Tuesday, November 20, 2012

Navajo Code Talkers were used by WWII U.S. Forces in the Pacific to keep military plans indecipherable. A version of this strategy was again employed by the US government when they persuaded (begged) JPMorgan to acquire Bear Stearns in 2008, over a weekend, to avoid what the government believed would trigger a financial meltdown. JPMorgan, at the government's behest, bid $2 per share for a bank they neither needed nor wanted. Bear Stearns' outrage over the low price forced them to raise their bid to $10 to assuage shareholders who had no other option. In 2008 the Federal code talkers appealed to JPMorgan's sense of duty to their country and their sense of a good deal, to avoid massive layoffs, a systemic liquidity crisis and possible Federal intervention or ownership of a complex financial institution. Subsequently, the SEC, a Federal agency, and the NYS Attorney General have fined and/or sued JPMorgan for the conduct in 2006 of the Bear Stearns mortgage business, a business which failed, causing the government to request that JPMorgan purchase Bear Stearns. The government's ethical process is the reciprocal of the apocryphal story of the teenager who shot his parents, but sought mercy from the judge due to his orphan status. Even if one were to set aside the elastic ethics in this "no good deed goes unpunished" behavior the public policy implications of this are even more stark. Executives are not going to act in the public good if the act is going to invite litigation and fines from the party seeking the favor. If the government had been forced to take over Bear Stearns instead of JPMorgan would they be fining and suing themselves? Perhaps a solution for this would be shared liability with the government officials who made the request to a private company in the event of subsequent litigation related to the request.

More than 99% of all stock traded on the exchanges is secondary or "old" stock. More than 99% of all commercial real estate sales occur as secondary transactions of existing rented buildings. Similar numbers apply to oil and gas leases, timber tracts and mineral holdings. Each time one of these assets is sold by a money manager, the manager gets paid for being responsible for the profit on these secondary trades. Yet, when the same event, a secondary purchase, occurs between private equity firms such a trade is being portrayed in the media or by consultants as less positive than some other forms of purchase. If stock manager A profitably trades 1,000 shares of Microsoft to stock manager B and earns a fee the business press is nonplussed. Yet headlines get devoted to the increase in secondary trades in private equity as if tracing a scourge. When Berkshire Hathaway purchased Oriental Trading from KKR, it was a simple secondary trade of the ilk being questioned in PE, but in reality no different than Berkshire buying more stock in a railroad. A keen evaluation of a PE manager is indifferent to the genealogy of an investment, but very sensitive to the manager's ability to identify investments that will increase in value.

The Presidential election created a sideshow of amateur analysis of private equity and the objectives of a private equity manager. One headline appearing frequently was "bankruptcy." Since the press never took the time to determine if the bankrupt companies were on life support or not when PE became involved, bankruptcy itself is not a simple measure of failure for a PE investment, but looking at overall trends can be instructive. PE firms regularly produce information on their rates of return and their capital multiplies. A prospective investor might also want to look at bankruptcies as a fraction of total investments made or at the ratio of losses lenders to portfolio companies incurred as a proxy for risk management. All IRR's are not equal. If two firms each made 10 investments and earned a 20% IRR, yet the first firm had five bankruptcies and the second had none, then their returns likely have been earned by accepting dramatically different amounts of risk. Neither is inherently better, but an investor needs to understand the managers risk tendencies and their own risk appetite before they vote with their money.

I’m Rob Morris and I approved this blog.

Navajo Code Talkers