CHAPTER 1

Wave Theory

Wave theory is simply the belief that all securities move in waves (patterns,cycles, or trends). History sometimes repeats itself, but with alternatives aninvestor can typically see similar waves repeating themselves. Equities move inwaves. Fixed income moves in waves. Cash moves in waves. There is now enoughdata to support the notion that alternatives also move in waves. Besides theseasset classes, there can even be styles such as "value" or "growth" investingthat move in waves. Securities can also move in tandem, forming huge waves inepic downturns or sharp rallies. Realizing this, one can either make a lot ofmoney or lose a lot of money while investing. After the Dow Jones dropped from14,164 to 6,469, many investors sold securities at precisely the wrong time andlost trillions of dollars. Ironically, when the market started to recover andpassed 10,000, many of these same investors attempted to jump back in and chasethe market after they sold at the very bottom of the market. The individual whocoined the expression "buy low, sell high" was not unintelligent. Yet investors(ones who are not paying attention to waves) frequently follow the news mediaand make the erroneous mistake of buying high and selling low.

Waves are found among all asset classes, including the fastest growing andcompelling asset class: alternatives. In other words, there are distinct wavesfound within the alternatives asset class. Since more data became available inrecent years, it is apparent that waves exist with alternatives. Those of themain alternative groups—hedge funds, commodities, and private equity(venture capital) — all have identifiable waves. One must be cognizant ofwaves found with alternatives to lower risk and maximize returns. Otherwise, theresults can be lackluster if not devastating.

Mergers and Acquisition Waves

There is very little written about waves in finance, and although severalindividuals have touched on the subject, none have written about alternativesand waves. Alternatives are a relatively new asset class and can be difficult tounderstand. Those who have discussed waves in the past tend to review them withregard to various aspects of finance, not asset classes. For example, Allen,Brealey, and Myers's Principles of Corporate Finance explained thatthere are merger and acquisition waves:

Mergers come in waves. The first episode of intense merger activity occurred atthe start of the 20th century and the second occurred in the 1920s. There was afurther boom from 1967 to 1969 and then again in the 1980s and 1990s (1999 and2000 were record years). Each episode coincided with a period of buoyant stockprices, though there were substantial differences in the types of companies thatmerged and the ways they went about it.

Robert F. Bruner also wrote about waves in Applied Mergers andAcquisitions, in which he describes "five periods of heightened mergeractivity; hereafter, I will call these 'waves'." The fifth wave, or his Wave 4b(which I will call Wave 5), was caused by a few large scale mergers andacquisitions (M&A) deals. According to Bruner, "Following the 1990-91 recession,M&A activity increased briskly in all segments of the economy and all sizecategories. The announcement of a few large deals signaled to some observers a'paradigm shift' in M&A where old rules about strategy, size, and deal designwere being replaced with new rules."

The graph in Figure 1.1 shows M&A activity in terms of deals and depictsone of the M&A waves described by Bruner. If one combines all of the M&A wavesover the last century, Figure 1.2 depicts a long-term trend of M&A waves(patterns, cycles, or trends).

Long before Bruner, Joseph Schumpeter noted "cycles" with M&A activity.Schumpeter originated the concept of creative destruction. His ideas have beenwidely applied to theories of evolutionary economics. Understanding M&A waveswith economics is helpful because of their effect on alternatives. Alternativeasset classes (such as venture capital or leveraged buyout funds) depend on theM&A market because it is an exit strategy or a means to take a profit or cashout. The M&A market has shown distinct waves, especially over the past 30 years(Figure 1.3).

Whether one measures the number of M&A deals or the dollar value of these deals,it is apparent that waves exist.

Initial Public Offering Waves

The discovery of waves with alternatives might be beneficial to a plethora ofinvestors from retail and high net worth to institutional investors. Also, waveswith alternatives might assist venture capital-backed private companiescontemplating going public as well as investors in venture capital (pre-initialpublic offering [IPO]) or even buyers of IPOs. Wave Theory can help a lot ofdifferent people, including entrepreneurs who would like to take a companypublic. Chief executive officers (CEOs) of fast-growing emerging companies(e.g., health care, technology, consumer), should be aware of the point at whichthey are approaching a wave before going public. Depending on where a venturecapital-backed company stands with regard to a wave, the CEO or venture firmmight decide to wait or hold off for a more opportune time to gopublic—that is, be one of the first to go catch the wave. IPOs at thepinnacle of any market tend to have precipitous drops.

Similar to M&A, there are distinct waves with the IPO market. Whether oneexamines the number of IPOs or value in IPO deals, it is quite apparent that theIPO market (like the M&A market) travels in distinct waves as depicted inFigure 1.4. Hilary Kramer wrote the following about...