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Monday, July 09, 2007

The Wages of Fairness (Jealousy)

we'll just need a blood sample, senator The Economist pens a typically astute article on the state of private equity, one part of several explorations into the field that make up a survey of the industry (and grace the cover of this week's issue).  The erudite Going Private reader will wince at the Economist's call for "reform" of the partnership taxation structure (rightly reasoning that triple taxation and/or any reform that discourages liquidity in the financial system is a bad thing and, further, that we should be on a flat tax anyhow) but the rest of the article presents mostly a balanced take on the industry, with a focus on the matters that should really be important.  (Hint, "fairness," is not among them).  To wit:

Takeovers, whether by private or public companies, tend to lead to redundancies and cost cuts. In the longer run, private equity makes money from investing in a business, because a thriving company is worth more than an ailing one. Studies in Britain suggest that over time buy-outs add jobs rather than cutting them, and, in America, that buy-outs that rejoin the stockmarket perform better than other new issues.

That would not be surprising, because of the weakness of public markets that private equity has pointed up. Since managers and boards of public companies are spending other people's cash, they sometimes do so wastefully. That is why public-company shareholders put a lot of effort into monitoring managers and boards, who, even then, can be hard to control without resorting to boardroom coups and confrontation.

Sometimes shareholders cause trouble. They often make conflicting demands that managers must struggle to reconcile. Institutional investors tend to insist on instant performance, because their funds are judged on that quarter's returns—which undermines criticism of private equity's short-termism. The threat of shareholder lawsuits and the regulation of the public markets have added to the distracting burden of compliance and to enterprise-sapping bureaucracy. Because private-equity managers answer to a single shareholder, they have clear instructions and can spend more time creating a business with a healthy future.

At the same time as providing a critique of the equity markets, private equity has helped turn illiquid bank-dominated debt markets into highways for delivering cheap credit. It has shown that debt can finance takeovers on an unimagined scale and in industries, including finance and technology, once thought beyond its scope.

And of the industry's future, and the proclivities of its critics?

But it is also possible that the weather is turning and the debt that powers private equity's siege engines is starting—just starting, mind you—to become harder to scrape together. It may not happen this month, perhaps not even this year, but sooner or later the private-equity boom will come to an end.

This possibility will delight private equity's many critics. Private equity is routinely charged with all sorts of iniquity.

A quick look at the current state of legislative demeanor (in this case courtesy of Bloomberg) reminds us of the irrationality implicit in the stance of "private equity's many critics."  Consider:

Congressional leaders are swarming like a school of piranhas around some of the most successful U.S. businesses. The work of two Nobel Prize-winning economists suggests that these efforts will be profoundly damaging to the long-run health of our economy.

Years ago, Congress set rules for private-equity firms and oil companies to play by. Under those rules, these firms took risks and profited handsomely. Now that the profits are in, Congress is targeting them with specific taxes designed to take back the winnings.

The measures are almost comical. Back in 2004, Congress decided to encourage domestic output and enhance our competitiveness by granting companies that produce goods in the U.S. a lower tax rate on most items. Many companies saw their rate on items that qualified under the new policy drop to 32.9 percent this year from 35 percent then. This lower rate applied to oil industry profits, as well.

As Alan Viard, my colleague at the American Enterprise Institute, has noted, Congress, ever worried about appearances, exempted pornographers from the rate reduction back in 2004. This year, the lawmakers are trying to exempt oil companies, too, perhaps on the theory that oil profits, like videos depicting sexual acts, are obscene.

Why attack profitable businesses that, on the whole, create value?  In this connection, it was hard not to wonder if The Economist's inclusion nearby of another article on ultimatum games isn't a subtle statement in and of itself.  Says that piece:

Psychologists have known for a long time that economists are wrong. Most economists—at least, those of the classical persuasion—believe that any financial gain, however small, is worth having. But psychologists know this is not true. They know because of the ultimatum game, the outcome of which is often the rejection of free money.

In this game, one player divides a pot of money between himself and another. The other then chooses whether to accept the offer. If he rejects it, neither player benefits. And despite the instincts of classical economics, a stingy offer (one that is less than about a quarter of the total) is, indeed, usually rejected. The question is, why?

The piece goes on to point out that the advantage to rejecting a "stingy" offer (which should probably be labeled "unfair" for the purposes of our discussion here) is better understood in an evolutionary context that selects for long-term relationships.  When multiple rounds of the game are played and reputational capital can be amassed (or lost) the long-term benefit to taking a hard line and establishing a reputation for enforcing against "unfair" offers is significant.  What, then, of "one-off" games, with no reputational benefit?  That is, no consequences for the stingy offering party in the long-term?

...when one-off ultimatum games are played by trained economists, who know all this, they do tend to accept stingy offers more often than other people would.  But even they have their limits.

What accounts for the limits?  A free dollar is still a free dollar even if the other participant takes the other $99.  No?  We are not kept in suspense:

As he describes in the Proceedings of the Royal Society, the responders who rejected a low final offer had an average testosterone level more than 50% higher than the average of those who accepted. Five of the seven men with the highest testosterone levels in the study rejected a $5 ultimate offer [the lowest] but only one of the 19 others made the same decision.

What Dr Burnham's result supports is a much deeper rejection of the tenets of classical economics than one based on a slight mis-evolution of negotiating skills. It backs the idea that what people really strive for is relative rather than absolute prosperity. They would rather accept less themselves than see a rival get ahead. That is likely to be particularly true in individuals with high testosterone levels, since that hormone is correlated with social dominance in many species.

Taken in this context, the irrationality of the particular (and large) demographic of private equity's Schadenfreude (and champions of "fairness" everywhere- read: "income equality" mouthpieces) may be understood to be suffering from the uncorrected, regressive artifacts of evolutionary biology.

This little bit of irrationality, particularly given the hormonal connection, would understandably be more prevalent in political leaders, these being, more likely than not, selected for what The Economist politely calls "social dominance."

This explanation also enjoys the support of another peculiarity of the Burnham experiment, namely that legislating such things looks a lot like a single round ultimatum game- one with few if any long-term consequences.  Specifically, because legislators face few (if any) real consequences from their "stingy" dividing of the pie.  Perhaps they might not later enjoy the financial-political support of the private equity folk (as if any legislators with such dispositions actually ever had a hint of said support), but that loss would likely be more than drowned out by the deafening applause from union and related populist groups- themselves pleased that "fairness" has been restored (read: they too lack any immediate consequences related to being stingy).  There might even turn out to be an incentive for "stingy" dividing in this connection, given the demographic of each group's supporters.  Perhaps even positive selection for anti-business politicos.

Of course, private equity heads may well be selected for their social dominance too.  But here, given the rather direct and immediate negative reinforcement of their returns, it seems less likely that irrational economic decisions are the norm among this set, or that individuals predisposed to irrational economic decisions (whatever their testosterone levels) would tend to rise to the top of the profession.

To the extent these levels result in irrational decision making at the expense of producing actors in the economy, perhaps we should actually be testing political candidates for testosterone levels.  These figures could be shown as a percentage of the general population's level and superimposed under each candidate during the debates, or perhaps posted on the ballot next to the candidate's name.  This might have the unfortunate side effect of electing certain female candidates for president owing to their low testosterone levels.  Then again, in coming to that conclusion I suppose that I am making some assumptions about the testosterone levels of certain female candidates for president.

Tuesday, July 10, 2007

Cash Flow Analysis

clink! It is a recurring theme here on Going Private (and more often in my responses to reader mail) that the risk-return calculation for actually writing on the blog is, shall we say, suboptimal.  There is some non-zero probability that the blog will get me fired.  It is quite a bit of work to write and the market for the scarce resource of my time is (at least at present) highly competitive.  No revenue from ads (which I am simply opposed to as I'm not in this "for the money," because I think ads are plain ugly on blogs, and I believe them a distraction to readers who should be focused on the content, not some statistically improbable phrase matching algorithm's idea of what is related to the content) makes it into my purse.

Thus far, the only benefits have been the occasional kudos of favorable reader mail and the cathartic effect of writing about my views and experiences in this industry.  In reality, this is enough.  Be this as it may, I have been inspired by Abnormal Returns' addition of a "tip jar" to include my own- more as an experiment than anything else.  (As they started the trend, please go there and donate before sending me anything).  Proceeds will be used to defer the cost of the Typepad subscription that keeps Going Private "out in the open."  Perhaps, if you feel you got something unduly useful out of Going Private, you will consider clinking the jar.

Thursday, July 12, 2007


Wisd Senior Hedge Fund Executive:  "Any boom has crevices for the cockroaches of capitalism to hide in."

Friday, July 27, 2007

Grace Under Pressure

innuendo The Debt Bitch is relaying the narrative of yet another filthy evening of hedonistic pleasures of the flesh.  That is, she's describing discussions with "that cute blond guy" from a smaller hedge fund that has been selling us debt.  I'm in my New York office getting ready for a trip to Chicago to negotiate price on a ~$750 million acquisition, "Project Facade."  It is my first full project since the accident, which is both a nice and an annoying thing.  Mostly annoying because I am reminded just how much I dislike London.

"We are sitting on that little platform bar-lounge or whatever the hell it is at the Peninsula.  That was his idea.  I hate that place.  There's this one call girl that haunts the bar doing crossword puzzles.  She looks like she's a graduate student or something and I guess her little story is that she's in town and really bored and doesn't know anyone and these suckers twice her age drift over and next thing you know....  But seriously, who does crossword puzzles in a hotel bar but a hooker?"  I usually don't interrupt Laura when she's on a roll like this, but I can't help myself.

"You mean to tell me that you aren't a debt whore?  I mean, certainly you don't put out for anything less than 25 basis points, but still."

"Duh, of course I am.  Didn't I just say I hate the Peninsula?  I guess I should be doing Sudoku instead of crosswords, like a good little finance whore, right?  Anyhow, that's not the point."  I don't understand this, because, at least to me, the point of any discussion with Laura relates to sex and money (not necessarily in that order).  It is only short steps from that, dear readers, to discussions of prostitution (or quasi-prostitution).

"So we are going back and forth with witty finance banter, you know?"  When the Debt Bitch says "witty" she means "laden with sexual innuendo."

"Like where I say that my model is thirsting for his inputs, and he says that he would be happy to have his massive interest rate figure entered into the appropriate box, and I point out that I'd actually prefer a smaller figure, as the model might not be able to take a large one- and by the way that's the reason I'm talking to him and not the guys from Golden Tree, and he says that the Golden Tree people are likely to slip the figure into the wrong cell... you know, really witty finance banter."  Laura has a high opinion of a few of the Golden Tree guys, but it is not clear to me if it is related to their financial prowess or some other measure.

"Anyhow, then I point out that I have a date later and we have to wrap things up and he gets all pissy with me.  He tells me that really they aren't doing any new deals at all.  That they pretty much have put the breaks on everything.  Of course, I'm pissed off because what the hell am I meeting with him for if it is not to broker a deal?"  For a split second I think maybe I should point out that her quarry was highly unlikely to expect to broker a deal at the Peninsula at 9:30 pm and refer back to our prostitution discussion but, thankfully, it occurs to me that Laura doesn't distinguish between debt and sex.

"So that's become the story everywhere.  I mean it's not that we can get debt so long as we pay more, almost no one is actually issuing any.  I mean any.  Lots of firms have standstills.  Total standstills."  Suddenly, what was an amusing tale of non-sex becomes an alarming warning.

"Well, I can see how the larger debt issuances might be an issue, but how much were you trying to score?" I ask.

"I wasn't trying to score.  He's cute, but not that cute."

"Bad choice of words.  How much debt?"

"Oh, that was for Project Yonkers, so $450 million?"  Now I am more alarmed.  "You can't get anyone to pick up $450 million?"

"Well, I haven't tried everyone yet, but I've never gone 48 hours without even getting a term sheet before."  I am stunned.  Laura is bored.

"You know, I think maybe it's time I let that guy from CIT cop a feel again.  I think the issue is that these small hedge funds can't lay off the risk to CLOs anymore.  The CLO market is thin and I suspect that a lot of these smaller hedge funds that had gotten into the buyout debt business did so in a very haphazard and 'me-too' sort of way and they had become just pass-through entities for debt, dumping it as quickly as they could into some CLO or another.  It is a measure, I think, of the spinal deficiency of these little hedge funds.  They were only interested in buyout risk so long as they could dump it quickly.  They weren't really in the business.  But, hey, that was fine with me so long as we were dealing with a small asset recovery team.  Those guys were never going to want to take the keys from us.  And we got tons of concessions from them in exchange for waiving the restrictions on debt transferability.  It didn't take me long to figure out that holding that transferability hostage was a huge chip we held since they were shoving stuff at CLOs as fast as they could."  I am barely listening, still trying to absorb what it means for Sub Rosa that we can't get anyone to write debt for us.

"Anyhow, this will go on for a few days.  The smaller funds will probably not be able to keep doing lead deals, but they will jump into some secondary stuff.  And what's the worst that can happen?  We go back to the banks that we used to deal with before these pussy little hedge dilettantes showed up.  Rates will go up, but they will write the business eventually.  Then, with more expensive debt, all these little body shop brass-plate LBO firms that keep fucking up the auctions can die on the vine, and maybe we can finally stop buying this overpriced crap and do deals that make real financial sense."

"What about the two open deals we have floating right now?"  I ask, trying to hide the panic in my voice.  I can just about hear the grin on Laura's face.

"Silly, silly girl, I've been writing in 5% and 6% reverse break-up fees plus legal costs into these debt deals for the last 9 months."

[Art credit: Isaac Cruikshank, "Female Opinions on Military Tactics" (engraving) c. 1795.  Caption: Young Soldier: "This, Miss, is what we call the Cock -- and this is the Swell." Young Woman: "Well, I never knew so much of a Musket before -- how I should like to marry a soldier!"]

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