Saturday, June 4, 2011

You All Know Brutus and Cassius Are Honorable Men

Much as it pains me to say it, O Gentle Readers of Tender Sensibilities, I'm afraid I must agree for once with those shills for the private plutocracy equity industry over at the Private Equity Growth Capital Council. They recently released a comment letter to the SEC's proposed rules on incentive-based compensation arrangements at systemically important financial institutions, which the Dodd-Frank financial reform act defines as any financial institution with at least $1 billion in assets.
In March, the Securities and Exchange Commission unveiled a plan to crack down on the kind of big bonuses that encouraged excessive risk-taking before the financial crisis. The proposed rules, which are expected to be completed over the next few months, are aimed at big banks and brokerage firms that nearly toppled in 2008. But technically, the proposal applies to any financial firm with more than $1 billion in assets, sweeping up private equity firms, too.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

© 2011 The Epicurean Dealmaker. All rights reserved.