Archive for January, 2012

 

Mitt Romney: Strip Mining The US Economy

Saturday, January 21st, 2012

So Newt Gingrich’s allies have funded a movie attacking Mitt Romney’s record at Bain Capital, called “When Mitt Romney Came To Town.” You can watch it here. It scratches the surface and shows a lot about the toll that Bain Capital took on the people who worked for the companies that Bain would purchase. It’s worth viewing.

But I wanted to delve into a bit more detail about what private equity is, how it works, and why it bears so little resemblance to what people think of as building a business. Private equity, fueled by massive debt, is much more akin to strip mining than to growing a business. And it is fueled by the easy money available from the Federal Reserve. So I think it’s worth taking a moment to understand it, and how it applies to Mitt Romney’s record as a businessman, a record that is mixed at best.

Private equity generally buys companies by way of a mechanism called an LBO, which stands for “Leveraged Buy Out”. This is not significantly different from how a person might by a small business normally. As the buyer, you would make your down payment, and use a bank to borrow money using all the hard assets of the business as collatoral. Finally, you would obtain a note from the seller for the remainder of the business. Obtaining a note from the seller is necessary because few parties if anybody will loan money against the future cash flows of a business. And the buyer needs some assurances that the business is functioning as presented by the seller. Therefore, making the seller take a note puts him in a positon where he loses if he’s lying about the cash flows of the business, and he has every interest to make sure the business is running profitably after he’s gone. Finally, oftentimes a bonus will be paid to the seller if certain financial milestones are met after the transactions take place. That bonus is called an “earnout”.

When a private equity firm buys a company, they will utilize all of these methods as well, but they have access to much deeper reservoirs of cash, which affords them the opportunity to outbid other potential buyers. Buyers tend to come in two varities, financial and strategic. A financial buyer is someone like a private equity firm. Their interest is in the cash flows of the enterprise. A strategic buyer, on the other hand, typically is already in the same business or an adjacent business as the company that is for sale. Under normal circumstances, a strategic buyer should be able to offer the highest price for a company, because they will integrate the new company’s product lines into their own, and cut out nearly all the management and overhead. Moreover, they strategic buyer will often need to make the purchase in order to be competitive in their industry, which can incent them to bid even higher for the company being sold.

So why does a financial buyer such a private equity firm even have a chance? The answer, I’m afraid, stems from loose money flowing from the Federal Reserve spigot. Here’s how it works: The private equity firm issues bonds to conduct the buyout. These bonds are underwritten by the major banks, the ones with the free access to the Fed spigot. These banks have asset to loan ratios that they need to maintain, and they also are “too big to fail”. The loan ratio limits how many loans they can make, which incents them to make the highest yield loans they can possibly find (and ironically, eschew loans that are more conventional, safer bets).  And because they are too big to fail, they worry little about the consequences in loading up on these risky loans.  Not that they want to fail, but having that backstop makes them feel like they can take risks that they would not otherwise take.

So the banks find buyers for the bonds, and buy the remainding bonds themselves. Because these bonds are incredibly risky (because the financial buyer is likely overpaying for the comapany) they pay astronomical interest rates. In polite parlance, these bonds are termed “high yield”. In common parlance, they are called “junk”.

So using these bonds, the private equity firm acquires the company. But they still have money stuck in the company. So they do something that would never be possible for a small business to do: they take on more debt in order to pay themselves a dividend. In technical parlance this is called a “dividend recap”. In common parlance, it’s called “completely insane.”

Can you imagine being a small business owner, say with a small chain of restaurants, or a couple of gas stations, what have you, and asking the bank to loan your business money so that you can take your own equity out? Every small business owner knows full well what kind of reaction they would get from the bank. That’s because the small business owner is dealing with a bank that is not “too big to fail”. And if they are dealing with a bank that large, they still won’t take on that kind fo risk for a penny ante player.

So how does the private equity firm do it? Well, part of how they do it is by cutting fat They call in the consulting firms of the world, names such as Bain, Boston Consulting Group, and McKinsey, to come in and find fat to cut. Since no business in the world operates at 100% efficiency, they invariably find some, which generates more cash flows to borrow against. But that’s not the whole story. Invariably, they mess with the company’s product pipeline.

In a normal company, products have a certain life cycle.  It goes something like this:  in conception the company spends money on research and development, while earning no money from the product, only earning money from older products.  They launch the new product, which is priced high to recoupe development costs.  Over time, the price drops as the cost of producing the product drops, and the volume of sales increases.  Profits increase as well, as the product goes mainstream.  But then, the product becomes commonplace, copy cats are out in the market, and with increased competition sales drop, as do prices.  Eventually, the product dies.  If you’ve managed your product pipeline correctly, you will have a new product coming out before your existing product begins dieing its natural death, and you will have steady increasing profits over time.  Companies like Apple and Gillette are masters at this sort of thing.  If you fail, then your company may die, and a rival company will take your place.  This process, of replacing old products with new products, was described by Josef Schumpeter as “creative destruction”.

But if you’re looking to do a dividend recap, then you need to find additional cash flows with which to pay the back the money you’re borrowing.  So if you’ve already cut out all your fat, you now need to start cutting muscle.  And there are two sources for this: you can degrade the quality of your current product lines by cutting corners, or you can cut R&D for future products, or both.  Either way, what you wind up doing is juicing the numbers today at the expense of future productivity.  Farmers might call this “eating one’s seed corn”.  

Now sometimes, shenanigans like this occur at the small business level as well.  A business owner looking to sell his business “juices” his numbers by cutting out repair and maintenance expenses, in the hopes he can sell his business for slightly more than it’s worth by faking a higher profit margin that he really has.  But to be sure, no small business owner cuts his own repairs and maintenance with the hopes of retaining ownership in his business.  It’s just not a long term strategy for success.

In the private equity world, some number of companies so abused by the methods described above do in fact survive.  Those companies reap enormous rewards for their private equity owners.  This is more common in good times than in bad, of course.  But nevertheless, it does happen.  But what concerns people is what happens when times aren’t so good, when the enormous risks taken do not in fact pay off.

Corporate bonds are typically issued for 5 years, after which time they must be paid back.  Now a company that is levered by 70-80% is not going to be able to pay back that much in 5 years.  So they are accepting a refinancing risk when they issue the bonds.  That is, they are risking that they can roll over their debt at the end of the five year period.  Their chances may be quite good if times are good in 5 years, or they could be poor.  But this is the risk that companies owned by private equity firms take.

As time progresses, the bank holding the company’s debt will make a judgment call as to whether or not it thinks the debt can be refinanced.  Based on this and its own portfolio management strategy, they may offload their bonds onto other parties.  In polite company these parties are typically called “foreigners” and “municipal pension funds”.  In common parlance, they are known as “suckers”.  But they may also be another kind of private equity firm, one that behaves as more of a vulture.

This second kind of private equity firm loves to buy up distressed debt.  They too are making a judgment call, as to whether or not the company is likely able to refinance its debt, and whether or not the private equity firm that owns it is likely to walk away from the company it owns and let it slide into bankruptcy.  They are also making a judgment that the assets of the company are worth more than the price of the debt on the open market.  If it is, then they buy in.

Let’s use some concrete numbers to illustrate.  Say a small manufacturing company is owned by a private equity firm.  They are purchased for $100 million.  They have assets in the form of their factory and inventory worth $25 million.  And they are levered by the private equity firm for $75 million.  While the bonds have a face value of $75 million, they are heavily discounted by the market, which believes are unlikely to be able to be refinanced or paid back.  So the second private equity firm buys on the open market for a steep 80% discount.  If you do the math, you will note that they paid $15 million for a debt worth $75 million, backed by a company with $25 million in hard assets.  If the company goes bankrupt, the new private equity firm will have earned at least a 60% profit on the deal, for essentially doing nothing, just for selling off the equipment.  Not that they will always opt for this route.  Sometimes they will in fact endeavor to turn the company around, and sell the company for the $100 million that it was worth at one time.  But that entails more risk, risk that the firm may just not want to take on.

As you can see, it is entirely inappropriate to describe the process outlined above as “creative destruction”.  In a scenario of creative destruction, there is some creation occurring that is causing the destruction: the iPhone kills the iPod, the Fusion kills the Mach III.  But here, there is no creation going on whatsoever.  Just reckless risk taking that didn’t pay off.  It is inconcievable that the economy as a whole is benefitted by overlevering profitable, working companies, and then selling the carcasses off to vultures for a profit.  It’s not creative destruction, but just plain destruction.  Or “destructive destruction” if you will.

To be sure, Mitt Romney’s record appears to be a mixed one.  He did some venture capitalism early in his career.  In particular his investment in Staples appears to be a true example of creative destruction, causing the demise of many smaller stationary stores.  And even in his private equity investing, he surely wasn’t the worst of the bunch.  From what I’ve read, he appeared to be the private equity guy with a conscience as opposed to the soulless villian.  Think Darth Vader instead of Voldemort.  Still, I have trouble wanting to vote for Darth Vader, no matter how effective he was a blowing up Alderan.

The point here though is much larger than any one candidate.  The point is that allowing for loose money from the Fed, coupled with a corporate income tax system that encourages firms to lever up, overlaid onto an economy that still has plenty of manufacturing assets to be sold off, run and operated by a banking class that seems incredibly dishonest is a recipe for looting every last bit of manufacturing out of the US economy.  And it is that that we should be concerned about if we are to survive and prosper into the future.

 
 

Why Mitt Romney is Completely Unacceptable

Thursday, January 12th, 2012

In my earlier post detailing the Republican candidates for the nomination, I didn’t say some things about Romney that I meant to. So consider this post a further declaration of why Romney is unfit to be the nominee. Should he get the nomination, and I think he likely will, then I will be casting my vote for Libertarian Gary Johnson.

  • Family Legacy: I don’t take any issue with Romney’s religion or ethnic background. But I do take issue with the fact that his father ran for president. Given that Mitt Romney doesn’t appear to stand for anything specific, I can only guess that he is running for office to somehow satisfy his father’s legacy. For those not in the know, George Romney was a serious contender for the 1968 Republican nomination, until he claimed he had been brainwashed by US military officials into supporting the Vietnam war. This is the worst of all possible reasons to run – to restore a lost family legacy. We elected a president like that in 2000 and look what it earned us. No, anybody running for president should be doing so because they have convictions or experience that they bring to the table. They should run because they believe they are uniquely positioned to make the country better, not because they need to slay family demons.
  • He Stands For Nothing: Mitt Romney appears to have no core beliefs whatsoever. His flip flopping has been covered in many places before and I feel no need to revisit the details here. But not only is it the case that he appears to have no core beliefs, but he is running a campaign that feels like an empty “Morning in America” campaign. Romney wants to make America great again, or something. Romney is incapable of arguing against the greatest abomination to come out of the last 4 years, Obamacare, because he masterminded the precursor program in Massachusetts. And despite his eloquence, he says nothing about the decade of bad legislation that has led us down this economic path, and what might be required to get us out. That’s in part because he supported TARP. He’s an establishment politician who supports establishment views at the precise moment when the establishment needs to be sent packing. As a result, he is incapable of expressing anything substantive. The result will be that he gets defined by Obama and the media, and gets run roughshod over in November.
  • He Is A Liar: Romney is fond of pointing out that we have “50 laboratories of innovation” in the country. He’s right about that. But typically, when a governor runs for president, he is running on the notion that he developed in his laboratory a successful formula that should be brought to the nation as a whole to either cure its ills or propel its growth forward. Romney is the first governor to my knowledge who is running for president while claiming that what he did for his state should NOT be propagated into the nation as a whole. This alone causes too much cognitive dissonance for most people, myself included. But it is also a giant lie. Romney instituted Romneycare because the Heritage Foundation published a paper in the early 90′s, when Hillarycare was being debated, suggesting that a preferable means to achieving universal coverage would be to mandate that citizens purchase catastrophic medical insurance for themselves. Romney viewed this suggestion as a classroom assignment, and raced to be the first in the nation to institute such a thing (ignoring for the moment that what Romney mandated was comprehensive insurance be purchased, not catastrophic). This alone is problematic enough, and suggests a lack of proper thinking ability. But what’s worse is he has been lying about it the entire campaign. In his book, he wrote that what he did in Massachusetts could be a model for the nation. And in 2004 he campaigned on the fact that he implemented Romneycare in Massachusetts. Now he claims to have never said that Romneycare could be good for the country.

    It is difficult to stomach that level of dishonesty generally. But when you couple it with the fact that the issue in question is bound to be the main issue of the campaign, it becomes impossible. Especially when you couple it with the fact that nearly everyone gets a creepy sleezebag vibe from the guy. He has shifty eyes, and he looks like he’s gauging the audience while he speaks. And people from all walks I encounter say he just seems dishonest. This is a massive handicap, especially for a Republican nominee going up against a Democrat who is well regarded on a personal level.
  • He will be a steward of the Status Quo: If you think that the problem with Democratic governance is that they don’t know how to balance the budget and keep the ship of state afloat, then Romney is a great pick. He will not likely repeal Obamacare, but will change it to make it more workable and less costly. At least that is what he was claiming early on in the campaign, saying he would repeal “the worst aspects of Obamacare”. Indeed, even now he promises to issue 50 waivers to every state to let them out of the requirements of Obamacare. But this is not repeal. And worse yet, it undermines the rule of law, which should apply equally to everybody. If Romney truly wanted to see Obamacare repealed, he would immediately revoke all waivers on day one of his administration. That would motivate people who got waivers to lobby for Obamacare’s repeal. But I would not expect to see a repeal of Obamacare should Romney become president, which he won’t. What we will see is the institutionalization of everything the Democrats have put into place, just run smoother. If your problem with Democrat governance is the governance, then Romney is the last guy you want to succeed Obama.
  • Romney will be a Racially Charged Candidate: Mitt Romney is a Mormon, and the Mormon religion was predicated on some racist beliefs, the totality of which were not repudiated until 1978. The Mormon church taught that American Indians were descended from white Jews, and that as those jews lost their faith and ceased to be monotheists, their skin darkened. It also taught that the mark of Cain was being black. And there are no shortage of appalling quotes from Brigham Young confirming that this was a core doctrine of the early church. As a result of this, the church refused blacks full membership, under the guise that they were not worthy by virtue of their race. Moreover, they did not reverse these policies until 1978, at which time they also revised the Book of Mormon to change all the references to skin color to references about purity of one’s soul.

    The issue here is that Mitt Romney had already completed his 2 year missionary work prior to 1978, meaning that he spent two years of his adult life proselytizing what was at the time a racist religion. If you don’t think that Barack Obama isn’t going to confront Mitt Romney about that point blank on stage at a debate, you’re nuts. Romney may retort by playing clips of Reverend Wright, but the end result will be a scorched earth campaign at the end of which race relations in this country will be markedly worsened, regardless of who wins. If that idea appeals to you, by all means vote for Mitt Romney. If it doesn’t, then you should choose a different candidate.

I am going to address Mitt Romney’s record at Bain in another blog post. But suffice it to say, it bears little relation to capitalism or even creative destruction as commonly understood. But that is a long post unto itself. Suffice it to say that Mitt Romney is not the guy we should have standing up and defending capitalism either.

UPDATE: Clearly Squared brings up Shannon O’Brien, whom I forgot to mention previously. Everyone should understand that Mitt Romney only ever became governor of Massachusetts because the Democrat nominee, Shannon O’Brien, was a townie who literally was offering to show off her tattoos on the campaign trail. In other words, Romney only won in Massachusetts because the Democratic nominee imploded, not because the state ever really liked Mitt. Furthermore, once elected, Romney was such an asshole in office that mayors and town managers soon refused to take his calls, requiring Romney to hire an ambassador of sorts to communicate with the cities and towns of the state. Remember that when you cast your vote as well.

 
 

The Republican Race

Friday, January 6th, 2012

I think I’ve figured out what’s going on.

What we have is a three way race between the libertarian wing of the party, the religious wing of the party, and the asshole wing of the party, otherwise known as the establishment. Ron Paul is the libertarian in the race. He was hoping to bridge the gap between the libertarians and the religionists by virtue of his libertarian policies and personal religious conviction. Unfortunately, the religionists seem to be demanding a candidate who begins every sentence with reference to God and/or family. Hence the rise of Rick Santorum. However, Santorum makes no bones about his disdain for the libertarian wing of the party and their policies, and hence is incapable of attracting their votes. Romney represents the wing of the party that is bought and paid for by crony capitalist lobbyists. He is unacceptable to the majority of the grassroots. He is still the likely nominee.

One question remains: can a fusion candidate emerge in time to unite the libertarians and religionists to defeat Romney? This is why Rick Perry is staying in the race. Also Gingrich I suppose. I would guess that it is possible for one of them to emerge and unite the base against Romney, but time is running out. I still think Romney will be the nominee, but anything is possible.

 
 

Predictions 2012

Monday, January 2nd, 2012

Let’s just get right to it:

Q: Who will be the Republican nominee for President:
A: Mitt Romney

Q: Who will win the apparent Romney-Obama matchup?
A: Obama.

Q: What will the electoral map look like?
A: Almost identical to 2008, though Florida may flip to the Republican column. NH will also flip. I should emphasize that this is true if Romney is the nominee, as predicted above. If Romney is not the nominee, then the electoral map will be very different.

Q: Will the Euro survive 2012?
A: Probably, though it will be very weak by year’s end.

Q: Will Scott Brown win re-election?
A: No, but it will be a close election.

Q: Who will Ron Paul endorse in the general election?
A: He will not endorse either the Republican nominee nor Gary Johnson.

Q: What percentage of the vote will Gary Johnson get in 2012?
A: Around 2%. He will break 1 million votes.

Q: Will SOPA pass and be put in to law?
A: Yes.

Q: Will the next major terrorist attack be carried out by Americans against their own government?
A: Yes, though it certainly won’t happen until after the election, and not likely to happen in 2012.

Q: What price will Bitcoins be in $US at year end?
A: $50

 
 

Predictions 2011 Revisited

Monday, January 2nd, 2012

I should revisit the things I predicted in 2011. What will the official unemployment rate be on December 31, 2011?

Q: What will the official unemployment rate be on December 31, 2011?
A: Between 9% and 9.5%.
Reality: The official number is 8.5%, but it will likely be revised upwards. Of course, Shadowstats says it’s more like 15%.

Q: Where will the Dow close at next year?
A: Under 12,000.
Reality: Closed at 12,200.

Q: Will Apple’s new Verizon iPhone be 3G or 4G?
A: 3G. Expect 4G phones to be released over the summer.
Reality: No 4g phone has been released by Apple, on Verizon or elsewhere.

Q: Name the top three candidates the Republican establishment will back for the 2012 Presidential nomination:
A: Mitt Romney, Tim Pawlenty, John Thune.
Reality: It’s Romney.

Q: Name the top three Republicans the Tea Party will get behind for the 2012 Republican presidential nomination:
A: Sarah Palin, Chris Christie, Mitch Daniels.
Reality: None of my picks chose to run. So the Tea Party vote appears to be split.

Q: Will an Android Tablet catch up to the iPad in sales this year?
A: Not a chance. Maybe 2012 if they’re lucky.
Reality: No Android tablet.

Q: Name three things that will jump the shark in 2011:
A: Silly Bands, Lady Gaga, Brick and Mortar Bookstores
Reality: I have no idea if Silly Bands jumped the shark. Lady Gaga appears to still be going strong, but brick and mortar bookstores are certainly a thing of the past.

Q: Will the home market enter a double dip recession next year? Will it recover?
A: No and no. The market will remain stagnant through the next year.
Reality: I appear to be on target here.

Q: Will we be out of the recession next year, from a colloquial, average man on the street point of view?
A: No. People are really tired of this recession, and may start making business decisions again, but the economy will not be in enough of a recovery such that the average man on the street feels good again.
Reality: The recession continues unabated.

Q: Will I become a father again in 2011?
A: Yes, sometime around July 17.
Reality: It happened on July 22.

I’ll post some new predictions in a bit.