Wednesday, May 25, 2011

The ghost of Emily Litella, as played by Gilda Radner on Saturday Night Live, has emerged to shape the conscience of the SEC. Emily was well-known for delivering aggressive news editorials on subjects where she had clearly "misheard" the topic in her editorial or committed some other malaprop. For example, she ranted “What is all the furor over Soviet jewelry?” in a mistaken editorial on Soviet emigration policy for their Jewish emigrants. Inevitably when her error was pointed out to her she would end her piece looking straight at the camera and exclaim: "Never Mind!" The Dodd-Frank bill, which was passed last summer, requires registration by Private Equity Funds by July 21, 2011. Via a mechanism only a government agency could invent, one has to apply for registration 45 days before one needs to be registered and be in full compliance with registration rules at the time of application. The time and money required to come into compliance are roughly two months and $500,000. A wide ranging effort to demonstrate the absence of systemic benefits, the job losses, the meaningless paper generation and the diversion of the SEC from monitoring real risk such a registration will cause has fortunately led to a sizeable political outcry over the application of Dodd-Frank to Private Equity.

If one were to cipher correctly the time line to begin the work, a firm would have to have begun the work, ironically, on or about April 1, 2011. In what at first appeared to be a burning bush moment an SEC Associate Director issued a public letter to the North American Securities Administrative Association on April 8, 2011 expressing the notion the SEC "might consider" a registration extension for PE into 2012. The SEC sent a similar letter to a Congressman. An extension would sensibly permit time for a new law to pass, making filing unnecessary, or for the creation of sensible regulation. However, when emailed directly to determine whether or not the SEC would grant the extension he replied, "one should ask one’s counsel if one can rely on my letter," a response that provides no guidance as to whether or not the imminent use of time and expense is necessary. He did promise to consider the question by July 21st, for those who are worried that the government is humorless. The stage is now set for the full Emily Litella. Billions of dollars will be spent this Spring to get into compliance and to file for registration by PE firms. People will lose their jobs to provide the funding. A repeal bill has been approved by the House Financial Services Committee, which should pass the House in June and then proceed to the Senate. At this propitious time, the SEC will announce . . . the money you spent, the time you allocated, the people you fired . . . Never Mind. Is this the kind of thinking that is going to prevent the next financial crisis?

The years of underfunding and cavalier legislating of pension benefits to public employees have been widely described. Less ink has been devoted to its consequences and to sensible ways to address the funding and determination of pension benefits. The implications of some of these choices could pose a challenge to PE funding if in future planning, liquidity and certainty of investment return receive priority instead of total return.

U.S. municipalities are beginning to reach the cash crisis that aggressive pension accounting has pretended was not in the offing. Prichard, AL and Vallejo, CA have each filed for bankruptcy due to their inability to pay the current cash cost of pension benefits. Rhode Island and Michigan are serving as the pilot plants for pinched pension posterity. Central Falls, RI which has huge unfunded pension liabilities, is looking to merge with another city, to outsource municipal functions or to file for bankruptcy. Michigan has passed a law permitting the governor to appoint a czar to oversee the finances of distressed municipalities which has led the czar in Benton Harbor to combine the police and fire departments. Detroit has sought to reduce current pensions, a benefit previously believed to be untouchable. Despite these extreme examples, large state funds such as CALPERS continue to use high actuarial assumed rates of return to ensure that there will be more Vallejos as accounting legerdemain continues to triumph over common sense. Even the massive-aggressive Governor Schwarzenegger tried to take a shot at pension reform, but the Balkanized structure of citizen’s government by referendum prevented that from being initiated.

One needs to look beyond our borders for municipal solutions. In the mid-1990’s Canada recognized that their original 1966 national pension plan, put forth by the Lester Pearson government, was woefully underfunded. The original plan called for a 1.8% annual contribution on behalf of the employee. The revised plan now calls for a joint employer/employee contribution of 9.9% on earnings up to $43,700 and 8.1% by the employee on earnings above that level which has led to a much more robustly funded pool today of $C140 billion managed by CPPIB for total return. Many of the superannuation funds in Australia have recently changed to a 401-K like structure. This shift mitigates the risk of underfunding as there are no longer defined benefits. However, this change has led to many of these funds to withdraw from private equity since total return is no longer a goal.

During the 2008 Presidential debate both Senator John McCain and Senator Barack Obama were asked who they would choose as their Secretary of Treasury. They each answered "Warren Buffet," a national investment icon who had successfully managed to merge his outstanding investment record with a Jimmy Stewart like public image. Events during the recent quarter have again challenged his Jimmy Stewart PR. In recent correspondence published on the SEC website Berkshire Hathaway declined to record its $413 MM loss in its holdings of Wells Fargo stock. Berkshire responded as follows to an SEC inquiry about it and four other stocks Berkshire declined to write down: "Each security’s market price will grow to at least the intrinsic value that existed" when Berkshire invested! In short, a stock purchased for $40 that declines to $25 is only a $25 stock if Berkshire declares it so. Both the SEC and Deloitte, their auditors, seem non-plussed by that approach. Imagine a similar response by a PE firm in their FASB 157 analysis of a portfolio company passing muster. “Despite a 30% decline in the market price of ABC corp. we still think it is worth our cost and will keep cost as its valuation.” Next we come to the matter of David Sokol. His trading in and out of Lubrizol, after receiving the idea from Citicorp in an M&A presentation, led to his resignation. Again we find the same actors in the play. The SEC has not acted. Buffet tells us “Neither David nor I feel his Lubrizol purchase were in any way unlawful”. Imagine if Ruth Madoff or Seema Boesky had made a similar declaration. Would the SEC or the press have been so accommodating? Bullying bureaucrats is not just the province of the financial frauds.

I’m Rob Morris and I approved this blog.

The Ghost Of Emily Litella