Thursday, October 31, 2013

Overstating the Case for Private Equity

Overstating the Case for Private Equity

For the past few days, I have been taking apart a report from the Private Equity Growth Capital Council.[1]  The council is the lobbying arm of big private equity firms. The report, entitled “Public Pension Fund Analysis,” is designed to send two messages.  First, that private equity returns have beaten the stock market over the last five and ten years.  Second, that some public pension plans have done exceptionally well investing in private equity.  While the basic conclusion that private equity beats publicly trade stocks is true, it darn well better be true if pension plans are going to take the risks associated with PE.  As I’ll discuss in a moment, the conclusion is overstated.  The second part of the report, touting the returns of certain states, is classic private equity marketing.  Just as a private equity firm will tout its winning investments, the PEGCC has done the same thing with the best returns among public pension plans.  The report’s conclusions are conveniently summarized in the one page chart show below.

Why should PE beat public equity hands down?  Investors are taking at least three risks with private equity that are greater than public equities.  First, PE uses much more leverage than public companies.  Second, private equity owned companies are smaller than the median public company held in a pension portfolio.  Third, the PE investment is far less liquid than a public one.  Investors should be compensated for each of these risks.
Fund Flows (1999)
Why are the PEGCC’s conclusions misleading and overstated?  In fairness to the PEGCC, the data for generating these results is messy.  The Council appears to have gathered its data from the annual reports generated by public pensions.  Unfortunately, pension plans are slow to produce these reports and inconsistent in how they present the data.  While the PEGCC alludes to these factors in their footnotes, the Council’s conclusion would lead to you believe that its approach was scientific and measured.  Go back and look at the bottom of the chart.  Good luck reading the footnotes; they are in tiny grey font on white paper. Here are few examples of the problems with the data. 

·      A few plans report their returns on a gross rather than net of fees basis.  Obviously, gross fees are going to be substantially higher.  I believe the Massachusetts Plan, which is ranked number one in the Council’s report, uses gross of fees data.
·      The private equity returns reported by public pensions overstate the results because they tend not to include the cash that has to be held in reserve to fund capital calls or the cash that is deposited when a PE firm realizes an investment.  While it is easy for pension plans to remain fully invested in publicly traded stocks, private equity creates a cash drag.  This cash drag isn’t factored into the results reported by public pensions or the Council’s report.

·      The annual reports issued by pension plans use compounded returns.  Admittedly, this is all the data that is publicly available on a consistent basis. However, compound returns can be extremely distorted if there have been a lot of cash flows in and out of an asset class.  In private equity and real estate this is very often the case. See “Another Quick Lesson in Private Equity: All Returns Aren’t Created Equal (November 16, 2012) for an explanation of IRRs use to calculate PE and RE returns versus compound returns.

·      When it comes to the state rankings, the Council report mixes end dates with some of data coming from June 30, 2012 and other data coming from December 30, 2012.  Admittedly, the PEGCC had to work with the available data, but their conclusions should be far more nuanced.

I understand that the PEGCC is an advocacy group.   They try to come off as researchers, but their aim is to promote the industry.  Much of the time, they issue reports to defend the tax preference for carried interest.  In this case, they are making a marketing push to protect private equity’s broad advances into the public pension market.

I laud the PEGCC for their marketing prowess.  Numerous news outlets have picked up the conclusions of their study without any further analysis.  However, they are grossly overselling the benefits of private equity to public pension plans.


Wednesday, October 30, 2013

Financial Cases: Hedge Funds versus Banks

Financial Cases: Hedge Funds versus Banks

SAC Capital Advisors is expected to plead guilty to securities fraud and pay a criminal penalty of $1.2 billion.[1]  The firm had previously settled civil charges with the SEC for around $600.  SAC will no longer invest money on behalf of outside clients.  In exchange for the plea, the government will dismiss all its civil forfeiture claims, which sought to seize assets from SAC.  As a result, Stephen A. Cohen and his employees would still have $8 or $9 billion of their own money to invest.

As I discussed yesterday, the Department of Justice recently won a civil fraud case against Bank of America.  The DoJ pursued a civil case because the standard of proof was lower than in a criminal proceeding.
Reassigning Colleagues (2007)
So why is SAC pleading guilty, while Bank of America and most of the other banks are being pursued under civil fraud statutes?  Unquestionably, part of the reason has to be the evidence.  Insider trading which is at the heart of the SAC case, underpinned the Galleon conviction, and has driven other money management prosecutions tends to produce a clear trail of phone calls, emails, and witnesses.  Moreover, in many of these cases, the government has been able to turn an analyst or portfolio manager into a cooperating witness or informant.

The bank cases, which typically involve the sale of mortgage-backed securities, leave a much murkier trail of evidence.  Since banks are extremely complex organizations, especially in comparison to money managers, accountability, intent, and other necessary elements are harder to establish.  It’s also useful to remember that the packaging of mortgages was undertaken under the watchful eye of attorneys.  By contrast, insider trading isn’t conducted with the lawyers in the room.

When the government pursues a hedge fund, it doesn’t much matter if it is suing the management company or the individual managers, since they own the company and usually have most of their net worth invested in the hedge fund.  By contrast, when the government pursues a bank, they are threatening investors.  Typically, management only owns a relatively small stake in the bank, so they have far less at risk than hedge fund managers when the government extracts huge penalties from a bank.

Evidence aside, banks have another thing going for them when it comes to criminal prosecutions.  Prosecutors are well aware that a guilty verdict against a bank could threaten the bank’s charter and result in massive layoffs.  When a hedge fund gets hit, the economic and employment implications are minor.

Even if SAC and the hedge funds are easier to pursue than the banks, you can’t feel too sorry for Stephen A. Cohen.  He gets to keep his billions of dollars and I’m sure he’ll still be welcome in the refined world of New York area charities and the estates in Greenwich.


Tuesday, October 29, 2013

DoJ Wins One Against BoA

DoJ Wins One Against BoA

Last week a jury in Manhattan found Bank of America liable of committing civil fraud.  The case involved Countrywide, the mortgage unit of BofA.  As the credit bubble was about to burst, Countrywide packaged up highly questionable mortgages and sold them to Fannie Mae and Freddie Mac as prime or investment grade securities.   The government sponsored agencies lost about $1 billion on them.  The outcome of the case seems notable to me for two reasons.
Random Meeting At the Bank (1996)
First, the Department of Justice’s case was built on the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), a piece of legislation enacted after the savings and loan scandals.  The act allows the DoJ to try cases of fraud using a lower standard of evidence than in a criminal proceeding.  The standard is a “preponderance of the evidence” rather than evidence beyond a reasonable doubt. DoJ’s case was aided by the lower standard.  In addition, the statute of limitations is ten years, which means that the DoJ still has plenty of time to sort through the misdeeds of the credit bubble.

Second, the government’s case targeted only one Countrywide executive, Rebecca S. Mairone.  She was responsible for overseeing the Hustle program, an acronym derived from an initiative called “high speed swim lane,” which quickly moved loans off the bank’s books.  The jury found her liable for fraud because her employees deliberately mischaracterized the nature of the loans as they packaged them up.  Apparently Ms. Mairone had recently joined Countrywide when she was put in charge of clearing these questionable mortgages off of the lenders books.  Ms. Mairone’s liability in this case has stirred up a great deal of controversy, much of it quite beside the point.

Her lawyers picture Ms. Mairone as a hard-working single mom who took time off to attend her kids’ events.  Her critics describe her as a very aggressive manager.  Evidently she was much admired by many women in the organization because she took on Countryside’s male-dominated culture and succeeded.  Whether she attended Girl Scout meetings or was able an able player in the bank’s culture seems rather irrelevant.

In my view there are only two relevant issues involving Ms. Mairone.  Was she culpable in passing off toxic mortgages to Fannie Mae and Freddie Mac?  According to the jury, the answer is yes.  The case will be appealed, and perhaps an appellate court will find some legal error in the DoJ’s case.  But for now the first issue is settled.

The second issue is much more troubling.  Why was Ms. Mairone the only executive pursued in this case.  Anthony R. Mozilo, Countrywide’s founder and chairman, settled fraud charges with the SEC.  The settlement was for only $67.5 million, and Countrywide paid $20 million of that amount.  The settlement hardly put a dent in Mr. Mozilo’s net worth.  Moreover, the DoJ decided not to pursue criminal fraud charges against him.  That leaves open the question of why Mr. Mozilo and other senior executives weren’t pursued using the FIRREA standard.

Critics have attacked the DoJ for its failure to bring cases against senior executives at any of the major banks.  Lanny Breuer, former head of the DOJ’s criminal division, argued that the evidence against the top executives was insufficient to bring a case. It’s hard to know whether Mr. Breuer was right or not because we’re not privy to the DoJ’s investigative files.

However, it should come as no surprise that midlevel bank executives have been easier targets than the higher ups.  Financial institutions are adept at creating level after level of hierarchy to protect the executive suite.  Thus it shouldn’t come as any surprise that the evidentiary trail grows thinner and thinner as investigators try to get closer to the chairman’s office.     

Monday, October 28, 2013

Creationism and Wall Street Meet Superbugs

Creationism and Wall Street Meet Superbugs

In the last week or so, I ran across the following anecdotes come from Bill Bryson’s new book One Summer: America 1927, the Frontline documentary “Hunting the Nightmare Bacteria”, and The Dallas Morning Herald.

Inverse Floater (1994)

  •           On June 30, 1924, Calvin Coolidge Jr., son of the President, played tennis on the White House lawn and got a blister on his foot.  By July 7th he was dead from blood poisoning.

  •            In 1928, Sir Alexander Fleming discovered that Staphylococcus bacteria could be destroyed by penicillin mold. In 1943, clinical trials were finally completed for penicillin, and thereafter it became rapidly available as an antibiotic.

  •         In February 2011 Pfizer, the first mass manufacturer of penicillin, announced it would dramatically scale back its antimicrobial research at its labs in Sandwich, England and Groton, Connecticut and locate its remaining effort in China.  Pfizer was the last major pharmaceutical company with a large-scale anti-microbial program.  The company cut the program because they couldn’t generate the return on investment required by Wall Street.

  •          Later in 2011, the Clinical Center at the National Institute of Health was struck with Klebsiella pneumoniae carbapenemase, or KPC, an infection that cannot be treated with any known antibiotic.

  •          In 2012 NIH’s budget fell by $1.7 billion to $29.15 billion, and its budget is slated to fall by another $600 million next year, unless the House gets its way and slashes the budget by another $5 billion. 

  •          The Texas textbook curriculum committee will require the teaching of creationism in its science courses.  As a member of the committee said, “I feel very firmly that creation science based on Biblical principles should be incorporated into every biology book that is up for adoption.”

Science is under attack from two seemingly opposite sides.  At one end, skeptics in scientific methods and theories are undermining our school curriculums.  At the other end, the so-called science of Wall Street is undercutting the ability of companies to fund long-term research.  The trading mentality practiced by all too many money managers makes microbial drug discovery financially impracticable.

Meanwhile a wide spectrum of conservatives from fundamentalists to Wall Street bankers are clamoring to shrink the size of the federal government.  One of the last bastions of basic research, the NIH, is in the crosshairs of that effort.  Neither the marketplace nor the government seems capable of funding the research required to combat infection.

While we’ve been hollowing out our pharmaceutical companies in the name of short-term profits and gutting the NIH in our eagerness to downsize the federal government, evolution has been hard at work.  While evolution may be hard to grasp when it comes to human development, it is plainly visible when we’re talking about bacteria and antibiotics.  The creationists and money managers might spend a little time contemplating evolution at the bacterial level.

Sadly, the creationists and Wall Street are helping to return us to a time when our sons or daughters could get a scrape or blister on the playground or tennis court and be dead within days.  The creationists will discover that prayer is no match for a superbug, and Wall Street will learn that all of their billions in short-term profits can’t stop a superbug either.

For more on our dearth of long-term investing see, “New Highs for the Markets and New Lows for Investing (March 7, 2013)”