It's Good to Be the King

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

So, in dutiful fashion, they ran an article this weekend on the use of corporate jets by CEOs' spouses and other perks of the executive suite.

When Nicki Mulally wants to travel, she can usually hop on one of Ford Motor Co.'s Falcon twin-turbo jets.

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

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

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

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

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

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

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

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

© 2007 The Epicurean Dealmaker. All rights reserved.

Marks in the Sand

Felix Salmon put up a nice commentary today on an article in today's Financial Times which delved into the mess surrounding collateralized debt obligations (CDOs) backed by sub-prime mortgages. In it, he identifies four underlying risks in the current CDO situation and then correctly concludes that we cannot predict a priori that they will combine to push the market off the rails:

Subprime defaults can, in theory, pass through into defaults on CDO tranches. That, in turn, can, in theory, trigger CDO liquidations. That, in turn, could mean the amount of liquidity in the credit markets drying up. And that, in turn, will mean that subprime borrowers find it much harder to refinance – thereby increasing the chance that they will default.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

© 2007 The Epicurean Dealmaker. All rights reserved.

J'accuse, Part Deux

Damn, now Justin Fox needs to be spanked.

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

Mr. Fox, who styles himself over at Time magazine as "The Curious Capitalist," has blundered into my field of fire with the following comment, which he appended to an otherwise anodyne catalogue of corporate tax rates around the OECD:

As I've studied the private equity taxation debate, I've become more and more convinced that the private equity boom of the past decade in the U.S. has been driven in large part by tax arbitrage. By buying corporations and then loading them up with enough debt that they no longer have any taxable earnings, then paying their partners with "carried interest" that for reasons that have more to do with history than logic is taxed as capital gains instead of as ordinary income, the private equity firms are doing an end run around the U.S. tax system. When things like that happen, it's always worth asking whether we should be saying shame on those private equity firms or shame on the U.S. tax system. [emphasis his]

Arrrrggghh! No, no, no!

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

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

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

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

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

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

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

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

© 2007 The Epicurean Dealmaker. All rights reserved.

Mere Anarchy

Bill Gross is at it again.

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

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

For an interesting echo in the kultursphere, we could turn to a piece in The New York Times today about Girls (and Boys) Gone Wild in Romantic Rome:

“It is unbelievable,” said Flaminia Borghese, president of a homeowners’ group in the historic center that is demanding greater noise control measures and police patrols. “There is a total lack of control.”

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

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

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

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

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

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

— W.B. Yeats, "The Second Coming"

© 2007 The Epicurean Dealmaker. All rights reserved.

Ouch, Babe

Apparently I missed this little morsel of goodness back in March:

Vice Chancellor Leo E. Strine Jr., who often presides over big deal-related cases at Delaware’s Court of Chancery, offered his opinion on [the] hot-button issue [of advisory conflicts at big investment banks].

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

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

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

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

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

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

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

Hat tip to DealLawyers.com for bringing this to my belated attention.

© 2007 The Epicurean Dealmaker. All rights reserved.