Going Private

Warm Blogs, Warm Bodies

Aleablog is a new found favorite, unsurprisingly introduced to me, repeatedly since I started blogging, by the always yummy Abnormal Returns.  And, I suppose, this marks a good point, at the risk of being accused of pandering, to tell an Abnormal Returns story.  As long-time Going Private readers might imagine, in person I am quite jealous of the online financial resources I read and cite here, lest my sharing them with a co-worker lead them by reciprocated hyperlink to my online abode here and present the beneficiaries of my link-generosity with familiar narratives that put the pieces together and lead to awkward questions in the halls of Sub Rosa.  I occasionally break this rule with Laura, "The Debt Bitch," but I have my reasons.  First, because she wouldn't really care.  Second, because she can keep a secret- if only because I have far more dirt on her than she on me.  Third, because she would probably enjoy the blog.  In any event, I (foolishly perhaps) introduced her to Abnormal Returns.  As such, dear readers, you will be able to draw your own conclusions, based on what you know of The Debt Bitch, and Abnormal Returns, from the email reproduced below:

From: Laura The Debt Bitch
To: Equity Private
Subject: Re: Abnormal Returns

Well, fuck me in a suit!

Where did you find this?  Who writes it?  A guy?  Do you know him?  Is it wrong that I fantasize about laying naked across his warm, boxer-brief clad body, listening to him breathe as he completes a linkfest on yield curves and ETFs in a king-size bed illuminated only by the backlit LCD screen and the muted flat panel display on the wall facing the foot of the bed?  I kind of picture him as a ThinkPad guy, but I suppose a MacBook could be in the cards too.  'ThinkPad / Think Different' those are pretty close right?  So my fantasy, that's just kind of sick, right?  And, yes, boxer briefs.  Boxers don't show anything worth looking at and briefs just make me think of French-Canadians in Speedos.  Yuck.  He's not French-Canadian, is he?

Is he married?

>Equity Private  wrote:
>
>You should really take a look at Abnormal Returns.  Trust me.  It's you.
>
>http://abnormalreturns.com

Of course, I ignored her email.  What reply could I send that would have any upside?

This as a rather indirect way to point out that Aleablog is a digital venue after my own heart.  Seriously, how could I not be enraptured with an outlet that highlights the propensity of human systems to be gamed (a subject very much after my own heart)?  And cites no less than Charlie Munger (256kB .pdf) to do it?

I wonder if it's one guy who writes the whole blog?

What do you think I would look like laying naked across his warm, boxer-brief clad body, listening to him breathe as he completes a piece on asymmetric information and abnormal returns in a king-size bed illuminated only by the backlit LCD screen and the muted flat panel display on the wall facing the foot of the bed?

Honesty Is Not the Best Policy

"All information submitted to BigMoneyJobs.com via this Web site shall be deemed and remain the property of BigMoneyJobs.com and BigMoneyJobs.com shall be free to use, for any purpose, any idea, concepts, know-how or techniques contained in information a visitor to this Web site provides BigMoneyJobs.com through this Web site. BigMoneyJobs.com shall not be subject to any obligations of confidentiality regarding submitted information except as agreed by the BigMoneyJobs.com entity having the direct client relationship or as otherwise specifically agreed or required by law. Nothing contained herein shall be construed as limiting or reducing BigMoneyJobs.com responsibilities and obligations to clients in accordance with BigMoneyJobs.com Privacy Policy."

On Sun, 03 Feb 2008 05:25:35 -0800 Richard Smith <[email protected]> wrote:

Hi Equity, DO you want this Perm Job in Hauppauge, Long Island, IF Yes, send me your resue now for Interview.

I can get you an interview for this job, please respond with resume to submit now.

What kind of base $$ you making now and seeking - Please advise. Respond with a resume to submit.

I will submit your response and resume to the client for an interview, I need this ASAP!

Call me to discuss.

Richard Smith
Director, BMJ National Staffing
[email protected]
tel: 516 569 3428
Top Jobs for TOP PEOPLE

----
Title: Sales Engineer

Location: Hauppauge, NY

Salary is OPEN - (Let me know what your making now and expecting)

Position Summary

This position is responsible for the maintenance and growth of the existing customer base as well as the development of new accounts in a designated territory.

The majority of duties are performed from the Hauppauge, NY, headquarters location in conjunction with outside manufacturers' representatives and distributors within the assigned territory.

Key Position Responsibilities

Contacts existing and prospective end customers in assigned territory by telephone to grow and maintain sales.  Works with design and component engineers to design discrete semiconductor products into end customer applications.

Works with independent field representatives by telephone and in person to deepen penetration at existing accounts and to develop new account engagements.

From:  Equity Private <[email protected]>
To:  Richard Smith <[email protected]>
Date:  Mon, 04 Feb 2008 23:00:39 -0800

Gee, wizz!  That sounds great!  My resume is available for download here:

http://equityprivate.typepad.com/ep/epresume.pdf

From:  Richard Smith <[email protected]>
To:  'Equity Private' <[email protected]>
Date:  Tue, 05 Feb 2008 06:43:39 -0800

I do have many other $$$ jobs for you on my website.

You have a nice resume, I want to work with you.
You Match a lot of Jobs we have open, let me run a job search for you.

First, post your resume into my database, www.BigMoneyJobs.com

Then apply to any posted job you want and we will call you to set-up
Interviews.
Richard Smith

www.BigMoneyJobs.com - Post resume here!   

Richard Smith
Director, BMJ National Staffing
[email protected]
tel: 516 569 3428

www.BigMoneyJobs.com
"Top Jobs for Top People"

From:  Richard Smith <[email protected]>
To:  'Equity Private' <[email protected]>
Date:  Tue, 05 Feb 2008 06:58:03 -0800

I can't submit you - your resume makes you seem like you have too much
emotional baggage and still not ready exist at any new firm.

Truer words words were never said.

We like your exp and work history and able to submit you if we get anther
resume.

Richard.

Debt Bitches, LPs and the FBI

Two of the guys from one of our limited partners are always floating around the offices at the beginning of a new quarter.  I feel like they always show up a few days after our investor letter goes out.  I haven't watched too carefully, but I suspect that if I started sampling data I would find that they start with the girl who runs investor relations, before drifting into the office of one of the more senior partners.  I don't need to do any more sampling with respect to where they end up.  That's easy because I've seen it almost half a dozen times.  They end up orbiting around or sitting in Laura the Debt Bitch's office.

"Fitz and Sam," as I will call them, always seem to arrive around 3:30 or 4:00, and their pre-Debt Bitch business seems to occupy them for about an hour or 90 minutes.  Of course, this puts them right in the zone for the quick afterthought of a watch-check and the kind of "subtle" hint drop that sounds something like, "Hey, Laura, we are headed out for an early drink.  Care to join us?"  Of course, and despite the fact that she typically works until at least 7:00 (or if she leaves earlier than that it is to stroke percentage points out of one or another debt provider over martinis) she normally takes them up on their offer.

On this last occasion I happened to be sitting in Laura's office when the drink solicitors dropped by.  They drifted past Laura's office slowly, careful not to look, paused briefly almost totally past her office, as if to consult each other on something totally unrelated in any way to the fact that they were, actually, mostly standing outside Laura's office, and then, as if on cue, Fitz checked his watch.

"Oh boy," The Debt Bitch chimed in.  "Here we go."

"What's that?" I asked.  My back was to her office window, and though I could see their ethereal and substance-less forms framed in translucent reflection on the surface of The Debt Bitch's external window, I pretended not to notice.  I didn't really want Laura to know I paid this much attention to the likes of Fitz and Sam.

"Frick and Frack are about to ask us to head out for a drink," she didn't even look up from the white legal pad she was scratching out "to do" items on.

Laura uses a ruler and a black, extra fine Uniball pen to draw perfect strikethrough lines through the to-do list items she keeps on a running legal pad- white 8.5" x 14", dated at the top of each sheet and not a single sheet torn off.  Instead, she folds them back behind the pad and holds the old sheets there with a binder clip.  Once I asked her why she kept them all she replied, "If any of those fuckers try to fire me for incompetence or related bullshit then I have quite a compelling bunch of exhibits to fuck them right back in court with." Makes all the sense in the world when you hear it that way and remember the mantra "Don't fuck with the Debt Bitch."  Still, the pads seem sort of strange, until you see a completed to-do list.  Very methodically filled with to-do items eviscerated with the brutal finality of a perfectly drawn strikethrough gutting them from crotch to head.  Very satisfying.  All that remains is a neatly un-struckthrough date of completion next to each item.  I suspect if she could, and though it might finally trigger the fifth indicator in the "If your employee exhibits any five of these ten symptoms of mental collapse, call the New York Police SWAT team immediately"-list that some human resources professional is doubtlessly checking Laura against on a regular basis, The Debt Bitch would use a straight razor to kill her to-do items.

"They never ask me anywhere, thank god." I point out.

"Oh, they will now."

"Why would they bother?"  Really, this is an honest and un-self deprecating question when I ask it.  I just consider myself beneath their notice (because they are mostly beneath mine).  If they were in the habit of hitting on anyone else besides The Debt Bitch I probably wouldn't even know they exist.

"Because you are sitting in my office.  They will rightly conclude that they have to ask us both out if they ask me out or I will think them rude.  Plus, there are two of them.  One or the other one, probably Frack (she means Sam) will glom onto you because he is tired of losing me to Frick's more engaging conversation on every outing." Laura is barely done getting this sentence out of her mouth before they make their move.  I watch their thin reflections look at each other, suddenly seem to "notice," they are standing outside of Laura's office and reach for her door to knock.  Laura waves them in with a sigh that only I can hear and that happens to be the precursor to the little chirp of surprise she emanates like some pleasantly startled cat suddenly away and happy to see you after a long absence.  Of course, she manufactures this chirp expertly, and solely for their benefit.

"Why hello," Fitz offers in return.

"Yes, yes, hello to you too."  She barely contains her annoyance here, a slip to be sure, but she manages to candy coat it with a perfectly delivered bit of plausible, if pompous, sarcasm.  "Have you completed your latest tour of our world-class, alpha inspiring, value creation facilities?"

"Yes... yes... I think... we have."  Listening to anything Fitz says is this kind of breathy, unsure until the last clause of his sentence of what his conclusion will be, sort of pondersome experience.  As if everything before the "we have," was just a very elongated and multi-sylable "hmmmmmmmm."

"You guys are our favorites," Sam beams.  Sam is as plain and afraid of conflict as Fitz is pensive.  One day I will do the research, but I suspect I will find that Sam was one of those analysts back in the "good old days" who had a two-word recommendation vocabulary: "buy" and "strong buy."  You know the one, prone to ask a difficult question on an earnings call but the mere hint of displeasure by the management team in responding to him and he is all apologies and "I see, I see. Yes, of course"'s.  Always looking to see if the company he covers is also an investment banking client.  Spineless and, on top of it all, very guilty about that too.  Ok, so I take it back.  I'm never going to bother to do that research.

"You knooooooooow," Fitz begins, with a hushed tone and a sideways glance in my direction, as if perhaps three kilos of cocaine are about to trade hands in that office but he's not sure if I'm "cool" with it. "We were... sort of... perhaps thinking of heading out... well..." and here a strained look, "...EARLY for a few cocktails."  Again, the last clause, clear as a bell after a long swim through chilled maple syrup. "If... you ladies... would want to...."

The Debt Bitch is in no mood for dalliances.  I don't blame her, we could be here all day.

"Yeah, let's go to the Peninsula."  Again with the Peninsula, I think to myself.  Laura is always taking me there.  I suppose that's not a bad thing.  It's a nice enough spot, pleasant seating and makes for nice conversation.

The four of us are sitting, just after the drinks have arrived and The Debt Bitch has asked for a larger martini.  The waiter just brings another martini and puts the still half-full shaker on the table next to it the second time.

Sam has put a stack of documents from other funds on the smallish table and Laura reaches over and grabs them when the drinks come.  This strikes me as rude, after all, are we supposed to know what other funds our limited is pondering?  Sam looks about ready to protest but Laura has him wrapped around her pinky toe and instead he just sits watching her, helplessly, with his mouth slightly ajar while Laura shamelessly peruses them, chuckling occasionally as if to say "Ha!  You are investing with them?"

She comes to a few colorful leave behinds and holds them up for us all to see.  They are from a fund with a rather elemental name that astute Going Private readers certainly would recognize.  But that's not what is amusing.  What is amusing is that they are laminated.

Everyone looks at her before Fitz chimes in.

"Yeah... that... it is... sort of... well... unusual... that they would be laminated."

Laura laughs out loud.  "You dolts.  You don't get the subtext?" Everyone looks dumbfounded.  I do my best to just look impassive and cover myself by starting to sip my drink.

"You are supposed to be so enthralled by the documents and so enraptured by all the money you are going to make that you can't help but drool and ejaculate all over the paper right on the spot, and then how are you going to give it to the investment committee with your 'recommendation,' so to speak?"

I almost snort my drink right out my nose and onto the table.

Sam looks like one of those effete foils in a Humphrey Bogart film that simply cannot believe you just slapped them and has no idea what to do next and may, in fact, have just forgotten their lines.

Fitz starts an extended "hmmmmmm" that is going exactly nowhere fast and is composed mostly of words like "incredible" "doubtful" "rather not what I expected."

My drink has now reversed course and wants to head down my throat which I am desperately trying to prevent less I descend into a fit of coughing.  Laura gives a cute little snort and with a short little "excuse me," drops the papers on the table, gets her purse and heads in the direction of the ladies room.  I am stuck with Frick and Frack and their stammering or silent disbelief.

After about five minutes I realize that my phone has buzzed me three or four times.  I try to be subtle about looking at my texts but I'm still really concentrating on not coughing up a lung.  It's The Debt Bitch on SMS.

Coming?

Where are you?

Equity?

I can't wait forever.

I type back.  "Where are you?"

"Downstairs, nimrod.  C'mon."

I type back again, "Oh, we didn't know we were leaving."  I am about to ask for the check when I get another SMS from Laura.

"Answer your phone."  I barely finished reading when my phone rings.

"Hello?"

"Oh my god, the FBI just raided the office!"

"The FBI?" I hiss.

"Yes  It's every girl for herself now sweetheart.  Look, I've been wanting to tell you for a long time.  I'm totally in love with you. All the other boys have just been a sad attempt to convince myself and others that I am anything but totally, irrevocably in love and lust with you.  I'm on the 10:15 to the Cayman Islands from JFK.  I have a bag full of money.  Let's go, just you and me."

I am as lame as they come this time.  It took me this long to catch the joke.  I am quiet for a long time before Laura speaks again.

"Wait a minute, did they just hear you say 'The FBI'?"  I look up at Fitz and Sam.  They are both staring right at me, wordlessly, no attempt to conceal the shock on their face.

"Uh huh," I manage.  Laura starts laughing hysterically.  "C'mon you idiot, tell them you have an emergency and let's go do some real drinking."

I stand up with the phone still in my ear.  "Guy, I really have to go."

They both nod in violent agreement.  "Of course.  Of course."

I am such an idiot.

There is No Such Thing as a Risk-Free Lunch

The always observant readership of Going Private will have little difficulty sharing my frustration with prominent public figures who, in their often dangerous zeal to fulfill the promise of Lake Wobegon for all their constituents, somehow believe that they can fundamentally alter or suspend the laws of mathematics, obtain return with no risk and otherwise lower the expense of daily endeavors by merely legislating that it should be so.  Of course, these efforts center around a particular type of moral hazard, namely, short-term political gain funded via the issuance of a big bond with a brutally compounding PIK tier and denominated in units of "later economic disaster."  The hitch is that the debtors end up being someone other than the issuer.  Examples, of course, abound, wherever public officials seek to deliver the long-term-impossible in the short-term.  The most charitable interpretation of these goings on is that public officials are daft.  I suspect the more likely reality is that some subset are quite cunning.

The 1996 California power markets, wherein a combination of fixed retail prices (below cost in some instances) to consumers, floating wholesale prices with resort to the spot market to resolve supply shortages, and strong disincentives to create more generation capacity, permitted our resident economic disaster bond issuers to promise (and for a time deliver) absurdly low electricity costs to the left coast population (who had grown quite endeared with low prices, to the point of badly abusing anyone who failed to keep them that way) for years.  These prices were, of course, often funded by utility bonds during the "transition period" to "free markets" (or the left coast equivalent anyhow) meaning the costs weren't really "low," they were just concealed in taxpayer funded municipal bonds and the like.

I suspect, dear reader, that you might already be aware of how annoyed I am with the word "fair."  This might be a good opportunity to introduce another one of my least favorites: "affordable."  This one particularly annoys me when "affordable" actually means "distribute costs to the productive class via cost-laundering them into the tax base."  It gets even more irritating when it means that compounded interest is added to the bill.

And once such a system is in place, surprise, horror, oh woe indeed, when, bound to service customers, power providers are forced into the spot market for electricity to make up shortfalls (helped along by the awfully convenient maintenance outages among some plants, but that's another issue).

Of course, because of the price capping, market actors happily bought up price-capped electricity in California from an impossibly naive market system (designed in the French tradition) to export to real markets where prices actually reflected reality.  This had the effect of decreasing even further the already problematic supply in California.  Wholesale prices quickly outstripped retail prices, an amusing turn of events, that is, if you aren't one of the debtors listed on the economic disaster bond that, day by day, grows ever closer to maturing.

Astute Going Private readers might be expected to have the same reaction of annoyance to this logic chain:

1.  Health care prices are so high they border on un-affordable.
2.  Everyone has a right to world-class (not merely sufficient) health care.
3.  Since boundless health care is so expensive, and everyone has a right to the best, we are going to make it free for everyone.

More sophisticated versions of this basic yarn might alter the pitch somewhat by changing the "right" asserted to an inalienable right to (cheap) insurance.  This is an improvement in so far as it introduces some risk pricing mechanism.  Unfortunately, it is hard to imagine that premiums will actually be risk based in a system where the goal is "universal coverage."  How can they be?  I have mused on what an old Lloyd's of London broker might have thought of the idea of insurance as a "right."  (Predictably, Ben Stein was involved).  Needless to say, I see a big bond issue on the horizon, dear readers.

Readers might recognize my continued attentions to these kinds of things in the Going Private category "Thermodynamics."  Sufficiently carnivorous readers will already be wondering what information asymmetries and market flaws may be lurking underneath such poli-economic moral hazards, and how to take advantage of them.  Fear not, there are many.  By virtue of an odd confluence of events, one in particular has caught my attention.

One of the chief properties of these pseudo-market delusions is the conviction that the inevitable is preventable, and that, if not, it should be cheap to insure against.  No one should stand in the way of every citizen's god given right to build on a 100 year flood plane (5.2 MB .pdf) (with cheap insurance, of course).  In this connection, catastrophe risk has become a pet project of mine.  Particularly where public officials get involved.

No story of improper risk pricing would be complete without a government funded buffer fund to soak up undesirable pricing signals that might actually reflect risk.  In the case of Florida, the Florida Hurricane Catastrophe Fund is the central character cut from this cloth.  In fact, it fits the bill perfectly.  The FHCF is a political animal, subject to the whims of legislators and their annoyingly short-term, populist aspirations.  This is a problem insofar as it provides artificially cheap re-insurance to the Florida market to keep insurers either from fleeing a circumstance where risk pricing is impossible, or quoting prices substantial enough to (gasp) prevent people from building in a spot where hurricanes are a (relatively) common occurrence.  This all, of course, assumes that insurers will pass the savings on, and it is not at all clear they would.

Barely a year goes by at the FHCF without some arbitrary tinkering, and major revamps in the nature and costs of coverage are not infrequent.  The impact is severe.  One market participant pointed out to me that premiums bounce wildly in response to, for instance, a 3000 basis point change in reinsurance costs as legislative whims either permit or forbid a given insurer from taking advantage of the program's rates.  Says this commentator: "I'm not surprised Florida homeowners feel like they are being jerked around with their premiums- they are."

One might be tempted to assign a high degree of confidence to such a fund, particularly given the level of public trust tied up in the confidence investors, insurers and homeowners have in the entity.  Such a temptation would most certainly require an upstream battle against the formidable currents of historical experience.  "Smart money," is not fooled.  Many market participants discount recoveries from the FHCF by more than 12%.  This snapshot balance sheet might shed some light on the deeper issues.  Those who suspect this kind of a discount reflects the fear that there is something more than a vanishingly small risk that the FHCF won't be able to meet the such obligations to insurers as it has assumed, might be on to something.  Never fear, dear readers, for Florida municipal bonds will be used to bolster the FHCF's obligations in the event of any concerns.  What kind of confidence will Florida municipal bonds enjoy in such an eventuality?  Wow, look at the time, how did it get so late?  Well, we have a lot to cover today so let's move on to another topic, shall we?

Let's talk about FHCF's premiums, yes?  That seems a safe topic.  I suppose we should avoid in our discussions those premiums rates that fail to cover even the historical losses.  I suppose we might also be better off leaving aside for a moment the fact that the FHCF tends to compute risks for the purposes of pegging premiums against the last calendar year of hurricane losses.  Bit of a limited sample size, no?  Luckily, 2006 and 2007 were boring years so reinsurers will enjoy minimal premiums for the next year to come.  Says one commentator I corresponded with: "The FHCF isn't even matching their losses one for one, much less factoring in a risk premium, operating costs, or the like. If a reinsurer charged such rates, their investors would have them murdered."

In essence, Florida is short Hurricanes, short the industry risk models, short the historical loss records, and long their credit worthiness.

These risk models bear some scrutiny as a general matter, perhaps.  Many reinsurers use their own models, or at least claim to, but three industry models tend to predominate, or at least represent the "baseline" risk model the industry seems to hinge on.  RiskLink, Clasic/2 and WorldCat.

The basic division in modeling philosophies seems to fall into one of two buckets.

1.  Frequency and intensity of hurricanes are increasing, making reliance on a long-term historical record problematic.  (Cause is sort of beyond this discussion, but it bears mentioning that global warming is not the only potential culprit.  An Atlantic Multidecadal Oscillation (AMO) warm cycle could create the same effect.

2.  Stick with the historical record.

These two differences make for very dramatic differences in loss predictions, as you might imagine.  You might also imagine that a model that results in lower loss predictions than either is either the product of some giant step forward in model accuracy by a quasi-governmental entity, or folly.  I suspect Going Private readers will have their own guesses on this question.

Oh, I forgot one:

3.  Adopt an average yearly loss model and use sample size n=1 after the two mildest Atlantic hurricane seasons in recent memory.

It is also worth noting that recently, "real" catastrophe models have "missed low" on loss prediction (Wilma, Katrina) with predictable consequences.  So what does it mean when the FHCF isn't even matching loses before the risk premium?

Never fear, dear readers, Citizens Property Insurance Corporation has for many years been the "state run insurer of 'last resort.'"  Well, until 2006.  True, Citizens enjoys significant tax breaks and doesn't bear the burdens of normal, private insurers, but, as of 2007 they have been tapped to be a "competitive player" in the "overpriced markets."  How surprising will it be for the astute Going Private reader to discover that the "wind premium" Citizens charges often doesn't even cover the historical average loss from hurricanes, tornado and hail?  Closer to the coast, Citizen's premiums start to look absurdly low.  One might imagine the impact on any insurer in the Florida market with a reasonable risk model.  (Or at least one that's not insane).  Clearly, they cannot compete with absurdly low premiums driven by major state subsidies and a rather... well... unique approach to risk modeling.

Now consider that Citizens is effectively obligated to offer policies to potential insured that the major private insurers in the market will drop as too risky, and it becomes fairly easy to see that Citizens portfolio is probably highly acidic.  Says one commentator: "Even a severely conservative 100 year storm model would tag Citizens with $10 billion in losses."

The most naive of Going Private readers will be able to construct the basic principles of insurance premium generation.  Premiums should cover all expected losses from all insured risks.  Premiums must at least match payouts over the long term.  Add in operating expenses, risk of ruin margin and you have the beginnings of a premium model.

Coming full circle, it seems clear that Florida either is not possessed of sufficient sophistication to grasp these concepts, or, perhaps more insidiously, someone is (someones are) making a huge bet, realizing short-term political gains by keeping premiums artificially low and hoping to be off and away before the poli-economic disaster bond matures.  This is never more apparent than when watching officials deal with insurers.  Rate increases are denied routinely, rate decreases are often forced, even as they dip below the levels any sane actuary would tolerate.  "Look at all those profits your company is making in Illinois, we aren't going to let you steal from our homeowners here in Florida, I tell you boy-o."

The result is that many insurers in Florida are structuring losses in the property markets and trying to make up the difference with e.g., auto premiums.  It is amusing that the state which "composes over half of the hurricane risk in the United States, somehow believes that its share of premium (which is already far below that), is way too high and unfair."

As one might expect, the major insurers (coincidentally the ones best able to provide stability and reduce volatility) are pulling out of the market.  "Mitigating Florida exposure," has become a required corporate strategy.  As I explored this issue a little bird whispered to me that at least one of the big three is considering removing any Florida exposure whatsoever from their portfolio.  (Similar things have happened in OB/GYN malpractice insurance in some states).

So what if (when) a catastrophe loss is around the corner?  Well, don't worry dear citizens, Florida has a plan composed of several layered defenses to such an unlikely eventuality:

1.  Issue bonds.  (Read: Charge the taxpayers).
2.  Raise taxes and real estate assessments.  (Read: Charge the taxpayers).
3.  Insurance company assessments with consummate cost passthroughs.  (Read: Charge the insurance companies and taxpayers).

Long ago I was privileged enough to take a fascinating graduate class on low intensity conflict and asymmetric warfare.  I still giggle at the optics of that.  Me, at least five years the junior of the next youngest student, sitting in a class filled with Naval Intelligence officers, a pair of FBI agents, these three guys from "SAIC," who never spoke a word beyond "We're from SAIC," some State Department folk and an attorney who specialized in National Security Law.

My favorite part of the class (and a major portion of it) was the discussion of the destabilization of systems and institutions, which eventually took the form of fifteen key goals an irregular actor could employ to cause the most problems for larger and more resourced adversaries. 

Three of these relevant to my discussion here include:

A.  Disrupt basic communications in order to force reliance on more vulnerable channels.
B.  Employ "area denial" strategies to prevent effective operations and require substantial resources for defense.
C.  Make it expensive (literally and politically) for allies (foreign and domestic) to continue their support.

One might think that Florida had waged such a campaign against insurers.

1.  They are unable to use risk pricing models or enjoy the efficiencies of the market because of the stranglehold on rate changes.
2.  They are increasingly priced out of the market both by the rate restrictions and the presence of a subsidized non-market constrained actor having the effect of denying the market to any insurer who wants to actually be profitable.
3.  Relations with major insurers have been so damaged as to make their cooperation in times of difficulty nearly impossible.  (Calling senior insurance executives "vipers," for instance).

I suppose one might call the circumstances in this connection, "interesting."

Mad Dear Disease

I wasn't a believer in the efficacy of "sheer willpower" in a deal-making context, but I may well be prone to alter my skepticism after watching the close of the Intelsat transaction last week- a deal which seemed teetering on the brink of failure on an almost daily basis.  Of course, deals with this kind of debt load (it floats at around 9.3x EBITDA) generally only get done when the underwriting banks feel they can easily lay off the debt to the public (or a set of Qualified Institutional Buyers ("QIB"'s) willing to endure the highs and lows of holding buyout debt bought though a Rule 144a sale.  As an aside, the rise of Rule 144a exchanges has been quite a boon for liquidity with respect to these sorts of debt instruments and, I suspect, has softened the blow to debt markets quite a bit).

In this case, however, the banks didn't even bother going to the street.  Bank of America, Credit Suisse and Morgan Stanley underwrite nearly $5 billion in new debt in the transaction, less than half of the $11 billion of debt that now burdens the weary shoulders of Intelsat.  Interestingly, the old debt holders were, somehow, lured into hanging on to their existing debt to reduce the amount the underwriters would have to float (and burden some debt market or another with) to close the deal.

The Wall Street Journal points out that Clear Channel Communications and BCE are queued up to saturate the debt market with their paper before long, so it's probably more than minor coup that Intelsat's underwriters aren't headed to the street with more than $10 billion in debt to place.  The less than pleasant, but highly entertaining Harrah's debt issue has already pushed the saturation limits, which makes one wonder how long those underwriters will have to hold the debt on their own books.  Maybe quite a while.

Some rather uncivilized behaviors by certain banks (ahem, Credit Suisse) that have gone to market with their share of Harrah's debt before the schedule agreed upon by their fellow underwriters (very bad form, that) will cause the always astute Going Private reader to draw many conclusions about the "desperation quotient" these kind of balance sheet lodestones can create.  This event also generates my favorite debt-related quote of the year so far from a Credit Suisse banker on the subject of front-running their underwriting colleagues:

"There is no contractual obligation.  We cannot concede control over our own capital."

This is interesting as, at least by the numbers, Harrah's is one of the better looking of the large LBOs right now.  $6 billion of equity has kept its debt:equity ratio comparatively low.

This is boring news compared to the sort of antics to be seen over at Clear Channel.  It doesn't take deep psychological analysis to read the internal memo from John Hogan back in January as originating from something resembling panic.  To wit:

From: Hogan, John
Sent: Friday, January 25, 2008 09:31
To: Radio General Managers - All; Radio Business Managers
Cc: Radio EVP's; Radio SVP's ; Radio SVPP; Radio RVP
Subject: First Quarter Contingency Plan

Good Morning,

As you are undoubtedly aware, we are generating less revenue for Q1 than we budgeted and less than what actually ran last year. At the same time, our budgeted expenses for Q1 are up 4%. While there are a number of factors contributing to our revenue shortfall the fact is we are behind on our revenue plan, up over last year on expenses, and as a result we will be well below our budgeted Q1 bcf. As responsible managers, we need to address the shortfall not only by continuing to find ways to increase our revenue but also by implementing cuts on the expense side until revenue production improves.

[...]

The following Q1 expense reductions are to be implemented immediately in your market and correctly reflected to San Antonio by having your Market Controller access the Flash website under Reporting Events and complete the form titled "Q1 Contingency Plan"

[...]

-any/all discretionary monies (i.e. travel, meals and entertainment, etc) for your market. If you can save it, do so.

[...]

I completely understand the challenges associated with implementing the above cuts. It will make your job more difficult and have some long term affect (sic) on your overall performance. It goes without saying that leading through these reductions will be challenging. If there were another better alternative, we would not be requiring these reductions be implemented. Unfortunately, there is not another alternative.

Impact on share price once the memo got out (instantly, of course) should be predictable.  (Spoiler below).

Still, add to the distress the fact that the bottleneck in loan markets is quite severe, and the picture looks dim indeed for banks holding CCC and BCE debt with the hopes of unloading it.  Standard and Poor's points out that something like $150 billion in unsyndicated debt sits on the books of various banks, the vast majority of it LBO related.  $0.90 on the dollar is a gift for many of these instruments at this point.

It resembles the sort of thing we started to see back in January.  Or as the Journal put it more specifically:

With the prices of existing loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do.

The result: More assets building up on bank balance sheets, growing tensions among rival bankers who had grown accustomed during the buyout boom to cooperating with each other and a deepening crisis in the market for buyout debt.

The crisis started last summer, when investors turned up their noses at billions of dollars in buyout debt, just after many buyout firms and their bankers made commitments to history-making megadeals. Many investors say January was the worst performance for this market since those summer months.

And this is why it is difficult not to let out a low whistle when reading about the Intelsat deal.  And that's before you do any sort of IRR calculation on the figures, which, after a January, 2005 investment of $128 million by Madison Dearborn (with Apax, Apollo, and Permira as co-investors) pulled down $1.2 billion or so for Mad Dear with the purchase of Intelsat by BC Partners, Silver Lake and others for $5 billion.  Add to this about $163 million in various other fees (management fees, probably) and you have a tidy sum.  Assuming those management fees were paid yearly or thereabouts and in equal measure (and this is probably wrong as a large chunk of the fees were likely for "early termination" of the management contract itself, as it's hard to imagine they predicted a liquidity event so soon) and you get figures that look about like this:

Yum.

Outstructuring Outsourcing

I would be surprised to find anyone surprised to learn that outsourcing private equity research and analysis has become a popular business to be in.  There are, of course, differing extremes of the basic business model.  Dump it all as far offshore and at the least cost possible, or, perhaps, retain an on-shore firm disposed to collecting e.g., bright, young ex-McKinsey sorts to run your deeply analytical due diligence.

Of course, the challenge in outsourcing effectively hinges less, I think, on picking the right provider, than structuring the incentives designed to produce the correct combination of quality and cost.  This is, no doubt, much easier when performance is easily measured by quantitative analysis (i.e. average minutes of hold music experienced by irate customer), but even here one must be careful to avoid incentivizing abrupt sign-offs and "pass-the-buck" behavior as individual customer support agents press to shave minutes and seconds off call duration.

An interesting thought exercise for outsourced private equity diligence: If you were an overworked private equity fund needing smart brains attached to bodies to keep up with the deal flow that you are drowning in (let's remember that we are talking about 12 months ago for a moment) how would you design a fee structure for an outsourcing provider?  It would depend, of course, on what kind of diligence you wanted.  Yes?  If it is your capital under management, I suspect you would want doggedly persistent and unrelenting diligence.  I suppose I am assuming you, as a firm, regard diligence as a defensive part of the investment process, rather than a confirming check-the-box exercise, but I think I can be forgiven this optimism.

I would engineer a rather dull, but not ruinous, hourly fee for the work that covered my provider's cost, plus a slim but not insulting margin.  To this I would add two sets of bonuses.  First, a kicker for every issue discovered by my provider that allowed me to bring purchase cost down from the figure in my letter of intent.  Second, a rather larger bonus if my provider unearths irregularities that cause me to exit the deal.  (This would be easy to fund off of someone else's dime with a break-up fee assessed to the seller in such an event).  I suspect my provider would be almost painfully skeptical, which is what I would want.

Leaving behind, for a moment, this fantasy world of aligned interests and prudent investment methodologies, what do you think the actual fee structure model looks like in these firms?

Fee with a major discount if the deal is not consummated.  In otherwords: No fees of any substance whatsoever if it is not.

Pray tell, how often do you think diligence delivered in this way leans towards not consummating a deal?  Give up?  With respect to the firm that was described to me, not once.  Glad I'm not one of their limited partners.

Happy Birthday To GP

Did anyone notice that Going Private's second birthday slipped quietly by early this month?  (Neither did I).  Seems a million eons ago, that first post.  I barely recognize the author who was writing back then.  Still, 1.34 million page views, 401 posts, 86 trackbacks, 26.3 points of lifetime IRR net fees, 18 transactions, 14 date requests, 8 ambiguous invitations to coffee, 5 marriage proposals, 4.5 death threats, 4 threatening legal letters, 3 cities, 2 years, 1.5 promotions and 1 love letter later, the blog remains.

Privately Public

It is a somewhat subtle, but recurring, theme on Going Private that losses are not crimes.  Even deeper, perhaps, that losses have utility.  They are, in fact, useful.  As sure as talking heads are to focus on large executive payouts after decades of outperformance, while somehow managing to ignore the decades of outperformance, there is no surer way to narrow the mind of the pundit and trim thinking of the "financial journalist" than to show losses.  Narrative fallacy is never so quick to emerge as after a reminder that markets can, in fact, travel in two directions.  This, unfortunately, is the way of things.  I am often inclined to attribute these effects to a badly spoiled population for which the belief that risk and return are not related is so ingrained, that evidence to the contrary is taken almost as a personal affront.  It might even be difficult to enumerate the number of times I have touched on this subject.

At the risk of exhibiting indicators of multiple personality disorder, this passage probably bears repeating:

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.

A post over on Naked Capitalism suggests that part of the most recent directional diversity issue the market has been having is the fact that there are no partnerships left among big investment banks on The Street.  Or, more accurately, that investment banks are publicly held.  Quoting Bloomberg, the entry notes:

Less than a decade after Wall Street's last major partnership went public, stockholders are paying the price for bankrolling the industry's expanding risk appetite.

Four of the five biggest U.S. securities firms lost about $83 billion of market value last year, almost 90 percent of their net income since 1999, data compiled by Bloomberg show. That cut the annual average return for Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. during those nine years to 9.7 percent from 16.8 percent.

Does it strike anyone else as somewhat tortured to compare market value losses to net income figures?

The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University's Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.

"If you're betting with other peoples' money, you're more willing to take risk than if it's your own,'' said Anson Beard, 71, who retired from Morgan Stanley in 1994 after 17 years at the New York-based company, where he ran the equities division and helped with the initial public offering in 1986. "You think differently if you're paid in cash and not in ownership. It's heads you win, tails you don't lose.''

Apparently, Bloomberg has to introduce the "moral hazard" family of principal-agent problems to its readers gently, and via aged Morgan Stanley retirees.

Naked Capitalism outlines their own take on the issue, channeling Ben Stein (who has been experiencing an unwelcome resurgence in these pages) in the process, to wit:

Gelb's ultimate failure, despite his determination, proves out Stein's point about political correctness, that board members chosen for how their bios will look in an annual report are unlikely to have the expertise to enable them to provide effective oversight of an investment bank.

I'll take the argument one step further. Investment banks should not be public companies. We will put aside the most important reason, namely, that investment banks were far more prudent when they were putting partnership capital, rather than other people's money, at risk, and the costs of having investment banks play with other peoples' money are turning out to be awfully high. They can and are creating messes whose costs extend well beyond their shareholders and employees.

Investment banks are composed of multiple businesses with demanding requirements for managing them. Historically, the businesses have been overseen by people who grew up in them and knew them intimately.

It isn't acceptable in a modern public company to have a board composed largely of insiders, but that's what you need to have effective oversight of securities businesses, although that also puts the foxes in charge of the henhouse (the whole point of having external directors is to act as a check on insiders). And the few recent high profile retirees, or say heads of institutional investors that might some relevant knowledge would often be perceived to be cronies rather than independent.

The argument here is, near as I can piece together, that the moral hazard problem, created by public ownership of investment banks, is responsible for these losses.  We never would have had this problems if we hadn't let them go public.  ("If Woody had gone straight to the police, none of this ever would have happened.")  Banks never had losses like this back when they were partnerships.

This argument, of course, exhibits a rather severe set of logical flaws.  First of all, it ignores the fact that different market participants have different sensitivities to variance.  Second, it ignores the role of diversification.  Third, it seems to make the misstep of ignoring the connection between risk and return.  Fourth, it cites Ben Stein.  It is this last that most concerns me.

Perhaps it would be useful to point something out at this point:

Public ownership of financial institutions does not cause larger losses.  Public ownership of financial institutions enables larger losses.  This is a subtle but absolutely critical distinction.

Let's explore the argument a bit.  Taking the matter to the other extreme, we have Switzerland.  Switzerland provides us with an interesting datapoint by having a rather significant number of banks with unlimited partners at the helm.  By "unlimited partner," I mean an individual who has unlimited liability with respect to the obligations of the bank.  Regular Going Private readers will, at this point, be recognized by the wry grin on their faces.

It always amused me that the words "private bank" and "private banker" meant something quite different in the United States than in Switzerland, where the Swiss Private Bankers Association is composed of:

...entrepreneurs in the privately-owned banking sector who conduct their business using their own assets, assuming unlimited liability with their entire fortune and exercising their independent powers of decision.

Very distinct from the United States definition of Private Bankers which, of course, is:

...sales and marketing types in the medium to high end retail banking sector who conduct their business by talking others out of their assets and assuming no liability for mistakes made with other people's entire fortune while exercising their independent powers of decision to try to corner the market on Russian Pinot Noir.

The most successful (or perhaps "enduring") private banks in Switzerland are those connected to old families with well understood (and respected) fortunes backing the bank.  Confidence in the institution is inspired both by the potential for ruinous loss to the general partner as well as knowledge that the vast resources of the general partner will be available to bank customers should any evil befall the institution.  Of course, it is not difficult to see how this might inspire conservative habits among general partners.  It would be interesting to compare the return on assets for the Lombard Odier's of the world with the rest of the banking world.

The disadvantages should be obvious.  The size of the organization is, by definition, limited by the size and scope of the personal fortunes of the general partners.  The extent of this prudence might mean that financial "adventure," so to speak, is limited to the business the partners can personally understand.  Since few of these institutions have any more than five unlimited partners, the ceiling is pretty low.

Seeking risk in such an environment is a difficult thing.  With your entire wealth on the line it is highly unlikely you will be able to tolerate a lot of variance with respect to your investments.  (Just watch Deal or No Deal once or twice to get an idea of the practical effect).  Diversification, obviously, prevents this sort of "risk of ruin" issue from creeping in.

It shouldn't strike the typically insightful readership of Going Private as at all doubtful that the separation of ownership and control and the specialization that this makes possible is a "good thing"(tm).  Obviously, this means that financial endeavors are not limited in scope by the universe of knowledge contained in the heads of those with sufficient capital to finance their own adventures.  In short, being brilliant but poor no longer prevents your unbridled intelligence from contributing to the collective progress of human endeavors.

It should also present no surprise that any sort of innovation (which has somehow become an evil word in finance) is also a "good thing"(tm).  It also requires the assumption of risk.

Somehow it escapes me why diversifying via a public offering is de facto a bad thing for an institution tasked with evolving products to create liquidity, price risk and diversify.  Or why it is not clear that, unless someone was so silly as to pour their entire life's savings into Bear stock, it is probably a good thing that we have larger, liquidity providing banks funded by well diversified, public shareholders.

Vegetable Capital Ripens

These pages have thoroughly enjoyed being critical of the many dazzled investors who have, in the absence of even the most basic filters, poured hundreds of millions of dollars down the sewer that is motion picture investment banking.  The list of swooning and once rich, but now poor, who have been led to slaughter by the studios (typically sharp Going Private readers will immediately recognize an information asymmetry problem when they see it) is amusingly long.  One of the primary reasons is the massive preferences and other (to the layman) esoteric financial instrumentation that tended to characterize external motion picture financing deals.  As I commented some time ago:

Certainly, funding films must feel a lot like the venture business. Reading the Journal article it becomes clear that all the people in line in front of an equity investor when it comes time to pay out, including exhibitors, the studio distribution fees, payback for production and marketing costs, actors and directors, make up for a pretty large black hole that has to be filled before investors see a dime.

So when a breezy piece in the Los Angeles Times (avoid brainless registration requirement via bugmenot) spins the apologist tainted back-story behind the great fleecing of the star-struck and naive, it is hard to extend the courtesy of a good-faith credibility assumption to the paper.  This is particularly so when the piece opens with:

On paper, "Evan Almighty" looked like a sure thing.

Uh huh.  To whom?

The spin continues:

Studios were looking to mitigate the financial risks of producing movies. Traditionally, they had relied on bonds and bank loans that produced dependable profit for lenders. But the studios bore all the risks of failure.

When the idea emerged to offer backers a piece of the action, rather than merely fixed interest payments, it looked like a win-win proposition. Although the studios would have to share some of the profit from hit movies, they also would shed some of the risk of losses.

Poor, poor studios.

I am not sure exactly how to characterize the recurrent figure of Ryan Kavanaugh in this drama, because his description varies wildly depending on the source.  The spectrum seems to range from "important, innovative genius," to far less charitable versions of "nefarious cad."  Tellingly, the Los Angeles times sits on the apologist side of the continuum for the first half of the article, before actually slipping into fact-based discussion.  One wonders how many editors touched the piece before it went to press.  To wit:

The most prominent intermediary between Hollywood and the hedge funds is Ryan Kavanaugh, a 33-year-old former dot-com deal maker. His West Hollywood investment firm, Relativity Media, put together some of the largest and most publicized financing packages, including the one that backed "Evan Almighty."

Kavanaugh sold hedge fund managers on the idea that investing in a dozen or more films at a time would reduce the risk that a single bomb would sink the portfolio. He also touted a computerized system he said he had developed to distinguish between potential hits and misses.

"He figured out how to create a financing formula that satisfied studios and investors and banks," former Columbia Pictures Chairman Mark Canton, a friend and business associate of Kavanaugh, said in an interview.

The Times then describes the typical structure:

The investors would collect their returns once all the films in a slate had opened and started to generate DVD and television revenue, usually five to seven years after their theatrical openings.

I have, below, corrected this text to remove any sell-side marketing slant:

The investors would collect their returns once all if the films in a slate had opened and started to generate DVD and television revenue, usually five to seven years after their theatrical openings.

And then, the passage that should have had regular Going Private readers looking with palpable excitement for a proxy to short these instruments and their holders:

At meetings in studio back lots and Wall Street skyscrapers, hedge fund managers heard investment banks and promoters project annual returns of 18% or better. They were so jazzed that they agreed to forgo some of the protections that bank lenders had imposed on film companies, such as limits on marketing budgets.  (Emphasis mine).

What absolutely astounds me, but then again, doesn't, is the tenor of "If only we knew" that permeates the remainder of the article.

One of the first movie transactions Kavanaugh helped broker was a $528-million fund called Virtual Studios, through which Stark Investments, the Milwaukee hedge fund, co-financed a slate of films at Warner Bros. beginning in 2005. The second picture in the package, the would-be blockbuster "Poseidon," bombed.

"Poseidon" cost more than $150 million, eating up a sizable portion of the fund's capital. As a result, the other films in the slate would have to do better than originally projected for the package as a whole to generate the desired returns.

Disappointments such as "Poseidon" prompted some slate investors to take a closer look at the structure of the deals. Some concluded that the terms tended to favor the studios at their expense.

I am shocked, shocked to find there there is structural inequity going on here.

The studios, for instance, typically were permitted to recoup their marketing costs up-front. They also collected distribution fees of as much as 15% of revenue before investors started to see any payback. These provisions reduced the incentive for the studios to control their costs.

The studios could also choose which films to put in the slates. They customarily gave the funds their most uncertain projects -- such as costly films lacking overseas appeal -- while keeping the surest blockbusters to themselves.

The slate funds were essentially "risk management vehicles," said entertainment industry analyst Harold L. Vogel of Vogel Capital Management in New York "The studios are pushing the risk to the investors."

The most basic downside analysis should have caused even the most vanilla straight-out-of-b-school analyst to wonder aloud "what is the story with all these preferences?" Stepping back, "the story" here is not just the predatory nature of large and medium scale movie studios (and realizing that this is an apt description does not require much imagination) but the absolute brain-dead investing process employed by the eventual holders of these instruments.  You can now pick up many of the interests in these funds for $0.70 on the dollar.  That is, if you like paying $0.70 for a quarter.

The War on Error

Defeating errorism requires a long-term strategy and a break with old patterns. We are fighting a new enemy with global reach. The United States can no longer simply rely on deterrence to keep the errorists at bay or defensive measures to thwart them at the last moment. The fight must be taken to the enemy, to keep them on the run. To succeed in our own efforts, we need the support and concerted action of friends and allies. We must join with others to deny the errorists what they need to survive: safe haven, financial support, and the support and protection that certain nation-states historically have given them.

The advance of freedom and human dignity through democracy is the long-term solution to the transnational errorism of today.  To create the space and time for that long-term solution to take root, there are four steps we will take in the short term.

Prevent attacks by errorist networks (private equity partnerships, hedge funds, speculators) before they occur.  A government has no higher obligation than to protect the lives and livelihoods of its citizens.  The hard core of the errorists cannot be deterred or reformed; they must be tracked down, killed, or captured.  They must be cut off from the network of individuals and institutions on which they depend for support.  That network must in turn be deterred, disrupted, and disabled by using a broad range of tools.

Deny Weapons of Mass Derivatives (WMD) to rogue traders and to errorist allies who would use them without hesitation.  Errorists have a perverse moral code that glorifies deliberately targeting innocent civilians.  Errorists try to inflict as many financial casualties as possible and seek WMD to this end.  Denying errorists WMD will require new tools and new international approaches.  We are working with partner nations to improve security in vulnerable markets worldwide and bolster the ability of states to detect, disrupt, and respond to errorist activity involving WMD.

Deny errorist groups (hedge funds) the support and sanctuary of rogue (tax haven) states.  The United States and its allies in the War on Error make no distinction between those who commit acts of error and those who support and harbor them, because they are equally guilty of financial murder.  Any government that chooses to be an ally of error, such as The Cayman Islands or the Netherlands, has chosen to be an enemy of freedom, justice, and peace.  The world must hold those regimes to account.

Deny the errorists control of any nation that they would use as a base and launching pad for error.  The errorists’ goal is to overthrow a growing bubble; claim a strategic country as a haven for error; destabilize artificial markets; and strike America and other free nations with ever-increasing bubble violence.  This we can never allow.  This is why success in The United Kingdom and The Cayman Islands is vital, and why we must prevent errorists from exploiting ungoverned areas.

America will lead in this fight, and we will continue to partner with allies and will recruit new friends to join the battle.

There is a basic bit of hypocrisy for which the edges, the contours, the topography, so to speak, has been, to me at least, quite evasive.  For whatever reason though, recently, it has come into sharper focus.

These pages have made much of the modern propensity to tax success, reward stupidity and criminalize failure.  (And by "failure," I mean educated risk-taking that ends badly.  I mean a bit of sage tangling with fates who elect not to smile upon your otherwise clever, bold and daring venture).  I have speculated on the causes of these dynamics in the entries that make up Thermodynamics, and a long standing series on Punishing Talent for Fun and Profit.  I have wondered often after the details.  I am left convinced that the War on Error is a social phenomenon rooted at the core in envy and malice.  It is disguised as a question of "fairness."  Of course, given that the average global per capita income is substantially below $10,000 per year, no one is suggesting we get that fair in the Western world.

But the War on Error is not merciless.  Not all error is verboten.  But for error to be permissible, you must have been totally unable to cover your losses.  You must have been entirely out of your league.  Risk management must have been beyond you, or too expensive for you.  You had to really be swinging for the fences with everything you had.  In short, you had to make a huge bet on interest rates not moving a quarter point in 30 years, or you'd lose everything and still owe two banks large numbers that dwarf your yearly income.  In these cases, when the victims are sympathetic enough, when they have been totally, utterly daft and irresponsible, our heart (or at least our tax dollars) pour out to them and, for them at least, salvation is close at hand.

There is a corollary, of course.  You can win by being smart, working hard and getting it right.  You can even do it at the expense of the stupid who had no business playing the game in the first place.  Of course, we will tax the stuffing out of your success, but you are expected to keep quiet about that.  But not too dramatically, lest Michael Lewis, who I am consistently tempted to appreciate until I read one too many of his sentences, pulls your name (or John Paulson's name in this case) from a list of financial successes and pecks out something resembling the venom-laden "How to Survive the Fortune You Made in Subprime."

For not since Michael Milken bootstrapped hostile raiders of public companies has Wall Street been so directly implicated in the misery of the little guy.

Just to remind you, this would be the little guy who took a huge flier at interest rates so he could brag about his square footage and oversized yard- and lost.  Lost with no reserve fund of any kind.  And the Michael Milken in this case would be a sharp market player who saw it coming before almost anyone else, and was willing to bet on it.  Big.  And if you win in this fashion, where the victim was so stupid that it just insults the discipline of behavioral economics?  What then?

[Paulson], and [other subprime shorts], may face a real social risk: Having made their fortune they must now subject it to public inspection. Articles will be written, hearings held, and lawsuits filed -- and all of these will be drawn inexorably toward the people who profited from the misery of others.

Funny, the rules must have changed since Joseph Kennedy's day.

(With apologies to the National Security Council's, 2006 National Security Strategy of the United States.  Describing the import of the fact that I can remove 20 "t"'s, change a pair of country names and one acronym to describe with near perfection the misguided, contemporary assault on modern finance and capital markets, is left as an exercise for the student).

The Path to Co-Investor Hatred

Sub Rosa, LLC generally dislikes co-investors.  First, we prefer to be the lead.  Second, there is always a lot of wrangling about the terms of management fee splits, who sits on the board, what sort of protections an equity co-investor will be entitled to if they are not the lead (and therefore have less say in the management of the company) and related nonsense that distracts from the key purpose in the first place: closing the deal and running the company.  Third, if its that large, we probably shouldn't be investing.  (We aren't doing $10 billion dollar acquisitions).  Plus, you have to deal with people you don't have the ability to put many hooks in.  (Ok, so that last one is more Laura the Debt Bitch's worry than mine- but it is also the key factor in today's reading).

Whatever Sub Rosa's particular attitude towards co-investors, I personally find them beyond endurance because of a single character.  "Robert P. Darlington, III"  I would say "I couldn't possibly invent a name so ridiculously obnoxious" but, in fact, I just did.  Rest assured, and never fear, "Robert"'s actual name is just as obviously dripping with sickly sweet, white and fluffy, WASP-pomposity filled goodness.  I suspect his shelf life is similar to a Twinkie, since he is the third in his line.

Robert is one of those younger finance professionals that has far too much attitude for his station.  I realize how obnoxious that sounds, but I'm not sure how to put it any more pleasantly.  He's an associate at CoInvestCo, LLC, his first private equity posting, where he has been for 6 months, and whom we were foolish enough to entertain as a partner on a buyout.  His endless critiques and complaints delivered in the course of performing his duties as a grunt in document collection quickly began to alienate the seller, and everyone at Sub Rosa who had occasion to interact with him.  This was a mere annoyance until Laura finally came to the point where she had enough.

Here is the thing, Robert has an undergraduate degree from Indiana University.

Now, that means nothing to me.  I have met smarter people from John F. Smith community college than Harvard, but Robert apparently thinks that the humble parentage of his parchment is a big deal, and spends a lot of time over-compensating for it by proving to everyone what a "go getter," he is.  Some idiot of a partner or MD at the not-quite-a-bulge he served as an analyst at must have told him that he needed to "work twice as hard for the same credit" or something equally daft.  Perhaps it means something negative at CoInvestCo, LLC that his degree is from the midwest.  Perhaps it meant something suspicious at the investment banking group of the not-quite-a-bulge Robert landed at after graduating.  Perhaps he just has institutional envy.  Whatever the cause, he is a serious pain in the ass to deal with.  To wit:

11:15am:
From: Robert P. Darlington, III, Associate, CoInvestCo, LLC
To: Partner, Sub Rosa; Another Partner, Sub Rosa; SVP, Sub Rosa; Equity Private, Sub Rosa; The Debt Bitch, Sub Rosa; CFO, Seller; CEO, Seller
Subject: Timetables

It is quite sad that none of the document production requests we made this morning have been complied with in any way.  Now we will have another day's delay as by afternoon it will be too late to ask for clarifications and amplifications.

Robert

No, I am not kidding.

This would be, perhaps, less offensive if the seller were not already a little skittish, if the seller were not actually trying to run a business, if Robert's requests were of critical financial documents rather than supporting, confirmatory and regulatory compliance issues.

Roll the cue roll forward about a week, wherein the Sub Rosa deal team are on a conference call with the CoInvestCo deal team.  Robert elects to use this moment to wax poetic on his dissatisfaction with the working conditions.

I should point out that I still have not gotten the debt assumptions I requested earlier this week.  I can't complete the model without them.  Am I going to see those soon?

Armin clears his throat as if about to speak but Laura cuts him off without a flinch.

Hi Robert, it's Laura.  You don't have the debt assumptions because I never sent them to you.  I never sent them to you because after reviewing your model it is clear to us that it is inadequate to our needs and I don't think it accurately reflects the prospects for the target.  In particular, you haven't made any provision for deductibility of quarterly payments on the debt.  I know you aren't on the leverage team though so that's understandable.

Instead, we've developed our own internal model that Sub Rosa is going to use going forward, we probably should have done this in the first place but CoInvestCo seemed to be on top of things and taking the lead with the lenders last week.  Regardless, you shouldn't really be relying on us to provide you with debt terms, instead you should probably be talking directly with the lenders.  Certainly, Sub Rosa doesn't want to be responsible for any loss in translation that causes you to miscalculate your potential returns.  Plus, just in terms of workload, it's probably easier for you to go direct to the lenders in any event, rather than have to chase us on a call where we are burning about $50 per minute.

So, did that answer your question?

Silence was her only reply.