Resistance Is Useless!

And then, one Thursday, nearly two thousand years after one man had been nailed to a tree for saying how great it would be to be nice to people for a change, one girl sitting on her own in a small café in Rickmansworth suddenly realized what it was that had been going wrong all this time, and she finally knew how the world could be made a good and happy place. This time it was right, it would work, and no one would have to get nailed to anything.

Sadly, however, before she could get to a phone to tell anyone about it, a terribly stupid catastrophe occurred, and the idea was lost forever.

This is not her story.

— Douglas Adams, The Hitchhiker's Guide to the Galaxy

Where are the Vogons when you need them?

* * *

I was thrilled to find out today that the bright bulbs at Pardus Capital have discovered how to make the world a good and happy place, and—unlike Mr. Adams' unfortunate girl in Rickmansworth—they were actually able to make it to a telephone (or an e-mail server) to communicate it before anyone obliterated the planet to make way for an interstellar bypass.

Their world-changing idea—in case you missed the public notice in the media today—is to effect a no-premium stock-for-stock merger of equals between Delta Air Lines and United Airlines. By way of this impressively clever and original mechanism, Pardus proposes to eliminate vast cartloads of duplicative costs ($585 million, to be exact) and put the merged airline on the path to prosperity in an age of rising fuel prices and looming Democratic re-regulation. Implicit in this strategic thunderbolt I can only assume there must be additional benefits, as well, such as the eventual recovery of pricing power by pathetic hub-and-spoke carriers, fresh pillows and mints for every economy class passenger, and the permanent global eradication of jock itch. Left unstated in the press release is whether anyone will need to be nailed to a tree or any other wooden structure to effect this revolutionary outcome, but I suppose we must take it on faith that our intrepid Pardusians have thought of this, as well.

"Damn!," you exclaim, "Why hasn't anyone else come up with such a brilliant and simple idea?" Good question. I guess the legions of M&A and corporate finance bankers plying their trade in the aviation sector over the past several decades just didn't have the intellectual firepower or sheer visionary drive of Pardus principals Karim Samii and Shane Larson. Either that, or they were too busy picking lint out of their collective belly buttons to notice a brilliant idea like this when it trotted up and pissed on their shoes. Who knows?

On behalf of my fellow investment bankers, I must humbly accept this rebuke for having had our collective thumbs up our asses for so long and express my sincere thanks to our hedge fund brethren for having so gently shown us the error of our ways. I confess that I, too, was ignorant of the fact that the firmament had been graced with the shooting star that is Pardus, but I am profoundly grateful that Mr. Samii was not content to rest upon the laurels of "a successful career at the investment firm W. R. Huff of Morristown, N.J." but rather chose to illuminate our pathetic fumblings with the radiance of his intellect.

Now, a cynic and a caviller might object to our heroes' proposal with a laundry list of the usual objections to airline mergers (chief among them the rather intransigent sticking point of how you merge employee seniority lists between pilots and flight attendants at two different airlines into one happy, cohesive family who are delighted—simply delighted, I tell you—to deliver improved customer service to a planeload of $49 passengers from Detroit to Orlando), but I for one will resist such negativity. After all, Messrs. Samii and Larson have correctly identified the looming threats of permanently higher fuel prices and crushing structural debt as problems desperately in need of a solution, and who are we to object to the patently obvious answer of merger and cost-cutting they lay before our dazzled eyes?

Others might say that the legacy airline business typified by carriers such as Delta and United is doomed to stumble along ad nauseum until public outcry breaks down the political and regulatory barriers to consolidation by merger or liquidation, but this is nothing more than unhelpful pessimism. Sure, both Democrats and Republicans have been diligent in preventing meaningful consolidation through cross-border mergers (no "foreign person" can own more than 25% of the voting stock of any US carrier), intra-US combinations (viz. the damp squib that was USAirways/United), or even the judicious application of Chapter 7 liquidation to the zombie air carriers who seem to revisit bankruptcy every few years or so, but we must understand that all those distinguished grey-haired pilots and curvy stewardesses wield a pretty mean lobbying stick. Furthermore, no Congressman worth his or her salt wants to preside over the (arguably necessary) destruction of (tens of) thousands of excess jobs in the name of economic rationality. After all, how can you serve the public good if you cannot get re-elected?

Besides, we know the Pardus Capital gang have already thought through all these trivial issues. After all, they spent a tidy chunk of their limited partners' capital on hiring both Gordon Bethune and SH&E to give them the answers they wanted to hear. They even went so far as to pro forma Continental's and Northwest's numbers into a two-page merger model with Delta, but their grizzled industry experts waived them away from the apparently greater cost savings of the latter and the "difficult management succession issues" of the former as non-starters. Whew. I'm glad those are out of the way.

And we know that Pardus is serious. A hundred and forty million dollars serious. They just added four million shares to their now-seven million share holding in Delta, so their interests are fully aligned with those of the rest of us widows and orphans who have a soft spot for legacy air carriers headquartered in Atlanta. Not for them to talk up the Delta shares just so they can trade out of the tar baby they just stumbled into, no sir.

So, in that spirit, I am offering my M&A advisory services to Pardus to help them effect the industry-transforming merger they have proposed. I suggest a modest success fee of $75 million if we succeed, and a "Sorry, better luck next time" pat on the back if we don't. Being successful hedge fund guys themselves, they should understand that kind of "trader's option" incentive structure perfectly well.

Not that that is what they do, mind you.

© 2007 The Epicurean Dealmaker. All rights reserved.

Ave atque Vale

Well, Percy Walker has taken his marbles and gone home. We citizens of the blogosphere are the poorer for it. (Approximately $10.4 billion poorer, if you take Ol' Perce at his word.)

This is a bad thing, in my opinion. Percy was "the world's foremost authority on the proper tax treatment of carried interest," in his own words, and it is always a great loss to the public weal when the leading theorist on a contentious social issue is forced to leave the field due to a few overzealous Spitzer wannabes. I would much rather have watched Percy and Vic "Carrot Top" Fleischer continue to mud wrestle over the issue and bite the occasional chunk out of each other's ear lobe. Everybody loves a good fight.

I suppose it is a sign of the maturation of the issue of private equity taxation that things have taken such a turn. Realizing that the private equity industry has no more than three actual friends on Capitol Hill (out of a total of 54 lobbyists and six dogs), Carlyle's David Rubenstein has dropped his previous strategy of wrapping Henry Kravis in the American Flag and wearing a lapel pin made out of apple pie in favor of pointing out that any tax targeted at carried interest will gore a great number of oxen that have no relationship to picayune plutocrats with Rod Stewart fetishes; namely, oil and gas and real estate. And everyone knows that we can't even look sideways at Real Estate nowadays without having the poor wretch burst into tears.

Vigorous theoretical defenses of the indefensible and scathing ad hominem attacks on your enemies simply no longer cut it in this Brave New Corporatized World of private equity. Christ, Rubenstein talked so much about "global brands" at the Deal M&A conference this week he began to sound like a Procter & Gamble ad manager. Plain speaking pioneers like Percy Walker are being frogmarched into retirement by weasely image consultants and PR specialists who are less interested in the truth than in soaking the previously principled PE firms for all they are worth.

Not that I agreed with Percy, mind you. I have no prouder trophy than Percy's blog post anointing me as one of his "Private Equity Haters." (You wouldn't believe how expensive and dangerous it is to bronze an entire computer while it is logged onto the internet, but I did it.) A great man is largely defined by the power and influence of his enemies. By that token, I am officially a Bad Ass.

Anyway, wipe away a tear for the passing of a great man. And pay absolutely no attention to those scurrilous rumors that Percy has eloped with sardonic memoirist Equity Private of PE fan site Going Private. While it is true that She Who Must Be Obeyed has been missing in action for over a month, I know for a fact that there is no truth to the rumor that she has been personally preparing a leafy love nest on a deserted Tahitian island in advance of Percy's arrival. Like all good private equity professionals, she outsourced it.

© 2007 The Epicurean Dealmaker. All rights reserved.

Being Bruce Wasserstein

Once again, I am sorry for any disappointment I may have caused my Faithful Readers for another extended absence, but I have been busy trying to persuade some Europeans and other unwashed furriners to use their ridiculously inflated currency to put a number of my US clients out of their undercapitalized misery. Attention K-mart shoppers, Blue Light Special in Aisle 3: Corporate America! Of course, being the upstanding patriot you know me to be, I refuse to accept payment of my fees in anything other than small-denomination pound notes, FOB the Isle of Man.

Anyway, in between moving assets frantically off shore, I dropped by The Deal's 2008 M&A Outlook conference in New Amsterdam today for a few giggles. A marquee list of the Great & Good—along with the usual admixture of shills and sponsors—trotted out the usual platitudes about the M&A market and its imminent climb to $50 trillion in volume any month now. A few people distinguished themselves by not making complete and utter fools of themselves, but it is against my policy to praise competitors in public, so I won't.

The highlight of the program for me was the triple billing of Bruce Wasserstein, Marty Lipton, and Leon Black, who did a creditable job of talking past each other in a very deferential and collegial manner. So polished was their family juggling act—Uncle Brucie, Grampa Martin, and precocious Little Leon—that they might want to consider the circus should credit armageddon or a Democratic Administration truly shut down the merger game for good.

For such a large bear of a man, Leon Black constantly surprises me when he opens his mouth to release a little, high-pitched voice more suited in my view to a prepubescent teen. That being said, there are plenty of squeaky voiced terrors out there with proven ability to kick my ass from here to Sunday—including Mike Tyson and David Beckham—so I never make fun of him to his face. Marty Lipton laid on the Grampa Munster act a bit thick, but knowing him he probably did it to keep the audience off balance for some devious ulterior motive of his own.

Bruce was another story. I don't know about you, Dear Reader, but I often scratch my head over the success and prominence of people at the pinnacle of my industry. I have met most of them, I have worked with and against them, and I usually can't see why they made it to the top of the slippery pole over dozens of other investment bankers with just as much apparent talent and ambition. Usually I just put it down to an over-developed Napoleon complex and leave it at that. I had not run across Bruce myself for several years, so I suppose I had slipped into thinking his ascent to his lofty, well-compensated perch was due primarily to a finely tuned talent for politics and some efficient knife work in a back alley.

But hearing him again in person reminded me of the impression he has made on me several times in the past. The man can talk. And by that, I do not mean the content of his speech, or the brilliance of his insights (which were middling). I mean his voice. For his voice is Bruce Wasserstein's true instrument, and he plays it like a master. It is persuasive, dynamic, melodious, and insinuating, with a noticeable throb and catch that cries out for his listeners to say, "Yes, yes! What that man is saying makes perfect sense. He is so ... reasonable." I always laughed when I heard him described as "Bid 'em up Bruce," but today I was reminded why he usually succeeded in advising his hardheaded clients to go for the gusto. They just curled up in a ball and purred, "Sure, Bruce, whatever you say. Just keep talking."

So with that in mind I offer up some free casting advice for Oliver Stone or whatever director decides to produce Bruce Wasserstein's life story: cast John Malkovich in the title role. The voice match is almost perfect—although Bruce actually has a lower register—and a little less hair and a little more tan would make Malkovich an almost perfect match in appearance. (Bruce has lost a lot of weight in the past six months or so.)

Besides, Malkovich the actor—whom I also admire—is in some deep, elemental way profoundly disturbing. Who better to play the Pied Piper of M&A?

© 2007 The Epicurean Dealmaker. All rights reserved.

Down the Rabbit Hole

It's a rainy day here in Manhattan. Perfect weather to stay in and read a good post on the "Demise of the Quants" by my fellow bloggist and tetchy ranter Baruch over at Ultimi Barbarorum¹. Fire up the coffee pot, break out a dictionary, and read it. You'll learn something.

Unless he² is actually perma-deb Tinsley Mortimer playing an incredibly elaborate joke on us all³, Baruch appears to invest in equities for an unnamed Swiss financial institution which shall remain nameless. (I will give him the benefit of the doubt and credit for his obvious native intelligence to conclude that it is not my favorite Schweizerdeutsch whipping boy, UBS.) He writes in reaction to a semi-triumphalist article on the quant meltdown this August in MIT's Technology Review magazine and his own informed reflections.

Most of what he says rings true, and—best of all—unlike Your weasely little ticket-scalping middleman Faithful Correspondent, he actually appears to invest for a living and therefore presumably knows what he is talking about. Like I said, read it.

I read the same MIT article recently, too. However, my strongest reaction had less to do with the trials and travails of a bunch of overpaid ex-nerds and more to do with the apparent epistemological and ontological underpinnings of the Grand Quant Paradigm: namely, that in financial markets, math is what matters. In its strongest form, this intellectual substrate can be characterized as described in the MIT piece:

Beneath all this beats the great hope of the quants: namely, that the financial world can be understood only through math. They have tried to discover the underlying structures of financial markets, much as academics have unlocked the mysteries of the physical world. The more quants learn, however, the farther away a unified theory of finance seems. Human behavior, as manifested in the financial markets, simply resists quantification, at least for now.

"At least for now." Classic.

I find it hard to believe that anyone with an IQ over 60 could believe such shit, but I am humble enough to know that even I can be mistaken.

* * *

Gosh, where do I begin?

Stripping away the sloppy journalistic overkill ("the financial world can be understood only through math" [emphasis mine]) and the drive-by analogy to physics ("a unified theory of finance") still leaves me with the gaping howler that at least some of these knuckleheads believe the financial markets can be understood primarily through math. This, as the man said, is nonsense. Even the eminence grise and pioneering quant Emanuel Derman has figured this out, although it is not clear he has figured out why:

Quantitative finance "superficially resembles physics," he says, "but the efficacy is very different. In physics, you can do things to 10 significant figures and get the right answer. In finance, you're lucky if you can tell up from down."

Interestingly enough, the repeated references to physics in the article are instructive, since that—plus pure mathematics—happens to be the academic background of many if not most of the quants practicing today. (Über quant and sesquitillionaire James Simons of Renaissance Technologies is a world class mathematician who co-authored the Chern-Simons theory on geometric invariants, widely used in string theory. No innumerate slouch he.) Their influence shows. Perhaps the most widely known formulation in mathematical finance—and arguably one of its foundational theories—is the famous Black-Scholes theory of option pricing, which holds as its central insight the assumption that a security price propagates through time based upon geometric Brownian motion, like the molecules in a gas.

By any measure, B-S⁴, along with its numerous variants and competitors, is a phenomenally successful theory, one that describes and enforces price relationships among cash securities and their derivatives in markets trading trillions of dollars every day. If anything has the status of Holy Writ in financial markets today, it is the Black-Scholes model. But Black-Scholes did not create the derivatives market; it is a heuristic construct which describes the arbitrage relationships and conventions which market participants use to trade these securities. The equity options market, while small, predated Fischer Black's and Myron Scholes' little exercise by some years, and seemed to function quite nicely before it had a rigorous quasi-physical theoretical underpinning. (In fact, if memory serves, Black and Scholes tried their hand at trading options using the insights from their formula and got their very large heads handed to them by the unenlightened louts in the options pit.)

Write this down: Black-Scholes works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that's how prices should work. It is a convention, not a physical or financial law. This is the central epistemological trap that quants fall into when they conflate the tools, techniques, and ontological assumptions of physics, which attempts to describe that which is (more or less independent of us humans), with those of mathematical finance, which attempts to descibe how human beings trade and value financial instruments and their derivatives.

It is a true and remarkable fact that mathematics, in the words of physicist Eugene Wigner, is "unreasonably effective" in describing substantial swathes of the physical world. (If you do not find this fact remarkable, even disturbing, I would posit that you understand neither math nor physics. Think again.) But at least part of the reason mathematics has been so effective to date in helping us understand the physical world must be due to how well-behaved the physical world is. Math can describe the orbits of the planets and the fissioning of an atom with astonishing accuracy, but that is because the questions we are trying to answer in these particular cases are so narrow. We can ignore mountains of superfluous data (presuming, for example, that the color of an orbiting planet does not affect its orbit) in order to use math to answer what turn out to be relatively simple questions.

But this approach breaks down in the social sphere, where the interacting particles under investigation happen to be living, breathing people with opinions, conscious and unconscious biases, and adjustable rate mortgages. Financial markets are social systems, comprised of the countless interactions of conscious (and self-conscious) agents. It is Heisenberg's Uncertainty Principle—according to which the experimental observation of a small enough physical particle affects the outcome of the experiment itself—writ large. Look back at the central point of Ultimi Barbarorum's discussion of the quant strategy blow-up. By all accounts, the data seem to indicate that these clever boys and girls arbitraged away the persistent mean-reversion tendencies they so carefully identified in the first place by crowding into the same pairwise stock and sector trades as everybody else. Then, when the subprime doo-doo hit the fan, cross-sector contagion induced by market wide leverage and other connections blew those carefully researched historical relationships clean out of the water. It wasn't arbitrage or Brownian motion at work here. It was panic. Gas molecules in a box don't all rush for the exit at the same time when you open a hatch; people do.

Anyway, I'll finish my rant with an exchange from the quant conference the MIT article described which I find illuminating:

"How many [people in the room] think spreads will widen?" [conference leader Leslie Rahl] asked.

The hands of about half the smartest people on Wall Street shot up.

"And how many think they'll narrow?"

The other half—equally smart—raised their hands.

"Well," she said. "That's what makes a market."

Equally smart, indeed.

¹ Don't ask. Better yet, read the site. It has something to do with Dutch-Portugese-Jewish philosopher Baruch de Spinoza ranting about some very naughty people in the mists of time. Hey, what did you expect the guy who publishes "The Epicurean Dealmaker" to read in his spare time? Gawker?
² Come on, now, girls, don't get your panties in a twist. Surely it is a safe assumption that "Baruch" is packing the Y chromosome, isn't it? After all, UB is a finance site, on the internet. Need I say more?
³ What are the odds? Hmmm.
⁴ Sorry. Couldn't resist. By the way, aren't footnotes great?
© 2007 The Epicurean Dealmaker. All rights reserved.

Dead Man Walking

The New York Times tells us today that the Board of Directors of Merrill Lynch is placing collect calls to a number of Wall Street personalities to gauge their interest in taking over the CEO position from current tenant Stanley O'Neal. You know, Dear Readers: that same Stan O'Neal who just announced the largest quarterly loss in Wall Street history, after projecting somewhat less than half the actual amount only weeks before, and who capped it all by going hat in hand to Wachovia begging them to consider a prophylactic merger. "Wachovia?," you ask. Yes, Wachovia.

Apparently the house of Pierce, Fenner & Smith has not sunk low enough for the MER board to tolerate this. O'Neal's handpicked director poodles are so upset that great clumps of their manicured curls are coming off in their jaws, and they are baying (privately) for O'Neal's blood. Not privately enough, of course, to prevent the entire financial media from picking up the story.

I cannot speculate what will happen next at Mother Merrill, but I can guarantee you O'Neal's days at the helm are numbered. Being a CEO at an investment bank is not unlike crowd surfing at a mosh pit: it's a pretty cool way to move around quickly, you are supported entirely by other peoples' efforts, and everyone tries to get a piece of you. Unfortunately, when the crowd loses interest in supporting you, you tend to fall fast, hard, and painfully. In addition, after dropping you lots of your former investment banking subordinates—both friend and foe—have the added charming tendency to skewer you repeatedly with long knives. Et tu, Brute?

By allowing the news that they are talking to potential CEO replacements to leak into the public domain, Merrill's board have guaranteed a complete collapse of confidence in O'Neal. His enemies (legion, by all accounts) will be gunning for him, and his friends and sycophants will be running for cover. Few administrations of any stripe can stay in office after losing a public vote of no confidence, much less one in the Lord of the Flies environment of investment banking.

Fortunately, O'Neal will no doubt have a plenty cushy negotiated severance package to fall back on. Plus, he always has golf. Should he still feel a little saddened by his newly straitened circumstances, however, he can always console himself with philosophy. I suggest Boethius, for a start.

"Why, O my friends, did ye so often puff me up, telling me that I was fortunate? For he that is fallen low did never firmly stand."

— Boethius, The Consolation of Philosophy

© 2007 The Epicurean Dealmaker. All rights reserved.