Tuesday, March 31, 2015

Having a Conversation Isn’t Progress: Pao versus Kleiner, Perkins, Caulfield & Byers

Having a Conversation Isn’t Progress:  Pao versus Kleiner, Perkins, Caulfield & Byers

Late last week, Ellen Pao lost her gender discrimination case against Kleiner, Perkins, Caulfield & Byers.  Kleiner is a major venture capital investor in Silicon Valley.  Ms. Pao alleged that she was passed up for promotion because of her gender and discriminated against her for complaining about her treatment.   Although Ms. Pao lost the lawsuit, many commentators have tried to extract a victory by asserting that the case has started a conversation on the role of women in venture capital and finance.

Over the past several years, “starting a conversation” has become a substitute for making change.  When white police officers aren’t indicted for killing unarmed black males, commentators intone that there’s been an advance because we’re having the conversation about racial profiling.  The same refrain is used when it comes to the reporting and disposition of sexual assaults on college campuses.  The idea is that we’re making progress because we’re sitting down and talking about controversial issues. The beer summit in the White House garden between President Obama, Vice President Biden, Professor Henry Louis Gates, and police sergeant James Crowley is cited as the great example of “starting a conversation.”

However, we’re not having quiet and reasoned conversations on any controversial subject.  Rather we’re engaging in a great deal of posturing and dueling press releases.    The beer summit wasn’t a model for starting a conversation.  It was just four guys having a beer.

When it comes to the investment business, males dominate the senior ranks of the industry.   I’ve written about this in the past (for example, “The Case for Diversity: Hire Women to Manage Money” [1/19/13] and “Drawing the Wrong Inference:  In-state Investing in NC” [9/2/14]).  The hard data suggests that nothing is changing.  Moreover, the Pao trial revealed a locker-room environment that is all too familiar at some brokerage firms, hedge funds, and money management firms.  To be clear, many firms do not tolerate sexist behavior, and some firms have promoted women into senior positions.  Nonetheless, the industry’s culture is still male-dominated, and its record is poor.

In a nutshell, here’s the conversation in the wake of the Pao verdict.  According to The New York Times, Kleiner issued a statement saying that it was committed to supporting women.[1]  At a press conference, Ms. Pao said, “If I’ve helped to level the playing field for women and minorities in venture capital, then the battle was worth it.”  This isn’t the start of a conversation; it’s just the usual platitudes.  One side makes a meaningless statement using the word “committed” and the other side invokes “level playing field.”  In the end, very few firms are committed to helping women or minorities.  They are committed to making money.  As to the playing field in finance, white males continue to occupy the high ground and it is largely impenetrable.

Until investors and politicians insist on a different set of values, the culture of investing will remain unchanged, even if the next woman to challenge the system wins her case.  My former industry is more than happy to have the conversation as long as they don’t have to make real change.

[1] http://www.nytimes.com/2015/03/28/technology/ellen-pao-kleiner-perkins-case-decision.html?_r=0

Monday, March 30, 2015

You Have Been Warned: Private Equity’s Glory Days Are Over

You Have Been Warned:  Private Equity’s Glory Days Are Over

In an opinion piece in the Wall Street Journal, Andrew Kessler, former hedge fund manager and financial writer, makes the case that private equity’s best days are behind it.  While Mr. Kessler cites all of sorts of reasons, the subtitle to his column succinctly captures an argument I’ve been making in this blog: “Too many funds are chasing too few opportunities, and many of those will be too expensive. It won’t end well.[1]

Moreover, as Mr. Kessler points out, the tailwind that has boosted private equities results is in the process of shifting.  Interest rates are about to rise.  Banking regulators are clamping down on lending for leveraged transactions.  Congress, including Republicans, is looking to limit the deductibility of interest payments by corporations.  The ingredients are coming together for a major shift in the prospects of private equity.

Mr. Kessler makes a fourth argument about the likely decline of private equity.  He suggests that private equity is bad for the economy because it diverts large amounts of cash flow from productive capital into debt service.  While I agree that this is a byproduct of private equity investments, I don’t think it is one of the reasons that private equity’s halcyon days are behind it.  In my view, the entire financial sector is far too large and drawing way to much capital away from the productive sectors of the economy.  However, I don’t think it is going to shrink any time soon.

Although private equity’s best days measured by investment returns are over (and have been over for quite some time), the industry’s ability to continue to raise large funds is going to continue for quite some time.  Notwithstanding the mounting evidence that too much capital is chasing too few good opportunities, institutional investors are continuing to pour money into private equity.  Dow Jones LP Source reported that the industry raised $266 billion last year.   And, Warburg Pincus has just announced that it is raising a $12 billion fund, only two years after raising an $11 billion fund.  According to a report from Bain and Company, PE firms have $1.1 trillion in available capital (known in the investment world as “dry powder”) for new deals.

Public pensions and sovereign wealth funds aren’t forward thinking investors.  They tend to follow trends and one another in chasing investment opportunities.  As a result, they will continue to fuel private equity until the returns go from disappointing to alarming.  Ironically, when the returns finally look awful, institutional investors will finally have a golden opportunity to make money in private equity.  However, very few will have the foresight, will, or courage to make commitments.

Mr. Kessler’s column provides a fair warning to investors.  I’m betting that very few investors will heed it.

[1] http://www.wsj.com/articles/andy-kessler-the-glory-days-of-private-equity-are-over-1427661933

Saturday, March 28, 2015

Carl Richard's on Financial Planning: Must Read

Carl Richard's on Financial Planning: Must Read


Week end reading.  One of the most sensible pieces of advice about financial plans.  It's not about spread sheets and models.   Rather it's about values, goals, and accepting uncertainty about the future.
Carl Richards' book,  “The One-Page Financial Plan: A Simple Way to Be Smart About Your Money,”" will be published on Tuesday.  If the book is as good as this article, the book will be a "must read."

Thursday, March 26, 2015

Healthy Indifference: How Regulators Should Behave

Healthy Indifference:  How Regulators Should Behave

During my tenure as Chief Investment Officer for North Carolina, I tried to avoid industry conferences.  As a government official with the potential to award investment mandates, I knew I was going to be hounded by money managers.   I turned down dozens of invitations from conference organizers begging me to share my wit and wisdom in speeches and panel discussions.  Every now and again, however, I was forced to attend a conference as a stand-in for the State Treasurer.    Whether I was merely crossing the hotel lobby or going to the gym, marketers couldn’t resist the opportunity to invite me to dinner or a round of golf.  Moreover, they acted as if I was their long lost best friend.  Some folks like that kind of attention.  I preferred my hotel room. 

I quickly learned that industry conferences, at least in the money management industry, would quickly disappear if pension officials and regulators didn’t show up.  While these conferences are usually advertised as educational opportunities, they are really fishing expeditions in which public officials are the bait.

Apparently my wit, wisdom, and value as bait diminished considerably when I left my position, because the invitations ceased with one exception.  One organization had me mistakenly identified in their database as the state treasurer.  To this day, I get invitations to speak at their events.

I’ve written about my experiences at conferences because Andrew Bowden’s remarks at a private equity conference continue to draw attention.  Mr. Bowden is the Director of SEC examinations and my former colleague at Legg Mason.  The latest comments about Mr. Bowden’s remarks come from Matt Taibbi of Rollingstone.[1]  Mr. Taibbi summarizes the same set of facts first set out by Naked Capitalism, including Mr. Bowden’s speech last May in which he revealed that his examiners had uncovered numerous problems during their audits of private equity firms.  Mr. Taibbi rightly points the change in Mr. Bowden’s demeanor since last May, as well as the inappropriateness of Mr. Bowden’s comments at the private equity conference, even if they were intended to be lighthearted.

Mr. Taibbi makes a big contribution to this discussion by setting the appropriate standard of conduct for a public official’s demeanor when appearing before industry:

We don't need regulators to be out to get anyone. But is a healthy indifference too much to ask? Do we really need for even the regulators to slobber over these people?

I think “healthy indifference” is a superb way to describe the appropriate standard of behavior for regulators and pension officials.  During my tenure as CIO, I aspired to that standard.  Interestingly, money managers, especially politically connected ones, would often complain that I was hard to read, aloof, or indifferent.   Thus, I have a bit of sympathy for Mr. Bowden’s lighthearted, but inappropriate comments.  It isn’t easy maintaining an air of healthy indifference in a room full of industry executives.  However, it is necessary.  Like Mr. Bowden I suspect I let my guard down every now and again.  Fortunately, no one was recording my comments.

As I opined earlier this week, I think SEC regulators and public pensions would be well served to stop attending conferences.  It’s a lot easier to maintain an air of “healthy indifference” if you aren’t sharing a golf cart, filet mignon, or panel discussion with the industry you are trying to regulate.

[1] http://www.rollingstone.com/politics/news/regulatory-capture-captured-on-video-20150325

Wednesday, March 25, 2015

A Double Standard: Executive Pensions

A Double Standard:  Executive Pensions

Over the past thirty years, corporations have been eliminating or freezing their defined benefit pensions because they did not want to bear the risk or cost of providing retirement security for their employees.  The rank and file have been left with 401(K) accounts that don’t come close to providing enough income to retire.  Even where the defined benefit pension has been eliminated, senior executives have little to worry about.  Their base compensation, deferred compensation plans, stock appreciation units, and stock options provide more than enough wealth to ensure a retirement bathed in luxury.

In today’s Wall Street Journal, Theo Francis and Andrew Ackerman report that companies that still provide defined benefits for their executives are defending the rising costs as merely accounting mechanics.[1]  For example, low interest rates used to discount liabilities and extended life expectancy are boosting the value of all pensions, but especially the large sums owed senior executives at companies like General Electric and Lockheed Martin.  These assumptions are the very same factors that have driven companies to freeze or eliminate defined benefit plans.  However, when it comes to senior executives, major corporations are telling shareholders and the public that we shouldn’t count these rising costs when we evaluate levels executive compensation because they are merely accounting conventions. 

To give you an idea of what I’m talking about, GE owes Chairman and CEO, Jeff Immelt, $74 million in pension benefits, which consist of about $2 million under the general plan, and the balance under a supplement plan (companies have supplemental plans because the IRS has a cap on the amount of pension benefits that can be deducted).  The prior year this figure was about $56 million.    Clearly, the accounting requirements drove up the total.   GE has created a separate column in its compensation table to strip out the affect of accounting.  Of course, they don’t do that when it comes to the pensions of the average employee.

The bigger issue is that Mr. Immelt has a huge pension coming that he will never need, no matter the accounting assumptions.  He’s receiving about $10 to $20 million in realized compensation per year.  He owns 6.1 million shares of GE stock (up from 5.3 million in 2014), which is worth $150 million, and has generous life insurance and other benefits. 

To be fair, General Electric’s proxy statement is model of transparency and disclosure.   Moreover, GE has eliminated termination and change of control provisions in their contracts, which are steps in the right direction. Nonetheless, GE and other big companies have an army of lawyers, accountants, and compensation experts to help justify their compensation, which GE and others are using to diffuse the rising cost of executive pensions. 

Clearly, disclosure is doing little to stem the tide of escalating executive compensation.  Senior executives would prefer to hide their pay packages from public scrutiny and dislike the disclosure mandated by the SEC.  However, given a choice between a bit of embarrassing publicity and receiving all the benefits and perks, they’ll take the benefits and perks.  The rest of us have a retirement crisis to sort out.

[1] http://www.wsj.com/articles/executive-pensions-are-swelling-at-top-companies-1427241963

Tuesday, March 24, 2015

A Warning That’s Not Required: Private Companies in Mutual Funds

A Warning That’s Not Required:  Private Companies in Mutual Funds

The New York Times made a significant mistake yesterday when it ran a story raising concerns about the growing amount of private venture-backed companies held by mutual funds.[1]  The headline, “Americans’ Retirement Funds Increasingly Contain Tech Start-Up Stocks” probably made more than a few retail investors nervous about their 401(K) or brokerage account.  While the story makes a series of valid points, it reaches a completely incorrect conclusion.

It is true that mutual funds are increasing their purchases of stock in non-public companies rather than waiting for those companies to go public.  It is also true that valuations for these companies (e.g., Uber, Airbnb, and Pinterest) have risen significantly, and some of them may turn out to be grossly overvalued.  It is also true that financiers and investors have given these companies a catchy name, “unicorns”, because of their magical ability to attract capital at ever-increasing prices.  Private stocks carry more risk than public securities because there is no liquid market to sell shares.  As the Times points out, the markets that exist to buy and sell private securities are fragile and tend to shut down when bad things happen to the companies.

However, this isn’t a major problem brewing inside mutual portfolios.  While I didn’t conduct an exhaustive survey, I did pull the annual reports for two funds cited by David Gelles and Conor Dougherty as big players in illiquid securities.  According the Times’ reporting, the Fidelity Contra Fund has about $400 million invested in Uber, Airbnb, and Pinterest, and according to the fund’s annual report has a total of $1.5 billion in highly illiquid securities (known as Level-3).  It sounds like a lot of exposure until you realize that the Contra Fund has $110 billion in assets.  That comes out to 1.3% of the fund’s assets spread across many individual holdings.

T. Rowe Price’s New Horizons Fund is also a large participant according to the Times.     According to their annual report, it holds $500 million worth of illiquid securities in a fund valued at $15.4 billion (3.2%).   There are a lot of things that might keep an investor awake at night, but the exposure of mutual funds to private companies isn’t one of them.

In fact, the real question is why the mutual funds are bothering at all.  Let’s assume that Contra Fund’s $400 million investment in the three unicorns doubled in a year.  The fund would rise by an additional 0.3% (before fees), a nice little return for investors but certainly not a home run.  My guess is that these unicorn investments are more about allowing mutual fund portfolio managers to be players along the fringes of venture capital rather than a strategy to help out investors.

[1] http://www.nytimes.com/2015/03/23/business/dealbook/tech-money-sends-funds-on-the-hunt-for-unicorns.html?src=me&_r=0