Fluctuat nec Mergitur

A girl came in the café and sat by herself at a table near the window. She was very pretty with a face fresh as a newly minted coin if they minted coins in smooth flesh with rainfreshened skin, and her hair black as a crow’s wing and cut sharply and diagonally across her cheek.

I looked at her and she disturbed me and made me very excited. I wished I could put her in the story, or anywhere, but she had placed herself so she could watch the street and the entry and I knew she was waiting for someone. So I went on writing.

The story was writing itself and I was having a hard time keeping up with it. I ordered another rum St. James and I watched the girl whenever I looked up, or when I sharpened the pencil with a pencil sharpener with the shavings curling into the saucer under my drink.

I’ve seen you, beauty, and you belong to me now, whoever you are waiting for and if I never see you again, I thought. You belong to me and all Paris belongs to me and I belong to this notebook and this pencil.

Then I went back to writing and I entered far into the story and was lost in it. I was writing it now and it was not writing itself and I did not look up nor know anything about the time nor think where I was nor order any more rum St. James. I was tired of rum St. James without thinking about it. Then the story was finished and I was very tired. I read the last paragraph and then I looked up and looked for the girl and she had gone. I hope she’s gone with a good man, I thought. But I felt sad.

I closed up the story in the notebook and put it in my inside pocket and I asked the waiter for a dozen portugaises and a half-carafe of the dry white wine they had there. After writing a story I was always empty and both sad and happy, as though I had made love, and I was sure this was a very good story although I would not know truly how good until I read it over the next day.

As I ate the oysters with their strong taste of the sea and their faint metallic taste that the cold white wine washed away, leaving only the sea taste and the succulent texture, and as I drank their cold liquid from each shell and washed it down with the crisp taste of wine, I lost the empty feeling and began to be happy and to make plans.

— Ernest Hemingway, A Moveable Feast

I am overdue for a visit to Paris. I suspect some of you are, too.


© 2012 The Epicurean Dealmaker. All rights reserved.

These Boots Are Made for Walkin’

These boots are made for walkin’
And that’s just what they’ll do.
One of these days these boots
Are gonna walk all over you.

— Lee Hazlewood

Her favorite position is beside herself, and her favorite sport is jumping to conclusions.

— Danny Kaye¹

Tamara Mellon, social climber, entrepreneur, and enfant terrible of cosmopolitan society everywhere—in addition to her not inconsiderable achievement as cofounder, builder, and seller of high-end global shoe retailer Jimmy Choo—has apparently followed through on her longstanding threats to bite the private equity hands that fed her. In a brief article in the fashion section [sic] of the Financial Times, Ms Mellon lays into her former partners with relish:

“What happens in private equity is they come in and they say we’re going to be a great partner. We want to hold this long term and we’re going to help you nurture and build this brand,” Ms Mellon, who left Jimmy Choo in November, tells the Financial Times. But “the day after signing, they talked about selling the business”.

She complains that, in addition to having a frustratingly short investment horizon—Jimmy Choo changed hands among three financial sponsors from 2001 to 2011—her (all male) private equity partners did not understand the business, fought her creative decisions, and refused to put additional growth capital into the firm. She came away with a very sour taste in her mouth:

Ms Mellon says that she has no problem with “people creating wealth and entrepreneurs and building businesses. It’s just how you do it. I think the private equity model is open to people who are more vultures and parasites because it’s a chaotic business . . . it draws a different type of personality.”

But don’t feel too bad for her, O Tender and Sympathetic Readers. Notwithstanding her struggles, Ms Mellon has been well paid for her forbearance. She reportedly made £85 million liquidating her remaining ownership stake in the most recent sale to Labelux. This is in addition to any money she may have already taken off the table in two preceding buyouts by successive private equity partners.²

I highly doubt the lady is short of pin money.

* * *

I am slightly surprised, however, that so obviously clever a person as Ms Mellon seems to have emerged from ten years of close tutelage at the hands of private equity investors and partners so entirely unscathed by the most basic understanding of what they do. It does seem at first blush that her successive financial partners might be fairly accused of rather unseemly haste to divest their investment in her company, given that none of them held its position much longer than three years. This is on the quick end of the normal three- to seven-year portfolio churn in the private equity world, although it is not unheard of nor particularly uncommon. But in addition to potentially itchy trigger fingers, the short tenures of each of her sponsors may have been due to little more than the outsize success of Ms Mellon’s efforts in building Jimmy Choo into a global lifestyle brand so rapidly. After all, private equity firms are in the business of making returns on their limited partners’ investment, and if a sponsor can return 2.5 to 3 times its initial investment within two to three years, it would be crazy—and arguably derelict in its fiduciary duty—not to do so. Surely this most basic fact should have seeped into Ms Mellon’s consciousness sometime over the past ten years.

It may also be true that her particular partners were unduly meddlesome in creative decisions and reluctant to put more equity to work to help build the company, but I find this hard to believe as she so baldly states it. Financial sponsors are in the business of helping their portfolio companies’ management teams build value, if only for no more complicated reason than that is how they make money: by buying a company at X and selling it some years later for a multiple of X. Most buyout firms are eager to invest additional money into their companies on top of initial buyout amounts, where it can be justified as creating additional value. Where private equity professionals are downright parsimonious, however, is making frivolous, ego-driven, or irrelevant investments to satisfy the whim of their management partners. Ms Mellon, for example, may have felt quite put out that her partners did not buy that juicy piece of New York or London real estate she mentions as a “good long-term buy” (what was it, a fancy office mansion in Mayfair or a pricey retail townhouse on Madison Avenue?), but she gets no sympathy from me. Jimmy Choo is a shoe and clothing company, not a goddamn real estate investment trust, and any investor in his or her right mind should not be remotely interested in tying up capital in an asset which has nothing to do with whether Jimmy Choo succeeds as a shoe and clothing company. Rent the damn building, fer chrissakes.

Countermanding her creative decisions about which merchandise to offer seems less justifiable, however, and runs counter to normal private equity practice. Most financial sponsors do not pretend to have the creative or operating knowledge required to run their investment companies on a long-term or day-to-day basis. That is why they hire and partner with management. But they do expect management to explain and justify significant decisions and actions to them, especially those requiring substantial investment or having material impact on the strategic direction of the company. After all, it is their (limited partners’) money which management wants to spend. Making major changes to merchandise lines for fashion reasons fits squarely into the kind of decisions financial partners on a buyout company’s board should expect to be informed and consulted about beforehand. I suspect an imperious and egotistical entrepreneur, which Ms Mellon gives every impression of being, might find that constraining or petty, but tough cookies.

For if there is a common pattern of breakdown in relations between private equity investors and their partner management teams, it is to be found in situations like this. Hard-charging, imperious entrepreneurs often mix with financial sponsors like oil and water. Private equity professionals are smart, driven, and entirely unsentimental investors who are absolutely unafraid to say no to a company CEO who wants to do something he or she cannot convince them to support. If the loggerheads continue, they are also completely unfraid to fire the charismatic visionary who founded the company and replace him or her with someone more pliant. The only thing which saves many of these bullheaded entrepreneurs is the fact that they are, in fact, very hard to replace. It is a measure of Ms Mellon’s talent, irreplaceability, and/or pliancy while her partners held the ultimate reins of power that she survived at Jimmy Choo as long as she did.³

There is a reason why financial sponsors call majority buyouts of companies “control investments.” They acquire a controlling share of the company’s shares and a majority of Board seats. They have the controlling vote, and they are not afraid to exercise it. If prima donnas like Ms Mellon don’t like it, they are more than welcome to pound sand in private.

Or cast public aspersions at their former partners in the Financial Times once the non-disparagement clauses run out.


¹ As quoted in Daniel Kahneman, Thinking Fast and Slow. New York: Farrar, Straus and Giroux, 2011, p. 79.
² I have no idea whether she did so, but it is common practice for existing management of a company bought by a financial sponsor to sell a portion of their current holdings for cash in the deal, in addition to rolling over the remainder into a minority equity stake in the newly recapitalized business. Putting aside Phoenix Equity Partners’ initial majority purchase of Mr. Choo’s stake in 2001 (in which she may have participated as well), it is likely that Ms Mellon had at least an opportunity to take three separate bites at the apple over the course of her tenure there.
³ Or fear/greed. It is also true that managers who are fired from private equity companies often lose most or all of the unvested portion of their equity stake in the company. Ms Mellon probably had strong financial incentives to submit to the wishes of her majority owners in these squabbles.

© 2012 The Epicurean Dealmaker. All rights reserved.

Stranger in a Strange Land

There was so much to grok, so little to grok from.

— Robert A. Heinlein, Stranger in a Strange Land

Simon Kuper has a lovely little piece in the weekend Financial Times today, talking about his experiences as an expatriate living in Paris these past nine years. He captures beautifully the freedom that someone living in a culture not natively their own naturally enjoys:

As an expat, you are freed from two blights that afflict people who live in their own countries: the “status dance” and the “media bubble”.

As Mr. Kuper points out, the media bubble works largely to report on and support what he calls the status dance—where everyone stands in relation to everyone else in a particular, bounded society—so they are different aspects of the same thing.

Freedom from a society's status matrix can be immensely liberating:

I can still see if someone is good-looking or nice or funny, but I don’t know what it means if they live in a certain neighbourhood or went to a certain school or know someone who is purportedly famous in France. Here, I can only dimly infer somebody’s status from their self-importance, and from the reactions of other people. I see who people look at during a conversation, whose jokes they laugh at, and I presume that’s where status lies. But I don’t care.

Nobody in Paris knows if I have status either (though they can probably guess). I think that’s what the American writer James Baldwin meant when he said he was always grateful to Paris for the utter indifference with which it treated him.

In addition, I can testify from the time I spent in London as an expat that standing outside the defined social structure makes one that much more approachable by those within it. The Brits have a well-earned reputation for being highly sensitive to class and status, and they are stereotyped as extremely reluctant to socialize outside the tight circle of friends and acquaintances they grew up with. Yet my family found most locals friendly and approachable, and we developed lasting friendships with a number of British families. Of course, it's easy to overstate this: the majority of friends we made during our stay were non-American expats, rather than Brits or other American families. It's just easier for everyone involved to establish new relationships when there are no status preconceptions or consequences on either side.

* * *

Of course, no state of social utopia can last forever. Human beings are social animals. All of us want, sooner or later, to be able to understand both our own place in society and those of the people around us. I had far more social mobility and freedom as an expat in London that I did or do in New York City, but had I stayed longer it would have dissipated. Novelty wears off. Most people prefer, over time, to discard the frisson of intercourse with the unranked and free-floating and replace it with a settled view of just exactly where everyone belongs in the social structure. I am somewhat amazed Mr. Kuper seems to have avoided this for nine years, although he may simply have become marginalized in Parisian society in ways even he is not aware of.

Newly formed social groupings follow the same dynamic. The beginning is all freedom and lack of restraint, high talking to low, strange talking to stranger. It is very exciting and liberating at first, if a bit unsettling. But sooner or later members sort themselves out, and social interactions become routinized according to proclivity, preference, and rank. Status emerges as a—if not the—dominant organizing principle of any social group, and people behave accordingly. You can see it happen to incoming freshman classes at university, new recruits at large corporations, and military inductees. You can even see such principles driving the evolution of online virtual communities like Facebook and Twitter.

It's all a bit sad, really, at least for us novelty junkies. But the social niceties must be observed.

Or so Mother told me.

© 2011 The Epicurean Dealmaker. All rights reserved.

American Baby

If these walls came crumblin' down
Fell so hard, to make us lose our faith
From what's left you'd figure it out
Still make lemonade taste like a sunny day

Stay, beautiful baby
I hope you
Stay, American baby
American baby

Nobody's laughing now
God's grace lost and the Devil is proud
But I've been walking for a thousand miles
One last time, I could see you smile

— Dave Matthews Band, "American Baby"

Let me just say at the beginning of this that I am no mindless patriot.

As a native-born citizen of the United States, I am deeply suspicious of the doctrine of American exceptionalism,¹ if only because I am deeply suspicious of exceptionalist theories—not to mention doctrines—of any kind. I am a fox, not a hedgehog, and 40+ years of observation of my species has disabused me of the notion that our behavior fits neatly into any coherent, circumscribed box. World- and system-builders need not apply within.

That being said, I concede that large aggregations of people, organized into semi-permanent sociopolitical entities persisting through time, do tend to develop distinctive and identifiable sets of behaviors and attitudes. Some people call this culture. And, notwithstanding the staggering breadth and variety of semi-permanent subcultures collected under the all-encompassing banner of the United States of America,² I think one can indeed identify a distinctly American culture.

Like most cultures, I think the American culture can best be described by a set of stories, or myths, we tell each other and ourselves. One of the most important and enduring of these is that the United States is the Land of Opportunity. Cynics both inside and outside the US and outsiders from cultures older, wiser, and/or more tired than ours may scoff, but I believe that deep down almost every American truly believes anyone can become President (or a doctor, or CEO of Goldman Sachs).³ This is an incredibly powerful belief. There is nothing magical, or special, about the political economy of the United States: nothing is materially different in the socioeconomic constraints and arrangements that characterize our country from myriad others now and in the past. Inequality and class divisions are real, persistent, and serious barriers to true socioeconomic mobility. But the mere fact that so many of us believe social mobility is possible, and indeed valuable, means that as a people we devote more time and energy into bettering our condition in life.

As a point of contrast, I have worked off and on for many years with both clients and coworkers in the UK and Western Europe. Almost to a man (and woman), these are intelligent, hard-working, and sensible individuals. Successful, too. But, like many of my compatriots who have worked with these people, I have often had to stifle a smile when my European colleague prefaces an otherwise cogent analysis about how to address a problem or opportunity with the remark

"The problem is ..."

Do not laugh. Such verbal tics are extremely revealing of a speaker's world view: what they believe is possible, and the probability of success thereof. Americans do not say such things. We are a "can do" people, and we stick to that, whether whatever we are talking about can be done or not. We are natural optimists. Most Europeans I know, for example, are not. That is culture.

* * *

Americans are famous for admiring success. Americans do not begrudge successful people their success, no matter how they earned it: through hard work, natural intelligence, luck, or a combination thereof. We admire Horatio Alger stories of scrappy youngsters who clambered their way out of the urban backwater of Queens, New York (for example) up to the pinnacle of the most successful, admired, and feared investment bank on the planet. We admire, at least in an abstract way, the youthful community organizer from a broken home who clawed his way into the most powerful political office in the world, even if we can't stand his politics. We admire talent, and brains, and hard work rewarded, because we instinctively know they are not enough. Good luck matters, too.

And, as long as we can believe that we have a chance, too—that luck has a chance to find us and reward our own faith and effort—Americans will pull contentedly at the grindstone while simultaneously ooh-ing and ah-ing over the social and financial success of our betters. But central to this implicit social contract is the idea of fairness: that the deck is not stacked against the little guy, and that he or she has just as much chance of becoming the next Warren Buffett, or Lloyd Blankfein, or Barack Obama as the next guy. It is not a belief in fairness of outcome, but rather one of fairness of opportunity. There is nothing that raises the cultural hackles of most Americans more than learning that the game is rigged, and that the guys at the top are gaming the system in their own favor.

Now, cynics (and Europeans) might laugh at such naïvete. Of course, they say, the game is rigged; of course the guys at the top skim more than their share of the cream and leave the dregs for the hoi polloi. What's new about that? But Americans understand that too, at least instinctually. That's why we have such a long history of suspicion and hostility against Big Business, and Big Government, and Big Anything. That's why, among other things, the Tea Party movement has gained such broad-based traction in this country: it is the natural outpouring of frustration and suspicion grounded in the most basic American myths and beliefs about ourselves. We may acknowledge that is the way the human cookie crumbles in any society with unequal distribution of wealth and privilege, but we do not accept it, at a very fundamental level, as the way things should be.

* * *

That is one big reason why the ongoing scandals rocking the financial sector are creating such outrage and upset among the American polity. Citizens are discovering that a very large percentage of people whom they used to admire and envy for mouth-watering financial success earned a large portion of that success by cheating, by gaming the system, and by rigging the rules in their favor. What seems to outrage many Americans even more is that these very financiers do not seem to recognize that they have violated the implicit social norms almost everybody else seems to accept. They hide behind a defense of arrogance, superciliousness, and moral obliviousness which makes most Americans' teeth grind in frustration.

This is a dangerous situation for the plutocracy. For, when you get right down to it, most Americans are not really interested in supporting a system that is designed to preserve the wealth and privileges of those who have already made it to the top. Instead, they want one that will give as many people as possible a reasonably fair shot at reaching the top themselves. That is a distinction which seems to elude many of the wealthy and powerful. They misperceive the struggle as one of capitalism versus socialism, when what it really is is a struggle for the heart and soul of capitalism in this country. On one side is a new aristocracy of money, entrenched interests, and cronyism, and on the other is an ethos of equal opportunity for all.

It will be a long, difficult fight. Given the money and resources arrayed on the other side of the ledger, it is by no means certain the country will come out of this struggle with a cleaner, fairer system. The Augean Stables look like an afternoon's Spring cleaning by comparison.

But I am optimistic we will arrive at the right solution. Heck, you knew that already: I am an American.<sup>4


1</sup> As always, apologies to the multitudes of people who live in the Americas, North and South, who do not reside anywhere inside the capacious boundaries of the United States. If you have not already noticed, we inhabitants of the USA have an ingrained difficulty distinguishing our country from the entire hemisphere in normal conversation, if not in our own minds as well. In our—admittedly weak—defense, it is awfully awkward to say "USA-ers" or "United States-ans" all the time. (I make no apologies for Dave Matthews, who is a musician and therefore perfectly capable of defending himself.)
² It is my firm belief that someone from outside the USA who wishes to understand our culture could do no better than rent a car and spend a week or so driving across the country. The diversity of regions, people, and geography one would encounter on such a journey would truly stagger an observant pilgrim. Such an exercise, in my opinion, would also have a highly salutary effect on most Americans, who tend to be distressingly parochial and pathetically ignorant about their own country.
³ Or, perhaps what is more powerful, most of us believe anyone should be able to become President, even if we doubt it is possible. In the context of human history, this is a surprising and extraordinary belief.
⁴ History is littered with the smoldering wreckage of nations and peoples who mistook Americans' native optimism for childish naïvete, softness, or lack of resolve in the face of difficult struggles. It is unwise to underestimate us.

© 2010 The Epicurean Dealmaker. All rights reserved.

For Every Action ...

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

The bankers they don't hire will all get fired by their employers and rehired immediately with guaranteed bonuses—which are exempt from the new tax, for now—or put on retainer as fiendishly well paid independent contractors. The Freelancers' Association of Great Britain should see its membership rolls and dues receipts increase 10,000%, and HM Treasury will no doubt promptly reclassify it as a bank for tax purposes. The stately annual dance of new tax regulation, evasion, and counter-evasion will begin to resemble a cage match at the Ultimate Fighting Championships.

The only parties for whom this will be an unalloyed benefit will be tax lawyers, accountants, and corporate relocation specialists. Their spouses and families won't see much of them over the Christmas holiday, but at least they'll be able to console themselves with frozen rum punch and figgy pudding in £10,000-per-night suites on St. Barts.

* * *

Despite all the frantic squealing by outraged bankers, it is clear the UK government enacted this policy not to "recapture" excess compensation from individual employees through personal taxation, but rather to dissuade banks from paying more than nominal bonuses at all. Instead, it wants them to use the money they save to bolster their weakened balance sheets. Chancellor Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

And, as the following little spreadsheet indicates,¹ he plans to do this by making banks choose between their employees and their shareholders:

Given a hypothetical bank with operating profit before discretionary compensation of one million pounds and one employee which management intends to pay half a million quid, the three rightmost columns show the effect on both employee and net income under the new policy under three different scenarios. Under the first, "equal bonus" scenario, the employee still walks away with his £500,000 pre-tax bonus, but instead of earning £360,000 as before, shareholders take a 66% hit to net income, to £122,500. Under the second, "equal net income" scenario, bank management preserves shareholder income at the pre-policy level of £360,000, but the banker walks away with 39% fewer pre-tax shillings. Finally, in the third, "equal pain" scenario, the bank tries to share the pain of the new policy equally between employees and shareholders, and each take a 24.5% hit to their earnings.

Of course, a stubborn bank could go right ahead and pay full discretionary bonuses to its employees, and under the new policy HM Treasury would drain half the excess straight out of the bank's equity account. This hardly seems conducive toward strengthening capital ratios in the financial sector, however. Presumably the government is relying on bank shareholders to scream bloody murder should management try this, not to mention bank creditors, who will scowl with disapproval as their obligors' creditworthiness looks to sneak out the door to a Ferrari dealership in the pockets of its employees.

Interestingly enough, this scenario is also one in which HM Treasury maximizes its own tax receipts, from the personal income and National Insurance tax paid by individual bankers on larger bonuses plus the direct corporate tax on excess bonuses. The silly thing about such a scenario, however, is that the UK government would be far more likely to have to plow its higher tax revenues right back into the newly weakened banking sector in the form of more direct support. Talk about a "doom loop."

Another complicating factor in this whole discussion is that employees often make up a substantial portion of their employer's shareholder base, especially at investment banks. At the extreme, if a bank had only one employee who also happened to be the sole shareholder, a proper tax minimization strategy would be to forgo a discretionary bonus entirely and book that amount into net income. This is because the standard UK corporate rate of 28% is far less punitive than the new 50% top personal rate for high earners, plus National Insurance deductions. But how would Mr. Eddington-Smythe pay his local grocer? Borrow money from his employer, perhaps? Oops, there goes the leverage ratio again.

* * *

On this side of the pond, the evil genius cephalopods at Goldman Sachs have come up with a different approach. The firm announced today that its 30 top executives will take all their discretionary compensation this year in the form of restricted stock, which they cannot sell for five years.

In principal, this strategy actually makes more sense than the UK tax policy does in terms of bolstering banks' and investment banks' balance sheets. For one thing, it implicitly acknowledges that a bank probably should pay something more than a £25,000 bonus to highly productive employees if it expects to keep them, and it puts no explicit upper limit on that pay. For another, it conserves the gajillions in cash a bank would otherwise pay out in bonuses and replaces it with common stock, and unvested common stock at that. That bolsters both the cash and shareholders equity accounts by the amount of deferred bonuses and strengthens the company's credit position. Furthermore, as I have pointed out before, bankers who receive deferred stock compensation are the best kind of shareholders to have, from a credit standpoint, because they are involuntary, long-term providers of permanent capital. No high frequency traders, these.

However, it's worth noting that as announced this policy only applies to the thirty Executive Committee members at the Squid. So, while it may conserve $300 or so million extra cash which would otherwise have been paid out as the cash portion of these executives' bonuses under prior policy, it says nothing about the up to $10 billion in cash which could presumably get sucked out the window in the pay packets of its non-executive employees. As a public relations stunt, and a sop to Congressmen and other populists on the warpath, it is genius, and Lloyd Blankfein and the other 29 sacrificial lambs probably have enough liquidity to weather the privation. But as a credit bolstering event for Goldman Sachs, it probably nets out close to a wash.

In addition, Goldman's new policy carries a real cost, too: increased dilution for non-employee shareholders. For, as our hypothetical little exercise above should have illustrated, there is a natural struggle over the spoils within a bank between its employees and its outside shareholders. The Goldman announcement makes no disclosures on this topic, but I can assure you top management is having heated discussions with major shareholders right now over just how many basis points of net revenue will go to investors and how many to the hired help.

* * *

This argument may be quite interesting to the parties involved—and their wives, mistresses, and household staff—but it has little practical import for those of us on the outside looking in. In fact, strong arguments can and have been made that an excessively large portion of the filthy lucre Goldman and other US banks' investors and employees are arguing over this year doesn't properly belong to them. A huge portion of the outsize sales and trading profits which have been fattening domestic banks' income statements is due to cheap funding provided both directly and indirectly by the government, direct subsidies from the US taxpayer, and the selective elimination of industry competitors through direct and indirect government action during the height of the financial crisis.

People who object to this situation claim the only sensible thing to do is for the taxpayers to claw back a chunk of these profits in the form of a windfall profits tax. Properly designed, such a tax would be levied against operating profits before compensation expense. Then, taxpayers would get back a portion of the outright subsidy they have been handing to the bankers, and bank employees and outside shareholders would be free to squabble over the remainder. The biggest challenge here, of course—apart from worrying about how to prevent politicians from making a temporary windfall profits tax permanent—would be to determine the proper amount of subsidy, and hence tax, to recover. The answer will always be somewhat arbitrary at the end of the day, but there is no reason a sensible number could not be figured out by a couple of accountants with a calculator and a bottle of scotch.

* * *

In any event, the policy tensions both here and abroad are clear: do we want banks to reduce employee payouts, retain capital, and bolster their weakened balance sheets, or do we want reparations of unearned, "excess" profits in the form of corporate, personal, or windfall profits taxes to the public purse? For conundrums like these, we have few instruments available except tax policy. But tax policy is a blunt instrument, and it acts on the economy a lot like a water balloon: every time we squeeze one end, the other end swells up bigger than before.

Moreover, I am sad to say that all available evidence seems to indicate our water balloon is a whoopee cushion, too.

¹ Please, please, UK types—especially accountants and tax advisers—cool your jets. I know this example is a gross oversimplification, and it simply does not reflect all the relevant details, the intense value added which you and your firm can bring to the discussion with your extensive expertise, blah, blah, blah. It is meant to illustrate a relatively simple point, for which task I believe it is perfectly adequate. As usual, regular readers of this site know not to take my scribblings seriously in any respect, much less in the cloistered thickets of taxation and accounting.

© 2009 The Epicurean Dealmaker. All rights reserved.

Psycho-geography

Pfuel was one of those hopelessly and immutably self-confident men, self-confident to the point of martyrdom as only Germans are, because only Germans are self-confident on the basis of an abstract notion—science, that is, the supposed knowledge of absolute truth. A Frenchman is self-assured because he regards himself personally, both in mind and body, as irresistibly attractive to men and women. An Englishman is self-assured, as being a citizen of the best-organized state in the world, and therefore as an Englishman always knows what he should do and knows that all he does as an Englishman is undoubtedly correct. An Italian is self-assured because he is excitable and easily forgets himself and other people. A Russian is self-assured just because he knows nothing and does not want to know anything, since he does not believe that anything can be known. The German's self-assurance is worst of all, stronger and more repulsive than any other, because he imagines that he knows the truth—science—which he himself has invented but which is for him the absolute truth.

— Leo Tolstoy, War and Peace ¹

Here's a fun new parlor game, kiddies. Match the famous Russian novelist's national psychological stereotypes from 200 years ago to current financial market participants. Here are some thoughts off the top of my head:

• Frenchmen = Investment bankers; recent MBA graduates
• Englishmen = Goldman Sachs employees; private equity professionals
• Italians = Hedge fund managers; CNBC commentators
• Germans = Economists; derivatives structurers

Naturally, I exclude the Russians from my analysis, because I am completely unaware of anyone currently operating in the financial sector who will admit to knowing nothing, much less take pride in it. (Actually knowing nothing does not count, since if we used that distinction 98.3% of all market participants would have to start wearing ushanki all year round.)

Your thoughts?

¹ Leo Tolstoy, War and Peace. New York: Simon & Schuster, 1970, p. 709.

© 2009 The Epicurean Dealmaker. All rights reserved.

Das Gift

Schwarze Milch der Frühe wir trinken sie abends
wir trinken sie mittags und morgens wir trinken sie nachts
wir trinken und trinken

— Paul Celan, Todesfuge

Poor Carlyle Group.

I am almost beginning to feel sorry for them. David Rubenstein and his partners must begin to tire of drinking the "black milk of daybreak," more colloquially known here as Bad Shit Which Happens to You When You Stray from Your Knitting.

We learned today that the legendary buyout shop has begun liquidating its Blue Wave hedge fund, which it launched as a joint venture in March 2007 with two former Deutsche Bank traders and in which it invested its own money. Apparently the fund assets have shrunk by a third to around $600 million, which puts it near the rounding-error column in each of Messrs. Conway, D'Aniello, and Rubenstein's personal checking accounts.

While DealBook is trying to characterize this as "the second major black eye for the giant alternative-asset manager this year," it pales in comparison to the $16 billion, highly-leveraged cluster fuck at Carlyle Capital, for which I have excoriated the Three Musketeers sufficiently elsewhere. I would characterize this one as a stubbed toe: painful, true, but hardly rising to the level of a black eye.

To their credit, the Trio Who Must Be Obeyed apparently pulled the plug on Blue Wave before it splashed more than a few gallons of water over the gunwales. I guess this time they remembered one of the key principles from their buyout business: better to fail fast than slow. (They must have gotten over their reflective, introspective phase.)

No, I blame the Germans.

After all, it was holier-than-thou Deutsche Bank which supplied the Blue Wave goons in the first place. (Sure, sure, their names are supposedly "Goldsmith" and "Reynolds," but that's just a smokescreen, I tell you. "Goldschmied" and ... —whatever—are far more likely.) We all know those Frankfurters have been beyond jealous that their pathetic little mittelstadt never made it into the finance big leagues like New York and London. I posit to you that this is just one more piece of evidence that they intend to steal into first place by bankrupting the rest of us first.

Fuckin' Krauts.

Der Tod ist ein Meister aus Deutschland.

© 2008 The Epicurean Dealmaker. All rights reserved.

Armageddon Outta Here

Food fight!

For those of you Dear Readers who nodded sagely at my most recent posts on the issue of banker pay, murmuring to yourself, "But of course. No-one could disagree with that clever chap TED, could they?," I have news for you.

Apparently Martin Wolf of the FT took umbrage at my scurrilous attack on his opinion piece on the topic today, and our little disagreement has spilled over onto the pages of FT Alphaville's comment section. I am sure that left to his own devices, Mr. Wolf would never have even known about my little drive-by blogging, much less respond to it. Nevertheless, those clever geezers at Alphaville saw a chance to stir the pot and generate more page views, so they incited Mr. Wolf to comment by drawing attention to one of the least flattering things I had to say about him in my post. (Naughty naughty, Mr. Murphy.)

Faithful Readers will already know that, because I cannot be bothered to defend my own irresponsible and intemperate jeremiads in these pages and because I do supposedly have a day job which normally consumes the bulk of my waking hours (except, sadly, in times like these), I do not offer a comments section on this weblog. I think it only fair, however, to share with you here a little of the badinage Mr. Wolf and I have exchanged as of this writing, if only so you can see how I defend the interests of my fellow financial parasites in a more public, and shall we say, more exalted forum.

So herewith is a direct transcription (copy and paste, for you youngsters) of our exchange for your amusement. Should you wish to see the original Alphaville post and its entire range of comments, you can do so here.

* * *

Martin Wolf's comment on my blog entry, posted at 16:32 GMT:

I really enjoyed Epicurean Dealmaker’s “hysterical and ranting” contribution.Indeed, to be called hysterical or ranting by this person is almost an honour.

I think he makes only one point that is worthwhile: investors desired high returns. How surprising! But, of course, the institutions made next to no effort to tell them that they couldn’t have these returns without taking on substantial additional risks.

Yet the heart of his contribution contains the following logic: Wolf’s proposal is unnecessary because it already happens; Wolf’s proposal is a mistake because it will impose massive and costly intervention in these institutions.Does this make sense to anybody else?

If we could abandon regulation of the financial system, that would be wonderful. But we can’t (for compelling reasons). So surely we must focus on incentives facing decision-makers, instead.

My response, posted at 17:46:

I will address Mr. Wolf’s comments point by point.

1) I am delighted and honored to confer hono(u)r wherever and whenever it is deserved. I am afraid, however, that Mr. Wolf appears to confuse my sarcasm, humor, and frustration with his article with the hysterical ranting I accuse him of. I concede that Mr. Wolf wrote a serious opinion piece in a serious publication, rather than a sarcastic hatchet job in a little-read, self-published weblog, but for that very reason I–and I assume many others–did and should hold him to a higher standard of argument than he demonstrated in his piece.

Really, Mr. Wolf, an unbiased observer (if he or she could be found) would find it hard not to conclude from a reading of your article that its tone and language is highly intemperate and inflammatory, given the facts at hand. Had I the time, energy, and inclination, I could write a lengthy response to your original article rebutting almost every statement you make, based on the facts as I know them, if for no other reason than to disabuse the less-informed among the FT’s readers of the facile exaggerations, elisions, and half truths scattered throughout.

2) Since when in bloody hell are the intermediaries in any financial system supposed to tell investors “they couldn’t have these [high] returns without taking on substantial additional risks,” as you say? Are we supposed to assume that every institutional investor out there is completely ignorant about the absolutely primary, fundamental fact about financial markets: that risk is inextricably entwined with return? Do not forget: it was supposedly sophisticated institutional investors which piled into “AAA”-rated CDOs, ABMSs, etc. 2007 is not 2000, when arguably clueless retail investors bought dot com fantasies based entirely on the recommendation of Wall Street analysts.

If these investors were too bloody stupid, or too bloody greedy, to wonder how and why supposedly AAA securities could consistently deliver market-beating returns, then I say it serves them right. Your comment smacks far too much of the unfortunate tendency among many investors to blame anyone but themselves for their own mistakes, and I for one won’t have it.

3) Well, yes, if you actually stopped to think about what I wrote in my two posts on the subject. First, yes, most major financial institutions already have long-term compensation schemes which tie bankers’ economics to the long-term health of their organizations. Second, and therefore, why would you propose to insert the government into a system which is already in place?

Government regulators, by your own example, have historically tried to regulate the financial services industry from the rear, and in many cases have worsened perceived problems by their very intervention. You may have faith in the perspicacity and effectiveness of regulators, but I have serious doubts. I would point out that it was your otherwise excellent FSA and the BoE which helped greatly to turn Northern Rock into a shambolic mess, and I would venture that both institutions lead by miles over our own SEC and Fed.

Furthermore, if you concede the fact that long-term compensation schemes already exist in the industry, I wonder that you still think they would be a panacea for the system’s current ills. Unless you are proposing–I shudder to think–that bankers’ compensation should be tied somehow to the performance and long-term health of the financial and economic system itself. If so, you should be receiving inquiries shortly from Vladimir Putin and Wen Jiabao about new openings in their Ministries of Finance.

4) I am all for regulation, believe it or not. I am firmly of the opinion that abandoning all regulation of the financial system would be a catastrophic error, as it would be for abandoning regulation of any significant part of the global economy. I just want to see sensible regulation, done with a light hand, that responds to and guides change and innovation in the industry in a measured manner. This has less to do with my (real) mistrust of the effectiveness of regulators than with the incontrovertible fact that no-one, including the bankers at the heart of it, knows how the global financial system will continue to evolve.

For now, I say everyone should take a deep breath, identify and acknowledge the mistakes that have been made (especially by oneself), and work together in a sensible, measured manner to find our collective way out of this.

For I assure you, Sir, that the old saying coined by one of the leaders of my country’s secession from yours so many years ago rings as true now as it did then:

“We must all hang together, or assuredly we shall all hang separately.”

* * *

Stay tuned to Alphaville to see if Mr. Wolf responds.

Now, really, I do have to get back to work.

© 2008 The Epicurean Dealmaker. All rights reserved.

Armageddon Rag

Paranoia strikes deep in the heartland
But I think it's all overdone
Exaggerating this and exaggerating that
They don't have no fun

* * *

Excuse me, did I miss something?

I had just finished mopping the blood off the floor this afternoon from today's little exercise in market hysterics—

NEWS FLASH!: Citigroup announces big writedown, reduction of dividend! Investors completely blindsided by totally unexpected news!

SHOPPING SHOCKER!: Wracked by rising mortgage debt and declining real income, consumers have the temerity to reduce spending in December! Hank Paulson "extremely disappointed" by fellow citizens' "lack of gumption."

—when I decided to surf to the Financial Times website for a little Old World perspective and reason. What to my wondering eyes did appear, however, but commentator Martin Wolf joining his voice to that of Raghuram Rajan in launching a second broadside against pay in investment banking.

Mr. Wolf starts calmly enough:

You really don’t like bankers, do you?” The question, asked by a former banker I met last week, set me back. “Not at all,” I replied. “Some of my best friends are bankers.”

But then, Mr. Wolf goes on to paint a picture of the global banking system which in olden days would have gotten the village populace out of their houses and into the woods with pitchforks and axes to dispatch the rampaging terror on their doorstep.

... the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation. Yet this combination can hardly be deemed a success. The present crisis in the world’s most sophisticated financial system demonstrates that.

I now fear that the combination of the fragility of the financial system with the huge rewards it generates for insiders will destroy something even more important – the political legitimacy of the market economy itself – across the globe. So it is time to start thinking radical thoughts about how to fix the problems.

And the "conflict of interest" at the heart of banking which drives this reckless and world-threatening behavior at banks? Why, banker pay, of course.

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

Mr. Wolf concludes with a solution which can only be admired for its breathtaking audacity and sheer bloodymindedness:

All bonuses and a portion of salary for top managers [at banks] should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five. I understand that the bankers will not like this. Yet one thing is surely now quite clear: just as war is too important to be left to generals, banking is too important to be left to bankers, however much one may like them.

Well.

* * *

I don't believe what I read in the papers
They're just out to capture my dime
I ain't worrying
And I ain't scurrying
I'm having a good time

* * *

Because I am such a magnanimous individual (and modest, too), I will not take offense nor blame Mr. Wolf for failing to read my recent blog post on the topic of banker pay, which I penned in response to his co-cabalist Professor Rajan's jeremiad of a few days ago. I will simply observe that if he had, he might have saved himself and his readers a great deal of confusion on the subject. Of course, he could have done the same by actually talking to one or two of these "best friend" bankers he reassures us he canoodles with on a regular basis. Had he done so, he would have discovered that, in fact, most senior executives on Wall Street and in the City at the type of banks he criticizes already receive the vast majority of their pay in the form of long-vesting restricted stock and equity securities. While ten-year vesting schedules are unusual, it is not at all unusual to find four- and five-year tails on banker compensation. (Plus, do not forget that most of these banks force a banker to forfeit his or her unvested compensation from previous years if he or she leaves the firm.)

I will not regurgitate the rest of my arguments against the good doctor here, in the interest of space (and uncharacteristic restraint), but I will note that Professor Rajan fulminated against banker pay primarily as unfair to investors in those very same investment and commercial banks. I pointed out, I hope to convincing effect, that those investors are the very ones who provided the demand for the risk-taking behavior Messrs. Rajan and Wolf deplore and therefore had a direct hand in the level and form of compensation doled out to greedy little investment bankers and their minions. (By the same token, having enjoyed along with their banker agents the plentiful fruits of profitable investing and trading over the past several years, they now have very little cause to whinge now that the return pigeons have flown and the risk chickens have come home to roost.)

Mr. Wolf, however, makes a larger argument, that banker pay is not only the root cause of this evil but also the proximate source of a looming crisis threatening the global economy and even capitalism itself. Frankly, my first reaction to many of his claims was that they were simply over-the-top exaggeration for rhetorical effect. I have had this impression of Mr. Wolf's screeds in the past, most recently with one in which he described the global credit squeeze and a likely US recession as an unholy combination second only in terror and impending doom to the prospect of some rough beast slouching toward Bethlehem to be born.

Where the hell was I, I wondered to myself, when the "world ... witnessed well over 100 significant banking crises over the past three decades"? One hundred? That's over three per year, fer chrissakes. What does Mr. Wolf count as a crisis: more than two bank tellers getting a paper cut in one week? Or this beauty: "large financial institutions ... are virtually the only businesses able to devastate entire economies." "Devastate"? I find it hard to believe the financial disruptions currently spreading through the global economy can be dignified with such a moniker. Pain for many, surely. Hardship for some, undoubtedly. But devastation? I think not.

Given the size and recent growth and performance of the global economy, the reversal of a few hundred billion dollars—or even a few trillion—of previously booked profits in the form of realized and projected losses hardly strikes me as Armageddon. Comeuppance, maybe, for the legions of people both within and without the banking industry who temporarily forgot that the nubile young maiden Return is inextricably conjoined with her ugly sister Risk, but not the end of the world.

And why, for God's sake, is Mr. Wolf so trusting that governments and financial regulators could implement a highly intrusive, massively unwieldy, and extremely complicated regulatory regime to enforce long-term banker pay, as he proposes? Aren't these the same entities that in his opinion have fallen down on the job of overseeing and regulating the financial sector in the first place? Does he really believe that any such plan would not generate all sorts of unintended consequences for the banking industry, financial progress and innovation, and the global economy as a whole? Who are the experts Mr. Wolf proposes design and implement such a plan? (And where the hell, for conversation's sake, does Mr. Wolf get the ludicrous notion that 10 or 12 years is the proper horizon for evaluating the profitability of I presume all investing and trading strategies? Poppycock, Sir, sheer poppycock.)

Finally, if he thinks his best friends and their colleagues at "all systemically important financial institutions" are just going to shrug their shoulders and get back to work once the mid-level career bureaucrats have put his compensation scheme in place, I would like to know what he's smoking. (And the name and number of his dealer.) Anyone with half a brain and an ounce of ambition would light out for the territories before the ink was dry on the legislation. The only people left in banking to do the work would be the dull, the unambitious, and the idiot sons of US Congressmen, who would have discovered an attractive new career path.

Intellectual capital is like mercury, Mr. Wolf: very hard to contain and control. Besides, if things are as bad as you say in the world of high finance, surely we should keep our best and brightest chained to the wheel madly innovating our collective way out of this mess, no? And unless you propose using real chains—which I would venture to guess neither Adam Smith nor the ACLU would look kindly on—you had much better realize that talent flows where the money is. (And given that your average managing director already has way too much of his net worth tied up in the depreciated stock of his employer, he already has plenty of incentive to right the listing ship.)

* * *

I don't know, maybe we should be grateful that the Brits have their own crotchety curmudgeon spewing forth half-baked nonsense in the financial press. That way, we do not have to feel so embarrassed when Ben Stein proposes to nationalize our banking system in The New York Times.

Cold comfort, say I. But then, I'm just a reckless young whippersnapper, aren't I?

Maybe I'm laughing my way to disaster
Maybe my race has been run
Maybe I'm blind
To the fate of mankind
But what can be done?

So God bless the goods we was given
And God bless the U.S. of A.
And God bless our standard of livin'
Let's keep it that way
And we'll all have a good time

— Paul Simon, Have a Good Time

© 2008 The Epicurean Dealmaker. All rights reserved.

Hedenüppendieaßeiten1

A target company stock price that is depressed.

A weak US dollar.²

Delusional foreign CEOs who never learn.³

All for this one moment.

¹ Noun : (head'-en-up-pen-dee-ass-eye-ten) : The condition afflicting any CEO who makes a cross-border minority investment in a passenger airline.
² John Stewart: "John, in your expert opinion, what has caused this steep decline in the value of the dollar?"
John Hodgman: "I would have to say God. I mean, it's right there on the dollar, 'In God We Trust.' We counted on Him, and we were fooled. I mean, what kind of Benevolent Deity would allow our money to be equal to that of Canada?" — The Daily Show
³ US Airways/British Airways. Northwest/KLM. British Airways/Iberia. Need I go on?

© 2007 The Epicurean Dealmaker. All rights reserved.

Full Fifty Men

"Follow. But! Follow only if ye be men of valor, for the entrance to this cave is guarded by a creature so foul, so cruel that no man yet has fought with it and lived! Bones of full fifty men lie strewn about its lair ... So, brave knights, if you do doubt your courage or your strength, come no further, for death awaits you all with nasty, big, pointy teeth."

— Monty Python, The Holy Grail

I guess the witch doctors at McKinsey ran out of chickens, so the executive bobsled team at UBS has decided to purify their sins in a bath of their shareholders' blood. So many shoes continue to drop in the global credit system that the financial sector is beginning to look like Imelda Marcos' closet in an earthquake.

Because the announced $10 billion in writedowns at UBS seem to be connected to subprime mortgage exposure, it remains unclear whether McKinsey's advice to push decision making authority for leveraged loans down into the investment bank helped the bank make better lending decisions or worse. Any guesses from the peanut gallery?

The good news is that Our Favorite Consulting Firm now has brand new material to work with, helping the fondue-eating writedown monkeys scour the streets of Zurich for loose change to fund the cash portion of its investment bankers' bonuses. That shouldn't take too long, but I expect compiling the report about it will add another six months to the project billings.

Talk about scope creep.

© 2007 The Epicurean Dealmaker. All rights reserved.

Rénmínbì

That's a relief.

With the courteous assistance of those clever Dutch over at greatfirewallofchina.org, I just tested whether TED has been blocked from viewing by the teeming hordes of Communist China. It has.


Up until this morning, I was beginning to worry that my snarky little posts pointing out the fraud, follies, and shenanigans in our lovely financial markets were beginning to disabuse all those budding criminals capitalists of their childlike hope in the future of the global market economy.

Fortunately, the Maoist-Confucian Society for Right Thinking has banned access to these pages by its citizens, no doubt along with all the other dreck and drivel collectively lumped under the domain "...blogspot.com." Therefore, we can safely conclude that China's direct and indirect investment in The Blackstone Group, various hedge funds, and that special form of crack cocaine known as residential real estate is safe from imminent withdrawal.

Feel free to breathe a sigh of relief that the Greater Fool remains blissfully uninformed of its error of judgment, comfy behind its protective defenses. By the time the Chinese have figured out we have sold them a bill of goods—matched only in size and extent by the time we sold the entire commercial real estate stock of Manhattan six times over to the Japanese for 200% of replacement cost, and threw in the contents of the Metropolitan Museum of Art to boot—we will all be lighting newly unembargoed Cuban cigars with worthless fifty dollar bills on our repossessed hedge fund yachts in the Azores.

Talk about information asymmetry.

Hat tip to Lee Distad, who checked first.

© 2007 The Epicurean Dealmaker. All rights reserved.

Go West, Young Sheik

Greg Corcoran over at the WSJ DealJournal has a cautionary message today for US investment banks already reeling from subprime contagion, LBO “pier” loans, and an M&A market gone AWOL: The Arabs are coming.

According to this eFinancial News story, Dubai’s ruling sheik will open an investment bank that will compete in the Middle East and Africa and eventually move in on Europe and the U.S. You might want to remember the name: Al Noor Islamic Bank.

I don’t know why. The trashbins of Wall Street are cluttered with the names of foreign commercial and investment banks that tried and failed to make a go of it in the cutthroat US market. Every few years or so—usually during an extended upswing in the markets—yet another bright-eyed foreigner gets a hard-on about the idea of muscling in on Goldman Sachs, Merrill Lynch, and Citigroup in the biggest market in the world. They launch fancy new offices, snap up a bunch of high-priced talent from other investment banks, and throw their balance sheet around in a futile attempt to buy market share. Often (First Boston, DLJ, Dillon Read, PaineWebber, Bankers Trust, Alex. Brown), they shell out an outrageous sum to buy the brand name and rapidly depreciating loyalty of a bunch of Yankee i-bankers. They usually run very nice, expensive, four-color ads in all the right magazines.

And in three or four years, if they are lucky, they are gone, with only a gaping hole in their balance sheet to show for the effort. Some do cling to life here and even prosper, to an extent, but this is usually because they have brought so many American investment bankers on board that they really look and behave completely like a US investment bank. There is absolutely nothing Swiss, German, Japanese, or French about any of the US branches of the survivors. And if the foreign parent tries to force a little of the old country culture or business practices on their American cousins, eventually the only sound you hear is the shuffling of Gucci loafers out the front door.

So what makes these benighted sods think they can succeed where so many others have failed? Well, usually, in addition to an overoptimistic assessment of their own manhood, the answer is money. “We have gobs and gobs of money,” they say, “Why can’t we beat those conniving bastards at their own game?” Mr. Corcoran seems to buy into this argument as well, given how approvingly he reports the bajillions of petrodollars those clever sheiks are packing under their burnooses.

The answer, of course, is that money is not the only thing, or even the most important thing in investment banking. (We are not talking about bonuses now.) Investment banks derive their power, capability, reach, and skill from the strength and connectedness of their bankers’, salespeoples’, and traders’ networks, both within and outside the firm. If you do not have multiple personal and institutional relationships with potential investment banking clients, you stand a poor chance of getting good, profitable mandates. Likewise, if you do not have multiple personal relationships with other bankers, salespeople, and traders within your own investment bank, you will find it hard to call in favors, threaten, and wheedle to the extent necessary to make that pig deal of yours fly. You need both to be effective, and it takes time to build such internal and external networks based on favors, information exchange, and back scratching.

You cannot hire a bunch of superstar rainmakers who do not know each other—a favorite technique of foreign entrants to our market—and expect them to be as effective together as they were in their previous institutions. They simply do not have the internal networks required to be as effective as you expect them to be. This is what investment banking honchos really mean when they talk about “culture.” Extensive, robust, and proven internal networks are as essential to the proper functioning of an investment bank as its external client list. Both take time to build, and both must be built organically.

But everyone knows that investment banking is only about money, right? I remember a business school professor of mine, a published, well-respected, intelligent professor of management strategy, who told me in 1989 that if I wanted to become a successful investment banker I should go where the money is. She recommended Japan. Oops.

What my professor did not realize, and what many other intelligent people—yes, even financial journalists—do not realize is that investment bankers do not need to go where the money is to ply their trade. The money comes to them, and it gladly pays their exorbitant transaction fees because they really do add value in connecting their clients with the internal and external networks for capital and governance.

So calm down, all you worried Analyst and Associate wannabes: you do not need to rush out and learn Arabic in order to have a job in five years time. (Or Chinese, or Russian, or Portugese, for that matter.) Other than bags of shekels, Al Noor Islamic Bank seems to have nothing of what it needs to become a credible threat to Goldman, Citigroup, or even Deutsche Bank in the US: no people, no clients, no skills, and no relationships. Furthermore, it appears to want to wade into the biggest shark tank on the planet with both feet tied together and a nasty cut on its forehead. How else would you describe a bank that wants to be a player but which cannot participate in the largest securities market out there, fixed income? “Daft” might be polite.

Although, now that I come to think of it, Al Noor’s Shariah prohibitions against charging interest might be an advantage in the current credit market meltdown. “We didn’t put you in those nasty CDOs or subprime mortgage derivatives, Mr. Investor. Now, how about a nice plate of dates?”

Who knows, it might be kind of fun to do M&A deals dressed like Lawrence of Arabia. Inshallah.

© 2007 The Epicurean Dealmaker. All rights reserved.

Monsieur ... Qui?

As if we needed further proof that life is simply not just, news comes from across the pond that the French—of all people—have no respect for money.

The crack financial investigators from Page Six of the New York Post sadly report today that the toast of toute New York, Steve and Christine Schwarzman, apparently could not get the time of day from the locals, tourists, and wannabes at the hoppin' jive joint Club 55 in beautiful downtown St. Tropez.

To top this vile humiliation off, it appears that the celebutant hoovering up all the oxygen in the room was none other than another miniscule Gothamite, Tommy Hilfiger. The nerve! As if Steve couldn't buy that Ralph Lauren wannabe twenty-seven times over. (And I have it on good authority that Steve wore newly-purchased Vilebrequin swimming shorts, to boot.)

No doubt on the advice of the Schwarzmans' publicist, who travels with them to both incite and document the fawning adulation of would-be mini-moguls everywhere, the Post writers put a brave face on the fiasco by venturing that the Schwarzmans probably preferred to be left in relative obscurity next to the kitchen entrance. But let me tell you, Dear Reader—one girl to another—absolutely nobody goes to Club 55 in search of peace and a quiet Croque Monsieur. Il faut faire un coup d'éclat, comprenez-vous?

And this, no doubt, was Steve and Christine's intention. What better way to goose the old ego after slaughtering gazillions of simoleons on the altar of not-so-private equity and escape the looming prospect of actually having to file a tax return next year than to jet over to the Gold Coast and accept the groveling admiration of legions of skimpily clad demimondaines and fashionistas? After all, surely the mere presence of a man and woman to whom most New Yorkers would sacrifice their first born child's guaranteed slot at The Episcopal School in order to get on their mailing list would reduce the charming but oh-so-much-poorer Continentals to a similar state of drooling incontinence?

Alas, it was not to be. Someone, I fear, forgot to flag the Cultural Idiosyncrasies chapter of The Squillionaire's Guide to All Things French for the happy couple. Had they read it, I am sure they would not have put themselves in harm's way by going to a society hot spot expecting to be recognized, much less celebrated.

There it is, plain as day, on page 22, among the Chief Principles of French Society and Culture:

"Money is BORING."

Merde.

© 2007 The Epicurean Dealmaker. All rights reserved.

Vendue!

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 video^{1, 2} showing you "How does this works?" can be found here, courtesy of IBD Monkey at The All Nighter.

Classique!

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.

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 peHub.com: 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.