SUBSCRIPTION LINE FINANCING IS ‘THE TELL’

“The word “Snake” has lost much of its derisive character, but there was a time when the term (from  “Snake Eater”) was a taunt reflecting on the-purely imaginary-diet of the West Virginia Mountaineers.

In some of the factories the departments sometimes “worked in a pool”; that is, the earnings of, say, men working on a bias cutter were pooled and all shared alike in the total piece work pay. The Snakes, told about the pool, were known to report to work in high hip boots.”   A.W. Jones “Life, Liberty, & Property”

I’ve taken my shot at Private Equity and was very disappointed Warren Buffett did not comment on it at Berkshire’s 2017 annual meeting in the same manner he did with hedge funds last year1.  Therefore I’ll add some fuel to the fire.

I believe astounding PE returns are fictitious and institutional investors are misguided in using those returns as the basis for reinvesting in PE.  That is if the returns are even available.  As I have analyzed and outlined, the logic doesn’t make sense.  In fact, the returns are so incongruous from an efficient-market hypothesis, and the lack of granularity encompassing them so opaque, that they have a Madoff like quality about them.

Thus it was interesting to read six months ago about a heretofore unfamiliar term to this capital markets veteran, called Subscription Line Financing (SLF).  No furor arose then, nor several months later when elaborated upon further in a Bloomberg article questioning its use, and I am of the belief that the journalists are not fully aware of what they’ve uncovered.  That’s probably because the decision-makers, aka institutional investors and consultants, also don’t have a handle on the full ramifications of what SLF means vis-a-vis their underlying portfolio.  As an example of this let’s examine a snippet from the aforementioned Bloomberg article: Continue reading

  1. He definitely would have been ahead of the curve if he had []

SO WARREN, WHAT DO YOU THINK OF PRIVATE EQUITY?

Let’s take an investment proposition whose model is to pay a significant premium to current market rates for acquisitions, throw in lots of leverage, charge enormous fees, and which allows the investment manager to value a company using basically any measure that they choose.  Are you as an investor ready to take the plunge and commit your savings?

Well what I have just described is Private Equity (PE), formerly known as the LBO business .1  Those that currently are invested in PE, as well as those who work in PE, point to the superior returns of this sub-asset class2 in the past.  Yet in aggregate, what have those returns really been?  Of equal importance, what do investors really think their returns will be going forward based on the dynamics I outlined in the first sentence?

My skepticism over historical returns in PE, is derived from a number of factors.  One of the most significant is that unlike the stock market and hedge funds, there is no easily definable and frequently cited index.  Equity markets have the most ubiquitous ones, such as the S&P 500 and Russell 2000, which are quoted daily in newspapers, radio, and TV, and can be brought up in real time on any financial website: Yahoo, Bloomberg, WSJ, etc.  Hedge funds also have easily obtainable indexes that are updated monthly soon after the funds report returns.  Here are two that are quickly googleable: HFRX and Barclay’s HFI.  While I would be the first to admit that these indexes are imperfect as they lump together a lot of completely different types of investment strategies under the vague moniker of “Hedge Funds”3, and may have many other imperfections4, at least third-party organizations have taken the time to painstakingly quantify a general number on a regular basis.  Furthermore, these indexes have increasingly been cited in the financial press, mainly to note how poorly hedge funds have been performing recently relative to other investments, and to question the large fees being paid out for this under-performance.  While PE supposedly also has third-party organizations compiling returns, just try and actually see them – it’s absolutely not going to happen on Google.  Worse, Continue reading

  1. Sure, I know that PE encompasses so much more than LBO’s these days, but whether a PE firm is buying a whole company in the public markets or a private company or a division of either public/private, it still usually entails a bidding process w/ the winner paying the highest price.  Leverage/fees/valuation methodology all still apply.  This goes for real estate, distressed situations, credit, and all the other assets lumped into PE []
  2. Alternative Investments is the usual moniker given to the full asset class, though really when you break it down PE is simply leveraged equity.  Furthermore, I fully concur with the sentiment that Alternatives are a compensation scheme, masquerading as an asset class []
  3. Where do I even start w/ this term: first off, some completely hedge, and some very transparently do not at all, and some do so to varying degrees.   Some use leverage, some do not, and then some use massive amounts.  About the only similarities that most hedge funds do share is that they charge much higher fees than conventional money managers, and are predominantly invested in publicly traded securities []
  4. are they weighted by AuM or not? Survivorship bias? []

WHAT BOGLE GIVETH, CEO’S TAKETH AWAY

The 40th Anniversary of the Vanguard 500 Index Fund was over six months ago, yet the well-deserved accolades for John Bogle and the momentum of indexing continue to mount.  Bloomberg estimates Vanguard has saved investors one trillion dollars.  Taking just half that figure1 would effectively make Bogle the biggest philanthropist ever, beating Warren Buffett and Bill Gates ten-fold.

Which makes it all the more galling that so much of those savings have been siphoned off Continue reading

  1. or even a quarter []

AS GOES SNAP IPO, SO GOES THE NATION

While many people may think that the inauguration of Donald Trump was the end of America as we know it, the reality is there is a much more under-the-radar yet tangible change that spells doom for most Americans: the IPO of Snapchat, or Snap Inc. as it is now called.

Critics of the company’s decision to solely issue nonvoting stock are completely missing the most significant ramifications of doing so, instead focusing on how the company will be managed and guided.  What they are missing is that for all Continue reading

FIVE UNUSUAL PREDICTIONS DURING THE REIGN OF DJT

Because I spent the 1990′s working on Wall Street, I’ll always refer to Donald Trump as ‘DJT.’  This was the stock ticker of his casino holding company which went public in 1995.  Had you purchased shares in the IPO, you would have been left with ten cents on the dollar a decade later.

In a few days this business maven will be the President of the United States, and though I am no longer analyzing public companies, I will make a few unusual predictions, predominantly financial, about what I think will occur over the next four years.

First of all a broad statement: All economic growth and wealth creation will come from financial conjuring, not through manufacturing or actual business activities.

The second is also a broad prediction and not especially revelatory or clairvoyant: federal deficits will become huuuge!  Fiscal hawks get out of the way.  In the words of Glenn Beck “The Democrats tax and spend, while the Republicans just spend.”

These two declarations will largely come about through the classic Wall Street arbitrage of doing something that is beneficial in the short term, and bad in the outlying years.  Frequently it ends up being really, really bad, ask Greece.

The simplest form of this arbitrage is borrowing money.12 But the hand on the till has to be a very deft one, otherwise over the long run the power of compounding interest will crush you.  Something that DJT knows very well.  Worse, in 2016 there are so many newfangled ways to ‘bury’ the debt for an extended period, that it won’t come back to bite, or even appear (be on the horizon) for say, another 4-8 years.

The third unusual prediction I will make is that millions of state and municipal pension fund beneficiaries will get seriously clipped.  This is due to 1) the considerable underfunding in many of these pension funds, 2) already stressed state and municipal budgets, and 3) the significant lowering of expected and actual returns.

Here’s how it happens.  In the not-so-distant future there will be a really big city or a state, that will be forced to permanently restructure.  It will be a litmus test, and due to legislation, a court ruling, or both, a road map will be put in place for all other stretched districts that will immediately be taken up by them.  Pensioners will be portrayed as having caused the problem and therefore will bare the brunt of the pain.  Of course in typical short-term/long-term arbitrage, it will be more like Chinese-water torture than amputation.  Bondholders and taxpayers will only incur minor nicks and cuts.

Next up: immigration, which at the heart of it is really all about economics. Continue reading

  1. A typical business takes on debt in the expectation and assumption that the deployment of that capital will lead to a return greater than the interest rate on the loan.  A government takes on additional debt seemingly because it’s allocation and deployment of it will lead to growth in the overall economy which will lead to greater tax receipts that can be applied to the greater debt.

    This theory hasn’t really worked out that well in practice, and contradicts the logic that the private sector is a better utilizer of capital than the government. []

  2. Two other classic s-t/l-t arbitrages are environmental and regulatory.  Similarly, both can have short term positives, but long term negatives []

CARRIE TOLSTEDT IS WHAT’S WRONG WITH AMERICA

Dragline: Why you got to go and say fifty eggs for? Why not thirty-five or thirty-nine?

Luke: I thought it was a nice round number.

Let’s face it, at the heart of all the animosity over this year’s presidential election, lies income inequality.  Whether one is a Trump supporter or a Bernie supporter, this is the issue that is turning these fringe politicians into mainstream ones. Immigration, taxes, and trade (healthcare and education too) are all a function of too many people believing (correctly) that they are getting a smaller and smaller piece of the pie.

Nevertheless while politicians and Wall Street seem to shoulder the bulk of the blame for income inequality, I argue that the ship has already sailed on these culprits, and that in 2016 it is the executive compensation at publicly traded corporations in America that is now the overwhelming cause of this problem.

There is probably no better example of how bad this issue has become, than by focusing on Carrie Tolstedt, the recently ‘retired’ Wells Fargo executive in charge of consumer banking, the division where her employees opened more than two million unauthorized accounts.  Three things revealed by this episode stand out in regards to why America’s biggest problem emanates from its publicly traded corporations.

First and foremost, according to Fortune, Tolstedt “is leaving the giant bank with an enormous pay day—$124.6 million.”  That is a massive number, and taking my cue from Cool Hand Luke, I have to ask “Why couldn’t this have been $50 million, or $75 million?” Would those huge numbers not have been enough to motivate Ms. Tolstedt over the years?  What was the board and the CEO thinking in giving such enormous amounts of the shareholders money to this individual? Continue reading

EXECUTIVE COMPENSATION REFORM NEEDS ACTION, NOT REACTION

“It is a notorious fact…that the typical American stockholder is the most docile and apathetic animal in captivity” – Ben Graham1

All attempts to reform executive compensation have been completely useless in the 21st century.  The march higher continues unabated at a compounding rate that would make Bernie Madoff proud.

The problem is that all battles to curb it, have been reactionary (not to mention tepid), say by voting “no” on a specific corporation’s CEO’s pay package for a given year. Here’s a perfect recent example:

More Pensions Funds Join Chorus Opposing GM’s Pay Package

“Chorus” that’s a perfect description of this toothless fight.  And what was the result of this chorus?

“In a largely symbolic vote, 38% of GM shareholders rejected a compensation plan at the automaker.”

Also, all twelve of the company’s candidates to the board were elected by shareholders with each receiving 96% of the vote.

The measures currently being used are the equivalent of using a thimble to put out a major forest fire – completely inconsequential.  The ability of corporate boards and executives to consistently end run these efforts, say by reducing a bonus by a million or two in a contested year, only to see it spring back in spades going forward, has given rise to Matt Levine’s first meta-rule of executive pay: “All executive-pay rules have the effect of increasing executive pay.”

Instead, it is time for shareholders to first put forth a systematic process to determine executive compensation.  Furthermore, it’s imperative that they set the narrative by putting forth a plan that by any other standards is overly generous.  With that in mind, here’s what I propose. Continue reading

  1. He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who, together, own a majority of the stock but by a small group known as “the management.” []

HEDGE FUND EXODUS TOO LATE, FOCUS ON WHAT’S NEXT

It started with CALPERS, then a year and a half later came NYCERS, weeks after it was Buffett’s turn, climaxing 48 hours hence with Stevie Cohen (of all people!).1  As the crescendo of hedge fund bashing reaches it’s peak, I’ll seize the moment to make three observations that differ from everyone else who’s piling on the financial topic du jour.

Before I do, let me say that I’m in no way a cynic of the criticisms that are currently being leveled at hedge funds overall.  Extremely high fees combined with a very crowded arena have more than eliminated any possibility of taking advantage of inefficiencies.2  Nevertheless, this was also the case 3, 6, and even 9 years ago3  to anyone immersed in Wall Street who made an objective back-of-the-envelope analysis (Warren Buffett wasn’t the only one).  Yet institutional investors, who’s objectivity may very well have been hindered by the extreme shortfalls in their projected pension funding, continued to pile into “alternatives” from what in many cases was a very small or non-existent base.

With that as a background, my first thought in reading the excoriating hedge fund headlines and quotes, is that after the effects of this verbiage leads to the inevitable exodus from hedge funds – in about 6-9 months4markets themselves will have reached a crescendo, and fall.  Wait, make that crash!  Of course they will, this always happens immediately following the removal of all hedges, doesn’t it?  In all seriousness, equity markets are currently at all-time highs, and bond yields are anemic.  As monies get taken out of hedge funds and redeployed into long-only markets, pension fund investors will inevitably have zigged, when they should have zagged.  They always seem to feel the need to “put-it-to-work”, and can’t -or don’t have the luxury to just let it lay fallow like Warren.

Of course they can, and probably will, reallocate some of this money into Private Equity (PE), in the hopes of garnering expected returns not tethered too closely to zero.  Thus my second thought in reading the hedge fund bashing headlines is “Isn’t Private Equity also due for similar scrutiny?”  So far investment in it has completely escaped opprobrium and continues to see big inflows.  In fact, just today – in the midst of all this HF bashing, comes an article saying the PE firms are regaining the upper hand on institutional investors.  Taking fees to all time highs and “eliminating terms from their current funds that are designed to protect limited partners, such as preferred returns, also called hurdle rates, and clawbacks.”

Personally, I think the lack of criticism towards PE has to do with the difficulty attaining real annual performance numbers5 and zero accounting for volatility; the lack of a suitable, or any, benchmark; and the opacity of their fees.  I have a lot more skepticism about investing in PE in the 21st century, but lack the time to script all my thoughts at this moment6, and don’t want to get too off topic.  Underlying this skepticism is many of the same critiques leveled at hedge funds, including crowding – whether one calls them trades or acquisitions, and Warren’s lament about “Wall Street salesmanship” trumping performance.

Finally, the third and most important thought I have in reading the latest financial brouhaha, is that both institutional managers and Warren Buffett are ignoring the biggest curse facing investors today: Continue reading

  1. This hf manager rarely, if ever, talks about the markets or to the press/public directly, and most news about him focuses on his art collection, home sales, personal wealth, and travails w/ the SEC.  Though long before he was famous, he did go on the Dating Game! []
  2. Ironically, Steve Cohen’s comments this week lamented the lack of talent in the hf industry today.  Personally I think it’s the exact opposite.  Largely due to his and others tremendous growth and financial success managing hedge funds, they have spawned a whole slew of Stevie Cohens.  Thus it’s a v crowded market and there is way too much brain power analyzing securities in 2016 []
  3. Huge tip of the hat to Buffett, who not only saw this but put money and his reputation on it in his $1 million bet w/ Ted Seides of Protege Partners []
  4. institutional investors are slow to act []
  5. instead of mark to market like in the hf world, it’s mark to whatever the PE manager thinks a company’s value is []
  6. though I will someday soon, so stay tuned []

WHAT IS TO BE DONE? START WITH THE BOARD

Whenever I see Bernie Sanders on TV and hear his proposals for income equality, all I can think is ‘This is what we are going to get if we don’t put something effective in place soon.’

If all I have posited in the Skim and Partial Ponzi is correct, then the road to reform comes through executive compensation.  While this has long been mentioned as a solution, the overwhelming focus has been on purely reducing/cutting it, and/or nebulously tying it to some performance formula.  So far any such changes have clearly not worked, as their has been a huge and continuing wealth transfer in corporate America from the 99.99% to the .01%.

So let’s take a very small step by starting with the people who determine executive pay: The Board of Directors (BOD).  Being a director on a corporate board should be viewed as quasi-volunteer work.  Back in the old days (pre-1980 for a number), serving on a corporate board was viewed as an honor and a responsibility.  It was something a person did for altruistic purposes, to give back to the capitalist system that had served us so well.

Nowadays it is first and foremost a form of remuneration. As highlighted recently in the show ‘Billions,’ the female board member (aka Evelyn Benson) who gets ‘Axed’ from Yumtime’s board, cares most about losing her $200,000 annuity when she’s voted off the board.  It was a completely offhand comment, and that’s because it’s become so ingrained in our system.  Of course $200k is probably a lowball number, cut in half from the average director compensation once all the committee fees and other perks are added in.  Multiply it by 3-4 boards, and I’d say that’s a pretty good way of making a million a year, especially for only 4-6 weeks of work!

Well guess what, there’s still an enormous amount of value in being on the BOD of a major corporation, net of any compensation. Continue reading

HENRY SINGLETON WHERE ART THOU?

While politicians and other critics have focused on stock buybacks being a poor use of cash versus investing in and growing a company, they have completely missed the boat.  As have those in the business press who have concentrated their critiques on the timing and high stock prices paid for these buybacks.  In so doing, all these parties have provided a smokescreen for executives of publicly traded corporations to continue their Chinese water-torture plundering of American’s savings.

Instead, the real charade of stock buybacks is that they have nothing to do with the shareholder and enhancing shareholder value, and everything to do with self-remuneration, as outlined in ‘The Skim and the Partial Ponzi.’

Yet a long time ago, buybacks really were very beneficial to shareholders, as they allowed good managers to take advantage of the inefficiencies and dislocations of the capital markets.  The underlying thesis behind value investing was that if a company’s ability to generate cash wasn’t recognized by the market, that excess cash could be used to buy back stock and shrink the float. If despite this buttressing, the stock price continued to languish, it could be done again and again as cash continued to pile up on a company’s balance sheet (now at an even faster rate due to the buybacks being accretive and increasingly so).  The key ingredient to all this was that the price of the company had to be undervalued.1

Nowadays though, stock buybacks are done indiscriminately, and usually executed very poorly.  The main reason for these “sloppy” buybacks is that they simply have to be done in order to offset dilution from employee stock and stock option awards.  Leading to the question:

What would happen if all publicly traded companies stopped buying back stock altogether? Continue reading

  1. Sure, this is a very discretionary measure.  I could just fallback and use Warren Buffett’s term of “selling for far less than intrinsic value in the stock market.”   But I’d prefer to hone in on a company’s ability to generate excess cash, both currently and going forward []