Always yummy Abnormal Returns calls our attention to a reaction from Michael Lewis, of all people, which throws enough heat off of his Bloomberg piece yesterday to fuse income inequality (lately a fashionable armchair socialism yarn for would be populists) with private equity returns and create a dense and opaque argument decrying what I can only brand "return inequality," a structural plague Lewis sees afflicting the market.
Why, wonders Lewis, isn't the "proletariat of Wall Street," the middle class, the "proles" permitted to participate in the private equity boom? (Amusing to call those with wherewithal enough to invest in stock at all "the proletariat," given that even Marx's definition of bourgeoisie is those who earn their income off of ownership or trade in capital assets). Lewis tell-tales his answer early on in his piece:
The job of the private-equity investor is -- again, speaking loosely -- to exploit the idiocy of the ordinary investor, and the corporate executives and mutual-fund managers who purport to serve him.
Ignoring, for a moment, that the job of every participant in the market is to "exploit the idiocy" of anyone else in the market dumb enough to display that idiocy in a public forum like the market, Lewis attempts to use Hertz to make the implicit case that an open auction on the most liquid market on the planet somehow perpetuated a massive fraud on the investing public and badly cheated the "ordinary investor," who willingly (even if not enthusiastically) scooped up the debt laden Hertz in one of the most successful LIPOs (from an IRR perspective) on record. Comments Lewis on the topic:
But it's hard to see how Hertz is a riskier investment simply because it is owned by the Carlyle Group and not by Ford.
I can't speak to the risk effectively, but Lewis, in my view, over-hypes the importance here of "risk" and under-appreciates the "conglomerate discount" imposed on Hertz by Ford, a corporate owner that doesn't exactly represent the shining platinum standard of management acumen in the United States. All it takes is a quick look to understand why private equity made out well here and, to summarize, that case includes "right place," "right time," "right checkbook balance."
A bit of history, though it has been badly neglected by Mr. Lewis, is probably useful. Amazingly, Steven Pearlstein over at the Washington Post recently gave a much stronger summary of the Hertz case then anything I've seen in Bloomberg, marking the first time, in a dramatic role reversal, that the Post has slipped to the right of Bloomberg on matters financial. (Then again, Bloomberg has of late been slipping badly).
Hertz found Ford as a major holder in 1987 back before Ford was rumored to be something other than a total charity case. (I cannot confirm this rumor as I am too young to remember a time when Ford was something other than a total charity case). Ford took the company over entirely by 1994, mostly under the thinking that if they didn't Chrysler or GM would. (GM had, itself, owned Hertz once). Not the best reason, perhaps, but it could have been a strong showing, handled properly. It was not. Partly because of the purpose that had been slated for rental car companies in the United States at this point in history.
Ford, as most of the big three had for decades, treated Hertz as a captive revenue machine (by selling, albeit for not much revenue, cars that couldn't compete in the consumer markets straight to Hertz). Because of the nuances of "total fleet fuel efficiency laws," this also helped Ford meet fuel standards, dumping fuel efficient but undesirable sedans into Hertz while still selling guzzlers to the lucrative consumer truck and SUV market. Decades of selling second-rate Tauruses to a captive customer who didn't much care what they looked or drove like didn't exactly prepare Ford to offer a decent car to the mainstream consumer market if something ugly were to happen to consumer tastes or (god forbid) gas prices.
While they couldn't sell well in the consumer markets, as former rental cars the sedans poured by the thousands into the used car market which meant those models had no resale value (a key metric for increasingly value oriented car buyers) compared to e.g., the Toyotas of the world. Once on the used car market they also canibalized the higher margin new cars the big three were trying to hock.
Two and a half years after slurping it up, Ford IPOd a Hertz minority interest off and bought that interest right back (urgently and without much reason) three years after that.
The initial IPO valued Hertz at nearly 17 times earnings. Read that last sentence again. Go ahead. Absorb it. Here. I'll give you a bit of white space.
That was the time of "irrational exuberance." Travel businesses were on fire at the time. All those New York investors going to board meetings for their VC interests on the Left Coast, I suppose. The stock, which IPO'd at $24.00, hit $64.00 inside of 4 years. Ford used a good bit of the proceeds to buy back Ford shares and attempt to buoy their flagging stock, it worked a bit, but not forever. The party didn't last and not four years later Hertz was back to $24 and Ford wanted it back Why, no one seems to know. They got it by paying something like a 46% premium over the stock price before the Ford offer. Read that sentence again too.
Moving forward, Hertz saw a 130% increase in net income from 2003-2004 (never mind that these figures were gains against the devastating travel years of 2002 and 2003, they looked sexy in offering documents) and coming off that Ford would be hard pressed not to want to divest the unit again (especially considering its own developing management issues and lackluster performance- due, not unsubstantially, to decades of short-term thinking in the form of piss-poor negotiations over what were eventually to become crushing pension and retirement benefits surrendered year after year to the UAW).
On top of this, Ford, along with the other big three, had no incentive to develop decent, fuel efficient automobiles. Why bother? No one cares much if a rental car is a keeper, or if it is particularly fuel efficient. As long as it is just efficient enough to keep the fleet efficiency rating under the federal requirement by two tenths of a MPG or so.
Desperate for cash, and fending off the bond ratings folk, Ford started the IPO process for Hertz again in 2005, hoping, in typical front-running fashion, that the filing would flush out deep pocketed strategic buyers. None appeared. The other big three were up to their eyeballs as well. Private equity came to "the rescue," but even from this sector there was limited interest. Only two clubs bid. The Clayton gang and a group including Bain, Blackstone, Texas Pacific Group and Thomas H. Lee.
Ford sold to Clayton's private equity gang for a net of $5.6 billion. 5.1 or so times earnings. Read that last sentence again.
Ford could have held onto Hertz and collateralized the automobiles for cheap debt, but instead they sold outright. The private equity guys and gals, seeing the demand for collateralized debt, collateralized, in turn using those assets to pick up $6 billion in very cheap debt to partially fund the transaction. Not bad.
Holding out the disparity between the latest IPO price and Ford's selling price as some evidence of injustice ignores the role of the cash crunch Ford was in (owing to their own mismanagement and cannibalistic short-sightedness) and the outstanding timing of the private equity folks, picking up an asset from a motivated seller on the cheap just when the seller needed it gone the most, few questions asked.
There is no better example, in my view, of the absurdity of large conglomerate ownership in recent memory than the fire sales we see- the last vocalizations, as they were, the death rattles of the big three. Their idiotic forays into the likes of consumer finance (GMAC) are coming to roost. I, unlike Lewis, am entirely unsympathetic to their plight.
So much for the evil of private equity. Ford's other option was a cheap IPO or to liquidate Hertz. Private equity just happened to be the best cash available for the asset given the market's assessment of it. I'm not crying for the market. Nor should you.
There seems, of late, to be a revival of a kind of social justice theory based not on risk return, or the value of liquidity, smarts and timing, but the "inequality" some see as implicit whenever a clever group creates and captures value. Green with envy, these fairness vigilantes target anyone who is written a large enough check, forgetting, time after time, that these transactions are as between willing buyers and sellers in a highly liquid and transparent market. Ford shareholders barely made a whimper when Ford announced the sale. Desperate, perhaps, to cash out right after the deal closed to save themselves from their own poor judgment in buying shares of Ford in the first place.
Lewis continues to lament the plight of the casual investor:
One day the private-equity markets may expand to the point where even proles are offered a little piece of the action. That will be the day the action is no longer worth having. Trust me. The ordinary investor is now and forever cast in the role of the peasant at the king's banquet. He's so happy to have any food at all that he fails to notice that bone between his teeth isn't the meal. It's the scraps.
Mr. Lewis should direct his ire towards the SEC, suggesting, perhaps, a repeal of the "accredited investor" requirement for participation in private placements. Maybe we should let anyone who can scrape up $9.95 put it all in LBO funds. And if they lose it there? Lewis, in my view, must decide which evil he is prepared to endure. Personally, I don't believe his course wise for two reasons.
First, the general public already participates in the private equity boom through the many institutions and pension funds that invest heavily in private equity, but, one hopes, with mostly prudent diversity. CalPERS certainly has enjoyed it, and so, therefore, have the "poor" California public employees. Unless, therefore, Lewis wants to suggest that the hopelessly poor household with joint income in the $300,000 range should be dumping all its retirement savings into Texas Pacific Group VII, L.P., he might have to admit that a good 401k or state pension plan is a better option. Looking to improve the return of the "everyman" through that kind of concentration in LBOs seems absurd to me. Moreover, I suspect a more measured investment by professionals who, smart or not, spend all their time investing rather than those who treat it as a pastime with financial benefits is the better option.
Second, let us not forget that the public is bathing in the bath they have themselves drawn. Ford, trying desperately to satisfy a quarterly-report driven public market culture, and a misguided (but very trendy) focus on "all the stakeholders" rather than the owners of the company, increasingly resorted to complex revenue structuring, internal product dumping, short-sighted developmental programs, ruinous pension concessions and market cannibalizing tactics to give the public shareholders and pressure groups what they wanted: quarterlies, now. Running factories, now. Jobs, now. Damn the costs tomorrow.
Moreover, there was far more than the tacit acquiescence of the public shareholders at work here. This evil was quite active and persistent in its menace. No manager who proposed a hard line with the UAW at the expense of a brief plant shut-down or four quarters of strong R&D expenditures would have lasted for more than a shareholder meeting cycle or two at Ford, or indeed any major public firm. Ford's stockholders got their returns when they wanted them. Back then. To what extent did they enjoy them because the basic illness of the company was masked by these schemes? Well, that's for you to decide. One thing is sure: today the piper is collecting. Damn that piper. He's a right nasty bourgeois pig, he is.
(Art Credit: "Liberty Leading the People" Eugène Delacroix, 1830)
