Subprime: Markets may continue to fall

Two of Ernst & Young's top executives say that when the markets re-open, financial instruments will become more complex and will require stronger regulation.
FinanceAsia talks to Dave Read, global vice-chairman of Ernst & Young based in London, and Robert Partridge, managing director of transaction advisory services based in Hong Kong, about how the subprime fallout is affecting the financial services industry and specifically their business.

Continuing disclosures from subprime-affected financial institutions are highlighting the role of auditors. How is your role changing?
Dave Read: Much of this is management issues. Regulators, management, advisers û including auditors and rating agencies û all need to take a look at how they function. Everybody is on æextra noticeÆ.

The problems arose because the instruments were complicated. Neither the people packaging nor buying them understood them. Having said that, I donÆt think the challenges are going to diminish. When markets re-open instruments will become more complex. ThatÆs not going to change. Stronger regulation will be required. Transparency may be part of the answer.

How do you resolve valuation issues with respect to your clientsÆ investment portfolios?
Read: Valuing portfolios is highly complex and we have specialists devoted to this. Despite the guidance provided by accounting standards, there is still a huge element of judgment.

What is your outlook for financial markets?
Read: I donÆt think weÆre at the bottom yet as more problems could emerge. I hope we are close to bottom. Markets in London and the US may not come back until next year. But I am optimistic that a large financial institution will not go belly up. Relevant regulators have moved quickly to ensure banks have enough liquidity.

Leverage for private equity deals has become more difficult to obtain. Do you see this changing?
Read: Private equity deals larger than $1 billion have dried up and Ebitda multiples have come down but the effect on Asia has been limited as few deals in Asia are that large or that highly geared. Private equity firms themselves are also waiting for valuations to come down further and to see the impact of lower growth.

Robert Partridge: In Asia most deals are less than a billion dollars in size and the market is still open for business. Between one- and five-billion dollar deals are looking difficult and bigger than five billion have completely dried up.

In China the private equity strategy has been evolving and currently the focus is on backing Chinese companies which provide a platform for going global via growth and acquisitions.

Do you think protectionism in target markets will adversely impact Middle East and Asia outbound deals?
Read: Some of this is substantive but equally some is headlines. Investee countries are in general seeking more transparency from the sovereign wealth funds especially, although assets in sectors deemed critical could face some protectionism.

How is the subprime situation affecting Chinese companies?
Partridge : Financial services companies in China are exposed to some risks on their portfolios but we donÆt think there is anything fatal out there.

It is typical that a downturn in some markets will translate to an opportunity in others and we are seeing a number of outbound M&A deals in the $100 million range. Note that the subprime crisis coincided with Chinese companies increasing their overseas forays. Now, Chinese companies are becoming more cautious û seeing global giants run into trouble makes them question their own strategies

Do you foresee a slowdown in exports from China and a cascading effect on the economy?
Partridge : Chinese exports are not yet a concern as the outlook for domestic consumption is so strong. Manufacturers are shifting capacity to cater to domestic demand. The trajectory will slow a little and may be less steep as China faces the indirect impact of what is happening in the US, but our clients are not seeing production slowing.

How has the hedge fund industry been affected by subprime?
Partridge : The nature of hedge fund investing means there are a lot more losers but winners yield higher returns. Some hedge funds which have collapsed had too much exposure to subprime, others picked up distressed assets on the real estate side. On their direct investments there have been some negative fall-outs but more home runs. Hedge fund returns, however, may be rationalised. The industry as a whole is currently trying to figure out which hedge funds will survive û and we believe those will be the ones with the highest level of financial discipline.

Read: Hedge funds occupy an important position in the market and thus the niche they occupy will continue to exist.
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