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March 28th, 2017

Twelve Years a Knave

Twelve Years a Knave befits the life led by Thomas Davis, the former chairman of Dean Foods, a Texas based public dairy company. In testimony at the William Walters insider trading trial, Mr. Davis describes himself a “virtual conduit” of secrets to Mr. Walters. They used prepaid cell phones referred to as the “Bat Phones” and the code name for Dean Foods was “The Dallas Cowboys” in their chats that revealed earnings, new products and company expansion plans. Another Austin Powers code device used to distract Sherlock Holmes was Walters asking “How is the milkman doing?” when he sought information about Dean. Davis eventually asked and received a seven figure loan from Walters in return for his illegal information. The real surprise is not that this conduct persists, but that the methods for catching the illicit behavior are the same today as they were during the eighties: Relying on trading reports from those that have the information. However, since violators know they are being monitored and therefore, never trade illegally in their own accounts, regulators wait for tips to come in over the transom. Certainly, more sophisticated algorithms connecting trades, shareholders and company insiders are available to pursue abusers.

Private Equity’s dry powder levels now require three chairlifts to navigate. Unsurprisingly, the effect of this capital is seen in purchase multiples, but less visible are the effects on the sale process. One of the effects I will call the Fukubukuro Protocol and the other The Regulator’s Vector. Fukubukuro are the opaque “lucky bags” Japanese retailers use on New Year’s Day to clear inventory. Households enjoy a two-day period to gamble by buying these inexpensive bags in hopes of acquiring a gem. Sales processes for PE buyers have begun to mimic the Fukubukuro, except for the discount pricing. Thick offering memoranda have been replaced by thin powerpoint presentations known as CIPS (or Confidential Information Presentations) that cover the details of the company like tiny flakes of snow. CIPs are supported by “gold card” meetings, akin to PE’s version of a Costco card, a one-hour session to provide a buyer with an early look. Due to the high demand, the actual time and information available has slowly truncated to Fukubukuro level before final bids are due. Buyers make decisions on less information and in less time than normally available. The Regulator’s Vector has added another chapter to the laws of unintended consequences. The goals of the regulators have been twofold: 1) to expand assets in their brief and 2) to make rules about how these assets need to be managed. Assets in their brief are confined to regulated entities. Ironically, middle market loans are growing fast among non-regulated entities as regulatory interference convinced GE to sell its assets to a Canadian Pension Plan, ironically removing it both from U.S. regulators and from U.S. tax revenue. CLOs and other non-regulated lenders have enjoyed sizeable capital infusions. Since the regulator-created the lobster-trap-like Shared Natural Credit (SNC) rating system into which a loan may be cast, but never leave, the practice of avoiding SNC to provide flexibility in both good and bad times has become an important objective for a PE deal. Consequently, in the formation of a loan syndicate, the omission of regulated banks has become de rigeur as the hassle of inflexible secretive regulation is seen as a risk too far. The question of what the Fukubukuro Protocol and the Regulator’s Vector do to an investment’s success is yet to be clear, but well worth watching.

I’m Rob Morris and I approved this blog.

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