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.