Honesty & Optimism

I've gotten a lot of feedback so far on my post from earlier today on The Quadruple Down Recession, and one of the interesting things about the feedback is that there is on the one hand an objection to the "negativism" of my outlook on the other hand to its honesty.  It confirmed an important tenet of my business philosophy (which developed as I witnessed the consequences of its inverse) that in our imperfect world, most optimism is simply not based on Truth.  If there is one thing we must all cling to, it is Truth, no matter how unpleasant it might be.  For if we avoid Truth in favor of our own concocted reality, then we will suffer significant psychological (and in the context of business, economic) pain.  

Over the last few weeks I have been doing a slow re-read of M. Scott Peck's masterpiece The Road Less Traveled, which continues to rank as one of the most influential books on my life and philosophy.  In the first section of his book, the one dedicated to Discipline, he discusses several techniques of dealing with the pain of problem-solving "which must continually be employed if our lives are to be healthy and our spirits are to grow."  One of those tools he terms "dedication to reality."  

Peck writes:

Superfically, this should be obvious.  For truth is reality.  That which is false is unreal.  The more clearly we see the reality of the world, the better equipped we are to deal with the world.  The less clearly we see the reality of the world--the more our minds are befuddled by falsehood, misperceptions and illusions--the less able we will be to determine correct courses of action and make wise decisions.  Our view of reality is like a map with which to negotiate the terrain of life.  If the map is true and accurate, we will generally know where we are, and if we have decided where we want to go, we will generally know how to get there.  If the map is false and inaccurate, we will generally be lost.  While this is obvious, it is something that most people to a greater or lesser degree chose to ignore.  They ignore it because our route to reality is not easy. 

 

How timelessly true this is, not only in our individual lives but in our corporate life  also (I use this term in its original meaning, not in its modern economic context, though it certainly applies to that context as well) .  Collectively, corporately, whether it is in our public policy-making for society as a whole or in our investment strategies, or our capital allocation strategies, we must be dedicated to reality, no matter how painful it is.  Many people are much happier with living in a fantasy land.  They want life to be as myopically twisted as Michael Jackson's Neverland Ranch.

These are the people, however, who bear the blame for the irresponsibility of the boom years.  They were the Federal Reserve analysts and policy-makers who advocated continuing to hold interest rates artificially low in the aftermath of 9/11.  They were the CEOs of Lehman Brothers, Bear Stearns, and AIG, who either willfully or negligently believed that unbridled debt could propel their firms to historic prosperity in perpetuity.  They were the realtors who sold houses to unwitting homebuyers with the promise of flipping the house for a mega-profit in only a few months.  They were the homebuyers who left their common sense at the door and bought the snake oil the realtors were peddling.  They were the investors in Bernie Madoff's ponzi scheme who never bothered to ask questions when their returns were too good to be true. They were the SEC investigators who ignored warnings that Madoff was a bad guy.

Unfortunately these people are not gone, they are simply with us in a new form today.  They are the politicians promising us pain-free government panaceas to our economic woes.  They are the Federal Reserve policy-makers who are repeating the mistakes that led to the 2001 tech bubble burst and the 2008 credit crisis.  Yet the mistakes are simply being repeated on a much larger scale.  They are the politicians promising "free" government health care with no cost to 98% of Americans.  They are the people who are buying into this false promise.  

How can we be so quickly forgetful?  Rudyard Kipling, in his timeless poem, "The Gods of the Copybook Headings" observed this phenomenon thusly--

As it will be in the future, it was at the birth of man,

There are only four things certain since social progress began:

That the dog returns to his vomit, and the sow returns to her mire,

And the burnt fool's finger goes wobbling back to the fire.

There can be no optimism without brutal, transparent honesty.  Optimism should arise out of a confidence in what we are going to do in response to our own problems, and how we will respond to the world's problems.  That is warranted optimism, for it is something that is within our control.  When our map reflects the way the world actually is, then we can respond accordingly.  We do not have to worry about disappointment, because when we are dedicated to reality, there will be fewer unforeseen obstacles.  What You See Is What You Get.  Even when what you see is not what you like.

I am most optimistic when I am most real.  Real about the present and about the future.  

Is it pessimistic to say that the European Banks are insolvent?  Is it pessimistic to discuss the $1.6 Trillion price tag of President Obama's health care plan?  Is it pessimistic to acknowledge the prospects of inflation?

Not if these are the realities.  And in acknowledging these realities we can find a source for warranted optimism: coming up with the alternatives and solutions to the negative reality we may face.  I am not filled with hope when I hear a political speech full of empty promises and meaningless rhetoric.  I am filled with hope when I spend an hour with my white board solving the next facet of the problems I face.  That means acknowledging the problems I can't solve and coming up with a way to work around them, rather than locking myself in my room and crying because I can't wave a magic wand and make the problem go away.

I will close tonight with a final thought from Peck.  It should be etched in our consciousnesses, both individually and collectively.  It should guide our policy-makers, our business leaders, our voters, our households, our private equity & hedge fund managers, our bankers, and everybody else.  It should also motivate us not only to dedicate ourselves to reality, but also to transparency about reality with all around us.  This transparency, predicated on honest reality, is the source of trust, whether in a marriage or in a business partnership.  If we all take Peck's counsel to heart, our world will be a far better place:

Truth or reality is avoided when it is painful.  We can revise our maps only when we have the discipline to overcome that pain.  To have such discipline, we must be totally dedicated to truth.  That is to say that we must always hold truth, as best we can determine it, to be more important, more vital to our self-interest, than our comfort.  Conversely, we must always consider our personal discomfort relatively unimportant and, indeed, even welcome it in the service of the search for truth.  Mental health is an ongoing process of dedication to reality at all costs.

Posted via email from skinnerlayne's posterous

The Quadruple-Down?

With all of this talk about green shoots and recovery, you'd think that Ben Bernanke, Barack Obama, and Tim Geithner were living in a different reality.  Just that they happen to be living in the same alternate reality as Mr. Market  who seems to have infected Wall Street yet again.  We are living in the midst of another bubble.  The MSM in the United States has turned to happy talk, primarily out of their sworn duty to keep Barack Obama's popularity rating high, while neglecting their ethical responsibility to the Truth.  The bubble this time is what I'd like to call the Recovery Bubble.  It is built on hype, a lot of government spending, and a lot more fiat money created by the Federal Reserve.  Incidentally it bears a close resemblance to the last bubble in all of those respects.  But underneath the surface (even apart from the long-term implications of the U.S. government's unfunded liabilities in social security and medicare) there are several looming collapses that could trigger the next domino effect.  

We looked at one of them yesterday in my article entitled Private Equity Hit & Run, where I analyzed a recent article from TheDeal.com discussing the maturation of more than $400 billion in senior debt in the Private Equity Market.  

Today I'd like to discuss a few others.  Nobody I have read so far in either the U.S. media or the foreign press has put all of the pieces of the defaults puzzle together, so I want to do that today.  

(1) Insolvent European Banks

(2) Credit Card Debt Defaults

(3) U.S. Sovereign Debt Rating

(4) Inflation (The UK is our Canary in the Coal Mine)

Insolvent European Banks

It [European Central Bank] said it is expecting fresh bank writedowns to hit $283bn (£173bn) by the end of next year..."The deterioration in the macro-financial environment has continued to test the shock-absorption capacity of the euro-area financial system. Prospects for a significant turnaround in the short term are not promising," it said.  In a ghastly day for Europe's lenders, Moody's downgraded 25 Spanish banks as rising defaults eat into reserves...The ECB's report said eurozone bank losses would reach $649bn by late 2010: split between $218bn on securities, largely written down already; and $431bn on loans, where the real damage lies. The banks have written down $150bn of loan losses so far.  The report said accounting rules were lax in some countries and there may be "under-reporting". There is a risk that "write-off rates could increase by more than currently anticipated".

In what is another prooftext for the argument that no amount of regulation can prevent financial crises, the highly regulated banking system on the Continent, seems to be in even worse a position than the U.S. banks, including several that have been taken over by the FDIC.  Western Europe is reeling from the near-default status of several Eurozone countries (Greece, Ireland, and Spain), while Northern Europe and Switzerland are on the hook for the now out of control downward spiral in Eastern Europe, especially Latvia.  Sweden, which had previously been insulated from many of the problems besetting the rest of Continental Europe, is now acutely endangered by virtue of its disproportionate share of Latvia's consumer debt orgy.  The Kronor's independence of the Euro had been one of the strengths of the Swedish economy.  It could quickly turn into its Achilles' heel.  

Assuming these write-downs are only as bad as projected, the situation looks grim, not only for a recovery in Europe, but in the United States as well.  Europe's spuriously perceived resilience (particularly Germany, in light of its dogged refusal to engage in the government spending binge advocated by Gordon Brown and Barack Obama) was, if not a silver lining around the storm-clouds, at least a candle in the midst of pitch-darkness.  Those ill-conceived notions are all but abandoned today, yet the American financial press and Mr. Market seem to ignore this fact regularly.

Massive write-downs in Europe can lead to only three outcomes:

(a) Government-bailouts

(b) Capital markets crowd-outs

(c) Defaults

(a) At least in Germany (assuming Angela Merkel's government is returned to power in the Autumn elections), the prospect of bailouts seems slim.  However, Germany is in a classic catch-22.  If they do not assist in preventing defaults in the rest of the Eurozone, they risk a severe devaluation of the Euro, hurting German purchasing power, and significantly altering the realities surrounding existing German industrial policy.  If they do assist, however, they will only undermine their own national fiscal policy efforts to maintain a disciplined and reasonable approach to the situation in addition to the prospects of inflation that would be raised in light of massive pan-European bank bailouts (see #4 below for the implications of quantitative easing as a means for bank bailouts with the UK as our shining example).  

(b) The European banks can of course go to the capital markets like the U.S. banks have, and raise additional capital.  Investors in U.S. banks did not have the benefit of watching this process, and if they had, the banks would have either had greater difficulty in raising capital or else would have been forced to raise it at far less desirable valuations.  European banks now must go to investors who have watched the continued drag on U.S. bank investors and consider the prospects of good returns in light of the foregoing reality.  In my view, at least, this is why the European banks have not raised more capital from the private sector.  Sovereign investors from Asia and the Middle East are shying away from the risk currently surrounding the developed world's banking system.  Even if the Euro banks can raise capital in the private sector, the amount needed to sustain themselves through the next round of the crisis is likely to be so substantial that it will adversely affect other private sector enterprise on the Continent, forestalling recovery even longer.

(c) The specter of default must still loom on the horizon.  Though the EU finance quango will not allow outright defaults, we must monitor the "behind the scenes" actions of the Eurocrats to discern when these pseudo-defaults are occurring.  We will likely see some forced M&A activity tantamount to the BofA and JPM deals arranged by the Federal Reserve.  Then there will be most likely a couple of "credit lifelines" tossed to then-Too Big To Fail banks rather than dozens of smaller bailouts.  I do not expect honest outright defaults and bankruptcy proceedings simply because it will be too politically damaging for the Eurocrats who were drubbed in the recent European Parliament elections and who are scrambling to save face and stave off their doomsday scenario of a Referendum on the European Constitution Lisbon Treaty in the UK.

Given that there are no pain-free options here, it seems that the insolvency of Europe's banks poses an indeed significant barrier to the Developed World's recovery, and even more likely will contribute to a second crisis.

Credit Card Defaults

The troubles sound familiar.  Borrowers falling behind on their payments.  Defaults rising. Huge swaths of loans souring.  Investors getting burned.  But forget the now-familiar tales of mortgages gone bad.  The next horror for the beaten-down financial firms is the $950 billion worth of outstanding credit-card debt--much of it toxic.  That's bad news for players like JPMorgan Chase and Bank of America that have largely sidestepped--and even benefited from--the mortgage mess but have major credit-card operations.  They're hardly alone.  The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy.  "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors.  Adss William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better."  What's more, the U.S. Treasury Department's $700 billion mortgage bailout won't be a lifeline for credit-card issuers.

This would be bad enough under normal conditions, or even in a situation we are facing today on its face, but there is another layer of complexity that will make this segment of the crisis even more difficult to handle.  Unlike the mortgage market, where there are assets (although devalued ones) to back up the bad debt, the revolving credit market does not benefit from simply repossessing the property the loans were used to acquire, since in many cases these revolving credit lines weren't used to buy any durable property at all.  The cost of litigation is high, and not only is it not scalable, it suffers from the truth of the old adage about getting blood from a turnip.  Suing consumers with no net worth is a losing prospect for everybody.  So the financial institutions are going to have to absorb the losses and write them down.  Market forces are cleaning out all of the misallocated capital in the economy, even as the government and the Federal Reserve system are trying to infuse more capital to prop up the malinvestment.  

Furthermore, under normal circumstances, the credit card companies would have the ability to adjust the prices, terms, and conditions in order to recover some of their losses.  Higher fees, higher interest rates, etc., could normally be employed to limit their damage.  But Capitol Hill and the Obama Administration have made it clear that they will not allow this to happen, and are in the process of passing a series of new regulations under the guise of consumer protection that will only complicate matters further.  

We should expect the Credit Card tailspin to double down the U.S. economy independent of any Hail Mary the Europeans can achieve with their banks.

U.S. Sovereign Debt Rating

Technical analyst Robert Prechter on Monday said he sees the United States losing its top AAA credit rating by the end of 2010, as he stuck by a deeply bearish outlook on the U.S. economy and stock market.  Prechter, known for predicting the 1987 stock market crash, joins a growing coterie of market heavyweights in forecasting the United States will lose its top credit rating as the government issues trillions of dollars in debt to fund efforts to bail out the economy.  Fears about the long-term vulnerability of the prized U.S. credit rating came to the fore after Standard & Poor's in May lowered its outlook on Britain, threatening the UK's top AAA rating. That move raised fears that the United States could face a similar risk, with the hefty amounts of government debt issued in both countries to pay for financial rescues causing budget deficits to swell...Despite the government and Federal Reserve's massive rescues for financial companies and securities markets, Prechter expects credit markets to clam up again as they did in the first phase of the global financial crisis and for the U.S. economy to sink into a depression.  Although U.S. banks' recently passed government "stress tests" that assessed the adequacy of their capital levels to absorb losses and have been able to raise some capital in debt and equity markets, "the banking sector is in severe trouble," as more loans turn bad, he said.  The economy "is obviously heading toward a depression," despite the government's efforts to dodge one, said Prechter.  Federal Reserve Chairman Ben Bernanke has not averted a re-run of the 1930s Great Depression, even though investors are becoming firmly convinced that the Fed has avoided disaster and that the economy has hit bottom.  "It's the next leg down (in stocks) that will make it clear that these things are not true," Prechter said.

The implications of the U.S. government's sovereign debt rating being downgraded cannot be underestimated.  Even if the ratings agencies shift their "outlook" to negative, the consequences could be severe.  We should pay careful attention as the next several months unfold to see if there is any appearance of political pressure on the independent ratings agencies to maintain both the AAA rating and a Positive Outlook for U.S. sovereign debt.  It will be ironic, considering the fact that the present administration has levied substantial criticism against the ratings agencies for playing favorites and turning a blind eye on corporate credit ratings in the past.  But nobody has ever accused politicians of being above some good old fashioned hypocrisy.  

So when the credit rating is cut, interest rates will skyrocket.  There will be major crowding-out as the Treasury tries to keep itself afloat in the private debt market.  There will be increasing pressure on the Federal Reserve (and increasingly will call its independence into question) to engage in yet more quantitative easing, which can and will only lead to inflation.  There is no other course.  The only other alternative is for the current Congress and Administration to radically reverse course on spending policy, something that has about as small a chance of happening as Mahmoud Ahmadinejad voluntarily stepping down as President of Iran.

Higher rates or inflation (or both, which is what is most likely), far from boding well for a recovery, are merely further circumstances that call into doubt these fantasy claims of recovery.

Inflation / Staglation & the British Canary

The Consumer Prices Index (CPI) - the Government's preferred measure of inflation - fell to a 16-month low of 2.2pc from 2.3pc in April, but it was a smaller fall than City economists had predicted.  However, that had been anticipated and factored into economists' forecasts, and it was the so-called discretionary spending categories which prevented the expected fall in inflation..."We continue to see upward pressure in 'high street' prices and we continue to attribute this in part to the sharp depreciation in sterling seen over the past quarters, notwithstanding the significant rally posted in recent weeks," said David Page, economist at Investec.  Inflation has now come in above economists' expectations in five of the past seven months.

It should be noted that it was the Bank of England that first embarked on the policy of quantitative easing in the Developed World.  That inflation has now several times surprised economists' expectations in the UK should not surprise those of us who believe in sound money.  It is almost humorous that these economists are baffled by the twin prospects of inflation and economic contraction, as if they have a completely blocked out the lessons of 1970s stagflation.  For Gordon Brown and the already beleaguered Labour Party, the Winter of Discontent should haunt their dreams.  Nevertheless, the rest of the world, at least those whose futures are tied to the Dollar, should take note: quantitative easing has consequences.  Either we will sustain severe stagflation or else the Federal Reserve will be forced to abandon its easy money policies once again to tame the inflation beast, thrusting the American economy directly back into the throes of recession.  Recession of course is the best medicine for malinvestments, and had the government permitted the recession to run its course, we would at least be closer to the path to recovery.  Instead, government and Federal Reserve policies tried to avoid the pain of recession by manipulating the markets with massive infusions of cash which will either have to be pulled out or allowed to run their course.

The further problem we should observe in this situation is that avoiding a further massive contraction becomes ever-more costly.  For it is not only a matter of leaving the current inflationary dollars in the system that is required to keep the economy on life support, it is the need to continually feed the monster with more and more newly-minted money.  Virtually any policy pursued by the Federal Reserve at this point will have adverse circumstances.

Conclusion

So what's an investor/entrepreneur to do?  The answer is to look to the handful of countries pursuing responsible economic policies.  The trouble is, you won't find many.  The Developed World has gotten itself into a position where it bet everything on Red 15 and the roulette ball landed on Black 7.  Doubling down on its debts in the hope that the new bets would pay off has only doubled downed the consequences (both immediate and long-term) of our current unpleasantness.  There is plenty of capital sitting on the sidelines today, and it has to have a place to go.  Developing Countries with stable monetary systems offer some haven for investors looking to escape the uneasiness of the over-leveraged developed world.  Emerging market equities in Asia, and Latin America's stable countries have a far greater chance of holding the value and outperforming investments in the developed world not only in the short-term, but over time.  

Posted via email from skinnerlayne's posterous

Private Equity Hit & Run

An excellent article on TheDeal.com [ http://bit.ly/AN1D5 ] validates my view that leverage is a speculative tool that endangers not only the long-term health of companies, but of the Private Equity industry itself.  The article doesn't make these conclusions, but they do follow from the observations the author makes.  Let's look at them one at a time.

(1) Deleveraging Changes the Landscape: "The deleveraging of the economy in the wake of the economic crisis has dealt an especially crippling blow to private equity, an industry long as reliant on debt as candy makers are on sugar.  For a blissful four-year span that lasted into 2007, leveraged buyout sponsors raked in vast profits fueled by oceans of cheap debt and by soaring asset valuations and a booming economy that were debt-propelled.  Today that golden age seems as remote as the lost empire of the Incas."

Indeed, it was private equity firms, far more than the much demonized hedge funds, that were responsible for much of the leverage bubble that tipped off the financial crisis when the game of Hot Potato ended.  Private Equity now must forge a new existence (a more responsible existence) in an era where their favorite food has been taken away from them.  Imagine Michael Moore without his Ben & Jerry's, that's where Private Equity is without cheap debt.

(2) Bright, but Dim Future: "In one key area, it turns out, private equity is sitting pretty.  Before the economy worsened drastically last fall, the industry replenished its coffers, drawing more than $550 Billion in pledges from institutional investors in 2008, a near record...But for now, that alluring prospect is vying for sponsors' attention with a worrisome, brewing development that could lay waste private equity returns and foster an industry shakeout.  Though previous downturns have forced slews of poor performers, including some well-known names, from the business, the body count this time could be great.  The problem lies in the staggering amounts of equity and debt capital that poured into LBOs from 2004-2007.  From 2012 to 2014, about $430 Billion of senior debt tied to that deal spree is set to come due.  And unless the leveraged loan market roars back to life by then--something experts consider doubtful [Skinner: I concur]--an avalanche of defaults could wipe out much of the equity the buyout industry wagered on scores of deals."

Casino capitalism strikes again.  This is the problem with leveraged deals in the first place.  Saddling good companies with a lot of debt for a quick turn sure made the gamblers a lot of profits, but those who were caught at the end of this game of Hot Potato are getting their hands burned, and they are going to have to make a choice between survival (read: burn through all that cash they have sitting around) or doubling down on sure losses by letting it ride.  There is a time and place for debt capital: financing the purchase of new equipment, expanding the operations of a company buy acquiring a smaller competitor with an innovative product offering, financing additional inventory to open up a new export market, etc.  But the time and place for debt capital is not leveraging the lifeblood of a company on 15 Red.  

Before we move on to (3), some math is in order.  PE funds have raised $550 Billion in pledges, but there is $430 Billion in Senior debt coming due.  So that's a net of only $120 Billion.  Not as much capital on the sidelines after all.  As I have stated before on this blog and elsewhere, there is another wave of defaults coming anyway, assuredly from the even-more insolvent European banks, and people are naive if they think it won't further ripple across the Atlantic.

(3) Big Deals Go Bust: "'There will be a lot of RJRs,' one buyout specialist predicts, alluding to KKR's $31.3 Billion buyout of RJR Nabisco in 1989, which held the size record for an LBO for 16 years and which lost money for KKR.  'Not bad companies, necessarily, but companies with capital structures the sponsors can't extricate themselves from and that can't be refinance.'  This investor says he expects one-quarter of the megadeals to be total busts, another quarter to make a profit and half to post a partial loss. 'But that's only if the economy recovers,' he adds. 'If it doesn't, those deals are all toast.'"

Notice that the problem isn't that they invested in bad companies; it's that they invested in bad deals.  There is a difference.  There is also such a thing as a good deal in a bad company.  I threw together a quick color-coded visual to help us understand the differences.

Private Equity's future no doubt must focus on Value Plays and Turnarounds rathe than chasing the biggest, sexiest headline-making deals.

(4) The Interest Rate Storm Cloud: "One top LBO banker calls even that scenario too bullish. 'If we do have capital markets in, say, 2012, sponsors could have to refinance at grotesquely high interest rates, and that will permanently impair their equity,' he says. 'That's the good case.'  If, on the other hand, credit is scarce, sponsors may have to sell stock in their albatross deals to pay off debt, massively diluting their own stakes.  Weak performers may end up being sold at a loss to deep-pocketed corporations or broken up and sold in pieces.  Creditors would recover of what they lent, and sponsors would get zilch."

Debt-heavy Private Equity can't operate in vacuum.  It is going to be subject to the topsy-turvy nature of an unstable bond market over the next several years.  For firms operating primarily in the U.S. market, this means interest rates that are only going to increase in the next few years (whether to tame inflation, or as the markets revolt against it), with the less probable, though still possible apocalyptic prospect of being forced to take out future debts in Yuan or IMF SDR-denominated bonds in order to refinance their investments.  

This data all points toward a leverage-free approach as the optimal way not only to preserve wealth for investors, but to create more of it--just on a less aggressive timeline than the speculators can traditionally "promise" (the problem with debt-driven speculation is that it always collapses.  It is a universal truth that is ignored when everybody gets bubble fever.  Investing with managers who maintain active awareness of these dangers will help investors protect their capital in the future).  

(5) Debt + Excessive Valuation = Low or Negative Returns: "Nevertheless, the returns that LBOs done at the market's peak ultimately deliver, many say, are apt to be skimpy at best, and not solely because of the colossal debt.  Another drag on returns will be the bloated LBO valuations of that era.  With money now tight, sponsors have little chance of selling their holdings for close to the valuations they paid.  'My prediction is that many private equity funds of that vintage won't return capital, won't break even.  Those that do will be top-quartile [performers],' says an executive at a mayor buyout house.  'The industry will be challenged and tested in a way it never has before.'"

Or, as Warren Buffett once said "When you combine ignorance and leverage, you get some pretty interesting results."  

(6) Will Private Equity Learn? "'What's more, there will likely be a drastic overhaul of how private equity operates, some sponsors say.  Many expect the hefty transaction fees firms have collected, which in some megadeals topped $200 million, to be reined in.  Megadeals themselves will be a casualty, and buyout funds will be scaled back to reflect the downshift in debt financing. 'A lot of people now are talking about a new alignment of financial incentives for private equity and hedge funds,' a buyout sponsor observes. 'The incentives to do deals were skewed by the fees that sponsors and bankers were pocketing.' Likening the deal binge to a hamster running furiously on a wheel, he says: 'People will look back and ask, Why did the hamster run like that? It was because of the food it saw in front of it. 'That kind of incentive makes sense for a hamster, but it led to the insanity' that gripped the buyout market, he says."

"He and others argue that when LBO activity revives, banks and sponsors alike, chastened by the pain they caused themselves in the mid-2000s, will keep a lid on leverage and structure deals prudently. 'It will be like what happened to venture capital' after the bursting of the tech and telecom bubble in 2001, he argues. 'People didn't dispose of the VC model,' but overhauled it.  Others aren't so sanguine about private equity's ability to learn. 'At some point the competition for deals will heat back up,' says UBS's Smith, 'People's memories fade.  I'm highly confident that we will overcook the market again.  It happens every 20 or 30 years."

Conclusion

Private Equity needs to be overhauled.  The inertia in the industry, however, will make it slow-going.  The guys with 20 years of experience in private equity will continue to long for the "good 'ol days," and will have the play book to prove it.  Like the music industry with the advent of online music downloads, like the telegraph industry when the telephone came along, like the American automotive industry in the face of Asian competition, most private equity managers will keep up their old ways in an era where they are archaic, outmoded, and useless.  

Out-sized returns are possible in a world without massive leverage and disproportionate debt levels, but they simply require more hard work.  It takes the full-court press.  

[To read about how David defeats Goliath with the Full Court Press, read this great article in the New Yorker by Malcolm Gladwell, Author of The Tipping Point http://bit.ly/m9zFn ]

The future of Private Equity will be mixed.  For those who respond to the changing times, who are willing to invest more in adding value than flipping for a quick profit, for those who are willing to invest in companies that they would be happy owning even if the stock markets were shut down for 10 years (to borrow again from Buffett), and that big IPO simply were never possible, for those managers, the future is bright.  But those who cling to the past will be eaten up by the mountains of debt that they once thought were their road to riches.

Posted via email from skinnerlayne's posterous

National CFOs

Yesterday, I was reading an article that quoted the head of Iceland's Central Bank as saying that they would soon be joining the Euro because Iceland might know a lot about fisheries but maybe they didn't have specialized knowledge about monetary policy. This was interesting enough (though I tend to think the European Union is an undemocratic bureaucracy that is expanding, destroying every economy in its path, but that is a topic for another day).
 
So it got me to thinking--why do some countries so consistently make bad economic and governing decisions? I look at my current neighboring country, Argentina, and the case is simply puzzling. I travel to Argentina with relative frequency, and have collectively spent several months in the country. The people I encounter there are intelligent, many are well-traveled, and they all recognize Argentina's caricature government and economy. The 10-year boom/bust cycle is accepted as an unalterable fact of life.
 
Economic policies in many countries are dictated from the top of the executive branch, since it is the economic health of a country that usually makes or breaks an executive's popularity. The Finance Minister is one of the most coveted jobs in a government, and it carries tremendous prestige. As a result, it is a tremendous political reward to the chief executive's most loyal constituencies. Or else it is given to somebody who can "tow the line" appropriately. Rarely are the finance ministers, who are in fact the CFO of the country, chosen on the basis of providing quality, independent counsel and direction on finance and economics matters. Instead, the tail always wags the dog. Economic policy is made out of political needs, rather than out of economic realities. This is no less true in the United States than it is in Argentina.
 
In the world of international business, CFOs are often accountable to the Board of Directors, not to the CEO. Perhaps Finance Ministers should be too--either accountable directly to the voters or else to the Legislative authority of the country. Greater independence could prevent election year business cycles from propping up otherwise weak executives. Since their own job wouldn't be on the line if the chief executive loses the election, the Finance Minister could make decisions that are wholly independent of their desire to "get the boss re-elected." Imagine the radical shift in government economic policy that could result from this relatively minor change.
 
It's at least worth considering.

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Rhetorical Lesson for the Republicans

I woke up this morning and began perusing the news, as I do most every morning, and the Daily Telegraph www.telegraph.co.uk is always one of my first stops, along with the Drudge Report.  I am increasingly finding that the British press is simply more insightful and well-rounded than the filth that passes for journalism in the United States these days.  Indeed, one can still distinguish between the News and Opinion sections of even the more partisan British papers--something that can hardly be said of the New York Times or Washington Post.  But I won't explore that issue today.  Today I wanted to make an important rhetorical observation that the Republicans would be wise to heed.  Here is the quote from the Telegraph article:

In Friday's Financial Times, Alistair Darling, who saw off Brown's attempt to replace him with Ed Balls, sounded a quite different note to the PM on Labour's spending plans. Gordon clings to the tired old formula that the Tories will "cut", while Labour will "invest". Mr Darling's position is altogether more nuanced. "I have always been clear," the still-Chancellor told the FT, "that, just as we support the economy now, in the medium term we have got to live within our means and I set out a clear commitment to halve the deficit over a five-year period."

The Socialist Left loves to use the word "invest" to describe their own hair-brained political constituency-appeasing largesse that they are permitted to pass off as "economic policy."  And they are equally apt to enjoy hurling the "cut" accusation across the aisle.  The Republicans need to turn the tables.  They need to say "every time you hear a Democrat say they are going to 'invest in education' or 'invest in healthcare' or 'invest in the economy' what they are saying is that they want to raise your taxes, take bonds out in the names of your children, and destroy America's standard of living.  What they really want you to invest in is a government-run version of Enron."  

This will be far more politically effective than "spending is out of control."  I don't think the current Republican leadership in Congress or at the RNC is smart enough to pull this off, but there's a new generation of Republicans brewing out there.  They are Ron Paul-supporting, little "L" libertarians who see America's promise of "the land of the free" as a lie, and who see the Republican and Democrat establishment as virtually one and the same.  If this new generation of Republicans will rise up, kick the Establishment out, and put together their own manifesto for decentralizing power, non-interventionist foreign policy, and a less intrusive, less paternalistic police state, they will win allies on the Left, the Right, and in the Center.  

This is what the Republican Party needs--not a bunch of wishy washy moderates--not a crowd of gay-hating evangelicals--but firmly committed, principled advocates of freedom and of a government that does not wreck our economy in pursuit of its ivory tower social agenda.  Not only does the Republican Party need this, but America needs this, badly.

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Skyscraper Capitalism has Killed the Free Market

Skyscraper Capitalism (which is hardly capitalism at all) is the real culprit in the waning affection for free markets in North America. The big banking interests, who utilized their political clout during both boom and bust, who abuse the average person through the manipulation of the credit systems and take advantage of their plutocratic connection to the Federal Reserve System--the big automotive industry that the government has been propping up for nearly 30 years now that had also been the beneficiary of three decades of loose credit and easy money (who buys a car with cash anymore? and that's precisely the reason car prices have so radically inflated compared to other consumer goods)--all of these and more have created a murky debate around "free markets" versus "state intervention." The reality is that for the entirety of American history since the New Deal, we have had far more of the latter than the former.

Much of the state intervention in the last 30 years has been to aid private sector interests, especially the interests of the major players (and therefore major campaign contributors). The development of bloated securities regulations has been a boon not just to law firms, but to investment banking, and created an entire industry around broker-dealerships with significant barriers to entry, not just for people wanting to get into that business, but for people who have to pass through those businesses in order to finance any nascent enterprise. Indeed, the state-interventionists have created the very financial services monster they now decry. The average guy wanting to start a business either has to get a bank loan (and pay interest to the banking plutocracy) or else go through the nearly insurmountable trouble of raising equity capital for his business, involving at least two attorneys and likely a couple of financial services providers. Now the state-interventionists want to implement price controls on the industry they created, meaning there will be a bigger black market in financial services, more of the business will move overseas, and there will be all kinds of other externalities to the proposed new policies that the policy-makers and politicians haven't even bothered to consider.
 
Far from being a defender of the Skyscraper Capitalists, I view them as the root cause not only of many of our political problems, but our business problems as well. These are the corporations that want to keep their shareholders at arms-length, who view the Board Room as their provincial palace where only their chosen insiders who have "played the game" are permitted to enter. It is the Skyscraper Capitalists whose abuses have turned people from free markets, and have instigated a massive rise in support for not merely a bit more state intervention, but the radical takeover of entire private sector industries by governments in the United States and abroad.
 
Ian Brown, writing in The Globe and Mail, discusses the new interest in Marxism that has been precipitated by the financial crisis. Those who care about the future not only of capitalism but liberty itself will be wise to read this article and consider its implications. http://bit.ly/bFYNq
 
What we need is a new generation of capitalists: Hard Hat Capitalists who are willing to get their hands dirty, who are willing to create long-standing partnerships and relationships with their shareholders, whose communication with their investors is more personal than an annual report. We need people who are willing to leave their ivory towers and go to where everyday commerce happens. Sam Walton and Warren Buffett are shining examples of Hard Hat Capitalists--men who did not allow their wealth or position to lead them to obsession about tall shiny buildings and New York cocktail dinners.
 
This week, I read that more college graduates are looking for work as government bureaucrats (the article termed it "public service," but we all know what that is a euphemism for) than ever before, and that there has been a substantial drop in college grads seeking jobs in business--even Business school graduates. We should not underestimate the long-term impact this will have on the efficiency of our economy. Our best and brightest should be engaged not in economic policy-making but in actual economic decision-making--ensuring capital is allocated most effectively with a profit motive, and their shareholders in mind. If not, we face a steady decline of our economic output, consumer demand being met less and less efficiently over time, and with all of our smart people in government, they will surely not be content to sit by and do nothing. They will use the force of law to try to "fix" things. America's status as the world's economic engine will go out (to borrow T.S. Eliot's words), "not with a bang, but a whimper."
 
A new generation of capitalists could not come along too soon, not simply to restore faith in free markets, but to be genuinely good stewards of our society's resources, invested with self-interest, but not greed, seeking returns for shareholders year after year, not a big bonus at the end of this one. There is no autopilot in the history of progress. We must all work hard to keep the faith in our values of liberty strong. The alternative is not so pretty.

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Testing

I have started using Posterous (http://www.posterous.com) to post to my blogs, but there are some serious formatting issues apparently. Fortunately, the folks over at Posterous are being helpful and trying to remedy this situation for me. (Can't say I have had customer service this good from a free site in a very long time.)
 
So the issue is that I have been sending in posts with several paragraphs, and the problem is that the paragraph spacing is completely lost when it makes it to my WordPress blog. In previous posts I have had to go in and add the "br" tags manually in order to get the paragraphs to show up properly spaced. I'm going to type another sentence here and then go on to my next paragraph.
 
By this point, assuming the problem is continue to persist this evening as it did yesterday and this morning, you can see that it's not spacing the paragraphs properly. It is pretty clear where the new paragraph is supposed to be, but the line spacing just isn't there. If this issue were to be remedied, I'd start recommending Posterous without any sorts of hesitation because I really do love the service. I appreciate Customer Service's support in trying to get this fixed.
 
Thanks so much!

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Pay Attention Private Equity: Enterprise 2.0

Andrew McAfee's blog today contains superb insight into the pattern language of Enterprise 2.0, and it is well worth a read for anybody involved in private equity trying to improve their portfolio companies using technology.  The framework McAfee outlines is really golden.  For those of us working in emerging markets, the question of being able to "leap-frog" a decade of technology advances cheaply is an attractive value proposition of Enterprise 2.0.  It also means we face less internal opposition from those who have spent millions of dollars already on now antiquated technologies.  The closer the starting point is to "zero" the better, when it comes to Enterprise IT.  Aggressive, but judicious implementation of Enterprise 2.0 methods and practices can really jump start an ailing project and open up new worlds of possibilities, not only in terms of efficiency, but creativity too.  And it is the creativity deficit that is usually so hard to overcome.  Unfortunately most of "high finance" is stuck in the dark ages when it comes to collaboration, openness, and the other things that characterize Enterprise Web 2.0.  Those of us who have caught on to it have an advantage facing off against the "big boys."  Let the full court press begin.

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Borrowing from Peter to Pay...Peter

The Wall Street Journal is reporting that the US Treasury is making $25 Billion in "recovery bonds" available to the states as part of the economic stimulus package Congress passed earlier this year.  So the US government is borrowing money in the name of future taxpayers to cover State spending that current taxpayers are not willing to finance.  It would be one thing if this were simple one-for-one exchange, but it isn't.  It is a special subsidy for the states who can't keep their financial affairs in order (California, Michigan, New York) paid for by the states who can (Texas, Florida, and others).  What is so outrageous about this is that Texas and Florida manage to keep their budgets balanced on a much lower tax burden than California and New York, who can't keep their budgets balanced.  It is more or less the federal government stepping in and equalizing the effective taxes paid by the citizens of all states, destroying our federalist system and usurping the power and autonomy of the states.  If the Union is to survive, it will require ending these perverse policies.

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Saving the City won't Save Brown

--But it is the right thing to do.

Today's Telegraph has an excellent article about the looming political crisis surrounding growing economic regulatory power in Brussels.  The City of London, the heart of global finance risks being crushed under the weight of growing European bureaucracy.  Gordon Brown, in spite of his overwhelming and unprecedented political weakness at home may yet have enough credibility in Brussels to put his foot down and stop the Europeanization of the British financial services industry.  

The Brown conundrum no doubt has faced many political leaders in the twilight of their power: Do I do the right thing or do I give my country what it deserves for abandoning me?  

Assuming this is indeed the calculation going through Brown's mind (admittedly he may be too myopic yet to see that Britain has abandoned him, so we mustn't take that for granted), then it shows how truly pathetic he is.  If the CIty of London is lost, it will be a loss to the world, to free markets, and to economic prosperity.  I care because I hate to see liberty and prosperity destroyed by the the growth of government, whether in my own country or in another.   But, the loss will only be temporary though.  The offshore financial centers will boom.  The Cayman Islands, Hong Kong, Singapore, and Panama will be the beneficiaries of the crushing regulatory hand of the European Commission.  Europe and Britain will be the primary losers.  

The lesson Brussels will soon learn, as Washington is going to learn as well, is that you cannot demonize the people who produce the money that you take in taxation for too long or else those people will simply disappear.  There are more than 180 countries in the world, and the world is a much different place than it was 60 years ago.  People have options.  The Internet and mass accessibility of air travel have made the world a smaller place.  

Living in Santiago de Chile 60 years ago would not have been an option for me--it would not have provided even close to the quality of life that America would have provided for me.  But the rest of the world has caught up.  Twenty miles outside of Santiago, I have cable television (half of which is in English), broadband Internet, a cell phone with crystal clear reception, and access to top of the line health facilities in a merely 10 minute drive.  The big countries with their mammoth bureaucracies will soon learn the lesson of David and Goliath.  

Gordon Brown could rescue his legacy.  Instead of going down as "The worst Prime Minister in modern history" he could go down as "The man who saved the City of London from the Eurocrats."  Let's hope he makes the right decision.

[Any UK residents who want to give me their take on this issue, email me by clicking on my name to the right: Skinner Layne]

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Austerity and Prosperity: Not Mutually Exclusive

An interesting blog today on the New York Times website entitled "The Joy of Less" that extolled the virtues of, well, living a scaled down lifestyle.  There seems to be a common perception that a robust career (especially in business or doing anything else that makes money) is mutually exclusive with a Thorequ-esque quiet life on Walden pond.  The NYT blogger writes,

I certainly wouldn't recommend my life to most people--and my heart goes out to those who have recently been condemned to a simplicity they never needed or wanted.  But I'm not sure how much outward details or accomplishments ever really make us happy deep down.  The millionaires I know seem desperate to become multimillionaires, and spend more time with their lawyers and their bankers than with their friends (whose motivations they are no longer sure of). And I remember how, in the corporate world, I always knew there was some higher position I could attain, which meant that, like Zeno's arrow, I was guaranteed never to arrive and always to remain dissatisfied.

No doubt his description of corporate America--or the corporate world in virtually any country, is apt.  It is an endless ladder to climb, with another wrung left no matter how high one makes it.  The corporate serfs who have dedicated their lives to making money for other people are forced to settle for the title on their business card or the pittance they are paid in relation to the actual hours they spend away from the people and activities they truly love.  These are not the most pitiable sorts though--the ones who know what they are missing out on.  The ones to be pitied are those who think their job defines their meaning in life, whose paycheck is the sum of their self-worth, and who stand ready to be anybody's mercenary for the right position and the right pay.

It is not difficult for those of us who have lived the "high life" for any period of time, driven the fancy car, lived in the expensive house, and who have left it, to realize that striving for those things was a waste of our time, a waste of our life.  Time (and its ultimate consequence, Death) is the one thing I have yet to see any technology overcome.  It is sure and certain for us all.  We must all ask ourselves what it is we want to do with that precious time we do possess (the quantity of which is our greatest unknown).  Many would argue that the austerity of "simple living" is mutually exclusive with a successful business career and financial prosperity.

The two are not mutually exclusive, but they do in fact require a most ardent dedication to discipline.  The shiny objects flashed in front of those of us who do work in the world of finance are alluring, and even distracting.  It would surely be easier to eschew all of them, move to the backcountry of Alaska or New Zealand with one's family, and live off the land with a stack of books as entertainment.  This escape has crossed my mind on more than one occasion just this week.  But this sort of escapism is a denial of our potential to do good, to utilize our talents in the most impacting way possible, and to work hard for something other than the applause of others or the number of zeroes after our net worth.  

Indeed, it would be easier to live one's life by a set of rules than by a set of guidelines.  Rules are hard and fast, they tell us exactly when we may and may not do something.  Surely, some rules are necessary, but not too many.  Living life primarily by guidelines is much more difficult.  It requires a heightened sense of awareness of ourselves, of our motivations, of our own purpose in this world.  It requires us to continually and relentlessly self-assess and self-criticize, painful and often depressing tasks that expose our weaknesses and yes, our sins too.  But we will only be two-dimensional beings if we live life only by a set of hard and fast rules that prohibit us from experiencing so much that life has to offer, though in moderation.  

In the context of our present subject, this means we must be willing to suit up and engage in an imperfect world in order that it might be made more perfect.  Most of human life centers around our economic needs--the allocation of existing resources to maximize our collective and individual utility.  Therefore the most aware, the most talented among us, must be willing to enter the vocation of business, and be the light where otherwise there seems to be so much darkness, and to make the world a better place through the seemingly mundane decisions of how to allocate certain resources the most profitably, without the central purpose of our work being our own profitability.

It is a great challenge to enter the halls of high finance and not be corrupted by money.  It is a great difficulty to enter the stately conclaves where our political decisions are made and not be corrupted by power.  But we must each ask ourselves that Kantian question--if not me, then who?

Austerity and prosperity are not mutually exclusive.  One can be in the world of money without being destroyed by it, but it requires discipline that can only be forged through the strength of will, for none of us are born with it.  Yet each decision, whether to pick up that phone call at home, whether to check our email incessantly on the weekends, these are all decisions we make at the margin.  These are all decisions for which we can choose the alternative.  We can cut out all of the sycophantic behavior that characterizes much of the corporate world, we can stop attending social functions and being a part of the chaos that poisons our own souls and those around us, too.  We can retreat to our modest homes, share our meals with those we love, and spend our evenings immersed in some work of literature or else emptying our minds of the clutter accumulated throughout the day.  

This is the challenging life we are all in some way called to--a life of engagement and not retreat.  It is the only way our problems, both individual and collective will ever be solved.  And it is a choice we must make daily or else the influence of laziness will drive us too far one way or the other.

[I would love to hear you feedback, so either post a comment or click my name to email me:  Skinner Layne]

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What a Difference 30 Years Makes

Today's 30-year Bond auction went off without a hitch, surprising many bond market observers who witnessed a near-catastrophe earlier this week with 10 year note yields rising at the fastest pace since 2003. The 30-year has had a rough time lately, as the increasing time preference of Asian & Middle Eastern sovereign investors has driven down demand. Far from today's bond auction serving as a "positive sign," I think there are more complicated issues at play than an rise in confidence in the U.S. Government's future ability to repay its debt obligations. It seems to me that Asian & Middle Eastern sovereign investors are working out a Prisoner's Dilemma "with fear and trembling."
 
30 years is a long time from now, and the likelihood that U.S. taxpayers and voters will tolerate significant inflation and government irresponsibility over the long-long-term is rather low. As foreign investors begin to price in the dynamic political prospects in the United States, I think it is possible that we will see an upside down V- or U-shaped yield curve emerge, where yields on the 10-year are higher than short term notes and bills but also higher than the 30-year bond. The real inflation (and default) danger for the United States is not 30 years from now, but 10 years from now. If I were a bond investor (which I am not), I would be better on a significant recovery for the U.S. in the long-term, with serious troubles in the medium-term. The question of course is, can the U.S. survive the medium-term and make it to the long-term, or will the 30-year bonds be priced in massively inflated dollars from the sticky period in the medium-term?

These questions require a decidedly political answer. What happens to the rest of the years of the Obama administration? Who will control Congress after the 2010 mid-terms? These questions have a more direct bearing on the political risk of the 10-year note than the 30-year bond.
 
And that is why I am not investing in bonds. Too many non-economic factors influencing the future. If there's one thing I don't want to bet on, it's whims of politicians and voters.

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