Thursday, July 31, 2014

Taking the Easy Way Out: Buying and Selling Private Equity Businesses

Taking the Easy Way Out:  Buying and Selling Private Equity Businesses

When making the pitch to public pensions and endowments, private equity firms tout the opportunity to add value by buying public companies, family-owned businesses, and orphaned subsidiaries of conglomerates.  The industry has argued that the private equity model enables them to make changes in businesses that aren’t possible under any other form of ownership.  As a result, a significant portion of the management fee is supposed to cover the process of sourcing deals.   According to The Wall Street Journal, over 60% of all acquisitions in 2014 have been between private equity firms.[1]  Only 3.5% of the acquisitions have involved public companies.  As the chart shows, this is a record and a trend.

This form of PE investment, known as “pass-the-parcel,” is extremely convenient for both the selling and buying PE firm.  The seller usually gets a clean exit from the business, because 100% of the company is sold.  If the selling PE firm exits via an IPO, it usually takes several years to actually dispose of the shares.  For the PE buyer, purchasing from another PE firm is easy and convenient.  The prospective business is neatly packaged and requires far less work to source and evaluate.

However, the prevalence of  “pass-the-parcel” undermines the central rationale of private equity.  If the goal of PE is to make operational and strategic changes in businesses, then the question is what’s the role of the second, third, or even fourth PE firm that own the company.  Shouldn’t the first PE firm have made the requisite changes over its five to seven years of ownership? 

These types of deals are bad news for investors.  Each “pass-the parcel” transaction is a great opportunity for banks to extract all sorts of fees for advising the parties, and to refinance the business’s high yield balance sheet.  It’s extremely expensive to buy and sell these businesses, and the investors absorb these expenses.   After the sale, many investors discover that they still own the business, less all the aforementioned transactions costs.  If they are investors in both the selling and buying PE firms, they’ve simultaneously realized the gain on their investment (less transactions fees and possible carry) and invested the proceeds plus additional capital right back in the business.

Private equity is in engaging in this practice because it is easy, and because they can get away with it.   So-called sophisticated LPs have failed to stop PE firms from charging portfolio companies with all sorts of consulting and monitoring fees.  “Pass-the-parcel” is merely another example of the inability of LPs to reach reasonable terms with their PE managers.  The LPs, especially big public pensions, are so desperate to increase their allocations to private equity that the industry is awash in capital.   The LPs generate reams of documents, but the actual terms of the deals greatly favor private equity.  Passing businesses from one PE firm to another is the fastest and most lucrative way to play the game.


Wednesday, July 30, 2014

Banking Ethics

Banking Ethics

After yesterday’s chance encounter with the ex-marine who tried to pull my car out of the sand, this morning’s New York Times returned me to the ethics problems of Wall Street.  Neil Irwin has a column entitled, “Why Can’t the Banking Industry Solve Its Ethics Problems?”[1]  Mr. Irwin begins his column by referencing Lloyds Banking Group’s attempt to manipulate the interest rate it owed the Bank of England as part of an economic stimulus program.  In other words, Lloyds took the brazen step of ripping off its primary regulator.

While Mr. Irwin doesn’t suggest his own remedy for the systemic lack of ethics in the banking industry, he puts forward remedies posited by two critics.  In 2006 before the financial crisis, Justin O’Brien of Queen’s University in Belfast suggested that Wall Street needed to impose severe economic penalties for improper behavior.  Since Wall Street only understands money, bonuses, and profits, Mr. O’Brien is suggesting that financial incentives can be used to promote ethical behavior.  In my view, severe penalties will not change much.  Banks will simply hire more accountants, lawyers, and risk managers.

Federal Judge Richard Posner has written that Wall Street has to eliminate the short-term incentives that attract people motivated by greed.  He also points out that the complexity of financial laws allows many on Wall Street to act in unethical ways that don’t violate the law.  

I don’t think any one change in the law or financial incentives will change the ethical behavior on Wall Street.   I certainly support these types of changes and want to drive up the costs of acting improperly.    The poor ethics of Wall Street is deeply imbedded in its culture, and culture is the hardest thing to change.  Unless Wall Street’s clients and the public rebel, little is going to change.  The last financial crisis was an opportunity to act, and we didn’t take it.  I guess we’ll just have to wait for the next financial crisis and see what happens.


Tuesday, July 29, 2014

Stuck in the Sand with an ex-Marine

Stuck in the Sand with an ex-Marine

I write a great deal about the bad behavior of money managers and investment bankers.  Today I want to tell a story about a Marine veteran.  In order to tell this story, I am going to have to admit that I got our car stuck on the beach north of Corolla, North Carolina on the Outer Banks.  While I didn’t commit the unpardonable sin of driving on sand without four-wheel drive, I did wind up in a rut where there wasn’t enough clearance for our car.

As we tried to clear sand from under the car, a family stopped.  The kids had insisted that they help us out, since they’d recently gotten stuck.  Despite joining us in digging around and placing boards under the tires, our car wouldn’t budge.  We thanked the family for their efforts and called a towing service.  However, good Samaritan number two stopped in an F-150 truck.  He said he’d been stuck before and was sure his truck could pull us out.  We dug around the wheels, attached a cable to the front of our car, and his truck became stuck in the sand.  So we dug around the tires of his F-150, but it wouldn’t budge either.

When you’re waiting for a tow truck to pull you out of the sand, there’s a bit of time to chat.  It turns out the driver of the F-150 is a retired Marine with tours of duty in Iraq and Afghanistan under his belt.  He’d driven across all sorts of desert sands and had never gotten stuck until now.  The rescue truck was a Toyota SUV.  It looked tiny next to the F-150 with its large tires and dual exhaust. 

For the tow truck operator, our Volvo wagon was just ordinary business.  However, he was excited about pulling out the F-150.  After a bit of digging and lowering the air pressure in the truck’s tires, the tow truck operator jumped into his SUV and pulled the F-150 out of the sand without any effort at all.

I offered to pay the ex-Marine’s towing charge.  After all, he’d only gotten mired in the sand because of trying to rescue our car.  He refused.  He said he’d been sure he could pull our car out and was responsible for his own predicament.  When I offered him $20.00 to buy beer for his buddies and himself, he also refused.    He told me that he appreciated the gesture, but he’d been happy to help.

After the F-150 had been rescued, the tow truck operator performed the same maneuver on our Volvo.  The SUV showed no signs of strain as it hauled us out of the sand.  Under most circumstances, I’d be extremely unhappy about having to pay towing charges for my mistake in judgment.  However, I spent my career in a business where every positive action only takes place because there’s a financial incentive plan designed to reward that behavior.  It was nice to be reminded that some times people do good because it is the right thing to do.

Monday, July 28, 2014

Fighting Accountability: Financial Intermediaries Resist Regulation

Fighting Accountability:  Financial Intermediaries Resist Regulation

In yesterday’s New York Times Gretchen Mergenson makes the case for regulating private equity firms as broker-dealers (see, “Private Equity’s Free Pass”[1]).  As Ms. Mergenson details, many private equity firms engage in exactly the same types of activities as investment banks in structuring deals, collecting fees, raising capital and doling out advice.  Since its inception, private equity has attempted to operate under exceptions to the securities laws.  In fact, most of the founding fathers of private equity began their careers in broker-dealers before abandoning them for the freedom and profit of private equity.  In the beginning, PE deserved the exemption.  They derived their capital from a small group of high net worth individuals and institutions and earned their profits from management fees and carry.  They also had a significant portion of their net worth tied up in their funds.

Two things changed.  First, the private equity business institutionalized and began to offer many more products to a wider audience.  Second, the industry became greedy.  Not only did they want to earn fees and carry, they decided there were additional profits to be made in providing portfolio companies with a variety of products and services.  To be fair, all of these types of practices, as well as the potential conflicts of interest, are disclosed and acknowledged in the legal documents signed by investors.  As the SEC has pointed out, all too many PE firms have taken gross advantage of these situations.  There are probably many smaller PE shops that deserve to remain exempt from registration as broker-dealers.  However, investment banks and large PE firms are indistinguishable, except that the former are regulated and the latter are not.

Although some PE firms have acknowledged the inherent conflicts and formed broker-dealers, the industry will fight any attempt to subject them to the costs and requirements of regulation.  Broker-dealers would probably like to see the playing field leveled and would support greater oversight of the PE industry.

However, broker-dealers are fighting their own battle.  For many years the
SEC and the US Department of Labor have been attempting to subject broker-dealers to a fiduciary standard of care when they provide customized advice to clients.  At present, brokers act under the looser suitability standard even though they are providing the same services as financial advisors.  The brokerage community claims that it wouldn’t be able to offer their clients as wide a variety of financial products if it were subject to a fiduciary standard of conduct.  That’s hardly the issue.  The brokerage community fears that the higher standard of conduct would lower their profits and subject them to greater liability.   They are right.  Appropriate accountability would cost them, just as it would cost the private equity industry.

It’s time to rein in private equity and broker-dealers.  Private equity no longer deserves its wholesale exemption, and broker-dealers don’t merit the suitability standard.  Greater responsibility is more than warranted.  I’m not holding my breath.   


Friday, July 25, 2014

Rural Infrastructure Opportunity Fund: A Fund Launch That May Be More About Politics than Investments

Rural Infrastructure Opportunity Fund: A Fund Launch That May Be More About Politics than Investments 

Yesterday the White House announced the creation of a $10 billion rural infrastructure fund.  Here are the headlines from the U.S. Department of Agriculture’s press release, which many media outlets dutifully reported:

White House Rural Council Announces $10 Billion Private Investment Fund to Finance Job-Creating Infrastructure Projects in Rural America

CoBank Pledges Initial Multi-billion Commitment for New Rural Infrastructure Opportunity Fund; More Private Investments in Fund Expected; Capitol Peak to Manage New Fund; USDA to Identify Projects in Need of Investment through New Fund and Other Sources

In reality, there is no fund at this point.  Capital Peak Asset Management has to go out and raise the capital from institutional investors.   Good luck.  Throughout my career, I’ve seen one rural initiative after another that promised increased investment in upstate New York or eastern North Carolina.  Political operatives rather than policy experts tended to write the press releases.   The rural initiatives never reached their lofty objectives. 

In my view, the Rural Infrastructure Opportunity Fund is likely to be another unfulfilled rural initiative.  As a general matter, drawing institutional capital into rural areas is extremely difficult.  The USDA’s initiative appears to make this task even more daunting.  First, the proposed structure is rather complicated.    CoBank is a national cooperative bank that lends and finances agricultural loans and infrastructure projects.  It has merely indicated its willingness to co-lend up to $10 billion subject to sign-off on each proposed investment.   In other words, CoBank hasn’t made a $10 billion commitment to the fund.  Rather it has agreed to consider funding projects.  Those projects will be identified by the Department of Agriculture.  I’m betting that institutional investors will be wary of this model.

So who has to go out and raise the capital and explain this structure to prospective investors? Capital Peak Asset Management.   I figured I’d look them up on the SEC’s website to see how much money they have under management.  They aren’t yet registered.  I went to Capital Peak’s website, and it became clear that this firm had been formed to manage this fund. 

How did they get this mandate?  Capital Peak’s website provides very little detail. Six folks are listed, but only two people seem to be solely involved in Capital Peak.  The Executive Chairman, Leo Tilman, continues to run his strategic advisory firm in Denver.  The CEO, Alfred Puchala, Jr., is listed as a senior member of Tilman’s company and also runs his own firm called Puchala & Company located in New York.   Mr. Puchala seems to have a great deal of experience dealing with the sale of public assets and appears to have had the connection to the Obama Administration.

Capital Peak’s chief marketing officer, RuthAnne Dreisbach, heads the strategic communications practice at Tilman & Co and also runs her own firm called Dreisbach Group located in New York.  The managing director for investor and partner relations, Beverly Karns, heads strategy and analytics for Tilman & Co.

This leaves two fully dedicated employees.   The managing director for business development, Matthew Davis, has three years of investment banking experience after a previous career in nuclear engineering.  The managing director for portfolio management, Jason Tepperman, previously ran the Small Business Lending Fund (SBLF) for the US Treasury, a successor program to TARP.   SBLF was supposed to get community banks to increase lending.  A significant portion of the lending Congress authorized under SBLF simply went to banks in order to repay TARP.  In other words, SBLF was another government initiative that promised to increase investment in underserved areas; it delivered far less than it promised. 

This team has to raise billions of dollars in institutional capital without being able to put forward a verifiable track record.  I’m sure Mr. Puchala and other team members can point to specific investment banking transactions or deals, but there’s little in their backgrounds that would suggest that the team has experience managing institutional capital.

Although the goal is worthy, this initiative has a very convoluted structure that will be managed by a team that is only loosely stitched together. The White House can say that it’s done something worthwhile for rural America.   Capitol Peak may be able to generate some fees, although I’m not sure who is going to fund them.   Perhaps I’ve become too cynical, but the Rural Infrastructure Opportunity Fund seems to be the by-product of politics.