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Monday, November 06, 2006

Goddammit Maverick!

too close for comfort With signs that all is right with the world once again, specifically, the return of the always yummy Abnormal Returns, it seems safe to emerge from the quiet period I have enjoyed the last many weeks.  Much has passed since I hosted your interest, dear reader, but it took Tom Cruise to finally rouse me from my literary slumber.

Abnormal Returns points us to a DealBook piece on Cruise, a piece that contains all the needed offense elements for an offensive vegetable capital offense.  To wit:

Hedge Funds
Massive Preferences for "Certain Investors"
Vanity Premiums
Tom Cruise, and, of course,
Dr. Mark Klein

Sayeth the New York Times (circumvent tedious registration with the always useful bugmenot) via the DealBook entry:

For MGM, which is owned by private equity firms in partnership with the Comcast Corporation, and the Sony Corporation, the deal offers an alliance with a major star on terms more manageable than the huge fees he commanded from Viacom’s Paramount Pictures for expensive films like last May’s “Mission: Impossible III.” It also offers a way to unlock the value of the United Artists name, which carries enormous cachet, but has been attached to only a few films lately.

The deal also offers a fresh twist on recent trends that have seen investors become directly involved with film producers, even as stars seek more creative and financial control over their careers. Established producers like Joel Silver and Ivan Reitman are among those who have made partnerships with outside investors, allowing them to finance films intended for distribution by studios.

Initially, Mr. Cruise and Ms. Wagner will have authority to produce about four movies a year, for distribution by MGM. Neither Mr. Cruise nor Ms. Wagner put up any capital, Ms. Wagner said. Mr. Cruise may or may not star in the pictures, and will remain free to work as an actor for other studios.

Mr. Sloan and his team have been working to revive MGM as a full-blown movie and television distribution company. Last year, several producers in Hollywood had sought to buy United Artists but were unsuccessful. So far MGM’s recent track record as a distributor of other producers’ movies is unimpressive.

Both the DealBook piece and the New York Times suggest this is a new and revolutionary form of financing for film production.  In fact, it is not anything like new and revolutionary finance.  What is new and revolutionary is the wonderfully refreshing spanking delivered to spoiled stars like Cruise, and a formalized setup to drag Vegetable Capital into Hollywood.

We've gone over this topic, that is the exploitative nature of Hollywood finance with respect to outsiders, more than once here at Going Private.  We've also touched on the somewhat silly, former state of affairs for "the talent" (to clarify, that means Tom Cruise in this context).

This recent news is sort of amusing, because back in August the Wall Street Journal was quipping:

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.

Sounds like that deal fell through, quietly.  Interesting, however, that now Cruise's deal is thinner still.  That is, his return is burdened by investor preferences senior to his cut.  Cruise is suddenly in a similar situation that outsiders looking to absorb some of the warm glow of Hollywood stardom by investing in a film or two used to find themselves in.  I outlined this setup with the help of the Journal and the New York Times back in April thusly:

Reading the Journal article it becomes clear that all the people in line in front of an equity investor when it comes time to pay out, including exhibitors, the studio distribution fees, payback for production and marketing costs, actors and directors, make up for a pretty large black hole that has to be filled before investors see a dime.  It must feel quite like being a later stage investor coming in behind a massive wall of pre-existing preferences.  (That sounds redundant).  The Journal gives "Batman Begins" as an example.  $150 million in budgeted costs, $372 million in worldwide ticket sales and Kavanaugh's investment entity, "Legendary Pictures LLC," is still in the red by "several million dollars."

The balance of power has shifted significantly against stars.  Part of that might be explained in this DealBook quote here:  "Neither Mr. Cruise nor Ms. Wagner put up any capital, Ms. Wagner said."  The rest might best be understood by reading between the lines here:  "If investors are not interested in financing the films, MGM said it would pay for them all."

What we have here is a Vegetable Capital fishing expedition.  MGM wants to pull in outsider money into the coffers so it can direct its attention to sure things.  Meanwhile, as to the the riskier projects, those that aren't part of an existing franchise, well that's where the Vegetable Capital comes in.  What's interesting is that, while this had become the norm, the only way the deal would fly this time was to throw Cruise and Wagner on the other side of the preferences.  Apparently this segment of Vegetable Capital is getting a bit smarter, even if it is still part of the Platyhelminthes phylum.  Even Cruise won't invest in his own films.  What does that tell you?

Well, MGM's Chairman, Harry E. Sloan has it all figured out.  How do you avoid scaring off investors with a film flop or two?  "We’ll take the model out to investors before the first picture opens."  Still, don't worry, Dr. Mark Klein won't be investing.  According to him:

Besides terrible scripts and relentless anti-male propaganda, contemporary movie soundtracks are very distracting and much too loud. Don’t need much of a sound track with a really good story played by properly directed strong actors. Almost no music in “On the Beach”, “Paths of Glory” and the “Best Years of Our Lives”.

That also goes for store music. One reason I shop mostly online is I hate being bombarded by love songs. For most men nowadays reminders of romantic love doesn’t bring up pleasant memories!

Definitely sounds like projection to me.

Wednesday, November 08, 2006

Filming By The Little Guy

excellent! It is hard to think I didn't personally open the floodgates when, just after I hissed my latest piece on Tom Cruise through clenched teeth, I find this piece on Hollywood financing by young inexperienced upstarts in the New York Observer via a DealBook entry.  The old guard is suitably annoyed and skeptical:

Old-timers are apparently not thrilled with Hollywood’s new money guys. “It used to be,” the aforementioned disgruntled agent said, “that wannabe producers would start off as assistants and then become C.E.’s (creative executives), and read and read and read, and start sitting in development meetings, seeing how movies are put together, how notes are given to writers—learning the tools of the industry.” Now, it’s “all about the formula, the numbers. It’s the conglomeratization of the business, and it’s why movies are getting worse.”

Vanity Premiums (those extra lifts in the price of an asset beyond fair intrinsic value that is related entirely to the ego boost it will give the new owner.  See e.g., Mark Cuban, most professional sports teams, newspapers, purveyors of luxury goods, etc. etc.) being what they are, we should expect to see more of these.  After all, who could resist funding a film when Russell Crowe is slated to play you?

But that's not the real horror-show.  The real horror-show is what too much surplus cash is putting in the drivers seat in Hollywood.  To wit:

Suddenly, Mr. Rizzotti burst through the door, a can of sugar-free Red Bull in one hand. (Normally he downs four to five cans a day; lately he’s been on a “Red Bull diet,” limiting himself to two.)

“Dude, I was just on a fucking amazing conference call!”
How sure are we this isn't an entry from the always wonderfully frightful Leveraged Sell-Out?

Dimensional Complexity

beyond complex Accolades in Private Equity are granted twice.  First, and most mercurial, for the successful close of a deal.  Second, harder won and more critical, for one's reputation and career, the successful sheparding of the highly illiquid assets through 4-7 years of challenges and macro uncertainty to realize the paper returns it better damn well have accumulated.  Appreciate this, and the difficulty involved, and it becomes easier to see why private equity is an intensely long-term endeavor requiring the same qualities it takes to move large icebergs: constant, even, unrelenting pressure.

Knowing these two career drivers one can gaze upon a representation of the political forces in a private equity firm.  I say "representation" for two reasons.  First, those political forces are possessed of such Byzantine quality and harbored by such secrecy that all that is available even to the astute insider is the woefully insufficient three dimensional projection of an intensely intricate four dimensional object.  Some of the lines of the projection are overt.  Others are quite thinly drawn.  Understanding with something remotely approaching clarity is both difficult and a essential element in preserving one's career, particularly when things start to get dicey.

Recognizing that actually closing a deal is only the short-term part of the career advancement equation, one sees that closing a "good deal" is the long-term component, and far more critical.  This is the mechanism with which the whims of private equity partners with respect to the careers of their minions take root.  Specifically, the selection of deals to which a given minion will be assigned.  Find yourself working on a deal that shows the promise of a 1980s Japanese real estate deal?  Start showing your resume around.

I was somewhat slow to recognize the foibles of deal politics in this fashion.  To some degree I was shielded from this glare by Armin, who looks upon me fondly, but my own naiveté often worked against me early on, let us say, shall we, several months ago:

Armin: "You know, I imagine your fancy would be titillated by a project I have come across this week."  (He meant that my "fancy would be tickled").

Equity Private: (Immediately on guard, fearful of being overloaded) "Well, I'm pretty bogged down with Project LameCashFlow at the moment...."

Armin: "Oh, yes, I know.  I think, however, that you might want to consider shifting your priorities, that is if you aren't set on closing the LameCashFlow deal."

Equity Private: (No bells.  No whistles.)  "I would feel bad jumping mid-ship, that's all."

Armin: "Ah, I understand of course."

Several weeks later and our best bid for Project LameCashFlow is soundly trounced by "Truly Massive Fund, LP" a FAR better resourced hedge fund that shouldn't even be in the space given the size of LameCashFlow.  It occurs to me about a week later that only days before my conversation with Armin, we had dinner at the Estate with "Tom," a rather senior type from Truly Massive Fund, LP just before Armin and Tom retired to the study for 3 hours of after dinner drinks.  I thought nothing of it while being driven home, rather tipsy I might add, in the back of the horribly cliché black Town Car.  This sort of thing was typical at the estate.  What was to worry about?

I am convinced, by the way, that the black Town Car has a calming, even a numbing effect on the brains of young finance professionals.  A kind of subliminal channel to the lizard brain whispering the soft words "sleep... relax... forget... ignore..." like some early John Carpenter social commentary film with Roddy Piper in it.  Armin was trying to steer me clear of a flop, I was too dense to listen.

When, some weeks later, I relayed these events to the Debt Bitch she laughed out loud.  "The old man sure wants in your tight little silk panties, doesn't he?"  This is a not-so-casual but good natured dig at the favor Armin shows me, but for Laura sex is always a factor in this game too.  Still, her own career is on track such that it becomes hard to discount this old standby career builder out of hand.  "Hah!  You'll be lucky if he hits on you again like that.  He hates stupid.  Reminds him of his ex-wife.  Hey, tell Minnie (this is her nickname for Armin) I dumped the guy from Goldman.  If I say something it will be too obvious."  She was kidding, of course.  I think.

I vowed to myself to pay closer attention, and started thinking about what signs I had missed up to now.  These worries lingered shyly in the background of my thoughts for a week before, one dark and rainy early morn around 2:00 am, I bolted upright just before drifting off to sleep and nearly barked outloud: "London."

I have been gently pressured to move to the London office of Sub Rosa for some time now.  I've been gently putting it off, making a show of wanting a raise beyond the cost of living adjustment out of the deal, or a uptick in carry perhaps.  The reality is that I have no desire to move and I feel I would be unhappy with any amount of money in London.  Well, ok, not any amount.  I don't mind confessing that the quandary has had me in tears more than once.

Still, we have been losing more and more auctions.  This, in itself, is not overly concerning.  There are fewer deals worthy of bids, and those that are are being pressed by fierce competition.  Hedge funds, once too large and new at the game to play in the middle market LBO domain that is Sub Rosa's hunting grounds, have begun to creep down to our space and thrash our bids.

To some extent I do not mind this.  Those bids we have lost in which I had enough involvement to speak intelligently about I never regretted.  The prices at which those companies traded hands were so absurdly high to make me quip: "Good luck" to the poor sods who were responsible for the debt service.  I have no doubt that the ability of the leveraged finance VP at the lending hedge fund (we haven't borrowed from an actual bank for any of our last three deals) to throw the obligation off to a CLO somewhere before it blows up plays a big part in the absurd deal terms we have been seeing of late.  Moral hazard at work.

Add to this the present boom in private equity and smaller shops like us have to begin to be worried.  Armin's answer to this has been the European office, where the LBO machine is going like gang busters.  The combination of old family-owned businesses, soft labor practices, weak management and plenty of room for cuts and outsourcing has made Europe the new hunting grounds.  I knew intrinsically that the encroachment of hedge funds was going to spoil things for us in the United States eventually, I've written it here in one form or another many times, but it never seemed quite as real as it suddenly became the last several weeks, and London weighed heavily on my mind.  I remembered suddenly that Armin's wife had been to London several times now and the word "schools" has been tossed around repeatedly on the Estate.  How could I be so blind?

Sometimes, two highly tense structural elements, pressing on each other in something like balance, only break with the introduction of yet another element.  I'm sitting in Chicago just recently when it all comes crashing together with this "third element."

We are quickly getting in over our heads on bidding on "Project Dustbowl," a significant piece of a corporate break-up in Chicago, a city I love to visit- before the winter sets in.

We're downtown after an annoyingly long drafting session with one of our lawyers, "Abe" who I first met in New York with the Debt Bitch.

Abe believes there is a black list for New York restaurants such that if you fail to show up for a reservation you will be shunned ever after.  Accordingly, he never makes reservations in his own name.  The Debt Bitch finds this as silly as I do, but she's more vocal about it than I am.  We're in a little café near our corporate target planning dinner.

"Reservations for four.  Ten o'clock.  Mossberger," Abe is on his cell phone.

The Debt Bitch intones loudly, "Why don't you just use H.E. Pennypacker or Art Vandelay?" 

Abe, covering the mic of his cell phone frantically, and who is probably the only Manhattan attorney never to have seen a single episode of Seinfeld in his life hisses back, "Shhhh! What the hell are you talking about?"

"Look, even if there is a blacklist in Manhattan there isn't one in Chicago."  She has a point here.

Abe is quick with a retort.  "You think these people don't talk?  Think of all the overlap in ownership between successful Chicago and New York restaurants.  I need a Red Bull," and with this he wanders off to the counter.

We drift over to the door rolling our collective eyes at Abe before we meet him out front of the café.  When Abe comes out he drops a handful of change on the sidewalk in front of the café.  It jingles loudly and passers-by, suddenly jarred by a Pavlovian response to the sound of fallen money, halt in their tracks and look to the pavement.  Abe, nonplussed, starts walking on his merry way as if nothing happened.  I am about to call out to him, just intaking the breath to do so when the Debt Bitch grabs my arm and starts pulling me away in Abe's direction.

"He doesn't believe in change," she says, rolling her eyes.  This all sounds very familiar.  I start to say something to the effect of "Who the hell 'doesn't believe in change'?" but Abe cuts me off from 5 paces in front of us.

"The six minutes of time I would have to spend to sort it later is worth far more, $35 to be precise, than the sixty eight cents I just threw away."  I notice he picked six minutes to make the math easy for himself.

Some guy standing next to me butts in with a "Nice friends you got there."  I am frozen by the comment, but the Debt Bitch steps gently to the side, fully in New York mode and ready to eviscerate the guy before I recognize that it is "Sean."  Sean is easily the smartest man I know, an old friend, also a private equity type in New York and a JD/MBA.

"Oh my god," I say stupidly.  "What are you doing here?"  He's grinning at me. 

The Debt Bitch is either alarmed or intrigued.  Sometimes I think they are the same thing for her.  "You know this suit?"  I don't point out that she's wearing a suit also.  She means it affectionately, after all, even if it doesn't sound it.

"Oh yes, I know him."  I repeat myself, "What are you doing here?"

"Oh, top secret.  Hush, hush."  His expression tells me it is exactly the same reason we are here.

Abe is itching to get to the hotel, but the Debt Bitch is suddenly not in a very big hurry.

"Who are you with?" demands the Debt Bitch.

"Adjuvant Capital," he smiles back.  This silences the Debt Bitch, which is unusual.  It silences her because they won an auction from us a few months back and Laura later found out they got better financing terms than we did.  "Do you have time to catch up," he asks me.  I am anxious to talk with him.

"Sure.  We're doing dinner at ten, but it is informal."  Abe is now stopped but standing seven paces away and glaring at us impatiently.  I can see that the prospect of adding another person to the reservation is already stressing him out.

"Let's go for a drink then," he suggests.

"Sounds good," this is Laura inviting herself.

"The Four Seasons is not far.  Nice bar there."  Abe shakes his head and starts walking back to the hotel.

And so the Debt Bitch, Sean and I end up at the Four Seasons drinking vodka.  Sean's perspective on the middle-market of LBOs is about the same as ours.  Things are getting tight.  People are getting squeezed.  He wonders if bidders are using the Yen carry trade to finance things, the bids are getting so high.  The Debt Bitch is unusually quiet on this topic.  Sean's solution, move over to The Dark Side.  Sean is job searching at hedge funds.

"If you can't beat them, and I'm having a hard time beating them lately, then join them," he comments.  "Plus, why in the world would I want to be illiquid right now when I can move over to the buy side in public equities."

The entire conversation leaves a sour taste in my mouth.  Are those my options?  London or hedge funds?  What in the world would I do in a hedge fund?  Seems bizarre to work for a LBO group in a hedge fund.  Nothing about the compensation structure is long-term oriented.  None of the advantages one gets from those structures can be used to extract value from the portfolios.  But Sean is convinced the future is elsewhere.  "Get out of LBOs.  Their time is passing."

The night passes pleasantly enough other than that.  Sean heads back to his hotel before we stalk off to dinner.  I can see that the Debt Bitch wants to ask him for his number or something but she can't figure out a classy way to do it.  I've never seen anyone disarm the Debt Bitch before.

My amusement is dimmed by the dark seed that Sean has planted in my head.  "Send me your resume," was his parting line.  "I'll pass it on to some people."

I'm brooding on it on the flight home sitting next to the Debt Bitch who pisses me off thoroughly when she asks, "Hey, how do you know Sean exactly?"  Never mind that I told her three times already.  "Is he single?"

All I can think about is his parting shot.  "Send me your resume."  It is a measure of how mixed up I am that, once back in New York, I do.

Yesterday, after lunch, I called in for my voice mail and my blood ran cold.

"Ms. Private, this is Linda Plotkin at Hedge Row, LP in New York.  I'd like to schedule a thirty minute phone call with you and our manager of recruiting, Sara Grace.  Please give me a call back at your convenience and we can try to find a suitable time."

Oh what, dear reader, am I to do?

Friday, November 10, 2006

Imminent Death of Private Equity Predicted (Again)

only the french flag is better (to laugh at) It seems just last week that I evaluated the many claims that Private Equity was about to go the way of over-the-counter Morphine, but, in fact, it was August 7th.  Writing these sorts of articles is quickly going to require an intern here at Going Private to collect the many link references to the latest anti-private equity financial pundity.  Just occasionally, however, the rare tone-setting snippet emerges.  Today I found it in the Financial Times (regrettably, my new London bent has pressured me finally to subscribe) that, citing Mr. Bonderman, of recent Going Private organized private equity crime pin-up fame quips:

Turning on German politicians who have been highly critical of buy-outs, he said buy-outs had led to just 6,000 job losses in Germany compared with the combined 100,000 workers laid off recently by Volkswagen, Siemens and Deutsche Bank.

“That hasn’t made the papers because they speak better German than we do,” he said.

The only thing that would make it more amusing is the addition of a French joke in there.  Somehow I expect Airbus has grown too full of holes to serve as a useful pin-cushion for this purpose, however.

Monday, November 13, 2006

Polonius, Act II, Scene I

doomed to a dismal fate, but not just yet I had a wonderful exchange over the last two days or so with a loyal reader, let's call him "Angelo" who wondered after my comments about the potential conflicts, mostly timing driven, between private equity firms and hedge funds.  Angelo, himself a hedgie in a larger first-mover activist fund, preferred to call what I termed "follow-on" activists (firms that pile into the disclosed investments of known activists) something a bit less, well, active.  "Activism Arbitrageurs" was the term he preferred, pointing out that these investors rarely do the heavy lifting required of activists who do battle with management, and also pointing out that this genre of investors is defined by, among other things, quantitative models geared to predicting the success of an activist campaign.

They are more pre-occupied with calculating the value/risk of the activist event and determining the odds of a successful activist campaign than the nuts and bolts of makings things happen.

These he distinguished from the crowd that might be late to the party, but actually contribute.  I'll call these "Secondary Activists" from now on.  "Tag teaming" in this way is generally a good thing, from this perspective because practice areas can overlap and improve results.  Wendy's, an activist success to use for example, was set upon by both Ackerman (financial improvement focus) and Peltz (operational guru).

Angelo puzzled, however, over why activists should come across private equity firms with any regularity.

What fund in their right mind would ask a PE fund to participate in an activist campaign?  Also, I have a hard time imagining many scenarios that would warrant an activist agenda on a company that was brought back to market by a PE fund.  If the PE fund is doing its job, it should unlocked most of the "hidden" value in the company.  All the things an activist fund looks for (i.e. high cash balances, M&A activity with questionable rationale, under-exploited asset values, earnings under-performance or the presence of disparate businesses with limited strategic underpinning wrapped within a single entity) should not be an issue after a PE firm is done with it.

Ironically, just as I received this question, another deal junkie, "Paul" at an activist fund, and a loyal reader, forwarded me an old Economist article about the battle over a European industrial giant, wherein a well-known private equity firm was set upon by activist hedge funds arguing the private equity giant was offering minority shareholders too little.

According to Paul, who happened to have sent lawyers to the very shareholder meeting discussed in the article, the private equity firm in question was ambushed from the podium by a well-prepared activist, and the meeting thrown into total chaos as the individual shareholders (who have a reputation as a rowdy bunch in this particular country) were literally rallied on the spot from the stage.  I envision a populist rising in the former Soviet Bloc complete with students holding forth from atop overturned Trabants.  (It is quite easy to overturn Trabants even with a small crowd- read: two students.  I attribute the fall of the former Soviet Bloc partially to the unintended consequences of this obscure oversight).  "It was quite a sight, apparently.  I wish I had gone myself to see it," says our dear reader.  One of the more vocal shareholders was actually ejected by security.  The matter was finally settled to the activist's satisfaction, according to lore, over a Starbucks on Madison avenue.

The "ecology" of these relationships, to quote the deal junkie, is complex.  Private equity firms often make good buyers of assets from activists, who are often eager to capitalize on the quick liquidity private equity firms can provide.  What activist hasn't at some point asked a large corporate to throw off an under performing division or two?  (I know we've bought at least one such divestiture here at Sub Rosa).  When the timing matches up, the two institutions can be the best of friends.


pavement cracks I am not typically inclined to post links to the many the new financial blogs that emerge like weeds from between the pavement cracks.  Be this as it may, "pure arb" might be worth a look if what appears to be something like quality continues in the analysis of alternative investment related S-1s.  We'll see.

Tuesday, November 14, 2006

The Cycle of Stein

ben is in pretty deep Long time readers of Going Private will recall that these pages took issue with Ben Stein's missive in the New York Times calling for buyouts to be criminalized.  I say this because that post was one of Going Private's most popular, behind only the first installment of "Imminent Death of Private Equity Predicted" and "Third Time Could Be the Charm."  This last, I suspect now in hindsight, enjoyed popularity solely because several search engines incorrectly assessed the nature of the entry (and this blog) as a consequence of the appearance of Paris Hilton's name on the same page as the acronym for "Research In Motion."

"Voodoo Economics" also resulted in quite a lot of reader mail.  Some polite.  Some not so polite.  Clearly, management buyouts create strong opinions in either direction.  Interesting then that always yummy Abnormal Returns would pick up again on the MBO trend, just as they originally did for Ben Stein's missive, this time with a bent towards one of my other favorite topics, CEO pay.

Within hours of that Abnormal Returns post I received an email from Daniel Primack, a reader, and author of PE Week Wire, who interviewed Stein recently and pressed him on his position.  According to the email, several of the issues I brought up here were then put to Stein.  You can read the set up and hear the entire interview via .mp3 by visiting Daniel's post on pehub.com, the modern heir to PE Week Wire- worth a visit in its own right.

It truly alarms me how often, and with what timing, things can come full circle.

Thursday, November 16, 2006

The Borat Effect

take our money, please The Financial Times yesterday reports that Borat's runaway success has opened the door for more investment by hedge funds into Hollywood, a theme that has caused rolling eyes here at Going Private just as long as it has been a flash in the pan.

Sayth the FT:

20th Century Fox is set to announce a hedge fund-backed film financing deal worth more than $520m thanks to the box office success of Borat and The Devil Wears Prada.

The agreement, which comes amid increasing hedge fund and private-equity interest in Hollywood, will see Dune Capital Management refinance a slate deal – or agreement to produce several films – it struck with Fox at the end of 2005. An announcement on the new slate could come in the next few days, according to a person familiar with the situation.

I predict disaster.

After reading the FT I found that the "Film Funding Blog" thinks I'm being hard on Cruise and seems to think this financing structure is all old-hat.  But, then again, they don't seem to know the difference between revenue and net income (in my not entirely limited experience a very common problem in Hollywood).  I'm not sure they understand the structure of film production financing, or the nature and purpose of the many preferences that plague such financings.  Clearly, the ramifications of changes in these structures in the Cruise case and way they give Cruise a major pay and status cut are lost on the authors.  This is a pity, since they purport to be experts on the subject.

Suddenly apologist for MI3, the Film Funding Blog quips:

MI3 is widely considered to be a flop, but that seems to be more the characterization of some bitter Hollywood types. MI3 has a worldwide box office gross nearing $400M. While more of these revenues were generated outside of the U.S., that is less a commentary on the film and more a statement of the importance of international distribution.

Budget estimates on the film vary, but range between $150 - $220 million in production, marketing and development costs.  Just to keep things in perspective, The first Mission: Impossible grossed $181M in 1996, ten years ago, to MI3's 133.5 million domestic gross now that it's run is basically over.  Note that the MI3 figures are not adjusted for the 10 years of inflation since the first installment of the franchise.  Note also that MI2 took in $215.4M in 2000.  Any way you cut it, MI3 was a domestic bomb.  The domestic box office didn't even break the movie even, and the studio's cut is subject to other preferences before they see a dime.

As for the international box office, which our favorite film financing blog claims is the gem in the rough for MI3, MI2 has pulled in $330 million to date.  MI3 is stuck at $262 in foreign sales and, again, that's without an inflation adjustment for the 6 years between the two films.  This leaves MI3 82nd on the list of worldwide box office receipts and 187th for the domestic box office.  Not all that stunning.

Once you understand the dynamics of Hollywood finance, specifically the comprehensive and willful blindness to real results and their concentration on obscure revenue numbers without the most basic profit analysis, it is easy to see why those without basic finance skills, or the inability to shade their eyes from the glow of star power, are drawn to invest in the industry.  $400 million in revenue!  Wow!  Who do I make the check out to?

It is also pretty easy to see why Cruise was sent packing, and, reading the apologists, why Hollywood film financing is among the least financially competent fields around.

But the real hint on what's going on here with the new hedge fund money lies in the middle of the FT article.  Right about here (emphasis mine):

Under the refinancing, Dune, formerly controlled by George Soros, the billionaire financier, will invest in at least 15 new films. These will include the fourth installment in the Bruce Willis Die Hard franchise and Fantastic Four: Rise of the Silver Surfer.

Hah!  Suckers.

Polonius v. Hamlet

cold shoulders So oft of late has my interest by the hedge fund private equity conflict been piqued, I have created the Polonius category.  You may recall my previous references to Polonius, that ill-timed and hapless soul eventually felled by Hamlet's blade as an accident of timing.  Of course, in this case I mean activist hedge funds, and not hapless manslaughter victims.  Often, however, Hamlet feels the cold sting of the blade from Polonius, not Laertes.

Paul, my sleeper agent in an activist hedge fund, points us to a dramatic demonstration.

Set the way back machine for the K-Mart bankruptcy, says Paul. 

In short, some pretty myopic pricing spooked the hell out of K-Mart's vendors who tightened or refused to grant the chain credit.  The vendor panic that ensued from the credit crunch spiral effectively sunk the company.

Eddie Lampert flies in to save the day, rescuing the flagging retailer and converting his debt into controlling equity.  Lampert effectively makes a private equity play out of it.

Lampert closes some five to six hundred stores and sells a half-hundred leases on existing real estate before renegotiating a series of contracts with vendors (which included Sesame Street, amusingly).  Things go mostly swimingly, and so Lampert's vehicle, ESL uses K-Mart after it exits bankruptcy to buy Sears.

This is fine, except that Sears happens to own 63% of Sears Canada.  Lampert wants the rest and offers to buy out the minorities at C$17.94.  The problem is that it is trading at upwards of C$32 at the time (though one astute reader points out that with the dividend Sears announced that amounted to a trading price of C$14 per share).  The independent directors at Sears Canada throw a fit, but to no avail.  And here's where things become more or less a matter of opinion:

Sears US harangues them so severely that they resign and are replaced with the finest quality wooden marionettes available in the northern hemisphere.

At this point, it shouldn't surprise anyone that Polonoius, in fact several Polonoiuses, have cows and refuses to tender.  The tender offer fails and Sears US doesn't have the support within the minority to squeeze-out the dissenters.  Then things allegedly get nasty.

Two of the banks advising Sears US are hedging against swap positions held by the dissenters with shares of Sears Canada.  Enough shares, as it turns out, to sway the vote.  A bit of accounting study suggests that a delayed closing will give the banks some tax benefits (not available to the other shareholders) and a timing for tender trade is in the works for the banks and Lampert.

Not so fast.  The minorities discover this ruse and before long the Ontario Securities Commission is delivering a good caning to Lampert who, as a hedge fund guy himself, should have had some sort of sympathy for the plight of the minorities.

This week the vote came in, minorities (and Poloniuses) prevailed. 

The Ontario Securities Commission factual summary is worth a read for anyone interested in the mechanics of the private equity vs. hedge fund conflict.  I think these are my favorite passages:

Pershing approached SunTrust with a view to entering into cash-settled total return swaps approximately equivalent to 5.3 million Sears Canada shares (the “2005 Pershing Swaps”).  The purpose of Pershing entering into the 2005 Pershing Swaps was to minimize its exposure to Canadian withholding taxes by disposing of its Sears Canada shares prior to receiving the dividend while maintaining an economic interest in the performance of Sears Canada shares.

On March 31, 2006, Pershing sold 1,600,000 shares of Sears Canada to SunTrust and entered into another cash-settled total return swap transaction with SunTrust (the “2006 Pershing Swaps”), on substantially the same terms as the 2005 Pershing Swaps.  SunTrust offered Pershing the alternative of cash or physical settlement.  At the time Pershing entered into the swap it elected cash settlement. Pershing did not maintain a legal or beneficial interest in, or the power to exercise control or direction over, the voting rights in respect of the Sears Canada shares that were sold by it at the end of March.

"To swap or not to swap," to bring The Bard into the fold again, is a delicate question.  Swap and avoid withholding taxes and such in a foreign jurisdiction and hope that the custodian keeps your best interests in mind when it comes to voting, or "go naked" and deal with the taxes.  Pershing almost got gelded here on this point and managed to pull the chestnuts out of the fire with a clever inequity argument.  One wonders if Lampert couldn't have prevailed if he had been more circumspect.  But, of course, that may well have run afoul of disclosure rules.

Suffice it to say that the dynamic between Polonius and Hamlet is quite complex.

Wednesday, November 22, 2006

Private Equity Down Under

briefed Stan Correy, of ABC National Radio, Sydney, has put together an interesting, if perhaps mildly alarmist, background brief on private equity for what has become the new happy hunting grounds of buyouts, namely, Australia.  I was fortunate enough to be asked to participate.  The result, which includes, among others, the far more famous than I, Andrew Ross Sorkin of DealBook fame, can be read, or heard, on the ABC Radio site.  I suppose I should point out that I might have picked Nicole Kidman as a voice actress for myself if I had the option.

Monday, November 27, 2006

Compensating Alpha

fewer twenties There are any number of avenues of attack open to critics of hedge funds nowadays.  Among the more recently fashionable is the accusation that hedge funds have fees out of proportion to their risks.  Or, more commonly, an unsophisticated barb that seems to resonate much more sharply with the public even if it avoids the question of risk-adjusted returns, that hedge fund managers simply charge too much.

Clients of hedge funds don't seem to be that annoyed, however.  And given the liquidity in the marketplace and the number of funds to choose from, it is difficult for the rational observer to find fault with the holy grail of hedge funds, "two and twenty," given the rather enthusiastic acquiescence of the many "victims" of hedge funds to the structure.  But, alas, Milton Friedman is dead.  There is no viable moderate political party in the United States clever enough to be socially liberal, or at least socially agnostic, and still possessed of the sense required to be truly fiscally conservative.  The second coming of financial paternalism is upon us, dear reader.

Blame for the ills that befall us now will be laid, I suspect, on the shoulders of the easiest targets.  Mysterious and envy inspiring hedge funds certainly find themselves on the short list.  The only question for me at this point is "how much damage can be done in the next six years and how long will it take to repair it?"

Pretending for a moment that a great outcry for hedge fund fee reform did exist amongst clients, what might such a structure look like?

The Economist points out (subscription required) that non-complaining hedge fund clients are, quite expensively, paying for beta, as well as for alpha.  The Economist, as usual, has a point.  Should managers be compensated so richly for, say, a strong quarter in the equity markets where their actual "outperformance" of the market was slim?  Wonders the Economist:

...hedge-fund returns have been increasingly based on beta in recent years. Hedge-fund managers have every incentive to take this route, since they take a percentage of all profits, however they are derived. But beta can be obtained at very low cost via index-tracking funds. Why pay hedge-fund prices?

The last three months provide as good an example as any in recent memory.

I see via Controlled Greed that The New York Times, for its part, whines at the timing of compensation, (avoid annoying registration with the always yummy bugmenot) and outlines an alternate fee structure, one that seems unduly complicated to me, being adopted by newcomer Lisa Rapuano.  Yammers the Times:

Getting paid annually does not always jibe with some styles of managing money like value investing — the art of buying undervalued companies and waiting for them to be properly valued. If managers show poor returns, impatient investors might yank their money before the market recognizes the stock as undervalued. In investing parlance, that is called being dead before you are right.

Lisa Rapuano, a longtime value investor, grappled with these issues and came up with a compensation structure based on the radical notion of delayed gratification. In January, she will start a value-oriented hedge fund that pays her a hefty incentive fee, but only every three years.

Lane Five Capital Management charges a 1.5 percent management fee and takes 40 percent of any profits that exceed her hurdle rate (the Standard & Poor’s 1,500 index) every three years. If the fund has negative returns, she gets nothing — a fact her husband finds very perplexing, according to Ms. Rapuano’s presentation at the Value Investing Congress in New York last week.

Combine this with the now fashionable concept of "portable alpha," and the separation of alpha and beta and it seems reasonable to suggest that separating the fee structures of alpha and beta returns might also be a useful endeavor.  The structure described above does a similar thing though I wonder after claiming 40% of alpha returns.

On a long, and otherwise drab, flight back from London, I wondered to myself what such a structure would look like and what the impact on existing hedge funds would be like from a compensation perspective.

The simplest measure would seem to be the isolation of alpha returns and the application of the "twenty" of the "two and twenty" only to these gains.  Fees for the remainder, the beta, should logically approximate the fees that might be expected of an index fund.  These returns, after all, were hardly the result of managerial acumen, but rather pure good fortune that the investor might well have enjoyed for next to nothing by dropping their capital into a cheap index fund rather than with an expensive manager who shaved 20% off the top simply for getting up in the morning.

Of course, this begs the question: which index is the best measure of beta in these cases and why?  Our earlier example, seems to have a somewhat exotic opinion (she uses the S&P Super Composite).  Of course, the investor should be careful to watch the benchmark selected.  Selecting an overly broad (and therefore less volatile) benchmark might have the effect of boosting the "alpha" component of returns for a manager by reducing the beta.  Clearly, there has to be some rationale for the index selection.  For example, that the manager will actively pick stocks only from the index components.  (This might explain the selection of the S&P 1500, as smaller stocks are probably a more serious target than the mega-caps).  A quick comparison shows that the Super Composite would have generally, but limitedly, reduced the alpha component of returns in this structure (probably because of the inclusion of so many mid and small cap stocks in the index).

The real answer here is probably "it depends."  The strategy of a given fund, and in particular its degree of focus, will likely (should) drive the selection.

Some more interesting wrinkles rise to the surface if you extend the concept of fees calculated on "outperformance" of whichever broader index we have decided to index against.  What is "outperformance" exactly?  I suspect many would be tempted to define it much less broadly than logic would dictate.

What if, for example, our new hedge fund, Sub Rosa Long-Short, LP charges 2% of assets under management and 20% of returns in excess of the S&P 500 for the same time period?  Let us then assume that for Period 3, the S&P 500 slips 9.00%.  Suppose, further, that Sub Rosa Long-Short, LP shows returns of -4.00%.  Should Sub Rosa Long-Short, LP charge 20% of 5.00%, the amount of capital preserved by the astute investment strategy of Sub Rosa and that which would have been lost had the client invested instead in the index?  Is a milder loss relative to the index "alpha?"  It seems that if one is being a purist about the concept of alpha indexed fees, Sub Rosa Long-Short, LP should be entitled to fees on those missing losses, just as that would be entitled to fees on positive abnormal returns.  This is, after all, one of the key marketing points of hedge funds.  They are, in theory, supposed to protect downside.  Should they not be incentivised to do so?

In the next period, then, if the index held at 0.00% but Sub Rosa Long-Short, LP managed to capture 3.00% in gains, should Sub Rosa charge 20% of this 3.00%?  Many traditional two and twenty fee structures don't start running the meter again until the prior "high water mark" is attained again.  But if we are really compensating for "alpha" then the "double dip" of charging on a loss and charging fees again on the way back up over already covered ground actually makes sense.  The client is, after all, now 8.00% above the rest of the market.  Are avoided losses as good as gains when we are scoring alpha?

How do these sorts of fee structures shake out in practice during strong bull markets?  Let's just see.

Credit Suisse publishes the Tremont Hedge Fund Index which shows the average for year to date hedge fund returns to be 9.55%.  The S&P 500 sits at about 9.04% at the moment.  Fees on the average hedge fund (assuming $1 billion under management which probably isn't really average) would look something like this:

hedge fund compensation: alpha v. beta

Kiss $18 million and any bonuses goodbye.  And for the best performers on the index, emerging markets funds with 13.58% returns year to date?

hedge fund compensation: alpha v. beta 2

67% of their incentive fees go right out the window.  Ouch.

Self Serving

lipos make the street The tasty Abnormal Returns points us today to a piece by Matthew Goldstein over at TheStreet.com on LIPOs.  It is notable both for its numbers and for its use of the term "LIPO" coined here on Going Private.  Goldstein's short-term analysis (he only looks year to date) is a flaw however, in his article.  It would be interesting to me to see if longer-term returns on IPOs are as dismal, particularly in light of other work I've done on the subject, or if they compare favorably to unlevered IPOs.

Tuesday, November 28, 2006

Business "Journalism" at Work

definitely a graduate of the stanford school of journalism Yesterday I pointed readers skeptically to the article on TheStreet.com warning investors off of LIPOs.  I wondered after the long-term performance of these issues, given that TheStreet.com only commented on the year to date returns of these instruments (which have been poor this year).  It does strike me as silly, given the dot-bomb era, to seek to make returns on IPOs with a sub-twelve year time horizon, after all.  That's so... 1998.

Luckily, a faithful reader in the employ of UBS (their bankers tend to be pretty sharp I find) pointed me to a paper titled Performance of Reverse Leverage Buyouts on the long-term returns of what the authors call "reverse LBOs" (RLBOs) or the performance of formerly LBO'd IPOs.  The results are interesting.  Say the authors, Jerry Cao and Josh Lerner:

In this paper, we examine 496 RLBOs between 1980 and 2002. The following conclusions emerge from the analysis:

RLBOs appear to consistently outperform other IPOs and the market as a whole. The positive returns appear to be economically and statistically meaningful.

No evidence of a deterioration of returns appears over time, despite the growth of the buyout market. RLBOs performed strongly in the late 1980s, the mid 1990s (less consistently), and the 2000s.

RLBOs sharply outperform the market in the first, fourth, and fifth year after going public; performance in other years is more ambiguous.

Much of the outperformance seems associated with the larger RLBOs, but this may be driven by the apparently superior returns of RLBOs by groups with more capital under management at the time of the offering.

There is no evidence that more leveraged RLBOs perform more poorly than their peers.

Perhaps more interesting are the debt figures for these transactions.  The authors identified the average post IPO total debt/capitalization of RLBOs for their study as 47.87 versus 27.84 for non-RLBO IPOs.  In other words, despite having (or perhaps as a result of having) nearly twice the debt load, these transactions outperformed IPOs over the long term between 1980 and 2002.

Beware, however, what the IPO proceeds are earmarked for.  IPOs with proceeds that are not used for debt service but rather "other purposes" exhibited dismal returns.

The paper is a must read for anyone interested in the topic, except apparently, TheStreet.com.

Wednesday, November 29, 2006


you dare to question two and twenty? Proving once again that the quickest way to make mortal enemies in the hedge fund or private equity world is to question the sacred two and twenty cow, I received dozens of emails commenting on my view yesterday, one that is, I might add, shared by The Economist, that hedge fund clients might be "paying alpha prices for beta returns."  You would have thought I had been at a "ban the bomb" rally in the 50s for all the popularity of my position.  I'm still waiting for the subpoena from the House Committee on Un-American Activities and I think the FBI has been following me ever since yesterday afternoon.

I suppose I should also make the observation that most of the emails came from hosts with the word "Capital" "Advisors" or  "& Co." in them.  I leave interpretations of these facts with respect to the demographic of the email senders to the reader's gentle predispositions.  In deference to those gentle predispositions I will also refrain from quoting the profanity in two of the emails.

Nearly 66% of the responses indicated that hedge fund compensation at two and twenty is justified just as it is because hedge funds are performing a service by developing portfolios uncorrelated to the market.  This, many voices argued, justifies the two and twenty structure.  Others commented that hedge funds provide "absolute performance" rather than relative performance.  This, they insisted, justifies two and twenty.

Said one reader/writer:

..suppose I promise my investors that I will deliver 14-15% returns, net fees, every year without reference to the market at all.  This causes them to invest.  Since I'm an investing genius, I deliver on my promise.

Reader #2 could well be finishing Reader #1's sentences with:

Why on earth would I want to tie my compensation to what the S&P does in a given year--a variable that I have no control over, and that has nothing to do with either my value proposition to my investors or the success or failure of my investments?

Reader #3 chimes in as if this were a AA meeting:

A hedge fund is suppose to construct its portfolio to eliminate/minimize market impact (beta) hence "looking for Alpha" so its theoretical benchmark should be zero, rather than any sector/market index.

This uniformity strikes me, frankly, as well conditioned responses from Kool-Aid drinkers in the industry.

"Why on earth would I want to tie my compensation to what the S&P does in a given year?"  Oh, I am sure a hedge fund manager wouldn't, but I am equally sure that the hedge fund manager would love to just be handed $100,000,000 at the end of the year, regardless of performance.

What is at issue here is a disconnect, I believe, in the value proposition.  Hedge fund clients are not, I suppose, particularly impressed with the quantitative elegance of a manager's portfolio.  For the most part, and aside from wanting to preserve diversity, they are interested in returns.  They are, after all, in business to make money, not to fund creative correlation discovery projects that under perform the market.  We are dealing with pension funds, not with theorists that derive utility from investing in some sort of aesthetic beauty in portfolio design.

If we agree that investors are in it for returns, and we also agree that cheap returns can be had for pennies via index funds during bull markets, then what justifies charging hundreds for the same returns in that environment?

"Clients aren't paying for returns, they are paying for uncorrelated returns," quipped one reader.  "They are paying for the downside protection."  Well, if that's so then why would they willingly chip in fees during a bull market when that downside protection is purely theoretical, and might not exist at all?  Is it an option on downside protection?  If so, it is an awfully expensive one when it also charges for the market portion of upside.  And then, there's the problem of enforcement.  How do you know if you are paying for alpha when your investment returns 11% on the market's 10%?  The answer is you do not.  Accordingly, it seems silly to permit compensation schemes to ignore the potential gap here.

And what of this reader: "..suppose I promise my investors that I will deliver 14-15% returns, net fees, every year without reference to the market at all."  I think that the manager that makes this promise will be leveraged 8:1 long on natural gas bets.  So much for downside protection.  Personally, I think The Big Picture covered this issue quite effectively back when it reared its ugly head last.

If we are serious about paying for uncorrelated returns, then our fee structure should be based on demonstrably uncorrelated returns. I'm open to suggestions but the only real obvious answer to me on this is the one I've already presented.  Index linking.  This is, clearly, presently unpopular, but I suspect that clients will wise up quickly.  Then again, maybe not.  Two and twenty has a lot of intertia.  It might take a sharp downturn that results in some unexpected losses (and some revealed beta) to shake things out.  Even then, who knows?

(Photo: The House Committee on Un-American Activities prepares to apply the thumbscrews).

The Running of the MBAs

put your hands up for detroit... er cambridge Each year thousands of MBAs searching for positions in venture capital or private equity nearly go without large salaries, bonuses and positions with responsibilities far beyond their experience level.  Worse still, many of them, in their despair, enter the field of management consulting.  Hi.  I'm Equity Private, author of the hit financial blog "Going Private, The Sardonic Memoirs of a Private Equity Professional."  Together, with your generosity, we can reduce the horror of management consultants by placing an MBA in the world of venture capital or private equity and preventing the spread of the BCG Box of Four.  You can help strike a blow against the growing and terrifying epidemic of McKinsey alumni.  For the small gift of just $175,000 per year and a reasonable carry, you can save an MBA from the horror of Booz Allen.  That's less than $480.00 per day.

PEHub's 4th annual recruiting drive seeks to place first year MBAs with venture capital or private equity positions and prevent their interns from enduring and inflicting on others the horror of strategic management consulting.  Won't you please give?  Operators are standing by.

Thursday, November 30, 2006

Private Equity, Private Lies

the real friedman? With Milton Friedman dead what else would we expect to but encounter all manner of schemes now afoot to defuse the market.  The scene suggests the death of a long-hated and aged dictator after a long illness or quick coup, given the number of parties vying for thought leadership and the demagogy involved.  I suppose that would equate the subject of the latest round, management buyouts, to Italian fascism.  Andrew Ross Sorkin seems to have jumped onto the bandwagon Ben Stein has been piloting in this capacity.  Michael Kinsley of Slate.com seems to have been relegated to the position of navigator, though given the position he recently penned for Slate on capitalism he should perhaps be sitting way out on the left wing.  Sorkin outlined his own four point plan to make management buyouts "fair" again.  I am reminded of the communists emerging once again, dusty faced, but bright eyed, from the ruins of Stalingrad, emboldened by the receding shadows of vanquished fascism.  You will see, I think, that the communists have always proved much better propagandists than the fascists.  Their lies are far more enticing as they are wrapped in the cloak of populism and contrasted to fascism's intrinsic elitist strain.  The reality is that communism is centered around its own elitism, it is just far more adroitly camouflaged.  Either way you go, you can smell the sickly sweet stench of lies.

Loyal Going Private readers will already be aware of my feelings about the word "fair," but for the uninitiated, it seems pretty clear to me that whenever someone calls for change to make things "fair," what they usually mean is that they plan to take someone else's hard work and hand it out to someone who hasn't gotten their hands dirty yet- in the interest of "fairness," you understand.

Sorkin begins:

Management led buyouts, by their very nature, are meant to benefit management and their private equity backers,” Stephen Lowey, a lawyer who often represents institutional investors, said to me last week.

No?  You mean they aren't meant to benefit starving African children?  Who knew?  Hard not to point out that Sorkin's foot dips into the water this way- with the assumption that these transactions are presumptively zero-sum games- and that this is somewhat concerning.  Just wait, dear readers.  Just wait.

The trip continues:

He contended that public investors almost always get cheated, and it’s not hard to see what he’s talking about. Every day, it seems, some stock that has been battered is being picked off by its own management and private equity firms at a paltry premium.

Watch carefully, this is the magic that is at the root of all these anti-MBO arguments, be they Steinisms or Sorkinettes.  Did you catch it?  It was a pretty quick slight of hand there, but it only took twenty words or so to point to an asset that is being traded in one of the most liquid and efficient markets on the planet and claim that it has been mispriced.  And this, dear readers, is the conceit at the heart of these arguments.  That we have to protect the market from itself.  That the very shareholders who have bid the company down need to be protected from the pricing action they, themselves created, by preventing interested parties from buying the asset at the quoted price.  You see, it's really worth more.  Damn the market, full speed ahead!

And even that isn't the whole story, as apparently these same shareholders deserve a premium.  Not just a "paltry premium," mind you, but a substantial premium.  Let's ignore for a moment that this would have the effect of rewarding the kind of short-term speculation that hangs on every fraction of a penny in earnings for this quarter to determine if the stock should be battered or not.

What we have quickly said here, is that because someone might, possibly, benefit in future, albeit at greater risk, and despite the fact that the shareholders as a whole don't see the value (if they did why is the stock price so depressed) we cannot possibly allow third parties to pay above market price for a company, undertake a risky (to themselves) plan to improve value and put their own reputation and capital on the line to do it.  In the interests of fairness, they need to share those "windfalls."  Please.  Where is Muffie Benson-Perella when you need her?

I cannot imagine we would feel the same way if a farmer, who had leased land from a landowner for years, paying via a portion of his crops, suddenly offered to buy it with a loan from the bank, and thereafter, following a systematic improvement of the soil, doubled his profits.  Even if he found oil one day we'd cheer him on and produce a half-hour comedy about his new life in Beverley Hills Greenwich.

In the United States we generally do not tax contingent, unrealized gains.  Why do shareholder's think they are entitled to them?

But, cry the masses, shareholders have no say in the company.  They cannot easily change management or challenge/force the deal effectively because (proxy contests are expensive/boards are staggered/there are poison pill arrangements in place).  Such masses often forget the purpose of the separation of ownership and control, of capital and competence- to permit management specialization generally unmolested by the old widow who wants to paint the plant pink.

It is also easily forgotten that shareholders knew or should have known full well how much power they had or didn't have when they bought the shares.  It is not as if such matters are opaque.  Arguing for more control (absent paying a premium for it) after purchasing shares you knew lacked such control strikes me as awfully disingenuous.  Not that that surprises anyone.

"Aren't managers who mount MBOs guilty of a conflict of interest?" wonders one commentator.  Here, I cannot help but be amused.  Despite what you might hear on CNN, one is not "guilty of a conflict of interest."  A conflict of interest is not, of itself, a crime.  Think on this long and hard.  It is easy to get another impression in this day and age.  A conflict of interest simply exists, or does not exist.  The solution to one that exists is simple.  Disclosure, additional scrutiny.  I don't think anyone observing an MBO will fail to recognize the various roles of the parties involved.  The danger of hidden self-dealing is actually quite low in a public transaction.  And, frankly given the transparency of the process, if outright fraud, (say, non disclosure of good news or dumbing down of the numbers pending the MBO) occurs you can well bet that the plaintiff's bar will be on it like white on rice, that is unless you want to take the somewhat dense position that there aren't enough shareholder lawsuits in the United States.

Really worried about some manager making too much in an MBO that you don't have the power to prevent?  Don't buy the stock in the first place.  Stick to firms with corporate governance policies that make MBOs nearly impossible, or slates of directors unlikely to approve such measures.  One public company director I know responds to MBO proposals by asking the manager to quit first, and then mount the bid if she wants the board's support.  Are all directors so tough?  Probably not.  If that's important to you as a shareholder, find out and vote with your wallet.

Let's take Sorkin's suggestions one by one:

Let minority shareholders decide, too.  While it’s understood that a controlling shareholder has the right to steer the company, that investor shouldn’t be able to do so at the expense of minority shareholders. You should be irate to hear Isadore Sharp, the chief executive and controlling shareholder of Four Seasons Hotels, tell shareholders that his offer for the company “is the only one I am prepared to pursue.” The Dolans of Cablevision pulled the same stunt.

That’s fine, but transactions like this should then require a majority of the minority shareholders to approve the deal. It’s not enough to have an independent committee of board members and an investment bank’s fairness opinion bless a deal that is clearly below market value simply because the controlling shareholder won’t allow a true market for the company.

Why should you, or anyone else be irate?  It was the daft shareholder that did not make herself aware of the corporate governance nuances of the company she just bought a piece of.  I have no sympathy for shareholders who willingly buy into Class B shares when there is a Class A with supermajority voting rights and then complain that they are being "oppressed" and file a minority shareholder oppression lawsuit as if we were dealing with a closely held firm.  These shareholders neither paid for control nor should they have it after having acquired the shares at a discount to what control bearing shares would have called for.  Again, they knew full well the nature of the transaction they were entering into.  Changing the rules now, particularly with regulation, is folly.

The reality is that if corporate governance is actually worth something to shareholders they will bid up or down based on their ability to oust management or block a transaction.  This is what gives rise to things like the "Dolan Factor," at Cablevision.  Even the New York Post is in touch with this effect.  When you recognize this you see that these shareholders want a free lunch.  Non-control prices for controlling shares.  Poor shareholders.  Even assuming our shareholders were a sympathetic bunch, why should this sort of thing be regulated, rather than left to each firm to decide via its public by-laws so that the market can price control accordingly?

Sorkin continues:

Use truly independent advisors. The investment bankers that run these auctions have a huge hand in shaping their outcome. Since management is part of the buying group, it already feels like an inside job. When an adviser has a longtime relationship with the family or company, it feels even more that way.

Again, one is not "guilty" of a conflict of interest.  And absent some actual showing of wrongdoing, which would, once again, garner the wrath of the plaintiff's bar, I am not particularly sympathetic.  This is, however, the more compelling of Sorkin's issues (for whatever that's worth).

More from Sorkin:

Give public shareholders a stake.  One reason shareholders are so suspicious of take-private deals is that they see private equity firms quickly flipping companies they just bought onto the public market and making a multiple of their original investment. Here’s a solution: Offer shareholders as much as a 10 percent stake in the deal. That way, shareholders who see long-term value — and are willing to have illiquid shares — can go along for the ride and won’t feel ripped off if the deal turns out to be a grand slam.

How to structure this would be a little tricky, however. It should be available only to shareholders who held the company before it announced its sale, so that you don’t have arbitrageurs and other fast money jumping into the fray.

A little tricky?  I'll say.  Now we are classifying shareholders based on their corporate structure and proposing regulations that say who can purchase public shares when.  Enforcement of this clause would require the SEC to develop a set of "shareholder thought police" to divine the intent of shareholders before permitting them to buy.  We can't let those evil fast-money shareholders get involved.  Instead, we have to give, not sell mind you, but give, shares away to existing shareholders because... well because they are existing shareholders.  Are they going to share in the risk going forward?  Not really.  The premium they were paid on their existing shares means that they were effectively paid to take 10% of their prior holdings.  That's about as backwards a plan as I have seen.  It is also pretty obvious that Sorkin doesn't understand the important role arbitrageurs play in markets.  That's not really surprising though, is it?

What is surprising, a little surprising anyhow, is the hypocrisy of Sorkin here.  Of course, this part of his plan screws shareholders by artificially depressing the price.  Hopefully, these shareholders will be able to sue Sorkin for the difference.  Wasn't it the same Sorkin that was moaning over supermajority holders who prevent a "real market for shares" just a few paragraphs back?  Looks to me like Sorkin has just become what he despises- one of those fascists who doesn't permit a "real market" for public shares.

What about regulation?  Does Sorkin propose that these shareholders who keep a stake will also be entitled to public disclosure of financials?  Will the company still have to file with the SEC?  Comply with SarOx?  How exactly will shareholders be convinced to forgo their rights to SEC regulation and disclosure in the shares?  If so, will the shareholders have to be "qualified persons" as if it were a private placement?  If not, what assurance does the SEC have that they are sophisticated enough to hold what amounts to private placement shares?  The SEC would never permit such an offering in other contexts, why are shareholders now suddenly smart enough to take advantage of a QP-type deal without being QPs?  What company would ever embark on a buyout in that circumstance in any event?  Few, if any.  It has the effect of locking effectively all companies into the public equity markets and the burdensome disclosure regimes for eternity or breaking safe-harbor laws.  Sorry, I just don't see it. 

Next genius idea:

Show us the business plan.  ...shareholders should have a chance to see the company’s future business plan so they can judge for themselves whether the same strategy could be accomplished if the company remained public. Companies shouldn’t have to give away all their secrets, but they should make available the same business plan that they provide to the banks and debt holders that are financing the transaction.

Shareholders should either take their premium and go on to other things or protest the deal.  Car dealers do not ask for a statement of use for a car before selling it to someone in order to determine the price.  Why are shareholders different exactly?

The reality is that the public equity markets are just not the place for many companies.  The public markets and public shareholders have failed, perhaps because they have become intensely short-term in the last 40 years, any number of companies that could prosper if they were free to manage their balance sheet aggressively (but not too aggressively), adopt long-term strategies that might well result in break-even returns for several years before bearing fruit.  The kinds of strategies that the public markets simply have no patience for.  Why should we look askance at the move to more efficient allocation of capital?  Because it is not "fair?"  And who's "fair" is it?

Sorkin's approach has the common thread I see quite a bit with the neo-marxists who struggle to redistribute "windfalls" to other segments of society who cannot be bothered to think long term or otherwise create wealth.  It is the thermodynamic theory of collectivism:

First, make sure they cannot win.  (e.g., a windfall profits tax).
Second, make sure they cannot break even. (minority shareholder oppression suits, compulsory disclosure of post-transaction plans).
Third, make sure they cannot get out of the game (compulsory public equity markets participation).

This is the sure sign of a scheme that is failing, its death rattle gurgling.  I am reminded of the music industry, desperately trying to legislate themselves into insulation, any sort of insulation, from any sort of progress that forces them to rethink their ancient and now flawed business model.

Those seeking to improve "fairness" (ahem, Dr. Mark Klein) would do well instead to concentrate on understanding the concept of risk adjusted returns and get out of the way.  I'm not holding my breath.

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