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The Illusions of Private Equity Print E-mail
by Martin Hutchinson    Wed, Jan 25, 2012, 10:54 AM

The controversy over Mitt Romney’s work at Bain Capital has led me to realize that private equity is a poorly understood business whose economic effects have not yet been fully explored and are in many respects pernicious. This is not a knock on Romney, who in my view would be a mediocre candidate for President however he had made his fortune (although that view might be modified if he had gained it through supreme business creativity like, say, Jeff Bezos of Amazon.) It is also not a knock on Bain Capital, which appears to have adhered to the standard practices of the private equity industry. However that industry itself is of questionable economic utility and many of its practices can fairly be described by Governor Rick Perry’s term of “vulture capitalism.”

I know, because I have been there, and done that – or at least seen it done. As a banker in Croatia I was responsible for a portfolio of over 50 private equity stakes the bank had acquired, mostly through debt-equity swaps in bankruptcy. In some of those cases, adding management value was fairly easy. For example we owned the largest naturist camp on the Mediterranean, whose management claimed that naturism was going out of style because their guests were getting older and older, now with an average age of 58. It turned out that management spent almost nothing on marketing – and I can assure you from observing naked and gloomy 70-year old Germans grilling bratwurst that word of mouth alone did little to attract the more youthful demographic!

The one feature of private equity investing we did not especially use in Croatia was leverage, since the bank already owned the private equity stakes concerned. However leverage, creatively applied, is the key to private equity’s remarkable track record of returns – and to its much less attractive record in creating economic value.

In its initial phase, in the early 1980s, the private equity industry, then known as the leveraged buyout industry, scored some spectacular successes, both in terms of profit and value creation. In January 1982, Wesray Capital, controlled by an investor group led by former U.S. Treasury secretary William Simon, acquired for $80 million (of which the downpayment was rumored to be $1 million) a greeting card company, Gibson Greetings; when this did a $290 million Initial Public Offering just 16 months after the original deal, Wall Street naturally sat up.

At that period, after a decade of inflation and low stock market returns, assets were available at low prices and there were a number of cases in which sizeable companies had been mismanaged by “country club” management, so a turnaround was easy. Leverage was used, but interest rates were so high that only low asset prices and easy turnarounds made the business profitable – it flourished primarily by picking this “low-hanging fruit.”

The growth of the LBO business was spurred by two additional factors: the existence of Michael Milken’s new “junk bonds” trading operation at Drexel Burnham Lambert and the beginning of the long secular decline in interest rates, which allowed buyers to refinance deals at lower than anticipated costs, making them spectacularly profitable.

Inevitably this exceptional profitability drew in additional money. Bain Capital, for example, had begun in 1984 by doing traditional venture capital deals, in which it financed fledgling companies and helped them grow, ideally realizing its investment through a stock market IPO. This initial business unquestionably created jobs, most famously at the office products retailer Staples, founded by my Harvard Business School classmate Tom Stemberg with Bain Capital financing. However venture capital was a chancy business, often taking several years to produce returns and was not especially well suited to Bain, since Bain’s consultants were more used to advising much larger companies. Conversely the well-connected Bain was well able to attract large pools of capital once it had a track record, and was highly plausible when claiming expertise in turning round companies subject to leveraged buyouts. The migration of Bain’s business from venture capital to LBOs was thus unsurprising.

The Drexel crash of 1989-90, the struggles involved in the $31 billion takeover of R.J.R. Nabisco and the tight credit period of 1990-92 caused a recession both in the returns of the LBO business and in its public reputation. The latter problem was solved by rechristening the business “private equity.” Theoretically, this term applied to unleveraged portfolios such as I managed in Croatia, and even to the traditional venture capital business. In practice, the vast majority of the capital involved continued to be devoted to LBOs. In an era of low and declining interest rates, they were by far the most profitable sector of the private equity market, and in those years they required very little ability to carry out. With interest rates low and declining, leverage at unprecedented levels was easy to obtain, at least until 2008 – after all, since the LBO business only got started after interest rates peaked in 1982, its loss experience was excellent.

High and cheap leverage has a number of effects. First and most important, it magnifies the returns available from what were at best marginal improvements in operations. Indeed, the return on saving $100 in operating costs is trebly leveraged. First, if the company is saleable at a multiple of say 7 times EBITDA, an extra $100 saving in the most recent year increases its value by $700. Second, by squeezing hard in the last year before sale, a seller can improve the profits trend, and produce apparent growth in margins where no such growth truly exists – thereby increasing the EBITDA multiple itself. Third, the $700 increase in value of the asset (plus any excess from increasing the EBITDA multiple) flows through entirely to the equity holders, so an asset leveraged 5 or 10 times and squeezed operationally can produce spectacular returns to equity investors. Even after the fees extracted by the management company, outside investors do well, while the management company, typically receiving 20% on any capital uplift for zero investment, gets rich very quickly indeed.

This super-incentive to extract the last penny of savings from the companies they control inevitably leads LBO companies to squeeze their companies too hard. Typically, an LBO managed company will stint on maintenance and research, thereby dressing up operating results and sticking the buyer with an asset that is in poor condition with no product pipeline. The effect of Eddie Lampert’s ownership at Sears exemplifies this. After he bought the company, Lampert determined that a retail operation could be run with far less money devoted to decoration and cleaning than was traditional, which savings could both service debt and increase the value of his investment. Unluckily for him (presumably) the 2008 crash prevented him from selling Sears quickly enough, while customers over time deserted its filthy and poorly staffed stores, so that now, six years after he bought Sears, he is looking at a loss of $421 million in the latest quarter, with domestic same-store sales down 1.2% at a time of 4% inflation.

A second adverse effect of leverage is to incentivize dodgy negotiating and financing tactics. Last week, a former Wall Street banker William Cohan described Bain’s negotiating tactics, whereby they would put in a “final” bid on a company and then chisel down the price during the “due diligence” process when other bidders had disappeared (apparently this tactic was by no means exclusive to Bain). Similarly, the habit of extracting massive dividends, far greater than earnings, from companies they controlled left those companies vulnerable to the merest breeze of recession, endangering excessively the jobs of their employees.

Apart from making business thoroughly unpleasant, such tactics immensely increase the deadweight legal costs of doing deals, as documentation and protections from all kinds of unlikely contingencies proliferate ad infinitum. As we London merchant bankers were very well aware, “gentlemanly capitalism,” in which protagonists can within limits trust each other not to behave badly, is a far more economically efficient way to do business.

A further myth of the LBO business is that it can improve the value of assets it controls through superior management. This may have been true in the early 1980s, after an exceptionally flaccid period of U.S. management, but it has not by and large been true for the last quarter-century. LBO companies typically attract graduates of the top schools, but with an emphasis on those most attracted by “get-rich-quick” schemes who are generally not the most insightful or creative. Add the superior pay and conditions received by LBO staff, especially compared to management of the industrial companies they take over, and you have an extreme “us/them” problem that is barely if at all mitigated by throwing a few top stock options to the favored few among the industrial company’s management.

The problem is exacerbated by cost-cutting, through which favored projects are shut down without notice, while comfortable pension and other benefits are hollowed out and replaced with inadequate money-purchase schemes. The hostility to the LBO’s overstuffed yuppies which this produces is only exceeded by the contempt that rapidly appears for their entire ignorance of many of the basic features of the company’s business and competitive environment. Naturally, with management and workforce hostile to those controlling the business, things go wrong and inefficiencies and corruptions proliferate. The private equity industry nourishes the myth that many LBO managed companies would fail without their involvement; against the companies for which this is true must be balanced the others for which LBO involvement, extracting resources and starving operations, produces failures that would otherwise not have occurred.

Finally, as has become clear in the Bain discussion, the high returns achieved on LBO investments are matched by job losses and deterioration in working conditions – both attractive means for the LBO companies to extract “value.” Even if successful LBO deals on average break-even in job creation, with jobs lost through cost-cutting being matched by those gained through genuine improvements in operations, there are also the unsuccessful deals, in which the LBO company, having invested little, loses relatively little money, but where bankruptcy or facility closure result in massive job losses. For the economy as a whole, the cost of these job losses (and the subsequent periods of unemployment suffered by the employees concerned) must be subtracted from the profits made by the LBO sponsors and their investors to get a true societal accounting.

Through leverage, LBOs often provide investors with higher returns than true venture capital, especially in periods like the present when real interest rates are negative. They also provide quicker returns, and require less effort, because the value creation required is less. However their contribution to overall economic welfare is at best modest, unlike that of true venture capital. We must therefore hasten the return of sharply positive interest rates, which will devastate the LBO business and redirect its resources towards true venture capital, where they are far more valuable to the overall economy.

 

 

Originally posted in The Bear's Lair 

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site www.greatconservatives.com–and co-author with Professor Kevin Dowd of “Alchemists of Loss” (Wiley – 2010). Both now available on Amazon.com, “Great Conservatives” only in a Kindle edition, “Alchemists of Loss” in both Kindle and print editions.

 

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Hammering Through the Numbers Print E-mail
by Paul Perry    Wed, Jan 25, 2012, 10:52 AM

Existing home sales were recently reported as being up 1.7 percent for 2011. That is cause for some economic optimism, but the underlying numbers should perhaps give reason for further examination. Inventories of existing homes dropped to a 6.2 month supply of homes. In other words, we have more than a six months supply of homes overhanging the market nationwide before demand for new homes would substantially increase.

New home construction drives a lot of things. In order to build a new home, materials are purchased -- everything from wood and brick to plumbing supplies and copper wire.

These purchases and construction cause beneficial effects on demand throughout the economy. Maybe most importantly, new jobs are created.

Currently, however, almost a third of homes are being bought for cash, many of them by investors. In other words, we are still working through the existing home inventory. And although new construction is starting to occur, strong demand for new homes is awaiting the inventory for new homes to be absorbed.

Analysts regard the large number of new cash purchases as being caused by the fact that it is currently far more difficult to qualify for financing, leaving many homes to be purchased by cash or with very large down payments -- by the few who can afford it. A few years back, it was far too easy to qualify for a home loan, but like we do so often it appears that now we have swung to the other extreme. It is now too hard to borrow.

In the meanwhile, according to the numbers, we have some sluggish improvement in home purchases, and no doubt many older homes are being remodeled. This helps employ a few people, but the national economy, the people and our local governments await a more reasonable increase in the pace of construction that would follow more rational loan guidelines from our masters in Washington.

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Constitution and Civility Print E-mail
by Wes Riddle    Mon, Jan 23, 2012, 11:07 AM

One of several important breakthroughs in political science our Founding Fathers achieved, is the establishment of an entirely new category of law; namely, the Constitution.  The Constitution is the nation’s highest legal and moral authority—popularly accepted as such.  Yet its ratification took place over 200 years ago, amongst a generation long since dead and gone.  Charles Kesler, professor of government at Claremont McKenna College , says “Thus for Americans, the oldest law is the highest law.”  And he continues to point out how unique this is among nations:

     This is not a normal or an automatic outcome of popular government. 

     Most of the time, republics and the people who move their politics

     tend to think that if they make a law “A” one day, and a law “B” that

     contradicts “A” the next day, the newer law supersedes the old.  What

     is unusual about the Constitution is that this rule is completely reversed

     in respect of it.  The oldest law is the most authoritative, and is indeed

     the only law that “the people” as such have ever passed.  Other law is

     statute law, law made by representatives of the people.  Thus every

     other law needs to be adjudged in light of the only law that is genuinely

     ours, the Constitution.

Clearly, some would prefer that the Constitution evolve and stay up with the times.  There is even a modern liberal legal theory that affirms a so-called “living Constitution.”  This is another way of saying the Constitution means what lawyers and judges say it means.   

Besides the Constitution as a category of law, the Founders also bequeathed an aspect of culture, which helped to give the Constitution stability and its impressive longevity.  Historically a part of America ’s democratic culture, the aspect has sadly deteriorated as “living Constitution” theory advances.  I’m referring to political civility, the idea that citizens will be civil to one another despite political disagreements.  The disagreements are less important than the resolve to remain fellow citizens.  Of course, a necessary precondition for this type of civility is that citizens do agree on certain fundamentals, so that disagreements really involve secondary issues.  This is possible when the central government remains limited, or when fundamentals are settled at State and local government levels.  The War Between the States was a time when folks (rightly and wrongly) disagreed on fundamental issues, which the federal government could not leave to States or localities.  With discrete fundamentals settled on the battlefield, we’ve stayed more or less civil since Reconstruction. 

Today I wonder about the Founders’ great handiwork.  Though altered much, it has survived in large measure.  But I worry as civility departs, because government has grown too big and too intrusive in matters belonging outside its scope.  I worry as respect for the Constitution itself declines, when citizens fail to distinguish rights from their desires, and political expediency supplants principle.  During the last presidential election, people were tempted to say the popular or consolidated national majority (pure democracy) should rule the day—even though the constitutional majority entails both democracy and federalism and is the only majority that may govern the United States as a free country.  What would George Washington have thought of the spectacle?  The first president was quintessentially both civil and constitutional, in his personal example and professional conduct.  He was also straightforward and literate.  The following is taken from his Circular Letter of 14 June 1783, but Washington ’s words ring true today:

    The foundation of our empire was not laid in the gloomy age of Ignorance 

     and Superstition, but at an Epoch when the rights of mankind were better

     understood and more clearly defined, than at any former period; the researches

     of the human mind, after social happiness, have been carried to a great extent;

     the Treasures of knowledge, acquired through a long succession of years, by

     the labors of Philosophers, Sages and Legislatures, are laid open for our use,

     and their collected wisdom may be happily applied in the Establishment of our

     forms of Government; the free cultivation of Letters, the unbounded extension

     of Commerce, the progressive refinement of manners, the growing liberality

     of sentiment, and above all, the pure and benign light of Revelation, have had

     a meliorating influence on mankind and increased the blessings of Society.  At

     this auspicious period, the United States came into being as a Nation, and if

     their Citizens should not be completely free and happy, the fault will be entirely

     their own.

 

___________________

Wesley Allen Riddle is a retired military officer with degrees and honors from West Point and Oxford .  Widely published in the academic and opinion press, he serves as State Director of the Republican Freedom Coalition (RFC) and is currently running for U.S. Congress (TX-District 25) in the Republican Primary election scheduled April 3, 2012.  His newly released book, Horse Sense for the New Millennium is available on-line and at most bookstores.  Visit: www.WesRiddle.com

 

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Train While you Claim Print E-mail
by Tom Pauken    Mon, Jan 23, 2012, 11:05 AM

I was pleased to see that, in the Presidential debate in South Carolina Monday night, Newt Gingrich came out in support of a proposal I presented in testimony before Congress on February 2011. It deals with the issue of extended unemployment benefits and is called “train while you claim.” Here is an excerpt from that testimony:

 

I recommend that, as a condition for receiving extended unemployment benefits, recipients would have an option to “Train While They Claim”.  Those without a high school diploma could choose to study for their GED.  UI claimants in that category would be entitled to first priority for participation in existing federally funded Adult Basic Education programs.

 

Those with a high school degree, but lacking specific vocational training, would be able to receive job skills training.  Again, this would not require an increase in federal funding, but simply give claimants top priority to participate in existing federally funded training programs.

 

Alternatively, those who don’t choose to get a GED or receive additional skills training would be required to gain additional on-the-job experience or training by volunteering for community service work for public institutions or approved non-profits like Habitat for Humanity.  Those who refuse to participate in one of these three options would no longer be entitled to receive extended unemployment benefits.”

 

To me, this is a commonsense approach for providing the unemployed with additional skills while they look for work as well as dropping from the rolls those who want to “game the system.” The full testimony to the Subcommittee of Human Resources of the House Ways and Means Committee can be found here:

http://www.twc.state.tx.us/svcs/commrs/021011chr.pdf

 

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Bored With the Movies? Go To the Courthouse Instead Print E-mail
by John Browning    Tue, Jan 17, 2012, 09:53 AM

Like many Americans, I had more than my fill of three things this holiday season: turkey, egg nog, and movies.  Not just the big, splashy blockbusters, mind you, like “Mission Impossible: Ghost Protocol,” but also those smaller art-house films that become critical darlings and Oscar favorites.  But now, just as I resign myself to the filmgoer’s malaise that accompanies the string of movies released early in the year that won’t light up the box office or garner golden statuettes, I’ve realized that there is an endless source of almost cinematic entertainment waiting for me down at the courthouse.  So forget your local multiplex and come with me to see what’s playing at a courthouse near you (and don’t forget the popcorn),

 

If you liked films like “The Parent Trap” or any movie with identical twins who get themselves into sticky situations where hilarity ensues, then you’ll love the case of State of Missouri v. Darrel W. White, Jr. in Jackson County, Missouri (not far from Kansas City).  Criminal defense attorney Dorothy Savory was representing the defendant at a preliminary hearing on charges of robbery.  When the victim was asked to identify the man who snatched her purse, she pointed to “Mr. White,” the gentleman sitting next to Savory at the counsel table, as her assailant.  However, in the hall outside the courtroom, the arresting officer noticed a familiar-looking person getting off the elevator—Darrel W. White, Jr.  In short order, it was revealed that the man next to defense lawyer Savory was the defendant’ identical twin brother, Darion White.  Both prosecutor Jean Baker and Judge Kenneth R. Garrett III were furious at the switcheroo.  Although Ms. Savory was reportedly mystified at the fuss and the allegation that her conduct was deceptive, Judge Garrett pulled no punches, calling her actions “disrespectful” and continuing the hearing until contempt charges (and possible disciplinary action) against the defense attorney could be considered.  That’s what I call “double trouble.”

 

If your tastes run more to horror flicks like “Paranormal Activity,” then check out the criminal charges pending against former police officer Joseph Hughes of Mount Gilead, Ohio.  Hughes was facing 20 charges, including theft and possession of stolen property, after a slew of stolen air conditioners and other goods (many belonging to the county) was found inside Hughes’ home.  The case took a supernatural turn when Hughes attempted to explain why he was unaware that all those stolen goods were in his basement.  “We believed that there was some kind of paranormal presence in the basement,” Hughes testified.  “It sounds kind of ridiculous but there was evidence to support it.”  The “paranormal defense” shocked prosecutors.  Tom Elkin  of the Morrow County Prosecutor’s Office said “I’ve been practicing since 1983 and I can say that’s the first time I’ve heard of paranormal activity in the course of a trial.”  As it turns out, Hughes’ defense didn’t stand a ghost of a chance; he was found guilty of 18 out of 20 charges.

 

Of course, if your preferences are for more Disney-style family fare, along the lines of “All Dogs Go to Heaven,” then follow the lawsuit recently filed in New York City by dog owner Elena Zakharova against an Upper East Side pet store known as Raising Rover.  Zakharova claims that the pet shop sold her Umka, a Brussells Griffon which was represented to her as healthy but which allegedly has bad knees and bad hips.  What makes Ms. Zakharova’s lawsuit unusual is that she does not want just compensation for Umka’s vet bills (which exceed $4,000); she also wants compensation for the dog’s pain and suffering and recognition by the court that companion animals are not inanimate property but “living souls.”  I’m not sure a court will be able to make such a declaration, but I’m cheering for Ms. Zakharova and little Umka anyway—all dogs do go to heaven, as Disney fans will attest.

 

Of course, if your movie of choice is a grisly horror flick full of dismemberment and “creative” deaths like the “Saw” or “Final Destination” movies, then a recent Illinois appellate court decision will make lively reading.  The bizarre case began with an unusual set of circumstances.  In 2008, 18 year-old Hiroyuki Joho was hurrying to catch an inbound Metra train in the Chicago suburb of Edgebrook when he was struck by a southbound Amtrak train traveling at over 70 mph.  In a lawsuit that even one of the lawyers involved described as “very peculiar and gory and creepy,” a passenger waiting on the southbound platform, 58 year-old Gayane Zokhrabov, was struck by “a large portion” of Joho’s body.  The flying body part knocked her to the ground, injuring her shoulder and breaking her leg and wrist.  Zokhrabov sued Joho’s estate, and a Cook County judge dismissed the case.  But the Illinois appeals court disagreed, and in an opinion worthy of a law school exam hypothetical reasoned that it was “reasonably foreseeable” to Joho that a high-speed train could kill him, sever his body, and fling body parts down the tracks at a platform full of waiting people.  Hollywood special effects people, get your moving trains and flying body parts ready.

 

Finally, if a romantic comedy where two people “meet cute” under unusual circumstances and eventually fall in love (like “When Harry Met Sally” or virtually any Sandra Bullock or Julia Roberts movie) is your cup of tea, then check out another lawsuit pending in suburban Chicago.  Stickney, Illinois police officer Chris Collins is apparently a lonely guy.  On October 22, 2011, the 27 year-old officer pulled over Evangelina Paredes for speeding and issued her a $132 ticket.  But he couldn’t get the comely motorist off his mind, and he allegedly searched her motor vehicle records for her address before leaving a handwritten note on her car windshield outside her apartment two days later.  The alleged note said “It’s Chris . . . that ugly bald Stickney cop who gave you that ticket.  I know this may seem crazy and you’re probably right, but truth is I have not stopped thinking about you since.  I don’t expect a girl as attractive as you to . . . even go for a guy like me, but I’m taking a shot anyways.”  The alleged note continues saying he’d understand if Ms. Paredes didn’t respond, but that “hey, I did cost you $132—least I can do is buy you dinner.”

 

Awwh.  Unfortunately, one woman’s cute is another woman’s creepy, and Ms. Paredes has filed a federal court lawsuit against Officer Collins, his police chief, and the village of Stickney.  The lawsuit alleges invasion of privacy and stalking that has caused Paredes to “suffer great fear and anxiety.”  It also accuses Collins of using his “authority and position as a police officer not to protect the public, but to attempt to manipulate the plaintiff into going out on a date with him.”  Not exactly a Hollywood ending.  Can’t you just see a movie version (with say, Eva Mendes as Ms. Paredes and Ryan Reynolds as Officer Collins) where, after a hilarious chain of events, the two meet up again in a climatic courtroom scene and realize that it’s true love after all?  I guess not, but the courthouse can still be as entertaining sometimes as the movies, and admission is free.

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