Showing posts with label amicus curiae. Show all posts
Showing posts with label amicus curiae. Show all posts

Sunday, April 13, 2014

In Loco Parentis

Kids: can’t live with ’em, can’t sell ’em for theater tickets.
“You know, Mrs. Buckman, you need a license to buy a dog, or… drive a car. Hell, you need a license to catch a fish. But they’ll let any butt-reaming asshole be a father.”

Parenthood

One of the advantages of being a sole pseudonymous proprietor of an obscure online opinion emporium—insulated from the interference of officious editors, hypersensitive advertisers, and unhinged commenters still seething over the unflattering piece I posted about their dipsomaniac uncle six years ago—is the freedom to write whatever I will. Periodically then, this freedom licenses me to post explanatory articles which illuminate often obscure features or issues about my chosen profession which, to be perfectly honest, will be of little interest to most of you Charming Visitors.1 So unless you would like to learn a little bit more about the current regulatory environment surrounding mergers & acquisitions, I suggest you skip over this entry and revisit the latest internet outrage du jour on Gawker or Slate, instead. Or better yet, read a book.2

The impetus for this post is the release, this January, of what is known in the trade as a “No-Action” letter by the SEC in response to a formal inquiry by a gaggle of M&A lawyers. Now in layman’s terms, a no-action letter is simply a formal statement by the SEC that, under a certain limited set of circumstances as laid out in exhaustive detail by the petitioners, it will choose not to enforce existing securities laws. In the particular instance under consideration, the no-action letter effectively eliminates the existing requirement for advisors who participate in mergers and acquisitions involving private companies to be registered as broker dealers with the SEC.

Now Charming Visitors like you, I am sure, can just imagine how this news was received among certain shouty quarters of the internet and associated environs:
“Wall Street Banksters Celebrate
SEC Trashcanning of Investor Protections
Over Lavish Meal of Roast Baby Seal,
Fricasséed Retirees’ Dreams”

Fortunately—or unfortunately, perhaps, if you are one who prefers to keep her mental map of the financial system conveniently colored in morally unambiguous shades of black and white—I am here to reassure you that baby seals and investor dreams face no greater threat than they did before, and this particular instance of deregulation running, as it were, against the tide of increasing regulation in the brave new world of Dodd Frank makes eminent and prudent regulatory sense.

* * *

It will help me make my case if you understand the historical background of the existing regulation which the SEC has decided to waive enforcement of. Historically, as you might expect from an organization entitled the “Securities and Exchange Commission,” the SEC has been particularly concerned with the regulation of anything and everything to do with securities. Simplifying greatly for the non-lawyers in my audience, the SEC has traditionally said that any financial intermediary who participates in the origination, solicitation, negotiation, marketing, or general fricaséeing of a security and gets paid a fee for doing so (i.e., all of us) is required by law to register as a broker-dealer. In other words, if you make money assisting the transfer of securities from one party to another–whether by making a market in secondary shares, underwriting a new bond issue, or selling companies—you need a license. What may not have occurred to you is that the securities of private, non-publicly-traded companies count as securities under the SEC’s purview, too. And M&A transactions, which usually involve the purchase, transfer, or exchange of securities for cash and/or other securities, definitely count.

Given the SEC’s mandate to protect investors, this makes eminent sense when M&A involves companies with publicly-traded securities. After all, if there are public securities involved, somewhere or other a widow or an orphan is likely to get caught up in the deal, and nobody—least of all the SEC—wants nefarious unregulated doings clouding the pale and fevered brows of said Ws and Os. At least not publicly. Of course pure M&A advisors almost never handle customer funds or securities—a big hot button for the widow and orphan protection unit—and they rarely provide financing for the transaction, unless they are one of the monster integrated investment banks intent on sucking more fees out of their clients’ wallets by lending their own balance sheet to the equation. But the overarching presence of public securities is as probably as good a reason as one can muster for the licensing of M&A advisors who participate in transactions involving public companies, even if it might be considered, for various reasons, a bit of overkill.

But the inclusion of M&A deals involving purely private companies under this licensing requirement has never made much sense. I will allow the helpful lawyers at Morrison & Foerster to explain:

The application of the broker-dealer regulatory framework to private company M&A advisers has always been somewhat awkward. Much of that framework is designed to protect customers against abusive sales or trading practices and to ensure that customer funds and securities are safeguarded. However, in the typical private company M&A transaction, the terms of the deal are negotiated directly by the principals with assistance from their financial and legal advisers. Unlike the customer who buys or sells stock based on a brief conversation with his broker, the owners of a private business are generally very involved in the negotiation process, which may take place over a period of weeks or months. Moreover, the financial intermediary never touches the customer’s funds or securities. The “broker” in private company M&A transactions functions essentially as an adviser to its client and its role bears little resemblance to more traditional broker-dealers.

This, I can tell you from long and painful experience, is absolutely true. The principals in a private company transaction are either other companies or financial sponsors, all of whom tend to be very experienced in doing M&A themselves and/or are protected by the advice and counsel of armies of very experienced lawyers, accountants, and professional M&A advisors like me. We take oceans of time for due diligence and negotiate the everloving crap out of every possible term of these deals six ways from Sunday. The notion that an average billion dollar corporation or financial sponsor with a three billion dollar fund needs the indirect, implicit investor protection that a broker-dealer license from the SEC purportedly conveys to its M&A advisor when it purchases a $25 million dollar business is patently ludicrous.

But historically the SEC has been a big fan of one-size-fits-all legislation: what’s good for Aunt Millie is good for Steve Schwarzman. I have complained in the past that the conflation of retail and wholesale finance under one legislative rubric structurally designed to protect the widows and orphans of 1933 and 1934 from boiler room operations is just silly. Financial transactions among professionally advised, intimately involved, professional principals like corporations and financial sponsors just should not be treated in the same way as Aunt Millie’s purchase of a mutual fund from her stockbroker Chuck. And M&A deals, both public and private, definitely count as the former.

* * *

The prior restrictions were not without negative effects, by the way. In order to satisfy the rules, M&A brokers who wanted to actively advise their clients often had to twist the transaction structure into an asset sale, thereby avoiding the requirements triggered by the involvement of securities, whether that was the most financially efficient structure or not. Or they simply ignored the law, in the hopes that the SEC would look the other way. In the latter case, their clients usually shrugged indifferently, since they knew they were fully protected by intensively negotiated legal engagement contracts and fully applicable anti-fraud provisions under the law anyway. Most aficionados of jurisprudence will tell you a law which only encourages scofflaws or evasion is bad legislation.

Lastly, the prior regime enforced a very inefficient structure in the market for private company M&A. In order to comply with the law, many individual advisors or small boutiques which could do M&A either had to associate with an existing licensed broker-dealer or apply for a license and maintain ongoing registration themselves. This, for smaller outfits, was not trivial, costing potentially hundreds of thousands of dollars up front and entailing substantial ongoing reporting obligations, dedicated compliance and administrative personnel, and non-trivial financial expense. It likely substantially curtailed the establishment of small independent advisors who otherwise wanted to and could provide professional advisory services to privately held companies. The outcome of this regulatory barrier to entry, of course, has probably been higher prices for customers who want to do M&A.

So I congratulate the SEC for finally seeing the light of intelligent market regulation in the M&A world. No true investor protections have been lost, and barriers to entry in a high cost service industry have been lowered at a stroke. Who knows, maybe this is the start of a new era of intelligent regulation of financial markets, not more regulation.

Naahh…3

Related reading:
United States Securities and Exchange Commission, No-Action Letter Dated January 31, 2014
Morrison & Foerster LLP, Private Company M&A Brokers Don’t Need to Register With the SEC as Broker-Dealers (February 6, 2014)
You’re Doing It Wrong (October 22, 2011)


1 This, of course, incorporates the perhaps heroic assumption on my part that anything I write here is of interest to more than zero of you. But, since this is my website, I can damn well assume as much such nonsense as I choose. So take it as given.
2 I hear some mid-range Princeton author has an inflammatory new book out about Wall Street traders who like to expose themselves in public that’s getting a lot of press. Flasher Boys, or something like that.
3 In the isn’t-it-interesting-what-a-coincidence department, the SEC no-action letter comes at a time when legislation is currently wending its way through Congress that would enshrine the exemption of M&A advisors from broker-dealer registration requirements in actual law. The original bill, H.R. 2274/S. 1923, and the omnibus bill which incorporates it, H.R. 4304, incorporate virtually the same exemptions from registration as are included in the no-action letter, with the slight addition of size limits for transactions. Note that neither the no-action letter nor the proposed legislation lets M&A brokers off the hook from registration if they do public company M&A or normal securities financing work, like private placements. Any investment bank which aspires to the full range of agency services, even if they do not have capital markets trading activities, will still have to register. Relax, Aunt Millie: the dogs of war are not completely off the chain.

© 2014 The Epicurean Dealmaker. All rights reserved.

Sunday, February 5, 2012

Apocalypse, Ciao!

Insure this
Francie Stevens: “I’ve never caught a jewel thief before! It’s stimulating! It’s like... It’s like...”
John Robie: “Like sitting in a hot tub?”

— To Catch A Thief


Part of the real pleasure of the interwebs for me, O Dearly Beloved, is the occasional opportunity Your Muddle-Headed Correspondent has to engage in a stimulating conversation with one or more individuals who are clearly more intelligent, better read, and cleverer arguers than Yours Truly. I tend to gain a lot from such interactions, if only a better understanding of my own opinions and the limitations of my knowledge and intelligence. They tend to generate a crush of sensations, including excitement, the sheer terror of discovery that I am out of my depth, and an urgent desire to land a couple of cheap shots on the champion before I scramble out of the ring to safety.

Today’s reflections are inspired by the response Carolyn Sissoko made to my recent post on unlimited liability in finance. While I am not equipped to address some of her points—especially on the topic of what she sees as the increasingly pernicious use of collateral by modern financial intermediaries—I would like to venture a few remarks and intuitions, in the spirit of a novice fighter taking a couple tentative jabs at Mike Tyson. Hopefully she will be gracious enough to let me run away thereafter.

First, Ms Sissoko uses historical evidence (what’s that?) to demonstrate that a regime of unlimited liability is not necessarily inconsistent with low required rates of return on capital:

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum. Market rates often fell as low as 2%. It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).
But I think this point misses the thrust of my previous argument. My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard. The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

I strongly suspect that if we attempted to reimpose a regime of unlimited liability on capital providers nowadays, the pool of capital available to the economy would shrink, and likely dramatically. People with capital would simply become unwilling to lend to or invest in risky projects beyond a certain point, and the evidence from 19th century Western industrial societies seems to indicate that point would be at a dramatically lower level than we have become used to over the past 70 years. Unlimited liability could well be massively contractionary. This, I assume we all can agree, would not be a good thing.

* * *

Second, Ms Sissoko rather loses me when she asserts that

from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit). If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises. Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

It may be that the intestinal parasite (me) within the dinosaur simply cannot conceive of a world without dinosaurs or dinosaur intestines, but I don’t get this. Capital is, in my understanding, at base a buffer against loss. Perhaps capital and bank lending vanishes when you sum all of its offsetting accounts across the entire economy, but capital serves a very important protective function at the “local” level of real creditors and borrowers. Capital absorbs loss, and either stops or slows the propagation of that loss through the daisy chain of economic interrelationships economic actors maintain. It is like the collapsible drums filled with water at the top of a freeway exit, whose function is to slow or impede the destructive progress of a runaway car. Sure, a runaway car will eventually stop of its own accord due to friction and gravity—if not another car or building—but do we really want to conclude from this that crash drums aren’t desireable or necessary?

I presume Ms Sissoko would counter that, with appropriate care and attention, we could design freeways and perhaps even cars so that we need not worry about collisions or runaways, but I fear that implies a level of omniscience—and systemic rigidity—which I find hard to credit. Financial loss is triggered both endogenously and exogenously. Being unable to anticipate all the ways financial loss can occur and directions from which it can come, I would much prefer to have various pools of capital sitting around the system, hopefully helpfully positioned between me and disaster. Besides, without capital, how can we enforce incentives? Capital belongs to someone. I thought the point was to reduce unnecessary systemic risk by presenting those positioned to create the risk of loss in the first place with incentives not to do so recklessly. How else can we do this except by making them the first to bear that loss; i.e., lose their capital?

* * *

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced. Leading up to the recent financial crisis, as financial actors’ capital at risk shrank and society assumed ever more tail risk, more and more of the spectrum of possible financial loss fell outside the capital markets’ risk pricing mechanisms. Risk, whether from risky investment projects, financial leverage, or whatnot, looked cheap because an increasing portion of it was not being priced. We all levered up and engaged in riskier activities because we thought those activities had somehow got less risky. Remember the “Great Moderation?” It turns out instead we were just hiding a lot of potential loss out of sight, in the Grandma’s attic of a taxpayer backstop.

I continue to maintain two important things about financial risk. First, that it is incompressible; that is, a certain level of risk is ineluctably tied to the pursuit of a particular level of returns. No matter how you slice it, you cannot reduce the risk associated with a certain return. If it looks like risk is lower than you anticipated based on past history, rest assured it has not declined. You have either transferred it to someone else (e.g., through derivatives, in which case you have transferred some of your return, as well), or you have just lost track of some of it (perhaps by shifting it onto taxpayers). Second, that the risk-return relationship obtains at a society-wide level, as well. It may very well be the case that we unknowingly assumed more risk than we are comfortable with as a society, because we lost track of some of it by shifting it outside the financial markets, unpriced, onto our own backs. We pursued a growth and consumption agenda that was a lot riskier, in retrospect, than we believed at the time. But lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy.

Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.1 But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects:

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down. But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or “solutions” we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place—if we do not make provision to address them.

But cheer up. Things could be a lot worse.

Related reading:
Carolyn Sissoko, A little fear is a good thing (Synthetic Assets, February 4, 2012)
The Blind Men and the Elephant (June 21, 2011)


1 Oops. I guess it was our money all along, after all.

© 2012 The Epicurean Dealmaker. All rights reserved.

Saturday, November 5, 2011

Methinks Thou Dost Protest Too Much

In God we trust. All others pay cash
Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke


Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.1 Go ahead, call me a dreamer.2

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *
First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.3 How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.4 What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)


1 An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
2 Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
3 For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
4 All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.


© 2011 The Epicurean Dealmaker. All rights reserved.

Friday, November 4, 2011

Tort Reform

Tell that nag Mary Schapiro I won't go quietlyOverheard this morning at breakfast:
Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.


© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, October 22, 2011

You’re Doing It Wrong

Snap out of it, America!
And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune


There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.1 Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.2 I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.3, 4

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.5 The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)


1 For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
2 The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
3 There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
4 As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
5 My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.

Tuesday, August 2, 2011

I Think I've Said This Before

Never underestimate the effectiveness of a true professionalHo-Fucking-Hum.

Let me tell you, Dearest and Most Patient Readers, that notwithstanding my admirable innate modesty, unstudied intellectual humility, and staggeringly handsome physical appearance, it is beyond boring to be proved right time and time again as often as I have been. Even if I were a lesser man—prone to having my head turned by the adulation and adoration of the admiring masses, which I am most certainly not—I might begin to find the repeated ruminations of slower and lesser minds than my own on subjects which I have definitively and decisively disposed of now and forever somewhat enervating and—dare I say it?—even dispiriting.

Even today we find Andrew Ross Sorkin, of the Liberal East Coast Establishment's Business and Finance Digest of Record, DealBook, revisiting well-trod ground. He worries at length, and finds the fact that government regulators of the financial sector of our economy and their supposed regulatees not only share bodily fluids and intimacies not to be named in a family newspaper with each other on frequent occasion but also, mirabile dictu, share paychecks and other commonalities normally associated with working for each other's organizations on a regular, rotational, and, dare we say it, even predictable basis to be of a disturbing and even alarming nature.

And I say: No fucking shit.

But I also say: What about it? Where would you propose we find adequately qualified people to staff the regulatory bodies of our fair if somewhat befuddled commonwealth?

Where do you think we will find people who: a) know what the fuck they are talking about; b) know how the fuck to talk to/yell at/kick in the gonads the assholes they need to talk to/yell at/kick without worrying whether they can make the current lease payment on their late-model Subaru in suburban New Jersey if said regulatee makes a stink up the lobbyist/Capitol Hill staffer/Congress(wo)man food chain about said regulator's "disrespectful" behavior; and c) can tell Lloyd Blankfein or his current equivalent on Wall Street to take a flying fuck in a rolling donut if he doesn't like the tone, content, or approach of said regulator's interactions with his overpriced legal flunkies on items of regulatory interest and concern?

The Legal Aid Society of NYU Law School? The Public Defender's office? Puh-fucking-leeze.

In order to properly regulate the Masters of the Universe (aka Big Swinging Dicks) of the financial sector, you simply must have a stable of ill-mannered, hyperintelligent, nail-eating, blood-spitting, old-lady-tripping, extremely bad-tempered mutated sea bass ex-investment bankers and private sector lawyers who can go toe-to-toe with these self-protecting, self-"regulating", self-pleasuring assholes on their own terms. I'm sorry, but the well-meaning corporate lawyers and career civil servants who currently staff the SEC and like regulators simply are not up to the task of telling Jamie Dimon and his General Counsel to go fuck a goat in the information hall of Grand Central Station if he doesn't like the settlement terms/discussion/cup of coffee they are offering. Give me 25 ex-bankers like me, and 10 ex-flesh-eating Wall Street lawyers like Economics of Contempt, and I will not only have Jamie Dimon and Lloyd Blankfein eating like kittens out of my horny, calloused hands, but I will also have them delivering flowers to your Great Aunt Petunia in Astoria on a weekly fucking basis.

It'll cost you. And it'll rattle the cages of bureaucratic precedent and protocol, but is that really such a bad thing? Nowadays?

It's just not that hard.

* * *

Go read this, right fucking now. Write a goddamn book report, and deliver me a nice, crisp memo on the topic in the morning.

Do I have to do everything for you people?

Related reading:
Poachers Turned Gamekeepers (March 16, 2010)


© 2011 The Epicurean Dealmaker. All rights reserved.

Tuesday, June 21, 2011

The Blind Men and the Elephant

Go ahead and squeeze him, if it makes you feel better
A HINDOO FABLE.

I.

IT was six men of Indostan
To learning much inclined,
Who went to see the Elephant
(Though all of them were blind),
That each by observation
Might satisfy his mind.

II.

The First approached the Elephant,
And happening to fall
Against his broad and sturdy side,
At once began to bawl:
"God bless me!—but the Elephant
Is very like a wall!"

III.

The Second, feeling of the tusk,
Cried:"Ho!—what have we here
So very round and smooth and sharp?
To me 't is mighty clear
This wonder of an Elephant
Is very like a spear!"

IV.

The Third approached the animal,
And happening to take
The squirming trunk within his hands,
Thus boldly up and spake:
"I see," quoth he, "the Elephant
Is very like a snake!"

V.

The Fourth reached out his eager hand,
And felt about the knee.
"What most this wondrous beast is like
Is mighty plain," quoth he;
"'T is clear enough the Elephant
Is very like a tree!"

VI.

The Fifth, who chanced to touch the ear,
Said: "E'en the blindest man
Can tell what this resembles most;
Deny the fact who can,
This marvel of an Elephant
Is very like a fan!"

VII.

The Sixth no sooner had begun
About the beast to grope,
Than, seizing on the swinging tail
That fell within his scope,
"I see," quoth he, "the Elephant
Is very like a rope!"

VIII.

And so these men of Indostan
Disputed loud and long,
Each in his own opinion
Exceeding stiff and strong,
Though each was partly in the right,
And all were in the wrong!

MORAL.

So, oft in theologic wars
The disputants, I ween,
Rail on in utter ignorance
Of what each other mean,
And prate about an Elephant
Not one of them has seen!


— John Godfrey Saxe, The Blind Men and the Elephant


Beware, O Dearly Beloved, those endlessly multiplying pundits who propose single-method solutions to the problem of financial reform. "The" answer is not minimum equity capital requirements, liquidity controls, return on equity caps, compensation reform, leverage or size limits, portfolio risk monitoring, or even slipping saltpeter into the lattes of testosterone-addled traders so they act more like risk-averse women. The answer—pace the sexual lobotomization of traders which many in society may wish for other reasons—is likely to be a combination of all of those reforms (and more), implemented in a dynamic and flexible regulatory structure which can respond and adapt to changing conditions.

For the fundamental truth which most commentators continue to overlook is that the global financial system is much more like our illustrative friend Panic Pete than an elephant. When you squeeze Mr. Pete in one spot, the squishy gel inside his rubbery body causes his other parts to bulge out. Squeeze him in those newly bulging areas, and he will return to his original form or bulge unexpectedly in new directions. Why? Because the gel inside of him is incompressible. Squeezing the flexible outer skin does not cause the toy to shrink. It just forces it into a new configuration. Likewise, the fundamental quantity in the global financial system which we are concerned with, and which we properly wish to control, is risk. But, given any specific level of return, risk is incompressible.

If you want to achieve a particular return, you necessarily assume a commensurate and ineluctable level of risk, whether the instrument of your investment is a single stock, a capital project, an individual business operation, an asset class, or indeed an entire economy. And what does return mean in the context of an economy? It means growth, increase in productivity, and real economic returns in addition to secondary (or even potentially illusory) investment returns. Investing in a business, an industry, or an economy is risky. There is no guarantee you will achieve your aims or desired returns, whatever those returns may be. There are no guarantees, period.

* * *

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down.1 But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? 2 Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or "solutions" we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place 3—if we do not make provision to address them.

* * *

Squeezing Panic Pete is fun. It's a great stress-reliever, too. It just so happens to be a lousy regulatory reform agenda.


1 "Go down" = become more expensive, less frequent, less available, more difficult, etc.
2 I do not speak of wealth distribution here, which is another socioeconomic debate admitting of other solutions which are not necessarily connected to the measures we decide to implement in financial reform.
3 Wait. That was all of us, wasn't it? Oops.

© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, June 4, 2011

You All Know Brutus and Cassius Are Honorable Men

Although, if they're so stupid, how come they're richer than me?Much as it pains me to say it, O Gentle Readers of Tender Sensibilities, I'm afraid I must agree for once with those shills for the private plutocracy equity industry over at the Private Equity Growth Capital Council. They recently released a comment letter to the SEC's proposed rules on incentive-based compensation arrangements at systemically important financial institutions, which the Dodd-Frank financial reform act defines as any financial institution with at least $1 billion in assets.
In March, the Securities and Exchange Commission unveiled a plan to crack down on the kind of big bonuses that encouraged excessive risk-taking before the financial crisis. The proposed rules, which are expected to be completed over the next few months, are aimed at big banks and brokerage firms that nearly toppled in 2008. But technically, the proposal applies to any financial firm with more than $1 billion in assets, sweeping up private equity firms, too.

In fact, given the growth of private equity over the past three decades, such a rule, should it be implemented, would likely sweep up a substantial percentage of the industry's players, affecting numerous firms well beyond the industry titans included in the PEGCC's membership roster.

But the DealBook article mistakenly emphasizes the wrong points in summarizing the PEGCC's remarks, focusing on the assertion that private equity paychecks "pale in comparison to bonuses at big banks" (an extremely dubious assertion, at best) and that PE pay is determined in direct negotiation with sophisticated institutional investors, unlike bank pay which is railroaded by sleeping shareholders in the dead of night (true, but entirely beside the point). Instead, the PEGCC letter itself makes the salient point comprehensively and at length: while private equity firms may be "systemically important" in some sense, they pose very few systemic risks to the financial system at large, and these pale in comparison to the risks which large commercial and investment banks threaten.

This statement of facts, while self-serving, happens to be true. With certain important caveats, which I outline below, I agree that private equity firms' compensation arrangements should not be subject to regulation under Dodd-Frank.

* * *

In order to understand why, we must first address the structure of the private equity industry. There are basically three entities through which private equity operates in the markets: private equity firms, also known as "financial sponsors"; private equity funds which financial sponsors use as vehicles to do their investing; and individual portfolio companies which PE firms and their funds invest in. The PE firm itself is a relatively small entity, comprised of a surprisingly small number of professionals and support staff. (Even the biggest multi-billion dollar firms usually have only a few hundred employees.) Its task is twofold: i) raise money from institutional investors ("limited partners," or LPs) for discrete, limited-life funds and then ii) go do the hard work of investing that money in individual portfolio companies. Because a PE firm normally acts as the general partner of each of the funds it raises, financial sponsors are often known as General Partners or GPs in the trade. It is also worth noting that a PE firm will often manage more than one fund at a time: an older one, fully invested, where its job is to wind down the portfolio of existing company investments and either liquidate failing ones or sell the winners and return remaining funds to the fund investors, and a newer one, where its task is to put the available funds to work in new business investments.

The material point concerning traditional financial sponsors, however, is that while the professionals who do the work reside in those entities, the firms themselves have very little money or assets of their own. The money, and the investments it enables, reside legally in the private equity funds which the general partners manage for their limited partners. Private equity firms normally get paid what is known as "2-and-20": an annual 2% management fee, calculated on the total amount of money committed 1 to the fund (e.g., $20 million per year on a $1 billion fund), and 20% "carried interest," which amounts to a 20% stake in the profits earned by the investments in the fund, after the management fee and certain preferred returns are paid to the LPs. While the management fee is intended to pay the light bills, the staff salaries, and all the operating expenses the sponsors run up by looking at hundreds of companies per year in the course of actually investing in just a few—and is mostly used for just such expenses—you can see that very large firms, with funds clocking in north of $10 billion, can actually make very good money just from management fees alone.

In fact, PE funds themselves really only act as accounting entities for the collection of portfolio investments within them. The real unit of investment of private equity is the portfolio company itself, which the PE firm buys either in whole or in part, with a substantial amount of equity taken from the LP fund and outside capital in the form of bank loans, high yield debt, or other debt financing. None of the portfolio companies in a PE fund cross-collateralizes the others—meaning if one goes bankrupt or liquidates, it has no effect on the entire portfolio or any other company within it. Lenders to leveraged buyouts look only to the credit of the company being bought, not to the fund in which the investment is made or the PE firm sponsoring the investment.

Therefore, you can see that notwithstanding the often substantial debt private equity firms take on in their investments, this leverage resides in carefully walled-off buckets at the level of each individual investment. If things go wrong with one company, it craters, but its cratering does not trigger a domino effect within any particular PE fund's portfolio, nor does it cause distress and financial contagion at the sponsor level. In almost all instances, neither PE firms nor PE funds take on debt of any kind for themselves. Therefore, they neither suffer financial distress nor have a mechanism to transmit such stress to the outside world. Sure, lenders to individual portfolio companies which go belly up are going to take it in the shorts, but that's where it ends. There are virtually no pathways of systemic financial contagion in the traditional private equity firm or its business.

This is accentuated by the fact that by participating in a PE fund, LPs agree to meet their funding commitments over the (normally 10-year) life of the fund and cannot contractually get their money back prior to its expiration. This is a material difference between the investment an institutional investor makes in traditional private equity and one it makes in a hedge fund. While hedge funds are gated, and have all sorts of mechanisms to delay investors from withdrawing their money at will, at the end of the day hedge fund investors normally have the ability to withdraw their money with limited notice. Investors in private equity do not. This makes a great deal of sense, of course, because hedge funds normally trade in relatively liquid assets, whereas private equity investments are almost the definition of long-term, illiquid investment.

* * *

Let's review. PE firms do not borrow money, and they have virtually no assets of their own. PE funds do not borrow either, and they call upon the irrevocable, unwithdrawable equity commitments of limited partners to fund investments in individual companies. PE investments (companies) are funded individually on a non-recourse basis to the fund and the financial sponsor. Lenders to PE company investments cannot cause a "run on the bank" at financial sponsors, and equity investors in PE funds cannot cause a run on the bank, either. Traditional PE firms and PE funds do not lend money to other entities, nor do they trade liquid securities, derivatives, or other financial instruments in any markets. Their investments in company buyouts are long-term, illiquid, and safe. At least from the financial system's point of view. 2

Therefore, what do we care about the risks private equity firms take in their investments? What do we care that other investors lend them way too much money at way too low interest rates with few or no covenants to fund their leveraged buyouts of companies? What do we care that giant institutional investors like CALPERS and Yale University give them hundreds of billions of dollars of equity to invest in risky buyouts? The answer is we shouldn't.

And since traditional private equity poses no material risk of financial contagion through highly liquid, interlinked debt and equity exposures which can be called at a moment's notice, why should we care how its executives are paid? Why should we care that they can get paid billions if their investments succeed? Why should we care if they make highly levered, risky investments in shaky businesses in order to make themselves and their limited partners rich? From the point of view of systemic financial risk, we shouldn't. Period. End of story.

* * *

HOWEVER, saying that traditional private equity, as a business and an investment class, does not add materially to systemic financial risk—which it does not—DOES NOT MEAN that we should not think carefully about the industry's incentives and the executive compensation practices which fall out of them. For one thing, my analysis above is based upon the well-established characteristics of traditional private equity: that is, leveraged buyouts and minority investments. But many of the largest financial sponsors have begun to build substantial businesses outside of traditional private equity—including trading (in-house hedge funds), real-estate, commodities, even investment banking—in pursuit of world-beating status as "alternative asset managers." The more they blur the line between their old identities and their new ones as highly-connected financial clearinghouses with multiple links into the global financial system and multiple pathways for financial contagion to spread, the less they can claim that their business model poses no risk to the system. And, therefore, the weaker their claim that regulators should not pay attention to how their executives are paid and how such pay practices may encourage the assumption of risk.

Lastly, of course, saying that traditional private equity compensation practices should not be subject to review and control by regulators because they do not foment systemic financial risk is not to say that there are not other good reasons to do so. Putting aside vexing issues of income inequality, stratospheric individual wealth creation for the poobahs at the top of the business, and the PEGCC's despicably meretricious advocacy of the ridiculously unfair tax treatment of carried interest, there is the social policy issue of the true value of private equity itself.

For while I have always admired the good which private equity investors can do for companies which are struggling, need to be fundamentally restructured, or face significant transformational challenges which are best conducted out of the glare of public scrutiny, I am also aware there is a strain within the business which is far less admirable. A strain which looks to the quick flip, the carving up of thriving businesses for the sum of their parts, the starving of growing businesses of the capital expenditures they need to expand, and the ruthless downsizing of employees driven by purely financial considerations. The pay structure and incentives of the industry definitely play into this dark side of private equity, too.

* * *

Saying private equity compensation should not lead to another potential financial crisis doesn't quite end the conversation, in my opinion. Not all the financial regulatory issues we address in the current environment should be restricted to the implementation of Dodd-Frank.


UPDATE June 11, 2011: Fixed reference to carried interest and added link to previous discussion.

1 Important side note: when KKR, for example, raises a $10 billion fund, they do not receive $10 billion in cash up front from their limited partner investors which they invest in a bank savings account until they spend it. Rather, they obtain contractual commitments from their LPs to respond in a timely fashion to their capital calls when they make an investment. The LPs do pay the 2% management fee on their entire commitment from the beginning, however, whether the funds are invested or not.
2 What causes bank runs? Liquid deposits. In other words, deposits (or loans) that can be withdrawn immediately by the depositor (lender). Illiquidity is a wonderful mechanism to prevent runs on the bank—whatever form a "bank" might take—if only because you can't withdraw it in times of stress.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sunday, February 27, 2011

Sympathy for the Devil

Don't hate me, I'm just doin' my job
Please allow me to introduce myself
I'm a man of wealth and taste
I've been around for a long, long year
Stole many a man's soul and faith

...

Pleased to meet you
Hope you guess my name
But what's puzzling you
Is the nature of my game


— The Rolling Stones, "Sympathy for the Devil"


I recently received an inquiry from an unnamed Professor at an anonymous law school, Dear and Long-Suffering Readers, who requested I grant his charges an interview or appearance. Demurring on the latter, since the effects of surgery to remove horns, tail, and cloven hooves have not completely healed, I elected to do the former. What can I say? After Charlie Green plied me with peyote and Balinese dancing girls, I appear to have gone all soft in the head, and am granting interviews left and right. I worry for my long-term reputation.

Anyway, Herr Professor Doktor steered his chicks toward my most recent post but two, on the vagaries and trials of travel as one of the Übermenschen, and suggested they ask me questions to their little hearts' content. HPD collected and transmitted said queries, which I have represented here, in lightly reordered and edited form, along with my discursive replies. Perhaps these nuggets will answer one or two unresolved questions in your own befuddled brains, or even while away some dull hours of a Sunday evening. I wish you joy of them.

What else were you gonna do tonight? Watch the Oscars?

* * *

Q: Do you hate your life, and if you do, do you simultaneously realize how good you have it?

A: No, I don't hate my life. Compared to most people, I know I have it pretty sweet. Could it be better? Of course. Is my job all fun and games? No, but overall I would not trade it for any other means of making a living I am aware of. A cushy retirement, on the other hand...

Q: What percentage of your job/income is built on intelligence, and what percentage of your job/income is built on bullshit?

A: Your question appears to presume that intelligence and bullshit are mutually exclusive. That has not been my experience in the real world at all. There is such a staggering quantity of bullshit floating around in the spheres of commerce, culture, and politics, that I find the occasional example of intelligent bullshit to be a pleasure and a relief. I pride myself on trying to increase its stock in the world, for others' entertainment and amusement. This applies to work, as well, where I would estimate the ratio to be 75%/50%.

Q: If your clients are constantly owning you bankers, when do they have time to own their lawyers?

A: Clients appear to have a practically unlimited capacity to own (or feel they own) their professional advisors. It's almost magical. The fact that one owns me does not impinge on his ability to own his lawyer too. On the other hand, bankers like me typically only swoop in for periods of limited duration, usually in connection with a transaction, so a client really only rents me. His lawyers, on the other hand, he owns outright in perpetuity: lock, stock, and barrel.

Q: Of the investment bankers you've worked with who are also attorneys, how do they add typically add value, if any, by virtue of having a legal education?

A: First of all, you can't bank and practice law at the same time. Regulators tend to frown on such things. However, bankers who have legal training and who have practiced law before can be quite effective in certain capacities. A trained mergers and acquisitions lawyer tends to be more technically proficient at M&A, and a trained securities lawyer can be more effective in arcane areas like structured finance than your average non-lawyer banker. But technical proficiency alone is not enough. Among other things, you need to be a good salesman. In my experience not all lawyers have that personality or skill. Those who do, and who can make the transition to a business predicated on eating what you kill, rather than slaving away at a sinecure, tend to do very well.

* * *

Q: Since you are apparently dissatisfied with the efficiency of your chosen line of work, what suggestions would you have for improving the efficiency?
– and –
Q: Would you say this seemingly inefficient client relationship model is where most of the “fat” is in investment banks, or some other traditional way of doing business?

A: I am not sure I agree with your premise that a client service business can be "efficient." There is a lot of sucking up and relationship building to do with my clients, in addition to actual deals, and sucking up in my experience is relatively time-inelastic. There is much wasted time, and many false starts, but those come with the territory of any business predicated on large, intermittent transactions. Like the Army, investment bankers do a lot of hurry-up-and-wait.

Unlike the Army and many other businesses, however, there usually isn't an enormous amount of bureaucratic fat or organizational sclerosis in an investment bank. We tend to recreate and retool ourselves too often in pursuit of the almighty buck to let much moss grow. When it does, however, it tends to happen at the biggest universal banks. Citigroup is perhaps the poster child for what happens when bureaucracy and inertia are allowed to take over an investment bank. It isn't pretty.

Q: You focus on the "pressing the flesh" aspect of your job mostly in this post. Is this what you spend most of your time at work doing, or is there another aspect of your job that you spend more time on?

A: It's important to understand just exactly what I mean in this regard. I do spend a great deal of my time with clients, traveling to them, and working on deals in their presence. But I do comparatively little of the traditional client entertainment—wining and dining, golf outings, $50,000 "bar" tabs at Scores—that you might think I do. In fact, I would guesstimate that investment bankers on average do less of this than many other professionals.

However, we do spend a lot of face time with clients both selling and doing deals, because when the future of your company, your career, and your net worth is on the line—as it often is in M&A deals and major capital raisings—the client justifiably wants to see the whites of his banker's eyes. Very little of what we do can be done solely by conference call or email. The client wants to meet us, look us in the eye, and shake our hand before he puts his fate in our hands. In large part, it is an issue of personal trust.

Q: Given [your heavy travel] schedule, how does a senior level banker adequately digest all of the research and information necessary to provide the client with a researched and informed pitch? It seems as though this working situation does not lend itself to a quality work product.

A: One word: subordinates. Seriously, I and every senior investment banker out there relies heavily on junior bankers for research, facts, financial analysis and modeling, and pitch preparation. We could not do our jobs without them.

But it's important to realize that the value I bring to a potential client or transaction is not entirely dependent on facts or analysis. The secret sauce I bring is my extensive, two-plus-decade knowledge of an industry, its participants, the executives in it, and the dealmaking and capital raising scenarios possible within it. That is network knowledge, which is not limited to shareholder lists, valuation ratios, or CEO resumes. Those are facts. Facts are critical to get right, but facts are, in the most important sense, trivial. What matters more is the mental model you plug those into; it is the network map which spits out the interesting answers.

Along these lines, you may now understand that all the travel I and my senior colleagues do—the deal pitching, the flesh pressing, the occasional schmoozing—is actually critical to maintaining our network knowledge. A client visit isn't a waste of time. It's research.

* * *

Q: You said dealing with Private Equity professionals is not all peaches and cream. What are the typical tensions between Private Equity and Investment Bankers? Is it just two egos constantly butting heads?
– and –
Q: Is it that hard to move into a position where you would be dealing with financial sponsor coverage? Would you want to, and if so, why haven't you?
– and –
Q: How is dealing with private equity firms a curse?

A: Private equity professionals are their own breed. While many of them used to be investment bankers, the nature of their job is quite different. They are tasked with investing other people's money in long-term, illiquid businesses through leveraged buyouts and the like: they are investors, not bankers. Many if not most of them are quite smart, but they are usually nowhere near as smart about any particular subject or industry as they think they are. Like most people who come from a background which they are happy to have escaped, they tend to sneer at people who still work there. They tend to look down upon us lowly investment bankers as a necessary evil.

If they have a dominant personality flaw, it is overweening arrogance. The successful ones are far richer than the successful investment bankers, but, as in banking, the number of truly exceptional and successful private equity professionals is much smaller than they think it is, and usually does not include the person expressing the opinion at the time. As you might be able to tell, I am not the best banker to assign to stroking these individuals' egos, no matter how much money they tend to pay investment banks in fees. I have my own arrogance to contend with, and that is not a good personality trait for a sponsor coverage banker.

Q: Looking back, how many of your clients (as a rough percentage) would you say have a good understanding about corporate finance and what is "best" for their companies in terms of equity versus debt and which types of securities to issue?

A: Technical proficiency with the tools and techniques of corporate finance? About 50%, with most (although not all) of those at larger companies. Strategic competence and vision—i.e., top-flight Chief Executive and Chief Financial Officers who make a real positive difference to the health and future prospects of their firms? Maybe 30%, at best, distributed almost randomly across size, scope, and nature of client. For do not forget: true value is created on the left side of a balance sheet—the assets of a firm, and how they are deployed—not in financial engineering of the right. The latter is important, but it's not where the real shareholder value rubber meets the road.

Q: What are some of the larger factors that you typically look at in a company when deciding what sort of deal to present to them?

A: I may be somewhat unusual in this respect, but I tend to like to listen to what the client thinks and wants before I start offering ideas. Until I learn otherwise, I like to assume that the CEO and CFO know their business, their competitors, and their opportunities and threats better than I do. Perhaps this humility costs me lost deals, but it certainly raises me in most executives' estimation as something more than just one more goddamn investment banker.

* * *

Q: Did your educational background play a significant role in preparing you for the real-world experience, or has that been something that you have had to learn on your own?

A: Not really. My undergraduate degree was in something completely unrelated to business or finance. My MBA provided no more help than to open the door to investment banking: an entrance ticket, or table stakes. You have to be able to communicate in my business, and it's hard (but not completely impossible) to get by without some basic level of numeracy, but I have seen people from all sorts of educational background succeed and fail in this business. A lot of it boils down to sheer grit and determination.

Q: You speak of the negative attributes of the lives of investment bankers, but what positives attributes of the job (if any), other than the money entice someone to remain in such a high-paced and high-pressured field?
– and –
Q: You tell what you thought your career would be like and what it is actually like. Are you disappointed at all? Would you change anything about your career?
– and –
Q: If were feasible for you to start over, would you choose another career? If so, what?

A: Let me tell you something: unless you're raking in Lloyd-Blankfein-level bucks, the money just isn't enough for what I do. Especially when you try to keep up with the Blankfeins and the Schwarzmans in a crazy burg like Manhattan. But that's my choice; I do not expect or deserve any sympathy on that account.

More importantly, money is not the only reason I have stayed in investment banking for over 20 years. The job is challenging, intellectually stimulating, and often a sheer blast. It's fun to work balls to the wall, day and night, for weeks on a big deal and see it hit the tape on Monday morning. It's fun to yell and scream at some numbnuts across the table at a negotiating session. It's fun to think up a multi-billion dollar transaction, initiate it, and see it to conclusion. And, notwithstanding what I said before, it's fun to fly home first class from Asia, swilling vodka tonics and watching Japanese films on DVD for 20 hours. My job can be a goddamn hoot.

Of course, it hasn't all been peaches and cream. If I could wish for one thing in my career, it would be for a few more big deals to have broken my way. On such serendipities careers—and true fortunes—are made. But I can't complain. It's been a good ride, and it's not over yet. If I started something new, it wouldn't be to make money. Maybe blogging...

* * *

Okay, kiddies. That's all for now. Happy lawyering, and if you meet me on the street one day, I suggest you tip your hat.

So if you meet me
Have some courtesy
Have some sympathy, have some taste
Use all your well-learned politesse
Or I'll lay your soul to waste, mmm yeah


© 2011 The Epicurean Dealmaker. All rights reserved.