As a rule, I usually don't spend a lot of time on reader mail, or on the analysis of it here in these pages. It always feels self-serving to wax poetic at audience response to one's writing. For the same reason I don't turn comments on for the entries here. (A few readers have asked me to, and sometimes I actually consider it). Recently, however, reader mail has been interesting and insightful enough to warrant more comment. The three recent posts that have gotten me the most reader interest (as measured by influx of mail) here at Going Private include:
The majority of replies to "Voodoo Economics," my critique of the piece in last Sunday's New York Times on the evils of management buyouts by econ guru, general figure of shareholder menace and sometime economics teacher actor, Ben Stein, began with some version of:
"Ben Stein is off his rocker, but..."
...and continued to suggest that MBOs really ARE evil, though not for the reasons Mr. (Professor?) Stein would indicate. My favorite in this vein is, by far, the opening penned by a fellow practitioner. Specifically:
"While I agree that Ben Stein's butter seems to have slipped off his pancakes..."
I have to say I admire the structural consistency many of Going Private's valued readers display in writing comments to the editor. The next phase of almost every Ben Stein letter was triggered by prose generally resembling:
"I think you're misinterpreting Stein's [noun]", or;
"Your critique fails to account for [shopping list of items]."
Here are some of the arguments Going Private readers made in defense of Professor Stein:
1. My critique relies on the existence of "efficient markets" in the philosophical sense. In other words, my argument falls apart if markets are not perfectly efficient in the economic theory sense.
I'm not sure where this criticism comes from as I thought I pretty clearly explained how one's theory of market efficiency was not operative on the question of MBOs except as to define if "inside information" could actually benefit an insider. (Proponents of "perfectly efficient" market theory would be hard pressed to show how inside information could be helpful to an insider). The question is not "are markets fair" it is "are shareholders oppressed by MBOs" compared to other transactions. A lot can be gleaned from simple resort to comparison between LBOs (to which Stein seems to have less objection) and MBOs.
2. There is some fundamental unfairness intrinsic to MBOs with respect to shareholders.
I was struck by the similarity of some commentators objections to the attitudes that caused me to pen "Beware Dark Figures Bearing Fairness." We should all know that in markets, as in life, fairness is a relative, subjective and therefore dangerous term. Oddly, the trend in the United States seems to be in the other direction, towards an entitlement to returns.
I suspect that the creeping entitlement to "market returns" that has begun to rear its ugly head is, to no small degree, fostered by the increasing linkage of high market returns to defined benefit (as opposed to defined contribution) retirement plans. The issue is framed nicely in a recent Wall Street Journal opinion piece by McMahon, a senior fellow at the Manhattan Institute:
Public funds, however, are allowed to discount their long-term liabilities based on the assumed annual rate of return on their assets-- which, for most public funds, is pegged at an optimistic 8% or more. In other words, the risk premium in the investment target is compounded in the liability estimate. (This accounting twist also explains how politicians can claim, with straight faces, that pension obligation bonds are a nifty arbitrage play.)
If the liabilities of public pension funds were valued on the same basis as private funds -- using, for example, the 30-year municipal bond rate as the discount rate -- funding requirements would be dramatically higher. Estimates of the nation's real public pension funding shortfall range from an added $500 billion for state retirement systems to at least $1 trillion for all public systems.
The 8% rate of return assumption, while shared by some major corporate plans, is certainly open to question. But public pension fund managers are in a pickle: If assumed returns were reduced, even "fully funded" systems like New York's would find themselves tens of billions in the hole -- as shown by alternative calculations buried in financial reports for Gotham's retirement systems. And so, in the name of protecting taxpayers from having to pay higher contributions in the short term, funds expose them to more volatility and risk over the long term.
Public pension funds used to be run on more of an insurance model, heavily reliant on fixed-income securities. But over the past 40 years, the vast expansion of government at every level has vastly expanded the pool of public pension liabilities. This leads to a vicious cycle: As the employee head count rises and unions lobby for bigger pension entitlements, funds feel pressure to pursue riskier investments with higher returns -- which explains their increasing reliance on stocks, as shown in the nearby chart. But when returns exceed expectations, as in the boom market of the 1990s, politicians and fund trustees feel irresistible pressure to raise benefits again.
Not surprising then, the news that pulling an 8.5% return on a $10+ billion portfolio gets you fired in this day and age. High returns have become an inalienable right.
I have also wondered to myself what a 1920s era Lloyd's broker would think if teleported to the year 2006 where auto insurance is mandatory in some U.S. states and somehow health care insurance has become a "right." Same issue. A "right" to a financial return. Something for nothing.
We should all know better than to believe that regulation can "level the playing field." I would love to be able to run as fast as Carl Lewis. Too bad for me. There ought to be a law!
I was surprised, therefore, then to find most of the pro-Stein arguments bearing some version of this "fairness" argument. That the poor shareholders were being fleeced somehow by clever management. That they were being deprived of returns that were rightfully theirs. Returns that they "already owned" somehow, even though these returns have yet to materialize. Arbitrage opportunities that were "rightfully theirs" in the words of one email contributor.
It is this attitude that permits market actors to indulge themselves with fantasies that returns that they themselves are in no position to create or realize, or returns that are not possible without substantial changes in the financial environment, perhaps even returns that they had expected when they bought the stock in the first place, are theirs to capture (even before they have been earned). This attitude, I believe, is what prompts writers like Stein to decry managers in a position to create returns when taking private a firm that the very shareholders now complaining made impossible to realize in the public capital markets in the first place though behaviors as varied as the fixation on short-term (quarterly) earnings prospects, poison pill arrangements, and pricing the company's stock below book value because of an aversion to risk.
"But you are ignoring the vast information disparity between managers and shareholders," worried one commentator. (The same commentator that only two paragraphs earlier had insisted that markets were perfectly efficient. My question as to how the managers could capitalize on "superior information" in a perfectly efficient market went unanswered).
Even in an inefficient market (and I don't believe U.S. capital markets are perfectly efficient) superior information only gets you so far. And in the United States there are any number of safeguards to prevent abuses here. Ex ante there is the shareholder vote and board approval requirements. Ex post there is a long and studied history of shareholder litigation over items like price and deal terms.
"They are sharing non-public information with potential buyers and showing favoritism in picking which buyers to share that information with."
Let's pretend for a moment that this is true. The redress for this is in Rule 10(b)(5), not in the outright ban of MBO transactions as Stein suggests. The disclosure of material non-public information to a potential buyer to the exclusion of others falls into the insider trading realm. Woe to the buyer who continues to bid in such a circumstance.
Shareholders are hypocritical here quite often. Insisting on full disclosure when "good news" might give them an upside, but quite happy for information to be secret and markets mispriced upwards when they are selling. In reality, shareholders like Stein don't care if markets are mispriced, they just don't want to be on the wrong side of the mispricing.
"But poor shareholders can be victimized by the tyranny of the majority, even if they didn't want to sell," said one writer.
I am unsympathetic. Shareholders knew or should have known when they bought the stock that they were subject to the possibility of a MBO (or any M&A transaction) where they would be on the losing side of a Board of Directors decision or proxy fight. That is "the deal." One wouldn't expect to be taken seriously if one's political candidate lost an election and one was moved to complain "I should have two votes! It is not fair that I lost and the voting rules I knew about before the election should be modified retroactively to permit my victory!" Strange then that this argument is constantly being forwarded in the context of shareholder actions.
Another reader points out something insidiously clever. Stein, he quips, is outraged at exactly the behavior he, himself, is exhibiting. Stein bought the stock in the first place convinced that he knew better than other shareholders how to extract value from the stock or that a price disparity would benefit him. Superior knowledge, therefore, is what Stein wants to profit from. How then can he, with a straight face, complain when management does the same via an MBO and most shareholders willingly sell? Stein is entirely free to start an activist fund to do the same, if he can garner the capital. Should we ban all transactions where homework, good sense and a lot of research give one participant an advantage? This same reader points out that Stein's argument is "so eerily similar to an argument recently put forth in the 8/28 New Yorker."
Another reader wondered if how these transactions could be fair given that management had all upside risk and no downside risk. I can't speak for that reader's experience, but I haven't seen an MBO where management didn't have substantial personal net worth at risk. Sub Rosa has done 4 MBOs since I arrived. All of them contain provisions (like co-investment) that would put the senior managers in the poor house if the deal blows up. This is not an accident. We do it, as do other private equity firms, for precisely these incentive reasons. While not my favorite example of excellence in financial journalism, a recent article in Fortune on the decision of former GE Vice Chairman Dave Calhoon to head up VNU when opportunities in much larger, public firms were available demonstrates this point nicely. Says Fortune:
Press reports valued his pay package at around $100 million, but its real value is uncertain because Calhoun is also making a substantial investment in VNU (no one is saying exactly how much).
The most interesting question arising from this situation is: Why couldn't a huge publicly traded company make Dave Calhoun an offer he'd accept, but a small privately held firm could? Again, the answer seems obvious. In today's climate of deep shareholder distrust, no public company would dare to offer a prospective boss such munificent terms.
Any public company that now offered a new CEO $100 million would be scourged without mercy by shareholder activists and TV talking heads nationwide.
And as to the question of "skin in the game," and sweetheart deals to management?
Calhoun is as sharp as anyone, and he was negotiating against people representing the Blackstone Group, the Carlyle Group, Kohlberg Kravis Roberts, and the other private-equity firms that bought VNU - collectively the smartest, toughest SOBs in business. Whatever deal they reached is the correct deal because it represents the market at its most efficient, ruthless best. Calhoun stands to make $100 million or more because cold-eyed investors with their own money at stake believe he's worth it.
Increasingly, public capital markets are beginning to look like the laws of thermodynamics (You can't win; you can't break even; you can't get out of the game) with Vegetable Capital actors playing the part of the universe and getting the free lunch. Managers increasingly are faced with reduced compensation for more risk. When they do profit it is called "windfall." Responding totally rationally to this perverse set of incentives, they choose to leave the public markets and, in doing so, find themselves under attack from the likes of Ben Stein, who feels he has been cheated because they didn't sit around and "do what they were supposed to do in the first place," i.e. make money for shareholders while taking less and less pay and adopting more and more personal legal and financial risks and incurring increasing opportunity costs.
Why does this increasingly feel to me like the plot for an Ayn Rand novel?