Going Private

Terms and Conditions

Harris Rubinroit's tour de force survey in Bloomberg of the nuances of interest rates in large buyout transactions is a must read for Going Private mavens.  Using HCA as a foil, Rubinroit points out five key issues.  First, that KKR and Bain will likely be paying some of the highest interest rates since 2001 on the $16 billion they plan to borrow.  (Rubinroit uses some sound logic to guess they are near 2.15% over LIBOR and then points out that LIBOR is at a 13 month high).

Second, HCA already is at junk bond credit rating levels (Ba2 from Moody's) but that interest rate spreads were still at record lows for risky loans as recently as April.  (Rubinroit cites 1.59% as the spread that month compared to the 2.15% mentioned earlier in his article).

Third, even with the aggressive lending of hedge funds, rates are headed higher.  Rubinroit cites Thomas Finke at Babson Capital Management in blaming "more balance between investor demand for loans and supply" for the imminent rises.

Fourth, citing S&P, last quarter buyout firms averaged 5.19x cash flow for acquisitions (4.10x was the average for 2003).

Fifth, all these factors, and others, have contributed to the rise of "covenant lite" loans, with which Going Private readers will likely be familiar as the topic has been addressed here repeatedly.  So hooked on low restriction loans have the buyout firms become that it has become habit to simply negotiate up interest rate in favor of limited covenants right off the bat.  Interest rate spreads were so "compressed," argues Rubinroit, that covenants became the only effective way for lenders to compete.

The impact of breaking covenants is then well illustrated via reference to Six Flag Inc.'s ongoing renegotiation of $1.03 billion in debt after informing bankers they were unlikely to meet the 4.00x cash flow to interest expense ratio required by the loans and requesting that ratio be lowered to 2.50x.  Lenders are likely to extract half a percentage point of LIBOR spread and a quarter point "renegotiation fee" for the concession.  I expect this figure is substantially larger than what could have been negotiated from the banks before the covenant was broken.

Additional peeks into Bombardier and Intelsat, Ltd. are well worth the look.

"Fan" Mail

Reader mail is both the joy and horror of writing Going Private.  Monday I got a missive from a European reader/writer that contained an unusual tidbit.  At first I shrugged it off, but after some reflection I have found myself increasingly offended by the tone and implications.  I suppose I should take the left handed compliment in stride given the sullied reputation that private equity types seem to have carefully and laborously cultivated for themselves, but still.

Congratulations on your blog! I do not usually read blogs as I consider them a waste of time and often full of typing errors and the authors' unimaginative views. I came across yours almost by accident and must admit it is fun to read and aesthetically quite pleasant if not poetic. However, the level of linguistic nuance and psychological insight, forgive my reservations, makes it hard to believe you are ‘a real private equity VP’ and not, for example, a well plugged in journalist.

Imagine my shock at being accused of being not just a journalist, but a financial journalist.  The horror... the horror.

Actually, the high level of punctuation and grammatical insight in the letter make it hard for me to believe, and forgive my reservations, that the writer is actually European.

Getting It From The King

The Wall Street Journal reports on Burger King's sad performance (subscription required) in its first quarter as a public company following its LIPO (Leveraged Initial Public Offering to new Going Private Readers).  Usually pointed on such subjects, the Journal is, this time, somewhat vague and forgiving of The King's regal lapse.  Maybe the Journal figures that the double digit stock price sacking would do the critical journalistic work for them.  It better, as the usual prodding over the massive dividends paid immediately prior to the offering is shamefully absent from the article.

Shares of Burger King Holdings Inc. fell 11% in midday trading as the fast-food chain reported a loss and tepid sales growth for its first quarter as a public company.

The results underscore concerns that Burger King's private-equity owners took huge payments while leaving investors with a company that has not yet turned the corner. Burger King spent $30 million on a management termination fee during the fourth quarter that ended June 30 that went to owners Texas Pacific Group, the private-equity arm of Goldman Sachs Group Inc. and Bain Capital.

I'm not sure why the $30 million break-up fee was cited and yet the massive $367 million special dividend and $33 million "make whole" payment (management bonus) prior to the IPO  was not.  Perhaps the Journal just didn't want to kick investors in LIPOs while they were 11% down.  And maybe that's important kindness for them.  If we are headed into an economic slowdown, (ahem) well, never fear.  Burger King's King will save you with his scintillating strategic acumen:

Burger King Chief Executive John W. Chidsey said Burger King will benefit from a slowdown in spending at sit-down restaurants that's prompting some consumers to trade down to fast-food chains. Burger King said its new value menu is performing above expectations.

Uh huh.  And how will we press forward into the new age, according to Chidsey as cited by the Journal?

Burger King intends to promote its breakfast menu, emphasize its Kids' Meals and encourage franchisees to remain open longer at night...

This sounds familiar.  Now where have I seen this before...?  Oh yes, of course.  Way back.  It was in their S-1/A.

Currently, 50% of Burger King restaurants are open later than 11:00 p.m., with 7% open 24 hours. Approximately 70-80% of the restaurants of our major competitors are open later than 11:00 p.m., with approximately 42% of McDonald’s restaurants open 24 hours. We have recently implemented a program to encourage franchisees to be open for extended hours, particularly at the drive-thru.

Innovation. That's what makes management teams great.  Adapting to new environments quickly and decisively.  Really, this makes me think there is more to the former CEO's departure than meets the eye.

In any event, it looks like the private equity folks timed this transaction right down to the quarter.  At the risk of saying "I told you so," do consider my musings on the transaction back in May. I had glowing things to say about management, after all, it is hard to sneeze at eight quarters of sales growth when contrasted to the seven previous quarters of dismal failure.  But even then, I wondered why the then CEO bailed, seemingly unexpectedly.  Still, back then I was already picturing the deal set to Peter Gallagher and Annette Benning's sex scene in American Beauty:

Private Equity Sponsors: "You like getting nailed by The King?"
Public Equity Markets: "Yes!  I love it!  Oh, yes!  Fuck me, your majesty!"

Now I wonder, didn't anyone bother to tell Burger King investors that you can't eat for at least eight hours before LIPO suction surgery?

(Photo: Burger King Crime Scene, September 2004, [daily dose of imagery])

Roles and Responsibilities

My favorite financial editor takes good natured issue with my prodding of the recent criticism of "club deals" by large LBO firms.  I wondered aloud, after comparing LBO firms with narcotraffickers, what the issue was and why limited partners would whine, other than because of the potentially reduced returns, about the developing habit of larger LBO funds to go in with a number of other LBO partners to close a deal that otherwise might be too large (and too risky) for any single firm.

Club deals do not, the editor argued, reduce risk for limited partners who might be invested in multiple funds.  In this way, a single limited could be overly exposed to one buyout failure if they were invested in 4 different LBO funds all in on the deal.  I just don't buy this argument.

It is as simple as this: Any limited that fails to diversify the small LBO allocation sliver of their small alternative investment sliver of their large portfolio by investing in five large LBO funds with overlapping (if not identical) strategies is downright lazy.  The LBO fund's job is to follow the investment strategy they disclosed in their offering documentation and seek high returns for their limiteds.  Tailoring those returns for the particular portfolio quirks (or oversights) of a given limited is just not in the job description.  That's what the investment committee of the limited is for.

Honestly, can you really justify whining about a lack of diversity in your LBO investments when your idea of an alternative investment strategy consists entirely of investing in KKR, Bain, and Merrill Lynch?

Mail Malice

A loyal reader and occasional critic writes of my link to interest rate discussions yesterday "penned" by Harris Rubinroit.  Apparently it is reader mail week here at Going Private.  Said reader is annoyed with Rubinroit, and me.  To wit:

Your recent post on the Bloomberg article discussing high yield financing that you described as a "tour de force". In the sense that he managed to copy most of a recent S&P article without making a mistake it was indeed a "tour de force". As an exercise in original thought or insightful analysis it was somewhat lacking. Mr Rubinroit appears to have written the article based entirely on secondary sources (such as the S&P article) without much in the way of primary sources or significant input anyone with any connection to the thrilling world of leveraged finance (the quotes from various sources notwithstanding). Amongst the points I would raise with the author would be:

(a) the cost of the HCA senior financing is likely to be significantly higher than L+215bps; I would suggest a figure closer to L+275-300bps. Its just difficult to place $8bn (or whatever the number might turn out to be) of bank debt without offering some premium to the market standard for LBO financing (which is somewhere around L+250 I suspect). Ask your colleague the debt bitch if you don't believe me.

(Note: The Debt Bitch agrees fully, and calls Rubinroit's assertion "Muffielike" in what I can only assume is a reference to Muffie Benson-Perella).

(b) The main reason that borrowing costs for HCA will be higher is because LIBOR is higher, rather than because spreads are higher. LIBOR is higher because US interest rates are higher. As the debt is floating rate, whether the deal was done in April or closes next year, they would have taken a hit from this (leaving aside the impact of any hedges that the company may have put in place) at the next reset date - generally every 3 months.

This was the one part of Rubinroit's argument that I still find compelling.  If the LIBOR spread is 275 basis points it is clearly more expensive than a LIBOR spread of 225 basis points no matter which direction (if any) interest rates are headed.  Of course, Rubinroit's credibility on LIBOR spreads seems awfully questionable now that my astute reader has chimed in. For what it's worth, the Debt Bitch does think spreads for LBOs were quite narrow back in "the spring."  She also sighed a wistful sigh and looked a heartbreakingly wistful and nostolgic look when remembering "those days."

(c) investors in leveraged loans generally are not as picky as the article portrays them to be - many can't afford to be. The CLOs mentioned in the article are heavily incentivised to remain close to 100% invested - they are very levered (c. 9x) investment pools and if they sit holding cash will suffer from significant negative carry, crushing equity returns (and more importantly for the managers, performance fees) and are forced to hold highly diversified portfolios (generally 50+ different borrowers). Finding 50+ high quality sub-investment grade companies can be something of a struggle particularly for 3rd tier and new managers that aren't close to the sell-side and so bad companies continue to get financed and will continue to do so until some of these CLOs start to crack (which will happen as default rates increase).

This is a critical piece of analysis which I (and Rubinroit) entirely neglected.  Shame on me for not pouncing, as I have fretted before about the wholesale sale of LBO debt in the context of covenant lite loans- in particular because the current practice as implemented seems to have more to do with "placing" funds than investing them.

I could go on but I won't suffice to say the article may have summed up a lot that is already well known but didn't provide any insight whatsoever.

However, my issue is not with Mr Rubinroit's article per se, but rather how you presented it: you basically took a summary of recent industry analyses and 2 minute conversations with industry "experts" and summarized it further. No insightful analysis. No commentary or opinion. No witty lampoonery. Not even a sarcastic swipe. This is not what brings readers to your blog. I daresay the bulk have access to Bloomberg or would have seen the article (or one like it) floating around. While you have made your views on debt financing clear in previous posts you really didn't elucidate on them here. What I'm trying to say is I'd much rather have your views on the subject that a summary of S&P stats (lies, damn lies and statistics and all that). I might not always agree with them (I'm one of those nice young men running LBO financing at a hedge fund that you often make (somewhat dismissive) passing comments about), but I'm generally interested in and amused by them, as I think the bulk of your readership are (all 4 other readers would no doubt back me up.....).

I was having an off day, that’s for sure.  Sorry.  But I'll have you know that I have 6 readers now (including me).

Things Are Not Cool

I am not at all quite sure what to make of "Things Are Cool," except that I think it's pretty uncool.  Is it a joke?  I'm unsure.  Things start to go south quickly for me once the author claims to be dating me.  I find this alarming because I was not actually informed I was in a relationship.  Apparently, the sex was equally unmemorable as I have no recollection of it whatsoever.  We must have had a lot of vodka beforehand.  Are you in finance?  Was I any good?  Then there is the picture of "me."  I seem to have spent too much time in a tanning bed and lost all sense of fashion since I started this relationship.

Normally Abnormal

Abnormal Returns (yummy) delivers a private equity link blitz followed by another one which, among other notables, cites Going Private.  Hard to dislike a blog like this.  Not to mention that their new header is quite pretty.  (I still miss the old New York skyline one though).  I would also be remiss if I did not call the particular attentions of Going Private readers to the excellent look into hedge fund-private equity convergence set gingerly against the backdrop of Carlyle's hedge fund re-entry and penned by "Information Arbitrage," in turn revealed to us via link by the always discerning eye of Abnormal Returns.

Information Arbitrage hits it on the head here, in my view, by identifying one of the key issues as a cultural one.

The first issue comes down to a melding of cultures which are very, very different. Private equity guys are deal guys. They tend to be pretty good communicators. The have a modicum of patience. They understand the concept of delayed gratification, i.e., waiting for the big payout when the investment is liquidiated or a large dividend is scooped out of the portfolio company. Hedge fund managers, conversely, are often lousy communicators, highly impatient, and want to be paid yesterday. OK, so maybe the private equity guys and hedge fund guys won't go bowling together on Wednesday nights.

Good guess.

I expect Going Private readers will find the remaining details captivating and find the predictions, if my prediction on them comes to pass, quite predictive.

Blame The Bankers

Abnormal Returns points today to Daniel Gross' Slate.com article that insists the real reason behind the flight of IPOs from Capital Markets in the United States is not what should be the obvious answer, "Sarbanes Oxley."  Instead, Gross insists it is that the United States isn't any good at IPOs anymore, citing, among other reasons, the investment banking expense.  Quoth Gross referring to an Oxera Consulting report:

Raise $100 million in the United States, and you pay the New York-based bankers at Merrill Lynch or Goldman Sachs somewhere between $6.5 million and $7 million. Raise the same amount in London, and you pay the London-based bankers at Merrill Lynch or Goldman Sachs about half as much.

Setting aside for a moment my constant amusement with financial reporters who believe that $3.5 million is a lot of money; and with reading an article that asserts that the costs of SarOx are insignificant without outlining the costs of SarOx, this, of course, is silly analysis.  In my view anyone who dismisses the impact of SarOx on U.S. Capital Market competitiveness just isn't paying attention.

An absurdly conservative estimate I made some time ago based on numbers from the Corporate Roundtable showed non-adjusted expenses for SarOx for a $250 million firm at around $12 million over six years.  This is around 400% of the disparity in investment banking fees Gross cites Oxera as citing and it's only over six years.  This basic analysis also ignores the fact that a $100 million IPO is likely of a much larger firm and therefore a firm that would endure much more substantial SarOx costs than my $250 million example firm.  Assuming that 20% is floated in the IPO, a $100 million IPO might be a $500 million firm.  SarOx costs for such a firm over six years might approach more like $3-5 million per year.  It doesn't take many years to make the investment bankers look cheap compared to the raping the firm will be subjected to by the auditors.

Gross also doesn't bother to explore the connection of high underwriting fees in the United States to increased liability and compliance costs investment banks have been saddled with post-SarOx.  I've yet to see the argument made that London underwriting isn't cheaper because of looser regulatory environments and limited litigation risk.

Also bear in mind that for the ever more popular LIPO, every dollar spent yearly on SarOx is a dollar that can't be spent on debt service.  That could prove far more expensive than the naked dollar cost of SarOx.

More concerning is the first day run-up figure in offerings disparity shown by the consulting firm Gross cites, suggesting that IPO pricing is a lost art among American investment banks and that money is being left on the table as a result.  Ignoring for a moment that Gross cites the high expense of using Morgan Stanley and Goldman Sachs for underwriting (probably because they are the two most expensive), but that the report uses an average of all offerings by all investment banks in the United States to argue for the poor pricing skills of American investment bankers (a clever trick), I worry here about the statistical validity of comparing the IPO market in the United States with that in, e.g., London.  Could the same company have raised as much in London as in the United States?  How do we know?  How exactly were the many variables (taxation, regulatory costs, litigation risk) normalized in Oxera's study?  Was firm size adjusted for?  Industry?  We are not told.

Just as an aside, it would be interesting to know how Goldman compares to the rest of the U.S. when it comes to IPO pricing accuracy as measured by first day (week?) run up.

Jeff Matthews Is Driving Through Burger King

I admit to being a sorta-kinda fan of "Jeff Matthews Is Not Making This Up."  I don't always agree with the big JM, but his entries are generally interesting.  His tidbit on Burger King is just one such, right down to the point where I don't agree with the general conclusion he makes from the specific example of Burger King's Henryesque, public regal flogging.

Matthews ties the dual observations of the difficulty of finding good deals and the "fact" that private equity firms are "stretching" for good deals, to a prediction of the imminent death of private equity as we know it.

I'm not sure it is sound logic to use a random press quote referring to a single transaction (in this case from an anonymous lawyer for one of the losing bidders on the Phillips unit eventually won this week by Silver Lake Partners who, according to Matthews, quipped "...everyone lowered their expectations on returns...."  First, let's try to remember that for LBO firms, lowering expectations on returns is the shift from 40.0% IRR to 26.5% IRR and second, this only sounds like every auction I've ever been in...) as a general proxy for private equity deal stress industry wide.  Matthews sums this up with:

Lower margin of error + lower deal quality = recipe for disaster.

"Disaster" is, of course, not defined here.  While interesting, I think this analysis ignores some factors.

First, critical mass in Private Equity.  Second, fundamental environmental factors.

When I started the Going Private adventure I posted a quick, dirty and jaded primer on the evolution of the field.  I pointed out that the early boom in buyouts was primarily due to flaws in the "conglomerate" theory of the firm.  In particular:

Consequently, by the mid to late 1960s large corporations began to interpret the need for "diversity" to mean that they should acquire anything and everything they were able to pay for. The less relevant to their own underlying business, the better. This marked the beginning of the "conglomerate wave" where a flurry of mergers and acquisitions activity dominated thinking about how large firms should look and act. Like portfolios, it was argued. Diversified and large enough to enjoy economies of scale, of course.

It was the crash of this wave, with the slow realization that a massive corporation with no history in beverage products likely shouldn't be buying a sports drink company just "because," that fueled buyouts.  There was, around this time, an amusing commercial (and I believe it was by Pace Picante Sauce) where a monolithic boardroom filled with identically appearing directors shaped the future direction of the corporation:

Chairman: Gentlemen, shall we manufacture salsa...
(The 6 directors on the left side of the room raise their hands).
Chairman: ...or oven mitts?
(The 6 directors on the right side of the room raise their hands).

The boom of buyouts waited carefully in the wings for those sorts of decisions to blow up and then applied simple factors that proved elusive to the conglomerates of the time to suceed marvelously. Specifically, focused and incentivized management teams, brutally fast accountability and merciless cost oversight.  Of course, these factors, the actual management accumen, were slower to develop than the key tool for high returns: Leverage.

Itself a great motivater, the results leverage produced were outstanding, but then it was low-hanging fruit picking off the former subsidiary of a massive, unfocused corporate machine.  Not a lot of management expertise was really required to double productivity.

Not all firms are LBO candidates.  Some economic environments create more than others.  Low interest rates, disincentives to remain in the public market or a previous period of high P/E ratios (and therefore cheap currency [stock] for acquisitions by large corporates that should leave well enough alone) all contribute to an environment where LBOs thrive.  Money flows into LBOs, opportunities dry up, money is allocated elsewhere, the cycle continues.  That one should consider this odd or unusual is tantamount to the admission that one is not a believer in market economies.

The prefect storm story for LBOs is not the approaching demise of the field (even after Drexel fell apart the business thrived among niche players with real advantages) but the fact that the last four years have seen such a confluence of events favorable to the business that nothing other than a massive boom could have been expected.

Record low interest rates, high disincentives to remove firms from public hands, a five year prior period of insanely high P/E ratios and the huge public equities growth spurred by the tech boom all contribute to the "target rich environment" we have been seeing in the buyout world today.  But, pour enough money into it and, like any arbitrage opportunity, returns begin to slip until you have to have an awfully significant information disparity advantage to do well.

In my view the act of "Going Private" is effectively the admission that public capital markets and the corporate governance system thereof were simply not sufficiently suitable to provide for the success of the firm in question.  At least over the last several years, the public capital markets fail because they tend to be the among the last of the "greater fools," and classic absentee owners.  I find it hard to imagine anyone could argue that, with the massive influx of the "casual investor" beginning in the dot-bomb era and that the market still sees, the average investment accumen of the market has improved in the last fifteen years.  (I fully include myself in this analysis as the only public equities I believe myself qualified to invest in- primarily because investing in public equities would never be more than a two hour a week hobby for me- are low-fee S&P 500 index funds).  I tend to think the new rise of shareholder activist funds supports my view in this.  They too have an ecosystem of deal critical mass that depends highly on the rest of the public markets being asleep at the wheel.  No signs of that abating, I think.

And so I ask two questions: What might actually be predictive of a "bust" in buyouts and what would a "bust" in buyouts look like?

If I am correct and the elements required to spur buyouts, or, in fact, a switch to any alternative capital structure, are two-fold:

1. An environment to generate targets for capital structure change:

• Correctable inefficiencies in:
  
  • Management accumen.  A general lack of comparable management talent in prevailing capital structures (today public equities)- and here the differences can be quite small and subtle.  Correctable where small, focused management teams exist outside the prevailing capital structures.
    
  • Management compensation.  Are management incentives competitive in the prevailing capital structures (public equities)?  This, of course, requires resort to analysis I haven't seen addressed anywhere other than Going Private- i.e. risk adjusted compensation to senior management.  If risk adjusted compensation is inefficient (i.e. not comparable) in public firms, then the arbitrage opportunity is obvious.
  • Corporate governance.  Do the prevailing capital structures do a good job of culling management talent, replacing inept management quickly and installing new management?  Clearly, if not, then a capital structure change might be less costly (in all senses) than a corporate governance revolt.
  • Information disparity.  How well can the prevailing capital structure monitor its investments and apply expertise to the data it collects? Can it take calculated risks, or does it just take risks.
  • The efficient deployment of capital.  Specifically, even if it has access to good information does the prevailing capital structure make smart investment decisions?  So long as this is not the case one can not only profit by using the poorly spent capital to buy, at a discount, grade A infrastructure already paid for by the equity holders in the current system (since they likely overbought) but you can clean a firm up after the capital structure switch and re-inject it into the inefficient capital system at a premium (Ladies and Gentlemen, introducing the LIPO!).  This works best when marketing plays a major role in the sale price of equity for the firm.  Guess which capital structure suffers the worst from that state of affairs today.

• Access to buyout capital:  This one should be self-explanatory.

Running over each of these briefly:

Management talent is being pressed out of public companies by the likes of Sarbanes Oxley and the general public sentiment that public company management are all idiots and crooks.  (Ironically, a self-fulfilling prophecy).

As a risk-adjusted figure, management compensation in publicly held firms is falling.

Ironically, even with all the "reforms," few systems are less able to police poor management than the public equities market.  The fact that special firms dedicated only to this disparity can make millions should demonstrate this well enough.

Stakeholders simply have too many filters between them and raw data to compete with, e.g., private equity shareholders.

As for the question "Are public markets 'smart money'?"  I will leave this to Going Private readers to submit to their own delicate predispositions.

Access to capital?  2005 was another record breaking fund raising year for private equity.  2006 is even pretty strong so far.  Jeff Matthews worries about rising interest rates with 3 month LIBOR at 5.50% today.  Consider that the $20 billion buyout of RJR Nabisco was agreed to in October of 1988.  Have a guess what the 3 month LIBOR was back then?

8.89%

I'll try to cover the "what if" on Monday, maybe.  Until then, signs of the imminent demise of buyouts as we know them?  I think that Jeff Matthews is making those up.

A Room At The PE Hotel (5:28)

DealBreaker, first with a John Weisenthal "Opening Bell" spot and then via its indespensible, daily Reader's Digest DealBook feature (thanks to John Carney who also has the good taste to link to me on occasion), that points us via witty link titled "Bono = Corporate Tool" to a DealBook entry, which then channels a David Carr missive that puff-pieces Elevation Partners (a.k.a. Bono's Press Release and Private Equity Playground, LLC) while purporting to cover that firm's acquisition of a minority stake in Forbes Magazine parent Forbes Media.  Harder to find a better example for my "Bono" catagory.

Selective reading is required to give you the real story though, which, when seasoned with my gratuitous speculation and a garnish of Hollywood hypocracy, is actually pretty juicy.  To wit:

This is the third deal for the fund, after investments in a video gaming partnership and a real estate Web business.

No one in the group has any significant experience in print properties....

Forbes’s competitors have significant corporate backing — Fortune is owned by Time Warner, BusinessWeek by McGraw-Hill, and Condé Nast will soon introduce a magazine to be called Portfolio.

For the last 25 years, Bono has stayed atop a fickle business by embracing the latest technology in order to build global reach, constantly renewing the creative product and engaging in public stewardship along the way, including work on trade issues and global poverty.

(Read: Debt Forgiveness).

Mr. McNamee said the stake in Forbes did not necessarily clash with his politics and his rhetoric, saying, “The way you solve poverty is giving people the tools to overcome it.” Bono could not be reached for comment.

"Bono could not be reached for comment."  Bono?  Could not be reached for comment?  Are you kidding me?  Attempting to separate that guy from a microphone is akin to a demonstration of the nuclear residual strong force.  One wonders if the honeymoon with private equity is actually over for Bono and, having already extracted value from his brand- as evidenced by the fact that every acquisition Elevation makes, no matter how silly, will result in a shower of "Bono buys Greenland ice cube producer" press releases- the other partners have now taken over the reigns.  "Thanks, we'll take it from here.  Loved your Chicago show.  Call me for squash next week."  I just can't see Bo"world economic forum"no voting "yes" in an investment committee meeting on "Project Flat-Tax-Magazine."

...Steve Forbes, whose hobbies run more toward flat-tax advocacy, said that “One” is his favorite U2 song. It begins somewhat portentously with a plaintive pair of questions: “Is it getting better, or do you feel the same? Will it make it easier on you, now you got someone to blame?”

...Mr. McNamee said that Elevation — the word is a U2 song, the name of one of its tours and an equity fund — was Bono’s idea.

Steve Forbes: “This is a natural step for the company with right people. Forbes as always been about entrepreneurial capitalists.”

So remind me why Bono is involved again?

From where I stand
I can see through you
From where youre sitting, pretty one
I know it got to you

I see the stars in your eyes
You want the truth, but you need the lies....

Oh, yeah.

Imminent Death of Private Equity Predicted

Jeff Matthews isn't the only one predicting a shake-up in private equity.  But then, that's easy since "private equity" is a pretty expansive term.  Depending on the proclivities of the person you ask it may or may not include hedge funds, may or may not include venture capital, may or may not include real-estate partnerships, may or may not include mezzanine funds, etc. etc. etc.  I'm not particularly qualified to comment on anything other than buyouts and hedge funds (as those are the firms I have direct experience with), and I might not even be particularly qualified to comment on those, depending, again, on the proclivities of the person you ask.

Peter "The Informed Observer" Cohan joins the fray in a pair of scribes, the first back on the 2nd of August, wonders if private equity is "long in the tooth," echoing the arguments of (rising interest rates, too much cash, tough to find deals) and even sounding remarkably like Jeff Matthews' same-day missive I referenced here yesterday- right down to the dangerously inductive logic used to draw from one lawyer's quote on the Phillips deal the conclusion that firms are "stretching for deals," and a particularly interesting, if historically miopic, view; as if "private equity" (which here I take to mean buyouts, as only buyouts are used for examples) is a new invention without an active history over the last 30 years, two boom-bust cycles under its belt already and tendrils going back to the 1960s.  (Much further if you start looking at original "boot-strap" deals).

HCA is mentioned also, presumably to support this "stretching for deals" theory, but the only evidence given in that context is that debt to EBITDA ratios of the company will soar by the rather vague figure of somewhere between 200% and 600%.  (Quoting the Debt Bitch: "Of course they will, it is an LBO, duh.")  There is, the argument goes, therefore less "margin for error."  Given the similarities to the Jeff Matthews piece, I sort of wonder which one was actually written (as opposed to "published") first.

I notice also that none of these missives mention the likes of J. Crew (which is certainly at the high end of LIPOs, actually managing credit rating upgrades after submitting itself gracefully to the gentle ministrations of the public and sitting today, as it does, nearly 30% above its initial offering price).

Cohan follows in a penning dated August 5th citing an Alan Abelson article in Barron's that happily cites him in order to jump on the shake-out bandwagon.  Curiously, in this post Cohan refers to the "August 7th" Abelson article, even though the post he does it with is listed as published on August 5th.  I'm not a huge Barron's reader so I don't know how well their publication dates actually match reality, but this is certainly somewhat curious and either Barron's is careless or Cohan is a time traveler.  I suspect the former because the later would beg the question "why is Cohan wasting his time blogging?"

Completing the circle and reminding me once again how inbred financial "reporting" is, Cohan cites the Bloomberg HCA article by Rubinroit, which an insightful Going Private reader adroitly deconstructed last week, to pulls his facts for the HCA deal.  That posting on Going Private prompted another Going Private reader, who wished to remain comfortably anonymous, to wonder in a highly detailed and example filled email if Rubinroit's job description was merely to transcribe for Bloomberg S&P's Leveraged Commentary and Data service articles (usually written by Chris Donnelly) and then a third Going Private reader in email again to question (this time with no small amount of vitriol) the facts in the Rubinroit piece.  Then a fourth reader chimed in via email to comment in the same vein on the HCA deal, and Rubinroit by proxy, but he/she asked not to be quoted.  I haven't read enough Rubinroit yet to have an actual opinion on the topic of his reporting prowess but Going Private readers seem to have formed a consensus of sorts.  Shame on me anyhow, as I had cited the Bloomberg piece somewhat blindly and neglected the much superior and well researched July 25th work (subscription required) by The Deal's debt master, Vipal Monga that, interestingly- because she never has anything good to say about anything- meets with the Debt Bitch's seal of approval.  "He gets it," she says.  It must be love.

Far from "a stretch," Vipal said instead of the HCA deal:

HCA's financing depends on a successful closing of the deal, which is expected in the fourth quarter. The agreement between the buyout consortium and HCA allows the company to solicit superior bids from third parties for 50 days, and the hospital group plans to search actively for higher bids.

Although there have been no confirmed reports of other bidders contemplating jumping in, one source close to the deal said initial interest in HCA from other mega-buyout firms has been high.  That's not surprising, considering that the proposed deal is modestly valued, at 7.8 times HCA's Ebitda in the 12 months ended June 30, well below the double-digit multiples that have become common in today's sizzling buyout market.

Setting aside for a moment the accuracy or non-accuracy of Matthews, Cohan and Abelson, (Vipal must be right if the Debt Bitch likes him) or if we consider 7.8 times EBITDA "modestly valued" let's consider what a "shake up" in private equity looks like.  And by "private equity" I mean the rather limiting definition of: "LBOs."

My own belief is that there is a size beyond which buyout funds stop being "pure" buyout funds.  Purity is in the eyes of the beholder, of course.  My belief here is not original, but rather formed after a magnificent conversation with David Jaffe of Centre Partners who, referring to the point where buyout funds get unwieldy, quipped, near as I can remember it, that "$750 million is about the right size."  I didn't believe it then, but I remembered it.  By April, I believed it.  Back then I mused:

Didn't we learn in the 1980s that unfocused conglomerates don't work particularly well?  Why are we running down that road again, with hedge funds, with Google?  Management fees, perhaps?  We are long past the point where the management fee just barely pays the bills at a fund and you have to find upside to get wealthy.  The incentives to bloat assets under management are simply too significant now, I think.

Buyout funds were designed and have every internal incentive, save one that I will address in a moment, to be smaller, focused and disciplined.  They are long-term return vehicles with a variety of golden-handcuffs to allow for (indeed, require) that rarest of qualities in investors today, liquidity-less patience.  The patience to endure years of little liquidity in search of value.  Larger firms are poorly suited to do the kind of deals I would call "pure buyouts."  Buyouts with a turn-around component.  Buyouts that look to their management talent to provide value, not just to leverage and financial restructuring.  Focused firms.  That is not to take away from the accomplishments of larger firms.  There are many.  But the opportunities for those firms to shine are likely to be the first to dry up.

The misplaced incentive I refer to is, of course, the management fee.  The "2" of "2 and 20."  2% of assets under management which go to the fund manager, in theory, to support infrastructure until liquidity events get everyone paid (rich?).  And getting rich (the 20%) is contingent on performance.  2% has, with larger funds, become more than just infrastructure support.  Moreover, when you start seeing $5 billion, $7 billion and $11 billion funds, 2% looks downright silly.  Certainly, funds are not scaling their infrastructure up in a linear fashion after around $1 billion in managed funds.  That 2% looks more and more like pure "bonus money."  And bonus money not contingent on performance, only on fund raising capacity.  Suddenly, you have an incentive problem (the incentive is to raise a lot and develop only limited infrastructure) combined with a last round problem.  Who cares if the $11 billion fund folds.  After 7 years they've pocketed up to $1.5 billion just in management fees.  That takes some of the sting out of being unable to raise $22 billion the next year because of low IRRs.

In my view, club deals and "mega deals" have become mandates on capital structure, not "value added buyouts."  LBO capital is cheap.  Going private transactions provider better management incentives and less risk, and all the other things I've been rambling about.  But turnarounds are few and far between in these larger deals.  Also, reading certain of the commentators I cite in this article one gets the impression that "private equity" is entirely going private transactions buying out large publicly held firms.  Indeed, that's where the headlines are.  But there are those firms that have been quietly doing buyouts for 15 and 20 years and haven't bought a public company yet.

This is oft forgotten today.  LBOs were an exceptional tool to undertake turnarounds of troubled and down-and-out business that, perhaps, had just fallen out of favor.  Today many of the headline deals are using buyouts as a tool to reform capital structure.  As capital grows cheaper, however, the need to find underpriced assets is not as essential as it once was.  There is a flight from deal quality.  Instead, you just need to find firms that aren't well served by the public capital markets.  That's an easy thing to do today.

It used to be that after reaching a certain size as a corporation, you were paying opportunity costs if you didn't go to the public markets for expansion capital and the U.S. capital markets were the place to do that.  Cost of capital on equity raised in the public capital markets was such that it was the best way to go in order to really grow the firm.  Those days are over.  Well, not over, but in decline.  Adjusting your balance sheet to enjoy low costs of capital is as American as pantless investment bankers on their third martini in the First Class section of BA's nightly JFK-LHR flight.  Now that the expanded reach of cheap debt and equity comes with the added bonuses of higher management compensation and less regulatory burden in the form of mega-buyouts, what's not to like?

The problem is that the focus has shifted.  Applying carefully constructed, long-term oriented structures (LBO funds) to buyout candidates in need of management acumen and focus that were poorly served by the short-term (and increasingly costly) public markets for capital has instead become a simple financial tool.  Specifically, the shift of any company at all from a public to a private equity structure.  Notable about the HCA deal is the constant theme among interviewees commenting on the details that the existing management will basically remain untouched.  That's always nice as a buyer, to have a strong management team in place, but it suggests also that not much value is being added on the management side.  That leaves only financial structure and regulatory burden.  From this perspective, the pattern looks exactly like the conglomerate wave of the 1980s, and it will "end" in similar fashion.  The large conglomerates are today not "gone," per se.  They are instead "focused on our core business."

The advent of LIPOs (Leveraged Initial Public Offerings, or IPOs of debt-laden, private equity owned firms, for the uninitiated Going Private reader) has also had an artificially extreme impact on IRRs.  Flipping something to the public market only a few years after having bought it up (so much so that the company ends up paying "break-up" fees for the prematurely terminated management contract) really boosts IRRs and, again, works against the LBO structure's big selling point: long-term focus and turnaround management.

It was much cheaper from a cost of capital perspective for the firms scooped up in those days to be bought by corporate behemoths and managed as a part of a larger economy of scale.  That too was a capital structure shift.  Eventually, so much money (stock) poured into the takeover craze that the movement simply ran out of breath.  The last many deals were the worst for exactly the same reason.  The easy targets were bought up, the model then extended (at greater cost) to pick up firms that never should have been corporate daughters in the first place.  The result: a better, cleaner capital structure alternative emerged and had the added benefit of being able to provide more focused management guidance.

As the cycle runs, one of two things will happen, I suspect.

1.  Costs of capital and regulation in the public capital markets somewhere will once again become low enough (maybe just because private equity and debt gets dramatically more expensive) and efficiencies high enough that even struggling private equity portfolio firms will just go public again.  I tend to think that this will be a jurisdiction other than the United States unless this country gets its act together with respect to being a friendly place to want to incorporate and list oneself, though I find a sudden positive reform by the United States highly unlikely at present- and then there's the whole subject of who wins the 2008 presidential election.  Frankly, this really makes me want to be in the foreign financial exchange business.  Some careful thought about these dynamics could make an upstart non-U.S. exchange the one stop spot for the former daughters of LBO funds.  The 1990's NASDAQ of modern LBO survivors.  I am reminded a little bit of the Cayman Islands, and the timely transformation engineered thanklessly by Louis Fenma in perfect sync with changes in the United States in the early 1980s.

2.  More likely, I think, struggling private equity portfolio firms will either be bought and broken up by a new generation of raiders (though the drama of the proxy fight will be both less entertaining and more expensive when the major shareholders are all mega-funds with IRR targets) or bought piecemeal by smaller, more focused firms around $750 million in size, exact mirrors of the early LBO funds in the 1980s, except with different sellers and more focused on value as debt gets more expensive.

Mega-funds are the conglomerates of 2007.  Big, unwieldy, potentially unable to attend to their many daughters properly.  But most of them will live on.  Weathering a storm, perhaps, getting a belt tightening, but enduring.

Personally, I quite like the prospects for the high end of mid-market LBO firms.  Big, ugly buyouts gone bad are great opportunities for those of us in the buyout business.  We like train wrecks here.

Death of the industry?  Hardly.  Not any more than the demise of Drexel was the death of the industry.  There's a ton of equity overhang still sitting around.  Even if the LIBOR pops up 2.5% we are still in very healthy debt markets.  The business isn't going away any time soon.  Maybe the headlines will, but that would be fine with me, and most of the people at Sub Rosa and the hundreds of firms like us that daily go quietly about the business of buying and, more importantly, improving companies.  That mostly orderly cycles and seasons in private equity would come to pass should surprise no one.

A flight to quality is certainly in the cards.  I can't wait.

If I were a limited partner evaluating LBO funds to invest in, I would look for small, focused funds with under $3 billion, and preferably under $1.5 billion, that weren't going to get rich on their management fee, that had good turnaround talent, actual management talent and not just financial structuring gurus, on the bench.  I would focus on funds that had expertise in sectors that I thought could benefit from a lack of short-term capital pressures- sectors that have fallen into disfavor and that needed more than a pair of years to turn around.  Let's remember that that's what LBOs were designed for.  If I had to look at larger funds because I had too much money to place without violating the concentration restrictions on my investment with any one fund (or theirs for any one limited) I would be very wary of funds with a history of liquidity events peppered with 2-4 year LIPOs with management contract break-up fees.  Their IRRs are probably high because they are exiting prematurely with dumb-money, not because they deliver value.  I would ask myself daily, "Am I buying into a short-lived corporate governance, cost of capital and regulatory arbitrage opportunity, or a team able to transform businesses?"  I'd also spend more time on vacation than I do now.

(Art: "Horae Serenae," 1894, The Baronet Sir Edward John Poynter, one time President of the Royal Academy and editor of Illustrated Catalogue of the National Gallery, 1900.  Depicted are the first generation of Horae: Thallo, goddess of spring and bringer of flowers, Auxo goddess of growth, and Carpo, goddess of the harvest, were the goddesses of the seasons and orderly customs who, among other things, dressed Aphrodite as she emerged from the ocean and traveled with Persephone each year to the underworld).

Priced By Experts

Recent discussion here on Going Private has led me to speculate about the "IPO expertise" in U.S. Capital Markets.  My interest is connected to a piece by Jeff Matthews or Peter Cohan (I can't tell which because both were written on the same day and are almost exactly the same) and the assertion by Daniel Gross for slate.com that with respect to global capital markets "...the United States... is more expensive and not particularly efficient at IPOs."

Poking around on the subject I found an older (August 1999)  Fernando, Krishnamurthy and Spindt paper out of Wharton's Financial Institutions Center titled "Offer price, target ownership structure and IPO performance" (.pdf file) the findings of which suggest, among other things (from the abstract):

...that firms select their IPO offer prices to target a desired ownership structure, which in turn has implications for underpricing and post-IPO performance.  Higher priced IPOs are marketed by more reputed underwriters and attract a relatively larger institutional investment.  These IPOs are relatively more underpriced, possibly as compensation for the monitoring and information benefits provided by institutional investors.  IPOs whose offer prices are below the median level seem to be targeted towards a retailed investor clientele.  These IPOs are also relatively more underpriced, possibly as a cost of adverse selection.  Our finding that long-run performance increases with offer price confirms that higher priced IPOs are better firms.

And later:

We find that instituional ownership increases with offer price. Controlling for firm size, offer fraction, underwriter reputation and other variables thought to influence IPO pricing, we find that underpricing is a U-shaped function of offer price.

Our findings are consistent with the characterization of high-priced IPOs as targeted towards institutions in which case underpricing compensates the institutions for information and future monitoring services.  Firms could choose a low offer price and discourage institutional investment to either preserve private control benefits or to avoid potentially costly investor myopia.  The resulting pooling equilibrium could lead to higher underpricing.  Our results also suggest that the offer price is positively related to the likelihood that the firm will remain viable after five years.

Of course, the authors might have drawn different conclusions had the IPO scandals and the "Friends of Frank" behaviors of the era been understood at the time, (and, in fact, other works I cite below find exactly this- that agency problems contributed to underpricing woes) but the point remains: IPO pricing is a complex dynamic among sophisticated players.  This makes me doubt the value of same-day IPO price fluxuations as a proxy for "IPO efficiency," and the paper points out nicely that many other factors not only may bring long term value to a firm, such as institutional monitoring or analyst coverage, but that players in the IPO game are aware of these nuances and that they presumably impact price.  In short, simple analysis of same day price variances are not a good proxy for "IPO efficiency." But then, if you are a consulting firm doing a study for the London Stock Exchange, the simple analysis serves you(r client) much better.

Still, let's see if we can't uncover some details about the "performance" of different IPOs by underwriter.

Opinions vary.  Koop, Lee "Valuations of IPO and SEO firms" (.pdf file) (May 2001) doubts any underwriter reputational advantage exists noting that "Theories regarding underwriter reputation or windows of opportunity for equity issuance are not supported in our empirical results."  Guner, Onder and Rhoades find that underwriter reputation seems to matter for emerging markets in "Underwriter Reputation and Short-Run IPO Returns: A Re-Evaluation for an Emerging Market." (.pdf file) confirming my suspicion at least that IPO markets vary significantly by country, and Binay, Gatchev and Pirinsky give us "How Important Are Relationships for IPO Underwriters and Institutional Investors?" (.pdf file) (January 2006) which finds, among other things that:

...underwriters favor institutions they have previously worked with when allocating Initial Public Offerings (IPOs). Regular investors benefit more than casual investors in IPOs by participating more in underpriced issues. Relationship participations are more important in the distribution of IPOs with stronger demand, IPOs of less liquid firms, and deals by less reputable underwriters. Overall, our results are consistent with book-building theories of IPOs and suggest that regular investors improve the efficiency of the IPO process. Interestingly, our results are weaker for 1999-2000, consistent with the idea that in this period other considerations (e.g., commission revenues from clients) affected the allocations of IPOs.

...and that...

Underwriter reputation, while not explicitly modeled in the book-building theories, could also be linked to relationship participations. If underwriters with higher reputation produce better information about the IPO (Carter and Manaster, 1990) then IPOs underwritten by such underwriters will have less need for the participation of relationship investors for information production. In support of this prediction, we find that IPOs underwritten by banks with higher Carter-Manaster ranks have lower relationship participation.

The implication is that higher reputation underwriters need less "regular investors" (i.e. repeat investors in IPOs by the same underwriter) and therefore need not underprice to the same extent required of underwriters who are more reliant on relationships to place IPO shares.

I've still not found scholarly work exactly on point for the issue at hand, "Does Goldman price IPOs better or worse than the rest of the world," but the search continues.

Corporate Nostalgia

Dealbreaker's John Carney points us to an absolutely stunning missive published today by Professor Michael S. Rozeff on the history of conglomerates, just in time, I might add, to supplement my recent musings on the topic and its connection to private equity and buyouts in particular.  Consider this passage:

How one company could create value for its shareholders by paying a big premium over market value to buy another company in an unrelated industry was a mystery, then and now. When the conglomerate sold at a price/earnings ratio of 20 and bought a company with a price/earnings ratio of 10, the combination seemed to fetch a price/earnings ratio of 20! This financial legerdemain (or was it ledger-demain?) created value, for a while. It was not permanent. By 1970 the days of reckoning arrived and the conglomerates crashed along with many other stocks.

The company heads were empire-building. They were being paid according to the revenues they managed, so they grew revenues by acquisition. If Wall Street made their paper (stock) worth a lot of money, it made good sense, they thought, to issue more of it and buy real assets. It made sense for the managers who made more money. It made less sense for the shareholders who saw companies overpay for acquisitions. For awhile the roller coaster rolled upwards before reaching the crest and speeding downwards.

The financial-historical goodness continues unabated for some time and is an absolute must-read for the erudite Going Private follower.

(Art: "Conglomerates Collide" Apple II business simulation game by Rockroy Inc., c. 1981.  Being a nostalgist for all things 1980s business- mostly due to the bitterness I experience due to the trick of fate, i.e. the late timing of my birth, that failed to permit me to be in LBOs back then- I cannot help but be totally fascinated by this ancient game.  Try your hand at it on-line, oh, would-be captain of industry.  Laughs by the dozen for the careful study of business irony.  Your managing director will surely see it as work-related study).  Consider:

GAME RULES

THIS  IS  A  GAME OF CORPORATE CONQUEST IN THE WORLD OF CONGLOMERATES.
EACH  PLAYER  CREATES  HIS  OWN  COMPANY  (BY  NAME),   SELELCTS   ITS
INTERNATIONAL  HEADQUARTERS  AND  STARTS  WITH  $20 MILLOIN IN ASSETS.
INITIALLY, EACH COMPANY HAS $10 MILLION IN CASH  AND  $10  MILLION  IN
CONTROLLED  CAPITAL  STOCK.   THE  CAPITAL  STOCK  VALUE OF 10 MILLION
REPRESENTS 1 MILLION SHARES AT $10 PAR VALUE.  THE  COMPANY  ALSO  HAS
BASE  EARNINGS OF $2 MILLION PER YEAR (TURN) WHICH REMAIN CONSTANT FOR
THE ENTIRE GAME. GIVEN THESE RESOURCES, YOU MUST INCREASE THE  EARNING
POWER  OF YOUR MULTI-NATIONAL CORPORATION BY ACQUIRING OTHER COMPANIES
KNOWN AS SUBSIDIARIES.  WHEN BUYING A SUBSIDIARY, LOANS TO  A  MAXIMUM
OF  50%  OF  THE  PRICE  ARE AVAILABLE TO FINANCE THE PURCHASE. ONCE A
SUBSIDIARY IS ACQUIRED, THE AMOUNT OF FIXED EARNINGS FROM THAT COMPANY
ARE ADDED EACH TURN TO THE BASE EARNINGS  OF  YOUR  CONGLOMERATE.  ANY
SUBSIDIARY  THAT  IS AQUIRED MAY NOT BE RESOLD-FORCING PLAYERS TO LIVE
WITH THEIR DECISIONS.  EACH YEAR (TURN) THE PRIME  RATE  WHICH  RANGES
FROM 7 TO 30% CHANGES RANDOMLY AND CAUSES THE BANK RUN BY THE COMPUTER
TO  COLLECT THE AMOUNT OF INTEREST DUE FROM EACH PLAYER'S COMPANY. THE
BANK WILL ALSO PAY INTEREST ON DEPOSITS AT A VARIABLE RATE  LESS  THAN
THE PRIME RATE WHICH PROVIDES EXTRA INCOME

Powerful Forces At Work

This morning, DealBook sends me to the Financial Times' latest article bemoaning the future of private equity and wherein I learn that "if one assumes that 80 percent of a buyout deal is leveraged, The FT hazards a guess of an astonishing $1.485 trillion in capital available for private takeouts." Well, I'd love to be able to get debt at 5:1 on my equity with some regularity, but it doesn't work out that way, really.

The FT calls the backlog of "uncalled capital" something like $297 billion.  I'd be more comfortable assigning a 4:1 debt to equity ratio which suggests $1.188 trillion in available buyout capital.  But that is neither half a billion here, half a billion there.  The FT goes on to point out, however, that the former sum is something like 12% of the market cap of the S&P 500.  It also pegs the "average spread on high yield bonds" at 350 basis points, that seems sort of high to me, though FT's terms are not defined here.  Concludes the FT:

By necessity, buy-outs must now be less selective. Investors can either own public equity or invest in funds that must pay large takeover premiums to own public equity – and which charge meaty fees for the privilege. If less discriminating buy-outs are the future, it is probably best to be on their receiving end.

Well, we forgot about the option to invest in funds that buy private firms, echoing the increasingly common treatment of "private equity" as purely "going private" related.

And try as I might, I still cannot get that worked up over buyouts that manage to snag assets for under 8.00x EBITDA (HCA).

All this is neither here nor there, however.  The real story is in the first reader comment on DealBook however, which finishes off with this gem from Mark Klein, M.D.:

"Too bad for us for the Baby Boomers and their progeny who govern today in their elementary schools sex education replaced thrift lessions."

Reminding us that one of the greatest conceits in the United States is the continuing demonization (or praise) of politicians conducted under the denial-laden belief that their monetary policy (and indeed their position on sex education in schools) actually influences the economics of things such as buyouts in any substantial way anymore.

(Art: "Tombstones in Whitby," Paul Townend, c. 2005)

[Edit: A watchful Dartmouth alum and Going Private Reader writes: "FT: does not suggest a 5:1 debt to equity ratio, but rather 4:1 (~300b = 20%, ~1200b=80%, ~1500b = 100% of buyout capital). 5:1 would = a 16.7% equity injection. Your sentence should read: 'I'd be more comfortable assigning a 3:1 debt to equity ratio which suggests $1.188 trillion in available buyout capital.'" Of course, our Dartmouth alum is exactly correct. Going Private regrets the error.]

Activist Activism

A number of things have started to spur my interest in activist hedge funds and I have started an internal project involving such funds.  You know the type, the Carl Icahn's and Pershing Square Capitals of the world.  When first I began writing Going Private, it was never my intent to use it as a forum for soliciting reader help.  I, after all, am providing a service to you- not the other way around.  Be that as it may, I am curious if any of Going Private 's readers know if a comprehensive (or nearly comprehensive) list of funds with activist strategies exists, or how a vaguely representative list of such funds might be assembled.  The winning entry will get lunch with Equity Private.  (Well, ok, not really).

[email protected]

May Well Have Been Underestimated

I've been posting about the cost of SarOx pretty much since I began Going Private, but with some renewed vigor these past two weeks as the debate over "the real reason" for the flight of IPO business from United States capital markets began (somewhere out there I suspect like-minded people are busy at work tracking down "the real killers" of Nicole Brown Simpson) and the imminent death of private equity as we know it becomes the theme of the week month for financial "reporters."

Regular Going Private readers will, therefore, understand my interest in some of the recent developments in the study of SarOx costs.

Corporate Tool started the trend with some personal observations about my SarOx cost calculations.  Following that, I ran into a piece on the very timely titled Conglomerate Blog pointing, in turn, to a Financial Times article which then cites a study by the law firm Foley & Lardner (subscription required) the findings of which "...confound predictions that US companies would only face a one-off increase in audit fees and other costs as a result of the legislation, introduced after the Enron and WorldCom scandals."  This suggests my calculations of SarOx costs are even more absurdly low than I suspected (and just as Corporate Tool indicated) as I assumed a trailing off of 404 compliance costs after the first year and this was clearly erroneous.  This, in turn, suggests incentives to bail on public capital markets in the United States due to SarOx are even higher than I expected and, following that logic, that certain commentators who should perhaps stick to reporting on how "Street Fashion Blogs Keep Tabs on the World's Most Stylish Pedestrians," instead of mouthpiecing for the London Stock Exchange got it awfully wrong.  (Not that there's anything wrong with the London Stock Exchange, mind you).

Conglomerate Blog goes on to cite an excellent paper by Emory Law Professor Bill Carney that I now re-cite both because of its excellent content, and because I enjoy harboring the fantasy that the paper's title ("The Costs of Being Public After Sarbanes-Oxley: The Irony of 'Going Private'") is a thinly-veiled fan-reference to my writings here.

COFI's Return

Certain dynamics in the world truly inspire me.  It is often difficult to express, even in the infinitely expansive vocabulary I enjoy within the cereberal confines of my own inner monologue, the glee that overcomes me when I discover a subtle and theretofore unnoticed connection in cause and effect that suddenly opens to me a wider understanding of the world around me.

I was aglow for days after finding the inventory calculation error in management's financial disclosures that vastly understated assets and permitted us to outbid everyone in the otherwise brutal auction we claimed victory in last quarter.  I could have walked on air after correctly identifying, through careful examination of their existing portfolio companies, the financial partner that would take a minority co-investment position with us in a recent acquisition.  My pattern of requiring of my analysts an automatic 2.5% increase in the discount rate for firms on the West Coast or with more than one Stanford graduate in senior management has earned us hundreds of thousands of dollars and me personally any number of free drinks.  And then there was the highlight of my pattern recognition joy; my highly focused take-over from Sinister, LLC's head of IT of the three week old witch hunt that uncovered in a matter of days the notorious and much sought after Sinister, LLC overhead projector thief (who even now languishes in the midst of a criminal prosecution for grand theft).

So it is equally difficult to express my pleasure at the wild success of my Cuban Overlap Failure Index, which old Going Private readers will recognize from back in May; an endeavor that seems almost prescient given recent developments.

Recent victories for the COFI score system?

COFI of Burger King: 18,700

Interesting new COFI analysis?

COFI of Xethanol: 61
COFI of Comverse: 375
COFI of ShareSleuth: 10,400

ShareSleuth is in trouble.  Big trouble.  COFI can feel it.  Xethanol?  Not so much.

One Plus Three

Friday means I have had at least a little time to absorb this week's Economist.  I have been hard on "financial journalists" this week, what with the Mark Cubans of the world poisoning an already flagging sector, and causing at least one to complain that I have been painting the group with a wide brush.  The Economist, which, by the way, usually leaves its articles uncredited, tends to assuage my bristles in this department.  This week is no exception.  As usual, the articles therein draw a keenly stitched thread through areas of great interest to me.  This week, however, that thread begins with DealBook, which, in turn, points to an Adam Lashinsky piece in Fortune on what might be signs of a pending correction in private equity.  Many of the old arguments are re-hashed.  LIPOs like Burger King are mentioned, J. Crew ignored (a quick reminder that the CNN/Money logo atop the Fortune webpage has deeper meanings).  New though, is the voice of University of Chicago's Steven Kaplan.  "Historically, this looks a lot like 1987 and 1998," says Kaplan.  This, at least, is concerning.  Some signs of hope exist, Lashinsky manages to admit.  Interest rate coverage is much better than "back then," and there is always the potential for well focused firms to pick up tasty morsels of any shakeout with distressed funds.

By contrast, the Economist's portion of the thread is less "pop" about its financial news.  It begins with a pointer to a survey by Hay Group, a human resources consultancy, (subscription required) that shows that, cost of living included, senior management compensation is not what you think it is, that is unless you're a Going Private reader and have been following the facts, rather than the hype.  By this measure management in India, Germany, Switzerland, Brazil, Spain, Russia, Poland, Turkey, Japan, Portugal and Ireland all turn out better than United States executives- wonderfully ironic given the amount of vitriol about executive pay spills in the direction of the United States via Europe in general and Germany specifically.

This easily sets up the observation by the Economist (subscription required) that European Leveraged Buyouts are the hot new ticket (as your humble author can attest to personally).  Ironically, the by-line reads "Paris," but then, nothing is perfect.  "Europe is behind Britain, which is behind America," the Economist quotes KKR's Europe guru Johannes Huth as saying.  Indeed.  Given the events of the last two days I suppose it would still be somewhat excessive to try to factor terrorist risk into my calculations of risk-adjusted compensation when arguing for my salary increase upon a European posting.  Can't blame a girl for trying.

Follow that with a bit on inflation worries in Europe (subscription required) and the Economist has the private equity trifecta for the day.  Typical Friday.

High Tension Cable

Blackstone's acquisition of a 4.5% stake in Deutsche Telekom got a lot of Going Private Headlines over the last several months, not least because of the highly atypical nature of the deal (a minority investment in a public firm by a generally control-obsessed buyout firm).  I read with interest, therefore, a self-proclamed "dilligent fan"'s email missive pointing out that the equity stake Blackstone had taken in the deal, and indeed the investment at large, has been pounded.  Bloomberg reports yesterday that:

Blackstone Group LP's stake in Deutsche Telekom AG has dropped by about 540 million euros ($689 million) in value after shares of Germany's former phone monopoly lost almost a quarter of their value in four months.

The New York-based buyout firm bought 191.7 million Deutsche Telekom shares for 14 euros apiece from KfW Group, the state bank said in April. At the time that stake was worth 2.68 billion euros. Shares of Europe's largest phone company have since dropped to 11.17 euros, cutting the value of Blackstone's 4.5 percent stake to 2.14 billion euros.

The stock sagged another 4% today, I'm told.

Blackstone's self-imposed two year lock-up prevents them from exiting, though I'm not certain why they would at this point in any event.  If they truly believe in their investment premise, and my speculation about their motives is anything near correct, now would be the time to start acquiring a larger stake.

Alternatively, perhaps rumors of their interest in a larger stake were buoying the shares, i.e. the next stage of the acquisition might have been already priced in, and the failure of such a plan to materialize with anything like speed is now weighing them down.

Certainly, given the size of the firm it would be a difficult deal to pull off without a club-like setup. Will other firms be confident enough in Blackstone's investment theory to join the party in the face of sagging shares?  More than ever, perhaps, at this new price if the balance sheet for DT looks as good to them as it sounded to Blackstone.  Still, one of the purposes of buyout funds is to structure for the long term.  If DT's assets are fundamentally sound and this is a temporary dip then it is an opportunity.

It will be interesting to see how one of the largest buyout firms responds to this very public short-term setback.  And this, in turn, highlights one of the problems with PIPE deals by private equity firms- they aren't private.  Are large buyout firms prepared to deal with foreign investor relations issues?  Charges that they are locusts?  Plagues?  A forward looking career consultant might suggest there will be a growing need for public and investor relations experts with finance backgrounds in large private equity firms as these low hanging fruit becomes harder to find, these sorts of deals become more common and this issue grows to a more significant one.

Buy High, Sell Low

The Wall Street Journal wakes me up today (subscription required) with an interesting piece on rising commodity prices and their connection to a recent return to favor of certain acquisition practices that had fallen by the wayside in recent decades, namely: vertical integration.

The Journal points out that a desire to control supply and prices has pulled vertical integration from the scrap heap of 1980s mergers and acquisition finance, where it lay quietly collecting standing water, breeding mosquitoes and rusting from the corrosion of inefficiency, before dusting it off and pressing it into use as a means to provide both for consistent and consistently priced supply in a commodity environment where neither existed.  At Sub Rosa we noticed a surge in activity in steel as early as January.  Not quite as big as the number of new ethanol plants we were asked to help finance (even though we don't really do start-ups) but close.

Other responses to pressures are also cited, namely new technologies and long-term contracts.  If, however, I am dubious about Airbus locking in Titanium prices through 2015 can be chalked up to a certain prejudice about highly subsidized, multi-nation state ventures that colors the odds I give Airbus of having much of a Titanium appetite or even surviving through 2015.

The article caught my eye for three reasons.  Firstly, it is interesting to see old, but perhaps once overused, arrows in the acquisition quiver nocked once again.  Secondly, because I spend too much time reading Abnormal Returns, which quite enjoys the topic of commodity prices.  Third, because I wonder if this is not a case of "too much, too late."  Successful supply strategy requires action before matters get out of hand.  (Think: Southwest's brilliant [.pdf] Jet A hedge that, at one time, had their costs at $26 a barrel, and unfortunately has now mostly petered out for them).  I wonder now if it isn't too late to be integrating vertically and if some firms won't be stuck with big suppliers purchased at the peak of the commodity market and which they aren't particularly good at running.  Depending on your commodity price sentiment, it could be that there will be some raw materials LBO opportunities in the next few years.  There are, after all, worse things than owning a raw material supplier in a market with sinking commodity prices, but I suspect that they all involve British dentistry.

Capitalist Insignia

I simply must have it.

LIPO Suction Malpractice

Continuing Going Private's shamefully incestious link-sex with Abnormal Returns, today it points us to a slightly more masturbatory bit of link-sex in the form of a DealBook piece in which Andrew Ross Sorkin cites an Andrew Ross Sorkin article (registration required but entirely avoidable as Andrew Ross Sorkin has thoughtfully copy-pasted the Andrew Ross Sorkin article in the New York Times into Andrew Ross Sorkin's DealBook entry) on the often unrecognized long-term holding strategies by certain buyout shops in the private equity world.

Says Sorkin, citing Sorkin:

But while private equity firms may be larding companies with debt, they aren't dumping them as quickly as you might expect.

Buyout firms often stay at the party much longer than critics acknowledge because public offerings don’t offer an immediate way for firms to generate big returns and attract new investors for future deals.

The firms typically have lockups that prevent them from dumping their shares, and it often takes them several years to sell their shares — if they do so at all. The firms that own Hertz will retain an 80 percent stake in the company after it is public.

Few people have acknowledged just how many private equity firms have ended up remaining big investors in companies after taking them public again. Little noticed — or at least little noted — is the fact that “tens of billions” of private equity dollars, according to Thomson Financial, are now floating around the public stock market.

As with most DealBook entries, this DealBook piece is not least remarkable for the reappearance of the previous butt of thinly veiled Going Private jabs, the wonderfully bitter and disillusioned comment gabster "Dr. Mark Klein" who would offend your author more if not for his inability to conceal an unending disdain for that backbone of capital markets, the investing public.  The good doctor whines:

Makes perfect sense private equity firms hang around longer. Today’s endentulous SEC allows the looting to continue until enough suckers are rounded up to buy the new common.

...before adding...

The John Q Publics are too sedated by sex, booze, gambling, and entertainments up the wazzoo to notice.

Modern version of Britain’s 19th century Opium Wars which enabled them to loot China.

I'm not sure which delusion of grandeur I prefer, comparisons of Google to Napoleonic France by The Economist (subscription required) or the metaphor, albeit soiled with a barely disguised reference to sodomy and poor understanding of the actual history of the Opium Wars, comparing private equity firms with rank extraterritorialism disguised as trade dispute.  I suppose I have to pick the Google comparison, as the private equity / illicit drug reference is old hat around here at Going Private.  (In fact, quotes from the Caryle Group's David Rubenstein referencing leveraged (read: dividend) recapitalizations as "the cocaine of private equity" tempt your author to get an even bigger head imagining the various luminaries of buyouts waiting with baited breath for the next Going Private entry, or more likely, ordering their assistants to print out the articles and leave them on the club seating in the Gulfstream V for the jaunt down to Anguilla).

Sorkin has managed, however, to hit an important point.  Certainly, leveraged recapitalizations used to pay large dividends to private equity shareholders, particularly when followed by Going Private's favorite new term of art, the "Leveraged Initial Public Offering" (LIPO), are viewed as opportunistic transactions by large buyout firms.  The resulting payments often, and likely this is not coincidence, look very similar in size to the initial equity outlay made by the buyout group, or (in more sophisticated cases) the initial equity outlay with the firm's targeted IRR tacked on top (see e.g., Blackstone).  I've been calling these large self-payments followed by a LIPO "LIPO Suction," after the giant sucking sound employees hear if they are near the CFO's office.

Sometimes, however, what appears to be shameless profiteering is the order of the day.  Sun Capital quietly leveraged daughter firm Hub Distributing Inc. and took a $71 million dollar dividend after only 16 months and on an initial equity investment of $2.3 million.  On its face this is offensive, until you realize that Sun Capital managed to increase Hub's EBITDA by 300% or so.  And even in the absence of such improvements to EBITDA, I believe it difficult to make logical criticisms of the practice.  And, as Sorkin indicates, critics often ignore the long term interest private equity firms have in the continuing operation of the business.  As if buyout firms were disinterested enough in hitting their IRR that a dividend recapitalization move that merely limits their downside without providing the targeted return would remove their incentives to attempt to grow (or salvage) the business.

Expecting private equity firms to look out for lenders or anyone else is a silly expectation.  In the case of closely held LBOs, as results from most buyouts, the people with standing to complain (i.e. the shareholders) are making the dividend recap decision in the first place.  I often hear the argument "yes, but the business is already on shaky ground, why would you lever it up?"  I can't imagine why you wouldn't.  Given the opportunity to pull risk off the table for the shareholders, i.e. return the initial investment- or even more, in the face of potentially deteriorating business, why would you ever leave the money at risk when you could protect the downside to a break-even (or better) level and still maintain upside in the continuing operation of the business?  To do less would be to sacrifice the interests of the shareholders in favor of the lenders who might be harmed in a bankruptcy.  This requires the assumption that these lenders need to be protected from themselves.  That is, in my view, dangerously paternalistic.

There are already tools to deal with leveraged recapitalizations that "shock the senses."  After Bain Capital took a $84.5 million dividend payment from KB Toys using a leveraged recapitalization for more than a 350% return on their equity investment and then tossed the firm into bankruptcy protection, lenders sued, recently got the go-ahead to make fraudulent conveyance claims against Bain and are now demanding the return of the payment.  I will watch that case with interest.

Shifting the analysis to public or about to be public firms, many critics of LIPO suction complain that companies are badly weakened before they IPO.  These critics strike me as even more insulting to the investing public than Going Private's occasional barbs, or the even curmudgeon "Dr. Mark Klein" (who appears ready to label Jim Cramer fans as evil drugged-out sodomites- though I suspect this suggestion means Dr. Klein owes an apology to evil drugged-out sodomites).  Are we at the point where we believe the investing public unable to understand debt ratios and credit ratings?  For they seem to flock to LIPOs regardless of these statistics.  Are we confusing an appetite for risk with stupidity?  Headlines that read "flippers leave Burger King IPO investors holding the bag" confuse me for this reason.  Either the investing public is smart and some fraud involving non-disclosure of debt obligations has been committed, or they are dense and who do we blame for that?  (The baby boomers and sex education, according to Dr. Mark Klein).

Comments from the likes of Standard & Poor's Steven Bavaria to the effect that "...we are trying to shine a light on an area of the market that was previously opaque," make me wonder what sort of investors S&P thinks are out there.

So are we surprised when private equity firms employ complex but entirely legal structures (say, a recapitalization with holding company preferred stock as collateral) to assure riskless profit to their limiteds (to which they owe a duty) and themselves?  Are we to blame sophisticated lenders for the loose state of the credit markets?  Were they unable to price the loan properly?  As if they are equally inept as llamas when it comes to assessing and hedging risk?  Should we point at collateralized loan obligation instruments as an evil?  Surely they must be opaque and illiquid instruments that befuddle and victimize the horribly financially naive victims like Stanford University of Chicago MBAs who studied under Eugine Fama and who hold a concentration in debt instruments.

Customers Can Reach a Human, Can't They?

Sinister LLC's Chief Technology Officer now lives in mortal terror of Laura The Debt Bitch.  A certain Sub Rosa partner woke up in the middle of the night and, likely still in a half-conscious, dreamlike state, had the "brilliant" epiphany that one of Sub Rosa's daughter firms should run our IT.  In the abstract this sounds like a clever idea.  Save on central costs, preserve confidentiality of sensitive email (except perhaps that email that talks about the sale of the daughter firm itself) and all the related goodies.  The plan came off its rails immediately when Sinister LLC was selected as the daughter firm to host our precious informational cargo.

Since the transition, we have become subject, quite literally, to weekly emails announcing that, beginning at 3:00 pm Pacific time on Thursday, email and the website will be unavailable for "a short period."  Apparently "short period" at Sinister LLC means "four hours."  No one seems more annoyed by this than The Debt Bitch.  Or at least, no one is quite as vocal about it.

Seemingly forgetting that this plan is the baby of a Sub Rosa partner, The Debt Bitch has launched a campaign to malign the information technology department of Sinister, LLC.  It isn't difficult.

About a week and a half ago she storms into my New York office at around 6:45 pm with a "Is your email working?"

"No," I replied.  "No one's is.  It's being... maintained."  I don't say that this is the second "maintenance" outage this week because she already knows.

"This is bullshit.  What mickey mouse bozo starts a major maintenance program at three in the afternoon on a workday and runs it for hours?"  I later discover that she's lit up because she's waiting on a rather important term sheet for debt financing from a hedge fund.  I'm about to answer her but I don't get a chance.  She sits down in front of my desk picks up my phone and is in the middle of dialing when she asks "Can I use your phone?"

"Go right ahead."  Like I could stop her anyway.  The Debt Bitch is typically animated, or at least expressive, when she talks on the phone.  Many a time have I walked by her office to spy her stalking back and forth in front of her window with her phone plastered to her ear, or lounging seductively on the little couch in her office with her legs up on the arm, pouring the sweetest golden honey into some debt dealer's ear.  (Now that I think of it, why does she get a couch?  She's only an associate.  I'm a Vice President and I don't get a couch).  This time she just stares at me with a blank and somewhat frightening look in her eye as the main line at Sinister, LLC rings.  Her expression turns dark when its answered and she leans forward, reaches over my desk and clicks on the speaker phone before depositing the handset back in the cradle.

"...Sinister, LLC, a Sub Rosa company.  Our office hours are 8:00 am to 6:00 pm Monday through Friday.  If you know the extension of the person you wish to speak to dial it now."  I recognize the apathetic, nasal voice that is Sinister's main receptionist.  We both look at the clock on my wall simultaneously.  It is 6:56 pm in New York.  3:56 on the Left Coast.

"What in the fuck is this?"  The Debt Bitch says "fuck" a lot around me, but seems to avoid it with anyone else around.  I'm not sure if this is some sort of seal of approval for me or not.  What does it mean when a co-worker feels free to use profanity in your presence but not around other employees?

"...For our directory by last name press 411.  For customer...."  She leans across my desk again and over the phone backwards to stab the "0" button on the number pad.

"Thank you for calling Sinister, LLC, a Sub Rosa company.  Our office hours are...."  The anger builds.  She stabs "1" with even more irritation.  A long pause.

"Thank you for calling..."  Fumes start to radiate off of her.

"Try three digits," I suggest.  "Maybe 001 will get you the CEO."  I'm joking.  I couldn't imagine wanting to talk to the CEO about an IT problem.

"...Monday through Friday.  If you know the extension...."  To my surprise she pounds "001" into the phone so hard the handset bounces briefly lifting the switch-hook and cutting the speaker off before settling back in place with a rattle and clicking off the extension.  It takes all my effort and restraint to keep from laughing.

Wordlessly, she hits the speaker phone and dials again.  "Thank you for calling...."  She smacks 001, a little gingerly this time, but I can still hear the irritation in her key presses.  A ring.  Another.  A third.  A fourth.  A quick pause, a fifth sort of half-ring as the call is dropped into voice mail.

"You have reached the office of Theodore Slone.  Mr. Slone is not able to take your call.  Please leave...."  Theodore Slone is Sinister new CEO.  Jeff, Sinister's old CEO, got the ax in no uncertain terms back in June.  It seems pretty clear that Sean, the Sub Rosa partner who tapped Jeff, is soon going to be "pursuing other interests."  I'm sure Sub Rosa will "wish him the best of luck in his new endeavors," however.  The Debt Bitch smacks "0" again.

"Thank you for..."  She smacks "411."  "Please dial the first three letters of the last name of the person you are calling."  This presents Laura with something of a dilemma.  She twists her neck to try and read the letters upside down.

"What the hell is the IT guys name?" she growls.

"Emmerson?" I ask.  She stabs "366" quickly just before I realize she was probably asking for the junior IT guy who sends out maintenance warning emails twice a week.  Todd Emmerson is Sinister's CTO.  Oops.

"Todd... Emmerson," says Todd Emmerson's voice.  "Press 1" says Sinister's apathetic, nasal receptionist.  Laura stabs "1."  A ring.  Another.  Three.  A fourth.  A quick pause, a fifth half-ring as the call is dropped into voice mail.

"You have reached the office of Todd Emmerson..."

"Does anyone actually work at this fucking company?" Laura demands.  I just shrug.  "Sinister has employees, right?  It's not populated with voice mail messages right?  Customers can reach a human, can't they?"

"...if this is an emergency Mr. Emmerson can be reached via cellphone on...."  The Debt Bitch brightens.

"Ah HA!"  She's getting quite good at dialing upside down by this time.  She punches in the cellphone number of Sinister's CTO.  A ring.  A second.  The phone is picked up.  A man's voice.

"Heh-low?" Car sounds.  Music is playing in the background.  I swear it's New Kids on the Block.

"Mr. Emmerson?"  Laura always uses last names of people older than her.  I picture her parents as old school German types who cling to the formality.  It actually serves her well.  She must sound like a IRS agent or a creditor or something because it tends to throw people off guard.  The music stops mid-lyric.  The car noises don't.

"Uh, yes?"

"Mr. Todd Emmerson?"  I swear she does that intentionally, that "Mr. so and so?  Mr. Bob so and so?"

"Yes?"

"This is Laura, from Sub Rosa, LLC."  A long pause, no recognition from Mr. Todd Emmerson.  "Your parent company?  The firm that owns you?"  I stifle a laugh and cover it with a deadly serious look because she said "Owns you," not "owns the company you work for."

"Oh... well..."  A pause.  "Heh-low."  Much more serious now.

"I'm here with Equity Private, my Vice President."  I am constantly tickled with the way Laura says that.  "We are very concerned about the continuing email outages and would like to ask you some questions, but if your in the car... I see it's nearly four o'clock perhaps this isn't a good time."  The sarcasm literally drips off of "four o'clock" like syrup.

"Well, no, of course.  Uh, how can I help you?"  Todd says "well" quite a lot.

"Mostly we are trying to understand why twice weekly maintenance is required?  Also, no one seems to be in the office today.  Is that because the email isn't functioning?"  She's being quite polite, really, but I can tell it's poised to get ugly.

"Uh, well, no one is in the office?"

"No one is answering the phones.  The main number goes straight to voice mail.  Who's in the office doing the maintenance?"

"Well, I guess I'm not sure."  The Debt Bitch says nothing.  A long, stony silence follows.  She's very good at those and she wins the stand-off.  "I expect it is routine maintenance on the Exchange server," Todd stammers.

"You are using... Microsoft Exchange?"  You would think Microsoft Exchange was illegal given her tone.

"Well, yes.  For email."

"I see," Laura deadpans.  A long pause again.

"Well, it is probably a backup operation."

"Probably.  Look, can you figure out what is going on and get back to me?  We are waiting on some critical and time sensitive documents here.  I would call someone else but no one else seems to answer the phones.  Is there maintenance going on with the phone system?"  I am sure The Debt Bitch was joking about the phones, but the question comes off as a serious one.

"The phones?  No."

"So you will get back to me today?"

"Well, sure.  Uh, what time is it there?"

"We are in the office every day until at least nine," Laura says.  "And most Saturdays until five or six," she quipps, rubbing it in.

"Uh, well, ok."

"Thank you."  -click-

He never called back.

Vanity or Opportunism?

A combination of time constraints and (more severely) the psychology of personal reflection make it difficult for me to properly evaluate the true meaning my recent tendency to measure the passage of time by the regular arrival of The Economist.  It seems only hours since I was reading the last issue and here is another one haunting me with ridiculously relevant insight and discussion (subscription required).  The loyal Going Private reader will know this because I violate today my usual literary disdain for all subjects macro.

Most interesting, at least this hour, is the discussion on the importance of recession in economic cycles and the potential for some wholesome economicy goodness to issue forth from a slow down in the United States.  I suppose it would be too clever by half to point out that it is conveniently easy for a British publication to call for a recession in the Colonies, though I think The Economist's piece falls short of that.  I am sorely tempted to point good natured, if gently accusatory, fingers towards the red ink in The Economist's logo anyhow.  Regardless, the piece brings up several important issues besides having the appealing property, always welcome in financial journalism, of using railroads as a metaphor.  Says an uncredited Economist writer:

In 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.

According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.

Back in high school I had an economics teacher who ignored all hand wringing about the deficit or trade imbalance.  "I expect it will just eventually be inflated or recessed away," he would quip.  You would likely be forgiven today for mistaking him for Joseph Schumpeter.

In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.

The Economist gets it exactly right, I think, in pointing out in a between-the-lines sort of way that a long brewing conflict between two schools of, if you will, recessionary thought, has come to a head.  Internationalists, with increasing volume over the last few years, point to the dangers of foreign sovereigns and financial institutions dropping the dollar wholesale in anticipation of a future recession.  Internationalists have typically been far more forward looking (at least when it came to monatary policy) than their domestic counterparts.  Now, The Economist argues, forward looking thinking has become en vogue for the domestic bunch, as recession could be the cause of a current account deficit shrink rather than the reverse.  Since, the Economist argues on behalf of domesticists (domesticates?), gross domestic purchasing is at something like 106% of GDP, there's room for a slowdown without any substantial job loss.  As if the Phillips curve didn't have enough problems already.

This rosy view fails, suggests the Economist without quite suggesting it, to contemplate the structural changes that would be required of such an eventuality.  A large shift towards tradable goods that would be required to make up for a strong slowdown in domestic spending (only 25% of goods produced in the U.S. currently are, if the Economist is to believed, tradable) would be needed to keep production stable.  Housing, therefore, might have to take it on the chin.  (Don't try to tell me you're surprised).  What, pray tell, will become of the massive infrastructure in labor and capital that has heretofore been devoted to housing?  Industry migration, or unemployment are, of course, the two options.

But let's put the macro thankfully aside for a moment to press weightier things, like Stanford grads.  I leave you with this short-term takeaway: Monetary policy has gotten more long-term.

"Venture is getting a renewed boost and is set for a major comeback," one self-professed Stanford grad recently wrote me to complain about my failure to adhere to the equal-time standards of the private equity blogging industry.  "All this buyout tallk [sic] is as much has-been bullshit.  Why don't you send your resume out to some venture shops and start covering venture capital deals more?"

This chart might help:

                                      Venture                Buyout &
                             Number   Capital     Number    Mezzanine
    Year/Quarter            of Funds    ($M)     of Funds     ($M)
    2002                      171      3847.7       88       25731.1
    2003                      144     10680.2       92       29310.4
    2004                      201     18253.3      134       50953.1
    2005                      202     26530.8      175       94669.7
    2006 YTD                  105     17972.6       73       54383.7

    2Q'05                     56       7676.0       63       26446.0
    3Q'05                     62       5608.1       60       21677.4
    4Q'05                     70       8083.8       50       32491.0
    1Q'06                     64       6762.5       46       23575.0
    2Q'06                     50      11210.1       35       30808.7

    Source: Thomson Financial & National Venture Capital Association

    *  These figures take into account the subtractive effect of downsized
       funds
    ** This category includes LBO, Mezzanine, Turnaround and
       Recapitalization-focused funds.

To put things in perspective, the three years ending 2001, probably the peak of the boom, raised $200 billion in venture money.  The three years ending 2006 are poised to bore the bank with a paulty $70 billion in venture money.  Texas Pacific Group alone raised almost a quarter of that just in Q1 2006.  Fortunately, a permanant membership to the highly exclusive club of my junk mail filter is only a mouseclick away.

Says Joshua Radler, assistant project manager at Thomson Financial in what is likely the understatement of the year: "...this liquidity will have a significant impact on the dynamics of corporate America and the US economy in the coming year."

The capital hanging over the business is staggering.  Even Henry Kravis is shocked... shocked I tell you to find there is fund raising going on in here.  (Does anyone else think he and James Carville were separated at birth?)  Consider the European impact as well:

A full quarter of all funds ever raised on the London Stock Exchange's AIM were raised in the first quarter of 2006.

Thomsons cited European private equity figures on fund raising as €72 billion in 2005, more than doubling the 2001 figures.  Some €58 billion was destined for buyouts.

It has been fashionable lately to predict the death of private equity as we know it.  Certainly, venture imploded even with substantial overhang and after record fundraising, but I just don't see the fundamentals for buyouts evaporating for reasons I've discussed here before.  That being said, what would recession do for buyouts?

Personally, I think LBO firms have their timing almost perfect.  A flurry of fund raising after several years of dynamite returns means they will be sitting on a pile of cash, much of it locked up, for years to come, waiting patiently for deployment in the right spots.  Indeed, you have seen them casting a wider net for opportunities (ahem, Blackstone) and, at least in my view, the surest sign of the approach of a bubble burst is a wholesale resort to the public equity markets, there are after all fewer "greater fools," for exit (but at super premium retail prices).  I cannot think of anything I would rather be than sitting on a pile of cash with multi-year lockups when the bubble bursts.  My big worry is that there will be so much cash floating around prices won't fall fast enough even in the face of an economic downturn.

Those LBO firms that have failed to hold true to structural and incentive models that encourage (indeed mandate) long-term holdings will likely be challenged.  The traditional LBO model, what I call the "purist" LBO model is to pick up trodden upon or out of fashion assets when their prices are low, impose cost cuts, apply consistent and disciplined management and remove the corporate form from destructive short-term accountability to shareholders (quarterly reports) so that it can be held for the long term and exited with an enhanced multiple.

Without doubt, the current environment is rife with opportunistic and highly creative examples driven by, among other things, SarOx, executive compensation, record low interest rates and public equity markets unable or unwilling to read debt ratios.  As "smart money" what else would we have private equity fund managers do but provide returns?

Coming full circle, and in the face of what must be some kind of economic adjustment (The Economist, after all, asks "recession how" not "if recession"), what can we expect?  A return to purism in LBOs?  Outstanding.  Now (or perhaps 6 months ago, depending on your temperament) would be the time to raise such a fund.

Personally, I'd put together a fund dedicated to the acquisition of firms that produce exportable goods.  Hey, Going Private reader... you in?

(Art: "Martha Rebuking Mary for Her Vanity," Guido Cagnacci, post 1660- probably during his tenure at the court of Emperor Leopold I)

Financial Vampires (or Lovers)

DealBook points us today to the conclusion by Fortune that there are no winners, no "heros" in the Heinz proxy contest.  Well, except for the shareholders that have seen a 23% gain in stock price since the beginning of the contest.  Shareholder's don't make for sexy financial reporting copy, however.

(Art: "Vampire," 1893-94, Edvard Munch.  Purportedly, was originally titled "Love and Pain" until being allegedly rechristened (so to speak) by friend and poet Stanislaw Przybyszewski as "Vampire."  As I use it here both to foil DealBook's artwork and to make a statement about certain financial writers, it is left to the Going Private reader to determine which is the more appropriate interpretation when applied to Fortune Magazine and the CNN/Money logo that lies above its every article).

Unstable Isotopes

Jeff Jarvis' "Buzz Machine" takes on a topic dear to my own heart, specifically, how much of a scumbag is Mark Cuban really?  My opinion varies by day.  Presently, Cuban reminds me of Ununpentium.  Both are entirely synthetic, highly dense elements that shouldn't really exist in the natural world, created almost by accident and only recently via the fusion of a series of other dense elements (isotopes of Calcium and Americium for Ununpentium, the shareholders and management at AOL and Yahoo for Cuban) through the judicious use of spin (a cyclotron, for instance- or perhaps a bloodless public relations firm and a penchant for controversy), require large amounts of expensive equipment to feed and maintain and that still have no use whatsoever other than for basic scientific research (chemistry or forensic psychology, depending which side of the metaphor you want to use) and to keep various wing-nuts chattering.  So far no one has created a particularly stable isotope of Ununpentium (or Mark Cuban).  The half-life of its most stable known isotope is 87 milliseconds or so, and without a massive research budget, it tends to degrade into less sophisticated (but more stable and less prone to decay) elements like Ununtrium (similar to Guy Kawasaki).

As for "ShareSleuth," I don't quite know what to say other than anyone with a high enough mass to volume ratio to believe that "altruism" or "helping the poor schmuck" should be found on the same page as "shorting capital markets for profit" deserves to have Mark Cuban as a recurring dinner guest.

Beware Dark Figures Bearing Fairness

The appeal of Mark Cuban's ShareSleuth, that he is making markets "fair" for the little guys (on the backs of which he extracts his short-selling profit), is in the wonderfully romantic but entirely absurd notion that markets can be made "fair."  If you actually give it any thought, in this context "fair" often implies a certain blindness to things like hard work, research, and superior knowledge or expertise gained therefrom.  Everyone, "fairness" proponents would argue, should share in the riches.  Everyone should share in prosperity.  Why should a lucky few enjoy disproportionate gains?  Sounds appealing from an asthetic point of view.  Really, very democratic, in the French sense, even.  Pas vrai?  No, not really.

This is the same logic, tied together with an insidious vein of political savvy, that causes people (mostly those facing an election year) to call for taxes on "windfall profits," as if record revenues for oil firms are somehow a gift from the Tooth Fairy rather than a good deal of strategic planning coupled to a sustained program of massive capital expenditure and exploration efforts.  Now we have a more dangerous strain of this fairness virus: shared pain.

Abnormal Returns gives me no peace, filing their daily link post in the afternoon hours after I thought I had my news hounding done for the day.  Today they point to two Wall Street Journal articles on an emerging trend (subscription required) (which has actually been around a long time) whereby slow to respond investors sue early exiters from a failed (fraudulent?) hedge fund arguing that the early exiters, and I'm not making this up, "should be sharing the pain."

The legal term of art is "restitution for unjust enrichment."  The rub, of course, lies in the definition of "unjust."

Some of the allegations include the suspicion that higher profile investors were "tipped off" and allowed to get out early.  Absent this, however, letting anyone recover on this kind of a legal theory you'd have to collect every Enron shareholder who sold before the plummet and chase down their assets.  So I ask, how far back do you go?  Surely, the original investors in Enron, the very first, are more deserving than the bandwagon jumpers.  Shouldn't they get a larger bit of the pool?  It's only fair, after all.  What about more "deserving" shareholders?  Widows and orphans!  They, certainly, are more deserving.  No?  Suddenly, "fair" becomes a political status question, not a concept of equality (if it ever was).  Are we really saying that we are going to punish the investor who, because she carefully monitors her investments, one day, smelling something sour, catching a nuance in the tone of a manager of the fund on a conference call, decides it's time to lock in gains.  We should, I suppose, transfer her gains to the passive investor who jumped on the next "big thing" and failed to pay any attention to the signs?  Sure, we sympathize with the second investor, but "fair" is in the eye of the beholder once you make it political.

Dangerous, this line of thinking.

Positive Suction?

Once again, Vipal Monga, the debt expert over at The Deal, scores with a review (subscription required) of dividend recapitalizations and leveraged initial public offering (LIPO) transactions data by Standard & Poor's.  Results, well, not what one would expect on first glance- dismal credit and high default rates.  Says Vipal of what the Standard & Poor's data says:

...the default rate for companies that underwent a dividend recap between 1995 and 2003 is 6%. That number compares with an 11% default rate for all companies bought by LBOs during the same period.

Why?  Self-selection.  Firms without the strong and consistent cash-flows to support the debt taken on in a recap/LIPO suction transaction don't get the loans to suction off a special dividend in the first place.  It suggests that these transactions actually tend only to be possible (due, one assumes, to bank scrutiny) in firms that are more stable in the first place.

Though Monga doesn't say, one assumes that the 11% default rate for LBO defaults spans time frames from 3 years (2003-2006) to 11 years (1995-2006).  Looking at Moody's study of rated debt defaults versus time we see that an 11% default rate over 11 years looks about like a solid "Ba" credit rating.  A 6% default rate over 11 years creeps most of the way towards "Baa" territory.  Looking at the 3 year boundary, the trend looks more like "B" to "Ba" (though we are mixing statistics a bit).

LIPO suction cases seem to come out of the gate with around a "B" rating (see BKC / J. Crew), suggesting that this might even be low given the statistics cited in the article.  A quick look at the facts for leverage multiples would give us a better sense.  Of course, Monga picks that up too, quoting Steven Miller to show that, at least when compared to other LBOs, recap / LIPO suction deals don't look that bad:

Steven Miller, managing director of the S&P Leveraged Commentary & Data unit, says companies that have been recapped actually have lower leverage multiples on average than traditional leveraged-buyout deals.  According to LCD's numbers, the average leverage multiple of LBOs in 2004 was 4.85 times, compared with 4.39 times for those companies that were recapped. In 2005, the LBO multiple was 5.25 times, compared with 4.45 times for the recaps. So far this year, the LBO multiple is 5.39 times, with the recap multiple at 4.39 times.

8 + 2 = 12

Revel in Stanford math: The twelve ten things to learn in school this year.  Learning to count is apparently not among them.

Brilliant Business Journalism

Leave it to the Financial Times to mint humor so subtle and sublime (subscription requried), so nuanced and multi-layered as to befuddle the "financial journalists" of the United States into something approaching dumbstruck madness- though astute readers will find this only slight at odds with the natural state of the typical financial journalist psyche.  (Leave it, of course, to Abnormal Returns [yummy!] to point us to this wonderful Sunday find). In this particular case, John Plender weaves a wonderful reductio ad absurdam chain with such skill and craft that both proponents and opponents of private equity are made light of.  It is artful to such a degree that lighter intellects might miss the joke.  Not surprising then that McBusiness Business Week rises to take the bait.  Spins Plender from the Financial Times:

With private equity investors gobbling up bigger and bigger chunks of the corporate world, fuddy-duddies worry that quoted equity will shortly become extinct. The usual party-poopers see a bubble and warn that hubris will soon lead to nemesis. For them, over-ambitious private equity folk deserve their status, shared with hedge funds, as the new bogeymen of the western world.

They have, of course, got it all wrong. The problem with private equity people is, in fact, their timidity. They have been desperately slow to raise their sights when so many institutional investors have been hurling ever larger sums at them in pursuit of better returns than those available in public markets. Why have they failed to tilt at the scores of companies much larger than HCA or NTL that have far less efficient balance sheets, bigger cash flows and a crying need for focus? Consider Microsoft, which has a balance sheet so inefficient that it would make a private equity investor weep.

[...]

In short, [Microsoft] has been preoccupied to such a degree with technology – so 1990s – that it has completely failed to take advantage of a period of unprecedentedly low interest rates, of banks that are falling over themselves to lend, of weakening bank covenants and a widespread recognition that leverage is the new alchemists’ gold. It is all too obvious: Microsoft just does not get it.

Before long he's gotten to:

The new management could take the axe to Microsoft’s $6.6bn of wasteful research and development expenditure. The bloated workforce of more than 60,000 could be slashed, to the point where the huge resulting increase in cash flow would at last permit the company to borrow mega-billions.

This brings us to the real joy of private equity: the so-called “dividend re-cap”, a dividend-for-debt swap. The enhanced ability to borrow would permit the newly private company to make the greatest dividend payment of all time. At a stroke it would solve the financial problems of the army of private equity investors who have been trying – hitherto unsuccessfully – to punt their way out of pension fund deficits.

...and the punch line, sarcasm served with a side of sausage, and delivered after a deadpan fry, as only the English can (good thing too because it is also the only cooking they can do):

Only the bankers will need a way out. Their horizons are traditionally fixed more on entrances than exits. Yet even they now have an exit strategy for private equity deals. It is called the credit derivatives market. This allows them to hedge the most outlandish risks. Of course, a curmudgeon might argue that this is morally hazardous since individual banks will take bigger risks in lending for over-leveraged deals because they can now shift risk on to others. So the quality of lending in the system deteriorates overall. But because in a very opaque market nobody knows where the risk ends up, why worry? Grab the dividend while it is on the table and let the devil take the hindmost.

Business Week, in an article dated September 4th (!?) and which displays the brazen gall to be found in the "News and Insights" section displays a dark flash of dazzling daftness:

Could Microsoft be bought out? That's precisely what the Financial Times of London recently called for. A consortium of private equity firms, the FT wrote, could cobble together the $288 billion needed -- nearly nine times more than the largest deal ever made. Why dare? "In truth," wrote the FT, "Microsoft would be worth more off the [public] market than on it."

The fact that anyone is talking seriously about such a colossal deal might in itself signify the high-water mark of the private-equity boom.

No, my dear, dear Business Week writer.  The fact that you are talking seriously about this Financial Times article might in itself signify the high-water maker of the "financial journalism" boom.  Honestly, is there no spell, no potion, no chant, no animal sacrifice... no human sacrifice that might rid us of suchlike?  Perhaps a buyout of McMedia ConglomerateGraw-Hill?

Ah, but it gets better.  No, really.  The diva of digital democracy herself, where everyone has a voice, i.e. the Business Week online comments section, yields this wonderful gem:

I've got most of my money invested in MSFT because its safer than a being in a bank.
- A Real Conservative

Ah, the delicious delights of Sunday afternoon.  The only pity is for those who must now travel in London on financial business while bearing the scarlet letter of a United States passport.

I do so love the intellect that recognizes there are wingnuts on either side of the Microsoft and LBO debates, and very few reasoned types in between.  Seeing the double entendre of "bi-polar" in the United States (a two party political system and the propensity to have schizoid breaks of mood) is what makes the Financial Times so charming and full of character.  Well, that and the sort of early-morning-vomit after-a-night-of-screwdrivers-and-peach-martinis color of the newsprint.

Mission Impossible Capital, L.P.

Your author's reaction to the news that Paramount had shown Tom Cruise the door and cited his behavior as the primary reason was probably predictable.  The story has driven the Wall Street Journal, among other publications, absolutely mad with print and resulted in any number of articles in other publications.  Ironically, Paramount had a reputation for being a difficult place for "top talent" owing to its overly cautious management.  The Financial Times was tickled pinkish orange then to relay the news (subscription required) that Brad Gray, who had been hired by Viacom to assist Paramount because of his "...close ties to Hollywood's creative community" (read: actors) did the firing.  God damn it Maverick.

A variety of problems plague the industry now.  DVD release times have crept, and continue to creep, closer and closer to theater releases.  Theater sales, aside from a brief recent blip, have been way down- and why not?  Who wants to pay money to be threatened with lawsuits, encouraged, Soviet bloc style, to snitch on your seat mate, and watch 10 minutes of advertisements for coke and cellular service?  DVD sales have begun to flag also.  DRM technologies, which attempt to solve an unsolvable problem (namely, how you can permit digital data to be played but not recorded) instead impose unreasonable restrictions on customer's use of their own data, not to mention attempt to sell less product for more money, are finally beginning to create serious customer push back (and indeed, outrage).  That's not even to mention the ill will the MPAA has been spawning by suing its own customers with a capriciousness that should offend even the most hardened Italian fascists.  Of course, the MPAA is just an anachronistic force, desperately trying to hold together a distribution model that is simply outdated and broken.

The signs of strain are beginning to show.  Disney has cut workforce.  Time Warner has followed suit.  Universal has lost its chairman.   Cruise is forced to go crawling to the dark side of financing: hedge-funds.  Or has he?

Apparently, it is often said that Cruise is one of the most certain "sure things" for large blockbusters (the last 7 films of his each pulled $100 million).  Says the Financial Times of his star power at its peak:

Mr Cruise had become one of the industry's best-paid stars, with a so-called "20 and 20" contract that gave him $20m up front for each film and 20 per cent of gross ticket sales.

Paramount's deal with Cruise was more complex than it seemed.  Technically, Cruise did not even work for Paramount.  Instead, Cruise and his partner, Paula Wagner, own Cruise-Wagner Productions which, in exchange for having their overhead covered (apparently about $5-$8 million per year) and a spot on the Paramount lot, gave Paramount first-bid on their projects.  The trade off is that Cruise-Wagner were taking 22% of theater and television revenues and 12% of DVD revenues. This is, according to the Financial Times, unusual in the business, where even the brightest stars get their cut of DVD sales after 80% is already taken off the revenue line.  This held until the recent release of Mission Impossible III, whereupon, according to the Financial Times (subscription required):

After the DVD industry began altering Hollywood's profit landscape, and because it was complicated to track all the expenses, Mr Cruise revised the deal with Paramount. His cut of the gross was increased to 30 per cent and, for purposes of calculating his share of the DVDs, he accepted a "royalty" but it was doubled to 40 per cent. So, he would get his whopping 12 per cent of DVD receipts with no expenses deducted by Paramount. From the DVDs alone, Mr Cruise gained more than $30m on Mission: Impossible II. With Mission: Impossible III, Mr Cruise still got his huge percentage of the gross. Both he and Paramount were, however, disappointed with the theatrical gross - $393m (£208m) - even though it has been Paramount's highest grossing film in 2006. Mr Cruise blamed Paramount, whose new regime, headed by Brad Grey, had fired a number of Paramount's top marketing and distribution executives in Europe, and Paramount blamed Mr Cruise's tiffs with the media. The bottom line was that Paramount could not make much of a profit from even a high-grossing film such as Mission: Impossible III. Faced with this disaster, Mr Redstone turned it into a morality play, with himself in the role of Mr Morality. with Mr Cruise getting a 40 per cent royalty of DVD sales. When Mr Cruise refused to reduce his cut, Paramount "played hardball", as an executive put it, and lost the Mission Impossible franchise.

So what's the truth of it?  Cruise fired because he is a moron? Paramount using hard-ball tactics to force a better contract?  The end of the reign of spoiled star?  The decline of "star power" seems in the cards, at least if the New York Times is to be believed (not a sure thing, that call).  Says the Times (requires free registration evadeable via bugmenot):

“There is no statistical correlation between stars and success,” said S. Abraham Ravid, a professor of economics and finance at Rutgers University, who, in a 1999 study of almost 200 films released between 1991 and 1993, found that once one considered other factors influencing the success of a film, a star had no impact on its rate of return. Employing a star had virtually no discernible impact on the box office itself. Mr. Cruise would no doubt object to that assertion. And to be fair, there is some theoretical pedigree to the idea that he may be worth every penny. In fact, there is a whole branch of economics that aims to explain how talented people generate so much more money than competitors who are only slightly less good. It’s called “superstar economics.”

Superstar economics, which has been used to explain the astonishing fees of top lawyers and the skyrocketing pay of star chief executives, dates back to the insight in the late 19th century of the British economist Alfred Marshall, who observed that “the relative fall in the incomes to be earned by moderate ability ... is accentuated by the rise in those that are obtained by many men of extraordinary ability.”

The dynamic was explained by a University of Chicago economist, Sherwin Rosen, in a 1981 paper entitled “Superstar Economics.” Mr. Rosen posited that improvements in technology that would make it easier for top performers in a field to serve a larger market would not only increase the revenue generated by stars, but would also reduce the revenue available to everybody else.

Or was it all, as the LA Times speculates, a publicity stunt?

Does it matter?  (The street thought so.  Viacom shares were up on the news of Cruise's departure).  I don't know.  But I do enjoy the drama.  And, of course, the opportunity to watch a pair of hedge funds take a bath.  Enter the Vegetable Capital angle.  Quoth the Wall Street Journal (subscription required):

During an internal presentation on film financing last year, Merrill Lynch & Co. executives entertained employees with the famous video of actor Tom Cruise manically bouncing on Oprah Winfrey's couch as he sang the praises of his new girlfriend.

Amid the laughter, recalls someone who was in the room, Michael Blum, Merrill's head of structured finance, asked: "How does one hedge that risk?"

Hedge funds will be the ones to worry about it, according to Wagner.  And there are plenty that might line up.  Quoth the Journal:

That's a rich vein to tap into: More than $4 billion in new movie financing has poured into Hollywood from hedge funds and other institutions recently. Outside financiers ranging from hedge fund Stark Investments to the private-equity arm of Bank of America Corp. have put large sums of money into movie slates at studios including Time Warner Inc.'s Warner Bros. and News Corp.'s Twentieth Century Fox.

After I thought about it, however, I realized what this move really is.  If he gets hedge fund backing, Tom Cruise is doing a management buyout of himself.  The key issue with an MBO, is of course, the management. That doesn't bode well for Cruise who, while he might have a stellar track record, is beginning to show more and more symptoms of Howard Hughes syndrome.  The absolute worst thing you can have in a MBO is a gifted but eccentric manager.  They tend to command deep loyalties and are difficult to remove without creating significant trauma to the organization, even when performance is beyond dismal.

Going Private has noted before that outsiders (and hedge funds in particular) have a particular habit of taking seriously cold baths on Hollywood investments.  The combination of preferences to production and studios (or in this case, Cruise) and a lack of expertise in the business tends to spell disaster quickly.

An MBO here with hedge funds at the helm presents some issues. First, the vertical integration of distribution that a deal with a major studio offered Cruise is gone.  Those costs will end up passed along at auction now, and the lack of a sure feed into a large studio (Paramount is unlikely to entertain Cruise movies in future) presents additional transaction costs.  Further, it is not clear to me that a liquid market for production projects actually exists.  There seems to be quite a lot of buyer power in large studios, and one of them has effectively blacklisted Cruise.  Any seller power Cruise had is in retrograde now, and I suspect Cruise will find Hollywood studio bosses akin to care bears compared to his new hedge fund masters.  In short, I predict disaster.

Efficient Markets Theories

The Wall Street Journal throws a pair of darts at the naysayers (including your author) who decry the present regulatory environment as overly burdensome and therefore detrimental to capital markets in the United States.  Head to the New York Times, however, and we discover that the markets might be "too efficient."  The first Journal article is a piece on the rise in monies raised by foreign companies on U.S. Capital Markets.  Sayeth the Journal:

In the two years since stricter financial-control rules took effect in the U.S., an unexpected trend has occurred: The amount of money raised by foreign companies on American exchanges has grown.

So far in 2006, non-U.S. companies have sold $5.8 billion in stock through U.S.-listed IPOs, the highest year-to-date volume since the tech-stock boom in 2000 saw $27.2 billion of IPO listings emerge from overseas, according to data from Dealogic.

Though the number of companies tapping American exchanges for their new listings isn't up -- Dealogic shows there have been 17 this year, compared with 20 in 2005 -- the amount of money raised has nearly doubled in that time. Bigger deals, including Canadian doughnut chain Tim Hortons Inc.'s $772.5 million offering in March and German semiconductor firm Qimonda AG's $546 million debut earlier this month, helped create the higher volume.

To its credit, the Journal goes to pains to point out that the comparisons don't necessarily explain away the SarOx pain, but the lingering questions remain.

Bolstering this piece is an editorial page entry from the CEO of an offshore provider.  He cites some reasons for the superiority of the NYSE as a capital market nexus:

Credibility: Meeting the financial reporting, corporate governance and disclosure requirements necessary for listing on the NYSE builds confidence among clients, the government and other regulators. Clients prefer reporting in U.S. Generally Accepted Accounting Principles, or GAAP -- the same high standards they set for themselves.

Global visibility: The prestige of an NYSE listing not only builds brand recognition among U.S. clients and potential clients, but also among international audiences, who recognize the high standards that must be met. The enhanced visibility associated with becoming a U.S.-listed public company translates directly into new business opportunities

Shareholder value: Companies that list in the U.S. have a valuation nearly one-third higher than those listed elsewhere, according to a study co-authored by professors Andrew Karolyi and Rene Stulz of Ohio State University and Craig Doidge of the University of Toronto. Companies that cross-list in the U.S. have a valuation 13.9% higher. This is attributed to the greater visibility, as well as the improved disclosure and transparency, of a U.S. listing.

Liquidity: A U.S. listing allows us to reach a wider pool of investors and to trade in scale. This, in turn, helps drive value for shareholders.

Part of me wonders if there aren't some perceptual issues at work here.  Specifically, if foreign firms, particularly those, like WNS Global Services, from whence the CEO author of the Journal piece hails, see greater returns from the credibility boost (the "credibility margin" perhaps?) that an NYSE listing (or any U.S. listing) gives them relative to the expenses they will incur.  For these firms the additional reputation and the additional capital available, which might not be should they not list in in the United States, might outweigh the costs of SarOx compliance, among other issues (the highly litigious environment in the United States, for instance).  Access to key clients in one of the largest outsourcing markets might also be a factor for the likes of WNS that doesn't apply to firms in other industries.

This, in turn, causes me to wonder if there isn't some private equity opportunity here.  After several years as a NYSE listed firm, and therefore several years of history in a highly regulated environment, is the credibility margin worth the yearly audit cost anymore?  Surely a firm with such history won't suddenly lose its reputation if it goes private or moves offshore?  I suspect mid and large cap LBO firms might consider stalking foreign firms from countries with local exchanges of ill repute that have been public in the United States for 2-3 years already.  If the theory holds, this should be right about the time when the costs start to hurt more than they are worth.

I haven't heard much on some of the other theories forwarded by various pundits (Daniel Gross comes to mind) on subjects as varied as "The United States sucks at doing IPOs now."  Have any Going Private readers come across any data, of the sort that I asked after earlier this month, that gives us a read on the import of underwriter reputation in IPO pricing accuracy?

Shifting to the New York Times, we get a later entrant into the world of insider trading as covered by, among others, the nicely face-lifted DealBreaker this month.  The Times, pointed to as usual by the wonderful DealBook, is shocked, shocked, I tell you (circumvent registration via bugmenot), to discover insider trading is going on in here.  That piece contains an absolutely yummy graphic and this choice quote:

"Martha Stewart got hurt very badly for something that happens every single day on Wall Street,” said Herbert A. Denton, president of Providence Capital, a money manager and an adviser to minority shareholders. “It’s a falseness and a hollowness to the capitalist system when you are pretending that things are pristine and they are not. Either the S.E.C. should get very, very serious and prosecute a lot of people or forget about it.”

Hard not to agree, really.  Or has insider trading law become a tool of political advancement?  (Not that I'm a Martha fan.  That woman makes my scalp itch).

Maybe this explains the sudden splurge in foreign listings: the management of foreign firms just finds it easier to trade on their insider information in the United States.  Lots more liquidity to hide in, after all.  How are you supposed to bet the farm on the earnings announcement you authored if the daily share volume is only 4600 shares on the Bombay Stock Exchange?

I wouldn't be the first one to call for the legalization of insider trading, which, by the way, the Capital Markets seemed to tolerate just fine until the mid 1960s or so when it was finally outlawed.  Professor Manne, for example, makes some pretty interesting arguments on the matter.  Definitely worth the read.

An argument that I don't often see articulated is that the "little guy," i.e. the "casual" or "hobby" investor, shouldn't be in the market in the first place and the use of insider trading law to present the appearance of a level playing field, which clearly the public equity markets are not, and thereby pull in the unwary is tantamount to fraud itself.

Of course, I am speaking against interest here.  If there weren't the greater fools of the small guys in the public equity markets, who would we pass off LIPO suction deals on?

Expensive Date

DealBreaker's John Carney is a big old flirt.  Still, that's ok with me.  Flattery (read: ass kissing) is an important skill in finance.  I have to wag my finger at him today, however, for though he cites me regularly, he has apparently missed my piece on SarOx costs, and their continual rise over time- contrary to the predictions of about everyone that they would decline after a first year peak.  Hasn't happened.  Says Carney:

...one problem with this idea is that evidence has begun to show that the costs of SOX decrease over time. Getting compliant costs more than staying compliant, so the scale of costs and benefits is sliding on both sides. That’s not to say it won’t work but it would take some more work to see if it does.

Says the Study I cite via the Financial Times (subscription required):

Accountancy firms have emerged as surprise long-lasting beneficiaries of the Sarbanes-Oxley Act, as US-listed companies have been forced to pay their auditors larger fees to comply with the tough corporate governance rules, according to a new study.

The findings, in a report by law firm Foley & Lardner, confound predictions that US companies would only face a one-off increase in audit fees and other costs as a result of the legislation, introduced after the Enron and WorldCom scandals.

Flattery Day

In classically detailed fashion, DealBook pens an enjoyable piece about LIPOs.  Not the least because it both cites me and takes up my LIPO definition.  It seems that today is flatter Equity Private day.  Didn't you get the memo?  Sorkin's DealBook points to Thomson financial data to point out that LIPOs haven't performed at all badly in the grand scheme of the IPO markets.  (And don't miss the always absurd ramblings of Dr. Klein).  Uttered DealBook:

...what do the numbers say about buyout-backed offerings? So far this year, these kinds of offerings have performed worse — but only slightly worse — than their non-buyout-backed counterparts. Figures from Thomson Financial on the 107 I.P.O.’s (68 conventional, 39 backed by private equity) that debuted this year show that I.P.O.’s connected to buyout firms are down about 2.8 percent on average, while non-buyout offerings are down about 2.3 percent. Excluded from the figures were several I.P.O.’s from blank-check companies, which raise capital solely for acquisitions.

[...]

While the top non-buyout-backed offerings outperformed those with private-equity origins, the worst of them also lagged behind their more-leveraged counterparts. The year’s most successful I.P.O. to date has been Chipotle Mexican Grill, with a 135.5 percent return. The biggest flop has been the similarly un-leveraged Vonage, which has falled 61.8 percent since its debut. Strip away the best and worst performers in each category and the average returns grow even closer. Regular I.P.O.’s are down 3.5 percent, while private-equity-backed offerings are down 3.6 percent.

Nicole Kidman Should Run a Hedge Fund

News on the MBO of Tom Cruise moves fast.  I regarded with skepticism the news that hedge funds were lined up to liberate Cruise from the evil and repressive forces of Paramount.  ("I am not a destroyer of companies, I am a liberator of them."  And speaking of Gekko, maybe we should buyout and breakup Tom Cruise.  Somewhere, right now, someone is desperately waiting in an ICU for Tom Cruise's kidney).  So imagine my non-surprise to learn from DealBook that Tom Cruise has taken a 70% salary cut and now works for Mark Cuban.

By "Mark Cuban" I mean someone who managed to dump a mostly valueless business at the hight of the dot-bomb boom and used the proceeds to buy a sports team.  The only difference is this time "Mark Cuban"'s name is actually "Daniel Snyder" and he also owns a big hunk of the flagging Six Flags, Inc. (because you know what Six Flags, Inc. really needs to turn itself around is an investment in a manic Scientologist movie star).  Not exactly the $100 million deal from well-funded hedge funds we were promised.  I'm disappointed.  Says DealBook:

While Ms. Wagner said they were eager to work with entrepreneurs, Mr. Cruise and his representatives have actually been shopping for another home in Hollywood all summer without success, talent agents and movie executives told The L.A. Times. At least three studios had rejected Mr. Cruise’s terms, they said.

Says the Wall Street Journal (subscription required), cited by DealBook:

First and Goal LLC, whose backers include Six Flags Inc. Chairman Daniel Snyder, who owns the Redskins, and Six Flags CEO Mark Shapiro, will put up cash each year for offices, staff and costs associated with developing movies at Mr. Cruise's Cruise/Wagner Productions. Their investment, which sources familiar with the deal said was about $3 million a year, doesn't include movie-production financing, which the production company will have to come up with separately.

So, let's review.  The smartest money in the business tells Cruise to pound salt, and people with no background whatsoever in the business (except that they have seen some Cruise films, oh, and they stayed at Holiday Inn Express) pick up his deal at 30% of the overhead, provide exactly zero of the production costs, and end up with some undisclosed terms on his cut of revenues.

Another thing to note.  Cruise isn't exactly poor.  Why isn't he putting together his own studio?  Investing $3 million a year in himself for a larger cut of the revenues?  Always beware MBOs where management won't put skin in the game.

If Cruise was going to take a bath like this anyhow, you wonder why he didn't stick with the studios.  Or perhaps they simply wouldn't have him except at a much larger discount rate for his risk than the Vegetable Capital entrants who have now funded him.  When even the hedge funds (and let us not forget that they funded Poseidon) won't touch you... well, I leave the rest as an exercise for the Going Private reader.

One thing occurs to me.  Maybe Vegetable Capital is what Cruise was looking for.  An absentee manager with no experience in the business who can be led around eagerly for the chance to hob-nob with the stars and when asked about the supervision of Cruise issue vague platitudes like:  "We have our day jobs to do."

Nah, I think Cruise has just outlived his usefulness, botched his own valuation, and was played like a cello by the world heavyweight champions of the business.

Someone needs to give Nicole Kidman a job at a hedge fund with an event driven strategy.  She shorted Cruise and, though her positions haven't been disclosed, seemingly went long on Jude Law, with admirable timing.