Month: April 2010

Are Private Equity-Backed Companies More Likely to Default?

During the Great Panic, there was some grumbling that private equity-backed companies were posing a great risk to the economy.

The Private Equity Council has done some research and came to the conclusion that the opposite is true. They are less likely to default.

Of course, there are lots of caveats and distinctions in the report. Of course, there is my own disclosure since I work in private equity.

One issue is how you define a “default.” The Private Equity Council use the the ISDA’s definition in credit default swap contracts: (1) a missed payment or (2) a bankruptcy filing.

They exclude exchanges where the borrower buys back debt at a discount or swap the debt for equity. You can make an argument that these types of exchanges are opportunistic, and not a genuine attempt to avoid a bankruptcy filing. After all, if the company were really in such bad shape, why would the private-equity backers pour more money into the deal by buying the debt or diluting their equity.

The Private Equity Report was largely in response to a report from the Boston Consulting Group and a second report from Moody’s Investor Service.

Get Ready for the Private Equity Shakeout

The problem with the Boston Consulting Group’s study, Get Ready for the Private Equity Shakeout, is that they used the credit spreads in November 2008. They found that 60% of the private equity portfolio companies had their debt trading at distressed levels.

I have to agree with the Private Equity Council when they find fault with that calculation. Credit spreads were huge for every company in November 2008. The economy was in the grips of the Great Panic for liquidity.

The PEC’s chart shows that the default rates have not held up to the BCG estimate.

$640 Billion & 640 Days Later

The big issue with the Moody’s report is that it includes “distressed exchanges” in their definition of default. More than half of the defaults in the Moody’s study fell into this category. Of those, about 70% were exchanges at less 15¢ on the $1. I would be hard-pressed to say at debt purchase at 90% of par should be considered a default. At 15% you are looking more like a default.

However, the Moody’s report ended up concluding that the 186 LBO deals in the study had roughly the same default rate as similarly rated companies.  Where Moody’s found the biggest problem was the biggest LBO deals from January 2008 to September 2009. Six of the ten were considered distressed or defaulted.

On the other hand, the study’s time frame was during the most tumultuous period in the financial markets for decades. Things are much calmer now than they were in September 2009.

What’s Ahead

How should I know? I’m just a compliance guy banging away on his keyboard. But it is hard to ignore upcoming debt maturities. Even though companies may be current on their debt service, all of that cheap debt is going to be hard to replace when it matures.

It is clear to me that we should be skeptical about statements that private equity transactions pose an exceptional risk to the financial system. Those statements are not backed up by the data.

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Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

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Incentives, Productivity and NUMMI

I recently listened to a great show from This American Life. They covered the story of New United Motor Manufacturing Inc. (NUMMI). General Motors and Toyota opened NUMMI in 1984 as a joint venture so Toyota could start building cars in the US. Toyota showed GM the secrets of its production system and how Toyota made cars of much higher quality and much lower cost than GM.

There are some great lessons in the story for compliance professionals. In part because the story can be seen through the lens of incentives and corporate culture. Two topics that are important to compliance.

For GM plant managers, their pay was based on productivity. They needed to get lots of cars out the door at the end of the assembly line. It didn’t matter whether the car could drive off the line or had to be towed. Workers told the story of cars coming off the line with a Monte Carlo having the front end of a Regal. They would just let them run down the line and out into the yard. Then they were fixed out there (with overtime). The emphasis was on quantity. At GM, the production line could never stop.

The Toyota system empowered the line workers to stop the line if there was a problem they couldn’t fix. The emphasis was to fix the problem at its source and not defer it for later. The emphasis was on quality. (Some of the recent problems at Toyota can be blamed on changing their focus to quantity. They wanted to be the biggest car company in the world.)

In spreading the Toyota system, there was resistance from both the company and the union. The union was opposed because the system was more efficient and would reduce the workers at a plant by 25%. The NUMMI plant was the re-opening of a shut down GM plant. The union was out of work and was more open to change. It was either change the way you work or don’t work at all.

GM had trouble empowering its worker and changing the corporate culture that comes along with the Toyota production line. They thought workers would just stop the line to play cards and get coffee.

Its worth an hour of your time to listen to the story.

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Weekend Book Review: The Informant

I’ve had Kurt Eichenwald’s The Informant on my reading list for a long time. It dropped farther down the list after seeing the previews for the Steven Soderbergh movie. Why read the book when you can watch the movie?

What raised my interest was hearing a great radio segment from This American Life that tells some of the background of the price fixing conspiracy and FBI cooperating witness Mark Whitacre: The Fix is in.

I have to admit that while reading the book, I had the image of Matt Damon in my mind as the character of Mark Whitacre. The other image that stands out is the scene in the movie previews with Damon (playing Whitacre) as he is fiddling with the hidden tape recorder in his briefcase. As you can see from a video of the meeting, Whitacre really did open open up the hidden compartment and check out the tape recorder.

The true story in the book is a crazy tale. Whitacre came forward as a cooperating witness to the FBI, telling them that his company, Archer Daniels Midland (ADM), was engaged in price-fixing for the global market for lysine. The allegations quickly spread to other products and to kickbacks. Whitacre was a great witness, eagerly taping conversations of illicit activity and clearly willing to take down his colleagues and management of the company.

The story wanders a bit, periodically gets stagnant, then explodes as new secrets are revealed. The author, Kurt Eichenwald, tells the story from the perspective of the FBI. If the story were not true, it could have been streamlined and the characters could have been explored in more depth. But it’s a true story with real people. So you have to let the story evolve as the FBI uncovers more and more of the activity of ADM, and unfortunately more and more of the activity of Whitacre.

Whitacre had problems. These problems become apparent and worsen as the story progresses. The perfect witness ends up not being so perfect. Inconsistencies begin to appear and then grow worse.

Kurt Eichenwald covered the story for The New York Times and interviewed most of the participants in writing the book. He tells the story by methodically recording the six-year investigation and deconstructing the disturbed Whitacre.

Add the book to your reading list and move it towards the top.

The SEC Drinks Its Own Champagne

The SEC has named its first chief compliance officer: Kathleen Griffin.

She will be tasked with oversight of employee securities transactions and financial disclosure reporting. The creation of a compliance program to prevent insider trading came from last year’s insider trading scandal at the SEC. The Office of the Inspector General reported that “the Commission lacks any true compliance system to monitor SEC employees’ securities transactions and detect insider trading.”

Ms. Griffin will have her hands full. From the SEC OIG Report:

The current disclosure requirements and compliance system are based on the honor system. and there is no way to determine if an employee fails to report a securities transaction. There are no spot checks conducted and the SEC does not obtain duplicate brokerage account statements. In addition. there is little to no oversight or check;ing of the reports that employees file to determine their accuracy or even whether an employee has reported at all. Moreover. different SEC offices receive each of those reports and do not routinely share that information with each other.

It’s good to see the SEC drinking its own champagne and hiring someone to focus on their own internal compliance issues. (Doesn’t “drinks its own champagne” sound better than “eat its own dog food.”)

Since the announcement came on April 1, I thought it was an April Fool’s Day joke. Why would the SEC hire the comedian Kathy Griffin? Clearly, I was being overly cautious about my news intake. I was not alone in this confusion and I’m sure will not be the last to draw the comparison between the two.

I’m sure Kathleen’s comments to the SEC employees will be less controversial than Kathy’s comments at the Emmy Awards.

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Compliance Bits and Pieces for April 2

Here are some recent stories that caught my eye:

Q&A with Ethisphere Executive Director Alex Brigham in Corporate Compliance Insights

The Ethisphere Institute recently announced the 2010 World’s Most Ethical Companies, highlighting 100 organizations that lead the way in promoting ethical business standards. These companies go beyond legal minimums, introduce innovative ideas benefiting the public and force their competitors to follow suit.

My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members from Francine McKenna in re: The Auditors

This is my commentary on the letter that Ernst & Young recently sent to Audit Committee members defending themselves against the findings in the Lehman Bankruptcy Examiner’s report. The Bankruptcy Examiner, Anton Valukas, found “colorable claims” against EY.

Q4 Whitepaper: The Current State of Social Media & Investor Relations

In a continuing effort to share how public companies are using social networks, Darrell Heaps, Co-Founder and CEO took a large audience of IR professionals on a guided tour of “The Current State of Social Media & Investor Relations”. Participants were provided with over 50 examples and case studies of how companies are using Twitter, Facebook, LinkedIn and IR blogs to mitigate share value, dramatically increase web site traffic and broaden their reach to potential investors.

WISPs Beyond Massachusetts by Joseph Lazzarotti in the Workplace Privacy, Data Management & Security Report

Over the past few months, many businesses, particularly in the Northeast Region, have been focusing on creating a written information security program (WISP) to comply with Massachusetts identity theft regulations that went into effect March 1, 2010. For many, this has been a significant effort, reaching most, if not all, parts of their organizations. However, it is important to remember that although Massachusetts may be the state with the most comprehensive set of rules for securing personal data, other states have enacted similar protections, and compliance with Massachusetts does NOT necessarily mean compliance with other states.

Broken Windows Fix Our Understanding by Don Boudreaux in Cafe Hayek

Do disasters help the economy? No, along with a video explanation: Disastrous Economic Fallacies – Terror as Stimulus?

Some of My Favorite April Fool’s Day Items on the Web

The web is full of surprises today. Here are some of my favorites

April Fool’s Day

April Fool’s Day is celebrated with hoaxes and practical jokes. I’m hesitant to post anything today for fear that a serious story would be seen as a joke or a joke would be seen as a serious story.

A few years ago, if I had told you that Bear Stearns, Lehman Brothers, AIG, General Motors and Chrysler would be bankrupt, out of business or owned by the US Government, you would have laughed. Today, you just cry when you look at your tax bill.

So I will sit motionless today, unsure if anything is real.

Yes, that is a Dharma Initiative Alarm Clock.