Friday, March 25, 2011

Fonzie, the lead character in the television sitcom Happy Days, was renowned for his magical power to snap his fingers while exclaiming, "Aaay!" to cause the world to behave as he deemed fit. Upon the finger snapping cute girls would surround him, broken lights would illuminate and silent juke boxes would begin to play; each a delightful Fonzie scheme. Congress, although not imbued with his fictional power, has engaged in their own Fonzie scheme with the passing of Dodd-Frank, a law that grants the SEC the mystical power to end systemic risk while being empowered to oversee everything in private equity from compensation to email. Ironically, in Apollo’s recent IPO filings they have to disclose less than what would be required under Dodd-Frank proposed rules. The illusion that the finger snapping of a law into existence would magically end the excesses of human financial behavior is tempting to only the most vivid imaginations. The predicates behind this attempt to identify the next Madoff are questionable. At the core of this Fonzie scheme is the delusion that mandatory disclosures by a crook will persuade a fraud to disclose his legerdemain. The next assumption, as Dodd-Frank applies to private equity, is that the SEC is equipped not just to analyze information, but also to judge PE's risk-taking and compensation structure. The final assumption, that the law, by causing firms to dismiss investment staff to pay for the compliance professional’s fees, will improve anything in the system or reduce systemic risk is the ultimate Fonzie scheme.

At the time of this writing, a perfect example of the absence of systemic risk in private equity is unfolding. The largest LBO in history is teetering on the edge of bankruptcy. Can you even name the Company? (answer below) The fact that a $45 billion company going bankrupt is only a page three story in the newspaper and that no one can name it shows how well the system is already prepared to handle the bankruptcy. If it files for Chapter 11, the Company will stay in business, the creditors will take control of the ownership and the private equity owners will have a capital loss. The system will have yawned. Intriguingly, this same company also went bankrupt in 2002. Would Dodd-Frank’s overseers, if in place in 2007, have seen too much risk in buying formerly bankrupt companies and banned the transaction? If so, what does that potential SEC veto power portend for creating its own systemic risk in discouraging private capital from investing in formerly distressed businesses? Or, if the deal were to succeed, under their new compensation authority could the SEC deem the reward too great for the risk and, like Fonzie, reduce the compensation? Would this be the end of notable turnaround investors? (Answer: TXU, now called Energy Future Holdings).

A new SEC rule would "prohibit incentive-based compensation arrangements that encourage inappropriate risk taking by providing excessive compensation or that could lead to material financial loss to the firm". Despite the existence of compensation arrangements that are the result of a negotiation between PE firms and their investors, a fascinating new Pandora’s Box is about to be opened. In no other business has a regulator placed itself in the position to judge the risk level a business takes and, if determined to be excessive, change that business’s compensation structure. Let's imagine that three firms invest in Google, when it was a startup enterprise. For the first two firms the investment is 10% of Net Asset Value, but 15% for the third. Further, suppose the SEC deems this prohibitively risky for the third and deposits two tablets on Mt. Sinai declaring the carry compensation arrangement on fund number three to be excessive and therefore, disallowed. Finally, assume Google becomes a 50x return investment and the shares are sold, three quick questions arise: 1) Who gets the money that would have been carry compensation? 2) Was this whole process fair? 3) Was adding the SEC as a General Partner what the investors had in mind for their investment?

Finally, we come to the intersection of the financial world, the legal system and the New York Metropolitans, the Shakespearean-like baseball squad perennially chasing victories in the NL East. The Trustees for the Madoff investors have launched a billion dollar litigation vs. the Wilpon family, a principal owner of the Mets', for recovery of not only their "excess" profits from Madoff, but also for hundreds of millions of additional dollars on the theory that the Wilpons should have known Madoff was a fraud. In the absence of a published "smoking gun" demonstrating the Wilpons had actual knowledge or knew anything untoward had taken place, "should have known" is a remarkable standard to apply. Applying this Carnac-like standard of mind reading would make a bank teller complicit with a bank robber if the thief looked suspicious as the teller "should have known." Perhaps the Wilpons “should have known” Luis Castilla could no longer hit, but they didn’t, so they are paying him millions not to play for the Mets. That may be a crime to fans, but should not be to a court.

I’m Rob Morris and I approved this blog.

Dodd-Frank: A Fonzie Scheme?