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Friday, June 01, 2007

Debt Attitude Arbitrage

losers Any number of interest groups have decried private equity with any number of motivations and for any number of reasons.  I read with interest, therefore, a rather interesting, if short, piece in the Economist on the topic of the losers in the private equity and hedge fund binge.  This particular passage is particularly insightful:

Private-equity funds profit by arbitraging between private and public markets, exploiting their different attitudes towards debt for example. In 1989, Michael Jensen of the Harvard Business School argued that the owners and managers of quoted companies were doomed to squabble over cashflow. “The pressure on management to waste cash flow through organisational slack or investment in unsound projects is often irresistible.”

By gearing up companies, private-equity groups withdraw managers' freedom to decide what to do with cashflow. In theory, this maximises the value of the firm. The losers are the shareholders of public companies who miss out on these gains by selling too early. Shareholders are suspicious of too much debt on the balance sheet, perhaps because heavily geared firms have more volatile profits.

Indeed.  But it seems pretty hard to be sympathetic to these "losers," much less propose protecting them from themselves in some paternalistic regulatory fashion.  The wonderful thing about the free market is that it permits the dense to pay for their mistakes.  This tends to weed out the dense, a goal, in my opinion, that is highly desirable.

Tuesday, June 05, 2007

Imminent Death of Private Equity Predicted II

behold the destroyer More than a year ago I wondered after the ego inflating effect the private equity world was having on me.  I noted the increasing propensity to regard with a calculated disdain the business practices of Sub Rosa's daughter firms, and mused that the increasing dissatisfaction with life in general might not be a consequence of the newly found quest to deliver crushing blows to mediocrity everywhere.  Back then I said:

Really, I think this kind of bitching is just a response to the pressures of the job.  It is a lot of really hard work.  Small things, like dry-cleaning- which drives me batty- get under your skin.  Near perfection is your metric for everything.  You are hyper-sensitive to any, even slight, waste of time.  (That's just a consequence of living in New York City).

You start to use phrases like "We can put a man on the fucking moon but no one in your marketing department can do a price elasticity regression?" with the portfolio companies.  You respond to the growing loathing the employees have for you with "I am here to get this business back on track, not to win a popularity contest."  Of course, these things are true.  You aren't in a popularity contest.  (Or you are losing it very badly).  We can put a man on the moon.  No one in the marketing department can do any kind of regression at all.  The new associate who just joined is lazy and can't be counted on to put the firm first and, goddamnit, there is just no place to get my best suit dry-cleaned.

A few months later, I bemoaned the many dunkels who seemed convinced that the "private equity bubble" was on the verge of a large and wet "pop."

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.

I still feel the same way, but a new element, a new dynamic has come to my attention that complicates the analysis.  That element is concentrated in and personified with absolutely painful clarity by Natasha Mitra, first brought to my attention by last month's DealBreaker "write offs" pointer to the profile of young Natasha, an Associate at Carlyle, in New York Magazine's "Look Book" feature.

But before discussing Natasha's revival (and significant personal advancement) of the "culture of excess," I want to pass on a bit of Sub Rosa daughter firm lore.

Project Deadline, once just a twinkle in Armin's eye, is now a Sub Rosa daughter firm.  I worked extensively on the acquisition and the subsequent (and ongoing) transformation of the firm.

An essential department of the firm that rhymes with (and resembles) "hugest quarter horses" was populated almost exclusively by women.  (One young man of decidedly ambiguous sexual preference also haunted the group).  Five women in the department had been with the firm for five years, had started the same month and lorded over the department (and the firm) with a reign of terror that, owing to the critical nature of the work, penetrated every orifice of Deadline, Inc. with dozens of fear-slime covered tentacles.  The sole young man endured the machinations of the department with good humor (having a highly compatible catlike disposition- and I refer here not to his dexterity but rather the frequency and venom of his easily prompted, cutting remarks about co-workers).

New to the department was a younger (and considerably thinner) woman who I will call "Jill."  Jill was overeducated for the position, holding a master's degree on top of everything else, but approached the job with, if not good humor, a strong "work hard, finish early, start something new" attitude.  She was unlikely to endure any distraction, she kept focused and, consequently, was intolerant of any laziness.  She was "goal oriented" in the true sense of the word and always had good insights into the flaws within the department as well as their best cures.  These delightfully refreshing attributes made her the most productive, effective and beneficial member of the team and, of course, also doomed her to total and utter ostracization and consequent career failure in the firm.  But I am getting ahead of myself.

The department, like most of the firm, had long since fallen into a lax and complacent set of business practices driven primarily by avarice and apathy.  The chief goal of most of the group was to avoid taking any shade of responsibility, ownership or initiative (all of which were punished quickly, brutally and reliably with more and more responsibility, career advancement and managerial opportunity- horrific consequences for a group that strove to coast as long as possible without so much as a toe on the gas pedal, as if carbohydrate-petrol was at $5.50 a gallon).

When I first met her, it became totally clear to me that she was exactly what the department needed to get itself in shape, its current state being at least partially responsible for the low price (and therefore the motivation to buy the firm) we paid in the acquisition.  This, of course, is the point of private equity.  Or at least, I think it is.  We are supposed to shake up daft and purge dead weight (or excessively heavy live weight) departments, cull them of drag and the elements that create drag and profit through a combination of our operational improvements and the leverage we have applied.  We are supposed to do this quietly, efficiently and without regard for politics and the like.  Our job is to get the company running, not to be popular.  Popular, in fact, is the mortal enemy of efficiency.

Before I even met Jill, the denizens of the Department of Dead Weight had already aligned against her.  They had, quite rightly, identified her as someone who would increase the burden of their daily recreation work routine and, upon revealing the "hidden" potential of the group in productivity, and thereby exposing the current and totally artificial lack thereof, condemn them to a life of fear of dismissal and/or the far worse fate of doing hard work on occasion.  Already, they had begun to marginalize her and proceeded to administer the "death of a thousand paper cuts," secretly assigning her "below average" ratings in their secret performance reviews of her, the most tragically comic of which I discovered a month or two after the acquisition and that indicated that Jill "lacked initiative and reduced the efficiency of the department overall."  I almost laughed out loud, and likely would have, had the situation not been so sad.

Because Jill's performance reviews were done both by her peers and her superiors, all of whom where now conspiring against her, the picture on paper was a classic projection of the reviewers.  Jill would appear to any less diligent acquirer or review group to be a shiftless, lazy, unmotivated and unresponsive bit of driftwood.  A blocking troublemaker.  She had been passed up for merit increases twice.

Amazingly, she hung on, convinced that one or another of her memos (one I discovered identified an accounting error that had the company overpaying salaries for executives which, in turn, inflated payroll by over $1,000,000 per year, another pointed out that a criminal background check on an employee had been ignored though it indicated the employee was wanted for fraud in another state- the employee was a friend of an existing member of the department) would finally be read carefully and her worth would be recognized.

After an acquisition, Sub Rosa, like most private equity firms, develops a personnel plan (that we pejoratively call the "hit list") that outlines the new form of the organization (and therefore who will be invited to leave the firm and under what terms).  These plans have particular guidelines.  Usually, to streamline payroll, to use outsourcing when cost effective to replace expensive payroll slots, and to form a plan that "aligns the employee base with the future needs and resources of the firm."  An unwritten goal of these plans has always been to break up the empires and defuse long running office political campaigns.  Sub Rosa believes, correctly in my view, these cults of personality to be extremely hostile to productivity.

I was responsible for developing the sub plan to "harmonize" the Department of Dead Weight.  My plan was painfully simple and brutally efficient.  This was how we had been taught to develop such plans.  This was my third.  I proposed to eliminate 75% of the group, outsource many of its functions it to a vendor I had already identified (and with whom we had worked successfully before) and put Jill in charge of the transition.

My presentation was nakedly forward about the problems the politics in the department, its vindictive attitude towards the only element within its ranks that was producing anything, and pointed out that Jill's many memos had already identified over $1.5 million in annual savings on top of these changes (savings we had, as it happened, not expected in our initial analysis).  I also pointed out that one of the group's employees was wanted for an out of state felony while another may well be liable for harboring the first, that Jill had discovered this months ago and that this might have severe consequences for the firm.

"We are not kindergarten teachers, Equity," I was once told early on in my career with Sub Rosa when going soft on a daughter firm's finances.  "There is no nap-time, there are no time-outs, we do not have parent-teacher conferences where we discuss developmental needs.  We are here to fix the problems that threw this company in our arms in the first place.  We are here to do it mercilessly.  Pity is not a useful emotion for us or for our daughter firms.  The company is most likely in our clutches now because of pity and forgiveness on the part of former management.  We are not needlessly cruel, but we are, of necessity, brutal.  We hack off rotting limbs without anesthetic and therefore we must saw quickly and move on."  That visual stays with me still.

I learned my lesson on this point, this part of the transformation process.  Zealously identify flaws.  Expose them.  Propose and execute corrective action swiftly.  It is the later generation of management , brought in a year or so after the acquisition and the subsequent "transformation," that possesses the softer touch.  The surgeons fade away, the anger at their swift and heartless action, one hopes, fades too.  New management is given a clean slate, and appears much kinder and gentler.  How could they not?  Then Esprit de Corps can be built again.  The survivors will bond together with them nicely.  Very "Imperial Rome," really.

And so I expected I had done what was asked of me.  That it would be accepted without issue.  I was quite wrong.

"Why are we eliminating Lance?"  Lance is the Department of Dead Weight's sole male of "catlike disposition."  The question is from a Principal, Chris, who is fairly new to Sub Rosa.  Chris comes from a "public relations" background and is part of Sub Rosa's new "image conscious" focus.  I have not had much contact with him before this meeting, fortunately.

"Lance is a major part of the murderous political cabal in the department," (my prior slide in the presentation was entitled "the murderous political cabal," bore the likeness of Charles II and included a time-line that outlined the department's systematic, and baseless in my view, elimination of six employees in eighteen months who had fallen out of the department's favor.  Three of these employees have since instituted wrongful termination suits one of which was going against Deadline, Inc.) and in the 5 weeks I have been poking around it has become clear to me that he not only produces little himself but, more importantly, he is a significant drain on productivity."

"How can we fire him?"  I feel I have not heard the question properly.  There is a long pause as everyone looks at Chris.  "Won't we be looking at a lawsuit?"  I am even more puzzled, lawsuits have never worried us before, but, amazingly, a few nods from the audience now.  "I mean it is discriminatory.  Because, you know, of his... status."  More nods.  Finally I catch on.  Chris means because Lance might be gay.  I play dumb.

"I'm sorry, what status do you mean exactly?"  There is an uncomfortable silence.  No one wants to speak it out loud.

"Carrie warned me about this."  Carrie is a member of the Department of Dead Weight.  I wonder to myself how Chris knows her first name and when/why he had been talking with her.  "Well, you can't just eliminate people because we feel they might be a drain on productivity."  Now I am close to shock.  Who are these people and what have they done with the Sub Rosa employees?

"Actually, that's my fucking job," I want to say, but I stay silent.

"Let's get a group together to review the personnel plan for the Department of Dead Weight," Chris suggests.  Murmurs of agreement.  That's code for "Death by Committee," for my plan, which is now, clearly, out of my hands.

And this is what I mean when I wonder after the future of private equity.  Suddenly, cost savings, efficiency and the like are secondary considerations.  Now public relations is the focus.  And why not?  There is enough cheap debt to use leverage to give us the returns, at least its cheap right now.  Why do the hard and unpopular work of improving efficiency?  Lance's feelings might, after all, be wounded.

And, dear reader, this is why I point to dear Natasha Mitra.  Natasha "I love to consume.  Consuming is my specialty!" Mitra, who totally works with "this woman at Louis Vuitton" to pick out just the right $3,500 accessory that looks like a broken rope bridge from some civilizationless jungle with cannibals still running about.  What missionary got eaten to provide you with that broken rope bridge of a purse, Natasha?  Natasha who thinks the oversized and overpriced Six-Flags theme park glasses are "wild and crazy and different."  She's not alone.  The male Natasha is our friend Joshua Butler, of recent DealBreaker and Fortune fame bent on "merging" with KPMG, which understands his needs and expects his commitment.

This could well be the beginning of the end for private equity.  This side effect of the public relations focus.  It is a vicious spiral really.  More puff pieces about private equity.  Showing the human side of the business.  Putting a kinder face on the process.  Hiring "finance professionals," whos finance degree is in public relations.  Putting the spotlight on the players, and pulling it from the game.  This is the new face of things.  This is the attitude that creates Natashas and Joshuas scores at a time.  And the more Natashas there are, the more consumption is their specialty (rather than cost cutting) the more resentment is bred via their painfully obvious excess, and, in turn, the more public relations and the more player focused the business will become.

Oh, and Jill?  She was the only one fired in the department.  So far, none of the errors or cost cuts she identified in her tenure at Project Deadline have been acted on.  Oh, and I have good reason to believe that Chris is sleeping with Carrie.

Lighter Than Lite

very light indeed Incredibly difficult to ignore today is the little blurb citing the "Editor's Blog" on LegalWeek in the newly discovered (for me) "Square Mile Law" blog on a new trend in UK lending.  Specifically, lending under the LIBOR base.  Alarmed?  At the very least it should be interesting to the intellectually curious Going Private reader (as redundant as that term may be).

The data shows that average lending by UK banks to non-banking institutions in April dropped to 5.24%, against the then-base rate of 5.25%. The rate was even further under LIBOR, the wholesale cost of money between the banks themselves and traditionally a good deal cheaper than any corporate borrower would get, a full 34 basis points below, as it happens.

Footnotes Found in the Reader Mail PPM

good luck Spam is, unfortunately, a fact of life.  When it poses effectively as real mail, however, it becomes a fact of life that there is no escape from spam that does not entail dramatically draconian measures.  Such measures are now a feature of Going Private's sophisticated interactive feedback system (read: reader mail).  The quantity of spam has lately begun to clog the inbox and even, on occasion, bounce mail because Going Private had its "quota expended."  I have, therefore, directed our mail servers to institute strict "white list only" incoming mail policies on the inbox.

If you attempt to gain access to the inbox and have not already been "white listed," your email will be relegated to the "junk mail" folder.  You will receive an error message when this happens.  At this point there are only two methods to extricate yourself from an ignominious fate (in all likelihood purging of your message without a second thought):

1.  I notice your email and because I am so fond of you I add your address to the "white list."  (Vanishingly small, but non-zero, probability of occurrence).

2.  You follow the instructions on the error message which urges you to click a link to the "human authenticator" to verify that you are probably not a marsupial.  Your mail will be delivered and all subsequent mails will be delivered until I tire of your ranting and remove you from the white list.  (High probability of occurrence).

I was originally going to apologize for the circumstances that caused me to institute this witheringly annoying policy, but it then occurred to me that the creation of these circumstances were, in fact, not even remotely of my making.  The credit actually belongs to Mr. Gary Chang, Director of Business Development for "Pocket Change," along with Pocket Change's CEO, Mr. Jeremy Abelson.  A quick review of the email exchange involved should leave faithful Going Private readers informed about the challenges that face the management of Going Private in the battle against idiocy and unsolicited commercial email (though I admit these terms are somewhat redundant).

On Thu, 31 May 2007 04:54:54 -0500 Gary Chang
[email protected], cc: [email protected], [email protected] wrote:

(Please foward [sic] to Director of Ad Sales)

I hope all is well. Pocket Change is a growing e-publication that covers the most exclusive items in New York and Los Angeles.

We are establishing a very unique self-servicing ad network with which we will call REX URBIS. It will serve as an exclusive consortium of online publishers that reach a young and urbane audience. We have already received a tremendously strong response to this network from a number of our advertiser contacts.

As a member of REX URBIS, you will obviously garner additional ad sales and revenues. However, unlike traditional networks, you set the price and you will be able to also sell network media to support your own campaigns and pitch for larger contracts.

We are only offering membership to a small and selective group of publications at this point. We really respect what you do; otherwise, you would not be receiving this email. I would like to set up a call or meeting and bring in our CEO Jeremy Abelson as well. Thank you in advance for your time and we look forward to doing business with you.


Gary Chang
Director of Business Development
212.671.1100 x 104

From:  Equity Private
To:  [email protected]
Cc:  [email protected], [email protected]
Date:  Thu, 31 May 2007 11:21:47 -0500

That's GREAT!

Now take me off your fucking list.


From:  "Jeremy Abelson (PC)" <[email protected]>
To:  Equity Private, [email protected]
Cc:  [email protected]
Date:  Thu, 31 May 2007 12:40:19 -0500

Sweetheart relax.

You're also not on a list, this was a personal communication.  I urge you to review the doc Gary attached.  You have no advertisers currently, not great traffic, but what looks like a good audience for us.  The doc talks about putting ads on your site for you...

De-stress, not Distress - you're not that special or sought after.



From:  Equity Private
To:  "Jeremy Abelson (PC)" <[email protected]>
Date:  Sun, 03 Jun 2007 18:50:06 -0500

I am NOT your sweetheart, fuckwit and I am perfectly relaxed.

A personal communication?  Yeah, that's why it was directed to the (very vague title of) "director of ad sales."  (Also, you spelled "forward" wrong).

Your program could not possibly generate enough revenue even to push me from the "sleep" level of consciousness up into the "waking sleep" level of consciousness, much less actually get me out of bed in the morning.

In future, please take pains to keep your actions consistent with your assertion that I am not "that special or sought after," by failing in any way to contact me again.  If you stop to think about it, this is the most logical step for you at this point (and the one with the least downside).

In the meanwhile, take your spam, your documents and your ads and go pound salt.


Wednesday, June 06, 2007

Elevated Dividend Recapitalizations

expensive revamp The pickings must be getting slim for Bono-populated Elevation "We aim to help media and entertainment businesses create and market great content and insure it reaches the widest audience possible" Partners.  It is hard to find any other viable way to explain their minority PIPE transaction resulting in a 25% stake in Palm, Inc. (hardly a media or entertainment business), particularly given that the use of funds "plus $400 million in borrowed money" is "to pay shareholders a $9 per share dividend."  (Around $940 million).

Of course, the dividend recap is a regular feature of corporate finance, but for Palm's part, doing it with such a large chunk of equity seems unduly expensive.  Elevation actually permitting this kind of use of funds in a company that is about to face a burning R&D need in the face of the availability of the iPhone and the competitive reactions of other smartphone makers thereto, is just daft.

But then, Elevation can probably compel Forbes to write nice articles about their newly "revamped" Treos.

Wait, The Lock Up Period is HOW Long? (Part II)

devilish Faithful Going Private reader, the "Inscrutable Chicken" reports that Elevation Partners just changed their website such that it now includes "consumer related businesses" in its investment criteria description.  (Perhaps the Elevation "investment team" reads Going Private?)  Of course, they seem to have done a rush job on the change as the supporting pages still don't contain any reference to "consumer related businesses."  (Oops).

If I were a limited partner I might be a little ticked off at the wide divergence from their original investment model.  Making PIPEs in PDA manufacturers seems a bit wide of their original mark, but then, I don't have their PPM so I have no idea what their original mark was (aside, of course, from "Hey, Bono, wanna be in our private equity firm?")

Don't change your brand Gimme what you got
Don't listen to the band
Don't gape Gimme what I don't get
Don't ape
Don't change your shape Gimme some more
Have another grape
Too much is not enough
I feel numb
I feel numb

Elevated Lowered Expectations

spare us Reader mail has been on fire today.  Perhaps it is a consequence of the new draconian white list policy I was forced to institute.  Perhaps not.  Whatever the cause, I am basking in reader mail goodness.  Most recently, loyal reader "JN" points me to the blog of an alleged associate at Elevation Partners.  (One more example in the rather full quiver of reasons I post anonymously).  The peek into his world is a fascinating tour of rudderless and inept piloting through the narrow straits of the pacific ocean with all the pointless intoxication you'd expect from a sailor.  But then, what did we expect from a blog named in part for a popular, foreign vodka?  This, I suspect:

"Myspace's best use has got to be for checking how drunk you were the night before."

Or perhaps, this:

Tales of Fattiness

This weekend was a complete disaster. Friday night I was partying with some friends at Vessel and we ended up getting bottle service, which is never a good idea for me. I remember eating at Yuet Lee afterwards but not much else beyond that point. The next day when I was hanging out with some of the same people, one of them mentioned how a friend might have left their camera at the pho place.

As if your taste buds had not already been literally burned off, in between the descriptions of the guilty pleasures of business class travel- awkwardly made "California Appropriate"(tm) via the addition of class warfare themes in which the airlines are segregating villains- and puzzling over the meaning of happiness (related to gambling in Vegas it seems) any number of topics are obliquely addressed with strangely intoxicating misdirection.  The gems of wisdom that can be harvested therefrom include:

The author on the dangerous nature of expectations:

When you come to expect things, it becomes more difficult to exceed those expectations and create happiness.

The author on the relationship between financial model size and social skills:

Size of excel model says nothing about technical competence of employee...it's really about how you use the model. If anything, there is a positive correlation between model size and creator's lack of social life.

Of course, I violently disagree.  Large unwieldy models are almost universally produced by financial "professionals" who have no clue whatsoever about their predictive value (hint: it is vanishingly small) and therefore the size of the model is, in my view, inversely proportional to the technical competence of the employee.  And what does this say about the author?  Let's see:

Usually I work with models that have file sizes around 1-2 mb. Well this one particular deal I am working on requires an unusually large model. Each version I save is a little larger and I'm up to about 250 mb. To give you an idea, I've saved 52 versions which implies total hard drive space of 13 gigs (not completely accurate since previous versions smaller). I'm sure the company keeps multiple instances on various days, which means this could easily require over 100 gigs of storage.

More on the danger of expectations and the purposeless of hope:

Hope leads to high expectations, which thus far seems to be a non-constructive emotion. I've mentioned how it slows down the healing process and can create dispair [sic] if the expectations are not met. This is what I have thought for quite some time now.

On the genius that is his fund (Elevation Partners?):

I was sitting there the other day thinking...I work at a media fund. I see the future. The future is online. Every part of my life is moving online. So why don't we ever hear about online dating?

Before long you'll be able to consummate the relationship without leaving home or missing a WoW session.

Who hires these people?  Who invests in these funds?  Oh, yeah wait....

If I just got a job, learned to be a street sweeper
I dance to the beat, shuffle my feet
Wear a shirt and tie and run with the creeps
Cause it’s all about money, ain’t a damn thing
You got to have a con in this land of milk and

Monday, June 11, 2007

"Johnny Fontane Never Gets That Movie"

dazzled There are certain moments when a good antiperspirant is simply critical.  Perhaps your husband comes home early.  Maybe Third Point acquires 8.5% of your common stock while you are on vacation in the South of France.  Mike Wallace makes an unannounced visit to your corporate headquarters with a camera crew in tow.  Then again, maybe it's that Vipal Monga and company highlight your losing (or soon to be losing) investments.  Given the sting of these sorts of moments, I'm long Southern California distributors of Right Guard after seeing the Richard Morgan and Vipal Monga piece on the new face of film finance, which just happens, aside from exposing the folly that is outside investing in Hollywood, to include a little dig at an old Going Private favorite, Ryan Kavanaugh.

These pages have often cast a dark eye on the "new money" in motion picture finance, often times to the loud protests of industry apologists who, tellingly, don't seem to know the difference between revenue and profits and instead crow- shades of the many "new metrics" popularized by the dark era of dot-com finance- about "domestic release ratio" or "first weekend box percentage."

Where as once, dreamy millionaires would happily pour large portions of their capital into film production just for a chance to hob-nob with the stars, to read the modern private placement memorandums pressed by the likes of "Gun Hill Road I" and "Legendary Pictures," you would think there is finally some adult supervision behind these ventures.  Unfortunately, it seems that Vanity Premiums, star allure and Vegetable Capital are all still very much alive in the world of film financing.  Monga and Morgan pull back the curtain on this twisted finance mess for us via the latest piece in The Deal:

The $600 million fund, named Gun Hill Road LLC, entrusts Universal with $200 million to co-finance seven films and Sony Pictures Entertainment Inc. with $400 million to co-finance 11. It was put together in January 2006 by Relativity Media LLC, a Beverly Hills, Calif., operation that in a few short years has made itself synonymous with movie-slate financing. Gun Hill Road I, as the fund is now called, marks the first time two studios received third-party financing from the same source. Relativity essentially replicated the deal five months later by assembling a $700 million package for the same two studios. This second fund, Gun Hill Road II, is co-financing nine films from Universal and 11 from Sony.

Aspects of Gun Hill I and II are similar to the two dozen co-financing deals in place at every major Hollywood studio and many self-styled "indies." Taken together, they represent a capital infusion of more than $10 billion and, for the six major studios, an estimated 30% of their respective slates' negative costs (all film expenses, including financing costs, bond fees and contingency reserves, necessary to create a filmed product). But the one element these co-financing deals share most — with Dune Entertainment LLC's $725 million funding of Fox Filmed Entertainment serving as the exception that proves the rule — is they'll wind up bad investments.

The open, dirty secret in these arrangements is that the riskiest money is typically supplied by outside investors, formerly the star dazzled captains of other industries, eager to touch a bit of grace and not particular about their returns as a consequence.  Today that takes the form of massive preferences for everyone from actors, to studios to inside investors.

...the reality is that Hollywood's structured financings may be the worst way ever to invest in the film industry. This is especially true for equity investors, located at the bottom of a movie slate's so-called waterfall. Mezzanine-debt holders, who often expect a double-digit return, are immediately above equity investors, and senior-debt holders, who usually secure a LIBOR-plus rate, are higher yet. Revenue from movies in a slate, after expenses and distribution fees are deducted, repay debt first, starting with the senior-most piece and moving down through the mezzanine. Whatever's left then falls to the fund's equity investors.

Fortunately, there are still some brains in the business.  These sort of arrangements seem to turn off some of the smarter money.  "The trouble with investing in Hollywood is that your money goes to paying for the champagne on the G4 that's flying the movie stars to Cannes," according to one hedge fund manager Monga quotes.  But even before that, studios take their "sure things" off the investing table, preferring to protect the more certain cash flows for themselves and let the outsiders take fliers at wild pitches.  Say M&M:

The separation of investors from their investments is a hallowed Hollywood tradition. Early on, with uneven results, the siren call of films plus femmes drew William Randolph Hearst from newspapering, Howard Hughes from oil drilling and Joseph P. Kennedy Sr. from bootlegging. The parade continued, though with less august glamour seekers, in the persona of industrialists, financiers and the proverbial dentist from Dubuque. Hollywood has attracted a stream of foreign capital as well, its klieg lights intermittently cast on Dutch, English, French, Israeli, Italian and Japanese wannabes.

So it went until the late 1990s — two decades after domestic film-financing incentives were written out of the U.S. tax code — when studios found themselves awash in billions from Germany. For good reason, considering that regardless of where a film was shot, German tax law permitted the immediate deduction of its entire negative cost. "With [German] tax rates in excess of 50%, the up-front deduction is a substantial benefit, which is magnified if the investment is leveraged with debt," Schuyler Moore, a partner in the corporate entertainment department at Stroock & Stroock & Lavan LLP, writes in his film industry text, "The Biz." As for Germany's location loophole, since tightened, the attorney remembers it as "an unintentional subsidy for worldwide production."

What is amazing is the speed and efficiency with which studios have found new, willing and careless investors to diversify away studio risk in "iffy" projects.

The story of how the film industry is about to leave more investors than ever holding the bag has a cast of hundreds. Much of this cast is new — by definition, given "The Biz" author Moore's depiction of Hollywood as "a roving predator ever searching for the next victim to suck dry of cash." And much of the story stems from the rise of hedge funds and private equity just when Hollywood's German investors began their retreat.

And how have these ventures fared now that it looks as if this next cycle is about to close?

Ultimates for "The Kingdom" will complete the Gun Hill I slate, leaving investors with a collection of projections that, in turn, provides a reliable measure of the fund's overall performance. What's being whispered in Hollywood corridors today will then resonate all the way to Wall Street. "My understanding from people who invested in the equity is that they are totally wiped out," says the expert on studio economics. "When this first deal formally implodes, much will be written and lawsuits may start. I think you're going to see these deals dry up completely."

Wednesday, June 13, 2007


good times The Times Online has named Going Private one of the "Top 50" business blogs, along side other greats such as the Freakonomics blog, the always yummy Abnormal Returns, the Becker-Posner blog, Boing Boing and 45 other wonders.  (I will pretend I didn't see Mark Cuban's blog on the list).

Escaping Modern Debtor's Prisons

debtor's prison?"Subject to the provisions herein-after mentioned, and to the prescribed rules, any court may commit to prison for a term not exceeding six weeks, or until payment of the sum due, any person who makes default in payment of any debt or installment of any debt due from him in pursuance of any order or judgment of that or any other competent court."



That such jurisdiction shall only be exercised where it is proved to the satisfaction of the court that the person making default either has or has had since the date of the order or judgment the means to pay the sum in respect of which he has made default, and has refused or neglected, or refuses or neglects, to pay the same.

This language, in the United Kingdom's Debtor's Act of 1869, effectively limited sentences committing debtors to prison to cases where the debtor was able to pay his creditors but refused to do so.  This in contrast to the more "strict liability" approach historically used and that simply asked, "did you pay your debts," responding to "no," with an order of incarceration.

I am unaware of any study that weighs in on the effects on collections of looming prison sentences, (might make for a good thesis in behavioral economics?) but I suspect that creditors like such provisions.  And, of course, if it had no effect then why are modern debtor's prisons (child support debtors and alimony debtors still face incarceration in many states, of course) still the law of the land?  The typically well educated Going Private reader will understand this assumption to be an extension of the supremely radical concept that behavior actually tends to follow incentives.  To the extent debtor's prisons were comfortable (marriages, aptly named "Fleet Marriages," were actually allowed in Fleet prison, one of the United Kingdom's most famous correctional institutions for debtors), or easy to escape, they provide little negative incentive and have little impact on behavior.

Still, baring a return to actual strict liability debtor's prisons, defaults and credit woes will plague the modern financial system, and though our attitude about debt is still a very conflicted one (witness the arbitrage opportunities presented in Going Private transactions and their subsequent IPOs) debt has its purpose, as do debt losses and bad loans.  Signs of the puritan (Germanic?) distaste for debt abound however, as do signs that it is poorly understood both by novice and sophisticate alike. Making bad investments in sub-prime loans should actually be painful.  Yes, we might be sympathetic to the "victim," but their fate was in their hands when they made the investments.  Let us not cloud these fairly effective incentives of the financial system in the name of "fairness."  (You might already be aware of my thoughts on this topic).

To listen to the gaggle of voices presently honking on the topic, one might be led to believe that defaults are a de facto evil, totally avoidable, that loan losses exist solely become some kind of simple policy oversight is lacking and that extending credit is (or should be) somehow a risk-less endeavor.  I find it interesting (but unsurprising) that these self-same voices also would like to impose regulatory burdens on "sub-prime" lending that would certainly have the effect of eliminating debt as an option to the "credit unworthy."  Of course, much of the "credit unworthy" definition is hung up on the most recent series of battles in the latest campaign of class warfare in the United States, and it is the hallmark of the modern "progressive" that their well-meaning (but poorly thought out) plans have a habit of substantially harming precisely those they want to help.

On that note, one can only hope that the pathetically low approval rating currently commanded by the Democratically-led Congress is a reflection of the distaste in the public over a battle strategy that includes massive tax increases, regulatory "progress," and steps towards socialized medicine of the sort that cause major political candidates to claim that healthcare quality can be maintained, costs decreased and everyone given free insurance all at the same time, but I suspect that would be hoping for quite a lot and attributing a collective intelligence to the sort of people who respond to these surveys that might well be excessive.  For now, it seems, we must deal with the cycles of "sub-prime" lending.

The political yammering aside, one wonders if the modern debtor's prison isn't being long an undesirable asset you probably never should have hoarded without better risk-controls in the first place.  Today, those assets may well be collateralized debt instruments.  (Natural gas futures are so last year).

If this is the case, it may be far easier than one might think to escape the horrors of a modern debtor's prison.  Just write a popular play, make some fool's gold, or, maybe, repackage your debts and get someone(s) to buy them.  Very Hogarthian, really.  (See art credit note, below).

Bear Stearns may be the prisoner of the day, having, as the case may be taken it on the chin (subscription required) for some time now (subscription required) over the bath they have been taking in sub-prime investments.  Says the Journal:

Hard hit by turmoil in the market for risky mortgages, a big Bear Stearns Cos. hedge fund has fallen 23% from the start of the year through late April, according to people familiar with the matter. The performance was disclosed late last week in a letter to investors from executives at the Wall Street firm's asset-management division, these people say. The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is widely exposed to sub-prime mortgages, or home loans to borrowers with weak credit histories, these people add. It has $600 million under management, but as the fund's name suggests, it borrows heavily to make bigger bets. A spokeswoman for Bear Stearns wouldn't comment on the fund's performance.

But the damage is limited, according to the Journal:

While the year-to-date performance of the leveraged fund is a blow for its managers, Ralph Cioffi and Matthew Tannin, the paper losses will have a limited impact on Bear, two people close to the situation say. The brokerage and a group of individual executives have invested about $40 million in the fund, according to someone familiar with the matter. The majority of the $600 million under management comes from outside investors such as hedge funds and wealthy individuals.

A senior executive of a large hedge fund currently short sub-prime "across the board," (and good friend to Going Private) disagrees with the soft-landing view of Bear (and similar banks with sub-prime holdings of note):

The Journal piece is just the tip of the iceberg.  Some of these banks are so long Collateralized Debt Obligation sludge, and many of these securities have at their root asset base sub-prime mortgages, that their internal hedge funds are choking on the stuff, especially their super-levered ones.  When these things blow, the losses are not only going to kill the equity in the hedge funds, but the collateral will go back to the bank as the leverage provider, and their practice is to immediately sell all collateral upon margin calls.

When that much product hits the market, the prices get driven down, leading other funds to realize losses on comparable stuff, leading them to sell.  It could well be the end of the credit bubble.

Bear is trying to dump this sludge so hard they're repackaging these equity and subordinated securities, which can only be bought by QIBs, into corporations which will probably just IPO over to mom and pop, and this is dangerous.

Some of us wonder whether Bear's talking about using these things to manipulate the CDS market wasn't a real threat, but merely an attempt to market them to third-party hedge funds (i.e. to get them off Bear's books) as options on market manipulation profits.

It is interesting to note that all the sub-prime lenders changing hands in M&A deals to hedge funds in the last few months have Bear as an adviser, and the merger agreements are bizarre.

It would be ironic, nay, if hedge funds were the only active means in the economy right now to keep negative incentives of the modern debt prisons working as they should?  Is Going Private's colleague right?

A quick look around does expose some rather unusual break-up clauses on deals of late.  Lone Star's purchase of Accredited Home Lending lets the buyer walk for $10 million plus another $2 million at closing for no real reason at all.

Reverse break-up fees have been around awhile, but, when these become a 3% option to walk on a 20%-25% equity investment in the absence of a material adverse change, the term "no financing condition" becomes meaningless.  Private equity firms increasingly have easy outs should they even get "bad vibes."  3% looks pretty cheap comparatively when you consider this option in a credit market this volatile.

Looking over at the recent McBusiness article on the topic we get this:

The situation is so bleak that Bear Stearns' asset management group is suspending redemptions at the onetime $642 million fund—meaning investors have no choice but to sit on their losses.

Even the vast amounts of liquidity, a favorite tool of astute Going Private readers in times of crisis, might not stave off the recent and rather ominous signs of credit tightening.  While large swaths of hedge fund and private equity money are a good thing, many liquidity providers are very "mark to market" conscious and cannot sit on deteriorating debt investments which could be held more or less indefinitely and still show up at or near acquisition cost on the books of their more traditional holders (banks).  This does make me think, however, that the safety valve of mark to market in this situation might actually avoid the kind of delayed response that helped gut Japan's banking system.

It is easy to be of the opinion that risk has been underpriced for a long while.  Might this be a wake-up call?

In the meantime, it appears this morning that a certain financial institution is working to dump several billion dollars of debt laden securities on the market.  They might well escape debtors prison, unless certain warden-hedge funds have anything to say about it.  We'll see how that works out for everyone.

Art Credit: "The Prison," painting number 7 in the series of 8 works entitled "A Rake's Progress," by William Hogarth (1733) and telling "...the story of Tom Rakewell, a young man who follows a path of vice and self-destruction after inheriting a fortune from his miserly father."  The painting is set thus:  "Tom is now an inmate of the Fleet, London's celebrated debtors' prison.  Beside him lies the rejected script of a play he has written in the hope of securing his freedom.  Other prisoners in the cell are trying similarly hopeless schemes.  One man has written a treatise on how to pay 'ye Debts of ye Nation', and another is attempting to make 'fools' gold."  (One wonders if anyone in the picture is drafting Collateralized Debt Obligation IPO documents).

The series "A Harlot's Progress," (1730) was the highly successful prequel (its popularity likely driven by the more sexual subject matter).  An outstanding Hogarth exhibit was on display at the Tate through April of this year (an amazing show, I might add) with these pieces on loan, but the works have now returned to Sir John Soane's Museum.

Thursday, June 14, 2007

Did I Get the City and State Right?

the good old days I'm trying to get back into the swing of things after a long convalescence and I've been pretty down about being taken out of the game for so long and the political capital it has cost me.  Typically, when I'm feeling professionally blue I dial up Laura the Debt Bitch.  It is not that she is cheery or full of sunshine or anything, quite the opposite really, it is just that her attitude is so dismissive that it makes me smile.  Laura has this thing about "face time."  If a firm is going to impose the silly requirement for "face time" on her and she has nothing to do, well damn if she won't use firm resources to entertain herself.  She's quite good at it and my growing collection of paper clip origami originated with her adept instruction.

I dial her direct line and it rings, seemingly endlessly, before she picks up with a hurried and annoyed tone.  I am about to tell her it is me, as is my practice.  She knows already because of the Caller ID, of course, but the Debt Bitch believes it is very rude to display phone number clairvoyance when answering the phone.  She's a huge proponent of feigning surprise on answering.  But not this time-

"Hold on a secon-" and she's gone.  A long pause ensues.  I strongly suspect now that the phone system on her end is designed to annoy her with a soft twittering after twenty seconds of leaving someone on hold (assuming that twenty seconds is too long for a "customer" to wait).  I suspect this because every twenty seconds she would pop back on the line with a "One more secon-" before dropping me into the holding pit again, probably just to shut the twittering up.  Finally, after the sixth or seventh time I try to interrupt her.

"Last time," she says for the third time.
"Laura, Laura."
"Yes?  What?  Hurry!"
"What are you doing?"
"I'm officiating the final gladiatorial bout of 411 v. 411."
"The final... oh, just a second I will patch you in."  The phone clicks, then I am on hold before I'm conferenced into automated chaos.

"Automated directory assistance.  What city and state please?"
"Automated directory assistance.  What city and state please?"
"Ok, you said Star Lake, Wisconsin, right?"
"Ok, you said Talbott, Tennesse, right?"
"Sorry, I didn't understa-"
"Sorry, I didn't understand, did I get the city and state right?"
"Ok, you said Longs, South Carolina, right?"
"Ok, you said Mount Sterling, Wisconsin, right?"
"Sorry, I did-"
"Ok, you said Star Lake, Wisconsin, right?"
"Please wait while I transfer you to an operator."
"Sorry, I didn't understand, did I get the city and state right?"

"What the hell is that?" I ask.  Laura starts laughing hysterically.

"Shh, you can't talk!  Oh, never mind."  There is a click, and the automated voices are gone before she continues.  "I absolutely hate, I mean hate to the core of my being, the automated, voice recognition information systems that 411 uses.  They are developed by 'TellMe,' this shitty little Microsoft subsidiary.  Why is it that every little firm that has something worth buying get snagged by Microsoft and simultaneously injected with a mediocrity adjuvant that proceeds to dumb it down to near useless goo right before using it as a foundation for major infrastructure building?"  I don't answer.  I know better than to interrupt the Debt Bitch when she's like this.

"I'm a busy woman," she continues.  "I am likely to be talking to the driver, someone next to me or someone on the phone or in my office while I am waiting the 20 seconds it takes for that stupid voice to finish telling me that it is 'automated directory service info by AT&T,' or whatever.  So, of course, I'm in the middle of a conversation and the damn voice won't wait until it is finished to start trying to understand me.  So I'm constantly getting 'Sorry, I didn't understand you,' or 'What listing in Bufu, Egypt?' before I even have said anything.  Well, now what?  Do I make one up, 'Andrew Dice Clay's Camero' perhaps, and wait for it to send me to an operator?  Then either the operator thinks I'm crazy, or the damn software proactively connects me to 'Achmed's Used Camel Paradise' in Bufu, Egypt and I have to call back."

"I see the problem," I lie.

"The damn things are always picking up external noise and interpreting it.  It is like they are hearing some satanic message in the noise of a backwards playing record, or those people who hear the voices and see the images of their beloved dead in the white noise of television snow.  It is total bullshit.  So I got to thinking, what do they do when you pit them against one another.  Try it.  Conference like three of them together.  The trick is the timing, to get one to start about half a sentence before the next one.  Then they are always talking to each other."

"Uh, you conferenced three of them?"

"Yeah.  Actually, I have to go.  Star Lake, Wisconsin needs two more points to win the championship.

Friday, June 15, 2007

Death by Dogmatic Documentation

paper process Project Dustbowl has required quite a bit of documentation review both in the pre- and post-acquisition process.  Part of my job for Dustbowl, after being effectively removed from the personnel review team, was to go through much of the miscellaneous documentation that wasn't deemed important or was discarded as irrelevant during the initial due diligence and distill these down to a summary for the transformation team.  Often you find interesting things in these "miscellaneous" sections after an acquisition.  Other times it gives you a picture of how dysfunctional the organization really is.  (This would imply, of course, that these documents should not have been discarded by the due diligence team in the first place, as evidence of dysfunction should bear on price, but that's another story).

Project Dustbowl's miscellaneous section contained this document (that I have redacted but is otherwise totally original):

Parking Garage Process Flow.pdf

Monday, June 18, 2007

Coming Credit Calamities

slow down Today's Wall Street Journal finally and devastatingly puts a face (subscription required) to the degree to which debt has been irrationally underpriced and gives, in my view at least, cause for great concern.  It is too bad the article is relegated to the Op-Ed pages, but given the source (Steven Rattner at Quadrangle Group) it is hard to ignore nonetheless.  This path simply cannot continue, and, ironically, spreads have still slipped, even in the face of continually mounting, and what should be already formidable, opponents to sentiment.  Says Rattner:

No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.

Anatomy of a Meltdown?

acorns? Sub-prime has been on the forefront of the news for more than a few weeks now.  I was recently asked to make some predictions about debt markets for buyouts, triggering a few e-mail and phone discussions with the debt mavens of the world (and long hours on the phone with the Debt Bitch, punctuated by brief moments actually talking about debt).  This bit of internal research has brought me into the depths of the Credit Default Swap (hereinafter "CDS") market, credit derivatives and, by extension, insight into credit markets generally.

One of the key takeaways for me was something I understood intuitively before but never completely absorbed or intellectualized in this context.  Specifically, the derivatives market on a given underlying security can be a lot "deeper" than the security.  Credit Default Swaps (which permit the shifting of default liabilities and might be best understood as insurance policies on default) can be levered up almost arbitrarily by the market participants.  The purse for the Australian Open might be $2,000,000 but Vegas might have $200 million riding on the results of the Open, for instance.  This has implications.

Given the leverage I've described, the astute Going Private reader will easily see how it might be an awfully tempting choice for a bookie with large "Federer to Win" exposure to simply pay Federer to throw the game (the difference between the winning purse prize and second place) rather than deal with the loss (tens of millions).  One can see why certain banks might feel themselves in a similar situation.

Buying out the entire block of recently flagging securities underlying a dangerous default swap market could, of course, cost a small fraction of the derivatives exposure such a bank would face in an actual default.  This approach also serves up a very nice populist PR story for the bank's mouthpiece.  They are generously helping out the beleaguered debtors.  Poor souls that they are.

But is this really so?  In the case of mortgage backed securities, buying a defaulted loan bundle at par (say $1.00) when actual value is near $0.50 has the effect of injecting cash into a mortgage backed securities bundle and propping up the appearance of credit worthiness of the bundle as a whole.  This, of course, has no effect at all on the debtor, who is still on the hook for payments, and, further, has no viable economic purpose other than to shift losses away from the bundle (and therefore prevent technical default or a downgrade that might expose the entire bundle- indeed, the entire issuer- to a "mark to market" run).  The slight of hand becomes obvious when the loan is later restructured for $0.66 after its purchase at $1.00, but who will complain?

Add to this the fact that there are any number of providers out there who will loan short-term to a mortgage bundle issuer to make a coupon payment or six.  The quick eye of the Going Private reader wonders, of course, if related parties might not make these loans and then forgo repayment, again shifting the losses out of a mortgage backed securities bundle.

Going even farther, it isn't the smallest leap in the world to then wonder if a clever bank might not run up rather large default pools, intending from the very beginning to cover the default risk in one of the ways shown above and therefore fixing the default market.  Like taking bets on a game you've already fixed, in addition to having a large line with another bookie for Federer to lose.

Add to this, the fact that the underlying securities often sit in proprietary portfolios and therefore on the books without markdowns to market, unless there is a catalyst event forcing the issue (and these catalysts are avoided via the loss-shifting described above).  This means that it takes a downgrade, for instance (or an exploding hedge fund with angry and vocal equity investors) to force a new "mark to market."  That, in turn, causes a hard look at collateral, margin calls and therefore more marks down to market.  Lather.  Rinse.  Repeat.  The question worth asking at this point is "can ratings agencies keep up," given that they are focused on credit worthiness analysis based on cash flows to the instruments and these are artificially kept high.

Now consider a entirely theoretical large bank with an internal hedge fund that has as its equity investors the management of the selfsame bank.  I suppose problems within this fund and its credit default swap portfolio might take a long time to surface, given that all the triggers that would douse the practices in sunlight have been buried under the miasmal duo of accounting and silence.

An interesting dynamic, to be sure.  I would love to entertain the thoughts of Going Private readers versed in the mechanics of these markets.

Tuesday, June 19, 2007

The Ignorance of Crowds, the Rise of Irrationality and Capitalist Decline

don't look too happy about it It is a recurring and decidedly unfashionable theme here on Going Private that crowds tend to be dense, rather than enlightened.  Naive rather than insightful.  Shallow rather than penetrating.  I make this observation with no relish and though I would that it were not so, all the personal experimental data I have bears it out (even if the statistician in me worries with constant whisperings in my ear that this represents rather a small sample size).

One of the appeals of the private equity world, at least for me, was that success in the field required what one friend of Going Private would call "deep thinking as a prerequisite for action."  That is, that a fundamental understanding of the underlying dynamics of the business and the finances surrounding the business forms the foundation for the decision to proceed with a transaction, how to proceed with a transaction and what to pay in a transaction.  From there, insights into the business drive how it should be transformed, and those assumptions feed right back into what it is worth paying for the business.

By definition, successful buyouts require a contrarian demeanor.  "Contrarian," in this context, is, I believe, a gentle euphemism for "arrogant."  Contrarian investors think the crowd is full of barely useful idiots.  They think the street has it wrong and they are just pig-headed enough to put their money where their mouth is.  "You sheep are all fools," they might say to themselves, "and I will fleece you for it."  It is this force of personality, this unbridled self-confidence that makes the hallmark of a good contrarian.

Amongst these I divide the field into two.  First, the thoughtful, deliberate contrarian.  The against-the-current investor who has armed herself with research, background and who has a method, even a mad one, that underlies their investment thesis.  Second, the rash contrarian who relies more on instinct and force of will than well structured, deep argument supporting a thesis.  To my way of thinking the Emperor of the Rash is personified in Steve Jobs.  Let's call this, henceforth, the Jobsian School of Contrarian Thought.  Consider this bit from New York Magazine:

When Jobs prepared to launch the first iMac, he was confronted by underlings who told him he was crazy: Every shred of market research had concluded that consumers wouldn'€™t buy an all-in-one computer. Jobs shot back, "€œI know what I want, and I know what they want."


...the most common descriptor applied to him, by friends and foes and even Jobs himself, is "asshole."€ (Running neck-and-neck for second are "genius"€ and "€œsociopath."€) His abrasiveness is legendary and omnidirectional. Asked by a writer from Wired, "If you could go back and give advice to your 25-year-old self, what would you say?," Jobs erupted, "€œNot to deal with stupid interviews, €”I have no time for this philosophical bullshit!"€ Given an early glimpse of the Segway high-tech people-mover, he bellowed, "I think it sucks,"€ then later called the company's founder, trashed his CEO as a "œbutthead," and said his marketing chief "€œshould be selling Kleenex at a discount store in Idaho."

Exploring why contrarian strategies are successful presupposes some thesis regarding the foolishness of crowds.  I submit that success as a contrarian requires one of two conditions.  Either that the crowd is fundamentally wrong in some respect or that the underlying conditions crowds are reacting to can be altered in a meaningful way.  The later, I suspect, is both rarer and more likely to benefit followers of the Jobsian School of Contrarian Thought.

Says New York Magazine of the changing nature of the information revolution that brought Apple back to prominence:

No longer were people using their machines just for serious stuff, documents, spreadsheets. They were using them for purposes that were purely recreational. E-mailing. IM-ing. Downloading purloined music. Devouring online porn. And once the PC entered the realm of fun, it became a province of fashion.

But I think this backwards.  I think it was the likes of Jobs, and others, who drove computing into lifestyle use rather than professional pursuit.  "I know what they want," in Jobs' words.  If this is true than it quickly becomes apparent that it might be more accurate for Jobs to have said "I know what they will want."  It should be equally obvious how much of an uphill battle this sort of contrarian success is likely to be and why massive egos, the kind that trample over disagreement with a certainty that may defy logic, are a prerequisite to this sort of success.  "If the data doesn't support the theory, change the data," might well sum up this approach.  Why is it that these mavericks, despite the profane labels we might assign them, are politically more correct than the thoughtful, dogmatic contrarians?

The less sexy but, to my way of thinking, more intellectually pure contrarian approach presupposes something else.  It presupposes that the data is in there, somewhere, to support the thesis, but it is either too obscure or has not yet been effectively collected by the crowd to be priced into the market.  I am predisposed to find this much more compelling and accessible an investment approach because it does not require the same force of personality or cult of personality to effectuate.  Rational actors will be receptive to the theory when presented because its foundation is one based on evidence, rather than will.  As Armin might quantify this sort of persuasive discussion: "Present the current state of affairs.  Present the inefficiency embedded in the state.  Explain the problem that has thus far prevented a correction of the inefficiency.  Present the new development that now permits the correction."

Consider the discussion I framed yesterday about credit markets as an example:

The current state of affairs is a credit market environment characterized by historically low, shockingly low, prices for credit.  The inefficiency is that defaults are not being priced into the market.  The problem keeping this inefficiency from correction is that incentives are aligned against actors allowing default information to be priced into the market, either because of the depth of their derivatives and exposure to same or because it is trivial to shift losses away from mortgage backed securities into other entities.  The new development is increasing market awareness (perhaps through presentation by us) of the accounting and derivatives structures that expose pricing inefficiencies in the credit markets.

An amazing amount of clarity can be introduced into investment theses just by framing the problem in this fashion.  This, in my view, is the essence of deep thinking as a prerequisite to action, the foundation of my approach to contrarian investing, and why I love buyouts.

For all the talk about the "Wisdom of Crowds," or the "miracle of aggregation," it isn't hard to see how crowds can get it wrong, and often.

The Economist chimes in with a review of some recent research on the nature of crowds in the form of voters (and, for the alarmist, an implicit prediction of the approaching death of democracy and capitalism).  One might summarize the piece best with the phrase: "Crowds are dangerous."

The "Wisdom of Crowds," is based upon the general case that "...if ignorant voters vote randomly, the candidate who wins a majority of well-informed voters will win."  This is why "prediction markets" tend to work, why futures markets are good sentiment indicators and why markets tend to price assets reasonably (usually).  But several flaws creep into this general case making for a specific bunch of exceptions.  Says the Economist of the case with voters:

[There are] four biases that prompt voters systematically to demand policies that make them worse off. First, people do not understand how the pursuit of private profits often yields public benefits: they have an anti-market bias. Second, they underestimate the benefits of interactions with foreigners: they have an anti-foreign bias. Third, they equate prosperity with employment rather than production: Mr Caplan calls this the "€œmake-work bias€." Finally, they tend to think economic conditions are worse than they are, a bias towards pessimism.

Mr Caplan gives a sense of how strong these biases are by comparing the general public's views on economic questions with those of economists and with those of highly educated non-economists. For example, asked why petrol prices have risen, the public mostly blames the greed of oil firms. Economists nearly all blame the law of supply and demand. Experts are sometimes wrong, notes Mr Caplan, but in this case the public's view makes no sense. If petrol prices rise because oil firms want higher profits, how come they sometimes fall? Surveys suggest that, the more educated you are, the more likely you are to share the economists' view on this and other economic issues. But since everyone's vote counts equally, politicians merrily denounce ExxonMobil and pass laws against "œprice-gouging€."

Consider also the implications in conjunction with this quote, oft (and erroneously) attributed to Alexander Tytler:

A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largess from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world's greatest civilizations has been 200 years.

For a rather detailed discussion on the surprisingly miasmal origins of this quote, Loren Collins has a great piece that will interest the always intellectually curious Going Private reader.  If nothing else, the mysterious origins of the quote also have the rather depressing effect of confirming just how much easier it is in an age with massive interconnectivity for "fact" to be supplanted by effective rumors.

Going Private readers are likely to have already dug through numerous used book shops to find a copy of the outstanding and, unfortunately, out of print work "The Psychology of Rumor," by Gordon Allport and Leo Postman.  Allport and Postman's "Basic Law of Rumor," that "rumor strength" [R] will vary with the importance of the subject to the individual concerned [i] times the ambiguity of the evidence pertaining to the topic at hand [a] or "Ria," will cause naturally cautious Going Private readers to immediately understand the counterintuitive import of the fact that ambiguity in evidence strengthens a rumor.

Regardless of the mystery of its birth, the quote's message may be a bit alarmist, and the market often works mightily to correct political missteps, but, I lack confidence in the power of the market in the face of the new and celebrated value of ignorance (more than half the United States believes Elvis is still alive) and what we have only recently discovered about cognitive biases.  More than sixty are outlined in a Wikipedia entry on the topic.

Moreover, contrarians who profit by their clever investment theses are often vilified in the public and have recently become the target for everything from taxation and regulation to outright legislative prohibition.  I am convinced this is because a powerful streak of envy runs through Western culture with respect to finance in this age.  Friedman was fond of pointing out that both envy and emotional notions of "fairness" often led to measures, particularly legislative, that did more harm than good to the very classes that the "do-gooders" professed to help.  The minimum wage was an oft cited example but certainly public education has been a much clearer case.  We need only to look at the latest craze for philanthropy to see why the likes of Bill Gates would decide to gift his wealth to countries crippled by years of development stifling, extraction model economies despite the fact that turning these same funds to capitalist endeavors would almost certainly result in many, many times the utility.

I have commented in these pages before (albeit humorously) about the strange schizophrenia Western capitalist systems seem to exhibit with respect to capitalist successes.  Nowhere is this more pronounced than in the vilification of the deliberate contrarian.  The man who made his fortune by exiting at the top of the bubble market is a clever, lucky hero.  The man who managed to profit famously in the stock market while others threw themselves from buildings during the crash must be a unrepentant, morally depraved cad.  (But really, do we as a society want to prefer Mark Cuban to Benjamin Graham?)

What does it say that clinging to baseless theories in the face of all evidence has somehow become a sign of inner moral strength?  It becomes quite hard not to view the "struggle of our time" as one between knowledge and ignorance.

And even if one sides with "knowledge," one must do so with the awareness that our models for describing the world around us are, almost by definition, fraught with error and flawed.  When was the last time someone predicted the weather right 7 days in a row?

The class warfare and the envious mewing over "income inequality" has gotten so thick that one can feel it as mist on the skin as one walks through markets.  It causes one to wonder:  If hedge funds are the "Galapagos Islands" of investing, and buyout funds the last salvage hope of ruined industry, what if we demonize them, by virtue of their success, into extinction?   

I want to take comfort in Churchill's quote to the effect that democracy is "the worst form of government, except all those other forms that have been tried from time to time," but the crowds look quite dangerous and riled.  It is a dangerous thing to be a wolf just now.

Wednesday, June 20, 2007

Implosion or Explosion?

rip it off quickly next time News of the ongoing collapse of subprime invested hedge funds at Bear Stearns in this morning's Wall Street Journal will come as no surprise to the typically well-informed Going Private reader, particularly after a pair of musings in these pages on the topic.  It probably isn't interesting for me to say "I told you so."  What is interesting, however, is to try to decode the deeper meaning in some of the language in the Journal's article.

Since 2000, Wall Street has created more than $1.8 trillion of securities backed by subprime mortgages, according to industry newsletter Inside Mortgage Finance. Now, the housing-market slump is causing a spike in mortgage delinquencies and defaults, which hurts the value of those bonds. Worried investors, in turn, are further driving down the bonds' prices.

On Wall Street, the Bear Stearns hedge funds' problems point to another sensitive issue: Markets for exotic investments like derivatives linked to subprime mortgages have exploded in size in the past few years, but it is often hard to attach an accurate value to those assets.  (Emphasis mine).


The huge [downward] revision [of the hedge fund losses] at least in part reflected conversations Bear Stearns hedge-fund managers had with bond dealers, three of which told them in late April that some of the funds' assets were worth less than the values stated on the funds' books, according to a person familiar with the matter.

So far the turmoil doesn't seem to be significantly hurting the broader bond markets. But as the Bear Stearns funds unwind positions, investors and traders could reassess the value of other debt securities. As a result, investors far beyond the reach of the funds could find their holdings of similar debt worth less than they thought.  (Emphasis mine).


Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don't have clear market prices. To come up with market values for these investments -- a process known as "marking" their positions to market -- investment funds often rely on their own valuation models.


The Virtues of Flatland

the opiate of the masses Off-topic only to the extent a discussion of crowds and their dynamic is out of place on these pages, Carol V. Hamilton's "Being Nothing," (2004) wonders, in essence, if the United States has reached a stage where only dumbed down public figures are compatible with the shallowness of the information age and does so using one of my favorite works of fiction, Jerzy Kozinsky's "Being There" (1970) as a metaphor for the observation.  While needlessly partisan overall by virtue of its focus on George W. Bush (of whom I am no great fan in any event), the otherwise outstanding essay brings up what I view as critical questions about the population at large.  I see the essence of the piece as less an indictment of a given leader (none in my lifetime have much to recommend them) than an exposition into the deteriorating collective of the public.  It is for this reason that I am able to forgive the work its bitter, partisan aftertaste, even if it requires extensive surgery and the extension of its theme to extract any real value.

Hamilton's selection of Being There, at least, is keenly on point.  The work's probing and satirical exploration into the impact of a different information revolution, the rise of television, makes for such timeless political and social commentary that one can absorb the book and, more ironically, appreciate the superb Hal Ashby film of the same name (highly recommended by your humble author; the combination of Peter Sellers and Shirley MacLaine is beyond hysterical) some 37 and 28 years later without more than a hint of temporal shock.  Says Hamilton:

In Jerzy Kozinsky's 1970 novel Being There, a character named Chance the Gardener, whose entire existence has been restricted to watching television shows and tending a walled garden, is suddenly thrust into the outside world. Here he acquires admirers who rename him Chauncey Gardiner, mistake his ignorance for profundity, and take his horticultural allusions for zenlike koans. His intellectual limitations and personal inadequacies become social and political virtues. At the end of the novel, the President's advisors gather to consider a candidate to replace the current vice-president. One of them suggests Chance. "Gardiner has no background," he declares. "And so he's not and cannot be objectionable to everyone! He's personable, well-spoken, and he comes across well on TV." Although Being There is over 30 years old, it is eerily pertinent to the current political scene.

Roger Ebert's 1997 re-review of the film for his "great movies" selections comments thus:

If Chance's little slogans reveal how superficial public utterance can be, his reception reveals still more. Because he is WASP, middle-aged, well-groomed, dressed in tailored suits, and speaks like an educated man, he is automatically presumed to be a person of substance. He is, in fact, socially naive... but this leads to a directness than can be mistaken for confidence, as when he addresses the president by his first name, or enfolds his hand in both of his own. The movie argues that if you look right, sound right, speak in platitudes and have powerful friends, you can go far in our society.

The impact of such a character and his necessarily neutral passivity as protagonist (an outstanding instrument itself, this choice) presses us to wonder after the lack of depth in the world around us.  If such a flat character can, in fact, meet with nearly unbridled success and fortune, what value is merit?  What is the cause of this disconnect?  Hamiliton gives us hints early on:

As a result of his immersion in television programs and limited experience with the outside world, Chance is unable to distinguish videotaped fictions from social reality. Being There recognized the capacity of images- the spectacle- to displace or colonize the real....

The result is an often comic demonstration of the old turn of a phrase to the effect that heaven keeps a special eye out for fools; or perhaps, that to the eyes of a shallow public, a blank slate takes the form of the viewer's own biases.  From the film:

Stiegler:  Mr. Gardiner, I'm Ronald Stiegler, of Harvard Books.

Chance (a two-handed handshake): Hello, Ronald.

Stiegler:  Mr. Gardiner, my editors and I have been wondering if you'd consider writing a book for us? Something on your political philosophy.  What do you say?

Chance:  I can't write.

Stiegler (smiles):  Of course, who can nowadays?  I have trouble writing a post card to my children!  Look, we could give you a six figure advance, provide you with the very best ghostwriters, research assistants, proof readers...

Chance:  I can't read.

Stiegler:  Of course not!  No one has the time to read!  One glances at things, watches television...

Chance:  Yes.  I like to watch.

Stiegler:  Sure you do!  No one reads!  Listen, book publishing isn't exactly a bed of roses these days...

Chance:  What sort of bed is it?

I wonder after the market effects of this sort of dynamic, particularly in the face of the wholesale launch of the "individual investor" into the field of equity investment and active investment management.  Complexity, somehow, has been cast aside in favor of shallowness.  With the new reach communications gives content providers of every ilk, I might be tempted to say that this shallowness is the new opiate of the masses, but believing this a revelation of any kind necessarily presupposes that religion, such as it was before efficient communications, was more than a mere delivery channel for the same shallowness the masses now seek solace in.  I think it more accurate to say that shallowness has always been the opiate of the masses, but that its delivery is no longer an endeavor confined to wealthy and influential institutions, or the higher "estates of the realm."  Sez Hamilton on this point:

Under the sign of postmodernism, the hermeneutics of depth have been replaced by the play of surfaces, and the flat celebrity has superseded the complicated historical figure. In his magisterial Postmodernism, Fredric Jameson commented on the shift between the deep subjectivity represented in the modernist novel and the postmodern "death of the subject." "This new order," Jameson writes, "no longer needs prophets or seers of the high modernist and charismatic type, whether among its cultural producers, or its politicians. Such figures no longer hold any charm or magic for the subjects of a corporate, collectivized, post-individualistic age."

This, in itself, would not be so concerning if not for the parallel tendencies, recent in my view, to penalize those who can perceive the complex and therefore profit by it.  Hamilton supposes that, "perhaps, a complex, three-dimensional personality, full of contradictions, corners, and real history is difficult to reduce to a flat surface."  If this is so, and unlike Hamilton, I am far less worried about the impact on various political leaders whose power is, to my way of thinking, threatened by irrelevancy, but rather on the figureheads of capitalist endeavors.  To the extent these actors are successful in the market and attract resources with which to augment their influence in the pricing of assets, the banality of flat surfaces (oil company greed and conspiracy being responsible for price fluctuations in gasoline for instance) might be repelled.  But what if these same actors who bring rationality into the equation are routinely vilified and attacked by a society that casts confused and envious eyes in their three dimensional direction?  This, perhaps, goes some way towards explaining my puzzlement after the very conflicted attitudes towards capitalism that make the likes of Mark Cuban a folk hero.  Hamilton illuminates this, inadvertently I think:

...Chance's ignorance of the "real" world causes him to remain silent when he doesn't understand questions, remarks, and behavior directed toward him. His strange passivity prompts other characters to interpret him as they see fit. When [the] wife of the elderly Mr. Rand, makes sexual overtures to Chance, for example, she regards his lack of response as indifference to her particular physical charms. When ambassadors at the United Nations meet Chance at a dinner party, they quickly leap to wildly inflated assumptions about his linguistic and cultural fluency. No one realizes that in every situation, Chance is completely out of his depth.

Hamilton views this metaphor as a referendum on a given leader (Bush), but I wonder if a deeper message doesn't lie at the base of it.  What reader hasn't at some time related to Chance's defense mechanism, feigning understanding in a meeting, nodding despite confusion, in the face of the fear of being discovered as shallow or unprepared.  Chance's success is intertwined with the collective and self-sustained illusion created by those around him.  Shallowness begets shallowness, as it were, and in the absence of some complexity to shatter the brittle surface, shallowness succeeds.  This is borne out in Being There by the character of Doctor Allenby, who eventually discovers the inadvertent artifice in Chance (and who Hamilton conveniently omits from her discussion).  Faced with disclosing the fraud to the wealthy king maker, Rand, Allenby instead remains silent, understanding, perhaps, that the crushing realization may be too much for the enthralled patriarch to endure.  From the film:

Allenby:  Ben, I want to talk to you about Chauncey.

Rand (smiles):  Oh, yes- Chauncey- you know, Robert- there's something about him that I trust- he makes me feel good.  Since he's been around, the thought of dying has been much easier for me.

Allenby is silent and thoughtful.

This, coming in the final act of the film, suggests to me that the real indictment belongs not attached to a blind distaste for a given elected official (I see in many, even all public officials shades of Chance), but in the difficult self-realization that we are all afraid of being Chance, and that the Doctor Allenby in us will likely keep quiet in the face of this collective fear.  To do otherwise in the face of public opinion, and fear of being exposed as shallow, would be to face ridicule and even ruin.  Whistleblowers historically fare quite badly in our culture.  It is this instinct that permits Chance's (and by extension banality's) quick rise.

What will be the fate of a culture that celebrates blank slates with a penchant for easily translated image and heaps ruinous scorn on the complex and difficult to describe who have the gaul to profit by their pursuit of complexity and truth over simplicity and form?

Dudly:  But what do we know of the man? Nothing!  We have no inkling of his past!

Nelson:  Correct, and that is an asset. A man's past can cripple him, his background turns into a swamp and invites scrutiny.

Caldwell:  Up to this time, he hasn't said anything that could be used against him.

Thursday, June 21, 2007

Securities (non) Valuation

the good old days A hedge fund junkie and devoted Going Private reader asks this morning after some rather philosophical nuances of market dynamics.  Is pricing information in an auction meaningful if nothing is sold?  (I would think so, but perhaps I am a minority here).  The context, of course, is the Bear Stearns sub-prime story that I have beaten nearly to death in these pages already.  The Wall Street Journal gives us this morning's local color on the subject.

J.P. Morgan Chase & Co., a lender to Bear's hedge funds, was scheduled to begin an afternoon auction of collateral it held from the Bear fund, mainly mortgage-backed debt. Minutes before the sales were to begin, the firm pulled back. Later, J.P. Morgan came to terms with Bear to eliminate its exposure to Bear's troubled hedge funds, said a person briefed on the matter. Some traders said the bank might have been forced to settle with Bear because the loans it had put up for sale would have fetched so little in the market.


Merrill also planned to sell collateral and stopped negotiating with Bear, according to a person familiar with the matter. Due to the mortgage market's restless state, some of the early prices bandied about for Merrill's assets were relatively low.

This brings up some interesting questions: What exactly does a "reserve price" mean in a forced auction of securities made to satisfy margin calls?  If, in fact, JP Morgan, was not able to meet its "reserve price" in the auction and therefore held the collateral instead what does this imply for the securities in question?  How does one now mark them to market.  At the reserve price?  At the highest non-accepted bid?

Clearly, there is some pricing information here, but it is obviously not beneficial for any of the parties involved to let that signal leak out if it is so low that it is likely to be damaging- and this seems to be the case.  This brings up another fuzzy issue (there seem so many of these in this story).  What amount of Bear's outstanding margin debt must Merrill or JP Morgan consider satisfied in such a case?  The highest non-accepted bid?  Some other amount?  Will JP Morgan just decide what amount the collateral is worth now?  Based on what formula?  Will they just put the collateral in the books at some invented level?  How will the amount the collateral is marked to market with relate to the margin satisfaction number?  Or will it be related at all?  After all, if JP Morgan takes the collateral and then discharges $200 million in Bear margin debt then hasn't a sale for $200 million taken place?  Will the collateral go on the books at this price?  (Want to take bets?)

Another email and a phone call this morning hint at the rumor that the bids on Merrill's forced collateral sale of Bear assets also resulted in prices so low that the auction was halted.  It is difficult not to be skeptical of the sudden re-negotiation with Bear these firms seem to have joined.

The implication here (and this is, of course, rank speculation) is that these firms are terrified of allowing any legitimate pricing information to leak out to the market.  Why not?  Why not hang onto the stuff and repackage or resecuritize it?  Bundle it with some higher rated instruments and pay (read: cajole) a rating agency to AAA it (I love using "AAA" as a verb- "Triple-A it!"  Try it with your friends) and pawn the same toxins off to the greater fools of the world.

What is the take-away here?  Who is the final authority on the value of these assets, a critical piece of data to price similar toxins in the rest of the market?  Is it acceptable to ignore- nay- actively conceal pricing information?  Who will force realistic disclosure here?  The Board of Directors?  The SEC?  Bank regulators?

Thursday, June 28, 2007

The Crime of Losses

there ought to be a law Today's Wall Street Journal has what I think might be one of the more elegant summaries of the market system's ebb and flow (with a focus on our favorite hand-wringing crisis of late, Bear Stearns).  The bemused surprise that would formerly accompany a free lunch has turned into something like annoyed restlessness.  Today, a free lunch is received with a look that says "what took you so long and where is desert?"  Return is expected without the attendant risks.  Enron employees screaming that they have been defrauded because they left their entire retirement savings concentrated in Enron stock.  U.S. consumers calling for price gouging prosecutions because gas is "expensive."  (They should try driving in Europe).  Or, as the Journal's OpEd more sagely puts it (subscription required):

Financial bets gone wrong are not a crime. In fact, they are essential. Financial innovation has been a great boon to the American economy, but innovation entails risk, and risk means the potential for failure. The key point is that, when financial players step out too far on the risk curve in order to earn larger rewards, they are then allowed to suffer the requisite market penalties for reckless driving.

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