A Cure Worse Than the Disease

Messenger: “I see, lady, the gentleman is not in your books.”
Beatrice: “No; an he were, I would burn my study. But, I pray you, who is his companion? Is there no young squarer now that will make a voyage with him to the devil?”
Messenger: “He is most in the company of the right noble Claudio.”
Beatrice: “O Lord, he will hang upon him like a disease: he is sooner caught than the pestilence, and the taker runs presently mad. God help the noble Claudio! if he have caught the Benedick, it will cost him a thousand pound ere a’ be cured.”

— William Shakespeare, Much Ado About Nothing

I suppose it does little harm to admit, O Dearly Beloved and Long-Suffering Readers, that this site is shot through and through with what my colleagues across the gaping divide in Sales & Trading would call “talking your book.” Notwithstanding the slings and arrows sent this way by those who can see no redeeming social or economic benefit to my profession, I am proud of what I do, and I firmly believe I offer real value to my clients in return for the shiny simoleons which they so graciously bestow on me, however so (and too) infrequently. This should not really be that surprising. I think there must be few human beings who do not find some sustaining or redeeming value in their daily occupation, even if only as a sop to their self esteem or a dodge against despair, and despite all your protestations I continue to aver that investment bankers are human, too.If you prick us, do we not bleed?

That being said, I think I have been pretty honest in these pages (and in the conduct of my daily duties, too) that M&A advisory services are not for everyone. There are many reasons a client might consider in deciding whether to employ someone like me, and not all of them make sense or can be justified by any honest calculus. While there are plenty of dissembling shysters roaming my industry intent on imposing their services and extravagant fees on anyone they can convince to write a check, I have always been of the opinion that you make a client happy in the long run by only recommending what is truly beneficial for them, rather than yourself. And often, hiring an M&A advisor is not the best course of action. At least not yet.

* * *

So I am pleased to take this opportunity to respond to an article on private equity and venture capital shill site peHUB, written by a corporate attorney, about things to consider when you are selling a private company. As advertised, it is geared towards the owners of private companies, who generally face a simpler and less complicated set of constraints and obligations than the Boards of publicly held ones. Of its type, it is a reasonably comprehensive and useful guide.¹

In it, Mr. Stewart offers the following considerations concerning whether you should hire a flesh-eating investment banker like me when you are selling your private company:

*Do You Need an Investment Banker? Investment bankers can add significant value in an M&A process, but they are expensive. Investment banker fees typically range from 1 percent to 2 percent of the deal value, although the fees vary by deal size and profile. Typical benefits of having a banker in an M&A process include having an agent to (1) advise on market trends and valuation, (2) approach potential acquirers with which the target’s executive management would not otherwise have contact, (3) take the difficult, “bad cop” negotiating positions, and (4) co-manage the sale process with the target’s legal counsel.

Now this is fine advice, as far as it goes, but it omits some pretty important content and nuance that I, your reliable guide to all things overpriced and intermediary, will be happy to impart herewith.

Deferring our discussion on whether M&A advisory fees are in fact “expensive” and if so how for later (I promise), I can first address Mr. Stewart’s itemized reasons for hiring a banker by contrasting them with what corporate lawyers typically do in deal contexts. On the first two points the author is correct by implication: rare (and professionally worrisome) is the lawyer who is concerned with markets and valuation, and even rarer (and in likely violation of her professional ethics) is the lawyer who spends time and energy soliciting buyers for her client. These are tasks for which lawyers are unsuited by training, focus, and predilection, and if the client wants someone other than himself to weigh in on such matters and perform such heavy lifting he needs to hire someone for whom they are suited. The third task is more nuanced, as lawyers are perfectly capable of acting (and often quite happy to act) as “bad cop” (read flaming asshole) in matters properly considered legal, but it is true that bankers adopt this role more naturally and properly in matters business.

The fourth task is generally a bone of contention for lawyers and bankers on a deal, as each usually considers the other an interfering nuisance who focuses on the wrong things at the wrong times. Nevertheless, it is true that a properly run deal process usually starts with the banker running things until definitive negotiations begin between the seller and the potential buyer, at which point the seller’s attorney takes over to control the legal minutiae of drafting purchase agreements and other such trivia. While I am convinced many if not most deal attorneys would be delighted if they never had to deal with another investment banker again, bankers are more than pleased to have lawyers around to handle the boring scut work of transaction documentation and risk mitigation. After all, somebody has to stay behind to argue over semicolons while the banker takes her client off for a nice, celebratory bottle of Échezeaux.

* * *

But Mr. Stewart misses three very important reasons why it usually makes sense for a private company, in particular, to hire an investment banker to sell itself. The first is the fact—evident if an attentive reader were to consider the range and complexity of the tasks Mr. Stewart himself recommends the seller perform—that selling a company is long, complex, and difficult work. A typical sale process, depending on its structure and the number of potential buyers it involves approaching, can last anywhere from four to six months or longer, and that is if all goes well. During that time, company management and owners (usually the same people) must continue to run the firm with the same level of intensity and focus they do normally, otherwise things being things and people being people results will start to wobble or decline, and the intrinsic value and earning power of the business will erode. Yet pre-deal preparation, internal due diligence, and identification and potential communication with selected potential buyers all take a substantial amount of time, and once the deal is launched keeping it humming along and tending to its myriad details and interruptions requires constant daily attention. Virtually no private company of normal size has the extra personnel or dedicated, trained professionals to handle this properly, and, frankly, few private company CEOs or CFOs have the skill or training either, even if they did have the time. (And they don’t. Or shouldn’t.) A skilled sell-side advisor will manage this entire process, and she will arrange things so company management spends as little time as necessary providing the input, attention, and personal presence they must so they can continue to focus on their day jobs. Lawyers just don’t do this sort of thing.

Second, a good² M&A advisor will bring market intelligence to bear on a sell-side assignment which nobody else—not even a dedicated internal M&A functionary at a large private company—can come close to providing. This is detailed, intimate knowledge of a firm’s potential buyers, based on comprehensive discussions and extensive deal experience and interaction with all of them. As I’ve written before,

You might think that a participant in a particular industry should know the strategic intentions and capabilities of its direct competitors well, but normally you would be wrong. Competitors do not talk to each other directly about strategy because—wait for it—they are competitors. On the other hand, it is the job and practice of any good investment banker not only to develop an informed opinion about how each significant competitor in a space thinks about strategy but also to have done so by talking directly with them, frequently if possible. This is simply not practical for most corporations. Investment bankers are normally far better informed about the strategic landscape of an industry than any one of its participants.

And this knowledge is not limited to other companies, either. A good advisor will also know the likely, potential, and just-barely-possible buyers of her client among the financial sponsor (private equity) community, too. Not only will such a banker know these parties and their own acquisition appetites and capabilities well, she will know which ones of them are complete and utter assholes, which ones tend to fire the management teams they acquire with companies within the first year of purchase, which ones like to bait and switch sale processes by bidding high then whittling down their offer during exclusive negotiations, and which ones are irredeemable bottom feeders.³ This is invaluable information which even the best informed private company in the most incestuous industry has very little of, if any.

Knowing the likely buyers in the private equity world and being able to bring them to the table is critical in virtually every industry sale process nowadays. Not only are sponsors often the best capitalized and most aggressive buyers, they are almost always faster and more professional than the strategic buyers in an industry, because unlike the latter the former do deals for a living. Incorporating this type of determined, fast-moving buyer into a sale process is very helpful even if the seller and his banker think the most likely buyer is a competitor in the same business, because it helps the banker keep time pressure and process discipline on the strategic buyer which might otherwise dissipate. They also usually offer a very different purchase alternative to a private company seller: sell us your business, then come work with us as a (junior) partner to build it bigger so we can sell it to the next guy, and you will get a second bite at the apple. This, in contrast, to the typical offer from a strategic competitor: sell us your business, then either join us as a salaried employee or go away. Many private company owners prefer selling to private equity firms for this very reason nowadays, but they are babes in the woods when it comes to knowing those buyers. A skilled investment banker can offer crucial guidance in this area.

Third and last, surprisingly enough—given the regular beatings good sell-side advisors give potential buyers in M&A deals—most serious buyers prefer private companies to have professional sell-side help engaged. This is for all the reasons cited above: they know most private companies do not have the time, M&A experience and discipline, or negotiating skill to run a tight, efficient transaction process. Buyers want to know the person sitting across the table from them is not procrastinating, flip-flopping on deal provisions or objectives midstream, or negotiating in a disingenuous or irrational manner. Being a buyer of companies is expensive and time-consuming, too, and buyers who are serious don’t like to suspect their time is being wasted. Having a professional investment banker across the table gives them some confidence, because everybody knows no investment banker would allow herself to be hired by a client who wasn’t serious themselves.

And this, at the last, is probably the most compelling reason a private company should hire a financial advisor to sell itself: because that banker will make sure to keep her client disciplined and focused on accomplishing the sale. Privately held companies—for all sorts of good, bad, and indifferent reasons—can often be pretty squirrelly, and nothing will kill a deal faster than a squirrelly seller. After keeping buyers in line, a good sell-side advisor’s principal role is to keep her own client’s eyes on the prize.

* * *

Which brings us to the matter of expense. It is true that, for most deals, the check a seller writes to his investment banker is usually the biggest one crossing the closing table other than the purchase price itself. Even so, one or two percent of the transaction value is arguably a pretty small price⁴ to pay for someone who has broadened the potential universe of buyers, guided and directed the sale to achieve the highest price and best non-price terms available given the seller’s other objectives, and performed all the tiresome, dirty work of managing a complex sales process for upwards of six months or more. Even more compelling, except for the occasional nominal retainer, the success fee a banker earns upon her client’s sale is just that: a success fee. If the sale fails, or her client withdraws his company from the process for whatever reason, she does not earn anything. Her risks and incentives are completely aligned with those of her client, assuming of course her client really wants to sell.

And that is the real answer: if you’re not really sure you want to sell your company, don’t hire an investment banker. It is our job and embedded in the way you pay us to do everything in our power to close your transaction, including beating you up if you’re backsliding, procrastinating, or otherwise doing anything unreasonable and likely to derail a potential sale. Other bad reasons—like you’d like to play investment banker yourself, no matter how much it costs you in distraction from your core business, diminished transaction value, and fruitless legal and accounting expense—are also good arguments for not hiring a banker, but presumably you are too intelligent to need me to tell you that.

Of course, any good corporate law firm would be more than happy to accommodate you in such circumstances. After all, they charge by the hour.

Related reading:
Matt Stewart, Things to consider when selling a private company (peHUB, July 28, 2014)
Eight Reasons Not to Hire an M&A Advisor. And One Reason to Do So (May 14, 2011)
A Good Start (January 19, 2011)

¹ If I’m being honest, as I claim, I think the author is a little lackadaisical about describing the necessary structure and elements of the sale process for a private company. While he gets the major elements right, he is a little slapdash in describing how they all fit together. It has been my experience that a robust and disciplined process is absolutely necessary to keep deals moving at an appropriate pace, to encourage potential buyers to play nicely, and to keep the seller focused on what needs to be done. Without a firm hand on the tiller (and an eagle eye on the clock), there is a tendency for all deals to fritter away into time- and money-wasting nonsense. Given the fact that, of all the players involved in these little dramas, lawyers are usually the only ones paid by the hour, I will leave it to the cynics in the audience to conclude whether this omission was intentional.
² The perceptive among you will note that my use of “good” here is definitely normative, if not prescriptive. The type of knowledge which informs nuanced, deep understanding of the strategic landscape of an industry is normally only collected by investment bankers focused on and active in that industry. This means if you value and want such knowledge you should search for an advisor from among those who actually have it, rather than the generalist sell-side firms who market themselves as one size fits all. They are prolific sausage factories, it is true, but all the sausages tend to come out the other end looking the same. Just sayin’.
³ Yes, we know who you are. All of you. You, too.
⁴ Unless you are paying 2% for a billion dollar deal or greater, in which case your banker is a shyster and you are a fool. Or neither one of you cares how much of your public shareholders’ money you waste.

© 2014 The Epicurean Dealmaker. All rights reserved.

You Go First

Don’t shit where you eat.

— Anonymous

Way back in the Dark Ages of Investment Banking, O Dearly Beloved—say in the 1970s or 1980s, before Your Humble Correspondent embedded himself in the front lines of global financial conflict—somebody or other decided in their infinite wisdom that new recruits to my industry out of college should, as a matter of policy, be hired for two-year stints only. After this period expired, they were thanked for their troubles, given a celebratory fruit basket or somesuch, and politely shown the door. A tiny minority of very strong promise were sometimes buttonholed by higher ups, slipped a tenner or two, and persuaded in whispered tones to stay on as regular employees, but virtually everyone else was gently or not so gently ushered out the door. Talented leavers were encouraged to reapply for admission after a stint at a recognized institution of higher networking obfuscation learning where they could bolster their professional credentials and familiarity with the latest corporate buzzwords. Talentless cannon fodder—as revealed ex post via mediocre or worse job performance—were graced with fixed grins and sotto voce imprecations muttered between gritted teeth. Almost everybody left.

The reasons for this odd system may be lost in the mists of time (or your Professionally Nonchalant Bloggist’s lack of interest in substantive historical research, which for all intents and purposes is the same thing), but it has obtained in my line of work for many a waxing and waning moon. As such, investment banks and college graduates—clueless children educated to within an inch of their lives in disciplines useful perhaps 300 years ago and no later—found a symbiotic relationship in which this program served each of their interests and predilections. College students found a well-organized, (then-)prestigious, (then-)well-paying industry with slick recruiting materials willing to take on their confused and ill-directed selves for a limited period of two years, in which the banks promised to provide very good money, an impressive notch on their virgin résumés, and all the Seamless food they could eat, with a free Get Out of Jail card tacked on at the end. In exchange, the investment banks got swarms of smart, eager young beavers willing to learn how to create and maintain 50 page spreadsheets and 100 page presentation books and generally make themselves available 24-7-365 for all manner of scut work while they figured out what they wanted to do with their lives. Lots of directionless college graduates got jobs which paid terrifically well and offered prestige far beyond their deserts, and investment banks got access to a much larger group of intelligent, ambitious youngsters than they deserved. It all worked out pretty well.

Back in these prelapsarian times, when majestic investment bank dinosaurs still trod the Earth, a cozy symbiosis developed between the much smaller private equity industry—small, nimble, clever mammals and clients of the dinosaurs, to boot—and big investment banks. Private equity firms were always looking for a few highly trained, intelligent, and motivated finance geeks to join their organizations at the bottom every year to both support the Schwarzmans, Blacks, and Kravises of the world and eventually succeed them. Naturally, they looked to the giant investment banks as farm teams for their junior recruits, and they cultivated a close relationship with promising young investment bankers they met on live transactions and found through industry gossip. They also pumped their counterparts and salespeople at the banks for information as to who was the best, fastest, and most ambitious among their large Financial Analyst classes in order to target their recruiting appropriately. Senior bankers were happy to cooperate, since 1) it made some of their best, highest paying clients happy, and 2) top junior bankers were likely to leave after their two year stint was up anyway. PE firms were free to recruit these tyro plutocrats and, since their recruiting tended to be focused near the end of the analysts’ two year terms and did not materially interfere with their duties, any minor inconveniences could be comfortably overlooked.

* * *

But now we live in much different times, Most Patient and Understanding of Readers, as many of you may indeed be aware. Banks face life-altering threats from Dodd-Frank lava flows and Volcker Rule asteroids, and the tiny, nimble private equity mammals of yore have evolved into lumbering colossi of hair, tooth, and tusk which are assuming the role of apex herbivores and predators in the global financial ecosystem. Financial Analyst positions at investment banks are nowhere near as numerous as they used to be, and those that still exist no longer carry the socioeconomic prestige or promise of outsize pay they used to. On the other hand, the largest of private equity firms have evolved into very large firms indeed, with a consequently magnified demand for cannon fodder of their own, and they have been joined by legions of small and mid-sized private equity firms with their own need for junior weenies. The tables, so to speak, have decisively turned.

And yet the private equity industry still chooses to recruit its junior personnel from the same place: the most talented among the junior ranks of investment banks. Except they are no longer following the old gentleman’s agreement of letting young bankers mature and learn in situ before they harvest them: they are recruiting them practically before the ink dries on the little buggers’ bank business cards. This, as you might imagine, is beginning to irritate investment banks, who spend a great deal of time and money recruiting, selecting, and training young bankers into useful employees. It is one thing to recruit and train a top Financial Analyst who will give you a solid two years of work and then depart, a friend of the firm, to an important client where he or she might eventually direct more business to you. It is another entirely for your new analysts to start receiving frantic recruiting efforts six months after they start their jobs and sign acceptance letters at new employers 18 months before they are supposed to leave. In addition to distracting them from time-sensitive duties for which we pay them ridiculously high wages and diminishing their incentive to work hard for the rest of their contracted stint (because they have guaranteed jobs waiting at the end), recruiting and hiring by private equity firms can introduce serious potential conflicts.

Notwithstanding their position at the very bottom of the investment banking totem pole—or in fact exactly because of it—Financial Analysts are privy to highly sensitive confidential information about many clients’ businesses and lots of live and potential transactions. This is especially true of those analysts who work in corporate transaction-intensive parts of investment banks like mergers & acquisitions, leveraged finance, and financial sponsor coverage. These are the very analysts which private equity firms are most interested in hiring, since their training, talents, and daily work resembles their own most closely (as opposed to, say, corporate financiers focused on capital raising, capital markets bankers, or sales and trading assistants). For one of these analysts to have divided loyalties, or an open information channel to a private equity firm which has already hired him effective 18 months from now, is a serious potential breach of confidentiality and maybe even a source of direct conflict. Even if one presumes there are no private equity professionals who would be tempted to pressure an investment bank analyst to share confidential deal or client information via friendly persuasion or even a threat of rescinding an outstanding future job offer—a towering assumption of dubious validity, I assure you—knowledge that a junior employee has a signed job offer from a particular client is going to make any investment bank compliance officer extremely uncomfortable. It is also going to cause more relaxed banks serious client management problems if KKR discovers the analyst working on their $10 billion proprietary buyout is going to work for Apollo in ten months.

* * *

And, if we’re being honest here, the suboptimal equilibrium falling out of this vicious prisoner’s dilemma is doing nobody any good. Because too many private equity firms are competing for too few analysts¹, they have begun recruiting them earlier and earlier, and they are signing them to offers before they are even halfway done with their two-year apprenticeships. This is a problem for PE firms for two reasons. First, it really isn’t that easy to determine who are the best (most competent and adept) financial analysts after only six months, because such competence is developed not only through training but also through sheer bloody volume of experience. Private equity firms like to think they have the interviewing skills to figure this out in advance of actual proof, but in this, as in so many other things, the PE firms are massively overestimating their own knowledge and skill. The only thing they can determine with certainty this early in a novice investment banker’s career is whether he or she is a hardcore finance junkie (see footnote 1, below), but these do not always turn out to be the best analysts.

Second, and more importantly, if a bank discovers their first year analyst has an offer of employment 12 to 18 months hence at a private equity firm, they may do one or more things to seriously diminish the value of said analyst to his future employer. Harsher banks may simply fire such analysts, on the not-too-ridiculous theory that it’s just too much trouble to manage an employee with potentially serious conflicts of interest (q.v. supra) whose motivation to work insanely hard and try to become the best analyst she can be is seriously undermined by having a guaranteed exit to what she sees as a better job in the future. Other banks, suspicious about such shenanigans, may ask employees outright if they have accepted offers from other firms. If the analyst lies and the bank finds out (and Wall Street and the private equity industry are very small worlds indeed), the bank may fire said analyst for cause, thereby simultaneously cutting short the apprenticeship her future employer was counting on to train her appropriately as well as tarnishing her employment history.

Still other banks, unwilling to can employees they have sunk serious time and money into training and developing to be investment bank analysts, may decide out of reasonable caution to reassign such juniors to areas where their future employment status will not create the reality or appearance of potential conflicts. But this means these analysts will likely be rotated out of areas such as M&A, leveraged finance, or sponsor coverage where they would have otherwise received the intensive hands-on experience their future employers were counting on to make them valuable hires. Even less draconian measures along such lines, such as reassigning compromised analysts to only work with corporate clients or relocating them to overseas posts where geography can provide some measure of conflict insulation, will have the same effect of rendering these prize recruits that much less experienced and valuable to their future private equity overlords.

And in all such outcomes, the entity screwed the hardest is, of course, the financial analyst him- or herself. If he or she dodges the bullet of summary firing for cause (or not for cause), they may still limp along in another position within the bank they have less interest in, have their training and experience gathering significantly curtailed or redirected, and/or work under a cloud of suspicion as to their motivation and team spirit (with consequent negative implications for performance reviews and pay) for the remainder of their employment in banking. Plus, it would be the rare and lucky analyst indeed who suffered any one or more of these fates who did not see his magical “guaranteed” offer of employment at Private Equity Megabucks, LLC evaporate like a fetid mist over the Bayonne Marshes once PEM, LLC finds out. Trust me here: private equity firms are not charitable organizations. They don’t give a shit about you.

* * *

The solution to this dilemma, of course, is simple. Private equity firms have become large and rich enough that they should do their own damn recruiting at colleges to hire junior personnel, rather than relying on investment banks to provide a pre-screened, pre-qualified employee pool to poach from. Given their focus on hiring the elite of the elite and hardcore finance junkies, this should not be too much of a burden, since PE firms almost uniformly insist on hiring recruits from the Wharton School and maybe five or six other top-name universities anyway. It’s not like they’re going to have to visit 100 colleges around the country. Of course, they would have to train these new graduates themselves, which will involve time, money, and effort they are normally loath to expend. But the time has come for private equity firms to realize they are too big individually and in aggregate to slipstream off the shoulders of investment banks anymore. The parasite-host burden has become too large.

The other solution, of course, is to chill the fuck out and go back to the old system of waiting to recruit IB analysts later. This would be better for private equity, better for investment banks, and better for junior professionals. It is a difficult collective action problem, which would require discipline on the part of PE firms and potential recruits, as well as support from investment banks, but it is not impossible to foresee.²

Private equity takes extreme pride in being disciplined investors, and they broadcast this message loud and long to anyone who will listen. The time has come for them to demonstrate they can be disciplined recruiters and employers, too.

And to stop taking dumps in the community watering hole.

Related reading:
William Alden, A Mad Scramble for Young Bankers: Wall Street Banks and Private Equity Firms Compete for Young Talent (The New York Times, July 5, 2014)
Curriculum Vitae (March 10, 2013)


¹ Private equity firms like to style themselves as even more selective than investment banks. At least in the past, when their relative numbers could support it, they preferred to hire only the top five or ten percent of IB analysts (as so ranked and paid by their bank employers) into their firms. The notion is that they are the elite of the elite, and they want 24-year-olds who can program 50-page LBO models in their sleep using Visicalc and chewing gum, as well as pure hardcore finance junkies whose every waking dream since kindergarten has been to have a bigger 60th birthday party than Steve Schwarzman. These are the kids who tape stock tables from The Wall Street Journal and glossy pictures of Warren Buffett on their bedroom walls in high school, enroll in the Wharton School as double finance and econ majors, and who viciously haze any coworker who cannot navigate a spreadsheet without a mouse. These are the kids who have summer jobs in college teaching Training the Street classes in basic accounting and financial modeling to liberal arts majors who want to apply to Goldman Sachs too. They have always wanted to be private equity professionals. In the past, they only applied to investment banks out of college because that was the only way to get into PE.
² Surprisingly enough, the junior recruits might be the best positioned of anyone to enforce such a return to sanity. If they were courageous enough to forgo immediate recruiting by private equity as soon as they get their sea legs, they could build their skills and experience at their bank employers for the full two years of their employment. I find it hard to believe such candidates, battle tested and thoroughly trained, would not find an eager audience of potential employers among the best private equity firms once they’re ready. They are certainly superior candidates to wet-behind-the-ears tyros six months out of college. But this, of course, requires wisdom and courage from 22-year-olds in a fevered and desperate job environment. That may be too much to expect from the poor lambs.

© 2014 The Epicurean Dealmaker. All rights reserved.

This Situation Absolutely Requires a Really Futile and Stupid Gesture

Bluto: “Hey! What’s this lyin’ around shit?”
Stork: “What the hell we supposed to do, ya moron?”
D-Day: “War’s over, man. Wormer dropped the big one.”
Bluto: “What? Over? Did you say ‘over’? Nothing is over until we decide it is! Was it over when the… Germans bombed Pearl Harbor? Hell no!”
Otter: [aside] “Germans?”
Boon: “Forget it, he’s rolling.”
Bluto: “And it ain’t over now. ’Cause when the goin’ gets tough…”
Bluto: “…”
Bluto: “…”
Bluto: “The tough get goin’! Who’s with me? Let’s go!”

— Animal House

Hamilton Nolan posted a really stupid piece on Gawker this past week.¹

Apparently the editor of our culture’s preeminent forum for snark and sarcasm was so outraged by Forbes’ annual encomium to the highest-earning hedge fund managers that he burst a gasket. I guess the shock was so great Mr. Nolan dropped a slice of gluten-free artisanal toast buttered with the tears of free range lambs raised on an anarchosyndicalist commune in Vermont face down on a rug woven by one-armed Peruvian orphans from the frayed fibers of their broken dreams. Or so I presume, given the fulsomeness of his resulting vitriol. Unfortunately for this forum, at least, Mr. Nolan’s righteous indignation was not matched by a similar zeal to get the most basic facts about the situation correct.

So the unsuspecting Whole Foods customers who read Mr. Nolan’s work were subjected to howlers like this:

Here is what George Soros’ fund did last year to earn him $4 billion: it underperformed the S&P 500 index by 8%. In other words, Soros charged his investors fees that are well over 1000% higher than what they could have paid for a simple index fund that would have earned them more money.

Which is amusing since, as Mr. Nolan subsequently appended in a parenthetical correction to those very words, George Soros only manages his own money. I mean, I suppose it is shocking Mr. Soros had the audacity to charge himself and his charitable foundations zero dollars for the privilege of earning only four billion dollars when he could have earned significantly more, but I suspect even the meanest intelligence would find the towering indignation inspired by the preceding sentences dissipating somewhat once he realizes exactly what that means. (Perhaps Mr. Nolan counts on his fellow snark and outrage aficionados to miss the embarrassing reveal…)

But this failure to do the most basic fact checking—i.e., reading the goddamn Forbes article he cites—is not the worst of Mr. Nolan’s sloppy misrepresentations. Even he seems to shrug off the fact that thousands of rich institutions and individuals seem content to pay billions of dollars in fees to hedge fund managers for results which, in aggregate, have underperformed the general stock market.² No, what really pisses Hamilton Nolan off is the notion these greedy plutocrats are stealing food out of the mouths of hungry refugees by paying preferentially low tax rates on their filthy lucre. He points out, correctly, that alternative asset managers like hedge fund managers benefit from the treatment of their performance fees as carried interest. Carried interest, for those of you ignorant of it, enables the managers of certain investment partnerships to treat the performance fees they earn (typically 20% of the positive returns they earn for their limited partners) for tax purposes as capital gains, presumably on the theory they are returns to the “sweat equity” (i.e., not real money) that managers contribute to the partnership. This can be advantageous to the extent these managers, like those in private equity and venture capital partnerships, generate returns over a period of several years, which can then be taxed at preferentially low long-term capital gains rates.

But what Mr. Nolan fails to recognize is most hedge funds earn the bulk of their returns by rapid trading of liquid investments and assets like stocks, bonds, commodities, derivatives, and anything else for which a willing counterparty can be persuaded to part with a bushel of folding money. They are trading vehicles, which means most of the capital gains they earn via performance fees are treated as short-term capital gains. And short-term capital gains, under our current tax code, are taxed at the same rates as ordinary income.

Which means, technically speaking, that Hamilton Nolan is full of shit.

* * *

Now this is not to say the treatment of performance fees for alternative asset managers as capital gains via the mechanism of carried interest makes much sense or is good tax policy. I have argued strenuously in the past that performance fees earned by professional managers with no underlying capital at risk should be treated as what they clearly are: ordinary income for services rendered. The current tax regime is patently unfair, and the counterarguments offered by interested parties involved are weak and self-serving. But this does not invalidate the fact that, under the law, hedge fund managers who trade their clients’ money actively (that is, most of them) pay the equivalent of ordinary income rates on their performance fee income.³ Private equity plutocrats—who, interestingly enough, tend to make less money every year and have lower net worth than the best hedge fund managers—are the ones who benefit disproportionately from the current biases of the tax code. But Mr. Nolan is not attacking them.

Nor is it to deny that hedge fund managers, like any other person richer than Croesus, have the money and means to pay legions of lawyers and accountants millions of dollars to structure elaborate tax shelters and help them defer or evade billions in taxes. But this is not limited to hedge fund managers: it is a privilege enjoyed by any rich and politically powerful person who is willing to spend a tiny fraction of their income to shield the bulk of it from the taxman. You may thank the complexity of our tax code and the ingenuity of clever men and women willing to delve deep in its bowels for that.

* * *

At the end of the day, O Dearly Beloved and Excessively Tolerant Readers, what really annoys me about Hamilton Nolan’s poorly researched and badly premised hit piece is that its own strongest feature—a deep suspicion of and revulsion toward enormous sums of money flowing to tiny numbers of human beings while billions struggle to make ends meet—is almost completely undermined by its almost comical disregard for the facts. Growing wealth and income inequality around the world is engendering serious sociopolitical conflict, but attacking the wrong people for the wrong reasons with the wrong arguments will do nothing to address it.

Polemics can focus the mind wonderfully, but they must be based in truth if they are going to persuade anyone. One of my favorite non-finance bloggers about academia and culture, Freddie deBoer, wrote an illuminating essay about this very issue in academia not long ago:

This is the problem with speaking the “emotional truth,” a common invocation for adjunct essayists and part of a lot of rhetorically counterproductive strategies that, I’m sorry to say, creep into this genre a lot. The emotional truth is invoked on the ground in the day-to-day discussions I have with adjuncts. People will make claims that I know to be factually inaccurate, or will advance ideas that I find politically misguided, and I will push back. When confronted, they will say something like “I am entitled to my anger,” leaping back and forth from a position of making a dispassionate economic analysis to a position of emotional truth that I am therefore, in their minds, obliged not to contradict. There are all sorts of ways bad arguments and misleading information get excused in these debates– “it’s agitprop! it’s not intended to be factual! it’s meant first to provoke!”– and I think each of these, while certainly understandable, are ultimately unproductive. And they have made this argumentative space one of bullying and rejection.

To extend Mr. deBoer’s analysis, most of the people involved in the analysis, practice, and regulation of finance “are people who think that facts matter, and so when you are loose with the facts, you make it harder to get their support.” Yeah, like impossible. Most of us—even those who might otherwise be sympathetic to your analysis or agenda—just throw up our hands and ignore you. If you can’t argue from the facts, you are simply pandering to your own anger and the prejudices of the uninformed elements in your audience. You may be penning compelling polemics, but you are wasting every serious person’s time, and you certainly aren’t convincing them. In addition, you make it easier for them to discard everything you write or say, because your argument is riddled with silly, obvious omissions, misrepresentations, and untruths. Your potential allies think you’re a harmful idiot, and your enemies gleefully disregard any valid points you might make because you are a careless, misleading boob.

Polemics are fine, but don’t neglect the foundation of facts you must build them upon. Otherwise you’ll become like Matt Taibbi:⁴ beloved by those who don’t know anything and scorned by those who do.

Related reading:
Tax Breaks for Everyone! (June 14, 2007)
The Taxman Cometh (July 11, 2007)


¹ “Gawker?!”, you gasp. Yes, yes, I know: most of you do not visit these pages with the view to enjoying the spectacle of me beating up the feebleminded, but I do have a larger agenda. Besides, it’s fun to go slumming on occasion. I promise I won’t make a habit of it.
² A more intellectually honest and curious journalist might explore why so many presumably silly rich people allocate so much money to hedge funds and other alternative investments. That same journalist might find it revealing that the class of such assets allows one access on occasion to consistent outperformance which handily trumps average market returns. That journalist might also find it suggestive that rich folk such as Mr. Soros and his former clients are happy to trade volatility and uncertainty of investment returns for the opportunity to make tons of money when their manager is right. Finally, that journalist might discover that hedge funds invest in a much broader and more diverse universe of asset returns than simple stock market indices, which can be handy when the latter are pissing the bed. But I suppose we must not hold Mr. Nolan to such unrealistic standards.
³ And on the distributed returns they earn on the personal capital they invest in their own hedge funds. It is quite common in hedge fund land for managers to have very large portions of their personal net worth invested in their own funds. This is one good reason to admire these swashbucklers: they eat their own cooking and put their own capital at risk alongside that of their investors.
⁴ Or Matt Taibbi Junior. Say what you will about Mr. Taibbi, who also undercuts his own far more effective polemics with a highly tendentious style of argument that runs roughshod over the truth, at least he tends to do research. I very much doubt he would have stumbled over the elementary source of Mr. Soros’s income.

© 2014 The Epicurean Dealmaker. All rights reserved.

It’s a Helluva Town

New York, New York
A wonderful town
The Bronx is up, and the Battery’s down
The people ride in a hole in the ground
New York, New York!
It’s a wonderful town!

...

Manhattan women are all in silk and satin,
So the fellas say
There’s just one thing necessary in Manhattan,
When you’ve got just one day:
Gotta pick up a date
Maybe seven or eight on your way
In just one day!

— “New York, New York,” On the Town

Hey, girls, get ready! It’s Fleet Week, and the drunken sailors are spending money like there’s no tomorrow. You’d have to be a stony-hearted harridan not to offer them a little fun and companionship, right? Especially since they’re buying.

* * *

Articles are beginning to appear in The Wall Street Journal and elsewhere documenting the return of the slightly disreputable and mildly creepy uncle of the financing world, the dividend recapitalization, or recap. I can already hear the sucking of teeth and clucking of tongues among disapproving maiden aunts in the mainstream media and blogosphere.

An article Friday in the Journal lays it out for us:

Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor’s Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis.

For private-equity investors, the deals produce payouts amid a slow market for initial public offerings and acquisitions. “It’s hard to be anything but happy” about the dividend boom, said Erik Hirsch, chief investment officer for Hamilton Lane, a Philadelphia firm that manages more than $163 billion in private-equity investments.

Likewise, many debt investors are happy to collect yields as high as 10%.

Critics say the dividends, which are disclosed in offering documents, saddle a company with debt, potentially burdening its operations, while reducing a private-equity firm’s investment exposure.

Also some of these deals involve a risky type of debt known as “payment in kind toggle”—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn’t use the bonds, according to a study by Moody’s Investors Service.

Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October, double the number sold in the previous 14 months.

Our Lady of Perpetual Fiscal Rectitude is surely spinning in her grave at these revelations.

* * *

But just as there are creepy uncles and creepy uncles, there are dividend recaps and dividend recaps. The PIK toggle example the article cites—Hellman & Friedman’s $525 million issue to fund a $600 million dividend for a recently purchased drug developer—looks pretty anodyne upon closer inspection. H&F bought the company last December, when lending markets were stressed, using approximately 50% equity and 50% debt.¹ Raising debt to dividend out $600 million leaves the company with approximately $1.35 billion of equity supporting an enterprise valuation and capital structure of $3.9 billion. At 35% equity-to-total capital, the resulting leverage ratio is pretty standard for a leveraged buyout and, pace any specific unusual risks in the company’s business model or operating prospects, should provide a pretty safe and secure capital cushion for the creditors.

This is no wild-eyed sailor barebacking his way through the alleys of Bangkok. Hellman & Friedman overequitized the purchase at closing because it had to (and because it could; that is, it had an extra $600 million lying around), and it simply came back to market under currently more attractive conditions to fine tune its portfolio company’s capital structure. It was the prudent, responsible, and appropriately fiduciary thing to do. Plus, the new PIK holders get a nominal yield of 9 7/8% on a fresh buyout undergirded by $1.3 billion of equity from a respectable financial sponsor. What’s not to like about that in an environment where fixed income investors are lucky to find yields in excess of 3%? Those pensioners’ medical bills won’t pay themselves, you know.

The same cannot be said, however, for the debt Leonard Green and CVC Partners raised to pay a $643 million dividend to themselves (i.e., to their funds and hence their limited partner investors) for the buyout of BJ’s Wholesale Club last year. According to the article, this debt repaid the entire initial equity investment the sponsors made to purchase the company in the first place, which means, essentially, that they and their fund investors are now playing with house money. Depending how much equity Leonard Green and CVC shared with current management and other co-investors, their funds now control something like 75 to 85% of the equity of a $2.8 billion corporation at a net cost of zero dollars. Pretty sweet, huh? I’d like a few of those deals myself.

What this skeleton outline does not reveal, however, is data which might explain why new debt investors decided to lend so much money in the first place. I have explained in the past that creditors principally base their decision to lend to a corporate borrower on what they calculate it can afford to pay, appropriately adjusted for risk, uncertainty, and the unexpected collapse of Americans’ compulsive desire to buy 50 gallon drums of olive oil for $19.95 apiece. There may be very strong operating cash flow support for the new and existing debt of BJ’s, I don’t know. But if I were an investor in the debt funds or a pensioner in the pension funds which bought these bonds, I would be very curious to find out.

The reassuring thing to consider in this scenario, from the lenders’ point of view and that of kibitzing journalists, is that the financial sponsors, while certainly facing a reduced risk profile, have not abandoned all incentive to make the buyout work by taking their initial stake off the table. Consider: returning your LPs’ entire initial investment after one year may be comforting, but it represents a return on capital of exactly zero percent (less if you adjust for the risk of tying it up for a year). No private equity firm can survive if it makes that its core business model. No, financial sponsors operate on an investment model that generally targets total returns of 2.5 to 3 times their investors’ money (more if they can get it, of course) over the course of 3 to 5 years. If they deliver that, they make their limited partners very happy and themselves very rich. Leonard Green and CVC have every incentive to work with management to make BJ’s a huge success, and BJ’s creditors know this. In part, they are relying on it.^2,3

* * *

When they are not simply delayed borrowings designed to adjust the capital structure of an LBO to its original intended optimal state, like the H&F deal, dividend recaps are risk adjustment tools for private equity firms. They convert the risk profile of the investment from a pure equity-like one—where you participate one-for-one in the increase of value of the firm but can lose your entire investment if the company goes bust—to one that looks much more like an option: limited (or zero) downside below the threshold of the amount borrowed and one-for-one participation in the upside.⁴ If you can buy yourself and your investors such an option for a reasonable price (i.e., interest rate), why wouldn’t you?

And that is the point, and one of the key reasons financial sponsors are beating a path to the doors of high yield investors nowadays. Lenders are selling these options cheap because their investment alternatives suck. Furthermore, unlike the prelapsarian glory years of 2006 and 2007, high yield investors have fewer opportunities to invest as part of the initial capital structure of leveraged buyouts and other acquisitions now because M&A volumes are way down. Deals aren’t getting done, so lenders have to lend to the people who are asking for money. On the flip side, financial sponsors are coming to lenders for dividend recaps hat in hand because there is so little M&A activity they cannot sell their portfolio companies for love or money. Financial sponsors are increasingly trapped in aging investments they can’t sell to strategic corporate buyers, because corporate boards and CEOs are still hiding in their executive washrooms sucking their thumbs in paralysis over global economic uncertainty. And they can’t sell their companies to public equity market investors via IPO unless they can persuade somebody their widget manufacturer is really a social media powerhouse.

So, tongue clucking and tut-tut-ing aside, dividend recaps are surging because they’re the only game in town. The girls are horny, and the Navy is in town. Deal with it, Aunt Betsy.

Related reading:
The Rape of Persephone (January 29, 2012)


¹ The article does not disclose whether H&F was able to assume existing company debt “on the balance sheet” or had to raise it afresh. It doesn’t matter for the purposes of our discussion.
² More to the point, they are relying on their own due diligence that the company itself can support the entire debt load placed on it in a way that gets their loans repaid timely and in full. From a creditor’s perspective, it is reassuring to know someone lies beneath you in the capital structure to cushion your fall if the wheels come off the bus, but you’re much more concerned to get comfortable that the chance of said wheels leaving said bus is very slight in the first place.
³ The wicked person in me wants the BJ’s deal to fall apart, because it would create an entire sub-industry of off-color joke telling in my business. “Did you hear about the BJ’s deal? It sucked!”
⁴ In effect, you buy a put option from the lenders for residual liquidation values of equity below the amount borrowed. The option premium is simply the cost of borrowing. The payoff looks like a call option, or, what is the same thing, a long equity + put option combination.

© 2012 The Epicurean Dealmaker. All rights reserved.

Too Much Is Never Enough

Villager: “How can we find a samurai we can pay with only rice?”
Gisaku: “Find hungry samurai.”

— The Seven Samurai

The private equity industry has a problem.

And no, by a problem I do not mean the Presidential candidacy of one of its former grandees and the unwelcome proctological scrutiny which that has called down upon its normally painfully private denizens. Instead, these fiercely proud ronin are running out of time.

Let Andrew Ross Sorkin explain:

The private equity world is sitting on [approximately $1 trillion of uninvested capital]. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.

Nearly $200 [billion] ¹ from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree.

Now a person educated in the aspirational propaganda of Atlas Shrugged and the Private Equity Growth Capital Council might wonder just what the panic is about. Surely the gimlet-eyed fiduciaries of Park Avenue, when faced with the unattractive selection of poor quality, overpriced corporate merchandise for which they blame their relative inactivity over the recent past would be cold bloodedly rational enough to simply return their investors’ capital with a smile and a shrug and a “Better luck next time, Old Bean,” no?

No, not really. Not even close.

* * *

First, to unpack this mystery one must dispense with a couple mischaracterizations Mr. Sorkin and his sources employ which cloud the issue at hand. Mischaracterizations, truth be told, which I and almost everyone else in the finance industry use as descriptive shorthand simply because it takes too much time to speak completely accurately. The biggest of these is that private equity firms actually have the hundreds of billions (or trillion) of dollars of limited partner funds they raise to invest in their sweaty little hands.

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

In fact, faced with the decision to stick to its investment criteria and let lousy, overpriced opportunities pass—thereby losing associated management fee income—it becomes painfully clear that many private equity firms face very strong incentives to take a flyer. After all, the funds they are investing are, for the most part,² not their own but rather their limited partners’. Why not invest them in second-rate, overshopped, undermanaged properties at 10 times EBITDA? Sure, the likelihood that you’ll earn a decent return is slim, but the financial sponsor’s employees hold a contractual option to 20% of the upside (the famous “carried interest”) on the off chance it does. In some respects, it is a free option, and everyone knows you shouldn’t give up free options without a fight. Sure, the investment will probably be crap, and may even go belly up, but dem’s da breaks, no? Caveat (institutional) investor.

* * *

So it is a fair and reasonable worry that the wall of soon-to-expire institutional commitments to private equity may trigger a bout of less-than-fiduciary shenanigans on the part of the finance professionals entrusted to manage them. This situation is also a timely reminder that the primary mission of any institution, once it becomes large enough, is the perpetuation and survival of the institution itself. Notwithstanding private equity’s reputation for attracting ruthless, clear-eyed homo economici, it is well to remember that incentives are not always what they seem, and often cut both ways.

It is also a salutary cheer to me and my colleagues in my industry, who are busy sharpening our skinning knives and licking our chops as the bison herd thunders toward the commitment expiration cliff. For it’s an ill wind that blows nobody any good.³

Kambei Shimada: “Go to the north. The decisive battle will be fought there.”
Gorobei Katayama: “Why didn’t you build a fence there?”
Kambei Shimada: “A good fort needs a gap. The enemy must be lured in. So we can attack them. If we only defend, we lose the war.”

Good. I’ve got a couple of real lemons to unload.


¹ The original article published Monday evening cited $200 million as the amount requiring investment, but I have taken the liberty of correcting it, since this is clearly ludicrous. Two mid-size financial sponsors could spend $200 million in an afternoon without hardly trying, much less Blackstone or Carlyle. I wouldn’t be surprised if Steve Schwarzman spent $200 million on crab claws alone each year. An otherwise uneducated reader might also wonder what the fuss is about if only 0.02% of the trillion dollar total is expiring by year end. It seems they need to teach some remedial mathematics in journalism school.
² Now to be fair, many private equity firm professionals invest a significant amount of their own money in their funds alongside limited partners, and this can act as a powerful reinforcement to their proper fiduciary duties. But without this natural alignment of incentives from skin in the game, limited partners should be exceedingly skeptical that financial sponsor employees have their best interests fully in mind at all times.
³ And it’s a big bison herd. Levered up at a typical 30% to 40% equity ratio, $1 trillion of uncommitted equity in private equity hands translates to $2.5 to $3 trillion of purchasing power. Fire up the barbie, Ralph!

© 2012 The Epicurean Dealmaker. All rights reserved.

Your Village Called...

Villager: “Wor, she turned me into a newt!”
Sir Bedevere: “A newt?”
Villager: “I got better.”

— Monty Python and the Holy Grail

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

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

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

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

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

* * *

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

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

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

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

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

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

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

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

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

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

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

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

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

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

* * *

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

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

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

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

Oh... It’s for you, Josh.

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


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

© 2012 The Epicurean Dealmaker. All rights reserved.

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.