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 amazon.com. 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.

Friday, February 10, 2012

Thoughts on Income Inequality - Part I

Ever since I wrote this post on President Obama’s increasingly strident language about the unfairness of reported increases in US income inequality, the issue has only become more prevalent in our Oped pages, political blogs and journals. The fervor of this newfound fascination is perhaps not surprising given the popular backlash against mind-numbing Wall Street compensation during these times of high unemployment and stagnating wages.

I have earnestly sopped up much of the recent writing and some of the scholarship on the issue, even wading into the pages Mother Jones (here is a good example). And while many of these authors bring up reasonable and concerning points, I find that they all suffer from the same fatal flaw of logic: they assume that the simple act of decreasing income inequality will, by itself, help the neediest among us. I do not necessarily subscribe to this view, and will outline common flaws in the typical analysis below.

First, let me make a stipulation: in any given society, there is a meaningful correlation between freedom and wealth. If you disagree with this stipulation, then you can stop reading right now – you will disagree with my conclusions. However, in order to disagree with it, you’d have to disagree with quite a lot of scholarship and some very simple, but quite compelling analysis. For instance, the chart at right from economist Scott Sumner is a linear correlation between the Heritage Freedom Index and GDP per capita for all the countries of the world with GDP per capita greater than $23,000. The picture is quite demonstrative: it suggests that the more economically free a country, the higher its GDP per capita.

Now, I’ll acknowledge that there are numerous problems with such an analysis. Historical circumstance, lack of natural resources and other considerations may depress a certain country’s GDP per capita in ways that would not be captured by a Freedom Index. Conversely, countries like Norway, with its vast oil wealth, and Switzerland, as the banker to much of the world, skew the analysis in another direction. Therefore, I only introduce this chart as reasonably compelling evidence that, on average, within certain boundaries, the more free a country, the more chance it will have larger GDP per capita. Finally, I hope it goes without saying that although economic freedom may be a necessary precondition for wealth, it certainly is not sufficient.

Next let me stipulate that the tools and policies which a country like the United States might employ to reduce income inequality would, in all cases, serve to reduce economic freedom. The most common solutions to the income inequality dilemma are increasingly progressive taxation schemes, transfer payments such as food stamps and unemployment insurance, and, in some cases, increased regulation to reign in the worst perceived cases of wealth generation (think of the call for regulation of compensation during the financial crisis and the more recent calls for hedge fund taxation reform and registration). Each of these things might be effective in reducing income inequality, but they would undoubtedly also place a country lower on the Economic Freedom Index. When someone finds a way around this, please let me know – we’ve solved the problem!

One implication of my initial stipulation is that there is an unintended consequence of the adoption of these policies: the whole pot gets smaller. If freedom means wealth, and reducing income inequality requires reducing freedom, then reducing inequality requires reducing wealth. Liberals, including many economists, tend to ignore this point in their editorializing; sometimes it’s simply due to ignorance, sometimes I’m convinced it’s disingenuousness.

Now, these policies may be implemented with endless variety, each having a different effect on GDP. In economic terms, the negative multipliers of various policies are different, and economists could fine tune a set of recommended policies to minimize the effect on the country’s ability to provide for itself. Unfortunately, I suspect that the Policies which might have the greatest effect on income inequality might also be the ones which depress GDP the most.

But let’s revisit my initial thesis: that liberals’ distaste for income inequality, qua income inequality, is misguided. Let’s look at the current income distribution in the United States. In its various reports on gross income, the Commerce Department divides Americans into quintiles. The chart to the right shows the mean gross income for households in each quintile, with the poorest 20% of households bringing home $11,000 per annum and the richest 20% bringing home $169,000. Indeed, the rich have a lot more income than the poor.

Two comments are in order before we proceed. First, by organizing the analysis by quintiles, I am really talking about the vast majority of Americans. Conversely, when one sees statistics about income inequality bandied about in the liberal press, the conversation usually compares the top five percent, the top one percent, or sometimes even the top one-tenth of one percent of earners to the rest of America. While the numbers might look incredibly compelling when viewed this way, the numbers of the truly, truly wealthy are so small that it is of little use to economists or legislators in crafting policy. There are not enough billionaires to make a real difference on the deficit, for instance, solely by taxing them.

Second, please note that these figures relate to mean gross income, not including transfer payments. In order to be truly fair, any analysis of income inequality should really be done on a median basis, net, after tax, including transfer payments. Those numbers are hard to come by, however (and they don’t look as compelling to liberals!), so most people use mean gross income. I’ll stick to the traditional method and remind readers of any misleading points. [For instance, if one divided the sum of welfare payments, Medicaid, food stamps, and child subsidies by the number of households in the bottom quintile and added the result to their mean income, I suspect Figure 2 would look somewhat different. It’s why conservatives often point out that the average household living under the poverty line owns multiple cars, even more television sets, and the most significant health issue for impoverished American children is obesity].

Let’s assume that a liberal administration implements a tax policy with a goal of both raising revenue and reducing income inequality. Presumably the intent of any such Policy would be to change the income distribution from the figure above to look more like the green line in this chart to the right. (Let’s ignore the fact that we are analyzing income on a gross, not net basis!).

But we’ve already established that these policies might also likely reduce the amount of GDP per capita. As such, we should ask ourselves a question: is it possible that rather than the new targeted distribution, we might actually get one which looks more like the one here to the right? This new income distribution also decreases income inequality, but everyone is worse off. Importantly, even the poorest people in the nation are worse off than before.

I would like to think that even the most die-hard liberal would concede that this is a suboptimal result, but I am not so sure. The prevalence of recent opinion pieces which conjure up happiness studies and other evidence suggesting that income inequality itself is a cause of mental distress may suggest that liberals are intent on providing cover for this dirty little secret. The line goes like this: well, yeah, maybe nobody in Europe has as much money as Americans at any level, but, hey, they’re all a lot happier than we are! This line of thinking has so many faults that it will require a separate post to deal with – here I’ll move onto more pressing topics.

Given the possibility that any particular policy might affect all points on the income distribution curve, it seems to me that each policy ought to be analyzed not solely on its capacity to flatten the curve, but also its likelihood of affecting income generally (either positively or negatively). Politicians should be required to tell us what they think the optimized income distribution curve ought to look like: how flat it should be and how much net, adjusted income should be claimed at the lower quintiles. It seems to me that the very least important consideration should be the steepness of the curve at the far right of the distribution, and yet this is the very point over which so many people are expelling so much hot air!

Unfortunately, economics being the dismal science, it’s not so easy to determine the true effect of a given policy on the shape of future income distribution curves. I suspect Paul Krugman would give a very different answer than Art Laffer if President Obama asked each of them to analyze his pending tax proposals. Nevertheless, this should not stop politicians from being required to tell us what they think the curve ought to look like and how we’re going to get there. Then, we can have a national debate comparing the merits of Laffer’s model against Krugman’s as a means to analyze the proposals.

Doubly unfortunately, this is not how politics works. I have been dismayed at the breathtaking disingenuousness of the current rhetoric surrounding Obama’s proposed “Buffet Rule” – the fuzzy notion that millionaires ought not pay a lower effective tax rate than secretaries. In the thousands of words that Obama has spent on this issue, he’s never once admitted that there is a difference between the taxation of labor and the taxation of capital, and the reason that Warren Buffett pays a very low effective tax rate is because virtually 100% of his income is from dividends and capital gains rather than salary. Somehow, it doesn’t matter anymore that we got here (i.e. Buffett paying 15% effective tax rate) for a reason. That reason is because people argued, correctly or not, that low tax rates on dividends and capital gains would be good for all of us, including those at the bottom of the income distribution. Instead of revisiting that proposition, for some reason, we’ve skipped the analysis and started appealing to Obama’s sense of “fairness.” Obama’s fairness may end up costing all of us – even those at the bottom of the income distribution – a whole lot.

In fairness to Obama, I do not know the answer. My gut tells me that low tax rates on dividends and capital gains are good for poor people, but I have not personally analyzed the issue yet to my satisfaction (another Polartics post coming!). But we should not let liberals jam policy down our throats without a clear answer from them on this issue. We should call out any politician, blogger or editorial page writer who favorably invokes the Buffet Rule, but does not tell us why they think raising Buffett’s effective tax rate won’t affect everyone negatively, including poor people. That even goes for Warren Buffett!

That’s it for now, but if you want more good thoughts on the issue, here is a splendid article (from the reliably unreliable Economist) on “fairness.”

And for those of you who suspect this article may be self-serving, unfortunately, I have not achieved that level of success yet where the majority of one’s income is comprised of dividends and capital gains; my effective tax rate last year was 30.1%.