Saturday, May 26, 2012

Your Village Called...

More slack-jawed, cinnamon soy latte drinkers
Villager: “Wor, she turned me into a newt!”
Sir Bedevere: “A newt?”
Villager: “I got better.”

Monty Python and the Holy Grail

You might be surprised to learn, O Dearly Beloved, that your Humble Blogosopher actually enjoys the jeremiads which periodic bank mugger and professional angry man Matt Taibbi publishes intermittently in Rolling Stone Magazine. The man is a talented and inventive writer, an excoriating polemicist, and usually funny to boot. Thanks to Mr. Taibbi, Goldman Sachs will forever be known as

a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

For that phrase alone, the surly assassin deserves some sort of permanent recognition, even if it is only a lifetime ban from Lloyd Blankfein’s country club. Of course, I rarely agree with him on the substance of many of his accusations, and I take real issue with the way he blatantly and unapologetically cherrypicks and alters facts to support his prosecutorial agenda, but there is no denying the force of his outrage on the page. Plenty of people did some really stupid shit in the years leading up to and including the financial crisis, and some peoples’ stupidity clearly shaded into criminal or near-criminal fraud, so I tend to agree with Mr. Taibbi that there is a lot of blame to spread around. I part ways with him when he tries to accuse entire firms and industries of premeditated bad behavior, and I reject his blanket attack on all investment bankers as irredeemable fraudsters and criminals. But I also believe my colleagues and I are big enough—and, ultimately, culpable enough—that we should be able take his pummeling (and occasional below-the-belt punches) without whining.1

On occasion, however, Rolling Stone chooses to give less talented and intelligent writers than Mr. Taibbi a platform from which to launch missiles at various targets in finance. This often has the unfortunate consequence that the magazine casts itself as one of the funniest self-parodies on the web, (apparently) populated and read by hairshirted, Birkenstock-sandal-wearing, cinnamon-soy-latte-drinking Upper West Side Starbucks Communists who wouldn’t recognize a stock ticker on a dare and who last balanced a checkbook in 1968 to figure out whether they had enough money to buy $50 of weed from their anarchist roommate at Berkeley. The latest example of this comes from somebody named Josh Kosman, who has written a gem entitled “Why Private Equity Firms Like Bain Really Are the Worst of Capitalism.” It’s so hairshirt shreeky it’s hilarious.

Apparently Mr. Kosman is the author of a book on the topic of private equity, too, about which one may presume he says many unflattering and unsupportive things, if this article and the book’s title are any indication. Based on some of the whoppers, special pleading, and flagrantly partisan contents of his article, I would not advise any of you Dear and Long-suffering Readers to part with your hard-earned cash to confirm my suspicions of the book’s contents further. It is not my wont to thwart the beneficent machinations of Commerce, but I suspect you would find more entertaining and informative reading on the back of a cereal box.

* * *

The faults with Mr. Kosman’s article are many, and I presume your patience is as short as mine, so I will try to be (relatively) brief. Mr. Kosman first trips my WTF-O-Meter five sentences into his piece, when he asserts, without further evidence or elaboration, that

[private equity is] a predatory system created and perpetuated by Wall Street solely to pump its own profits.

Huh? Doesn’t this clown realize that private equity is a financial industry separate and apart from investment banking? That private equity was created independent of investment banks, sometimes by former investment bankers and sometimes not, and that it is almost without exception populated by firms which have no owners other than their own partners and professionals? Private equity firms—aka financial sponsors—are clients of Wall Street. Wall Street works for them, not vice versa. Seriously, it’s like this putz just wrote “WalMart creates and perpetuates 300 million American consumers solely to pump its own profits.” Take a closer look, Mr. Kosman: the cart usually gets hooked up behind the horse.2

And, like every sustainable industry and company in history, private equity did not will itself into existence as a means to make profits and support its members’ lavish lifestyles simply because its founders wanted it to. Private equity arose in response to a real emerging opportunity in the market for corporate control which began to manifest itself in the late 1970s and early 1980s. Private equity seized upon the opportunity to buy companies using newly available sources of debt financing alongside their own and limited partners’ equity, work with management to transform those businesses, and sell them for substantial profits. In the beginning, because competition among private equity firms (and from outside the industry, in Corporate America) for businesses to buy was limited, most of the investment profits to be made came from financial engineering. Financial sponsors tended to buy stable companies with strong, predictable cash flows using very little equity and lots of debt, and then use those cash flows to pay down debt and boost the value of their equity. (This was the model very much in effect when Mitt Romney ran Bain Capital decades ago.) Nowadays, however, that simple leverage play is almost nonexistent. There is plenty of competition for businesses, which pushes purchase prices up, and most lenders now refuse to finance buyouts with less than a 30% or even 40% equity contribution by the sponsor. Nowadays, private equity has to improve the value of their portfolio companies in order to make any returns.

Second, it is clear that Mr. Kosman—much as it might surprise a reader who might rationally presume otherwise from someone who has researched and written a book on the private equity industry—has a very shaky grasp of what it is that private equity actually does. Here is his “explanation” of LBO financing for his latte-sipping, hemp-wearing audience:

Here’s what private equity is really about: A firm like Bain obtains cheap credit and uses it to acquire a company in a “leveraged buyout.” “Leverage” refers to the fact that the company being purchased is forced to pay for about 70 percent of its own acquisition, by taking out loans. If this sounds like an odd arrangement, that’s because it is. Imagine a homebuyer purchasing a house and making the bank responsible for repaying its own loan, and you start to get the picture. [emphasis his]

Uh, no, Josh. The company pays interest and any required amortized principal to its lending banks and other lenders out of its own operating cash flow. Unlike your typical owner-occupied, unrented house, you see, companies tend to generate cash from the conduct of their own businesses. That’s what a company is supposed to be. It’s an LBOed company’s cash-flow-generating capability that lenders lend against in the first place, numbnuts, not the private equity owner’s ability to make a mortgage payment like a homeowner.3

Lastly, Mr. Kosman displays his ignorance of the actual behavior of financial sponsors nowadays with this embarrassing display:

that’s when the fun starts. Once the buyout is completed, the private equity guys start swinging the meat axe, aggressively cutting costs wherever they can – so that the company can start paying off its new debt – by laying off workers and cutting capital costs. This process often boosts operating profit without a significant hit to the business, but only in the short term; in the long run, the austerity approach makes it difficult for companies to stay competitive, not least because money that would otherwise have been invested in expansion or product development – which might increase revenue down the line – is used to pay off the company’s debt.

It takes several years before the impacts of this predatory activity – reduced customer service, inferior products – become fully apparent, but by that time the private equity firm has generally resold the business at a profit and moved on.

I have countered this naïveté before, with the simple and verifiable notion that private equity firms have to not only preserve the value of the companies they buy but more importantly improve it if they have any hope to make the kind of profits their limited partners, ex-wives, and girlfriends expect and depend upon. With your kind forbearance, I will quote myself at length:

... remember: the private equity firm and its investors only make money if they take more money out than they put in. And starving a company of resources it needs to sustain and grow future earnings destroys value. Think about it: the next buyer of the company is almost certain to be a sophisticated buyer itself, and they will figure out pretty quickly if [the financial sponsor] has permanently weakened [its portfolio company’s] earnings power. If so, it will pay less, and the reduced debt balance will likely be more than offset by the lower value it offers for the entire business. Levering up businesses with huge amounts of debt and making your equity returns primarily from the paydown of debt with excess cash flow was the old model of the leveraged buyouts of the 1980s. It only worked then because private equity firms could get businesses cheaper than they can now. Fierce competition has shut this sort of financial engineering down.

So the only reliable model for private equity to make the returns it promises to its [limited partners] is to increase the earnings of its portfolio companies. And that is what they all try to do. Sure, a lot of this involves cutting costs, and labor costs are often one of the biggest line items in company income statements which can be trimmed. But private equity also looks to improve the sales and margins of its companies, and this often entails increased investment in productive assets, company infrastructure, and, yes, employees. Many financial sponsors invest additional cash in their portfolio companies over the life of their investment, in order to support increasing sales, improved productivity and margins, and occasionally add-on acquisitions. Their objective is to make the company stronger and healthier than it was when they first bought it, and hence more valuable. Financial sponsors frankly don’t care whether increasing EBITDA and free cash flow comes from cost-cutting or revenue and margin increases—a dollar is a dollar is a dollar, after all—but most of them are fully aware that the latter is normally sustainable in a way the former is not.

In contrast, Mr. Kosman seems to believe that private equity’s fundamental business model depends on selling portfolio companies to Greater Fools who do not bother to do due diligence on the past investment, current asset quality, and future business prospects of these very large, very expensive investment opportunities. This assertion is stupid on its face for sophisticated institutional investors (many of which include other private equity firms which buy companies from their peers and competitors) and—pace the embarrassing folderol surrounding the recently botched IPO of Facebook—very rare even in the case of a sale via public markets.

* * *

In closing, I will not address directly Mr. Kosman’s list of failures, near-failures, or potential future failures of private equity deals both in the industry and during the tenure of Mr. Romney, other than to note he highlights a particularly small sample set for an industry which transacts hundreds if not thousands of mostly successful deals every year. As I am sure Mr. Kosman will admit, no human enterprise admits of 100% success. There are always stinkers in every bunch. Even, one might note, among articles of financial reporting and opinion.

I will also not quibble with Mr. Kosman’s observation that private equity has taken aggressive advantage of the government- and tax-code-sanctioned deductibilty of interest expense on corporate debt for tax purposes. This is a real and meaningful subsidy from taxpayers, and private equity has always (wisely, in my opinion) taken full advantage of it. I will only note that private equity is not alone in being eligible for this treatment: all corporations are eligible for this deduction. And, given that private equity-owned companies constitute a rather small minority of all taxpaying corporations in this country, it is worth noting that taxpayers subsidize far more debt owed by non-PE-owned companies than by those which are.

I have asserted elsewhere and often that private equity is a natural, productive element in our current system of financial capitalism. It is neither evil nor saintly, but rather plays an important specialized role which no other class of financial institutions is capable or willing to perform. It screws up occasionally, as we all do, and its failures and negligences should by no means be given a special pass just because somebody who used to do it years ago—when it was a very different industry—happens to be running for office. By the same token, we should not encourage ill-informed, underresearched, ignorant attacks on the entire industry for the very same reason.

Anyway, it’s time for me to go: I hear the phone ringing.

Oh... It’s for you, Josh.

Related reading:
The Rape of Persephone (January 29, 2012) — A rather thorough and relatively clear (for me) primer on private equity
J’accuse, Part Deux (June 27, 2007) — Private equity and the tax deductibility of corporate interest expense
We Didn’t Start the Fire (December 7, 2009) — A rant on the non-role of private equity in the recent financial crisis, and links to posts on the issue of carried interest

1 Fisking Mr. Taibbi’s various attacks on my industry alone would constitute a full-time job, and I have a day job to consider. Furthermore, the man is no idiot (unlike, say, above), so a comprehensive response to many of his accusations would require careful research and closely argued reasoning. It is no task for a hobbyist commenter, and that is without question what I am.
2 Which is not to deny what I will (here) charitably assume is Mr. Kosman’s real point: that private equity’s activities—buying and selling companies, doing IPOs, and raising debt to finance acquisitions—are immensely profitable for Wall Street. Financial sponsors, as a class, are the largest fee payers to investment banks around. Believe me, we are very happy that they exist and require our services as often as they do. But we did not create them, and we thrive upon their sufferance, not they on ours.
3 Another unheralded toxic legacy of real estate’s implication in the latest financial crisis: overmatched, undereducated prognosticators using stupid, poorly-conceived housing analogies to explain complex financial topics. Please make it stop.

© 2012 The Epicurean Dealmaker. All rights reserved.