Wednesday, August 09, 2006

One-in-a-million shot: I agree with a WSJ editorial

Yesterday afternoon, I suggested that the Federal Reserve erred by not raising interest rates. This morning I was surprised to learn that the Wall Street Journal [subscription required] editorial page shared my view that the evidence of inflation in the economy was sufficiently clear that the Fed should have raised rates to damp inflationary expectations.

The WSJ cited Richmond Fed President Jeffrey Lacker, the one dissenting vote at yesterday’s Fed meeting, who found the 4.2% increase in unit labor costs in yesterday’s productivity report to be a strong piece of evidence supporting the need to raise rates.

I have been reading the Wall Street Journal and its editorial pages for about 30 years. In many recent cases I have skimmed these pages because I feared that reading them in detail would cause me to spontaneously empty the contents of my stomach.

This morning’s editorial was the first time I can remember actually agreeing with a WSJ editorial. I guess if you live long enough, such coincidences are bound to happen.

Monday, August 07, 2006

Stewart settles: smart

So Martha Stewart has finally settled her insider trading case – agreeing to pay $195,000 and accept a ban as serving as a director of a public company, and limiting her ability to serve as an executive at Martha Stewart Omnimedia.

I thought she would settle because her odds of winning at trial were not great and that it would be better for potential advertisers if she could get the charges behind her.

This settlement sends a tough message to executives but it also lets her maintain her current role.

This May I gave some thoughts to a Business Week reporter on two key questions. Stewart evidently came to the same conclusion I did then – her best option was to settle.

Here are the questions:

If she pleads not guilty, and appears for a deposition, do you think this “precarious” legal position is worth regaining her title and clearing her name for Martha Stewart Omnimedia?

Martha Stewart’s legal situation would make an excellent case study for a class on decision analysis. What she must do is estimate the expected value of the financial outcomes that would result from taking each of the branches of a decision tree. That is, she must estimate both the likelihood (say, 40%) of each outcome and the value of that outcome (e.g., a $50 million drop in MSO market capitalization). To calculate the expected value, she would multiply the likelihood by the value (e.g, $20 million).

I am not a lawyer so it is hard for me to assess the odds of her prevailing at a trial. But last time when she went to trial, there was a very unexpected result -- her company’s stock price quadrupled from $9 in December 2003 to $36 in March 2005 when she went to jail. I think the reason was that a lot of her fans bought the stock as a sign of support for her. I don’t know if this would happen again. Nor do I think that it really matters to her company whether she regains her title.

If she appears for a deposition, it will remind corporate advertisers that she is in legal trouble. Especially in light of today’s Enron convictions, many of these corporate advertisers might fear being associated with a publication owned by someone in such visible legal trouble. So it could hurt her business. And my hunch is that I don’t think she will get the same stock market support this time as she did before – her stock is now way down from its peak. And investors may realize that they may have overestimated the importance of Martha to the company’s performance

What do you think the effects of (1) Settling (2) Denying or (3) Asserting her 5th Amendment right would be on her empire?

These three are the key branches of the decision tree. I think the best option would be to settle and get the whole matter behind her. Even though it will cost money, settling would get the legal uncertainty behind her which would thus limit corporate-advertiser-skittishness-due-to-her-legal-problems as a factor in the value of the magazine and TV businesses.

Denying the allegations might fail as they did earlier. They would cost legal fees and generate bad publicity for her company. And it would take time away from her TV programs and other business promotion activities.

Asserting her Fifth Amendment right would have a similar effect from legal, PR, and business opportunity cost standpoints.

Saturday, August 05, 2006

Abelson on private equity

Barron's editor Alan Abelson quoted from my previous post in his August 7th Up & Down Wall Street column.

Here's an excerpt (with Barron's spelling errors corrected):

Money, both institutional and individual, has been coming out of the woodwork in staggering quantities and pouring into private equity. (Admittedly, we're envious, since whenever we tap our woodwork all that comes out are carpenter ants.)

As Peter Cohan of Peter S. Cohan & Associates writes: "Private equity, the business of using debt and a sliver of equity to take companies private, borrowing to extract big fees and multiplying the equity through an IPO or acquisition, is getting long in the tooth." He likens it to the venture-capital boom of the 1990s in "stretching outside its comfort zone to find big deals into which it can pour the new cash." In the process, it's suffering a rash of busted IPOs while its supply of "cheap debt is drying up as credit quality falls and interest rates rise."

Noting the rush of mutual funds into private equity, Peter purposefully recalls that the handwriting was on the wall for the venture-capital boom when in December 1999 a venture-capital firm, Draper Fisher Jurveston, launched meVC, a venture capital mutual fund. All you innocents out there, beware smiling brokers offering the private equity equivalent of meVC (which sounds like something Tarzan might have put a few coins into when he and Jane were a tree-swinging couple eager for financial security preparatory to starting a family).

Peter cites the deals to take private HCA, the hospital chain recently reviewed in Barron's, and Philips Electronics' semiconductor unit as indicating the private equity gang is struggling to find deals big enough to put all that gusher of capital to work. Plainly dubious about the buyout, he relates that it'll leave HCA with debt that'll be a cool six times earnings before interest, taxes, depreciation and amortization.

In like vein, the Philips Electronics' deal strikes him as highly problematic. In light of the "high capital intensity and rapidly changing technology in the semiconductor business," he contends, "it's difficult to see how KKR and Silver Lake Partners," the winning bidders in a bruising bidding war, will be able to generate attractive returns on their $10.2 billion investment.

And, all the while, borrowing costs are mounting sharply.

Maybe private equity should have stayed, well, private.

Wednesday, August 02, 2006

Is private equity past its prime?

Private equity, the business of using debt and a sliver of equity to take companies private, borrowing to extract big fees, and multiplying the equity through an IPO or acquisition, is getting long in the tooth. Similar to the venture capital boom of the 1990s, private equity is attracting scads of new money from traditional and retail investors, it’s stretching outside its comfort zone to find big deals into which it can pour the new cash; it’s suffering more busted IPOs, and its supply of cheap debt is drying up as credit quality falls and interest rates rise.

To be fair, private equity returns were great last year, with Cambridge Associates’ private equity index rising 27% compared to 5% for the S&P 500 (including dividends). But the trends outlined above suggest it will be harder to achieve these returns in the future. Here’s why:

  • New money. With fundraising up 43% in the first half of 2006, the private equity industry this year will easily blow past the $151.8 billion raised in 2005 and may even surpass the record $177.9 billion raised in 2000. And money is flowing into private equity from retail investors as the Wall Street Journal [subscription required] today highlighted -- retail mutual funds are investing in private equity from T. Rowe Price, Morgan Stanley and Deutsche Bank. Back in the dot-com days, I sensed a peak was coming when in December 1999 venture capital firm Draper Fisher Jurvetson launched meVC, a retail mutual fund for venture capital. I wonder whether history will repeat itself with private equity.
  • Stretching for deals. The recent deals to take private HCA and Philips Electronics’ semiconductor unit suggest that firms are struggling to find deals big enough to put all the capital to work. While HCA had a successful round trip in the past -- HCA's ratio of debt to earnings before interest, taxes, depreciation and amortization may more than double to six times after the buyout – suggesting that there is little margin for error to make this $33 billion deal work. And with the high capital intensity and rapidly changing technology in the semiconductor business it is difficult to see how KKR and Silver Lake Partners will be able to generate attractive returns at the $10.2 billion they’re offering after winning a brutal bidding war. If these deals don’t work out, the lower returns will make it tough to raise funds in the future;
  • Busted IPOs. Two recently busted IPOs could make it harder for private equity firms to find the exits. Bain Capital and others lent Vonage (VG) $200 million before taking this money-loser public. VG has lost 62% of its value since the May 2006 IPO. That same month Bain Capital and others took a $30 million “management termination fee” out of Burger King (BKC) before taking it public. (This fee is chump change compared to the $367 million dividend Bain Capital and its partners extracted from Burger King in February.) BKC has tumbled 26% since its IPO and it just announced that it lost $9 million in its fiscal fourth quarter due in part to the management termination fee. Investors will lose their appetite for private equity IPOs if there are more such busted deals;
  • Rising interest rates. With the Fed having raised interest rates from 1% to 5.25% since June 2004, the cost of borrowing has risen dramatically. Moreover, the borrowing rates that private equity investors must pay are higher than they’ve been in five years. For example, in the HCA deal, the investors will pay 2.15 points more than the London Interbank Offer Rate (LIBOR) – which last reached its current level in early 2001. With the credit ratings of LBO debt declining and LIBOR rising as the Fed tries to squelch inflation, private equity borrowing costs will rise – making it more difficult for them to find businesses which generate sufficient cash to pay off lenders and still maintain that sliver of equity on which private equity returns depend.
If private equity is indeed peaking, there’s nothing to worry about. Top hedge funds managers are still enjoying their average $363 million annual compensation. Unless hedge funds are in trouble too…