Saturday, June 30, 2007

It's Good to Be the King

Just when my faith in humanity was beginning to languish at a low ebb, due to the recent dust-ups surrounding the Blackstone IPO and the Bear Stearns hedge flush—and the utter failure of anyone in the Lynwood Jail to slip a shiv in between Paris Hilton's ribs—along comes The Wall Street Journal to save the day. I guess they got the word from Washington that they should stop beating up on big Republican campaign donors titans of finance and turn their focus back on Corporate America.

So, in dutiful fashion, they ran an article this weekend on the use of corporate jets by CEOs' spouses and other perks of the executive suite.
When Nicki Mulally wants to travel, she can usually hop on one of Ford Motor Co.'s Falcon twin-turbo jets.

The reason: She's married to Alan Mulally, Ford's chief executive.

To woo Mr. Mulally from Boeing Co. last fall, Ford promised that his wife, five children and guests could fly on corporate aircraft without him, as long as he authorizes the travel. Personal flights by Mr. Mulally and family members cost Ford $172,974 during his four months with the auto maker last year. A Ford spokesman declines to disclose the family-member and guest component of that sum.

The families of top corporate executives lead gilded lives, supported by multimillion-dollar paychecks and cushy perquisites. But many relatives of executives and directors get perks of their own. They enjoy trips, gifts, recreation, medical check-ups and product discounts -- all on the stockholders' tab. Some companies even cover the resulting tax bill.

Now, I don't know about you, Dear Reader, but I detect a distinct whiff of disapproval in these words. I guess the WSJ takes umbrage at the fact that Mulally famille racked up forty-three grand a month in flight expenses on the company dime, even though Mulally père took home 28 large for the four months he spent on the job. They also seem to sniff at the fact that the spouses and children of senior execs at Nordstrom get a 33% discount on purchases at the company store, even though the rank and file only score a 20% break.

(Well, I guess this is just one more example of the occasionally bizzare split personality syndrome over at the Journal, which oscillates unpredictably between fawning adulation of miniature colossuses bestriding the financial markets and pursed-lip disapproval of the peccadilloes of their much taller CEO brethren.)

But I think the Journal has got it wrong. These CEO wives they so casually disrespect are really tireless servants in the cause of their husbands' companies. They crowd onto garish, gold-plated G V jets to join their husbands at all-expense-paid client entertainment events in Boca, even though they would much rather eat pretzels and read American Way magazine in the middle seat of an MD-80 on the way to visit Aunt Millie in Omaha. They bravely set their teeth and spend $75,000 a year at high end department stores—all in the name of unpaid market research—when they would much rather stay home and order inexpensive jewelry from QVC.

And if these spurs are not enough to persuade these matrons to sacrifice their values and principles, along comes the Chairman of the Board, who insists that Mrs. CEO and her brood fly privately in the interests of "security." By which, he usually means to keep a close eye on the Imperial Hubby, so he does not slip into dalliance with a comely private stewardess or eager young personal secretary. After all, anything which can prevent Acme, Inc.'s CEO from spending 50 hours a week in depositions with divorce lawyer Raoul Felder is definitely in the interest of shareholders.

So brush away a tear of thanks, and light a candle for those selfless CEO spouses, who upend their quiet, tidy lives for the oppressive swirl and glamour of Gulfstream jets and tax-free shopping sprees. They do it all in the name of love.

© 2007 The Epicurean Dealmaker. All rights reserved.

Thursday, June 28, 2007

Marks in the Sand

Felix Salmon put up a nice commentary today on an article in today's Financial Times which delved into the mess surrounding collateralized debt obligations (CDOs) backed by sub-prime mortgages. In it, he identifies four underlying risks in the current CDO situation and then correctly concludes that we cannot predict a priori that they will combine to push the market off the rails:
Subprime defaults can, in theory, pass through into defaults on CDO tranches. That, in turn, can, in theory, trigger CDO liquidations. That, in turn, could mean the amount of liquidity in the credit markets drying up. And that, in turn, will mean that subprime borrowers find it much harder to refinance – thereby increasing the chance that they will default.

But while all the risks are real, the linkages between them all are far from clear, and the different risks don't necessarily cascade onto and exacerbate each other in this way. They might – or they might not. If investors turn out to have reasonably strong stomachs, they might not want to liquidate at prices well below their entry points. And CDOs themselves, even the ones based on subprime mortgages, might not default nearly as much as homeowners. And without the passthrough mechanism of risks two and three, the vicious cycle loses a lot of its teeth.

So there is cause for concern, to be sure. But there isn't cause for panic.

This is correct as far as it goes. But it misses an important aspect of the puzzle which the FT article authors point to in their article. This is the fact that, to date, the CDO "market" has been largely theoretical:

[U]nlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading.

Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use – and thus what value is attached to their assets.

This is the origin of the market argot "mark to model," which stands in contrast to the more traditional "mark to market."

The models used are sophisticated, but they are just that: models. Therefore, many investors in CDOs look for confirmatory quotes from third-party data sources, the banks that sold them the paper in the first place (hmm ...), and levels implied by current credit agency ratings. For reasons I will leave to you Dear Readers to discover, all of these supporting "market" quotes are flawed, and demonstrate a structural inertia that may not reflect true underlying fundamentals.

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen’s Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used – which had been supplemented with brokers’ quotes.

Furthermore, there is little incentive or outside pressure for a CDO investor to push for accurate security values, especially when these may be below the current "marks" in its portfolio.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits – even when markets fall.

So why is this so important, and why does it indicate a potential flaw in Felix's reasoning?

Well, the secret sauce in the CDO market stew—as in many, many other asset classes worldwide—is leverage. Many of the investors in CDOs and other structured financial products are hedge funds, and many of these have justified their hefty fee burdens to investors by using leverage to juice up returns. Buy assets yielding 6 to 8% and lever them up 3- or 5- or 9-to-1 and presto, you're delivering hefty double-digit returns to your investors, even after 2-and-20 fees. But, as anyone who has bought a stock on margin or taken out a mortgage on a home (at least recently) can tell you, leverage cuts both ways.

Hedge funds get their leverage from Wall Street, and they are not stuck with that old 50% Reg T initial margin requirement that you, me, and Aunt Madge have to pay. No, their initial and maintenance margin is determined by their prime brokers using sophisticated "value at risk" (VAR) models that usually require substantially smaller margin balances. Typically, these VAR models set comfort bands based upon some estimate of the future volatility of the underlying security (or portfolio of securities) which by necessity is heavily influenced by historical volatility. But if, for example, CDO marks in broker dealer and hedge fund portfolios have been artificially elevated—and their associated volatility has been artificially dampened—by marking to model in the absence of true market price data, what happens when someone liquidates a position at real market prices which are substantially below the mark? I'll tell you what: all hell breaks loose.

First, the prime brokers reset their hedge fund clients' margin requirements to match the current lower market prices. Bang! First margin call. Second (or simultaneously), the bank resets the input expected volatility in its VAR model to reflect the new, more volatile behavior of the securities. Bang! Second margin call. All of a sudden, a hedge fund that was sitting fat and happy with a portfolio of nicely behaved CDOs on its books is looking at a huge margin call and usually no way to meet it without liquidating securities. Oops. Fire sale, look out below.

Furthermore, if the broker dealers are holding meaningful inventories of CDOs and other structured products on their books as well—which is often the case—a general decline in price levels will put their own highly levered balance sheets under pressure, which has the knock-on effect of dampening their appetite for buying such securities from their clients and otherwise providing market-making liquidity. And, other things being equal, less liquidity means lower prices. And lower prices ... well, we saw what those caused in the preceding paragraph.

Maybe this is why Wall Street pulled back from the brink when it came to liquidating collateral in the Bear Stearns' CDO funds:

So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.

In other words, they saw just how deep the abyss was, and they chose to break for tea instead.

A similar risk dynamic exists in any market which consists of relatively illiquid, uncertainly priced securities and which has a material portion of its participants indulging in margin leverage. Now, I do not claim to be a market expert on CDOs, but I think I can assert without fear of contradiction that a material portion of investors in CDOs are in fact hedge funds which employ leverage as part of their investment strategy. And all it takes is a few such forced sellers to turn a market decline into a comprehensive rout.

This is the trick. Even if a hedge fund manager is convinced that the market is underpricing CDOs right now, he will have to sell in order to meet his broker's margin call no matter how strong his stomach is. That is one of the instructive lessons from the Long-Term Capital Management implosion: Meriwether and his colleagues were convinced all throughout LTCM's long collapse that the market was irrationally selling into all their positions. They did not want to liquidate because they knew they were right about their portfolio's underlying value. Guess what? In retrospect, they probably were right. But that didn't help them avoid the forced liquidation and takeover of LTCM to meet their Wall Street financiers' margin calls.

A strong stomach won't help you when you've borrowed a lot of money and your broker wants it back.

© 2007 The Epicurean Dealmaker. All rights reserved.

Wednesday, June 27, 2007

J'accuse, Part Deux

Damn, now Justin Fox needs to be spanked.

This time, I nominate Ann Coulter for the job, since I know she looks good in bondage gear, and Maureen Dowd is all tuckered out from whacking Holman Jenkins' butt as punishment for his previous misdeeds.

Mr. Fox, who styles himself over at Time magazine as "The Curious Capitalist," has blundered into my field of fire with the following comment, which he appended to an otherwise anodyne catalogue of corporate tax rates around the OECD:
As I've studied the private equity taxation debate, I've become more and more convinced that the private equity boom of the past decade in the U.S. has been driven in large part by tax arbitrage. By buying corporations and then loading them up with enough debt that they no longer have any taxable earnings, then paying their partners with "carried interest" that for reasons that have more to do with history than logic is taxed as capital gains instead of as ordinary income, the private equity firms are doing an end run around the U.S. tax system. When things like that happen, it's always worth asking whether we should be saying shame on those private equity firms or shame on the U.S. tax system. [emphasis his]

Arrrrggghh! No, no, no!

By saying that the spectacular growth in private equity over the recent decade "has been driven in large part by tax arbitrage," Mr. Fox stumbles pell mell into the same reductionist trap that Holman Jenkins did just a week or two ago. Attentive readers will remember that I pilloried Mr. Jenkins in these pages for asserting without qualification that "any tax is a disincentive" to economic behavior. Mr. Fox now appears to proudly display the opposite side of the same counterfeit coin, viz., that tax incentives are the primary drivers of economic activity, in this case private equity.

Now, I have already acknowledged—if such acknowledgement was even necessary—that tax incentives and disincentives do indeed influence economic behavior. And, when they become large enough or comprehensive enough (e.g., the personal mortgage interest deduction), they can introduce meaningful distortions into otherwise market-driven behaviors. This is common sense, and common experience. But to aver that the corporate interest expense deduction and the treatment of general partner returns as capital gains rather than income are largely responsible for the boom in private equity is to put a very large cart in front of two very small horses.

First of all, the corporate interest expense deduction which Mr. Fox flags for our attention has been available to all corporations, of every stripe, for many, many moons. The income tax code has indeed favored borrowed money as an element of any corporation's balance sheet, so much so that the tax shield available to corporate borrowers has become enshrined as a permanent feature in our favorite unprovable financial theorem, the Capital Asset Pricing Model. The US government, for inscrutable reasons of its own, has offered companies an economic incentive to borrow for a long time. (Your Faithful Correspondent is old enough to remember when the IRS used to allow individuals to deduct personal interest expense from their tax bills, too.) Interestingly enough, most corporations, public and private, have been characteristically leery of becoming profligate debtors, notwithstanding the 35% after-tax carrot Uncle Sam has dangled in front of their noses.

Not private equity, though. Sensibly enough, they have figured out that if the tax collector is willing to juice their after-tax returns to equity with a hefty interest rebate for borrowed money, they should soak willing credit providers for all they are worth. Why not? But the interest expense tax deduction—which, as I have pointed out, is available to every corporate entity—is simply gravy. The bulk of the juice to equity returns in most leveraged buyout deals comes from buying a company at X and selling it three to five years later at (for example) 1.6X. Let's say in this example that the PE fund only ponies up 30% of the purchase price in equity and raids the pockets of Wall Street banks and their bitches, hedge funds, for the rest. Then, anyone with a functioning calculator can figure out that you will net 0.9X upon sale (assuming, as is the case now, that your creditors do not require you to amortize or pay down any debt principal), for a very respectable return of three times your money. While adding a nice little fillip to the mix, the interest expense tax shield in this instance is overwhelmed by the true economics of the trade, which is leveraged price appreciation. They won't tell you this, but private equity guys would do this type of trade even without the interest expense deduction.

Mr. Fox next alludes to the capital gains tax break which private equity—along with venture capital and partnerships of all sorts and descriptions—receives on carried interest. Now this is indeed a very nice tax break for the private equity professionals who do the work of buying, overseeing, and selling portfolio companies. With it, they get to pay lower capital gains taxes on their earnings, even though they get a 20% slice of the profits but only contribute somewhere in the neighborhood of 3 to 5% of the actual equity to a buyout. I have blathered on in these pages repeatedly about this little goody, so I won't repeat myself here. Suffice it to say, however, that all this tax preference really does is encourage more people to become PE professionals, since it allows an ambitious finance professional or hanger on to pay (lower) taxes on his or her labor as if he or she were an investor, rather than a common wage slave like a CEO or investment banker. But the limited partners who pony up the vast majority of funds used in the PE business already get capital gains treatment on their investments—like every other slob with a Charles Schwab account and 300 shares of Microsoft—so capital gains treatment for carried interest has the exact effect of nada, zilch, zero on their decision to allocate funds to that asset class.

And here we come to the rub. Private equity has boomed in recent years, but not for the tax reasons Mr. Fox claims. It has boomed because it has been successful, thereby attracting all sorts of LPs who want to invest their capital in an asset class (or way of investing) that delivers good returns while offering diversification from other more liquid traded asset classes. It has boomed because there has been a coincident global liquidity glut in the credit markets, which has delivered very low-rate, almost condition-free debt financing to PE firms to grease their acquisition of more and larger companies. And it has boomed—in the face of this massive dual influx of debt and equity capital—because it has continued to be able to find plenty of target companies, both public and private, which it can buy for X and sell for 1.6X. Private equity indeed comprises a larger part of the capital markets and the M&A scene than it ever did, but this is because there continues to be a very large number of underappreciated, undermanaged, and underinvested companies out there in the economy that are ripe for the kind of transformational investment private equity does so well. And it appears that there are a lot more of them now than we ever thought there were in the past.

Paying taxes is a drag, a burden, and a source of friction in economic activity. Less friction is a good thing, and makes any gainful economic activity relatively more attractive. But the economic activity has to be gainful in the first place to attract peoples' energies and capital. We all buy our lunch and pay our rent with after-tax dollars, after all.

And the last time I looked, Steve Schwarzman and Henry Kravis would still be able to afford a very nice lunch, even if they paid the top marginal income tax rate like the rest of us.

© 2007 The Epicurean Dealmaker. All rights reserved.

Monday, June 25, 2007

Mere Anarchy

Bill Gross is at it again.

The Chief Poobah and Prognosticator at PIMCO has just released his July Investment Outlook, and it's a doozy. Paris Hilton, "six-inch hooker heels," and Heidi Fleiss, and those are just the G-rated comments. He saves his most scathing remarks for that seething cesspool of economic turpitude, residential real estate. Yikes!

Although this bond guru is in dire need of an editor—the first reference to a Petri dish was spot on and apropos, the second simply a distraction—his message is unmistakable. In vilifying the great unwashed of the credit markets, and their supposed guardians the credit ratings agencies, he sounds like nothing less that a town elder bewailing the loose morals and bad behavior of the young.

For an interesting echo in the kultursphere, we could turn to a piece in The New York Times today about Girls (and Boys) Gone Wild in Romantic Rome:
“It is unbelievable,” said Flaminia Borghese, president of a homeowners’ group in the historic center that is demanding greater noise control measures and police patrols. “There is a total lack of control.”

Ms. Borghese seems uniquely suited to lead the charge for decorum: she is a descendant of the House of Borghese, a family of noble and papal background. She faults the city for issuing far too many restaurant and bar permits and the police for failing to enforce noise control ordinances. “The foreigners come here because they know that they can do whatever they want,” she said. “Nobody says anything.”

Now, being myself already on the rapidly accelerating downslope of life into crusty curmudgeonhood, I can sympathize with both Mr. Gross and Ms. Borghese about the careless disrespect and boorish irresponsibility of the Youth of Today, whether in the bars of Sunny Rome or the leafy enclaves of Hedgefield, Connecticut. But I am not so far removed from my youthful peak that I cannot appreciate the casual vigor and energy of youth, either, and the sense of invincibility and novelty which drives the young to assume risks and take liberties which their elders would not contemplate. From such energy and thoughtless confidence comes the promise of the future, albeit with the occasional hangover or busted hedge fund to show for it.

So today I will remain firmly ensconced on both sides of the fence, and will not give voice to either the worries of wisdom or the enthusiams of optimistic youth. Who has contributed more to humankind: Sober Experience or Youthful Vitality? I cannot say.

What I will say, however, is that in my experience the curmudgeons have been pretty good at predicting the hangovers.

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

Surely some revelation is at hand;
Surely the Second Coming is at hand.
The Second Coming! Hardly are those words out
When a vast image out of
Spiritus Mundi
Troubles my sight: somewhere in sands of the desert
A shape with lion body and the head of a man,
A gaze blank and pitiless as the sun,
Is moving its slow thighs, while all about it
Reel shadows of the indignant desert birds.
The darkness drops again; but now I know
That twenty centuries of stony sleep
Were vexed to nightmare by a rocking cradle,
And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?

— W.B. Yeats, "The Second Coming"

© 2007 The Epicurean Dealmaker. All rights reserved.

Sunday, June 24, 2007

Ouch, Babe

Apparently I missed this little morsel of goodness back in March:
Vice Chancellor Leo E. Strine Jr., who often presides over big deal-related cases at Delaware’s Court of Chancery, offered his opinion on [the] hot-button issue [of advisory conflicts at big investment banks].

In a panel discussion Thursday at Tulane Law School’s Corporate Law Institute, Vice Chancellor Strine suggested that a conflict-free bank is not always the best choice.

“I question bringing in a Mickey-Mouse-size bank to [represent] a go-shop,” he said on the panel. “I still err on the side of repeat players” — meaning banks that may already have an interest in a company or a deal — who “know the tricks of the game.”

A pure adviser, he suggested, can sometimes end up being a “purely ignorant adviser.”

This line of discussion brought out what is likely to be one of the most memorable quotes of the event. It was spoken by panelist Robert Kindler, vice chairman of investment banking at Morgan Stanley.

Referring to the universe of big banks such as his own, he said: “We are totally conflicted — get used to it.”

Now, I would expect a weasely little soundbite like that from Kindler, who seems to have had trouble figuring out which wing of the House of Morgan he wants to inhabit. But Strine?

So much for asking that little bugger to be on the Advisory Board of my "Mickey Mouse" advisory boutique. Piss ant.

Hat tip to for bringing this to my belated attention.

© 2007 The Epicurean Dealmaker. All rights reserved.

Echo ... Echo ... Echo

Is there an echo in here?
Meriwether's only nagging worry was that Long-Term hadn't been volatile enough. The fund had told investors to expect an accordion, with pockets of losses tucked between its bellows, but over the first two years, in only one month had Long-Term lost more than 1 percent. "Where's the accordion?" one investor wondered. To William F. Sharpe, a Nobel Prize-winning economist and an adviser to one of Long-Term's investors, the returns seemed surreally smooth. "We distinctly asked, 'What's the risk?'" Sharpe recalled. "Myron [Scholes] said, 'Well, our goal is to get the risk level [the volatility] of the S&P 500.' He said, 'We're having trouble getting it that big.'"1
* * *

The strategy paid off for a long time -- so well that in August 2006 Mr. Cioffi's team created a similar fund that would rely significantly more on borrowing to fund its investments to boost returns. At the time, the High-Grade fund had returned more than 36% in less than three years, according to documents reviewed by the Journal. By January 2007, it had gone through 40 months without a decline, and boasted a cumulative return of 50%.

The first quote, of course, is from Roger Lowenstein's book When Genius Failed, which chronicled the rise and fall of Long-Term Capital Management. The second quote is from a Page One article in The Wall Street Journal this weekend on the developing story of the potential collapse of Bear Stearns' two hedge funds connected to the subprime mortgage loan fiasco.

The parallels don't stop there. This from the September 1998 meeting held at the New York Federal Reserve among sixteen major Wall Street banks to discuss the rescue of LTCM:

James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term's trades—which would put it out of business—if the fund's available cash fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term's capital had been $4.7 billion. But during the past five weeks, or since Russia's default, Long-Term had suffered numbing losses—day after day after day. Its capital was down to the minimum. Cayne didn't think it would survive another day.


[Merrill CEO] Komansky recognized that Cayne, the maverick Bear Stearns chief executive, would be a pivotal player. Bear, which cleared Long-Term's trades, knew the guts of the hedge fund better than any other firm. As the other bankers nervously shifted in their seats, Herbert Allison, Komansky's number two, asked Cayne where he stood.

Cayne stated his position clearly: Bear Stearns would not invest a nickel in Long-Term Capital.

For a moment the bankers, the cream of Wall Street, were silent. And then the room exploded.2

Fast forward to this past June 14th, when the creditors to Bear's two mortgage bond hedge funds met to discuss their deteriorating condition and what to do about it:

Many attendees were puzzled by Bear's apparent unwillingness to bail out the struggling fund, according to people who were there. After the meeting, these people say, there was sympathetic talk about Mr. Cioffi, a loyalist to the firm who seemed to be getting no help in return, and grumbling over memories of the Long-Term Capital Management crisis.

That afternoon Steve Black, J.P. Morgan's co-chief of investment banking, put in calls to Bear co-presidents and chief operating officers, Mr. Spector and Alan Schwartz. "Is Bear going to stand behind your asset-management company?" he asked Mr. Schwartz, according to people who were briefed on the conversation. Mr. Schwartz said he'd get back to Mr. Black.

An hour later, he called and said that on the advice of Bear's lawyers, the firm wasn't going to get involved, these people said.

Oh, Alan. Since when has Bear had to hide behind its lawyers to DK a trade? Just tell Steve to fuck off, like you normally do.

Since then, the continuing deterioration of the mortgage CDO market and inability of Wall Street banks to trade their way out from under their exposure to the Bear funds has pressured Bear to step up and bail out its progeny. More to the point, Bear has probably realized that letting these funds go completely down the toilet would piss off its bank counterparties and hedge fund clients so much that it could put a serious dent in its ability to continue minting money in the mortgage securities market, which has been a profit driver for the firm for years.

So, at last report, it looks like Cayne has knuckled under and agreed to lend up to $3.2 billion to its less leveraged fund to bail it out.

Too bad. Profit before principles, eh?

1 R. Lowenstein, "When Genius Failed: The Rise and Fall of Long-Term Capital Management," Random House, 2001, p. 77.
2 Ibid., pp. xx–xxi.
© 2007 The Epicurean Dealmaker. All rights reserved.

Saturday, June 23, 2007

Use of Proceeds

Best post-deal commentary on the Blackstone IPO so far:
Blackstone (NYSE: BX): Stephen Schwarzman will use his cash proceeds from the IPO to buyback shares of his own soul.
Market Impact 666

It's not clear whether he'll get voting rights with that.

Hat tip to our friends and investment advisers at Long or Short Capital.

© 2007 The Epicurean Dealmaker. All rights reserved.

Friday, June 22, 2007

Backdoor Man

With the opening this morning of The Blackstone Group's $4.6 billion IPO for trading on the NYSE, I expect vast quantities of pixels and electrons to be sacrificed on the altar of public commentary, as pundits, kibbitzers, and assorted wackos of all stripes weigh in on "What Does It All Mean?"

Given the dimensions of the personal wealth event the IPO will be for Steve Schwarzman, Pete Peterson, and a few others at the company, I also predict we will see much wailing and gnashing of teeth from predictable directions on the ever-popular themes of rising income equality, preferential tax treatment for diminutive squillionaires, and the sclerotization of society arising from the upsurge in dynastic wealth creation. Being a prime offender myself in the first instance, and having already commented to the point of exhaustion in the second, I will add nothing further to the general frowst on these two issues. (Nevertheless, I predict you will not lack for reading material in this regard.)

However, I did discover a throwaway piece at the tail end of the Marketplace section of The Wall Street Journal today that might give hope to those who worry that this country's fabled social mobility is fading in the face of the rise of a new plutocracy. After all, not only do the rich seem to be getting richer, but there is also anecdotal evidence that they are procreating faster than the hoi polloi. (In my neighborhood, for example, it is a point of social pride and competition to have at least four children whom you can clothe in Hermes, take skiing in Gstaad, and send to private elementary schools at $30,000 a pop.) Some fear that the wealthy are getting so jiggy with the baby batter that there won't be any room for new entries in the privileged classes. (A little noticed provision in billionaire Mayor Mike Bloomberg's recently unveiled plan for NYC is to turn the entire island of Manhattan into a gated community for the über-wealthy, with a modest service entrance for maids and personal trainers located in the South Bronx.)

The WSJ snippet referred to a recent article in The Atlantic which talks about how the increasing use of genetic testing for diseases has had the surprising side effect of revealing just how many children are not the natural sons and daughters of their supposed "fathers." Oops.
The rate of nonpaternity can vary from community to community. The Sorenson Genealogy Foundation in Salt Lake City found that the nonpaternity rate from a sample of father-son pairs among its 100,000 volunteers is less than 2%. At the other extreme, Mr. Olson reports that an unpublished study of blood groups in a British town found that around 30% of the town's husbands weren't the fathers of their children.

Wow. Maybe "Coronation Street" isn't so unrealistic, after all.

Anyway, champions of social mobility and other egalitarians should take this as good news. It turns out that there is a lot more "mixing" going on in the gene pool than most of us suspected. This should help prevent the sort of socially constrained inbreeding among the rich that led to the demise of the Bourbons and other royal families, and it means that you do not need to be the natural child of a wealthy man to be born into wealth. Cool. Perhaps we need to rechristen such privileged souls members of The Lucky Egg Club.

There is also a gender fairness issue here. As a man, it has always struck me as unfair that physically attractive females with no other redeeming qualifications have had such easy access to the monied classes. All you need do is become a secretary, or a nanny, or otherwise put your smokin' hotness in the way of some rich man—married or not, it doesn't matter—and Presto! a couple of indiscretions and a quickie divorce later you are married to the bozo and your children are guaranteed a cushy ride for life. Hunky men with no education and no pedigree have been limited to modeling for GQ and hanging out at The Ramrod.

But now we learn that there is another path into the inner circle for men, if not for you at least for your offspring. Forget college, business school, or trying to get into a hedge fund. All you need do is become a gardener, a pool boy, or a "Manny." Then, just keep those abs chiseled and take your shirt off at every opportunity, and sooner or later the Mistress of the house will come looking for you, martini in hand, in desperate need of "a nice foot rub." Hubby will be away on business or typing e-mails frantically on his Blackberry poolside in East Hampton, so you will have plenty of time to give your children a bright and comfortable future.

Gregor Mendel would be proud.

© 2007 The Epicurean Dealmaker. All rights reserved.

Thursday, June 21, 2007


You know, it occurred to me today that I have been banging on about private equity and leveraged buyouts for months in these pages without taking into account how educated all of you may be about the particulars of the business. Some of you may have been quietly mumbling to yourselves, "Yes, I see what he's getting at, but bankers? Buyouts? What's the connection?"

For those of you Dear Readers who may be a little fuzzy on the role investment bankers play in the LBO game, here are some stills from a French documentary on the subject that should be enlightening.

You see? It really is that simple.

The entire instructional video1, 2 showing you "How does this works?" can be found here, courtesy of IBD Monkey at The All Nighter.


1 A minor quibble with the Franglish translation: Sous LBO means "under, or subject to an LBO," not "victim of an LBO."
2 Another thing: If anyone finds out who this mysterious Mr. X and Mrs. Y are, please let me know. The fact that they made 10x on their initial equity investment in Construct is pretty impressive, considering that they sold all the equipment in the business, cut safety spending, and slashed the workforce in half. I would like to put a few million euros of their "investement fund" in the Dealmaker portfolio.

© 2007 The Epicurean Dealmaker. All rights reserved.

Wednesday, June 20, 2007

Ay! Whatta Ya, Stoopid?

Much to the delight of acquisitive corporations, strategic buyers in private equity sheep's clothing (also known as portfolio companies), and M&A intermediaries everywhere, the official guardian of economic competition in this country, the Federal Trade Commission, has officially been on vacation for much of the current administration's tenure. You would be hard put to find a more merger-friendly FTC in recent memory, based on its smiling acquiescence to virtually every takeover deal put before it. If ever there was a time for Microsoft to have tried to buy Apple Computer, and consolidate its share of the computer software market to over 137%, the past seven years would have been it.

Accordingly, market observers have been mystified by the fact that the FTC has blocked the $700 million merger of Whole Foods Market with its fellow purveyor of tasteless, overly crunchy comestibles to the Birkenstock set, Wild Oats Markets. I mean, sure, Whole Foods and Wild Oats are a couple of the biggest chains of natural foods markets out there, but saying that together they would comprise a meaningful portion of the eleventy-trillion dollar US grocery market is like saying Goya's line of ethnic Mexican foods comprises more than fifty percent of the gross revenues of Bob's White Supremacist Food Mart in Cedar Rapids, Iowa. I don't think so.

So we learned with interest this morning from The Wall Street Journal that the culprit in this surprising drama is none other than Whole Foods' CEO John Mackey. Apparently, this idiot had the temerity, the stupidity, or the sheer knuckleheadedness (all related ailments) to make the government's case against his proposed acquisition of Wild Oats for them. I quote from the introductory paragraph of the FTC's request for injunction (courtesy of the WSJ):
Whole Foods' Chief Executive Officer John Mackey bluntly advised his Board of Directors of the purpose of this acquisition: "By buying [Wild Oats] we will ... avoid nasty price wars in Portland (both Oregon and Maine), Boulder, Nashville, and several other cities which will harm [Whole Foods'] gross margins and profitability. By buying [Wild Oats] ... we eliminate forever the possibility of Kroger, Super Value, or Safeway using their brand equity to launch a competing national natural/organic food chain rival to us ... [Wild Oats] may not be able to defeat us but they can still hurt us ... [Wild Oats] is the only existing company that has the brand and number of stores to be a meaningful springboard for another player to get into this space. Eliminating them means eliminating this threat forever, or almost forever."

*** We will now take a brief intermission to allow the corporate lawyers in the audience to wipe down their keyboards and go change their shirts, after they spit their morning coffee all over themselves in reaction to the preceding paragraph. Thanks to the rest of you for your patience. ***

What a moron. (Perhaps Carl Icahn was right about corporate CEOs. This one certainly appears to be a prime specimen.)

Never mind the blustery self-delusion of Mr. Mackey's assertion that taking out Wild Oats will fix Whole Foods' competitive situation "forever." (After all, what are the real barriers to entry to flogging granola and wheat germ?) Who let this fool put this shit down on paper?

Now, in all fairness, Mr. Mackey's rationale is not an uncommon one in M&A land. In addition to revenue and cost synergies, increased market share, and getting a much bigger corporate jet in the fleet, eliminating a competitor in your industry can be one of the chief reasons any company decides to buy another. It is a time-tested business practice: if you can't beat 'em, buy 'em.

Normally, however, even the most insulated CEO is sensitive to the fact that the government has taken a dim view—since, say, the turn of the last century—to the creation of unregulated monopolies, and they do their best to put forward a case that persuades the regulators that such is not the projected outcome, intended or otherwise, of their merger. Usually this consists of an elaborate exercise in persuading the FTC to define the relevant market as one in which the combined entity will remain beset on all sides by fierce and unrelenting competitors, who will make sure, through the mechanism of the invisible hand, that Aunt Millie can buy her goats milk tofu as cheaply as possible.

In contrast, however, this doofus seems to have gone out of his way to leave a paper trail the size of the wake from an aircraft carrier showing exactly the opposite. Among other things, Mr. Mackey characterized markets where Whole Foods or Wild Oats operated alone as "monopolies" and documented Whole Foods' strategy to enter Wild Oats' monopoly markets as increasing competition and lowering prices to consumers. Furthermore, he broadly dismissed other purveyors of natural and organic foods—including WalMart, Trader Joe's, and mainline supermarket chains—as dabblers who did not pose effective competition to dedicated natural foods sellers like Whole Foods. Dismissing WalMart as an effective competitor? What was this guy thinking? Now, he may be right, for all I know, but I can tell you that my filing to the FTC would have consisted of a single word: WalMart. Nuff said.

Of course, the real villains in this piece are the lawyers who were supposedly advising Whole Foods. Even a lowly investment banking associate knows not to put the phrase "market dominance" or any of its variants in the Merger Rationale section of a preliminary pitch book to a corporate client, for fear it will be found in the legal discovery process of a merger application or its litigious aftermath. Failure to comply with this rule usually leads to a surgical strike by a Skadden Arps associate, who swoops in and chops the offending banker's pecker off with a rusty Bowie knife. Whole Foods' lawyers, whoever they are, had better be on a plane to some vacation spot far away, because letting their client put pen to paper appears to be one of those "sins for which," as a Managing Director I used to know loved to say, "even your death will not atone." I suggest Zimbabwe.

In the meantime, I think the only way the Whole Foods/Wild Oats merger is going to revive would be for Rush Limbaugh to become President. He might think imposing higher prices on a bunch of rich, hemp-wearing ex-hippies in Boulder, CO and Portland, ME would be a public service.

And, if any one of you runs across Mr. Mackey, please give him a big dope slap from me. I suggest you deliver what those dope-slap experts the Magliozzi brothers (who so kindly provided the instructive diagram at the top of this post) have called a "scupalona:"

If the infringement is not too serious, start just below shoulder level. For a serious infraction, begin your dope slap far down, near the waist. We refer to this latter dope slap as a "scupalona." The scupalona is a massive dope slap--the mother of all dope slaps, as it were.


© 2007 The Epicurean Dealmaker. All rights reserved.

Monday, June 18, 2007

Give Back; Feel Better

Lest you have any doubt, Dear Readers, rest assured that Your Dedicated Correspondent in All Things M&A is as red in tooth and claw as the next fellow. I am sure that I have left just as many broken, twisted bodies in my bloody wake as the next investment banker. Nevertheless, on occasion even I have been known to look up from the grindstone and take a glance at the wider world.

Nine times out of ten, this mood passes quickly, and I can put it down to gas or a bad oyster. On the tenth occasion, however, some inkling of the broader context in which I and my fellow mercenaries ply our trade does seep dimly into my consciousness, and I am inspired to the uncommon act of reflection.

My thoughts turn this direction today in reaction to the news that Blackstone co-founder Pete Peterson, who is pulling out somewhere in the neighborhood of $1.9 billion from his company's upcoming IPO, plans to give the lion's share of his loot to charity. Now this—whether you like the man or not (I do)—is an admirable thing. Certainly more admirable than recent behavior by certain shorter, more socially active colleagues of Mr. Peterson.

So, in tribute to Pete the Greek's magnanimous gesture, I offer below a short list of noble causes which would be delighted to accept your filthy lucre and tainted simoleons should you feel compelled to atone for your sins, or simply share your monetary spoils with a few deserving fellow travelers on this small blue planet. While there is nothing inherently more noble or deserving in these organizations than many, many others, the Dealmaker family likes them because they are slightly off the beaten charity path, they tend to put your hard-earned dollars directly to work in very focused ways, and they are just as happy to receive $25 in cash from a struggling Financial Analyst as $1 million in Google stock from a hardened Managing Director. Plus, you can give to most of them directly online.

If you have better ideas, by all means donate there. (And send suggestions for similar charities to TED at epicureandealmaker [at] hushmail [dot] com: I am always looking for good ideas, and your suggestion may just make it onto this list, which will become a permanent feature of this blogsite.)

Give back, and feel better.

The Nature Conservancy — They save endangered ecosystems the old fashioned way: they buy them. Capitalism at its finest.
The Doe Fund — (For New Yorkers) They help the homeless with jobs, training, and support. Plus, they pick up a hell of a lot of trash around the city.
The Smile Train — Two hundred and fifty bucks fixes an impoverished kid's cleft palate, and gives him or her a shot at a normal life. Cheap, cheap, cheap. And efficient, too.
Heifer International — Give a family a cow, a goat, or some bees—plus some training—and they just might be able to pull themselves out of grinding poverty. Cool concept, and the little Dealmakers love it.
Phoenix House — Rehab that works. Lots of folks who aren't celebrities need it, too.
Team for Kids — (For New Yorkers) They run after-school fitness programs for New York City public schoolkids. (NY City has not offered organized phys ed classes in public school for decades. I kid you not.) Plus, they get crazy people to raise money for them by running in the New York City Marathon. Excellent.
Row New York — (For New Yorkers) Historically, rowing was a sport for rich white males. This outfit teaches the skills and discipline of the sport to public high school girls in NYC. Making young women better butt-kickers since 2003.

© 2007 The Epicurean Dealmaker. All rights reserved.

Friday, June 15, 2007


Holman W. Jenkins, Jr. should be taken out to the woods and spanked.

I nominate Maureen Dowd for the job, because I hear she looks good in black leather, and I understand she and Holman have had these sessions before.

How, you may ask, has Junior incurred my wrath? From his bully pulpit at the soon-to-be New York Post-it Note The Wall Street Journal, Ol' HJ penned an opinion piece on Wednesday entitled "This Year's Man Behind the Tree" (you see now why I suggest the forest for his birching), which annoyed me.

Normally Mr. Jenkins resides comfortably at #6 on my Not Usually a Complete Idiot list of business commentators, which is pretty strong praise from me, given my view of pundits in general. And, in fact, I initially had little to quibble with when I perused his screed, which opened by rather presciently noting that Congress was gunning for private equity's current tax incentives and that one could have foretold this by remembering an old Beltway truism:
When vast new fountains of wealth open up in the economy, Congress must receive its ransom in campaign donations.

He then moved on to a reasonable summary of the carried interest imbroglio which I have recently addressed in these pages. But then he just had to go and ruin the ride:

But what about the economic issue? Any tax is a disincentive, so let's just say the tax code imposes less of a disincentive than it might to what private equity does: buying, overhauling and reselling companies. Is there a public-interest reason suddenly now to use a tax-policy bludgeon to reduce the attractiveness of this business?

Holman, Holman, Holman. Have you been sneaking around with Arthur Laffer again? Do we really need to have this conversation once more?

Saying any tax is a disincentive to economic activity is like saying friction is a disincentive to driving. It is prima facie ludicrous and utterly wrong-headed. Now, I completely agree that very large or punitive tax rates can indeed disincentivize economic actors from pursuing the penalized activities (or at least chase them offshore to a more welcoming tax jurisdiction, a la the Beatles and other high earners during the 60s and 70s, when the top marginal tax rate in Britain topped out near 95%). But any tax? Bullshit.

Taxes are a part of life, and a remarkably pervasive one, too, the last time I looked. I don't know many people who undertake to feed their families, pay their rent, or accumulate wealth nowadays who expect to do so with pre-tax dollars. Now, we may not like the bite the government takes out of our paycheck, or even approve of all the uses to which it puts our hard-earned cash, but I think most of us realize that paying taxes is one of the prices we pay for living in society and therefore a normal cost of doing business.

Making the opposite argument reminds me of those pitiful souls I occasionally run across in my travels around Corporate America who hate any and all taxes so much that they are willing—nay eager—to spend sixty cents on the dollar to avoid a 40 cent tax. Usually, of course, it is with shareholder money, so the executives in question do not worry about the upside-down economics of pursuing their particular obsession. And obsession it is, seemingly driven by some pathetic nostalgia for a prelapsarian Golden Age of high collars and no taxes when billionaires could accumulate fortunes free of tax and machine gun striking mine workers with impunity. Well, wake up gentlemen, and smell the soy milk latte: those days are gone for good.

Follow along with me now through the rest of Mr. Jenkins argument. He asks why Congress should want to impose a bigger disincentive (tax) on private equity now and "reduce the attractiveness of this business." But wait: I thought it was pretty clear that private equity fund managers currently pay less tax on their earnings (15% capital gains tax versus the top marginal income tax rate of 35%) than the average overpaid CEO, ludicrously wealthy investment banker, or common working stiff. So, if I understand him, Mr. Jenkins' argument is that by proposing to eliminate or reduce their current special tax break, Congress would somehow inflict a special tax "disincentive" on private equity professionals. Come again?

Only an interested special pleader or fellow traveler could argue that eliminating a special tax break to a small number of extremely wealthy and privileged investment professionals somehow amounts to the use of a "tax-policy bludgeon" against the PE business. Mr. Jenkins, you should be ashamed of yourself.

Let us not forget that the investors in private equity who pony up the lion's share of the money in this asset class—limited partners consisting of investment funds, pension funds, and the like—do not currently benefit from the carried interest tax treatment. So reversing the current tax break for private equity professionals is hardly likely to dent the appeal of private equity to its investors or, therefore, reduce the positive effects which private equity is currently having on our economy. All it will do is bleed off a little of the upward price pressure on houses in the Hamptons, co-ops on Fifth Avenue, and party catering services at the Park Avenue Armory.

And it might bleed off some of the political pressure to do something more radical that would hurt the PE industry, and consequently the rest of us.

Private equity pooh-bahs: Shame on you for not "getting the message" earlier and heading off the legislative juggernaut at the pass with a well-timed campaign contribution or two.

And Holman? You're grounded, young man.

© 2007 The Epicurean Dealmaker. All rights reserved.

Thursday, June 14, 2007

Tax Breaks for Everyone!

Recriminations are flying across the pond among the private equity pooh-bahs of Old Blighty today after senior officials of the industry public relations arm, the British Venture Capital Association (BVCA), were cut to ribbons on the floor of the House of Commons Tuesday by snarling MPs slavering for blood. Ostensibly primary on the hearing agenda was the MPs' keen interest in having the BVCA explain to them why private equity firms and their partners are subject to only 10% capital gains tax on their earnings, compared to the nominal income tax rate of 40% for high earners. The real agenda, as outlined by FT Alphaville this morning, was rather more political:
Expecting the BVCA to mount a robust, well-argued defence of the indefensible is frankly unreasonable. Expecting them to do so in the full glare of the House of Commons, while being set upon by predatory politicians, well-versed in the art of the sound-bite and salivating at the prospect of glorifying themselves by coming up with the most scathing put-down for the next days papers, is bordering on inhumane. The MPs must be cock-a-hoop. No political downside on this one.

In other words, it was a perfect opportunity for MPs to build a little of their own political capital by beating up the big, nasty private equity beast in the public eye.

Of course, the BVCA walked into this firefight wearing a big, fat target on its ass and carrying a rusty penknife for defense, so unlike Alphaville I cannot feel too sorry for them. Putting aside the issue at hand—for which the BVCA has been pitifully remiss in articulating a coherent, comprehensive, and convincing argument in defense of the current tax treatment—their cause was not helped by Nicholas Ferguson's recent public remark that even he did not understand why private equity partners managed to pay less tax than the ladies who clean their offices. And Mr. Ferguson is one of them, too.

(News flash, via Amanda Palmer at Peter Linthwaite, Chief Executive of the BVCA, has volunteered to fall on his sword and resign, after he cravenly failed to block all incoming cannon fire from the Treasury Select Committee with his own body, as was his assigned task. Leading members of the BVCA are currently debating whether to string up Mr. Linthwaite's body from a gibbet for the sport of Labor MPs, Fleet Street, and other crows or grind him up for fertilizer to feed the plants in senior private equity partners' offices.)

We are experiencing a similar uproar in this country over the preferential capital gains treatment that private equity receives on its 2% management fees and 20% carried interest. I think the hullaboo in Britain has been exacerbated by the outrage many Britons feel that their PE plutocrats pay even lower tax rates than the 15% nominal rate here. The fact that PE bigwigs from the red-in-tooth-and-claw home of Rambo, George W. Bush, and Enron pay more tax than their English peers must drive the historically more egalitarian Brits batty, especially in the redistributive hornets' nest that is New Labor. Never mind that—as Alphaville notes—it has always been easier for rich residents in the UK to avoid almost all tax through the clever use of generous offshore loopholes. There is nothing like the whiff of hypocrisy to make the self-righteous more violent in their vituperations.

Many industry players, commentators, and other kibbitzers from both sides of the Atlantic and all sides of the debate have contributed a great deal more heat than light to this discussion. It has been very hard to hear the arguments over the sound of various axes grinding. Since I do not have a dog in this fight—other than a natural admiration and appreciation for the role that private equity, properly conducted, performs in the economy, and a counterbalancing appreciation that all market participants should contribute some support in the form of taxes to the institutions and structures which enable their daily livelihoods—I thought it might be useful if I introduced some measured considerations on the issue.

* * *

In the US, the basic concept of taxation falls into two buckets: income taxes, based upon monies earned from an individual's labor, and capital gains taxes, based upon returns earned by a person's invested capital. The key concept attached to income taxes is that of "constructive receipt," which means that a person is taxed only when he or she actually receives said income. An illustrative example is compensation in investment banking, which often consists for employees at listed investment banks of cash plus some sort of deferred compensation, restricted shares, options, or whatnot. When Great Big Ugly Universal Bank used to pay Yours Truly my eye-popping bonus at the end of each year, very little of this lucre was actually of the filthy, legal tender variety. Most of it consisted of some useless restricted GBUUB stock which vested over an indefensibly long time period (provided I remained in GBUUB's irksome employ). Quite rightly, the Internal Revenue Service only expected their cut when this crap vested, in other words when I actually received true ownership of the stuff. This is constructive receipt, and I can find little to complain about such treatment.

After these shares vested, I could do with them as I wished. Normally, I would sell them as fast as possible, just to reduce my excessive financial exposure to GBUUB (the trifecta of job security, current income, and personal net worth). If, however, I chose through inattention or otherwise incomprehensible logic to hold onto this stock, my investment in GBUUB looked for tax purposes like any other capital investment. The value of the stock already vested (after the IRS haircut) became the new tax basis for my new/ongoing investment in GBUUB shares, and I became subject to capital gains taxes on the gains (or losses) in excess of the tax basis of my original "investment" when I finally disposed of them. Again, fair enough.

Now, nowhere is it written that this is the only approved way for a government to tax its citizenry. We have elected in the US to make this distinction between returns to labor and returns to capital—and to tax the latter at a lower, more favorable rate—because as a nation we want to stimulate investment in commercial enterprise, on the very sensible assumption that said investment will benefit the entire economy and generate, among other boons, increased tax receipts from businesses and individuals who would otherwise be unemployed. There has been a further bias to stimulate the creation of new businesses, on the similarly sensible assumption that creating healthy, growing, tax-paying entities where none existed before has an even more beneficial effect on the economy and the Treasury's purse. This, as I understand it, is the historical background to the specially favorable treatment of venture capital investments (with their associated carried interest) under the capital gains rules.

Balancing this special treatment of returns to capital is the crucial assumption that in order to receive such favorable tax treatment, the person in question must actually have put some capital at risk. In other words, the investor must have exchanged something of real value for their investment, and there has to be a non-zero chance that the investor could actually lose some or all of it. Here is where we come to the rub with private equity.

The usual arrangement for PE is that limited partners agree to pay the general partner a 2% fee on funds under management and a 20% carried interest in the returns to the fund investments the GP makes. Many GPs have structured arrangements with their LPs to have their management fees credited toward a larger carried interest in the investments, thereby deferring recognition of current income and often converting it into capital at risk in the fund. From what I can tell, this is perfectly in keeping with the current tax regime. (After all, there is nothing illegal about deferring taxes; it is tax avoidance which is frowned upon.) The GP's partners' capital is truly at risk, since nowhere is it written that all or even any private equity investment must be a success, and many PE funds have the GP's carried interest subject to performance hurdles anyway. Likewise, any additional investment by the GP's partners of their own money into these funds should rightly be treated as a normal capital investment subject to the normal capital gains treatment.

Ah, but I can see a couple of weaknesses with private equity's argument that the status quo tax treatment should remain in effect. The first is one of structure and proportionality. In other words, if in fact what GPs do to create value is invest alongside their LPs, why do they get a 20% slice of the profits for investing, say, only 1 or 2% of the actual equity? It is like the GP gets the equivalent of founders stock in an entity that is already well past the founding stage, whereas their limited partners invest at the much higher buyout price. Or, if the value supplied by the GP—who, after all, is not the normal passive, non-insider investor we commonly think of in an investment context—really comes from the sweat of their brow and their constant attention to strategy, execution, and monetization of their portfolio investments, then why is that not properly viewed as the result of income producing labor? After all, this is what private equity firms claim they do. They work their investments; they do not sit idly back and clip coupons.

You can view this argument, correctly, as questioning the entire concept of carried interest and its associated capital gains treatment. In this sense, the argument is moot, since the tax code is clear on this front. However, this point leads directly to the second major weakness I see with the current tax treatment of private equity, which is a thornier issue, and which is harder to argue away.

This is one of intent: is a special tax treatment originally designed to encourage investment in start-ups, small partnerships, and other new businesses really appropriate for leveraged buyouts and take privates of multibillion dollar established enterprises? What are we encouraging: new job creation, improved profitability at portfolio companies, and the resulting higher tax receipts? Sure, but do we really need to give private equity an additional, non-market-based (i.e., tax-based) incentive to pursue this business? Is it really that unattractive or underinvested-in that the US taxpayers need to subsidize private equity? And why—given the fact that we want regular enterprises owned by entities other than PE funds to create jobs, grow profits, and pay taxes as well—are we giving capital providers extra incentives to invest in PE-backed firms which do the same thing?

Actually, when you think about it, we are not even giving the people who invest their cash in private equity—the limited partners and, by extension, their retirees, pensioners, etc.—any break at all. Instead, the American taxpayer is subsidizing the tax bill of private equity professionals. The current tax system is broadcasting loud and clear that we do not have enough investment professionals in private equity at all, and as many Harvard MBAs as possible should jump on the PE tax gravy train, because the US economy is in dire need of more tiny, aggressive, Rod-Stewart-loving squillionaires.

Now, the US tax code is riddled with all kinds of extra-market incentives to economic behaviors that we as a nation have empowered our elected representatives to encourage, some of which are profiled in a recent rant by PE practitioner and apologist Equity Private. But it is a known fact that tax breaks of any kind distort natural market behavior and encourage overinvestment in businesses and asset classes so singled out, whether they be residential housing, oil sands, or solar power. I find it amusing that the strident free-marketeers among private equity's ranks can be so adamant in supporting an existing special tax break which has so clearly been stretched far beyond its original intent and which is so obviously unnecessary in today's brave new world, where PE is in the ascendant.

What's next, private equity support for "green" energy?

© 2007 The Epicurean Dealmaker. All rights reserved.

Wednesday, June 13, 2007

The $7 Billion Mouse ... er ... Man

I am sure by now that most of you have read The Wall Street Journal's puff piece on Steve Schwarzman this morning. I wonder if you, like me, were struck by the rather pervasive attention writers Henny Sender and Monica Langley paid throughout the article to the subject's—how shall I put this delicately—untallness. There it is, staring at you, right from the first sentence:
Stephen Schwarzman, who stands 5-foot-6, describes himself as a scrappy "little man" who finds ways to win.

It reminds me of the classic epithet formulated by the late, lamented 1990s society rag Spy magazine to describe Mr. Schwarzman's peer and apparent nemesis in private equity, Henry Kravis: "tiny 80s relic."

Mr. Kravis is somewhat optimistically described in a few places on the internet as 5-foot-7, which would give him primacy over the Blackstone poobah, if true. Having met the man in person some years ago, however, your Dutiful Correspondent must reluctantly disagree and suggest that Mr. Kravis only cracks 5-foot-4 on those rare days when he wears paratrooper boots with lifts in them. For those of you who doubt me—and Mr. Kravis's publicists—I would point you to the following undoctored photograph on a website profiling some of Mr. Kravis's achievements. (As a point of reference, Kareem Abdul Jabbar's height is well documented at 7-foot-2.)

In any event, Mr. Schwarzman seems quite proud of his many achievements as an altitudinally-challenged go-getter:

Mr. Schwarzman says he was president of his junior-high and high-school classes; that he was on the podium on Class Day at Yale [as an aside, what the hell does that mean?]; and that he was president of the prestigious Century Club at Harvard Business School. "I'm a consistent little person," he says of his leadership abilities.

Consistent, and aggressive, too:

"I didn't get to be successful by letting people hurt Blackstone or me," he said. "I have no first-strike capability. I never choose to go into battle first. But I won't back down."

He certainly seems to be using this profile to take a few potshots at a rival or rivals unnamed.

Mr. Schwarzman says he would never go after a company just to thwart a rival firm, and that he isn't a "marauding, low-class, low-brow inflictor of random damage."

Ouch, babe. Where was that missile aimed, 9 West 57th Street? Perhaps Mr. Schwarzman was so willing to let the WSJ emphasize his lack of physical stature because he knew it would get under the skin of his rival New York Society Grandee and tycoon, Mr. Kravis, who apparently suffers in comparison.

You 6-footers reading this should not smirk, however (unless you, too, are billionaires). There is a long history of short, aggressive men cleaning the floor with their taller peers, once they graduate from high school and gain legal protection from assault and battery. Women learn this too as part of their post-high school education in life, and take it to heart. As Mrs. Dealmaker has often said, "Short men just work harder." (And she wasn't talking about yardwork, either.) That, plus the widespread tendency of short men to turn their energy and aggression to accumulating lots of money—and the attendant juicy blondes—leads me to believe that being short may be a selective adaptation in our post-Darwinian world. It could explain current statistics which show that average height in the US is shrinking, as filthy rich shrimpos procreate relentlessly with the hot babes who marry them for their money.

Don't get in their way, either. History is littered with the pathetic, taller victims of aggressive short males. In fact, this may be a cross-species phenomenon, as well, as the following profile of the famed Mighty Mouse can attest. Some of it reads just like the back story that the WSJ editors chose to omit from the article on Mr. Schwarzman.

The early, operatic Mighty Mouse cartoons often portrayed Mighty Mouse as a ruthless fighter. He would dole out a considerable amount of punishment, subduing the cats to the point of giving up their evil plan and running away. Mighty Mouse would then chase down the escaping cats, and continue beating them mercilessly, usually hurling or punching them miles away to finish the fight. A favorite move [was] to sudden[ly] fly up to just under a much larger opponent's chin and [throw] a blinding flurry of punches that [left] the enemy reeling.

... [Mighty Mouse's] arch-enemy [was] an evil villain cat named Oil Can Harry ...

Hmmm. "Oil Can Harry" sounds suspiciously like Henry Kravis to me.

But despair not, Dear Readers, if you are among the pitifully unshort: you can take comfort that Mr. Schwarzman puts his pants on one leg at a time. (At least, I think he does. You never know with these diminutive squillionaires. He may have purchased a special device which enables his pants valet to put them on both legs at once. I bet Henry Kravis doesn't have one of those.)

Short or not, billionaire or not, one-pant-leg-at-a-time or not, Mr. Schwarzman is still subject to most of the same economic and physical laws as the rest of us. And he has chosen, wisely or not, to expose himself and his firm to one of the great roulette wheels of modern society, the market for initial public offerings. For every moonshot like Fortress, Google, or Netscape, there are dozens of busted deals and failed offerings that slink back to ignominy and obscurity, often for no better reason than the IPO window has decided to shut of its own accord. I would not bet against the success of Mr. Schwarzman and his IPO, but hey, a tall guy can hope, can't he?

But, Mousie, thou art no thy lane,
In proving foresight may be vain;
The best-laid schemes o' mice an 'men
Gang aft agley,
An'lea'e us nought but grief an' pain,
For promis'd joy!

Still thou art blest, compar'd wi' me
The present only toucheth thee:
But, Och! I backward cast my e'e.
On prospects drear!
An' forward, tho' I canna see,
I guess an' fear!

— Robert Burns, "To A Mouse ..."

Mark your calendars: Blackstone's IPO is scheduled for the week of June 25th.

© 2007 The Epicurean Dealmaker. All rights reserved.

Monday, June 11, 2007

Waiting for the Barbarians

Why this sudden restlessness, this confusion?
(How serious people's faces have become.)
Why are the streets and squares emptying so rapidly,
everyone going home so lost in thought?

Because night has fallen and the barbarians have not come.
And some who have just returned from the border say
there are no barbarians any longer.

And now, what's going to happen to us without barbarians?
They were, those people, a kind of solution.

— from C.P. Cavafy, "Waiting for the Barbarians"

© 2007 The Epicurean Dealmaker. All rights reserved.

Thursday, June 7, 2007

Shades of Pemberley

It is a truth universally acknowledged, that a single man in possession of a good fortune, must be in want of a wife.

— Jane Austen, Pride and Prejudice

Were I ever to receive a damaging blow to the temporal lobes which compelled me to devise a curriculum for first year MBA students, one of the chief works I would have the eager young beavers in my charge read and comprehend—in addition to the usual dry and dusty tomes on CAPM, merger accounting, and operations research—would be Pride and Prejudice. Like many of Jane Austen's novels, I have long been of the belief that P&P is severely underrated as a how-to manual for success in both my chosen vocation, investment banking, and the broader socioeconomic sphere in which I and many of my brethren move, New York Society.

Like New York Society today, the social sphere which Miss Austen chronicled was riddled through and through by one aim, one topic of conversation, and one obsession: Money, and how to get it. Of course, the props and trappings of money during the Georgian period in England were different from those in 21st century Gotham, as were the specific ways in which men and women pursued it. But I ask you: how much real difference is there between Whites and the University Club; between "covering skreens" and serving on the Spring Benefit Committee at The Spence School? My answer? Not much.

Of course, anyone with a soul in England during Jane Austen's time was as conflicted about this monomaniacal focus on filthy lucre as are the current denizens of New York City who retain a scrap of human decency (all 36 of them). Nevertheless, practicality—then as now—dictated a certain resigned acceptance of the rules of the game. In any event, I defy you to find a more pithy and perceptive analysis of the traumas and tribulations of post-merger integration than Charlotte Lucas' speech to Elizabeth Bennet:

"Well," said Charlotte, "I wish Jane success with all my heart; and if she were married to him to-morrow, I should think she has as good a chance of happiness as if she were to be studying his character for a twelvemonth. Happiness in marriage is entirely a matter of chance. If the dispositions of the parties are ever so well known to each other or ever so similar beforehand, it does not advance their felicity in the least. They always continue to grow sufficiently unlike afterwards to have their share of vexation; and it is better to know as little as possible of the defects of the person with whom you are to pass your life."

And what are investment bankers but middlemen writ large (or not so large, depending on your perspective). We are the moneychangers in the Temple, the indispensable yet despicable greasers of commerce.

For proof of both the contempt in which many market participants hold investment bankers and our undeniable indispensability, I refer you to an early post from my reluctant inamorata at Going Private, Equity Private:

See, [private equity firms] hate investment bankers. Investment bankers sell their services by convincing a firm's owners that their firm is worth "X" and then, right or wrong, blocking even the hint of any deal that makes their wild ass guess of "X" look silly. It is like hiring a real estate agent who promises to sell your $900,000 house for $1,000,000 and then refuses to even inform you about the 6 buyers offering $925,000. Well, ok. That's not really fair. Really we dislike them because Investment bankers mean negotiations and auctions. Negotiations and auctions mean paying fair prices for what we buy. We hate paying fair prices for what we buy. We love free markets. Except auctions. Then we want illiquid markets.

Later, EP admits, grudgingly, that i-bankers can occasionally be useful, as well:

Ok, I know I said we hate investment bankers. Well, sometimes we don't hate investment bankers. "Sometimes" is when they call us trying to avoid sounding desperate because the deal they had thought was all sewn up to sell a company they were trying to dump fell through at the last minute. Their auction broke. Maybe we had bid on it but [came] in second, or third. Or not at all. Suddenly we love investment bankers. Illiquid market again.

Within the current capitalist ecosystem, investment bankers fulfill a critical intermediary role. We grease the skids, we oil the palms, we ease the path of transactions both high and low that make the great Schumpeterian wheel go around. We are the midwives of Creative Destruction, and we are as despicable, as ineluctable, and as indispensable to our current system of financial capitalism as Johnnie Cochran was to criminal defense litigation. We will never be as cute and cuddly as panda bears or meerkats, but try to eliminate us and your teetering edifice will collapse.

You see, at the end of the day, the character in Pride and Prejudice investment bankers most closely resemble is Mrs. Bennet, the mother of the five nubile Bennet daughters, whose chief and apparently sole aim in life is to have each of her impecunious daughters married off advantageously, no matter what arguments may exist for or against any particular matrimonial union. She is not very bright (although quite crafty), and she has absolutely no qualms about making a complete and utter fool of herself and her family in pursuit of a deal.

And, when both Jane and Elizabeth Bennet are married to rich and handsome men whom they happen—by completely and utterly irrelevant chance—to love, Mrs. Bennet takes full and singular credit for the happy matches.

Now there is a woman I would hire for my firm.

© 2007 The Epicurean Dealmaker. All rights reserved.

Wednesday, June 6, 2007

Pattern Recognition

I had nothing better to do this morning in between client meetings in Beantown, so I decided to trot on over to the ACG Boston Growth conference and listen in on a panel session on the state of the M&A market. (I registered as Ben Bernanke, just to see if anyone noticed. They didn't.)

I usually try to avoid such feel-good gabfests, since they uniformly sound like variations on the old Buster Poindexter song, "Hot! Hot! Hot!," but I thought this one might offer more variation than normal, since the focus of the conference and the panel was the middle market. I was wrong.

The panel was emceed by the redoutable and charming Jay Jester (I kid you not) of private equity shop Audax Group and consisted of an investment banker, a lawyer, a capital provider, and an accountant. (I am reminded of the joke about the Arab, the Jew, and the Ukranian who walk into a bikini waxing emporium, but my lawyers have warned me I cannot tell such jokes to a mixed audience such as yourselves. Sorry.)

Anyway, a great deal of call and response ensued between Jay and the panelists on the state of said market, and whether or not one should expect a great clanging and crashing sound anytime soon as the wheels come off the proverbial bus. I was unsurprised to learn that everyone remains cautiously upbeat—code words for "Who the hell knows? I am burying acorns as fast as I can before the first snow comes." And, while everyone could see signs of stresses and strain, particularly in the leveraged finance market, no-one could identify the likely catalyst for a true market shutdown.

Anodyne stuff, really, and definitely not worth me giving up reading Maxim in my hotel room while I waited for my second sell-side pitch meeting of the day. Just as I was beginning to compose a vicious e-mail to my assistant decrying her failure to pack a copy of the lads' mag in my briefcase for the trip, however, my attention was yanked back to the presentation. Jay flashed a series of charts up on the screen which compared and contrasted the annual M&A volumes in the mid market between the last M&A cycle and this one.

Now, due to the clever slight of hand he used in applying different vertical scales to the different time series, the patterns matched up quite nicely, and an unsuspecting member of the audience could draw the conclusion that, based on prior experience, we are a good three to four years away from the end of the current M&A boom. In fact, Jay then asked each of the panelists where they thought we were in the cycle, based on the last cycle's pattern: 1996, 1997, 1998, or 1999. Most of them chose 1996, which I found amusing since it implies we have a good 40% upside in deal volume from last year before it levels off for three years. Only the investment banker demurred and chose 1997 or 1998—still good, but by implication closer to the end of the cycle and less susceptible to growth in deal volume.

Inattentive readers of this blog and members of the general public might be surprised that a financial prostitute an investment banker failed to abjectly whine and grovel at the feet of a paying client and displayed even the slightest hint of behavior at odds with rampant optimism. Perhaps his relative caution was due to the fact that investment bankers always urge their clients to do a deal RIGHT NOW, before the window closes, as Jay alleged. Or perhaps it could be attributed to the banker's 20 years of experience, and having lived through a couple of real M&A cycles. I prefer to think the answer lies in the fact that of everyone on the panel, the investment banker was the only one whose business does not rely for 70% of its revenues and 120% of its profits on the current overheated deal frenzy of private equity groups.

In any event, I am sure the investment banker will soon send a Ukranian prostitute or a case of champagne to Audax to atone for his presumption, so all will be well.

In the meantime, the question of if and when the current M&A boom will stop remains unanswered, at least to my satisfaction, and probably remains unanswerable to us poor souls caught in linear time. There are a few suggestive indicators out there, like Ray Soifer's Harvard MBA index, which bode ill for the general equity market and, by extension, the M&A market. However, the optimists among us can always point to contrary indicators that show all is for the best in this best of all possible worlds.

Barring an unequivocal sign or an ineluctable argument, though, I prefer to rely on my gut. And I am telling you, Dear Readers, something just doesn't feel right.

© 2007 The Epicurean Dealmaker. All rights reserved.