Going Private

The Lost Wisdom of Polonius

Laertes:
O, fear me not.
I stay too long:--
but here my father comes.
[Enter Polonius.]

A double blessing is a double grace;
Occasion smiles upon a second leave.

Polonius:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There,--my blessing with thee!

[Laying his hand on Laertes's head.]

And these few precepts in thy memory
Look thou character. Give thy thoughts no tongue,
Nor any unproportion'd thought his act.
Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them unto thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledg'd comrade. Beware
Of entrance to a quarrel; but, being in,
Bear't that the opposed may beware of thee.
Give every man thine ear, but few thy voice:
Take each man's censure, but reserve thy judgment.
Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy:
For the apparel oft proclaims the man;
And they in France of the best rank and station
Are most select and generous chief in that.
Neither a borrower nor a lender be:
For loan oft loses both itself and friend;
And borrowing dulls the edge of husbandry.
This above all,--to thine own self be true;
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

Laertes:
Most humbly do I take my leave, my lord.

Polonius:
The time invites you; go, your servants tend.

I was once told that the brilliance in Hamlet is, Hamlet.  I think this view trite and shallow.  I've always understood the brilliance in Shakespeare, as a whole, to be the many layers in which he writes.  Every tier of the audience can draw something from his best work.  Hamlet, while a tragedy, is sprinkled nicely with humor.  Some dark, some light, some subtle, some slapstick, some all four.  And Hamlet, while perhaps one of the deepest and certainly the most existential of the Bard's works, (The Life and Death of Richard the Third is it's only rival for complexity and depth of exploration in my opinion) still holds enough lighter fare for the young to pleasantly sit through a good production thereof.

One of the down sides of such flexibility is that people see what they want in Shakespeare, and they tend to do so by missing subtleties.  Dick the Butcher's famous "...kill all the lawyers," quip in Henry VI is perhaps the most notorious example.  It pays, therefore, to pay attention to the details and the deeper meanings in his works.

The humor in Polonius, I have always found, is his begging insistence to be a part of the play in a role much larger than he warrants.  His contradicting advice (rambling wisdom to those willing to ignore those details I speak of) amuses both because it sounds contradictory and mostly useless (though deeper reflection shows it actually to be quite wise) and seemingly endless (at least to the characters unfortunate enough to be on stage with the ill-fated advisor).

His interests work entirely against the world that the audience associates itself with, and to which Shakespeare deftly distracts their attention.  The trials and travails of Hamlet.  Hamlet's plight is so terrible to contemplate that without some relief the play would doubtless would lack the potency it enjoys.

Consider, however, if the play were titled "The Tragedy of Polonius," (his demise is awfully tragic after all).  Hamlet's existential whining and endless moping might well grate our nerves in this new play as we anxiously await the next development in Polonius' struggles to preserve his place in the King's court, to prevent his daughter's flirtations from Hamlet from marring his reputation with the King, to see his son off to University well, and so forth.  There is a whole nuance there, a play within a play, (at least the second in Hamlet) keenly ignored- or at least overlooked.

Polonius plays against the audience expectation that a minor character, would prattle on so, and outlive his welcome in every instance of his appearance, so much so, in fact, that it eventually kills him when he finally wanders for the last time into a scene that should have much earlier carried the stage instruction "[exit Polonius]" or perhaps even "[exeunt all but Polonius]."

Indeed, at least for Polonius, timing was everything.  I want to explore this conflict- but let's use something more "Going Private" for the theme today.  Let's use finance.

My Polonical fascination with timing stems from an ongoing conversation with the head of activism for a hedge-fund on the neglected topic (as if it were Shakespearean detail) of what has in recent years, and against the backdrop of private equity and hedge fund convergence, become an increasingly common occurrence, namely, cooperation and, occasionally, conflict between private equity and hedge funds as common shareholders.  I believe that the fluid transformation of these dynamics has changed the landscape of shareholder activism and, in turn, unveiled a new interplay in corporate governance.  This, I believe, is worth no small amount of attention.

Sub Rosa has had occasion to work with some of the more active and prominent hedge funds (including, by the way, the likes of the luckless Amaranth, with which I have, in particular, done quite a bit of work).  While it had been mostly rare for us to encounter activist shareholders given the smaller size of deals we tend to pursue, we have begun to find ourselves in cahoots with such shareholders more often in the last several months as the fluidity of the market place causes them to reach for smaller deals and for us (and smaller private equity firms like us) to reach higher.

I have been lumping hedge fund activists into two categories.  First movers and follow-on activists.  First movers tend to seek out, target and attack publicly held firms as a primary strategy.  Follow-on activists jump on the bandwagon after someone else has started the fight.  I am less responsible for this categorization than Morgan Jospeh, the mid-market investment bank, and they have probably lifted it from common usage themselves.  (Their white paper on the subject is highly recommended).

The dynamics of the cooperation between these two classes of hedge funds are themselves very complex and driven (or restrained, as the case may be) by disclosure requirements.  13Gs are filed before the intent to exert an active role through the shares.  However, within 10 days of acquiring 5% or more of the voting interests (or having options to do so) of a listed firm Schedule 13D must be filed disclosing, among other things, the intent of the investor (acquisition, management replacement, etc.).  Complicating matters, if any group acting in concert together owns 5% or more of the voting interests, or has options to acquire them, they must together file Schedule 13D within 10 days of the acquisition of the shares or options.

This lower bound is complicated by the upper bound of 10%, after which the firm or group must file a Form 3 within 10 days.  A Form 4 must be filed within 2 days of any purchase or sale of shares thereafter.  The 10% number is sticky not for the reporting requirement, but because the 10% ceiling imposes an "insider" status to the investor and this triggers some ugly matching and profit disgorging rules that most activists will badly want to avoid.  For this reason firms with under 10% are wary of appearing to act in concert with other shareholders as they may be branded as a "group" holding in excess of 10% and, therefore, subject to disgorgement, etc.

Even more burdensome, the Hart-Scott-Rodino threshold, surprisingly named for the "Hart-Scott-Rodino Antitrust Improvements Act."  This obscure restriction requires notices and prior governmental clearance after a 30 day waiting period as the government looks for anti-trust issues if more than $56.7 million in shares are owned by an entity.  That's a time consuming and expensive process.  Says the Head of Activism: only the likes of Carl Icahn, who expect to be in for a long haul, bother.

All this is a long way of pointing out that the dynamics between activists are complex and often require a lot of tip-toeing.

According to my Head of Activism friend, the former class of activism seems to take very heavy lifting.  There are few first mover activist funds and fewer "pure" activist funds (who concentrate primarily on activism as a strategy).  First movers require quite a bit of work and high adept legal teams, as the threat of litigation, and eventually proxy fights, is the primary "stick" activists wield.  They are expensive to run, have long-term horizons and, accordingly, are the rarer variety.

Targeting firms is probably the "highest art" in the tasks undertaken by first mover activists.  Morgan Joseph outlines a set of criteria for "activism vulnerable" firms that Going Private readers will likely have anticipated:

...high cash balances, M&A activity with questionable rationale, under-exploited asset values, depressed valuation multiples, earnings underperformance or the presence of disparate businesses with limited strategic underpinning wrapped within a single entity.

Follow-on activists tend to join first movers once a firm is in "play" and join, either formally or informally, in the agitation.  This strategy is often less lucrative (as the news of a well known activist's attack often itself drives stock price up in anticipation of positive change) but also doesn't hold the up-front and ongoing costs that first movers might.

This effect can look "wolf-packish" or, in an analogy brought to my attention by the yummy Abnormal Returns citing Jeff Matthews, "…when the market smells blood in the water, it goes after whatever is bleeding and doesn’t let go."

Clearly, publicly held firms present the cleanest targets for activism as the liquidity in shares makes it easier to both gain a significant stake in the firm, and also exit quickly once return targets or other goals have been achieved.  (Despite this, some jurisdictions with significant- even misplaced- concern for the oppression of minority shareholders in closely held firms make good hunting grounds for activism in closely held firms.  Often these efforts tend more to the sinister and sleazy).

Quick reflection will cause the Going Private reader to realize that activist firms would do well to target public firms with highly concentrated blocks of major institutional shareholders likely to have similar goals to the activist, rather than fragmented equity structures that will make it difficult to generate a credible threat of a victory for the activist(s) in a proxy fight.  Depressed share prices in combination with a number a large (and theoretically cranky) institutional shareholders are, therefore, likely a beacon for activist interest.  Retail shareholders are generally considered a "minus" and high insider or employee ownership (where it tends to vote with management) is equally annoying.

Interestingly, this dovetails nicely with recently IPOd (and I now wonder after LIPOd, *ahem, Burger King*) firms with significant "leave behind" investments by private equity firms.  Almost by definition, if a public firm has a private equity fund as a significant investor, that investment is near the end of its term for a private equity investor.  Even assuming a 1-2 year time frame between initial investment by a private equity investor and an IPO (and this would be wonderfully quick) it is doubtful that the private equity fund has more than a 2 year lockup, and perhaps not even that.  More likely, the IPO was after 3-4 or even 5-6 years and the private equity fund is itching to get out.  Perhaps the life of the fund is drawing to a close.  Certainly, distributions to the fund's investors are a strong pressure for a quick private equity exit.  Not only that, but given the importance of IRR to the fund, and that the fund is already probably sitting on 35%+ of it, the private equity fund has sharply different motivations with respect to timing than an activist.  A quick example might be illustrative.  I draw this from a highly sanitized real-world Sub Rosa example:

Let's assume for a moment that Sub Rosa invested $10,000,000 in Loser Management, Inc. back in 1/1/02 for a leveraged buyout.  Sub Rosa acquired 100% of Loser Management in the transaction, did all the things private equity firms do for the next four years and then, with great fanfare, IPOd Loser Management, Inc. on New Year's Day 2005.  (Since Sub Rosa is so influential, and the IPO so hot, the market was opened specially for the IPO).  Let's give Sub Rosa paper gains of 300% on the investment and assume, for argument's sake, that it held its entire position in Loser Management, Inc. pursuant to a 1 year lock-up agreement that forbid the selling of any shares by Sub Rosa (even in the IPO) until 1/1/2006.  This isn't particularly realistic, as Sub Rosa would certainly have insisted on exiting a good portion of the investment and probably given itself a fat dividend in the meantime before the IPO, but the Debt Bitch was asleep at the wheel after a hard night of martinis with the folks at Pershing Square and bungled the pre-IPO loans.  (This simplifies things and the outcome isn't particularly different for the purpose of the analysis- don't tell Laura about this hypothetical, thanks).

Unfortunately, on 12/31/06 (right before the corks pop) Activism, L.P., calls up Sub Rosa and introduces itself as the next largest shareholder of Loser Management and indicates that it intends to agitate for change and anticipates a sharp increase in share price as a result.  Would Sub Rosa like to participate?

Sub Rosa is torn.  Big boost in the stock price sounds good, but Sub Rosa has ties to the management of Loser Management (we probably actually installed them, actually, but the private equity firm could well have slipped out of the power circles intentionally as the IPO approached) and really isn't sure it wants to alienate them.  So the senior people at Sub Rosa ask some poor, young, Vice President to do a quick analysis.  What kind of returns can Sub Rosa expect from an activism campaign?

In this particular case I used Bally Total Fitness, a long and protracted campaign involving litigation, but generally considered a success.  (The campaign yielded a 58.1% ROI to Liberation Investment Group after almost 2 years).  Should Sub Rosa jump on board?  The math looks about like this:

As you can see, the impact to the IRR of Sub Rosa is not good.  This late in the game Sub Rosa, like most private equity firms, is highly time sensitive when it comes to exit.  In this case a 25.74% IRR (tasty for the hedge-fund) is just not enough to keep Sub Rosa in the game.  This is in addition to the additional risk of a failure of the campaign, and it becomes easy to see why private equity firms might choose to pass on the opportunity to participate and, in fact, might find themselves on the other side of activists angling for a better price on a sale when it looks likely to be a 6-12 month fight.  At this point, Sub Rosa would just love to hook Polonius right off the stage.

Later this week:  Ophilia was a private equity Vice President.

(Special thanks to a certain Head of Activism for some local color and a certain SVP in a private equity firm for war stories, three hours of discussion and as many hours of martinis).

Polonius, Act II, Scene I

I had a wonderful exchange over the last two days or so with a loyal reader, let's call him "Angelo" who wondered after my comments about the potential conflicts, mostly timing driven, between private equity firms and hedge funds.  Angelo, himself a hedgie in a larger first-mover activist fund, preferred to call what I termed "follow-on" activists (firms that pile into the disclosed investments of known activists) something a bit less, well, active.  "Activism Arbitrageurs" was the term he preferred, pointing out that these investors rarely do the heavy lifting required of activists who do battle with management, and also pointing out that this genre of investors is defined by, among other things, quantitative models geared to predicting the success of an activist campaign.

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

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

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

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

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

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

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

Polonius v. Hamlet

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sacrifices

One of the major advances in media in this decade surely must be the advent of "Free Exchange," the Economist Blog.  Nearly twice daily some content of value seems to spill out from the electronic pages of the venerable publication and, as is typical of the Economist, those pages are not afraid to share credit, point to important thinkings outside its own firewall borders, and otherwise lay any number of reading hours on the sacrificial altar of knowledge.

Small wonder then that hedge funds have been a topic much revisited by the Economist, and its blog.  Cause for wonder, however, that Foreign Affairs would get in on the act.  Certainly, a noble publication, but not one I would have perused this quarter absent the pointer from the Economist blog.  Any chance to read Sebastian Mallaby, (who's pieces on the World Bank, the worthy death of an intellectually dishonest movement against "Liberal Imperialism," crushing criticism for a weak executive, and, in perhaps his best known work, the case for America as an Empire, inject piercing and apt, if alarming, cases for wielding terrible powers, economic, military and political) however, is worth any temporal sacrifice.  He is, with this most recent scribing, at his usual best:

Imagine two successful companies. Both are staffed by very smart people; both are innovative; both have an impact far beyond their industry, improving the productivity of the capitalist system as a whole. But the first, based near San Francisco, is the subject of adoring newspaper profiles, whereas the second, based in the New York area, is usually vilified.

Actually, you do not have to imagine any of this, because it describes a double standard that already exists. The first company in the story is a technology firm; the second is a hedge fund. As any newspaper reader knows, technology firms are the leading edge of the U.S. knowledge economy; they made possible the productivity revolution of the past decade. But the same could just as well be said of hedge funds, which allocate the world's capital to the companies, industries, and countries that can use it most productively.

Would that the authors on Economist's blog were less modest and more apt to sign themselves to their entries, then I could sing their praises by name.

As for the topic at hand, marketing seems to me the issue entangling hedge funds.  This seems comic in the face of venture capital's reputation leaving the dot-bomb era, but there it is.  Time to hire (buy?) the top public relations firms, I suspect.

The Overlapping Roles of Private Equity and Activism

Going Private readers will, no doubt, be familiar with product and firm life cycles, characterized primarily by the "Introduction, growth, maturity and decline," patterns of expansion and contraction.  It will come as no surprise, then, that these life cycles apply equally to financial services firms, financial services products and capital structure driven acquisitions (LBOs).  The forces in the case of private equity are slightly different (credit availability and the existence of viable target firms and by extension of these two, available returns to LBO actors) but the cycle is equally valid.  I tend to think that there is a first derivative order to the cycle for private equity as well (as debt financing never really goes totally out of style as a product) and we should, therefore, not be surprised by the regular ebb and flow of private equity.

Perhaps we should be slightly surprised by the immense growth in the field in the last 24 months, but then again, perhaps not given the perfect storm of SarOx, low interest rates and multiple targets.  (At this point a quick pointer to the yummy Abnormal Returns' "Five C's" article and its follow-up seems in order).

Of course, it was fashionable to predict the imminent death of private equity as we know it far before I even began to pen Going Private, and the calls have continued unabated since.  (As a side note, this month is Going Private's one year anniversary).  After one of these back in August I postulated aloud that:

Mega-funds are the conglomerates of 2007.  Big, unwieldy, potentially unable to attend to their many daughters properly.  But most of them will live on.  Weathering a storm, perhaps, getting a belt tightening, but enduring.

The Economist, it seems, has quickly come over to my way of thinking as they penned this back in December:

Are private-equity firms the new conglomerates? The two look more and more alike. The dozen or so top private-equity firms have taken positions in an extraordinarily diverse range of operating companies, much as big conglomerates have done. Each week brings another batch of multi-billion-dollar deals.

But, even as these cycles work their cyclical magic on the economy, we have other forces joining in the fray.  Are poor performance issues marked by governance, inefficient capital structure and sub-optimal strategic initiatives best addressed by the harsh shocks of a surprise LBO?  Or are activist investors enough of a check on public companies to drive efficiency and solve agency cost problems?

The answer, of course, is that both play different if somewhat overlapping roles in keeping the management and/or performance of public firms in check.

With the release of Brav, Jiang, Partnoy and Thomas' paper, "Hedge Fund Activism, Corporate Governance and Firm Performance," we see both that activist hedge funds command abnormal returns of some substance (I predict a growth in start-up activist firms given the publication), and that they look far more like value investors (particularly in terms of their holding periods and target profiles) than they have been given credit for.  Their holding periods tend to be 2-3 years, in fact, before dipping back under the 5% metric.  This is, however, a far cry from the 3-10 year holding period that typifies private equity investments.

A 5% interest in a $5 billion firm is, of course, $250 million and the need to keep long-term holdings mean that borrowing is not practical for activist funds.  This means that in terms of size, all but the largest activist funds and the Carl Icahn's of the world are constrained to firms generally under $10 billion, though firms willing to press publicly and threaten proxy contests can accomplish their goals with lower stakes.  (Relational Investors only holds about 1.2% of outstanding common in Home Depot, the homebuilder store with nearly $85 billion in market capitalization, but has still managed to badger the beleaguered retailer into caving to all Relational's major demands.  Interestingly, this is over $1 billion in capital or over 15% of Relational's assets under management- a pretty serious concentration of assets in one bet).

These sorts of bets are well above all but the most determined, largest and cooperating private equity players.  The more interesting interplays exist in the > $7.5 billion market capitalization area, where the two genres have more interaction.  Reading the literature it becomes apparent that some of the highest gains in activist strategies are those where divisions or, indeed, the entire firm is sold.  Private equity buyers wait eagerly in the wings.  (Even now Home Depot struggles to shed itself of its commercial building business at the behest of Relational).  One more force to prevent the "maturity and decline" segment of the private equity life cycle.

Polonius is (Posthumously) Avenged

The astute Going Private reader will recognize, on behalf of the private equity audience at the Shakespearian play of the marketplace, the character of Polonius.  Loud, distracting, full of unsolicited advice that issues forth almost constantly from his mouth no matter the circumstance, often appearing in places he is decidedly not wanted, always determined to become the center of the stage, usually bearing evil tidings, typically meddling in the affairs of the other characters and, just occasionally, hiding behind the wrong draperies at exactly the wrong time.  So tedious does his intrusive toiling become that it is not long before the audience wishes him a speedy, and preferably painful, exit.  For the private equity world Poloious is, of course, the activist investor.

Increasingly, activists and private equity have become at odds.  This is particularly so in going private transactions.  Activists have begun to ask serious questions about auction processes as well as the prices being paid for publicly held firms.  "Why," the question goes, "should we sell you this firm cheaply today so you and your private equity partners can make hundreds of millions later when you re-offer it publicly?  We are leaving a lot of value on the table.  We, and the other public shareholders," (activism can be a highly populist pursuit, but only when the institutional shares are already a tight proxy race) "are being cheated."

While I am generally sympathetic with the activist cause and I believe shareholder activism serves important (nay, critical) purposes in the public and private capital markets, this argument is about as compelling as Martin Short playing in the role of Stalin.

A close friend of Going Private and activism manager at a fund with activist tendencies points to the latest Clear Channel spat as a case in point.  Bain Capital and Thomas H. Lee Partners have posted a $39.00 per share bid for Clear Channel, up from their original bid of $37.60 per share.  ISS opposed the original bid as have a number of large shareholders, of which Fidelity seems the be the loudest.

Clear Channel makes an attractive target for a bit of modern day greenmail.  Under Texas law two thirds of the shareholders must approve the transaction.  Distinguish this from two thirds of the votes cast.  Uncast votes will cut against the merger.  This gives minority holders a strong position and makes for a particularly retail-oriented campaign.

The problem with these kinds of battles, however, is more about risk than price.  Or, rather, while price is the public face of the issue, the more important and latent issue is risk.  In order to pay $40 per share (the rumored "magic number" for Clear Channel) Bain and Thomas H. Lee will have to pile on more debt.  This being the fourth serious bid for the company, one might imagine that a lot of pencil sharpening has already gone between the debt capital markets guys and whoever the Debt Bitch over at Bain is.  (Hope she doesn't have rug burns yet).  As should be obvious, default risk increases as the debt load gets higher.  Bets on the company's future performance are, in effect, being leveraged to pay current shareholders.

Let's go back, for a moment, to the basic scenario.  Public shareholders lose confidence in a company, let's call it "Opaque Channel."  Opaque Channel (not to be confused with "The OC"), a communications company and once great purveyor of obscure, Kafkaesque commentary, Byzantine news analysis and spin of such magnitude that the headquarters (gyroscope like) slowly wobble about their central axis, has had a difficult run recently.  Over the course of a year, the shareholders bid the stock, which was sitting at $25 a share a year ago, down to $10 per share.  It doesn't really matter why.  Perhaps they don't believe in management anymore.  Perhaps they believe the market for the company's twisted informational products is shrinking amid the increasing stupidity of media consumers and the consummate boost in demand for short, shallow news and commentary.  (CNN.com has deftly avoided this problem by leading their stories with a prominent, red colored "Story Highlights" section with the 4-6 bullet points that summarize their already curt 500 word articles).  Perhaps margins are low.  Perhaps the company has issued depressing guidance.  Whatever the case, the market does not believe in the prospects for the company.  The market has set the price for the firm at $10.

Now, some guys and gals who think they are pretty smart (the private equity locusts) do their homework and decide that, with some changes, they can make some money by buying the company in a leveraged deal, holding it for a period of time, improving the operations, and, perhaps, eventually reissuing it to the public market for substantial profits.  Let us pause for a second and reflect upon what this really means.

The private equity locusts are willing to take the company private, forgo any real liquidity (and therefore opportunity to exit the investment easily if things go south) and, further, will add debt such that there is little room for error.  They are, in effect, signing a contract to hold the company for 5 years even if it sinks down the tubes the entire time.  Their only early exit would be to find another buyer eariler.  Either the public, or another private firm that sees the value in deeply miasmal content providers.

Not only this, but the private equity locusts who think they are smart, have also managed to convince some debt market leeches (who also think themselves smart) that they are smart, and that their plan for the resurrection of Opaque Communications can work.

Moreover, the private equity locusts are willing to provide the public shareholders with a premium to do so.  They put their money where their mouth is.  They bid $11.50 per share.  15% over the company's currently trading price.  This is pure surprise and purely found money for the public shareholders, who, two days ago and as a group, couldn't imagine the company was presently worth more than $10.

A couple of shareholders, and it is not clear if they are new or old shareholders, but this really doesn't matter as share certificates are not wine, nor are they cheese, and therefore do not somehow gain nobility with age, start making noise.

"How can you expect us to sit here and let you take this company private and make hundreds of millions of dollars and not cut us in on it.  You are cheating us."

Consider the assumptions being made here by the complaining shareholders.

1.  That a 15% premium over the value that the shareholders themselves have set is somehow unfair.
2.  That, de facto, the private equity guys and gals will make hundreds of millions of dollars.
2.  That, if left to its own devices, Opaque Channel could make shareholders hundreds of millions of dollars if only left on the public markets long enough.  Management, about to be out of a job, doubtlessly feeds these delusions eagerly.  "We need just a few more quarters for our strategic obfuscated media product to catch hold in the market place."
2a.  Note the inconsistency in 2 above.  Namely that, if shareholders believed in management and felt that Opaque was only a few quarters away from greatness, why isn't their confidence reflected in the stock price?  This is an important attitude to look for.  The hope for a windfall which is not backed up by the resolve to pay more for the stock in the first place is quite telling.
3.  That the shareholders today should enjoy the potential future benefits of the LBO today (undiscounted) and without assuming the risks (liquidity, default risks, time frame) that the private equity locusts assume.

Consider point 3 carefully.  This is the essence of the "we are being cheated" argument.  Please note that "We are being cheated," really boils down to "We want you to pay us for the right to take a risk with this company.  And, actually, we want to boost the risk you take after you finally buy us off.  We want you to be paid less for more risk because we, deserving public citizens, are being cheated of our entitlement to a windfall of more than 15%."

In this connection, consider a subtle nuance of point 2.  By definition, what I will call a "pure" going private LBO (one that relies on actual top line and operational improvement to drive return rather than just clever debt loads) is a contrarian investment.  Private equity groups plan to make money by finding value that others have forsaken, and taking risks on these investment theses.  That's the point.  If you doubt this, all you have to do is watch what happens when an buyout firm withdraws the only bid from a public firm.  Anyone in risk arbitrage will tell you that the stock price quickly descends back to its original level in the absence of bidders.  Once again, the public shareholders show their colors.  The shareprice sinks back to $10.  The stock is worth $10 to them in the absence of a cash bid for their shares.  How can it be anything other than obvious to the impartial observer that the "entitlement" to more for these fickle shareholders is a fantasy?

Of course, in the political and economic climate that is the United States today, these fantasies are drawn as reality.  Giving someone 25% of what they ever imagined it was worth, and in the process piling additional risk onto the purchaser, is somehow transformed into "fraud."  Pretending that capital markets are anything but broken for these firms, and that therefore some enterprising group trying to unlock value is some kind of con job, seems to be a hobby.

So what are buyout groups to do?  Certainly, as prices are driven up by purely political (and I include both legislative and capital markets politics here) pressures they will have to, increasingly, bow out of otherwise useful and value-creating transactions.  They cannot, in good faith to their limited partners, assume the risks associated with these sorts of price elevations.

So how does one quiet unruly shareholders to consummate these transactions?  KKR and Goldman Sachs Capital Partners may have the answer in the structure we find attached to their purchase of Harmon International.

Here, KKR and Goldman give existing, public shareholders the option to convert up to 12.5% of the firm into 27.0% of the new.  The new firm will be registered under the Securities Exchange Act of 1934, and therefore, while not listed, will issue financial statements but trade over the counter only.  That keeps out the retail investors but gives institutional the opportunity to play along.

Consider the many problems this solves for the private equity buyers:

1.  Noisy public shareholders are (we assume) silenced because they can participate in the LBO and its subsequent success (or failure).
2.  The short term pressure of "the mob" and the "tyranny of the quarterlies" is suppressed.
3.  The populist argument against the transaction is (mostly) neutralized.
4.  The above are accomplished without the addition of more risk (debt).

Consider the problems it creates for the rest of the market:

1.  Specious, populist arguments against going private transactions are bolstered.
2.  Going private transactions (which I believe act as a "do-over" for firms which the public markets are not mature enough to serve) will see reduced returns and, accordingly, this particular public market safety valve for value will be damaged.

What is, at least from my perspective, sad, is that the reason buyout shops are resorting to this sort of tactic is because they have not been able to convincingly make the anti-populist case in their going private transactions.  This is probably because private equity as an industry is PR brain dead.  This, in turn, is because private equity is dominated by massive and myopic egos.  Private equity is about as accomplished at PR as Larry Ellison when separated from his handlers.

Activists will continue to make these arguments, because they make money by doing so, as they will, quite rightly, criticize poorly run auctions and conflicts of interest in "sweetheart deal" buyout transactions with the tacit complicity of management.  This latest development, however, is a sad reaction to overreaching by public shareholders.

Activists are Sort of Hot

You know what I mean.  In that sort of squirmy-can't-hold-still restless-leg-syndrome we-can't-afford-a-dividend and I can't-not-get-the-wife-jewelry this year sort of way.  Well, and they are just hot in general too, frankly.  Forgetting even that they fear no CEO, and love causing discomfort to others at cocktail parties.  What's not to love?

(muffiehbs05 has joined the chat)
3:17:54 PM ohhoneyitstess: look what the pussy dragged in
3:18:45 PM muffiehbs05: Hey tessy!
3:19:06 PM muffiehbs05: What's doing?  Did you meet that guy over the weekend?
3:19:46 PM ohhoneyitstess: which one
3:19:57 PM muffiehbs05: You had more than one date?
3:22:01 PM ohhoneyitstess: no, just one date, but i thought you meant the guys we were talking to saturday
3:22:06 PM ohhoneyitstess: w/ EP?
3:22:28 PM muffiehbs05: Gawd! No!  Ew!
3:22:51 PM muffiehbs05: That one guy worked for Morgan Stanley, for crying out loud.  Where the hell IS ep?
3:25:29 PM ohhoneyitstess: i don't know, working? that harpy bitch.
(equityprivate has joined the chat)
3:25:56 PM ohhoneyitstess: it's almost close, maybe she'll be done soon
3:26:02 PM ohhoneyitstess: by close i mean the close of the market, muffie
3:26:20 PM muffiehbs05: What?  It closes at 5, doesn't it?
3:26:51 PM equityprivate: muffie, you are so mercifully free of the ravages of intelligence.
3:27:19 PM muffiehbs05: That's absurd.

3:28:53 PM ohhoneyitstess: muffie, tell us what you did today
3:29:05 PM ohhoneyitstess: you didn't go into the office, i'm assuming, yes?
3:29:52 PM muffiehbs05: I was too tired.  And I'm kinda sore after last night.
3:29:59 PM equityprivate: hi tess
3:30:29 PM equityprivate: do I even want to know how you managed to get sore on a monday night?  clearly not from the treadmill.
3:31:25 PM ohhoneyitstess: you didn't go in b/c you were sore?
3:31:29 PM ohhoneyitstess: how'd the md take to that excuse?
3:31:49 PM muffiehbs05: I don't really do excuses anymore.
3:31:55 PM ohhoneyitstess: oh, that's nice for you
3:32:03 PM muffiehbs05: Well it really just saves everyone time.
3:32:24 PM muffiehbs05: Plus, the guy I was working for, I don't think he's working anymore.  I guess the fund he worked for didn't do very well.
3:32:39 PM equityprivate: wait, your boss worked for the flagship fund?
3:32:52 PM muffiehbs05: Not my boss, my patron.  You know, my sponsor.
3:33:08 PM equityprivate: from the orientation class or what?
3:33:34 PM muffiehbs05: No, you know, like he looks out for me and we go out when his wife isn't in town?
3:33:57 PM ohhoneyitstess: wait
3:34:05 PM ohhoneyitstess: you mean the guy who looks like our activist crush?
3:34:11 PM muffiehbs05: Who?
3:34:21 PM ohhoneyitstess: dl!
3:34:30 PM equityprivate: he looks like Dan Loeb!?!
3:34:42 PM muffiehbs05: What?  Who is Dan Loeb?
3:34:54 PM equityprivate: my god, he is so hot!
3:35:06 PM equityprivate: and so married.  its such a shame.
3:36:51 PM ohhoneyitstess: yeah it is a shame, although it's not as though marriage has ever stopped big muff before
3:37:34 PM muffiehbs05: Hold on, let me google Dan Lobe.
3:37:42 PM equityprivate: muffie, it's Loeb.
3:37:46 PM muffiehbs05: Oh.
3:37:56 PM equityprivate: Activists in general are just... hot.
3:38:44 PM ohhoneyitstess: yeah they are
3:38:47 PM ohhoneyitstess: they get so riled  up
3:38:53 PM ohhoneyitstess: u still have a thing for tom?
3:39:08 PM equityprivate: Loeb wrote me an email once.  he was the namesake of one of my worst management prizes on the Going Private blog.
3:39:20 PM equityprivate: oh, tom hudson DOES make me weak in the knees.
3:39:32 PM ohhoneyitstess: even though his fund has shit the bed?
3:39:44 PM muffiehbs05: Activists?  Like protestors?
3:40:01 PM equityprivate: just getting back to his roots, tessy.
3:40:30 PM ohhoneyitstess: hehe
3:40:36 PM equityprivate: no, muffie, shareholder activists
3:40:39 PM equityprivate: you know, they buy up 5% of a publicly held...
3:40:42 PM equityprivate: ...that triggers a SC 13D filing requirement...
3:40:45 PM equityprivate: ...then they proceed to alpha-male-investor away at the current management *swoon*
3:40:56 PM muffiehbs05: They are not hot.  What about Carl Icahn?
3:52:19 PM ohhoneyitstess: carl icahn is hot, objectively, but i'm not attracted to him
3:52:22 PM ohhoneyitstess: something about his...
3:52:23 PM ohhoneyitstess: age
3:52:35 PM equityprivate: oh, that's the part I love!
3:52:51 PM muffiehbs05: EP just wants her daddy to spank her, that's all.
3:53:08 PM equityprivate: carl icahn does NOT look like my father.
3:53:16 PM muffiehbs05: Ok, EP wants her uncle to spank her.
3:53:42 PM ohhoneyitstess: eww
3:53:45 PM ohhoneyitstess: to the uncle
3:53:48 PM ohhoneyitstess: the spanking?
3:53:49 PM ohhoneyitstess: maybe
3:54:40 PM equityprivate: whatever, I still think icahn is kinda hot.
3:57:51 PM muffiehbs05: Yeah, if you want to be spanked by your uncle.
3:58:23 PM equityprivate: muffie, you should be so lucky that Carl Icahn would want to put you over his knee and smack your little, lilly white ass.
3:59:45 PM muffiehbs05: I've been spanked by better.
3:59:55 PM equityprivate: better *what* exactly?
3:59:55 PM ohhoneyitstess: oh, yeah?
3:59:57 PM ohhoneyitstess: who
4:00:02 PM ohhoneyitstess: spanks
4:00:05 PM ohhoneyitstess: who
4:00:06 PM ohhoneyitstess: names
4:00:06 PM muffiehbs05: Just never you mind.
4:00:09 PM ohhoneyitstess: where/when/what appartus
4:00:11 PM ohhoneyitstess: shut up muffie
4:00:13 PM ohhoneyitstess: you love to talk
4:00:16 PM muffiehbs05: Hairbrush.
4:00:20 PM muffiehbs05: If you must know!
4:01:03 PM equityprivate: the newly promoted MD down the hall from your office doesn't count, muffie.
4:01:19 PM muffiehbs05: Why not!?  That's bullshit!
4:01:25 PM equityprivate: see, i knew it.
4:01:49 PM ohhoneyitstess: why doesn't it count, ep?
4:01:52 PM ohhoneyitstess: just out of curiosity
4:02:00 PM ohhoneyitstess: does it have to be a fund manager?
4:02:05 PM ohhoneyitstess: cause they take no prisoners?
4:02:10 PM equityprivate: because she didn't do anything but walk by his office once (since she's only been there once)
4:02:31 PM equityprivate: well at the very least he cant be from the same office.
4:02:50 PM equityprivate: its not some kind of HR thing, its just keeping the crush pure.
4:03:10 PM muffiehbs05: Well how am I supposed to compete then?
4:03:40 PM equityprivate: muffie, we weren't talking about guys you slept with, it was crushes.  you don't have to bang everyone you have a crush on.
4:03:49 PM muffiehbs05: Wait, I don't understand...
4:03:53 PM equityprivate: nevermind
4:04:14 PM ohhoneyitstess: sorry, dozed off there for a sec
4:04:17 PM ohhoneyitstess: but wait
4:04:18 PM ohhoneyitstess: muff
4:04:21 PM ohhoneyitstess: re: how can i compete
4:04:27 PM ohhoneyitstess: showing up to the office would be a start
4:04:36 PM ohhoneyitstess: it's all smooth sailing/spanking from there
4:04:49 PM equityprivate: you working or something tess?  I notice most of the articles are from you nowadays.
4:05:00 PM muffiehbs05: Ok, just shut up.
4:05:35 PM ohhoneyitstess: ep, tell us who the latest hf crushes are
4:05:57 PM equityprivate: well, I kind of have a thing for Bob Chapman.
4:06:06 PM equityprivate: he reminds me of the alien bounty hunter guy on x-files.
4:06:30 PM ohhoneyitstess: i don't know him
4:06:39 PM ohhoneyitstess: hey, if you like ichan, what about james simons?
4:06:43 PM ohhoneyitstess: he's a dinosaur
4:06:52 PM equityprivate: that sort of deep, penetrating look that says, "just try to avoid completing a stock buyback program."
4:07:46 PM equityprivate: well, he's not really an activist, tessy.
4:08:10 PM muffiehbs05: That guy looks like Camilla Soprano's father.
4:08:12 PM ohhoneyitstess: bob chapman does?
4:08:22 PM muffiehbs05: No, no no.  Simons does.
4:08:26 PM equityprivate: you know Simons muffie?
4:08:38 PM muffiehbs05: Sure, I was at a party somewhere and he broke it up.
4:09:01 PM equityprivate: I don't want to know.  really.

Activism is Hot

Long-time Going Private readers will express little surprise when confronted with hints that I dislike Andrew Ross Sorkin's style.  (Or that I just plain dislike Andrew Ross Sorkin).  My disdain tends to be connected to the phrase "a little knowledge is a dangerous thing," and, unfortunately, that tends to be magnified by the fact that Sorkin has the resources of the New York Times at his disposal to spread his pet theories.  Like all good practitioners of the narrative fallacy, Sorkin's explanations sound reasonable at first blush.  They do not, however, stand scrutiny well- but then I don't think the typical New York Times reader regards skeptical inquiry as a virtue.  This would not disturb me so much were most of his spoutings not of the populist variety.

This sort of demagoguery previously prompted me to describe Sorkin as...

...a dangerous fool who is prone to do some serious damage wandering around carrying a Louisville slugger with nails driven through it while wearing a red bandanna fashioned into a blindfold and swinging wildly at dangling financial issues in the middle of a seven year old's birthday party.

So back in August, Sorkin speculated aloud that "...the credit crisis may have just claimed its latest casualty: the so-called activist shareholder."  He went on to spout off that:

"...activism, for the most part, is a one-trick pony. For all of activists’ hemming and hawing about strategic change, their real mission boils down to four things: have the company sold, break the company up or push it to take on debt so it can buy back stock or issue a big dividend."

Let's examine that closely.  Activism is a "one-trick-pony."  What if we were to outline the activist strategy as a "one-trick" approach?

1.  Activist Goal:

1(A).  Sell company
1(B).  Break company up
1(C).  Assume debt to:

1(C)(1).  Mount stock buy-back program
1(C)(2).  Issue dividend

So that's how Sorkin defines "one-trick" I suppose.  Of course, Sorkin has neglected some activist "tricks" in his analysis, including:

1(D).  Acquire company in tender offer, and:

1(D)(1).  Improve operations before:

1(D)(1)(a).  Selling company to private buyer
1(D)(1)(b).  Going public

1(D)(2).  Hold indefinitely for cash flow

1(E).  Agitate for corporate governance improvement and:

1(E)(1).  Sell stake for gain, or
1(E)(2).  Push for sale of improved company, or
1(E)(3).  Mount proxy fight, and:

1(E)(3)(a).  Sell stake for gain
1(E)(3)(b).  Push for sale of improved company

I am, of course, only scratching the surface.  Still, that's a pretty big "one-trick" for a pony to have.  Sorkin continued:

All of those strategies rely on cheap capital, but because of the current credit squeeze, that financing is vanishing. The big buyout firms have already been stopped cold in their tracks. That may mean the activist bravado of yore — and the typically unspoken symbiotic relationship between buyout firms and activist hedge funds — may disappear along with easy credit.

Reading this, I suppose Sorkin couldn't have been much of a Going Private reader, since that "unspoken symbotic realtionship" was the subject of much discussion on my part several months earlier.  Indeed, almost a year before Sorkin's great revelation about the one-dimensional nature of activism, Going Private already had an entire category dedicated to the topic.  I was hardly the first person to cite these kinds of relationships either.

Equally unsurprising, given the shaky ground his assumptions stood on, is the fact that Sorkin was dead wrong.  The only surprise is that DealBook (a.k.a. Sorkin) bothered to cite Sorkin's wrongness.  But Sorkin seems to like citing Sorkin, so perhaps that was actually more predictable than we might have thought.  Funny, I wouldn't have even noticed had it not been for (the always yummy) Abnormal Returns.

We can hardly blame Sorkin, however.  Like many (most?) of his peers in financial journalism, familiarity with the basic tenants of investor strategy is, apparently, not a compelling prerequisite to writing pieces on the investors who employ them.  It is difficult to hold Sorkin to any kind of higher standard.  Really, his awareness that there is such a thing as an "activist investor" probably gives him a B- on the curve of the financial journalism knowledge test.  Being unaware that activists do more than just employ leverage is par for the course when it comes to the universe of anti-capitalist journalists.

Still, one gets a lot of negative points from me for badmouthing activist hotties.

Deep Debt Impact

While I tend to bristle when pressed into involuntary service as a professor, teaching first year investment theory or financial instruments to people who, though they love to belittle MBAs, never bothered to learn these concepts- believe it or not, my role simply is not to correct the many misconceptions exhibited by, or to fill the gaps in financial education possessed by, certain financial journalists who find themselves the subject of my musings- the connection between debt, debt markets and activism as an investment strategy bears some additional scrutiny.  Lest I be accused of failing to substantiate my accusations of intellectual sloth, a somewhat in-depth discussion is probably warranted.  In this vein, the role of debt generally as it is tied to returns (alpha, if I may be so crude) realized by active (not just activist) strategies likely could benefit from some discussion.

To complete the professorial metaphor, some classroom background may be helpful.

It amazes me how many market actors profess to be adherents to "perfectly efficient markets" theory (all information is perfectly reflected in prices all the time) and still engage in active investment strategies.  Below this threshold there are any number of more limited versions of efficient market theory- but unless one finds oneself on the far opposite side of the spectrum (no information is reflected in prices- they are a perfect source of entropy- and this would be beyond fascinating for reasons only interesting to those investors, like me, who also have a deep lust for theoretical physics and information theory) you should agree that information asymmetry, while not the only source of alpha, is probably the most influential.

My own disposition is towards limited market efficiency- prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital.  This implies two major sources of pricing error:

1.  Insufficient distribution of material information.
2.  Insufficient capital applied by those in possession of material information.

This further suggests that active management can exploit asymmetric information (learn something the market doesn't yet fully understand) or asymmetric capital (apply capital where the market hasn't yet bothered to) in the pursuit of "true" alpha.  Although, technically asymmetric capital is just a derivative of asymmetric information.

There is hope for those of us who believe that information grows more and more "imperfect" every day, at least if you listen to the likes of Moody's (though the wisdom of that decision could occupy several posts by itself).  Abnormal Returns points us to Alea which, quoting Moody's, suggests that:

One of the key reasons for the lack of information on the extent of risk and its location has been financial innovation, leading to greater complexity.

The combination of financial innovation, opacity and leverage is generally explosive.

Financial innovation often leads to an uneven distribution of the information available to the different parties at risk.

The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards.

Overall, the financial system suffered from flawed incentives that encouraged excessive risk-taking.

In no small measure, information asymmetry as a pricing force has all the elegance of a unified theory and (ironically) a certain symmetry (even super symmetry) in application.  I have referred to this phenomenon before in the context of CDO/CLO structures and the incentive structures that encouraged the (potentially reckless) growth of these instruments, as well as in the context of "debt attitude arbitrage."  The take-away message is that information asymmetry is a thread that runs through what are essentially pricing models.  To the extent one, as an investor, does not examine the incentive structures of the market, one risks being on the wrong side of the information asymmetry balance.  As an aside, this has what can only be termed "very serious" ramifications for an analysis of investment banking markets.

The passage from the Financial Times' Raghuram Rajan that follows may well be the most important thing reproduced in these pages in 2008, as brought to my attention (again) by Alea.  To wit:

Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compens­ation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha.

This is important enough that it bears repetition.  Particularly this bit below.  Really.  Read it again.  It's that important:

If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage.

The important thread to follow into the rest of the discussion is that these questions should have set off alarm bells loud enough to deafen, if only market actors bothered to listen.  Of course, the social rub is that this analysis shifts the burden of loss to the market actors who incurred the losses (an effect that tends to inspire rejection of the premise of information asymmetry, or prompt the invocation of the magic regulatory conjuring spell "That's unfair!" which is often laid across a rotting floral bed of "the losers were snookered by sophisticated financial insiders," where "sophisticated financial insiders" usually translates to "educated investors" and "losers" usually parses to "armchair investors who feel entitled to abnormal returns.")  Let's face it, losers make sympathetic victims, and, as I quoted recently:

...[the somewhat spoiled sense of American entitlement] can spawn vices. One is impatience. Another is a culture of chronic complaint. A third is the belief that every problem has a solution, that trial is possible without error, that risks must always be zero, that every inconvenience is an outrage, every setback a disaster and every mishap a plausible basis for a lawsuit.

One can see the change over the last few decades in the comments of one astute reader's response to the Alea entry.

Nearly 3 decades ago, at a large commercial bank, the risk management effort was based on not ‘what-if’ analysis (the statistical analysis relied on by firms like Moody’s) but ‘if-what’ analysis. That is, first determine all the conditions under which an transaction could lose money. Then assign probabilities to those conditions. If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

There is no entitlement to abnormal returns.  And, to quote our favorite tag line (from Abnormal Returns), "investing is hard."  This, I think, is the point where certain financial journalists and other pundits fall off the moving train and start looking for explanations that permit them to reject this basic (and very undemocratic) inequality.  Information asymmetry looks awfully unfair.  This is because it is.  The mistake is not in the label "unfair," but the assertion that "unfair" is, somehow, intrinsically evil.

Investing is hard.  But it is not impossible.  I will make no claims whatsoever to having "called" the credit crunch, but the incentives issues in these markets were a frequent topic on these pages early on.  Part of this approach flows from my personal view of the human condition:

Confucius: Man basically good.  (Significant evidence during the brutal warlord infighting of the Chou Dynasty to the contrary notwithstanding).
Rousseau: Man basically good ("Noble Savage").  Society makes man evil.  Widespread peasantry is the ideal state.
Scientologists: Man basically good, but the machinations of certain evil aliens long ago complicate matters.
Kierkegaard: Man is impossible to classify.
Puritans: Man is basically evil.  Fire purifies.  (Though this is hard to compute given how deeply carbon stains).
Baptists: Man is plagued by total, hereditary depravity.
Equity Private: Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

It is ironic that those with more optimistic views of behavioral sciences ("give sanctions a chance!") end up defending these notions to the death in the face of all evidence to the contrary.  And so, myths and misconceptions not only appear about the world of finance, but are latched onto by those desperate to defend the rosy refractions that color their world view.  When so colored, these misconceptions tend to show themselves rather glaringly to anyone who cares to subject the assertions and predictions of these human optimists, (dare I say, populists?) to scrutiny.

This brings us to certain attitudes about activist investors, and the most prevalent in my field of view today happen to be those of Mr. Sorkin.  (In my defense, this is entirely the fault of Mr. Sorkin).

Misconception number one is a common one among Maxwell Smarts, that is that financial investors (as opposed to "strategic investors," and there is much fudging among Smarts as to where the line here actually lies) are short-term profiteers.  The corollary to this misconception is the conviction that short-term investment is intrinsically evil, but we will leave that for another day.  Taking just activism,
we find that average holding periods range from 1 to 3 years (depending on the study and whether the investment holding period is measured from the filing of the first 13D, or from the first appearance on a 13F).  In the case of activists this misconception stems from a basic misunderstanding of what activist investing is, and in particular that activist investors are generally value investors first.

Misconception number two is that activists are just reformed corporate raiders.  It is true that former raiders make up a large portion of the list of who we might call "activists" today, but anyone convinced that the game is the same (or that greenmail takes place with any frequency anymore) has simply seen Wall Street too many times (and forgotten that it was released in 1987).  It is probably prudent to point out that back in their day, raiders did not have available to them the plethora of tools for injecting accountability to corporate management that they do today.  The only tool was the threat of a loss of control and liquidation (which begs the question if liquidation is also intrinsically evil).  Regardless, activists today have a much broader set of tools to inject accountability.

Misconception number three is that activists depend on cheap debt for their returns.  The corollary to this misconception is that debt today isn't cheap anymore.  Even the most cursory study of historical debt rates and relative debt prices today (72kB .pdf from Clearbook Financial as cited by Infectious Greed) would disabuse the most research averse financial journalist of this misconception.  (Only five countries have rates lower than the United States today).  But "work is for suckas," in the world of the average financial journalist- and unnecessary as the narrative fallacy is alive and well in the psyche of the news consuming public.  Maxwell Smarts wouldn't bother to notice that in mid-2000 LIBOR rates were nearly 7.5%.  Chapman Capital was busily squeezing change out of the American Communities Property Trust back then.  And in 1988, 1989 and 1990, when the same rates were in or nearly in double digits for a period of over 18 months?  Ralph Whitworth (who would later found Relational Investors in 1995 when rates were again peaking around 7-8%) was running insurgent campaigns via the United Shareholders Association (T. Boone Pickens was a major investor). Today LIBOR rates sit around 4.3% or so.

So it is not surprising that Mr. Sorkin might be possessed of the mistaken belief that the last six months of activist performance (which he documents poorly in any event) could somehow be explained by debt prices.  (Even if there were a connection as direct at Mr. Sorkin claims, it is his lack of understanding with respect to activist holding periods that compounds his error- since a six month debt pricing spike will hardly show dramatic results on returns if investor holding periods average at least twice if not six times that duration).

All of this is a rather extended way of saying that astute Going Private readers will regard with skepticism any pundit or financial journalist (or indeed, anyone) claiming that leverage is intrinsically evil, that returns for a given strategy are dependent on cheap debt (amazing the profits the early buyout kings made when they had to borrow at 12%) or that "losers" in a given marketplace have de facto been the subject of fraud and deception.

Indeed, Going Private regulars will smirk at such suggestions, and recognize the attempts of lesser students of financial markets to disguise their ignorance, and that of their populist peers, by calling investment strategies "black magic," and mistaking the role of leverage in legitimate strategies as often as they are fooled by its complexity creating effects for merely beta-based returns.

Debt can either magnify returns generated by true alpha, or disguise (that is increase information asymmetry in) returns that may or may not have anything to do with alpha.  The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest.  Or, to emphasize the commenter of earlier fame:

If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

Follow that?  If you don't understand what you are buying, don't buy.  Quite simple.  Or so you would think.

Cheap debt does not cause losses.  Being on the wrong side of information asymmetry does.  When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.

Activism is, along with value investing strategies and in my view, one of the few pure sources of alpha.

Activism is not hard to understand.  If you bother to educate yourself.

Wealth and Fame

At least in contemporary finance culture (is there such a thing?) the interplay between money and fame is most glaringly apparent in the world of hedge funds.  Be this as it may, some recent incidents have caused me to wonder to myself if this dynamic, like many in contemporary finance culture (if there is such a thing), isn't more complex than it first appears. Incentive fees (and management fees) being what they are, there are strong incentives for hedge funds to grow assets at (nearly) any expense.  There are some noted exceptions to these rules (I can think of an activist or two who have returned rather large sums to investors when they have been unable to, in good faith, place the funds in sufficiently worthy investments) but these are few and far between.  Getting the word out, and pushing the hype is, as with any financial product, part of the fundraising game.

Of course, technically hedge funds aren't supposed to be engaged in "general solicitation."  That is covered by Rule 502(c) which provides in part:

Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

Hedge fund managers who are prone to quoting returns and figures in publications, or chatting too liberally with members of the press are likely to get something of a spanking from the SEC.  We must, after all, protect non-accredited investors from themselves (though I suspect this bit of nanny-statism is preferable to a legislative unwinding transactions between consenting parties because they are judged "unfair" after the fact and in the context of a shift in markets to something other than permabull dynamics).

Fame, then, would seem a shortcut, even a loophole, to such restrictions.  Many managers court such publicity actively.  This is, to the extent this term has any meaning whatsoever, "marketing."

It amuses me then when such managers are described as "secretive," "publicity shy," "reclusive," or "intensely private."  It is hard to take, for instance, Bloomberg very seriously when they "speculate" on the "ever secretive Renaissance."  Apparently, Renaissance wasn't so secretive that its founder the "reclusive" James Simons couldn't be persuaded to give Bloomberg an exclusive interview (or three), pan his life story and sit for an extensive Bloomberg photo shoot.  Of course, Bloomberg tries to maintain the illusion of hard hitting investigative financial journalism with lines sprinkled with breezy comments like "...according to Bloomberg calculations," and "...though Simons dislikes talking about it...."  Ah, yes.  Of course he does.  But not so much that he won't talk about it.  Guess the hard hitting investigative reported had a nice pair.  ("Of what," is the question- but then I think Simons' smile in the picture might be a clue there).

Any number of hedge fund mangers or private equity firms have found themselves in warmer-than-comfortable water with the SEC after a puff-piece appeared on Bloomberg under the "Bloomberg.com: Exclusive" banner.  And Bloomberg, by the way, is particularly guilty of such sins.  This should be enough to land them in Going Private's Maxwell Smart category by itself, but their ethical lapses are not limited to managers cast from the publicity hound mold.

Rare are the managers who are, in fact, "secretive," whatever Bloomberg may try to sell you- but they do exist here and there.  Not that Bloomberg has much regard for such privacy in the rare instance that they encounter it among the rolls of professional managers.

Recently, a good friend of Going Private pointed me to a Bloomberg profile on a number of hedge fund managers, including his boss, the head of a rather successful family of funds which have made him quite wealthy by almost any standards one would care to articulate.  In the course of reading the article I managed effortlessly to determine:

1.  His street address
2.  The price of his house
3.  His daily exercise habits and, thereby, his daily whereabouts
4.  The school his two minor children attend
5.  His performance and management fees for the year
6.  His wife's habits

I could go on, but time forbids me.

Ah well, I thought, another ego-driven hedgie who's publicist managed to score a puff on Bloomberg.  *yawn*  Yeah, except not.

Turns out that the subject of the article had nothing to do with it, refused to comment and asked Bloomberg not to print it.  Forgive me my cynicism, but I wonder if the classic journalistic threat (Want a favorable piece?  Give us access.) wasn't at work here.  If so, and this is just my speculation, it borders on criminal in my opinion.

Suffice it to say, if I was running an international kidnapping cartel, my arrival in New York would be followed immediately by a visit to the most anonymous internet cafe I could find (or some wireless wardriving perhaps) and several Bloomberg searches.  (Law and Order had a totally cool episode about a hedge fund manager kidnapped by his employees recently, so you just know that I'm current).

Still, some hedgies, and other professional "money runners," do get some use out of publicity.  For some, this is merely an ego gratification.  (You people know who you are).  Indeed, publicity hounds in this category are, at least in my view, violating at least the spirit of Rule 502(c), and the hedgies I respect avoid rather than court publicity.  Still, it can be useful in some circumstances.  For instance:

Your investment vehicle is going public.  I don't know that anyone would make the argument that Steve Schwartzman's stock suffered when the over-the-topness of his birthday parts became (and by this I mean, was encouraged to become) public.  Sure, Congress might be pissed off, but a few dollars in share price buys a metric ass-ton of lobbyists.

You are an activist.  Before you ever get to the point where you are soliciting shareholders for your proxy fight, the pure intimidation factor your name lends to the initial discussion with management can keep campaigns simple, quick and effective because you are a "credible threat," (Dan Loeb filed a 13D?  Go to threat level RED: severe risk of activist campaign!)  This helps even more if management decides to fight and you need to go to street for support.  So here, well, I'm more sympathetic.

As for the rest?  Really, let your performance do the talking.  Or my hedge fund friend would say:

"Just because you have $10.00 and everyone knows about it doesn't make it $11.00."

But then, he gets mad when investors leak their (outstanding) performance figures to the press- so he's a rare bird.  Think, dear hedgies, about the company you keep:

In America, I find, it's fame, rather than money.  Now, after all this unpleasantness, I always get the best table.

- Klaus von Bulow

Dear Anti-Activist

Dear Ms. Chairman:

I am in receipt of your letter dated May 23, 2008.

I was particularly taken with your description of the venerable and populist history of your firm.  It is, indeed, remarkable to note that your firm has survived for 117 years, a term which necessarily includes the first and second world wars, and some rather interesting times in the economy of the Japanese mainland.  I will refrain in this letter from wondering in detail what a firm was required to do to remain in the military's good favor during the height of Imperial Japan, but I suspect such an inquiry would make for good reading.  At the very least, it seems clear that any firm that endured during this era (and particularly a firm whose founder garnered great personal wealth in this period) enjoyed the monopoly benefits of the World War I and World War II era zaibatsu wartime conglomerate system- and rather close ties with the Japanese military.  Frankly, it is hard not to make money in such circumstances.  But I digress.

Regardless of the particulars of your firm, I think this background highlights a particular class of assumption in your brand of corporate archeology, specifically, that firms necessarily should endure forever, or even for a century.  There is a reason that the modern world does not easily endure dynasties.  Ironically, Japan is a classic example proving the rule.

Without a doubt, investment in Japanese real-estate was, at the time, an outstanding trade.  Your founder's exceptional vision in this respect deserves every reverence (the economics of the period notwithstanding), and I am pleased to add my name to the list of his admirers on this particular issue.  What he did with this real estate later, however, concerns me, and should disturb any individual in favor of the separation of ownership and control, and hence the modern capitalist system.

Whittling out shareholder-owned real-estate to maintain full employment for the sake of full employment is borderline criminal.  Only the vanishingly small corpus of shareholder rights in Japan at the time even permitted your founder to embark on such a larcenous plan.  If full employment and lifetime job security were the goal of corporate industry then perhaps we should remove all automation from Toyota's plants and present each employee with a single flathead screwdriver.  I suspect we would have half of Japan gainfully employed quite quickly to maintain Toyota's production.  I will avoid rendering any opinion on the quality impact of such a move.

It is no secret that Japanese corporations, while technically "publicly held," historically kept large, interlocking holdings of their respective stock.  The fact that large corporations bought and held large tracks of each other's stock and allowed only the smallest float with the public seems, on its face, a noble measure.  Promises that such holdings would never be sold were iron clad, and that these promises were almost universally kept is a rather definitive statement on the importance of "honor" in Japanese society, and- eventually- the price thereof.  For decades these interlocking holdings permitted Japanese firms and their management teams to destroy value, pursue reckless (and generally ineffective) social policy, which, incidentally, is something corporations are about the least suited for, and generally avoid any accountability to shareholders- the owners, after all, of the company. The small "float" meant that even the most abysmal corporate policies would result in little, if any, impact on the share price of Japanese corporations.  Clever, that- if unsustainable.

In the short term, this was wonderful for shareholders.  It was not that long ago that Nippon Telegraph & Telephone traded at 158 times earnings.  I would have enjoyed owning that stock, right before I sold it.  This was, of course, part of the great "Japanese Post-War Miracle," helped by the strict protectionism of the Japanese government and a brand of massive "over loaning" that makes today's sub-prime crisis look like a few youthful indiscretions.  The Japanese Government at one point was issuing 100 year bonds.  Many large firms borrowed in excess of 1000% of their net worth, sums they could never in the wildest fantasies of permabulls hope to repay, but which were made up to the local city bank lenders (the first line creditors) for years by the Bank of Japan to avoid any defaults.  Tokyo land in Ginza could fetch $150,000 per square foot at one point, so flush with cash was Japan.  Today it is 1/100th of that price.

The keiretsu (conglomerate and quasi-monopoly groups that are effectively the progeny of the wartime zaibatsu system) effectively prevented any takeover threats, and, again through interlocking holdings, prevented any management accountability to earnings, revenue, solvency or any of the other modern measures of corporate success.  The Japanese Government supported, so far as it could, many of the larger firms that, without these direct subsidies, would have collapsed.  Many more became the now famous "Zombie Companies," existing only by the grace of the Government's pocketbook (and therefore the taxpayers pocketbook), and only permitted to survive so that some official in the Japanese Department of Labor could announce reasonable unemployment figures for the year and perpetuate the myth of Japanese solvency.

Of course, what followed was "the lost decade."  Could there have been any other result?

I applaud the sorts of social experimentation that "lifetime employment," conglomerate systems, state-encouraged monopolist and trade protectionism provide the anthropologists and sociologists of the Western world with.  These people need good dissertation material, of course (call it the Leftist Employment Act Fund: LEAF, if you will) and so I encourage these sorts of experiments within the carefully controlled bounds of leftist think thanks.  These are not topics for study using shareholder funds.  If I wish to fund social research into socioeconomic topics that were settled over 25 years ago, I will give my money to the Brookings Institution or perhaps Yale Law School- not buy stock.

As your largest single shareholder, I cannot allow the wanton spoilage of shareholder wealth to continue a policy of "lifetime employment" for the sake of "social justice." And while the notion of corporate sponsored social welfare is quaint, it is equally backward.  Incentives produce results, nothing else.  I would have thought Japan's history might have taught you that.

I might add that having many happy customers, seemingly a key metric for you given the tone your letter, is not the key to success.  I can promise you near 100% market penetration in six weeks.  Simply set the price of your product to 50% of any of the competition, and sell for massive losses as quickly as you can.  You will have, I assure you, many happy customers.  Your shareholders will, however, be sharpening disemboweling cutlasses.

In the end, what is important to remember is this: The perpetuation of a corporation for sentimental purposes is not, of itself, utilitarian.

I am sorry that your firm has responded poorly to the new exposure to global trade.  I am sorry that its encounter with the realities of a market economy, which Japan has thankfully, and finally embraced to- at long last- bolster Gross Domestic Product growth into the 2% range, has been difficult. But it is entirely possible that yours is a firm that should not survive once required to provide shareholders with competitive returns.  The problem with protectionism is that, in the absence of a sure competitive advantage or unique product, its benefits always come due- with interest.

Indeed, you may not thank me for your firm's present fate.  You may, however, thank me for Japan's.

Most Sincerely,

Hugh G. Fallis
General Partner
Chief Activist Officer
The Greenmail Fund
Main Street
Greenwich CT
USA

A Brief Delay

Unfortunately, there will be a brief delay in service while I dry off my undergarments and descend into the plateaued euphoria of the newly minted Icahn Report.