to get through the current problems.

Another might be for the government to provide assistance with a sale, similar to the Federal Reserve Bank of New York’s approach in the JPMorgan-Bear Stearns merger. Such a move would help reduce the blow to the acquiring bank’s capital caused by a sale, and allow it to start benefiting from such a deal.

“If you can get through this initial capital defect, you are going to be buying guaranteed earnings for as long as the eye can see,” Mr. Willens said.

I have faith in Fishman. I know he wouldn't have taken the job if he thought he couldn't fix it. I wouldn't bet the house on WaMu, but as gambles go, it's interesting. .

Dry Australian humor at its best. In case you missed yesterday. This little video clip tells the story of the oil tanker whose front fell off. Click here. It's hysterical. Use Internet Explorer.

Tennis court help: Has anyone played on Nova-Pro Bounce and / or synthetic grass with sand infill? What's your feelings about which surface you prefer and why? Background: Four of us own an indoor tennis club in a metal building with three courts, one of which is Har-Tru. It's been difficult. We're looking to resurface the Har-Tru with a surface that's easier to maintain. Any thoughts?

Sticking by him
As the old man lay dying, his wife of many years was sitting close by his bed. He opened his eyes and saw her. "There you are, Agnes," he said, "at my bedside again."

"Yes, dear," his wife said.

"Looking back," the old man said, "I remember all the times you were at my side. You were there when I got my draft notice and had to go off to fight in the war. You were with me when our first house burned to the ground. When I had that accident that destroyed our car, you were there. And you were at my side when my business went bankrupt and we lost every cent."

"Yes, dear," his wife said.

The old man sighed. "I tell you, Agnes," he said, "you've been a real jinx."

The Jewish telegram:
"Start worrying. Details to follow."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.