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August 22nd, 2011

Playing Chicken: A National Policy?

In 1856, Senator Preston Brooks, using his cane, severely beat Senator Charles Sumner on the Senate floor. Until the recent embarrassing game of chicken played with the debt ceiling Mr. Brooks’ beating had been viewed as the nadir of U.S. political behavior. In a nation whose birth was partially midwifed by a pamphlet entitled “Common Sense” the national leadership has become woefully chippy and seemingly unable to see the obvious sensible course. In stark contrast to the vacuum of leadership at the national level we have the inspiring selfless examples of Tariq Jahan, whose son was killed in the recent London violence, calling for calm and the many kind people in Indiana who rushed toward the collapsing State Fair stage, as it collapsed, to help those in need. Post the legislative debate we are treated to an escalating game of finger pointing in its wake. Even more remarkable is the legislative result calling for the establishment of a national political committee to hunt for ways to reduce debt. In Rip Van Winkle style one could have fallen asleep the day the Bowles-Simpson Committee was formed and awakened this summer to believe you had only slept for a few hours. Bowles-Simpson produced a thoughtful list of spending, tax and deduction adjustments which were selected to remedy the national debt situation, not to protect a favored constituency. Its conclusions were balanced, politically difficult and therefore, buried. Now we are going to perform the same play, but featuring puppets instead of real actors.

Before the debt debate headed to Dead Man’s Curve, the private equity world was making its best effort to revive memories of 2007. Leverage and purchase multiples on new deals had reverted to “pre-Lehman” levels. More interesting to the shrewder limited partners is what has happened to the levels of other risks being taken by PE firms. A large percentage of deals were being signed without financing conditions. (Source: Kirkland & Ellis data base). In other words, if debt markets softened or closed, precisely as they have done in August, nearly one-third of deals would have required either paying prohibitive rates as lenders “flex” terms or funding 100% equity from capital calls to the limited partners. Another 37% have no Market Adverse Event condition which means if you agreed to buy an American beer brewery and beer is outlawed before the deal closes the buyer still has to pay the full price! If all goes well these risks are moot, but if August 2011 occurs while you are waiting to close financial disaster greets the investors. Careful investors include understanding a PE firms’ approach on terms such as these when selecting funds.

The measure of the greatness of any system or person is how either responds to adversity. Does the system try to solve its problem or rather, expend its energy on deflecting responsibility. Pheidippides can feel the proverbial arrow in his back on both sides of the Atlantic. Much of Europe has banned or restricted short selling of stocks, the equivalent to broadcasters banning war news to prevent wars. In the United States the loudest voices are heard blaming other political parties, specific officials, regulators or dame fortune. Instead of pursuing a locavore approach to policy we might consider looking north to Canada to see what home lending and banking practices there helped avoid a foreclosure crisis. We would find policies dominated by common sense instead of the lending casino the U.S. became. Interestingly, there is no mortgage interest deduction in Canada, nor were there sub prime, no doc loans and mortgages are full recourse to the borrower, a term that likely focuses the borrower on repayment.

At the nexus of regulation and private equity sits Dodd Frank. In June, the House Financial Services Committee unanimously passed a bill exempting PE from registration, subject to certain leverage tests, and the SEC simultaneously extended the compliance date until March 31, 2012, which should allow the legislative process time to complete its task. At first glance, an optimist might think a wise man had stepped into the process, but then the SEC released the other registration exemptions rules including the full exemption for “Family Offices.” Since the theory for including PE in Dodd Frank was to identify and control “systemic risk” the exemption fails convincingly when held up to the light. George Soros recently removed a few non-family investors to ensure his $24 billion asset pool, which is believed to be heavily leveraged, and occasionally buys small countries, would be exempt, while a $151 million capital pool that invests in “green” dry cleaners would be deemed to pose systemic risk. This standard feels as reasonable to us as losing points for class participation in AP Physics. As the rules for marriage in many states rapidly change, Olympus Partners is seeking a haven in which we can all marry and confer upon us a family office exemption.

Simmering on the back burner in Washington is the carried interest tax debate. Rather than let it simmer and permit national debate to focus on other matters Leon Black decided to throw himself a birthday party from the Dennis Kozlowski “Manual of Shyness”. Leon spent several million dollars on his bash, including NY Times coverage, which featured Elton John who sang Leon (to the tune of Levon) and the rapper Kerry Dintris for entertainment. Despite Leon’s appearance in DC criticizing the plans to increase the tax rate on carried interest a careful read of the legal structure of Apollo’s new public vehicle suggest the IPO has immunized Leon from the potential tax increase and favorably adjusted his basis, so a celebration was in order.

I’m Rob Morris and I approved this blog.

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