Wednesday, August 20, 2014

War Is Not The Answer...

The beheading of American journalist James Foley by the Islamic State yesterday keeps making me think of the people who ride around with bumper stickers on their cars which say "Peace" or "War is not the Answer."

How's that Peace thing workin' out for ya?

Sure, I'll admit that peace is a wonderful thing - who wouldn't? And I'd go even further to say that war is definitely not the answer... until it is. But those bumper stickers rub me the wrong way because they don't even allow for the possibility that the world might want to stop, say, Hitler.

It is woefully na├»ve to believe that there are not really evil people out there trying to do all sorts of bad things to other people. Sometimes, it becomes necessary to beat those people back with what might be called war. By foreclosing that possibility before it even becomes necessary, one only emboldens the bad guys.

I very much like the saying that abortion should be legal and rare. There's a similar thought which should prevail about our military: it should be strong, vocal, and mostly idle.

How about a new bumper sticker: War Is Not the Answer... Until It Is.

Saturday, January 25, 2014

Individual Mandate: DOA?

For the most part, Americans are law-abiding, ethical people. We pay our taxes and mortgages, we comply with contracts, and we suffer through long lines and surly clerks to register our cars. To a certain extent, we do these things because we don’t want to pay the consequences of not doing them. But it is also true that Americans obey the law because we see the law as an extension of our shared morality. We are citizens, and citizens adhere to the social contract.

Having done business extensively on every continent except Antarctica, I can say with confidence that there are parts of the world where the law and contracts are viewed as annoyances, rather than prescriptions for behavior. As a proxy, consider that NGO Transparency International ranked the United States 19th out of 177 countries in its 2013 Corruption Perceptions Index. I would propose that being nearly tenth percentile is high for an enormous, heterogeneous country such as the United States. It may suggest that even our numerous lower income immigrants are an ethical bunch.

In short, with modest exceptions, we prefer to obey the law. I think to a certain extent, the opposite is also true; if a behavior or undertaking is not against the law, we tend to view that fact as a license to partake in such behavior. We’ll have a chance to see how this theory plays out in Colorado, where as of January 1, citizens are free to buy and smoke marijuana free from government intrusion. But that is another subject.

It is because of this corollary to my original thesis that I think the individual mandate, and thus Obamacare itself, will eventually founder.

As we all know, the Affordable Care Act of 2010 includes a provision stating that every American adult is required to purchase health insurance. This “individual mandate” was drafted in order to guarantee the solvency of insurance plans, the profitability of which were to be tested by several other provisions of the Act. Most notably, the ACA requires that insurance plans accept enrollees with preexisting conditions.

In order for insurance companies to shoulder the burdensome cost of these new, sick participants, they would need a slate of young, healthy participants with low health care costs relative to their premiums. Thus was born the individual mandate, requiring healthy people who might not otherwise purchase insurance to do so. Under the original reading of the Act, it was against the law to live without health insurance. If you broke the law, you’d have to pay a fine.

Opponents of the ACA took it to court. Ours is a constitution of enumerated powers, they said, and nowhere does the document say that the Federal government has the power to compel citizens to purchase a good or service like insurance. Obamacare seemed doomed. The Roberts court, with its tenuous conservative majority, was thought to be much less willing to stitch together such powers out of whole cloth than its predecessors.

The country held its breath while the court deliberated. When the verdict came in, it was the Chief Justice himself who wrote the opinion preserving the ACA. You wouldn’t have to pay a fine for breaking the law, he argued, but rather you would simply have to pay a tax. The authority was vested in the power to levy taxes.

Liberals cheered the decision while scratching their heads a bit, and conservatives abandoned Roberts in droves. Very few people, though, wondered about any troublesome implications of the decision. It was off to the races! Obamacare would soon be implemented, and all Americans would finally have healthcare coverage.

I am deeply convinced, however, that the court’s decision has robbed the individual mandate of its moral compulsion, and thus a significant number of individuals will choose to pay a small tax rather than sign up for expensive health care premiums. The economics of the ACA will be destroyed, and insurance companies will be required to raise premiums dramatically, or the law will need to be adjusted.

Imagine a hypothetical conversation between a father in Dubuque, Iowa calling his 27 year old struggling actor/waiter son in New York City.

“Have you bought your health insurance yet, David?”
“Uh… no dad.”
“It’s the law. You need to go on today and get yourself some insurance.”
“I looked.”
“I can’t afford it!”
“Doesn’t matter.”
“Plus, it’s not against the law. All I have to do is pay a small tax.”
“That’s not true..”
“Yes it is, dad. I read about it in the New York Times. All my friends are talking about it. Nobody’s going to buy insurance.”

Early indications suggest that this is indeed happening. Young people are not signing up for insurance in significant numbers yet. A majority of those who have signed up seem to come from the pool of already insured who are simply switching plans for one reason or another. If the trends continue, Americans may be in for a nasty surprise in 2015, especially once the employer mandates kick in.

There are many possibilities for what happens next if this comes to pass, but one thing is for sure: Obamacare and the Democrats will suffer. The direction we take in fixing the problem will depend heavily on who wins in the 2014 midterms and the 2016 Presidential election.

Thursday, August 8, 2013

Peak Oil is Dead?

The world’s press has been effusively promoting a new story line about energy: the Peak Oil theory is dead. The shale revolution killed it. North American production of liquid fuels is growing again, and soon enough, the US will be a net exporter. OPEC is in trouble as oil prices are about to fall, and members’ subsidized supply and generous social programs are at risk. National deficits and social unrest may follow.

In addition to the shale story, there are several other components to this new worldview:

·         For the fourth straight year, demand for crude oil in OECD countries has fallen

·         Renewable power generation has increased significantly, led by new hydropower in China, wind in North America and solar in Germany

I don’t buy it.

First of all, those who claim that we have entered a happy new world of energy abundance have to account for the fact that energy is now more expensive than ever. To the right is a chart of the price of a barrel of oil since we first started pumping it out of the ground in Pennsylvania 150 years ago.

If oil is flowing so freely, why is it so damn expensive? Greedy speculators are not the answer. Speculators don’t care whether the price of oil goes up or down – they make money either way. Did they cause oil to briefly drop to $30 at the end of 2008? Furthermore, if oil prices are too high by $40 or $50, as some people suggest, then where the heck is all that profit going? The world consumes 80 million barrels per day. That would equate to $1,500 billion in annual excess profits. Where is it? That’s 210 times the profits of Goldman Sachs last year. Commodities traders make up only a tiny fraction of their profits. Oil companies don’t have that kind of money either – look at their cash flow statements and you’ll see that most of their money is being spent on operating costs or development.

 Furthermore, the causes of this supposed new reality are simply window dressing. The much larger macroeconomic drivers which fueled Peak Oil theory are still intractably at work. Let’s take them in order:

Growing North American supply: promoters of this story point out that North American production has recently increased by approximately one million barrels per day (bpd). While this is true, it is partly a gimmick: the conversation is now about total liquid production, instead of crude oil production. The lions’ share of this gain has come from increased natural gas liquids and refinery gain. You can’t run your car on natural gas liquids, and refinery gain is being generated because we’re using heavier oil, which is also more expensive to transport and refine. In addition, as mentioned previously, the world consumes 80 million bpd. Even if all of the increase is refined and consumed, that increase equates to a whopping 1.25% of global demand. This hardly seems like a change which would cause us to utterly alter our worldview. Finally, and most importantly, depletion rates for fracked shale wells are considerably higher than for conventional wells. As conventional production is replaced by shale production, the supply problem might be getting worse, not better.

Declining OECD demand: It is also true that crude oil consumption in developed economies has declined recently. We’re insulating our houses better and driving more fuel efficient cars. This is all good. But did anyone notice that the world’s developed economies have been in the doldrums for about four years, too? Is it possible that these two phenomena are linked? As far as I can tell, nobody has rebutted the seemingly ironclad relationship between wealth and energy consumption (see here). We’re driving Priuses but we’re also consuming less oil because we’re not taking vacations to Hawaii like we did in 2007.
And in a subtly different but related point, isn’t it possible that this declining oil consumption is also due in part to high energy prices? And yet now we’re celebrating this wonderful new fuel efficiency because it’s going to lead to much lower energy prices. Frankly, I find the argument bizarre.

Finally, and most importantly, the residents of OECD countries are already rich, and already consume massive amounts of energy. But the residents of OECD countries are only 18% of the world’s population. The benefit of a small marginal decrease in their consumption will be absolutely swamped by the increase of consumption by residents of the third world as they move into the middle class. There are 700 million peasants in China who would like to live like Americans. Getting them there will make all of our Prius driving irrelevant when it comes to Peak Oil math.

The rise of renewables: There is more confusion and misunderstanding about this issue than any other in the current energy debate. The sad fact is that, even after hundreds of billions of dollars of investment, wind and solar power combined generate only 3% of our total energy supply in the United States. Hydropower generates a considerably greater percentage, but we are essentially at the limit of that resource. We’ve already dammed the most obvious rivers. Environmental and transportation concerns preclude significant new hydro resources. As much as I hate for it to be true, we will bankrupt ourselves if we attempt to replace liquid fuels with renewables over anything but the very, very long run.

The reality is that the macroeconomic conditions which caused people to be concerned about our hydrocarbon resources have not changed. If anything, they have gotten worse in the last ten to fifteen years as economic development in China and India have proceeded at a pace greater than anyone ever thought possible.

 Part of the confusion, I think, lies in the fact that most people are unaware of the subtleties of Peak Oil theories. Peak Oil is popularly described as a theory which says that we are running out of crude oil, and that once the death spiral starts, the world will be plunged into a Road Warrior-like dystopia. While there are indeed believers in this bleak future, most thoughtful Peak Oilers describe a more extended version of the slide, where the initial signs of Peak Oil are primarily reflected in high prices and a gentle plateauing of energy production. Gains in prices are met with capital investment to reap higher profits, but also cause economic shocks. The world slips in and out of recession as economies adjust to new, higher energy prices. The world will never actually run out of oil, it’s just that the marginal cost of new barrels will rise so high that it’s quite irrelevant.

 Does this scenario sound familiar? (See my post of January, 2009 (!) for my own prognostications on the issue). Eventually, even these more optimistic Peak Oilers believe that production will eventually slide downward with ever more devastating effects. How long that takes depends on who you’re talking to.

Another reason why I think people have misunderstood the dynamic of crude markets is that they are using an incorrect definition of marginal cost. In traditional economic parlance, marginal cost relates solely to Cost of Goods Sold – the true operating costs of extracting oil from the ground: depreciation of the well capital investment; labor for the rig workers; variable costs at the plant like fracking water and chemicals. But the oil world has changed. Extracting oil from the ground is not quite as simple as poking a hole in the ground and conjuring up a gusher.

 The world rejoiced a few years ago when Petrobras confirmed the existence of approximately 7.5 billion barrels of light, sweet crude off the Brazilian coast. Everyone said, “See? We’ve got plenty of oil!” Unfortunately, the oil is located in a spot where the ocean floor is 1.2 miles below the surface, and, once there, the drill has to venture through another 3.0 miles of almost impenetrable salt, sand and rock. Getting all those barrels out of the ground will cost staggering amounts of money. What is marginal cost in that case? The cost of the rig, labor and consumables are only a part of it. Just to start a program like that requires tens of billions of dollars in overhead: engineers; consultants; lobbyists; bureaucrats; and specialists of every sort, not to mention the costs of safety, insurance and environmental protection. In effect, the marginal cost of that oil becomes the entire cost side of the Petrobras P&L. And for what? 7.5 billion barrels of oil is about three months of global demand. Big whoop.

Now, I’m not saying that the price of oil will never go down again. Like the stock market, the price of oil will go up, and it will go down. But I truly believe that the medium and long term trend is only up, and maybe substantially. Further, if price does go materially down, it’s not because we’re driving yet more Priuses or Teslas, it’s because the world economies have taken it on the chin again like 2008.

If it sounds like I am pessimistic, it’s because I am. However, I am also a true believer in the power of human spirit and ingenuity. I believe we’ll muddle through the problem, but it’s going to be rocky. Ironically, if you’re worried about climate change, Peak Oil is actually a good thing. Here were Obama and Steven Chu wanting to furtively increase the price of oil to choke off demand. If I’m right, it turns out they can just sit back and watch Mother Nature and the laws of economics do their work for them.

Sunday, February 10, 2013

Sophist in Chief

“But we have always understood that when times change, so must we; that fidelity to our founding principles requires new responses to new challenges; that preserving our individual freedoms ultimately requires collective action. For the American people can no more meet the demands of today’s world by acting alone than American soldiers could have met the forces of fascism or communism with muskets and militias. No single person can train all the math and science teachers we’ll need to equip our children for the future, or build the roads and networks and research labs that will bring new jobs and businesses to our shores. Now, more than ever, we must do these things together, as one nation, and one people.

Barack Obama, Inauguration Speech, January 21, 2013

It’s been several weeks since Obama’s inauguration and I can’t seem to get these thoughts out of my head. I am vexed, and can’t let it go.

Frankly, I find it disturbing that a President of the United States would elevate such an ill-conceived straw man to such an eminent place in such an important speech. As if anyone - anyone! - has ever suggested that a single person might train all our math and science teachers, or build all the roads and networks that we require.

And yet it is even worse that he would construct an elaborate non-sequitur upon this gobbledygook of a premise. For it is sufficient that men, acting alone and in their best interest, might collaborate to build things both great and small. To call these efforts collectivism is simply wrong.

The most excellent exposition of this point I have ever read is the essay I, Pencil (link here). I was introduced to this gem by pundit Jonah Goldberg, who invokes it regularly when confronted with sophistry such as Obama’s speech.

If you are tempted to think that Obama was simply saying that it’s great that we all get together to get things done, maybe even while acting alone and in our best interest, I would point out that this is a patently obvious principle. Why would anyone go to great lengths in a speech to point out something so plainly obvious? Furthermore, please note that Obama began the paragraph with the word “But”. If you go back and read the speech, the prior paragraph was about “initiative and enterprise...hard work and personal responsibility.”

No, Obama was after something more in this speech. He wanted to use a string of soothing words to furtively make a case for his ideal of collectivism - a collectivism where, out of a sense of fairness, government redistributes wealth and is the solution to everyone’s problems. And he used a sloppy, illogical argument to get there. Sorry to be petty, but I just had to call him on it.

Now, don’t get me wrong: there are plenty of logical, consistent arguments for collective action, regulation, redistribution, etc. I am simply pointing out that the argument that Obama made is not one of them.

Thursday, January 31, 2013

Prediction: Stocks

If I were a stock picker (I am not - I buy index funds exclusively), I would short both Herbalife and Tesla Motors right now.

In my opinion, Herbalife ($37.60 today) was convincingly outed as a pyramid scheme in a long presentation by hedge fund manager Bill Ackman. It's a complicated story, but I find it compelling. He's posted the presentation online, and if you're interested, it makes for very good reading. The FTC should read it.

Tesla ($37.15) is essentially out of cash. I think they are finding it harder, and more expensive, to start up a new automobile company than they thought. Since the first half of last century, many people have tried to start new automotive companies, and approximately zero have succeeded.

Tuesday, December 11, 2012

Book Review - My Grandfather's Son

I’ve just finished reading My Grandfather’s Son, Clarence Thomas’s autobiography. It is certainly the most inspiring autobiography I have ever read. The short version is that Clarence Thomas was born a desperately poor black child in Jim Crow-era Georgia and grew up to be an Associate Justice of the United States Supreme Court. In his speech after being nominated by George H. W. Bush, Thomas stated “only in America…” After having visited numerous countries on every continent of the world except Antarctica, I firmly believe this is true.

There are many aspects of this book which deserve mention, but the one which stands out most auspiciously is the degree to which Thomas comes to believe that, perhaps more than any other ethnic group, black people in America ought to be conservative. To Thomas, it becomes self-evident that the conservative virtues of self-reliance, hard work and determination are truly the only way for black people to improve their lot. Further, the type of nanny-statism offered up by the left only serves to undermine those very virtues and trap black people in a state of second class citizenry.

Thomas and his younger brother came as young boys to live with their grandfather in Savannah after their parents had divorced. “Daddy,” as Thomas called him, was an illiterate, hard working, irascible man who took it upon himself to impose an austere regimen on his new charges. Though ostensibly a Democrat, Daddy’s temperament and philosophy were profoundly conservative. He worked his fingers to the bone on their farm and delivering fuel oil in a beat up old truck, and wouldn’t be happy accepting anything from anybody that he didn’t earn. He worked hard to instill these virtues in the Thomas brothers, often to their great consternation.

Thomas, who attended Holy Cross and Yale Law School in the 60s and early 70s, was initially a Black Panther-admiring radical, as all young black men of the time were supposed to be. Starting slowly at Holy Cross, however, and over a long period of time, Thomas began to see things through the prism of his grandfather’s experience. He came to realize that the solutions offered up by the left to solve the black underclass problem were exactly the wrong remedy. He saw how policies, from racial preferences at his own schools, to welfare in Savannah, sapped his friends and colleagues of their determination and relegated them to poverty on the government dole.

I think about Thomas’s grandfather, and wonder what he would have thought of Barack Obama’s online election-year vignettes, The Life of Julia, describing all the wonderful benefits that the Federal Government can bring to a person throughout his or her life. I think he would have been appalled.

Reading the book, it makes me wonder two things. First, it makes me wonder why there aren’t more black conservatives. The argument which Thomas makes – vindicated by his very existence – is so compelling that it makes me wonder how to get the story more widely read. It might make people scratch their heads a bit and wonder.

Second, it makes me seethe that Thomas is so vilified by the left. It makes me think that many parts of the left, far from being open-minded and liberal (the old kind), are narrowly dogmatic, irate that a black man might dare hold views antithetical to the party line. In their words and deeds, they constantly subject him to a “high tech lynching,” to use Thomas’s own words. It is loathsome.

Sadly, a good part of the end of the book is consumed by the Anita Hill affair. It is a shame, but I suppose it had to be. Thomas needed to have his public say about the whole thing. Thomas makes a reasonably compelling case that Hill was acting in bad faith for political reasons. Whatever the truth, it tarnishes an otherwise uplifting and educational story.

Even though you’ve got to slog through the Anita Hill affair, Thomas’s story is quite simply incredible. I urge you to go read it, and pronto.

PS: I am off to purchase that other autobiography with an eerily similar name, penned by a famous American black man, Dreams from my Father. Check back for another review coming soon!

Note: Since this is a book review, I have double-posted this is Contemplarscion, where all my book reviews live.

Monday, September 3, 2012

The Perfidy of Matt Taibbi

The recent issue of Rolling Stone has another instantly notorious piece about villainy by Matt Taibbi (here). This time, Taibbi sets his sights on villains Mitt Romney and Bain Capital. While I would generally ignore a publication such as Rolling Stone, whose better days are decades past, and a writer such as Taibbi, who seems to specialize in nothing but hyperbole, I have been driven to blog about this particular article for a couple of reasons.

First, the article seems to have achieved a readership far beyond the usual denizens of Rolling Stonedom. Numerous of my acquaintances have linked to the article on social media sites, and a quick Google confirms that Taibbi has been making the rounds, even appearing on network TV to elucidate his theories. Second, the topic of the article is private equity, something about which I know a fair bit, being a private equity investor myself. Finally, the article contains so many factual and conceptual errors about private equity and Bain Capital that they were impossible to catalog in a Facebook post. Put it all together, and here I am.

The first thing which one notices in reading the article is the excoriating prose which Taibbi uses to describe his subjects: Romney, Bain, and many other characters of the financial world (Taibbi saves some of his sharpest barbs for these bit actors: Lloyd Blankfein is a “two bit, shifty-eyed huckster,” Jamie Dimon is a “sighing, eye-rolling arrogant jerkwad.”). In writing this review, I am tempted to employ the same verbal techniques against Taibbi which he uses against his subjects - to question Taibbi’s motives, impugn his integrity and shower him with insults. It would be easy to do given what I actually think about him now, but I will actually try to stick to the facts and let readers decide.

False Premise

Taibbi’s main thrust is that Mitt Romney is pulling a con of biblical proportions on the American public because one of Romney’s central complaints against Obama relates to the growing national debt, while at Bain Capital he was a serial user of debt to finance buyouts of companies. The validity of this claim requires that the selling of bonds by the US Treasury is somehow comparable to the employment of leverage by a PE company in financing a buyout.

In reality, every instance of leverage is different, and requires its own risk analysis. But on a more basic level, these two situations could not be more incomparable for the following reason: private equity funds themselves provide an important backstop to leverage if things go wrong.

It is true that banks and other institutional investors are generally willing to provide massive amounts of debt to help finance private equity transactions. But one of the reasons that they will do so is because there is a private equity fund with a vested interest in making sure that things go well. If a $2 billion private equity fund invests $100 million to buy a company together with another $800 million of debt, one of the reasons that the banks are willing to finance that transaction is because of the simple existence of the $2 billion private equity fund.

If things go wrong in a private equity investment, the PE fund itself can, and often does, invest additional equity into the business to shore up the balance sheet. It does happen occasionally that a PE firm will abandon the company to bankruptcy, but this is generally a sign of a broken company, not a broken PE firm or one lacking moral fiber (more on this point later). Most PE funds will go the ends of the earth to save one of their investments.

Conversely, if things were to go wrong with the national debt – if interest payments increased dramatically at the same time as revenues decreased, such that it became impossible to meet our obligations – what is backing up the US government? Well…, nothing! That’s it. Kaput.

We can have honest disagreements about how close we are getting to the breaking point with our national debt, but there can be no disagreement about what a default by the US Government would look like. You think the financial crisis of 2008 was severe? Hold onto your hat if the US government defaults, that would be a cold wind indeed.

So the leverage analysis of US debt vs. portfolio company debt is simply not relevant. Until we find a generous galactic quadrillionaire benefactor who is willing to backstop the US national debt, we’re just going to have to keep analyzing things as if a default would be of historic proportion.

That Taibbi thinks Romney is pulling a massive con on the American people makes one scratch one’s head a bit. How, exactly, would that be possible? Aren’t there quite a number of financially sophisticated Democrats out there? Isn’t it possible that one of those people would be onto him? Why would it take a middling Rolling Stone author to let us in on this massive undiscovered truth? I’ve often thought that when something like this just doesn’t make a whole lot of sense, perhaps there is more to the story.

A Few Other Major Issues

The next major error which Taibbi makes is even more infuriating because it is a lie which is easily believed by financially unsophisticated readers. Here’s how Taibbi describes the genesis of Mitt Romney’s fortune: “But what most voters don't know is the way Mitt Romney actually made his fortune: by borrowing vast sums of money that other people were forced to pay back…”

As a private equity investor, all I have to say about that one is: “Hunh?” This line of reasoning is simply nonsensical if you know how the world works. Boy, would I love it if other people were responsible for the debt of my portfolio companies!

In Taibbi’s parlance “other people” consists of the private equity company’s own portfolio company. But who owns that portfolio company? Well, that would be the private equity firm. Ultimately the responsibility of paying back company indebtedness rests with the company’s shareholders. In the case of a Bain Capital investment, that would be Bain Capital. If Bain Capital chooses not to cause that money to be paid back, they will lose their investment in the equity of the Company. Try as Taibbi might to convince us that this is inconsequential to Bain Capital, this is simply not true. Any private equity company which regularly lost its equity investment in its portfolio companies wouldn’t be in business for very long.

Taibbi tries to make you think that there are reasons why a private equity firm might be so cavalier about abandoning a company to the wolves. Foremost among these is the fees. Romney, we are told, regularly loaded up his companies with hundreds of millions of dollars of debt, and then “extract(ed) million-dollar fees from those same companies…” for his services.

Yes, private equity firms do charge fees to their portfolio companies, but please note the scale here. To Taibbi, “million-dollar fees” is a big scary number just like all the other big scary numbers he runs across, but in reality it is two orders of magnitude smaller than the debt we’re talking about, or the earnings of those companies, for that matter. Fees charged by a PE firm have never resulted in the failure of a company. Furthermore, they couldn’t – they are subordinated obligations. If a company ever gets in trouble, banks just turn off the fees – the PE firm never even gets paid. Such fees are actually an indication that things are going reasonably well. Finally, the principals of private equity firms do not get fabulously wealthy on fees. Fees are generally used to pay salaries, staff and overhead. The real money is made from capital gains on carried interest. Importantly, these gains are also an indication that things are going well, not badly.

There is one case in which Taibbi may have a point. In a transaction called a “dividend recap,” a portfolio company borrows money to pay a dividend to its PE fund shareholder. In some cases, these dividends can be larger than the original investment in a company. It is possible that a PE firm which has recaptured its entire investment in a company may have a reduced incentive to support a company if it subsequently gets into trouble. MidMark Capital has not had any troubled situations after a dividend recap, so I don’t have any personal experience about how it might affect our behavior. In any case, a private equity firm still stands to lose its residual equity interest in any bankruptcy, so the existence of the recaptured investment is certainly not dispositive. I do not believe that it has the consequence that Taibbi would have you believe.

The final major gripe I have with Taibbi’s analysis is his portrayal of the way that interest payments affect a portfolio company. Here is the completion of that sentence above about fees: “…a man makes a $250 million fortune loading up companies with debt and then extracting million-dollar fees from those same companies, in exchange for the generous service of telling them who needs to be fired in order to finance the debt payments he saddled them with in the first place.”

In numerous places throughout the article, Taibbi makes it sound like private equity investors load up their companies with debt, then later go around firing everyone in order to pay for the interest payments. He writes as if private equity executives wake up after having completed a buyout and say “Hold on - wait a minute! Omigosh - we have a bunch of interest expense! We better go fire a bunch of people to increase our earnings!” This would be a thunderously stupid way of going about business. And if Taibbi thinks Mitt Romney is really that stupid, he’s got another thing coming.

In fact, it happens in exactly the opposite way. When a private equity firm makes an investment in a new company, it undertakes a comprehensive analysis of the company’s operations. If there is any fat in the organization, or if there are ways to increase efficiencies, the private equity firm will make provisions to extract those savings. Sometimes that means people are let go. If it happens at all, layoffs are usually modest. Nor is this ever the fault of the private equity firm; rather, it is the fault of former management which ran an inefficient, bloated operation.

But the more important point is that this all happens before and in conjunction with the raising of the debt. Private equity firms (together with company management!) must prove to banks how much money this new, leaner, more efficient company might be able to earn. Only then do the capital markets decide how much debt and interest can be layered onto the operations.

The difference is perhaps subtle to an uninitiated reader, but to a private equity professional, Taibbi’s rendering of this aspect of the PE world is simply infuriating.

The private equity business is a risky one, and it doesn’t always go well. Sometimes, companies end up in bankruptcy. The reality, though, is that companies end up in bankruptcy in spite of the efforts of their private equity owners, not because of them. Taibbi has it exactly backwards.

Two examples often touted as proof of Bain’s excess are GST Steel and KB Toys, both of which ended up in bankruptcy. But as the Wall Street Journal points out, GST Steel was one of 31 US steel companies which declared bankruptcy between 1993 and 2002 because of cyclical global steel prices. GST Steel was just another bankrupt steel company which also happened to be owned by a private equity firm. Bain’s mistake was in investing in the steel business, not in bankrupting GST by its practices. Similarly, KB Toys faced massive competitive threats during Bain’s ownership from both chain stores such as Walmart, and KB Toys was most likely a goner, Bain or no Bain. Again, Bain’s mistake was in making the investment in the first place. It may be easy for former employees to demonize Bain and Romney for these failures, but the truth is quite a bit more complicated.

Some Nits and Nats

  • Not content with accusing Romney of this “calculated bluff of historic dimensions,” Taibbi is also intent on implicating him in the financial scandals of the 80’s, and accuses him of taking Michael Milken’s “dirty money” in the form of high yield debt placed by Drexel, Burnham & Lambert. Sorry, but this doesn’t work, either. Milken was prosecuted for insider trading scandals. Drexel placed billions of dollars of perfectly legitimate debt for transactions. The fact that Bain worked with Drexel on a deal and Milken later went to jail for something completely unrelated certainly didn’t make those bonds “dirty” in any way, even if they were “junk bonds”. By the way “junk bond” really just means “high yield bond.” The collateral for it isn’t really junk. It’s just the way people talk.
  • The piece is full of indications that Taibbi himself is financially illiterate. Here he is introducing the Drexel angle: “In the Eighties, when Romney and Bain were cutting their teeth in the LBO business, the primary magic trick involved the junk bonds pioneered by convicted felon Mike Milken, which allowed firms like Bain to find easy financing for takeovers by using wildly overpriced distressed corporate bonds as collateral.” This sentence is so confused it’s almost impossible to discern what he means. Any distressed bond, for instance, is going to be priced high by its very nature. High risk demands high interest rates. And using bonds as collateral? Best not to dig too deeply here, he’s just starting to blather. Apparently, precision is not a prerequisite for publication at Rolling Stone.
  • Taibbi mischaracterizes the business interest tax deduction as something “specifically designed for mortgage holders…” Again, hunh? How did this make it past the editors at Rolling Stone? The personal mortgage interest deduction is a relic of the business interest deduction, not the other way around. For taking advantage of the business interest tax deduction, Romney gets accused by Taibbi of “exploiting” the tax code. Another way to describe it might be “filing one’s taxes properly.” Is Taibbi exploiting the tax code if he buys a house and deducts the interest? I doubt many people voluntarily pay any extra tax because they disagree with the policy!
  • What is with Taibbi’s personal animosity toward these people? Besides the aforementioned insults directed at Blankfein and Dimon, the employees of Blackstone are “spooky Democrat-leaning assholes…” Does he know these people? How can he call all of the employees of a huge financial services firm assholes?
  • Just as an aside, do all of you readers know who the investors in private equity firms are? It’s mostly pension funds and endowments. This money is not run by highly paid corporate titans. It’s run by mid-level bureaucrats who do their due diligence very comprehensively. Even after they’ve done their extensive due diligence, they still invest in Bain Capital. Pension funds! Is Taibbi’s article making any less sense yet? Perhaps there’s more to the story?
In Closing

Private equity is a complicated business. It’s also not without some train wrecks. Because of the complicated nature of the business, it is definitely possible to describe the same set of facts in two very different ways.

The tone of this article is so brazenly critical of this complicated business that I can’t decide whether Taibbi is just fantastically ignorant of how the private equity world really works, or is taking advantage of uncritical readers who want desperately to believe that Mitt Romney is as evil as portrayed here. I suspect the answer is a little bit of both.

For sure there are unethical and/or uncaring people in the private equity business. I just don’t happen to believe that Mitt Romney is one of them. I think he probably did the very best he could to help the operations of his businesses, and if certain of these companies ultimately failed for one reason or another, I am quite sure that it pained Romney dearly. How do I know this? I don’t, really. But I do know that it would be possible to write an article exactly like this about me. And I know that every failure of MidMark’s has hurt me to the core. I am simply guessing that Mitt Romney is much the same based on the collective judgment of those who knew him best. I’ve met several of them and asked the question directly. He is a good and decent man.

Those are my thoughts for now. I will continue to add additional points as they occur to me. Please feel free to comment below and I will follow up if warranted.