The World Is Not Very Flat In Emerging Markets......

Mr. Griffin's Awkward Dodd-Frank Remark

There was an important meeting of finance executives in Los Angeles last week. The topic of discussion was primarily on the new Dodd-Frank regulations set to come in effect in the US this year. During the conference, Mr. Griffin made a remark that struck me as... well... odd.

“The governments guarantee should be limited to very narrow risk taking activities. High quality consumer loans, high quality mortgages, high quality corporate loans. We should keep those parts of our financial systems walled off from that part of our financial system that revolves around aggressive risk taking.”

How can this possibly be a solution? The entire financial system (in fact our entire free market system) is based on rewards for taking risks. What exactly is a 'high quality corporate loan'? Is it one that is given to AIG or Lehman Brothers because the markets are soaring and the perceived risk is non-existent?

The reality is that bail outs are and will always be inevitable. Just because regulators tell us that there will be no bail-outs will not eliminate our instinctive nature to take ever greater risks during times of economic growth. The cycle of boom and bust simply cannot be stopped.

What we need is to instill into corporate management, a sense (some may even go as far as calling it 'fear') of accountability and consequence of legal/criminal corporate actions. This may have more of an effect than trying to put together a confusing set or regulations.

 

The Struggle Between PE, LP and Regulatory bodies.

BEVERLY HILLS, Calif. — Getting private equity titans to agree on anything is often a difficult task.

via dealbook.nytimes.com

Some very interesting points coming out of the private equity conference in Beverly Hills concerning the relationship between private equity firms and regulatory bodies... especially in the emerging markets. The continuous struggle between general partners, limited partners and regulatory bodies continue to play out on a massive scale across the globe.

 

Turkish Economic Growth: Is It Sustainable?

With the exception of a brief drop in GDP during the last financial crisis, the Turkish economy has been on a spectacular growth path for over a decade now. With it's history of volatile and painful crashes, it would only be prudent for investors to ask themselves if the country can sustain the current growth rates.

If we look back and try to analyze growth trends, impact of various global crashes have almost always hit Turkey harder than any other country. The country also has a history of creating homegrown economic disasters, as was the banking crash of 2001.

Although we should never dismiss historical trends, we must also analyse the ever changing financial environment if we are to create good forecasts in any emerging market, including that of Turkey.

One of the primary negative trends in the Turkish economy stems from run-away consumer demand, which seems to be unstoppable. This growth is further instigated by local banks willingness to extend easy retail credit to millions of people with very little credit history.The result is an explosion of the current account deficit, where local production cannot keep up with consumer demand and therefore imports of products and services outpace exports. This gap is widening and therefore forcing the country to rely increasingly upon foreign capital (primarily in the form of 'hot-money'). This is a dangerous trend, especially if global investors ever get even the slightest chill over the prospects of the economy.

On the other hand, there is a tremendous homegrown entrepreneurial environment that has flourished over the past five years. The pace of new start-ups (which traditionally has been the growth engine all around the globe) is nothing but stunning and the flow of funds (although not accurately and formally recorded) is very significant. The overall structure of the economy is also very different today than it was a decade ago and can withstand a much stronger impact (although it is still far from invincible, as some may think).

So, is the economic growth sustainable? Yes, but only if the government regulators can slow consumer demand and therefore in-turn slow the deterioration of the current account. One way for them to do this is to introduce tighter regulation of the retail credit sector. Banks (especially their foreign partners) must realize that if there is a crash in the local economy that is a result of retail credit defaults, they cannot merely exit the country and leave the mess to be cleaned up by the government (another bail out). Accountability, it would seem is a curiously elusive term.

Having said this, the sustainability questions should not only be confined only to the Turkish economy. Investors should be very careful in analyzing other similar scenarios such as in Brazil, South Africa and Argentina. These countries seem to be registering economic growth similar to that of Turkey.

This is an inherent risk of emerging markets. That is why they are so exciting!

 

Scrutiny between G20 peers?

The U.S., China and five other large economies will face deeper scrutiny from their peers to ensure their policies don’t derail a global expansion that finance chiefs bet is strong enough to absorb recent shocks.

via www.bloomberg.com

We have all witnessed the tragic financial collapse of both global conglomerates as well as global economies over the past four years. As heartbreaking as these events are, it is very important for the international community to learn from its mistakes move forward.

One thing I’ve personally ‘learnt’ from the past four years of the unprecedented economic value destruction is the demoralizing similarities between the G20 and the ECB; two very critical organizations.

Both organizations convene regularly to discuss global issues. Both organizations often seem to pass judgment on those nations (and/or corporations) who have stepped out of line.

…neither organization has the teeth to actually enforce their agenda and to this end, nothing concrete ever comes about from these meetings.

We all continue to see the ineffectiveness of the ECB against the collapse of the periphery EU nations. In addition they continue to raise interest rates, as if to intentionally push the PIGS to leave the Euro zone. The latest comedic initiative comes from the G20. They seem to think that each member state will actually interfere with the economic policy of another member in order to prevent financial instability.

I wonder when we’re ever going to learn from these mistakes and move forward.

Will Dodd-Frank Forever Change Private Equity?

Singling out the private equity sector and trying to force reporting and other types of regulation will harm the sector more than help it. Investors into private equity are highly sophisticated and any reporting or other fund conduct is ironed out in LP-GP contracts called LPA's (Limited Partner Agreements).

Don't Panic Folks: Capitalism Will Save Us!

All morning, I’ve been reading articles about the inevitable decline of capitalism as we know it.

All a bunch of hubris. Capitalism is alive and is doing very well, however I believe it is being undermined by this unprecedented and tremendously ineffective ‘bail-out’ plan.

I think the very statement of ‘capitalism on the decline’ refers to the concept of ‘economic bubbles’.

Economic bubbles are a common phenomenon in nations whose industries work under highly unregulated systems where the concept of ‘oversight’ is nothing more than an institution responsible for tracking statistical data. Yes, I'm referring primarily to the US system here. We have to ask ourselves why we don't see purely 'European' economic bubbles (note that the current troubles in the European and Asian economies can be traced primarily to the practices of US companies).

Economic bubbles come and go in cycles of 10 years or so. The Savings and Loans(1980-90), Internet (2000) and now the Financial (2008-??)...

The solution is not 'bail out' but 'prevention'. This entire financial debacle could have been prevented and you only have to dig below the surface of only one of the conspirators’ (AIG) investment practices to know why.

I am a spectacular believer that capitalism works and it works well - only through careful and prudent oversight by truly 'independent' regulatory institutions. If these institutions (SEC) happen to fail, I believe they should also take partial responsibility of the crisis.

At this point, our argument is that AIG and its posse were able to con so many institutions and governments around the world that it 'cannot' be allowed to fail because if it does, then it would bring down the rest of the world. There is no doubt that the failure of these massive institutions will cause havoc, however forcing each and every US tax payer to save these companies is only akin to taking money from your left pocket and putting it back into your right pocket.

It is not a solution.

The closure of these institutions will leave a legitimate void in the system and there are other companies all around the world that were prudent enough not to take on faulty practices, who will fill in this void. This is how capitalism works. The closure of these toxic institutions will not drive us back to the stone ages. As painful as this transition of power will be, there is nothing to worry about.

One good example of this is the closure of so many of the investment banks. There are thousands of profitable and 'working' investment houses that are now taking over the role of their bankrupt and careless 'brothers'.

Contrary to common belief, we should all view the capitalist system as one that is dynamic, self preserving and continuously evolving.

 

 

Is Private Equity Really Evil?

My personal disclaimer: Now, please don’t misunderstand me while you read this post. I’m not advocating the virtues of greed here. I only wish to examine all the points being made against the private equity industry in the hopes that we can better understand and hopefully lead change where it’s required. There is my disclaimer so let’s get on with the post…

What does ‘private equity’ have in common with ‘hedge funds’, ‘derivatives’, ‘nano-technology’ and ‘stem cells’?

They are some of the most widely used terms in the media these days and therefore almost all segments of society are familiar with them. The problem is that these terms are also known as ‘grey industries’ where no one really knows what they really are, who the participants are, where they are located, and in general what they really do. This is a serious vulnerability of the private equity industry that has allowed it to be kidnapped by certain politicians and economists with the aim of making personal gain (‘greed’, it would seem has many faces).

I was curious as to the accusations so I did a little research to see if I could list them. Maybe this way I could get a clearer perspective of the industry that I work for. Needless to say that by far the most vocal critic of the private equity industry are the unions and other employment organizations.
We all know why.

The sole purpose of a private equity firm is to increase the value of its portfolio of companies. This includes any which way possible; such as reducing the size of the portfolio companies’ workforce. The ideal take-over candidate for a private equity firm is one that has grown too much, too quickly, is in moderate debt, and is too cumbersome to compete effectively within the marketplace. This makes the company vulnerable and gives the advantage of the negotiation to the private equity firm (of course it is slightly more complicated than this; however it’s generally how it works). Upon acquisition, the easiest way a private equity firm can start turning the company around is to adjust the size of the workforce in order to free up operating costs and force an increase in productivity.

Many private equity firms will argue that if they hadn’t intervened, the company would eventually exhaust itself into oblivion and at that point everyone would lose their jobs.

And there you have it. This very argument will go in a perpetual circle.

The great irony here is that many private equity firms are actually capitalized by pension funds, unions, and other large institutions representing employees. They demand the high returns, the private equity firms consistently deliver these returns but it is in fact the laid off employee who knows firsthand how this ‘value’ or ‘return’ was actually achieved.

The fact is that I don’t believe the private equity firms have been very eloquent in their explanation of the intricacies, methods, and objectives of the industry. In addition, even the most ardent capitalist must admit that private equity firms should have at least some sort of social responsibility toward the employees of their portfolio companies. At this point no one has been able to come up with a sound solution to the problem.

Upon a some more analysis of the problem, one idea that comes to mind is to somehow force private equity firms to invest a certain portion of the acquisition amount towards helping to find new work for those employees who are cut. This could be capped at 2% of total acquisition price, for example. The allocation would be immediately paid to the government and be refunded back to the private equity firm once they spend the amount. This would require private equity firms to allocate double (in this case 4 percent) of the acquisition amount towards the financing of re-employment.

This could maybe replace the proposed tax hike for carried interest.

In conclusion I do have to admit that the private equity industry must show a more concerted effort in trying to educate the public as to how it goes about its business. It can no longer afford to be an entity in the background but must show the public that it too has good intentions and is here to stay for the long term.

Should Carried Interest be Taxed?

Before we deliberate our judgment on how to tax carried interest, I believe it is important to first determine how to categorize carried interest within the context of tax law.

There are two perspectives with regard to the classification of carried interest and depending on which one you choose, it will determine the level of tax you wish to see applied by the authorities. Do you see carried interest as an income from a sale of assets or as income from an investment into shares of a company? In other words, should carried interest be treated as income or capital gains?

In many countries the two rates of tax are different; however in Turkey the two rates are considered the same so this article is more in tune with US or UK funds rather than Turkish funds. However, many of the investors in Turkish funds are international (primarily from the US, UK, or the Middle East) so fund managers should pay close attention to developments concerning private equity tax structures.

In general, I will use US rates for the purpose of this article: income tax is about 35% whereas capital gains tax is 15%. The fierce debate is to categorize private equity as ‘services rendered by management’ (consulting) to a company and therefore automatically apply the higher tax of 35% on carried interest.

I am obviously biased in this matter as I work in the private equity industry. I am a believer that a prospect of a massive windfall from carried interest is the only reason why so many highly qualified people leave their posts in highly paid positions to join the ranks of general partnerships at private equity firms. The greatest asset of this industry is to have access to these super stars of business being able to grow companies. The entire point of private equity is based on the ability to take sizable positions in companies that you know your GP’s will be able to accelerate growth rates within a set time frame (two to four years). This involves tremendous amounts of expertise and the ability to calculate risk/reward in a very dynamic environment. If the rewards of private equity did not match the risks involved, the industry would simply seize to exist.

Any exit from a portfolio company should be regarded as capital gains and therefore be taxed at lower levels. Similar to buying stock, private equity funds often buy a controlling stake and guide the company to grow faster.

We should note that there is another factor that essentially makes this tax increase a mute point. The fact is that many private equity firms are structured in such complex ways such that its LP’s are often under a tax shelter of some sorts.