[R-G] [BillTottenWeblog] The Predator's Ball Resumes

[Bill Totten]

Financial Mania and Systemic Risk

An interview with Damon Silvers.

www.multinationalmonitor.org (May/June 2007)


Damon Silvers is an associate general counsel for the AFL-CIO, where he
works on corporate governance, pension and general business law issues.
Silvers led the AFL-CIO legal team that won severance payments for laid
off Enron and WorldCom workers. He is a member of the Public Company
Accounting Oversight Board Standing Advisory Group, the Financial
Accounting Standards Board User Advisory Council, and the American
Academy of Arts and Sciences Corporate Governance Task Force.

Multinational Monitor: What is private equity?

Damon Silvers: Private equity is a term that was designed to mislead
people. The term encompasses all sorts of investment funds that take
controlling interests in companies that are not public - private
companies - through holding equity in them. And it confuses basically
three kinds of very different investment strategies.

The first, venture capital, involves investing money in companies that
are in their early stages, with new ideas and technology. The hope is
that the company will ultimately be a big success and everybody that was
involved at the ground floor will get very rich. That type of investment
usually involves no or little debt or leverage, because people are
reluctant to lend money to ventures pursuing untried ideas.

The second area of private equity is what's called the vulture fund.
Vulture funds invest in companies that are in trouble, often by buying
the debt of companies that are either bankrupt or about to go bankrupt,
and thereby gaining control over them. This is also a type of investing
that, oddly enough, involves relatively little borrowing.

The third category, which has come to overshadow the other two, is
leveraged buyouts. Leveraged buyouts were a big deal in the late 1980s
and early 1990s. They involve buying a company by putting up a little
bit of money as equity and borrowing the rest. When leveraged buyouts
really get going, leveraged buyout investors tend to borrow at least
eighty percent of the purchase price and put up no more than twenty
percent as equity.

The firms that you read about in the newspapers these days as "private
equity firms" are almost entirely leveraged buyout firms. Leveraged
buyouts got a bad name in the 1980s because they were associated with
enormous job losses, and radical shrinkage and breakup of companies.
Ultimately, they overleveraged, which led to some of the very big deals
of the 1980s either collapsing or being relatively poor investments for
long periods of time.

When this kind of activity got going again in a big way about two years
ago, the deal-making firms decided rather than call it leveraged buyouts
again, they would call it private equity. That blurred the distinction
between what they were doing and, say, investing in new technology,
which most people think is a relatively good idea.


MM: What is a hedge fund and how does private equity relate to hedge funds?

Silvers: A hedge fund is another term that doesn't tell you much about
what it really is.

A hedge fund is an informal term for an investment fund that operates
under a Securities and Exchange Commission (SEC) exemption. If you're
running an investment fund, you typically have to register with the SEC
and comply with the rather extensive set of regulations designed to
protect investors. The exemption is that if you're only taking
investments from sophisticated investors - from large institutions and
wealthy individuals - you have an exemption from these securities rules.
In the last 25 years or so, people have used this exemption to put
together investment funds that both buy stock, called going long in the
investment parlance, and take positions that essentially bet on the
stock or the bond or the other instrument going down, which is called
shorting. If you mix short and long positions, that can potentially be a
way of restricting the risk in your long position.

Here's how this might work: An auto company benefits from low interest
rates; more people buy cars when they can borrow with less expense. You
buy the stock of an auto company and then you short debt instruments
which also do well when interest rates are low. Then, if interest rates
rise, your exposure to losses in your auto stock is hedged by your short
position in the credit instrument.

These unregistered investment funds pursued this type of strategy, so
they became known as hedge funds - they were involved in investment
strategies that hedged risk. But the truth is that a hedge fund can do
pretty much anything. It can invest in any type of security and it can
invest in any type of strategy. It can make private equity investments.
As somebody once said, a hedge fund is really a legal category in search
of an asset class.

Hedge funds and private equity have a couple of things in common. Hedge
funds, like private equity funds, or leveraged buyout funds, tend to
borrow money - they tend to leverage their investments. That is, they
have a pool of money that people have given them to invest, and they go
to a bank, or some other lender, and borrow money to invest in more
assets than they could have had they just taken the money they had been
given by their investors. If the investments do well and return more
than interest costs, then the fund can increase the rate of return for
its investor. So both hedge funds and leveraged buyout funds, or private
equity funds, live off of cheap debt. But this type of strategy is quite
risky, because if your investments fail, your fund goes bankrupt much
more quickly than if it wasn't leveraged.

The second thing they have in common is that they're both opaque. Both
hedge funds and private equity funds, in general, tell the government
regulators and the investing public relatively little about what assets
they have, which strategies they're pursuing and what they're doing with
the money that they invest.

These two characteristics - the fact that they rely on leverage and that
they're opaque - have led many academics, regulators and investor
advocates to be concerned about the impact of these two categories of
investment vehicles on our market system as a whole.


MM: To the extent these funds are opaque, do the big institutional
investors have more insight than either an average person, or even an
average rich person?

Silvers: Very, very large investment funds tend to know more about the
hedge funds and private equity funds that they invest in than the
average person or the average small institution.

As for rich people, there are rich people and rich people. If you're a
mere millionaire, if you're investing $5 million or $10 million, you
don't know anything anyone else doesn't know. On the other hand, if
you're Bill Gates, or basically if you have hundreds of millions of
dollars to invest personally, then you can play in this league. If you
have very smart people working for you or you're personally attentive,
you can have access to information that other people don't have.

Because of the networks of wealthy individuals involved in this type of
investing, I think some of those people may actually know more than the
institutions. But it depends on the institution and it depends on the
rich person.

There are certainly institutions that specialize in this area that are
extremely well informed. The most obvious ones and the most prominent
ones have been university endowments: Harvard, Yale and the University
of Texas, which have invested very large portions of their assets in
both hedge funds and private equity funds, have done very well and are
very embedded in information networks around those funds.


MM: Can you elaborate on how hedge and leveraged buyout funds pose
systematic risks?

Silvers: First, let's talk about dollars. No one really knows because
these markets and this landscape changes very quickly, but there's
probably between $1 trillion and $2 trillion today invested in hedge
funds globally, and probably close to a trillion dollars in various
kinds of leveraged buyout firms. Again, who knows what's happened since
the recent market turmoil, but that's the basic landscape. These funds
have borrowed a lot of money on top of that. And again, no one really
knows exactly how much. But a good estimate is the leveraged ratio
across this whole asset category is at least fifty percent, so you're
talking about potentially $4 trillion or $5 trillion invested,
controlled and in the marketplace through these funds. That's enough
money to move markets. And it is enough borrowing to potentially affect
the stability of the global banking system.

On top of that, hedge funds - this is not so much the case with private
equity funds - can do anything they want, literally anything, unless
they've signed a contract with their investors limiting their investment
behavior, which most don't. Other types of money management, like an
insurance company or a mutual fund, must tell their customers what their
investment strategy is and have a legal obligation to stick with it;
mutual funds also have legal obligations to maintain relatively
diversified portfolios. The implications of that for systemic risk are
profound. On a given day, a hedge fund could make a very large leveraged
bet any place it wishes. It could take a very large leveraged short
position in the currency of any given country; it could take a very
large long position on the stock of any given company, or the bonds of
any given company, or a particular mortgage-backed security. I don't
suggest that any particular hedge fund is doing this, but nothing is
stopping one from doing so if they want to. This ability to concentrate
and leverage risk, and to do so with relatively little disclosure and to
shift what they are doing very rapidly, makes these funds particularly
capable of causing systemic risk.

In what manner am I talking about? If a hedge fund borrows money to take
a large position in a security and then that security or that pool of
securities collapses, or it turned out to be worth a lot less than the
hedge fund thought it would be worth, what happens? First, the investors
in that hedge fund can lose their money very fast. Then the institutions
that lent money to that hedge fund will find themselves out of luck. If
the borrowings are large enough, the financial stability of the lenders
could be implicated. If that begins, then it's not just that lender and
those transactions at stake. A general doubt could be triggered in the
marketplace about the creditworthiness of hedge funds and the
enterprises that lend to hedge funds.

We have seen something like that go on in the last few months in a
series of cascading credit markets. It turned out that mortgage pools
that were represented to be credit worthy were not credit worthy. There
were defaults in the underlying assets (people could not pay off their
mortgages). Then the people who'd invested in those funds, and borrowed
money to do so, lost a lot of money and in some cases went under. Then a
broader doubt began to grow in the credit markets about the credit
worthiness of other funds that had similar structures and similar credit
ratings. All of a sudden one day in August, no one was willing to
purchase certain types of asset-backed commercial paper - in markets
that a month earlier had been considered close to completely risk-free.

Credit markets have dried up and businesses have failed over the last
couple of months because of this systemic cascade of doubts about the
credit worthiness of whole sets of market participants, and then because
of actual failures like with the Bear Stearns funds. And I suspect that
we will see more of this in the next couple of months. How much more, I
don't think anybody knows.


MM: What's the incentive for the private equity firms to put the deals
together?

Silvers: To get very rich, astoundingly rich!

It's inherently the case that if you borrow money to buy an asset and
the asset performs well then you'll make a lot more money than if you
pay 100 percent cash - 100 percent equity - for that asset.

Think about a home. Suppose you buy a house for $100,000, put $20,000
down, and in the course of time the value of the house doubles. You've
made $100,000 profit on your $20,000 investment. That's a five-fold rate
of return. If you buy with cash, you put $100,000 down, you double it,
you've made a two-fold rate of return. The difference is big.

That principle is what drives leveraged buyouts. If you buy companies by
borrowing money, you can make a lot of money. But you're taking a risk.
The risk is if instead of going up, the value of your company goes down,
or your company starts to lose money, very quickly the equity in the
company will be exhausted and the company will be bankrupt. If the
company was financed largely with equity, it will have a greater ability
to absorb economic downturns.

The labor movement obviously is very concerned about what happens when
large pieces of our economy are financed through leverage. Companies
become more vulnerable to economic instability, and so are workers. And
so we have a problem with the widespread use of this type of leverage in
buying and selling real companies that do real things and employ real
people.

This inherent nature of leverage, of debt, is bolstered and multiplied
with all of the tax subsidies that go to private equity firms.

Payments on corporate debt are tax deductible, whereas payments to
equity are not. This means that, once you take the tax effect into
account, any given company can support much more debt than it can equity.

A second tax subsidy that has been widely publicized is the carried
interest rule. The private equity guys have structured their companies
in the form of limited partnerships, and have persuaded the IRS against
the obvious evidence that the money the private equity firms make as
management fees should be treated as though they weren't management fees
but actual returns on investments. That allows them to pay taxes at a
capital gains rate on their income rather than paying income tax rates
like the rest of us pay.

The punch line is that the people that run private equity firms,
leveraged buyout firms - who are many of the wealthiest people in the
world - are paying income tax rates on much of their personal income
that is in some cases half the rate paid by most middle-income people in
the United States. That is obviously something that the labor movement
is viscerally opposed to. Increasingly, on a bipartisan basis, a lot of
people in Congress also think this is just outrageous and ought to be
stopped.


MM: How would a leveraged buyout firm put a deal together? What are the
steps?

Silvers: First, you have to have some money to invest. If you're a
private equity manager, you go around to wealthy individuals and pension
funds and university endowments and foundations and you collect money.
Then you have a pool of money, which is structured as a partnership.
You're the general partner and the investors are all limited partners.

Then you look for a company which is undervalued versus what your
analysts think it's really worth. Let's assume it's a public company.
You put a bid together for that company. You go to banks and get a
commitment letter from those banks. The commitment letter says that if
for some reason this company is unable to raise money by selling bonds,
then the banks will lend this company the money to cover the purchase price.

With the commitment letter from the banks, you go to the management of
the company and say, "We'd like to buy your company. We'd like you and
your board to vote to sell the company to us, and we will pay some
premium over what the stock is trading at today. And by the way, we will
offer you guys - the management of the company - the opportunity to work
for us going forward, in the company after we control it. And we will
give you large stakes in the equity in this company, much larger than
you have today in your role as managers in a public company." The idea
is to incentivize management to recommend to the shareholders that the
company be sold at the price the leveraged buyout firm would like to buy
it at. The subtext may be that the firm would prefer that management
sell at a price lower than what the company might really be worth.

Assuming this approach to the company works and the shareholders vote
the transaction through, then immediately the private equity firm goes
to the bond market and borrows the rest of the purchase price. But the
private equity firm is not the borrower, the company it has just bought
is the borrower. So for every dollar's worth of shares that the private
equity fund buys to take control of the company, the private equity firm
pays maybe twenty cents and borrows eighty cents. Now they own the company.

When they own the company, the private equity firm looks for ways to
make money off the company. What they'll typically do is look for ways
to cut costs. Increasingly, they will also look for ways to very quickly
pay out dividends to themselves as the equity holders. And sometimes
this will involve actually borrowing more money on the company's credit
to pay out to themselves - this is called a leveraged recapitalization.
And it's resulted in companies being leveraged up over ninety percent.

Then the private equity firm will hold the company until it is
economically advantageous to sell it back into the public markets. They
cut costs, dress up the company to be as attractive as possible to the
public markets and sell it back, aiming for a price significantly higher
than the one they paid. Then they pay off the loans and pocket the
difference for the private equity fund. Private equity funds say that
their timeline for selling back into the marketplace is three to five
years. During this boom period that's occurred over the last couple of
years, in some cases that flipping period has been less than a year,
particularly for some European-based deals.

This is a cycle. You borrow money, you buy companies out of the public
market, you tinker around with them, and then you sell them back into
the public market. The fact that it is a cycle goes to show that
leveraged buyout (LBO) firms are not a substitute for the public
ownership of large corporations. They are a phenomenon that lives off of
the public markets. They take companies in and out. They depend for
their success on their ability to sell back into the public markets.

On occasion, you'll hear academics and some in the media talk about
leveraged buyouts or private equity as the new form of corporate
governance. It's nothing of the kind.

It's exactly what was done in the late 1980s. It's not going to replace
the public markets, it's simply going to live off of them as long as the
credit market conditions are advantageous to this type of business.

By the way, the credit market conditions flipped against them this
summer, and I think we're going to see a lot less private equity
leveraged buyout activity in the next year or two as a result.


MM: What does it mean when you say that the leveraged buyout firms are
trying to find ways to cut costs? Why do they have any better ideas to
cut costs than the company did when it was publicly traded?

Silvers: They'll say that it's because they're smarter, that they know
how to do better with their businesses than the managers who managed the
business before. It may be true that some of these firms are run by very
smart people, but there really isn't much evidence that, as a group, the
people who run leveraged buyout firms know how to run any particular
line of business better than anybody else.

In fact, there's a lot of evidence, built over decades, that financial
management of business enterprises without any sort of industry-specific
talent, is poorer at running businesses than people who really know the
business. Some academics have compared private equity firms in this
sense to conglomerates, which were all the rage in the 1970s, but did
not perform well. A leveraged buyout firm is just another organization
that owns a bunch of unrelated businesses - why should they be any
better at it than the conglomerates were?

What LBO firms do have - and this is part of the reason why LBOs got a
bad name - is a relatively short-term time horizon, and they're
sophisticated about the capital markets that they operate in. They tend
to be more willing to undertake short-term-oriented business decisions,
because they're not going to have any interest in that business after
their flip date.

This has led a lot of people in the labor movement to view private
equity firms, as a whole, as being relatively more willing to cut
companies' cost structures - meaning their employees, their capital
investment - to levels that will in the long run make the business not
sustainable, in the interest of making the company appear to be more
profitable than it really is on the flip date. To the extent that the
markets can be fooled by this type of activity, it's certainly in
private equity firms' interest to do it.

There are some people who believe capital markets can't be fooled and
they sort of take it as an article of faith that therefore nobody tries
this kind of strategy. My own view is that after Enron and WorldCom, you
just can't really credibly say that capital markets can't be fooled.
There's just tons of evidence that they can be fooled and are fooled
every day. And the private equity firms have an incentive to fool
capital markets by dressing up their companies to look like they're
healthy and capable of generating very high rates of return over a long
period of time, when in fact what's happened is that they've been
gutted. The LBOs have under-invested in both human capital and physical
capital, and cut their employee levels to the point where they can't
actually produce value.


MM: Why do creditors go along with a ninety percent leveraged business
model?

Silvers: I think they're more or less not going along with it now, but
they go along with it during periods of leverage-mania because it's
profitable. When credit is cheap, they can put money into these deals,
get a lot of fees out of them and gain the interest payments.

For banks, I think it has a lot to do with the way people are
compensated, and so forth. Bond lenders do what they do because they are
relying more or less on credit ratings. There's not enough data yet to
really be sure what has happened during this mania, but in the housing
market we know that credit rating agencies have been willing to rate
pools of mortgages that were clearly risky as though they were not risky.

There is a larger issue overhanging all of it, which is that there's
been an enormous glut in fixed-income financing in the last few years.
This has produced what a number of central banks and international
economic authorities have described as a compression of risk spread. And
this is really, in our view, the source of the private equity, and to a
great extent, the hedge fund boom.

It's been possible to borrow money to do things that are quite risky,
like leveraging a company ninety percent, without having to pay very
much to do it.

In theory, if you're going to borrow to do something really risky,
you'll have to pay a very high interest rate because there's a
significant risk that you'll go under and won't be able to pay off your
debts. The kind of people who lend to risky enterprises make multiple
risky loans with high interest rates, knowing that some will go under
and the high interest rates will pay for those which go under.

The last few years, it's been possible to borrow money for very risky
enterprises with a very low spread to non-risky borrowing, say a
treasury bill. That compressed risk spread has fed this boom.

Where does the compressed risk spread come from? It came from a glut of
dollar-denominated debt investing. And there's two sources of that. One
source is that the Fed has been pumping dollar-denominated money into
our economy since 2001 in an effort to end and hold off recession. The
other source of it is the US trade deficit, which has produced an
enormous pile of dollars in the hands of our trading partners, in
particular China and Japan. In China, which is the holder of the bigger
pile of dollars, the government has concluded that they wish to reinvest
those dollars almost entirely in fixed income, in debt securities. So
there's a trillion dollars in Chinese sovereign holdings in US dollars
being put to work in the debt markets worldwide. That has fed the
private equity boom, the hedge fund boom and the real estate boom.

Now suddenly, in recent months, this whole process has come to a
screeching halt as a whole chain of lenders, starting in the housing
area, have discovered that they weren't getting adequate compensation
for their risk, and that there's a lot more risk in these debt markets
than they thought.


MM: What has been the scale of private equity in the United States and
globally?

Silvers: There's more than a trillion dollars involved in this type of
investing. It's a global phenomenon. It is significant in the United
States, but much more so in Europe. One academic source has estimated
that 25 percent of the British workforce in the private sector today
works for a company that is owned by a leveraged buyout firm. That's an
extraordinary number, a little hard to believe. There are similarly high
numbers in other European economies. In the United States, the number is
nowhere near that. Our economy is much bigger and the scale of leveraged
private investing in the United States in relation to our economy is
nowhere near where it is in some of these European countries.

But there is no questions that, as a whole, in the last three or four
years, leveraged private investing has gone from a relatively minor
feature of the world's economy to a very significant one, particularly
in Europe. It's no coincidence that Europe is where the political war
over the behavior of the leveraged buyout firms is at its most intense.
The collapse of the risky credit markets in the last few months may, at
least temporarily, put a stop to this particular mania, but we just
don't know. And there isn't much information today to be sure what
exactly the ultimate consequences of the mania are likely to be.


MM: Should governments impose measures that would make it more difficult
to do these deals?

Silvers: The public policy issues surrounding this are completely
dominated by the political and economic power of the actors in this game.

In private, as far as I know, there isn't a single economist that will
tell you that the tax subsidy to corporate debt, which private equity
funds live off of, has any basis. I'm not just talking about left-wing
economists; any economist will tell you that the tax system ought not to
favor debt versus equity in the financing of companies.

A responsible public policy approach would be to ask, do we want to
subsidize debt over equity, and to what levels? Is it really in the
public's interest to maintain a tax system that encourages operating
companies to leverage up to eighty and ninety percent when we know
that's almost certain to lead to companies getting into financial
distress much more quickly and companies being much less able to be
productive and operate through economic downturns?

Similarly, there's just no basis to subsidize the personal incomes of
private equity managers by having them pay capital gains tax on their
income. It's just indefensible.

To the extent that these types of tax subsidies continue, we have a
policy regime that (a) subsidizes the income of the wealthiest people in
our society at the expense of the rest of us, and (b) encourages
boom-and-bust cycles in private equity, which are almost certainly not
good for the productive capacity of the United States' economy or of the
world's economy.

Those issues should be taken up, and I think are being taken up by
Congress to some degree right now, in an environment where there is less
and less sympathy for straightforward subsidies for the most wealthy
Americans.

I think we are less likely to get measures that deal with the systemic
risk issues involved in both private equity funds and hedge funds,
despite the fact that there's a crying need for that. A variety of
people both in and out of government have been trying to get that type
of regulation in place for some years now. The SEC took a minor step in
that direction a couple years ago and had it knocked down by the federal
courts. But if there isn't some responsible action, it's likely that
something very unpleasant will happen, and then the issue will be taken
up in an atmosphere of panic.


MM: What are the kinds of policies that might deal with these systemic
threats?

Silvers: The most important one is transparency, both to the regulators
and to the investing public. The hedge funds need to tell regulators and
the people who invest in them what assets they hold and what strategies
they're pursuing. Bank regulators need to know with a great deal more
detail where banks are lending, and how banks, derivatives markets and
hedge funds are interacting with each other. It would be very helpful to
stop the nonsense of having the Commodities Futures Trading Commission
regulate the derivatives markets, when there are derivatives that are
all linked in with securities.

That's an area where we're just asking for trouble by having that kind
of regulatory incoherence. That combination of things, transparency and
a unified and coherent oversight system on the part of the regulators,
are the two things that most need to be done.


MM: How have the private equity and hedge fund firms responded on
Capitol Hill to efforts to enact some of the controls you're talking about?

Silvers: As it has dawned on them that people have figured out that they
are taking advantage of outrageous tax subsidies, both the private
equity funds and the hedge funds have in the last few months thrown a
lot of money at Washington. They are seeking to block changes to the tax
rules, including legislation that's been proposed in the Senate by
Charles Grassley, Republican from Iowa, and Max Baucus, Democrat from
Montana, and in the House by Sander Levin, Democrat from Michigan, and
Charles Rangel, Democrat from New York. Those proposals would, in
different ways, put an end to some of the tax subsidies.

The House bill would put an end to the capital gains treatment of
carried interest income. It's been interesting to watch various lobbying
firms, law firms and PR firms fight over who gets what cut of all the
money that's been thrown at Washington by the private equity and hedge
fund industries.

They have made a series of arguments, which really have no merit, about
how if they have to pay taxes somehow this will hurt the pension funds
that invest in their funds, and if they have to pay taxes suddenly
nobody will take any more risks either in capital markets or in American
business. There's a long list of utterly baseless arguments they make.

But if you have enough money, you can get people to take utterly
baseless arguments seriously in Washington.

However, we're in an environment right now where I think increasingly in
Congress there's less sympathy for tax subsidies for the very wealthy,
and that's true on a bipartisan basis. I think that they're going to
have a hard time winning this argument. At the end of the day, they're
probably going to lose, at least on the tax issues. On the transparency
issues, I'm not so sure. I worry that these systemic risk issues have
not been adequately addressed and may not be adequately addressed.

http://www.multinationalmonitor.org/mm2007/052007/interview-silvers.html


TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/