Category Archives: Private equity

the SEC says issuers of private securities, like hedge funds, can now advertise their wares

July 11, 2013 By in Current Market Thoughts, Getting financial advice, hedge funds, Private equity, securities markets, Securities regulation Tags: , , , , , , Leave a comment

SEC disclosure 

The SEC has very specific rules that limit what a company can say, either about itself or about the securities it’s selling, when it’s in the process of issuing stocks or bonds.

The securities of some companies aren’t subject to general SEC oversight,  either because the firms are tiny or the securities are being sold only to a small group of supposedly savvy buyers.  In such cases, the SEC rules have been, basically, that the firm can say nothing publicly.  In particular, the issuing company can’t solicit interest from the general public or advertise its offerings in ways the general public might see–like in newspapers or on the internet.

a rule change

That changed last year when Congress passed the JOBS (Jumpstart Our Business Startups) Act.  This legislation requires the SEC to take back the regulations that bar solicitation and advertising by issuers of non-regulated securities.  Mary Shapiro, former head of the SEC, decided this was a bad idea and didn’t comply.  The current chairman, Mary Jo White, has followed the Congressional directive and removed them.

Yes, Ms. White had no legal choice…

…but is this a good idea?

At first blush, it would seem that it isn’t.  After all, the consensus is that the JOBS Act, by eliminating the requirement for many issuers to offer audited financial statements to potential buyers, is an open invitation to fraud.

Washington is the same crew that repealed the Glass-Steagall Act in the late 1990s, allowing commercial banks to reenter businesses they helped cause the Great Depression with–and which they promptly used to help cause the Great Recession that we’re still digging ourselves out of.

In this case, the glaring issue is that there’s lots of evidence that significant numbers of hedge funds misstate in their marketing materials their investment performance, their professional qualifications and the size of their assets under management.  It doesn’t take a genius to guess what side of the ledger the misstatements fall on.  (Search PSI for my posts on hedge funds.  If you read one, maybe it should be about an NYU study.)

Why would hedge funds change their stripes when selling to a much wider group of individual investors.

accredited investors

Yes, issuers are supposed to sell the bulk of their offerings to “accredited” investors.  But that only means that buyers are supposed to have either:

–net worth of at least $1 million, excluding the value of a primary residence, or

–income of $200,000 in each of the past two years, with prospects of the same in the current year ($300,000 for couples).

That doesn’t mean they know anything about finance.

maybe it is

But there may be a method to the apparent madness.

Ms. White seems to be drawing a sharp distinction between the character of the buyer of a private offering (supposedly sophisticated parties, who are outside SEC purview) and the disclosure materials relating to it.

Because the offering documents have so far been disseminated only to qualified buyers, the SEC had no say over their accuracy. That was up to the buyer to judge.  Now, thanks to the JOBS Act, these materials can be disseminated to everybody, whether “accredited” or not.  The issuer subsequently screens potential buyers to ensure they meet the accreditation criteria before he allows them to purchase.

The SEC is asserting that the wider dissemination gives the agency jurisdiction over the accuracy of the materials.  It is preparing rules it intends to have issuers of private securities follow.

It may turn out that the JOBS Act has accidentally given the SEC another weapon in addition to prosecution for illegal insider trading in its fight to clean up the hedge fund industry.

the DELL story heats up

February 13, 2013 By in Industry Analysis, Private equity, Stock ideas, Technology Tags: , , , , , , , , , 1 Comment

latest developments

The New York Times reported yesterday that influential investment manager T. Rowe Price has joined the chorus of holders of DELL who are protesting that company’s board-approved proposal to be taken private by CEO Michael Dell and private equity firm Silver Lake at a price of $13.65 per share.

DELL’s largest institutional shareholder, Southeastern Asset Management of Tennessee, who we now know from a 13-D filed with the SEC owns 8.44% of DELL’s common (acquired at a price of just below $16 a share), seems to be leading the opposition to the deal.  

Specifically:

–Southeastern has published on its website an open letter to DELL, in which it outlines its argument that the company is actually worth about $24 a share, almost twice what the board has okayed as an acquisition price.  

–In the letter, Southeastern also gives a thumbnail sketch of a plan, using brokerage house earnings estimates, by which DELL could leverage itself (to the sky), pay shareholders a $12 special dividend and still be able to generate annual free cash flow of over $1 per share.

The NYT Southeastern has hired a proxy firm and a mergers and acquisitions lawyer.  In its letter Southeastern says it intends to pursue the matter through a proxy fight, lawsuits and, if I understand correctly, an appeal to the Delaware Chancery Court.

what I find interesting–and worth monitoring

–Southeastern is really upset, in a way I can’t recall ever seeing in a US-based institution.

It isn’t opposed to having DELL go private per se, only to the combination of preventing existing shareholders, ex Michael Dell, from participating, and what it sees as the low-ball price.

–Proxy fights are tricky things.  Why?  Individual investors support management overwhelmingly, even when it’s loony to do so.  It’s also hard to tell how much stock has been scooped up by arbitrageurs in the high-volume trading of the past month.  These guys aren’t in this for the long haul.  They want a quick profit and an exit.

Experience tells me it will be extremely hard for Southeastern to come up with enough votes to block the deal.  But it sure does seem motivated.

Always an advocate of the ad hominem argument (e.g., “You’re ugly!”), I wonder how the directors make out in this deal.

–Southeastern says in its letter it intends to avail itself of  “any available Delaware statutory appraisal rights.”

Here’s what I think this means:  if a tender offer is successful in acquiring 90%+ of a company’s stock, the buyer can go to court and compel the remaining 10%- to tender their shares.  That 10%- have recourse, though.  They can appeal to the court for a hearing to argue that the price is too low.  If successful, they (and no one else) receive the court-determined higher price.

I’ve only followed this kind of appeal once.  The process took three years.  During that period, the company in question deteriorated markedly.  It turned out in hindsight that the acquirer had paid a crazy-high price.  So the court stated the (now) obvious–that the original price was too much.  So the reluctant 10%- ran up a pile of legal bills and got the original acquisition price, only three years late.

I wonder how things will turn out this time.

nits (or maybe slightly bigger issues) to pick

I understand the Southeastern letter only has the bare bones of its valuation argument.  Still, I view DELL has having much less cash than Southeastern assumes.  Yes, it’s there as $$$ on the balance sheet.  But a lot comes from DELL being able to hang on to the money it gets from customers before it needs to pay suppliers–sort of like a restaurant that gets cash every day but only pays for vegetables, rent and power at the end of the month.  Another big chunk comes from advance payments from corporate customers for IT services.  That’s sort of like magazine subscriptions, where the publisher gets money as much as a year before he puts the last issue in the mail to you.  Yes, things are fine in both cases as long as the business expands.  But the money evaporates if the business begins to contract.  As I read the balance sheet, DELL’s cash, net of these timing differences and   debt, is around zero.

Borrowing a gazillion dollars does mimic what I imagine Silver Lake intends to do as/when it takes DELL private.  Pay that out in a special dividend as Southeastern suggests is an alternative to going private, however, and how is the now highly leveraged company ever going to pay the principal back?

I understand that Southeastern wants to use third-party figures in its public analysis, but I find it humorous that its authorities are:  a management whose performance has lost 2/3 of the stock’s market value in a rising market; and Wall Street securities analysts who, as a group, are notoriously optimistic and deeply beholden to company management.

 

 

 

Michael Dell taking Dell Inc. (DELL) private–why?

February 11, 2013 By in Current Market Thoughts, Industry Analysis, Private equity, Recent Market Action, Stock ideas, Technology Tags: , , , , , Leave a comment

the deal

On February 6th, DELL confirmed the rumored buyout of the company by founder Michael Dell and private equity firm Silver Lake.  The board has approved an all-cash deal in which holders of Dell common will receive $13.65 for each share.

The structure of the private Dell isn’t 100% clear.  From press reports, Michael Dell will contribute his 14% holding in the company, worth $3.3 billion at the buyout price, plus $700 million in cash in return for a majority stake in the new entity.

Let’s assume MD’s $4 billion buys a 50% interest.  Given that the overall assets of DELL are being valued at $24.4 billion, this would imply that the private company will have $16.4 billion in debt to go with $8 billion in equity.  That’s a tripling of the financial leverage that publicly traded DELL now maintains–no great surprise for a private equity deal.

DELL is a mess

Profits peaked in 2005, when the company achieved a return on invested capital of an extraordinary 83%.  This year’s results (the fiscal year ends in January) will be around 40% lower than that high water mark, and will likely represent a 15% return on capital.  Strangely, the company has decided to celebrate this adverse turn of fortune by initiating a dividend.

In recent years, DELL has been attempting to transform itself from being an assembler of heavy, clunky (but inexpensive) PCs for mostly corporate users into a purveyor of corporate IT services, using IBM as a template.  Nevertheless, by far its largest expenditure since its profit peak has not been on service company acquisitions or on internal development.  Instead DELL has chosen to retire a quarter of its outstanding shares since 2005, at a cost of (I almost can’t believe the numbers) $22 billion or $23.80 a share.  With the stock was trading at around $8 before rumors of going private surfaced, this continuing decision represented $14 billion in lost value to shareholders.

Since the beginning of 2005, the S&P 500 has risen by 29.6% on a capital changes basis.  Over the same time span, Lenovo is up by 118%.  Hewlett-Packard is down by 12.7%.  Dell has lost 66.8% of its per share market value.  Acer and Asustek have been equally bad performers, although that’s cold comfort.

shock therapy?

That’s what I think this buyout is about.  It’s been clear for years that the traditional PC assembler model is broken.  AAPL’s success clearly demonstrates that.  Samsung has emerged as a very powerful competitor, as have Lenovo, Asustek and Acer.  INTC’s Chromebook initiative and  MSFT’s Surface both show frustration with the lack of competitive relevance of assemblers like DELL and HPQ.  Yet, as far as I can see, DELL hasn’t improved its PC offerings, or its service, much at all.

In my experience, mature companies can resist change in an almost unbelievably stubborn way–the source of the saying that “Turnarounds never happen.”  Maybe managers lack the skills needed to succeed in a new environment, so they simply can’t do a better job.  They may not understand the issues.  Or they may not be risk takers, preferring a mediocre-to-bad present to an uncertain, but possibly better, future.  In any event, they drag their feet.  What can one man do, even the founder of a company, in the face of widespread inertia?

Bring in a whole new management–a firm like Silver Lake that specializes in straightening out mature, underperforming tech companies.  The going private part of the maneuver is at least partly that it’s Silver Lake’s price for taking on the job.

some big DELL holders aren’t happy

Southeastern Asset Management, which owns just under 10% of DELL, is one of them  Reuters reports that there are at least a few others.

Even a cursory glance at a stock chart will tell you why.  Unless the firms in question bought DELL in the last couple of months,  or during the final days of the market meltdown in early 2009, they will be forced to recognize big losses from holding the stock.

They have some justification, since they’ve stuck with DELL through thin and thinner.  This is what value investors do.  They buy mediocre or weakly managed companies and wait for change to happen.  They’ve been right in this case that change would happen, except that it’s coming in a way they didn’t anticipate.

On the other hand, DELL probably needs much more radical surgery than the institutions ever imagined, meaning that it would best be done away from the requirements of public disclosure, from media attention and from the reach of short-sellers.  That way customer confidence is easier to maintain.

 

 

 

 

 

is the income tax preference for private equity justified? …I don’t think so

January 29, 2013 By in carried interest, Private equity Tags: , , , , 1 Comment

simplified preliminaries

Private equity investors raise money from institutional investors.  Those funds become the equity portion of highly debt-leveraged capital cocktails used to purchase underperforming companies.  Once in control of a target company, private equity typically tries to streamline operations.  It cuts overhead (including marketing and R&D) and staff, with the intention of selling the made-over and hopefully more profitable project firm, as a whole or in pieces, within five-seven years. 

Private equity is paid in two ways:  through recurring management fees for its projects, and through a share of the profits when the project company is sold.  Applied to private equity, carried interest refers to the practice of having the private equity managers’ compensation structured, either mostly or entirely, as equity–ownership interests in projects.  As a result, although the compensation sounds a lot like what hedge funds charge, it is taxed as long-term capital gains rather than ordinary income.   This “tax shelter” feature of private equity was highlighted in last year’s presidential campaign, which showed that Mitt Romney’s paid Federal income tax at about a third of the normal salary rate.

most investment professionals pay normal income tax

Last year, Representative Sander Levin of Michigan introduced a bill to close the tax loophole that private equity uses.  Mr. Levin has been quoted as saying that it isn’t fair for investment professionals to pay taxes at a lower rate than workers in other industries.  I agree.  I should point out, though, that Mr. Levin is wrong about one thing.  The income of the vast majority of investment professionals–private equity being the only notable exception–is already taxed as ordinary income.

is there reason for a tax preference for private equity managers?

Do private equity managers perform an important economic and social function that would not be accomplished if their compensation were taxed at normal rates?

The two potentially positive arguments that I can see are :

1.  that private equity managers are an essential part of the “creative destruction” that continually reinvigorates the US economy.  They take idle capital out of the hands of those who use it badly and put  those corporate assets into the hands of people who can employ it more effectively.  Sounds good.  But I haven’t read a single study of the private equity industry that shows conclusively that private equity makes the companies they acquire very much better.  Yes, barnacles get scraped off the bottoms.  But researchers I’ve read conclude that any supernormal returns generated by private equity projects come from the debt-heavy (read: very risky) financial structure they fashion in their project companies.

2.  that they provide counterbidders to trade buyers ( i.e., industrial companies) who would otherwise capture M&A targets too cheaply.  That’s probably true.  But this doesn’t man any extra social good is created.  This is more an issue of into whose pockets the purchase premium goes–the buyers’ or the sellers’.  Private equity tilts the field toward the sellers–who, by the way, happen to be the guys who have spawned and tolerated the inefficient entity.

lobbying legislators has been the key to preserving carried interest (no surprise here)

Heavy lobbying by the private equity industry, both in the US and in Europe, has protected the carried interest tax avoidance device so far.  Not for long, though, in my opinion.  Mitt Romney, a key figure in private equity a generation ago,  became a public illustration of how private equity mega-millionaires use the carried interest loophole to make their tax bills from Uncle Sam all but disappear.  It didn’t help, either, that Mr. Romney was inarticulate and disorganized during the campaign–and completely blown away organizationally and in the use of technology by Mr. Obama.  And Mr. Romney was supposed to be the cream of the private equity crop.  

dissecting the fiscal cliff

November 12, 2012 By in carried interest, Current Market Thoughts, economics, fiscal cliff, Private equity, Strategy Tags: , , , , , , Leave a comment

I’m back home, in the land of electric power and heat, but no internet or TV.  I’m using my phone as a mobile hot spot, but I can’t seem to get a look at the layout of this page.  Sory if the numbers below are hard to see.

Hurricane Sandy humor:

–a runaway Coca-Cola truck knocked down a utility pole on our street on Saturday, splaying live wires all over the place.  Luckily it wasn’t the more important one the big tree knocked down during the storm.  PSEG cleaned up in a matter of hours.

–I called/chatted with Comcast to find out about restoration of internet/TV service.  The two people I spoke with were very nice but said they had no idea.  Both confirmed that Comcast continues to charge customers for service even though there is none.  You have to call them and ask for a refund!!!  Why am I not surprised?

Today’s post:

“Economic Effects of Policies Contributing to Fiscal Tightening in 2013”

On November 8th, the Congressional Budget Office issued an update on its fiscal cliff analysis, titled “Economic Effects…”.  The report makes several points:

1.  “driving over” the fiscal cliff isn’t a good idea

The problem is the domestic economy is still very weak.

The CBO predicts that continuing Washington stalemate would cause a short but sharp recession in the US during the first half of next year.  Growth would resume from the crunch, but from a lower level, in the second half.  But this would be by a small enough amount that real GDP would still end up in the negative column for the full year.

More important, unemployment would spike upward to an estimated 9.1% a year from now, postponing the return to economic normality for the country (meaning reduction in the unemployment rate to 5.5%) until early in the next decade.

2.  the status quo isn’t so hot, either

Continuing the current situation where Washington continually spends more than it takes in will ultimately force interest rates in the US–both for the government and for private borrowers–higher than they would otherwise be.  Maybe a lot higher.  At some point we’ll have a repeat of 1987, when domestic lenders refused to buy any more government debt and the long bond spiked to 10%.  The CBO implies that this is only a remote possibility at present.  But as the debt grows the problem becomes progressively harder to solve.

3.  the long-term solution

(I haven’t seen anyone write about this.)  For the CBO, two moves are important.

–broaden the tax base, don’t raise rates.

–reduce entitlement spending.

4.  in the short term, however…

(short = the next two years)

…postpone part or all of the fiscal cliff elements.  Address the deficit issues in an aggressive way in 2015, when the economy will presumably be healthier and unemployment lower. That way, we have a much better chance to get chronic unemployment under control.  If so, we’re likely to reach full employment in 2018–a time when we can attack the government fiscal mess in a more serious way.

5.  components of the cliff

The numbers are the boosts to real GDP that each would likely provide:

extend expiring income tax provisions for everyone          +1.4%

do so, but omit high-income earners                        +1.3%

extend payroll tax reduction, emergency unemployment benefits             +.7%

eliminate defense spending cuts               +.4%

eliminate non-defense spending cuts          +.4%.

my take

–The CBO analysis doesn’t take anticipatory effects into account.  In other words, it doesn’t address the issue of whether the slowdown in growth we’re now seeing in the US is adjustment in advance to the worst-case (“driving over”) scenario.  If so, the positive economic effects of breaking the logjam in Washington could be greater than the CBO estimates.

We can certainly see effects in the number of M&A deals being done before yearend—DIS/Lucasfilms is a good example.  But there are lots of others.

–Whether income tax rates rise for high-income filers has very little economic significance.  +/- 0.1% in GDP growth amounts to a rounding error.

–From a stock market perspective, the Obama-proposed increase in the tax on dividends is the key possible change that I see.

–Generally, I’m skeptical about arguments that depend on “fairness,” because I think the concept is so perspectival.  In a lot of cases, “fair” equates to just “I get more and you get less.”  Having said that, I think one of the most un-fair things in the tax code is Romney-esque carried interest, whereby high net-worth financiers turn ordinary income into capital gains.  I wonder if that loophole will be closed.