Category: Economics

The Economic Effects of Private Equity: Good or Bad?

It depends.

But it’s certainly not the scourge portrayed by the Stop Wall Street Looting Act. That bill is clearly myopic in equating private equity with leveraged buyouts. Even with that subset of private equity, the results of leveraged buyouts are not bad for the underlying companies.

In a recent paper a group of economists looked at the data. They jumped in data from CapitalIQ and collected a sample of 9,794 private equity led leveraged buyouts. They divided those deals into four groups: the buyout of an independent, privately held firm (private-to-private), the buyout of a publicly listed firm (public-to-private), the buyout of part of a firm (divisional), and the sale of portfolio firms from one PE firm to another (secondary).

Does a PE buyout result in job losses. According to the paper, relative to control firms:

  • In private-to-private buyouts employment at targets rises 13 percent
  • In secondary buyouts, employment rises 10 percent
  • In public-to-private deals employment falls by 13 percent
  • In divisional buyouts, employments falls by 16 percent

That’s a push. One would assume that one of the reasons a public company ends up under-valued and in the sights of PE firms is that its underperforming.

To support that, the research shows a rise in labor productivity of eight percent at target firms. The researchers note that as striking given that the target firms tend to be mature firms in mature industries.

I think the problem is the public perception of private equity caused by poor results in public-to-private deals, like Toys ‘R Us, catch all the headlines, while the run of the mill deals with good success or great success don;t make the headlines.

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Weekend Reading: Can You Outsmart an Economist?

Can I outsmart the economist Steven Landsburg? I tried getting the answers right in his new book: Can You Outsmart an Economist?

The answer: No. I can’t.

Mr Landsburg’s book present us with 100+ puzzles to illustrate some principles of economics. The puzzles bleed into understanding the interpretation of those principles in statistics, law, math, science and philosophy. You can see the political implications of some of these puzzles as well.

The publisher provided me with a review copy and I felt ready for the challenge.  I felt pretty good as I went through the warm-ups questions in chapter 1. I didn’t get them all correct, but I quickly realized my errors.

The questions got harder and more in depth. Sometimes I got the right answer. Other times I did not. But I learned quite a bit. The book is less about the quizzes than it is about the principles each question is trying to get across to the reader.

You can test yourself.  Can You Outsmart an Economist? goes on sale September 25.

No BitCoin ETF

I’ve said before that BitCoin is the Dutch Tulips of investments. The blockchain approach to recordkeeping is an interesting use of decentralized computed power for recordkeeping, but BitCoin units are less interesting. The main users are less than scrupulous users looking for ways to avoid things like anti-money laundering rules.

Many bankers/traders see BitCoin as a way to make money. All of those transactions and lack of regulation seem ripe for profit-making.

One tactic has been to set up an ETF to track BitCoin prices. Much a like a gold ETF means you don’t need a safe and security guard for gold bars. A BitCoin ETF would allow you profit on runaway BitCoin prices without having to get involved with all of the technical stuff of BitCoin.

I should say, at least people are trying to set up a BitCoin ETF. Two requests have been denied recently. The decisions from the Securities and Exchange Commission state that they fail to “to prevent fraudulent and manipulative acts and practices” and fail “to protect investors and the public interest.” In an identical statement for the two rejections:

The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter.  First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.

One problem that surfaces is that is hard to pin the value of BitCoin. The Chinese exchanges for BitCoin have become a separate market from the US. Even in the US, there are different exchanges with different values. Each of the rejected ETF planned to use a different measure for the ETF value.

The linchpin in the SEC’s denial is the lack of regulation. The very thing that attracts user to BitCoin, the lack of government oversight, is the main reason the SEC rejects the ETFs.

For the commodity-based EFTs approved so far, there have been well-established, significant, regulated markets for trading futures on the underlying commodity. Those are gold, silver, platinum, palladium, and copper.

BitCoin is not to the SEC’s liking.

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President Trump’s Two for One Regulatory Reduction Is Headed to Court

It seems like just a week ago that President Donald Trump signed an Executive Order requiring two regulations be repealed for every new one adopted.  It was. And this week a lawsuit has been filed challenging that executive order.

The lawsuit was filed by Public Citizen, the Natural Resources Defense Council and the Communications Workers of America. In addition to President Trump, the lawsuit tags the Acting Director of the OMB and the current or acting secretaries and directors of many government agencies.

The Securities and Exchange Commission is noticeably absent from the list of defendants. I guess the plaintiffs concluded that the SEC is independent and not subject to the Executive Order.

The plaintiffs are asking the court to prevent the agencies from implementing the order and to kill the executive order because it cannot be lawfully implemented.

According to the complaint, the executive order to repeal two regulations for the purpose of adopting one new one, based solely on a directive to impose zero net costs and without any consideration of benefits, is “arbitrary, capricious, an abuse of discretion, and not in accordance with law.” The complaint spells out the three big reasons the plaintiffs think so:

There is no statute that tells agencies to withhold regulations because of cost. Of course there is the cost-benefit requirement for some regulations. But that is different than saying there are no costs imposed by the regulation.

Second, the Executive Order forces agencies to repeal regulations that have gone through the administrative process and concluded that they comply with the enabling statute and advance the purpose of the statute. The complaint stops short, but in my view the argument is that the Executive Order is trying overturn legislation passed by Congress authorizing regulation.

Third, no governing statute authorizes an executive agency to base its decision making on there being zero net cost across multiple regulations.

The second argument is certainly applicable to many of the financial regulations imposed by Dodd-Frank. The SEC is taking steps to rollback the Extraction Disclosure Rule.  A rule that was specificaly required by Dodd-Frank.  (Of course, the SEC is not specifically subject to the Executive Order.)

The two big problems with the lawsuit are standing and ripeness.

Two of the causes of action are violations of the constitution, violating the separation of powers and the Take Care Clause. That last one is new one for me. Under Article II, Section 3, the President has duty to “Take Care that the Laws be faithfully executed.” I’m skeptical that individual citizens have standing under these provisions. Congress is not about to bring suit.

The other causes of action would seem to not be ripe for suit until an agency actually starts trying to repeal regulations because of this order.

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Tesla, Self-Driving Cars and Compliance

Tesla Motors is under investigation by the Securities and Exchange Commission for failure to disclose that one if its car crashed while in self-driving mode. The question is whether whether Tesla should have disclosed the accident as a “material” event: a development a reasonable investor would consider important. That opens a bigger question about the nature of driving.

red-tesla-model-s

Take a look at the IIHS Fatal Crash data:

There were 29,989 fatal motor vehicle crashes in the United States in 2014 in which 32,675 deaths occurred. This resulted in 10.2 deaths per 100,000 people and 1.08 deaths per 100 million vehicle miles traveled. The fatality rate per 100,000 people ranged from 3.5 in the District of Columbia to 25.7 in Wyoming. The death rate per 100 million vehicle miles traveled ranged from 0.57 in Massachusetts to 1.65 in South Carolina.

Humans are far from perfect and we do a fine job of killing ourselves behind the wheel. The fatality rate has improved over the last near century of car use.

USA_annual_VMT_vs_deaths_per_VMT

The red line of deaths per mile travelled is flattening out, indicating to me that we can not eliminate fatal car crashes. Humans are not perfect.

Self-driving cars will not be perfect. There will still be crashes and there will still be fatal crashes. The big question for self-driving cars is whether they will do better than humans at keeping ourselves alive behind the wheel.

In looking at the SEC inquiry, the question is whether the fatal crash was a material event that should have been disclosed.

According to Tesla’s news release their cars have driven for 130 million miles on Autopilot and this is the first death. That’s a rate of 0.77 deaths per million miles driven.

According to that IIHS data, that rate is less than the nationwide average of 1.08 deaths and less than the Florida average of 12.5 deaths.  At least statistically, it does not seem material to investors. (It’s obviously very material to the family and friends of the crash victim.)

Google cars have driven more than 1.3 million miles since 2009. Those cars have been in at least 18 crashes, 17 of which were blamed on other drivers.

Can self-driving cars do a better job than humans?

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BE-10 Survey Requirements: What Private Equity Funds Need to Know

Under the International Investment and Trade in Services Survey Act of 1977, the U.S. Bureau of Economic Analysis in the Department of Commerce conducts a “benchmark survey” of U.S. direct investment abroad every five years. U.S.-based companies with ownership of “foreign affiliates” are required by law to participate in the survey by completing and submitting a series of forms known as the BE-10 survey. It’s been a while since fund managers have seen this request and my wonder if it applies. (It does.)

BEA_LOGO_2PMS [Converted]

Private funds may be required to participate in the BE-10 survey if they own “foreign affiliates,” either directly or through portfolio companies they control. The initial deadline for completion of the survey was June 30, bu the BEA has granted extensions for private funds that requested them through August 31.

In particular you should note that willfully failing to fill out the survey could result in criminal punishment. At least that it is what the instructions say.

The Association for Corporate Growth and the U.S. Bureau of Economic Analysis will be holding a webinar on Thursday, July 16 at 2:00 p.m. ET to discuss how the BE-10 survey applies to private funds and answer questions.  This webinar will explain the filing requirements, offer tips and answer questions to assist private funds in completing the survey.

Click here to register.

The BEA wants to hear from you! Submit your questions for this webinar in advance to [email protected] or [email protected].

Asset Management and Financial Stability

Asset management report cover

The US Office of Financial Research recently released a report raising concerns that the largest asset managers could pose a threat to financial stability. That puts firms like BlackRock, Deutsche Asset & Wealth Management, Prudential Financial, AXA Investment Managers, MetLife, Invesco and UBS Global Asset Management in the cross-hairs of being considered “systemically important.”

The Financial Stability Oversight Council decided to study the activities of asset management firms to better inform its analysis of whether to consider such firms for enhanced prudential standards and supervision under Section 113 of the Dodd-Frank Act. Section 113 gives the FSOC the power to designate a non-bank firm as a “systemically important financial institution”. Being considered “systemically important” means heightened supervision by the US Federal Reserve and also makes the firm subject to risk-based capital requirements and leverage rules.

The FSOC asked the Office of Financial Research to step in and collect data. The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Office of Financial Research within the Treasury Department to improve the quality of financial data available to policymakers and to facilitate more robust and sophisticated analysis of the financial system.

This report is the first step to seeing greater regulatory control of large asset managers. According to the Report, the U.S. asset management industry oversees the allocation of approximately $53 trillion in financial assets.

The Report asserts that separate accounts managed by large asset managers are less transparent than those of mutual funds, banks, and private funds because the activities are not publicly reported.

The Report identifies four key factors that make the industry vulnerable to shocks:

(1) “reaching for yield” and herding behaviors;
(2) redemption risk in collective investment vehicles;
(3) leverage, which can amplify asset price movements and increase the potential for fire sales; and
(4) firms as sources of risk;

To me, (1) and (3) seem to miss the point of separate accounts. Pension plans and institutional investors usually choose a separate accounts strategy to have greater control over their investments. The active involvement of the separate account holder acts as a control against the asset manager reaching for yield or using excessive leverage.

Of course, the findings in the Report do not mean that the big asset managers are imminently subject to additional regulatory oversight. There is a lengthy process for designated a firm as “systemically important.” However, this report could lead to adverse regulation that might adversely impact the separate account business of large asset managers, including those with real estate investment management platforms.

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How Much Did the Stimulus Affect Unemployment? Not Much

stimulus and spending

While the New York Fed is increasingly tasked with regulating financial institutions, its bread and butter is economic analysis. A recent report debunks the theory that the stimulus spending lowered unemployment.

James Orr, vice president in the Federal Reserve Bank of New York’s Research and Statistics Group, and John Sporn, a senior analyst in the Federal Reserve Bank of New York’s Markets Group, analyzed $860 billion (6 percent of GDP) stimulus contained in the 2009 American Recovery and Reinvestment Act, adopted in the context of rising unemployment rates.

Their analysis of the distribution of ARRA funds across states shows that the expanded assistance to unemployed workers was highly correlated with state unemployment rates. However, most other state allocations had little association—positive or negative—with state unemployment rates. You can see that reflected in the chart above.

In this battle of Keynes vs. Hayek, it looks like Hayek won.

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S & P and the SEC

standard and poors

The Securities and Exchange Commission took the bold step of filing charges against Standard and Poor’s, one of the three giant rating agencies. Personally, I think the role of rating agencies in the run up to the 2008 financial crisis has been under-appreciated. Without the the top AAA rating they bestowed on securitized mortgage bonds, the flow of cash into those toxic instruments would have stopped much earlier and decreased the size of the bubble.

The SEC complaint claims that S&P continued to give subprime mortgage securities high ratings as the the securities looked increasingly fragile and financial crisis began to bubble to the surface. In the first half of 2007, S&P rated a large number of large mortgage-backed securities, bestowing top grades on the investments. It then quickly downgraded the securities, which defaulted in months.As a result, federally insured banks incurred losses. That gives the SEC jurisdiction.

As with any government investigation, the SEC found emails saying stupid things. In one case there is a March, 2007 satire in an email based on the Talking Heads song “Burning Down the House”:

“Watch out
Housing market went softer
Cooling down
Strong market is now much weaker
Subprime is boi-ling o-ver.
Bringing down the house.”

The SEC claims that S&P knew that the performance of non-prime residential mortgage backed-securities was bad and getting worse. The firm expected deals to rush in before those packaging the mortgages were stuck with them on their books.  The SEC takes individual instances of ratings failures by S&P and ties them to losses sustained by the banks that bought them.

Another e-mail from an analyst in response to a question about how his new job was going reads:

“Job’s going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we’re all running around to save face … no complaints.”

But then went on to state the central part of the case:

“The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.”

….

This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats [sic] up with that? How are you possibly supposed to be impartial????

There is an unforgiving conflict in the way mortgage bonds were rated. The issuer pays for the ratings work. So there is an incentive by the ratings agency to met the issuer’s expectations, keep them happy, and retain their business.

Finally, in July, 2007, S&P downgrades 612 classes of RMBS, totaling $12 billion in securities. Of course it was too late for the securities that S&P had favorably rated just days and weeks earlier. It is the ratings issued between March and July of 2007 that the SEC is focused on this complaint. The SEC claims that S&P could see the walls crumbling, but held back saying anything to appease the pipeline of deals in the works.

My big unanswered question is whether the SEC is going to make a similar case against Moody’s and Fitch.

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Manufacturing Jobs, Robots, and the Economy

We still make lots of stuff in the United States. China is our closest competitor. The two countries are very close at the number 1 and number 2 positions of manufacturing output.  In the past decade, manufacturing output in the US has risen by a third. What hasn’t risen is the number of jobs in manufacturing. In the last ten years, those have decreased by a third. About 6 million jobs disappeared.

Adam Davidson of NPR traveled to South Carolina to get a better picture of what has happened. In Greenville, he found shuttered textile plants but found lots of hi-tech factories.

The double shock we’re experiencing now—globalization and computer-aided industrial productivity—happens to have the opposite impact: income inequality is growing, as the rewards for being skilled grow and the opportunities for unskilled Americans diminish.

Its going to get worse for unskilled workers. A factory owner puts it bluntly. He is willing to invest in a machine that will earn back its cost in two years. If a robot can do your job, hope that it costs at least twice your salary.

This all leads back to thinking about the Great Recession that come from the 2008 financial crisis and comparing it to the Great Depression. One theory is that the Great Depression stemmed from the movement from agricultural jobs to manufacturing jobs. It’s starting to look like the Great Recession stemmed from the movement away from manufacturing jobs. We were using residential real estate as a piggy bank to help through the transition, but we eventually broke the piggy bank.

The latest numbers from the end of 2011 show some solid signs of job growth and consumer borrowing is on the rise. it seems clear from Davidson’s story that some of the jobs will never come back. It’s more important than ever to invest in education and training.

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Image of a closed factory is by Rubbertoe