The Blind Men and the Elephant

A HINDOO FABLE.

I.

IT was six men of Indostan
To learning much inclined,
Who went to see the Elephant
(Though all of them were blind),
That each by observation
Might satisfy his mind.

II.

The First approached the Elephant,
And happening to fall
Against his broad and sturdy side,
At once began to bawl:
"God bless me!—but the Elephant
Is very like a wall!"

III.

The Second, feeling of the tusk,
Cried:"Ho!—what have we here
So very round and smooth and sharp?
To me 't is mighty clear
This wonder of an Elephant
Is very like a spear!"

IV.

The Third approached the animal,
And happening to take
The squirming trunk within his hands,
Thus boldly up and spake:
"I see," quoth he, "the Elephant
Is very like a snake!"

V.

The Fourth reached out his eager hand,
And felt about the knee.
"What most this wondrous beast is like
Is mighty plain," quoth he;
"'T is clear enough the Elephant
Is very like a tree!"

VI.

The Fifth, who chanced to touch the ear,
Said: "E'en the blindest man
Can tell what this resembles most;
Deny the fact who can,
This marvel of an Elephant
Is very like a fan!"

VII.

The Sixth no sooner had begun
About the beast to grope,
Than, seizing on the swinging tail
That fell within his scope,
"I see," quoth he, "the Elephant
Is very like a rope!"

VIII.

And so these men of Indostan
Disputed loud and long,
Each in his own opinion
Exceeding stiff and strong,
Though each was partly in the right,
And all were in the wrong!

MORAL.

So, oft in theologic wars
The disputants, I ween,
Rail on in utter ignorance
Of what each other mean,
And prate about an Elephant
Not one of them has seen!

— John Godfrey Saxe, The Blind Men and the Elephant

Beware, O Dearly Beloved, those endlessly multiplying pundits who propose single-method solutions to the problem of financial reform. "The" answer is not minimum equity capital requirements, liquidity controls, return on equity caps, compensation reform, leverage or size limits, portfolio risk monitoring, or even slipping saltpeter into the lattes of testosterone-addled traders so they act more like risk-averse women. The answer—pace the sexual lobotomization of traders which many in society may wish for other reasons—is likely to be a combination of all of those reforms (and more), implemented in a dynamic and flexible regulatory structure which can respond and adapt to changing conditions.

For the fundamental truth which most commentators continue to overlook is that the global financial system is much more like our illustrative friend Panic Pete than an elephant. When you squeeze Mr. Pete in one spot, the squishy gel inside his rubbery body causes his other parts to bulge out. Squeeze him in those newly bulging areas, and he will return to his original form or bulge unexpectedly in new directions. Why? Because the gel inside of him is incompressible. Squeezing the flexible outer skin does not cause the toy to shrink. It just forces it into a new configuration. Likewise, the fundamental quantity in the global financial system which we are concerned with, and which we properly wish to control, is risk. But, given any specific level of return, risk is incompressible.

If you want to achieve a particular return, you necessarily assume a commensurate and ineluctable level of risk, whether the instrument of your investment is a single stock, a capital project, an individual business operation, an asset class, or indeed an entire economy. And what does return mean in the context of an economy? It means growth, increase in productivity, and real economic returns in addition to secondary (or even potentially illusory) investment returns. Investing in a business, an industry, or an economy is risky. There is no guarantee you will achieve your aims or desired returns, whatever those returns may be. There are no guarantees, period.

* * *

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down.¹ But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? ² Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or "solutions" we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place ³—if we do not make provision to address them.

* * *

Squeezing Panic Pete is fun. It's a great stress-reliever, too. It just so happens to be a lousy regulatory reform agenda.


¹ "Go down" = become more expensive, less frequent, less available, more difficult, etc.
² I do not speak of wealth distribution here, which is another socioeconomic debate admitting of other solutions which are not necessarily connected to the measures we decide to implement in financial reform.
³ Wait. That was all of us, wasn't it? Oops.

© 2011 The Epicurean Dealmaker. All rights reserved.

The Two Beds of Procrustes

In the Greek myth, Procrustes was a son of Poseidon with a stronghold on Mount Korydallos, on the sacred way between Athens and Eleusis. There, he had an iron bed in which he invited every passer-by to spend the night, and where he set to work on them with his smith's hammer, to stretch them to fit. In later tellings, if the guest proved too tall, Procrustes would amputate the excess length; nobody ever fit the bed exactly because secretly Procrustes had two beds.

— Wikipedia, Procrustes

So, here we go again. Pandora priced its initial public offering well above the upwardly revised indicative price range. Unlike LinkedIn, however, Pandora's stock price spiked up on the day of the offering and then fell, closing modestly above the offer price. In my business, this is generally viewed as a weak but acceptable outcome.

Nevertheless, I fully expect we will be deluged with all sorts of half-baked, idiotic commentary from people who would not recognize a stock certificate at fifty paces about Pandora's underwriters' performance, integrity, motives, and competence. (Note that Morgan Stanley was left bookrunning manager—lead underwriter, to the unwashed among you—on both LinkedIn and Pandora's offerings. It will be amusing to see the critics twist themselves into knots on this one.) Rest assured that the leading conclusions (or, for the more cowardly among the peanut gallery, highly-qualified insinuations) will break down to two alternatives: either the investment bankers were devious scammers, or they are pathetic fuck-ups.

I can't be bothered to reenter the fray on this deal, so I will simply point those readers among you who would like a fact-based education on IPOs to my earlier pieces. In the meantime, I will offer a simple observation, which I think cuts to the heart of the true issue at hand, which is most certainly not whether Pandora was priced correctly:

If your world view depends on believing everyone you disagree with is either corrupt or incompetent, you are not clever.

You are a fool.


© 2011 The Epicurean Dealmaker. All rights reserved.

She’s Got Legs

That woman speaks eighteen languages, and can’t say “No” in any of them.

— Dorothy Parker, 1893–1967

I suppose I should say up front, Dear Readers, that as a heterosexual male of a certain age—one with what I suppose are all the common urges, appetites, and cognitive limitations of my like-gendered and -oriented peers—I have always found women’s fashion a complete and utter mystery, in turns baffling, fascinating, and ridiculous. My normal reaction to discussions and images of non-utilitarian women’s clothing is a puzzled shrug and a nervous laugh, the kind one normally gives when one realizes one is in deep water, miles from shore, with shark fins circling in the middle distance. In short, when it comes to fashion I am, like most men, an uninformed, insensitive lout.

I say this now to avoid giving the impression that I intend to offer any sort of advice on fashion qua fashion in this piece. Heaven forfend. Nevertheless, as a non-brain-dead male who retains his power of sight, I count myself an attentive observer of the outfits that women clothe their bodies with, so I do have a point of view. While a lady friend has explained to me that women dress for each other and undress for men (thank you, ladies), we men are at the very least unintended or secondary members of your audience if not, on occasion, your primary intended victims.

So I thought it might be useful, or at least amusing, for the distaff members of my audience to hear what I have to say about the weekend Wall Street Journal article on women’s suit-and-shorts outfits, at least in so far as it pertains to a work environment. For while the brief article limns the appeal of suit jackets and shorts for leisure time and entertaining, at least part of it is directed at wearing such combinations at work, too. While I do this, any men who have made it this far into the text can toddle off to watch sports on TV or click on the accompanying picture above and construct elaborate late-night negotiation fantasies with the lovely models above for their amusement. We will return to this site’s regularly scheduled male chauvinism in due course.

* * *

Now, I am sure I will say nothing here that many if not most professional working women do not already know in spades. I bear no illusions that I have thought anywhere near as deeply about these issues as they. But there may be a few younger women just starting careers who could use a little advice, and perhaps my remarks here will prevent them from making an unintentional and perhaps career-compromising mistake.

For make no mistake, if any woman who worked for me showed up at the office wearing any of the outfits pictured above, I would send her home immediately to change. There is nothing wrong with those outfits per se: to my untrained eye, they look attractive, professional, and high-quality. The open tops on a couple of them could be a problem for a woman with a more normal-sized chest than the washboard torsos of the runway models, but the real problem is the shorts. Almost all of them show way too much thigh to be remotely professional in my office. Perhaps that is an artifact of their display on the freakishly long and thin legs of the models, and they would fall lower on any genetically normal female, but as pictured they are simply unacceptable.

Of course, I say this in the context of my work environment: the corporate finance and M&A department of an investment bank. But I think few would disagree that similar norms apply in any corporate law firm, accountancy, consulting firm, or indeed any mainstream professional services corporation outside traditionally “creative” industries like publishing or advertising. Why? Because showing all that thigh is just too sexy. Clients of professional service organizations generally do not want the people who work for them to be flashy, extravagant, or prone to calling attention to themselves. They want service. They want reliability. They want sobriety. Calling excess attention to yourself in any way that is not directly related to identifying, analyzing, and solving the client’s needs is both offputting and counterproductive.

And face it, girls, naked thighs are sexy. You know this. Show up at a client meeting dressed like this and you will not win the order, solve the problem, or build trust with your client. You will get an invitation to dinner (or worse). And that’s only if your client is a receptively inclined man based in a large city in the developed world. If your client is a man from a less sophisticated or tolerant part of the globe, or a woman, you are far more likely to offend them with your brazen presumption and get tossed out on your shapely, underdressed derriere. That type of outfit just doesn’t play in Peoria, much less Cairo.

By the same token, it doesn’t work at the office among coworkers, either. Shorts can actually be more professional than a short skirt, because they obviate the opportunity for loutish male colleagues to sneak peeks à la Sharon Stone in Basic Instinct, but length is critical. Why would you, as a dedicated, serious professional, want to introduce undertones of sexual availability and interest in a work environment, anyway? Especially one, like investment banking, which is already dominated by men. Why would you want to let the Sex Monster out of its cage? Or even rattle the bars?

If you’re serious, you would not. And men know this. We may not know fashion, but most of us can recognize the subtle clues that a woman is dressing, not for professional success, but for sexual or romantic conquest. It may be mere millimeters on a skirt, a just-slightly-too-sheer blouse, or heels just a fraction of an inch too high, but we see it, and we register it in our primitive hindbrains. And you automatically risk demotion in our minds from serious professional colleague to unprofessional flirt, borderline floozy, or “fair game.” Unless you are in business to catch a boyfriend, lover, or husband, you have just failed the test.

* * *

Sexual attraction is an ineluctable fact of human life. It is an elemental, distracting force which does not meekly obey social niceties, workplace strictures, or the best intentions of men or women. In contemporary Western society, women have developed a massive variety of approaches to clothing themselves which convey all kinds of deeply nested, often conflicting messages, sexual availability being one of the most potent. In some respects, fashion and beauty can be deeply at odds with the conduct of business. In my business, for example, human beauty—whether male or female—is usually viewed as evidence of lack of intelligence, and can be a serious disadvantage. If you look really good, no-one takes you seriously. Is this fair? Of course not, but that’s the way it is.

Therefore, younger professionals in my business, whether male or female, are best served by dressing well but inconspicuously. Convey an image with your dress that is sober, reliable, and—dare I say it—nondescript. The impression you want to project is one of a competent, intelligent professional who lives but to serve the client’s every need, not some über-hot sex bomb whom everyone wants to fuck. (This is even more important on an investment bank trading floor, where the generally stratospheric level of testosterone and even greater scarcity of women makes it questionable whether a burka would be nondescript enough.)

Once you rise in the ranks and attain a position of power, however, you can play much more loosely with these rules. Female Managing Directors can wear flashy Chanel suits, short skirts, and high heels if they want. Men can make themselves ridiculous with loud patterned shirts, bow ties, and braces. Why? Because they have attained a position of power. When you have power, your dress can be much flashier, because your dress is a marker of your power. The message you convey is: “Yeah, that’s right. I can dress however I like, because I’m a Big Swinging Dick. Fuck you.” The flashiness, the outrageousness, the sexiness do not disappear, but they become servants to the bigger message of power. Of course the sad fact, at least for most female investment bankers, is that few achieve this license to adorn themselves until they are no longer young.

I never said the rules were fair.

* * *

So, pace the Wall Street Journal, I suggest that young ladies who aspire to career success in investment banking eschew skirts and shorts that are too short, unless your idea of success is landing an investment banker husband. Just remember the observation offered not so long ago by the mordant Ms Parker, a woman who knew what it was like to try to make a mark in a man’s world:

Brevity is the soul of lingerie.

There are other no-nos, too, including plunging necklines, excess cleavage, too-tight fabric, and provocative stockings, which I am sure every woman out there knows and can recognize better than me. Just ask yourself before you put it on: is it “daring,” “flirty,” “sporty,” or—God forbid—“sexy”? If so, save it for dates and leisure time, at least if you work on Wall Street. Your career will thank you for it.

So will your male colleagues. We need that blood in our brains to do our jobs.

Related reading:
Fingernails that Shine Like Justice (May 21, 2007)


© 2011 The Epicurean Dealmaker. All rights reserved.

Milestone

Early this morning, O Dearly Beloved, while the East Coast of the United States slumbered (or at least I did), some poor benighted soul clicked an unsuspecting key on their computer, and the 1,000,000th page of this opinion emporium was summoned from the ether into view. Now, put in context with the pageview monsters of the econoblogosphere—much less the ultra-monsters of the internet itself, to whom the popularity of the most visited business and economics site extant is but a pimple on the ass of irrelevancy—one million pageviews is indisputably small beer. But it took four years and four months for me to reach this numerically impressive but otherwise meaningless marker, and I intend to lord it over you for at least a few paragraphs more.

My achievement, if I do say so myself, is all the more impressive (at least in my eyes) because I accomplished it while violating almost every possible stricture of financial blogging known to man, the most important of which include writing punchy, concise, frequent blog posts about stuff one clearly understands. In addition, I employed language not normally seen outside P.G. Wodehouse novels and the 18th century edition of the Encyclopaedia Britannica, liberally sprinkled with blistering invective strong enough to make paint peel. I salted my prose with arcane allusions and abstruse quotations of dubious relevance. I illustrated my posts with arty, recondite images whose pertinence to the subject at hand was often obscure and usually tenuous at best. I denied everyone the ability to comment on my pearls of wisdom, which I believe is considered a capital offense in the echoing halls of Conventional Bloggery. And finally, to compound the degree of readerly difficulty, I swathed the entire site in enough twaddle and misdirection—most notably by refusing to label any topic with search terms that would be easy to find and use—to make even the most tenacious student of the Torah toss it over to study Dianetics.

Given all that, I have only one question for all of you: Are you guys effin' masochists, or what?

* * *

Anyway, I suppose I should try to summon a shred of gratitude from the dismal depths of my curmudgeonly heart, at least for the fact that there have been so many of you who seem to take pleasure from my monstrous self-indulgence. But now is not the time to rest upon your lexical laurels, Dear Friends, for there are new mountains to climb. In particular, I remain several hundred thousand visitors short of one million, and I have promised various ex-girlfriends and securities regulators that I will strip naked, paint my dangly bits blue, and streak down the Washington Mall reciting each and every provision of the Dodd-Frank Financial Reform Act at the top of my lungs once I achieve that mark.

So hop to it, please. The monkeys I hired to click pages have proved remarkably unreliable, and we all know business school majors and MBAs are utterly useless in this regard.

See you at the next mile marker. Cheerio.


© 2011 The Epicurean Dealmaker. All rights reserved.

Scruples

Everyone has heard the story of the man of Picardy to whom, on the scaffold, they presented a wench, offering (as our justice sometimes allows) to save his life if he would marry her. He, having looked at her a while and noticed that she was lame, said: "Tie up, tie up! She limps." And likewise they say that in Denmark a man condemned to have his head cut off, being offered similar terms when he was on the scaffold, turned it down because the girl they offered him had sagging cheeks and too sharp a nose. ¹

* * *
Indeed, just as study is a torment to a lazy man, abstinence from wine to a drunkard, frugality to the luxurious man, and exercise to a delicate idler, so it is with the rest. Things are not that painful or difficult of themselves; it is our weakness and cowardice that make them so. To judge of great and lofty things we need a soul of the same caliber; otherwise we attribute to them the vice that is our own. A straight oar looks bent in the water. What matters is not merely that we see the thing, but how we see it. ²

— Michel de Montaigne, Essais

So what does Montaigne intend to tell us, that the man from Picardy and the Dane had so little fear of death that mere uncomeliness in a potential wife and savior was enough to throw away their lives? Or that both men were more afraid of marriage than death?

Inquiring minds want to know.


¹ "That the taste of good and evil depends in large part on the opinion we have of them." The Complete Works, trans. Donald Frame. New York: 2003, p. 40.
² Ibid., p. 56.

© 2011 The Epicurean Dealmaker. All rights reserved.

You All Know Brutus and Cassius Are Honorable Men

Much as it pains me to say it, O Gentle Readers of Tender Sensibilities, I'm afraid I must agree for once with those shills for the private plutocracy equity industry over at the Private Equity Growth Capital Council. They recently released a comment letter to the SEC's proposed rules on incentive-based compensation arrangements at systemically important financial institutions, which the Dodd-Frank financial reform act defines as any financial institution with at least $1 billion in assets.

In March, the Securities and Exchange Commission unveiled a plan to crack down on the kind of big bonuses that encouraged excessive risk-taking before the financial crisis. The proposed rules, which are expected to be completed over the next few months, are aimed at big banks and brokerage firms that nearly toppled in 2008. But technically, the proposal applies to any financial firm with more than $1 billion in assets, sweeping up private equity firms, too.

In fact, given the growth of private equity over the past three decades, such a rule, should it be implemented, would likely sweep up a substantial percentage of the industry's players, affecting numerous firms well beyond the industry titans included in the PEGCC's membership roster.

But the DealBook article mistakenly emphasizes the wrong points in summarizing the PEGCC's remarks, focusing on the assertion that private equity paychecks "pale in comparison to bonuses at big banks" (an extremely dubious assertion, at best) and that PE pay is determined in direct negotiation with sophisticated institutional investors, unlike bank pay which is railroaded by sleeping shareholders in the dead of night (true, but entirely beside the point). Instead, the PEGCC letter itself makes the salient point comprehensively and at length: while private equity firms may be "systemically important" in some sense, they pose very few systemic risks to the financial system at large, and these pale in comparison to the risks which large commercial and investment banks threaten.

This statement of facts, while self-serving, happens to be true. With certain important caveats, which I outline below, I agree that private equity firms' compensation arrangements should not be subject to regulation under Dodd-Frank.

* * *

In order to understand why, we must first address the structure of the private equity industry. There are basically three entities through which private equity operates in the markets: private equity firms, also known as "financial sponsors"; private equity funds which financial sponsors use as vehicles to do their investing; and individual portfolio companies which PE firms and their funds invest in. The PE firm itself is a relatively small entity, comprised of a surprisingly small number of professionals and support staff. (Even the biggest multi-billion dollar firms usually have only a few hundred employees.) Its task is twofold: i) raise money from institutional investors ("limited partners," or LPs) for discrete, limited-life funds and then ii) go do the hard work of investing that money in individual portfolio companies. Because a PE firm normally acts as the general partner of each of the funds it raises, financial sponsors are often known as General Partners or GPs in the trade. It is also worth noting that a PE firm will often manage more than one fund at a time: an older one, fully invested, where its job is to wind down the portfolio of existing company investments and either liquidate failing ones or sell the winners and return remaining funds to the fund investors, and a newer one, where its task is to put the available funds to work in new business investments.

The material point concerning traditional financial sponsors, however, is that while the professionals who do the work reside in those entities, the firms themselves have very little money or assets of their own. The money, and the investments it enables, reside legally in the private equity funds which the general partners manage for their limited partners. Private equity firms normally get paid what is known as "2-and-20": an annual 2% management fee, calculated on the total amount of money committed ¹ to the fund (e.g., $20 million per year on a $1 billion fund), and 20% "carried interest," which amounts to a 20% stake in the profits earned by the investments in the fund, after the management fee and certain preferred returns are paid to the LPs. While the management fee is intended to pay the light bills, the staff salaries, and all the operating expenses the sponsors run up by looking at hundreds of companies per year in the course of actually investing in just a few—and is mostly used for just such expenses—you can see that very large firms, with funds clocking in north of $10 billion, can actually make very good money just from management fees alone.

In fact, PE funds themselves really only act as accounting entities for the collection of portfolio investments within them. The real unit of investment of private equity is the portfolio company itself, which the PE firm buys either in whole or in part, with a substantial amount of equity taken from the LP fund and outside capital in the form of bank loans, high yield debt, or other debt financing. None of the portfolio companies in a PE fund cross-collateralizes the others—meaning if one goes bankrupt or liquidates, it has no effect on the entire portfolio or any other company within it. Lenders to leveraged buyouts look only to the credit of the company being bought, not to the fund in which the investment is made or the PE firm sponsoring the investment.

Therefore, you can see that notwithstanding the often substantial debt private equity firms take on in their investments, this leverage resides in carefully walled-off buckets at the level of each individual investment. If things go wrong with one company, it craters, but its cratering does not trigger a domino effect within any particular PE fund's portfolio, nor does it cause distress and financial contagion at the sponsor level. In almost all instances, neither PE firms nor PE funds take on debt of any kind for themselves. Therefore, they neither suffer financial distress nor have a mechanism to transmit such stress to the outside world. Sure, lenders to individual portfolio companies which go belly up are going to take it in the shorts, but that's where it ends. There are virtually no pathways of systemic financial contagion in the traditional private equity firm or its business.

This is accentuated by the fact that by participating in a PE fund, LPs agree to meet their funding commitments over the (normally 10-year) life of the fund and cannot contractually get their money back prior to its expiration. This is a material difference between the investment an institutional investor makes in traditional private equity and one it makes in a hedge fund. While hedge funds are gated, and have all sorts of mechanisms to delay investors from withdrawing their money at will, at the end of the day hedge fund investors normally have the ability to withdraw their money with limited notice. Investors in private equity do not. This makes a great deal of sense, of course, because hedge funds normally trade in relatively liquid assets, whereas private equity investments are almost the definition of long-term, illiquid investment.

* * *

Let's review. PE firms do not borrow money, and they have virtually no assets of their own. PE funds do not borrow either, and they call upon the irrevocable, unwithdrawable equity commitments of limited partners to fund investments in individual companies. PE investments (companies) are funded individually on a non-recourse basis to the fund and the financial sponsor. Lenders to PE company investments cannot cause a "run on the bank" at financial sponsors, and equity investors in PE funds cannot cause a run on the bank, either. Traditional PE firms and PE funds do not lend money to other entities, nor do they trade liquid securities, derivatives, or other financial instruments in any markets. Their investments in company buyouts are long-term, illiquid, and safe. At least from the financial system's point of view. ²

Therefore, what do we care about the risks private equity firms take in their investments? What do we care that other investors lend them way too much money at way too low interest rates with few or no covenants to fund their leveraged buyouts of companies? What do we care that giant institutional investors like CALPERS and Yale University give them hundreds of billions of dollars of equity to invest in risky buyouts? The answer is we shouldn't.

And since traditional private equity poses no material risk of financial contagion through highly liquid, interlinked debt and equity exposures which can be called at a moment's notice, why should we care how its executives are paid? Why should we care that they can get paid billions if their investments succeed? Why should we care if they make highly levered, risky investments in shaky businesses in order to make themselves and their limited partners rich? From the point of view of systemic financial risk, we shouldn't. Period. End of story.

* * *

HOWEVER, saying that traditional private equity, as a business and an investment class, does not add materially to systemic financial risk—which it does not—DOES NOT MEAN that we should not think carefully about the industry's incentives and the executive compensation practices which fall out of them. For one thing, my analysis above is based upon the well-established characteristics of traditional private equity: that is, leveraged buyouts and minority investments. But many of the largest financial sponsors have begun to build substantial businesses outside of traditional private equity—including trading (in-house hedge funds), real-estate, commodities, even investment banking—in pursuit of world-beating status as "alternative asset managers." The more they blur the line between their old identities and their new ones as highly-connected financial clearinghouses with multiple links into the global financial system and multiple pathways for financial contagion to spread, the less they can claim that their business model poses no risk to the system. And, therefore, the weaker their claim that regulators should not pay attention to how their executives are paid and how such pay practices may encourage the assumption of risk.

Lastly, of course, saying that traditional private equity compensation practices should not be subject to review and control by regulators because they do not foment systemic financial risk is not to say that there are not other good reasons to do so. Putting aside vexing issues of income inequality, stratospheric individual wealth creation for the poobahs at the top of the business, and the PEGCC's despicably meretricious advocacy of the ridiculously unfair tax treatment of carried interest, there is the social policy issue of the true value of private equity itself.

For while I have always admired the good which private equity investors can do for companies which are struggling, need to be fundamentally restructured, or face significant transformational challenges which are best conducted out of the glare of public scrutiny, I am also aware there is a strain within the business which is far less admirable. A strain which looks to the quick flip, the carving up of thriving businesses for the sum of their parts, the starving of growing businesses of the capital expenditures they need to expand, and the ruthless downsizing of employees driven by purely financial considerations. The pay structure and incentives of the industry definitely play into this dark side of private equity, too.

* * *

Saying private equity compensation should not lead to another potential financial crisis doesn't quite end the conversation, in my opinion. Not all the financial regulatory issues we address in the current environment should be restricted to the implementation of Dodd-Frank.


UPDATE June 11, 2011: Fixed reference to carried interest and added link to previous discussion.

¹ Important side note: when KKR, for example, raises a $10 billion fund, they do not receive $10 billion in cash up front from their limited partner investors which they invest in a bank savings account until they spend it. Rather, they obtain contractual commitments from their LPs to respond in a timely fashion to their capital calls when they make an investment. The LPs do pay the 2% management fee on their entire commitment from the beginning, however, whether the funds are invested or not.
² What causes bank runs? Liquid deposits. In other words, deposits (or loans) that can be withdrawn immediately by the depositor (lender). Illiquidity is a wonderful mechanism to prevent runs on the bank—whatever form a "bank" might take—if only because you can't withdraw it in times of stress.

© 2011 The Epicurean Dealmaker. All rights reserved.

Path Dependency

... and the wineshops half open at night and the castanets and the night we missed the boat at Algeciras the watchman going about serene with his lamp and O that awful deepdown torrent O and the sea the sea crimson sometimes like fire and the glorious sunsets and the figtrees in the Alameda gardens yes and all the queer little streets and the pink and blue and yellow houses and the rosegardens and the jessamine and geraniums and cactuses and Gibraltar as a girl where I was a Flower of the mountain yes when I put the rose in my hair like the Andalusian girls used or shall I wear a red yes and how he kissed me under the Moorish wall and I thought well as well him as another and then I asked him with my eyes to ask again yes and then he asked me would I yes to say yes my mountain flower and first I put my arms around him yes and drew him down to me so he could feel my breasts all perfume yes and his heart was going like mad and yes I said yes I will Yes.

— James Joyce, Ulysses

We like to think, in this country, that we can invent and reinvent ourselves at will. But we are born embedded within a matrix of possibilities, in which most of the paths forward have been blocked forever. Are we blessed with brains, or beauty, or ambition, or none of these? It doesn't matter. For as we move forward on our chosen path, we spiral inexorably downward, in ever narrowing circles, as the funnel of our potential narrows with age and circumstance to its inevitable conclusion.

And yet, since most of this is beyond our control—if not indeed our very imagining—is it not incumbent upon us to make the most of our passage? Should we not struggle against the tightening bonds? Should we not "rage, rage, against the dying of the light"?

You already know the answer. The answer is yes.

... and I thought well as well him as another...

Because the spiral is fun. The spiral is beautiful.

The spiral is all we have.

Happy Birthday, Norma Jean.


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