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 []

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 []

THE SKIM AND THE PARTIAL PONZI

Come gather ’round people
Wherever you roam
And admit that the waters
Around you have grown

“Sir, if you have a milkshake and I have a milkshake and my straw reaches across the room, I’ll end up drinking your milkshake.” – Senator Albert Fall

Come gather round doctors, lawyers, and accountants and let me tell you the tale of the Skim and the Partial Ponzi.  You won’t hear this story in mainstream publications, largely because it’s not sensationalistic and takes place very, very slowly over a long period of time.  Plus, the documentation and scrutiny required of traditional media makes the subject a non-starter for any editor.  Nevertheless it has a huge impact on 99.99% of U.S. citizens.  So heed the call small-business owners, professors, journalists, students, and retirees.

To start, let me share with you two sets of data:

1. According to a study by Standard & Poor’s equity analysts Todd Rosenbluth and Stewart Glickman, in the 18-month period ending June 30, 2007, 423 companies in the S&P 500 engaged in stock buybacks and repurchased almost 20 billion shares of stock for approximately $700 billion dollars.  Yet the number of shares outstanding for these 423 companies was only reduced by 4.4 billion.  What happened to the other 15.6 billion shares?  Both the study and I conclude that they were simply repurchased to offset the dilution of employee/executive stock and option grants.

2. Companies in the Standard & Poor’s 500 Index were poised to spend $914 billion on share buybacks and dividends in 2014, or about 95 percent of earnings, data compiled by Bloomberg and S&P Dow Jones Indices show. S&P 500 companies will spend $565 billion on repurchases this year (2014), and $349 billion on dividends, based on estimates by Howard Silverblatt, an index analyst at S&P. Profits would reach $964 billion should the 8 percent growth forecast by analysts tracked by Bloomberg come true.

Distilling the above two sets of data, we get the following:

78% of shares repurchased by companies in the S&P 500 have no effect on shrinking the float – they are a complete wash in terms of boosting net earnings. (15.6 billion/20 billion = 78%)

58% of net income for the S&P 500 companies is being spent on stock repurchases ($565 billion/$964 billion)

Finally, we combine the two percentages above to come to the conclusion that if 58% of net earnings are used to repurchase stock, and 78% of that stock is actually going to executives and employees, then:

45% of the total earnings of the S&P 500 are completely fictitious as it pertains to the average common shareholder (78% of 58%).

Yeah, yeah, yeah, there are a lot of holes that can be poked in the above.  One of the most obvious is the timing differences of the two sets of data 2006-7 vs. 20141.  Another that critics might point to is the fact that stock options and particularly stock grants, are already expensed and accounted for in net income. (of course if they are, then why is there 15.6 billion shares in leakage?)2  I’ll leave my detailed rebuttal to these in footnotes, but for the sake of brevity, let’s just slash the 45% number listed above to 25%.  That’s still a pretty jarring cut, and it means that those shares of stock or the equity ETF’s that you hold in your 401K, really only entitle you to 75% of your share of the companies earnings.  Worse, that percentage is slowly going down.

The other 25%, and growing, has been usurped by management.  We’ll detail exactly how that’s occurred in the next few weeks, so stay tuned to The Shadow Banker…

Are Buybacks an Oasis or a Mirage? – “U.S. equity investors in aggregate—contrary to appearances—have not realized a benefit from the recent spate of stock repurchases”

Buybacks That Bite Back – the original Glickman/Rosenbluth article detailing the stock buyback “leakage”

S&P 500 Companies Spend Almost All Profit on Buybacksmore like 58% of profits

Goldman Sachs Partners Reap $175 Million from ’08 Options“In December 2008, Goldman Sachs granted 36 million options in an effort to give top performers an incentive to stay after the bank reduced compensation expense by almost half during the financial crisis” Huh???? In December of 2008, where the hell else were they going to go???

Top 100 CEO Retirement Savings Equals 41% of U.S. Familiesthey’re skimming it from the bottom of the economic pile, and from the doctors, lawyers, and scientists at the top

Why Management Loves Share Buybacks“The conclusion is that what looks like buybacks are actually thinly veiled management-compensation plans”

 

  1. $565 billion in stock buybacks in 2014, versus an average of $467 billion in 2006/7.  Both periods occurred in a year of large stock buybacks by corporations, as highlighted in both stories below []
  2. I don’t know if this is a critique of my argument, or makes the 45% even worse.  I think it’s due to low balling the option valuations, a continuation of the backdating of option strike price’s (the consultants approved it, now they probably have come up w/ new schemes) and huge stock grants doled out when stock prices are low – think Goldman Sachs’ bonanza to employees in late 2008/early 2009 []

HEALTHCARE AND THE UPPER MIDDLE CLASS

Did you know that 10 out of the 12 largest foundations in the U.S.1 are those of pharmaceutical companies?  And do you know who the beneficiaries of their largesse are? Themselves.  And do you know who the victims of their largesse are?  First and foremost The Upper Middle Class, and secondly America.  Well, maybe it’s the other way around, at least in absolute terms. Nevertheless, the existence of these “foundations” leads to an enormous allocative inefficiency that feeds off the Honeypot Economics of healthcare.

Basically, all the “donations” from these foundations are used to ameliorate or eliminate the co-pays on the drugs their parent companies manufacture, for those who can’t afford the co-payments.  For example Continue reading

  1. ranked by total giving, not by assets []