When it does.

Some Private Equity firms make purely finance deals where the main value is in the financing, but the frequency of these deals are on the decline.  So what are they counting on, and how do they make it happen?

Before we answer that question, let’s look at a related play that is still operative; breaking up the parts.  Many companies are so large that their public valuation is less than the sum of its parts.  Despite the delicious innuendo of the movie “Wall Street” often buying these companies and splitting them up is a good play in the long run.  If you have ever worked in a subsidiary allowed to languish hidden, unchallenged and unloved within a large corporate umbrella, and you have any aspiration at career development or in pursuing excellence in general, then you know that this is true.

Specialized and top industry knowledge in the sectors in which they operate.   Most Senior management in equity firms are high profile managers with intimate knowledge of the sector, able to bring their decades of experience to the table but also the benefit of an extensive list of industry insiders and vendor and customer contacts.

Especially with all that talent, operational improvement is a good possibility.  If you’re running your company 4-5% over industry cost structures, you can bet the private equity owners are going to be looking to shave that off.

At its best, more active and aware boards of directors.  Too often public company boards border on dysfunctional.  Many members not do not understand the industry in which they are serving, they really don’t have much business experience either.  Private equity firms can bring a very active board to senior management, with measurable, active targets and ongoing project reviews.  In that regard, they act not as some older brother looking over your shoulder; they are an added resource and an ear to discuss strategies, as well as keep senior management focused. 

Imagine a well informed Executive coming into your Senior management’s offices and one at a time, asking what the benchmarks of their jobs are, and the hard, measurable bottom line responsibilities they manage.  It’s quite energizing to the top say, 25 Senior Executives of the firm to realize they must justify the value of their existence, especially when the explicit implication that there be a synergism with the rest of the company.

This type of situation is really all too rare, and at least one of the reasons Enron situations can exist.  Think for a moment of Kenneth Lay’s defense; basically claiming he had no knowledge of the activity that brought the company down and therefore was ‘innocent.’  As CEO, he was implying he didn’t know what his right hand was doing, and also that his Board didn’t care either.  There is a huge fiduciary gap here which is almost ludicrous to ponder, not withstanding that one of the reasons we pay upper management millions of dollars a year is first and foremost to “take care.”  Claiming unawareness is like showing up at bank robbery with your friend and claiming in court that you didn’t realize that’s why you were there.  In my mind, Senior Management must be held accountable just because they were there.  It’s their job.  We’ll have more to say regarding fiduciary duty in other articles.

Incidentally, our example also brings up another aside worthy of a future article; the terrible record of the government deregulating industries.  A look at them, including energy, telecommunications, and the airlines is really a look at under-performing companies, still shackled by culture and regulation decades later, generally holding the entire sector back from stepping into the current century.  More on that later also.

At its best, a high performing Executive not only appreciates this kind of active, measurable accountability, she demands it.  How else can one gauge their and most importantly the firm’s success?  Private Equity brings a much better chance that the Board knows how to put such a process in place, and that the people they send to help have real specialized knowledge and value to the positions they are over seeing.

The Club for Growth sponsored 1,028 economists from all 50 states to pressure congress not to enact protectionist policies against China.  Democrats have been rattling their sabers for months now with any number of suicidal thoughts on trade.  Not only is the trade helpful to both countries, but China buys billions of dollars of low interest treasuries with their American dollars, keeping rates low.  Who in their right mind would want to stop either of those things?   Here’s the 2007 petition (PDF) as it ran in the Wall Street Journal this morning.  It is deliberately reminiscent of the 1930 petition (PDF) also signed by 1,028 economists as it ran in the New York Times, in hopes of dissuading the government from signing the Smoot-Hawley Tariff Act.  The 1930’s petition was not successful and the resulting tariffs drove the nation into depression. 

PETITION

 Concerning Protectionist Policies Against China

We, the undersigned, have serious concerns about the recent protectionist sentiments coming from Congress, especially with regards to China. By the end of this year, China will most likely be the United States’ second largest trading partner. Over the past six years, total trade between the two countries has soared, growing from $116 billion in 2000 to almost $343 billion in 2006. That’s an average growth rate of almost 20% a year. This marvelous growth has led to more affordable goods, higher productivity, strong job growth, and a higher standard of living for both countries. These economic benefits were made possible in large part because both China and the United States embraced freer trade. As economists, we understand the vital and beneficial role that free trade plays in the world economy. Conversely, we believe that barriers to free trade destroy wealth and benefit no one in the long run. Because of these fundamental economic principles, we sign this letter to advise Congress against imposing retaliatory trade measures against China. There is no foundation in economics that supports punitive tariffs. China currently supplies American consumers with inexpensive goods and low-interest rate loans. Retaliatory tariffs on China are tantamount to taxing ourselves as a punishment. Worse, such a move will likely encourage China to impose its own tariffs, increasing the possibility of a futile and harmful trade war. American consumers and businesses would pay the price for this senseless war through higher prices, worse jobs, and reduced economic growth. We urge Congress to discard any plans for increased protectionism, and instead urge lawmakers to work towards fostering stronger global economic ties through free trade.

I love it.  Congress would be beyond silly to go ahead now.  And I wonder what the reaction will be in The New York Times, after this incredibly silly article of a few days ago.  This story will be fun to watch.  Reason backed up by statistics and logic vs. alternate reality claptrap always provides great theater.  It’s like watching Hitchens debate Michael Moore.

Stay tuned.

Tags: Free trade, Economics, China, Politics, Sanctions

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From Morgan Stanley’s Richard Berner:

In our view, housing activity is clearly at risk, and we see no real recovery until 2009.  We believe that the economic costs of subprime loan defaults largely will be borne by lenders rather than borrowers because such borrowers have scant equity in their home.  Thus, the spillover risk to the economy depends on whether lenders tighten lending standards significantly further.  We do expect that the tightening in lending standards will crimp demand; indeed, the downdraft in June home sales to new lows suggests that the tightening in mortgage credit is already starting to bite.  The ongoing buildup in inventories of unsold new and existing homes points to a mismatch between supply and demand that will require at least a 20% decline in 1-family housing starts to correct; that drop is already built in to our forecasts.  In addition, we estimate that foreclosures over the coming year could add 7% to the inventory of homes available for sale and put further downward pressure on home prices and thus, potentially, on consumer spending.  Likewise, the increase in the cost of capital and tighter standards for business borrowers means that the sluggish capex expansion is also at risk. 

But there are also several reasons to be suspicious that such forces will materially weaken the economy.  First, magnitude and duration both matter for assessing the extent to which any such credit tightening will affect growth; this episode has been modest and recent — so far.  Second, other dimensions of financial conditions are moving in the opposite direction.  Third, and contrary to the pessimists’ claims that the US economy’s sole source of fuel is a high-octane credit market, we continue to think that strong overseas growth and hearty domestic income gains will support overall US growth in general, and consumer spending in particular.  Indeed, while market participants are ignoring past economic data on the theory that they don’t reflect the recent changes in financial conditions, initial economic conditions do matter.  In particular, net exports have added 0.4% to overall US growth over the past year for the first time in a decade, and prospects for global growth remain strong.  And US real disposable income rose by 3.2% over the past year — faster than the pace of spending. 

Exactly.  The economy needs one year’s grace for housing and consumer spending to get back in line.  That is what it needs, and happily, that is what it will have.  And the dollar will help.

In the long run though, government spending, especially in huge apportionment programs like social security, must be resolved to some semblance of sanity.  And there’s one other spending spree that’s really being hidden in the numbers; the politicization of the military.  What proportion of the military budget is really just politics finding a way to get a local income stream?  Put another way, if you were king for a year, how much could you shrink military spending and actually increase the effectiveness of the best men and women in the country while providing in capital and research and wages for their future?  Is it as high as 50%?  There’s some smart military folks around who could make a pretty good guess.

Tags: Economics, Globalization, Taxes

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Econbrowser has a great graph on the latest economics numbers.  Perhaps more impressive, his Recession Probability Index graph is purporting a great track record in predicting recessions.  It’s not predicting one right now.  Remember my earlier post.

Tags: GDP, Economics, Recession

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I like the way Arnold Kling thinks: let’s focus on the assumptions in political debate.  It might actually raise the level of discussion, which is very low.

These are strong numbers for the quarter and June:

We’re hearing mixed signals regarding the economy despite the rather strong showing of GDP at 3.4% for the second quarter; a lot of folks are antsy regarding the looming sub-prime issue which hasn’t totally come home to roost yet, and personal consumption is a concern at only .89% of GDP growth.  Meanwhile, Greenspan is warning that the cost of capital won’t stay low forever and oh by the way, it’s already masking the effects of a slumping dollar.

That analysis may be correct, but I’m not sure it necessarily means we’re headed for trouble in the next 12 months.  First, government spending isn’t going to let up any time soon.  The war and Katrina will take care of that, ready to fill in any vacuum that personal consumption leaves behind.  And by the time it does settle down, the dust will be settling with everyone’s personal finances, and who knows where personal consumption will be.   Second, until countries like China untie their currencies from the American dollar, I don’t exactly see how the slumping dollar is going to affect us as much as the graphs show.  The not so dirty little secret is that even in many countries with free floating currencies, where theoretically we expose ourselves to inflation as our dollar gets cheaper, often the dollar is the predominant currency on the street anyway.  So what happens to us happens to them. 

Incidentally, I believe everyone who is bashing Greenspan for his easy money strategy for the last decade tends to miss a point that has a significant dampening effect: many of those dollars are ending up in fallen iron curtain countries and other parts of the ‘third world’ acting as their actual national currency.  This tends to minimize the effects in the US; those dollars just aren’t here.  Now there’s a brain twister for you.

I’m a Greenspan fan by the way.  But he never was a very great forecaster.  If you’re going to pay him $150,000 for his next presentation, you may want to remember that when you’re discussing topics with him.

 It seems like we’ve been fighting over the yield curve for close to two years.  Sure it’s one of the most powerful graphs in economics.  But its magical power to predict a recession is what everyone has been talking about since at least January 2006 when the dreaded inverted yield curve began rearing its ugly, gnarly head.  This is not exactly your friendly every day Punksatony Phil type of prediction.

There have only been two instances in the last 50 years when the negative yield has not accurately predicted recession, making it the best predictor of recession ever.  It doesn’t cause recessions mind you, just predicts them.

The reasoning is really quite simple; banks make money by taking your deposits and lending them out to people who will pay higher interest rates than the bank is paying you.  As the yield curve flattens, banks can’t make money doing that anymore.   So they stop lending, which tends to slow business and personal investment down, which slows down the growth of the economy.

So the pundits have been arguing; will the magic of the curve hold true?  My argument has remained steadfast; the economy may slow down as it readjusts to money contractions, but recession would be very difficult given current government spending on the War and Katrina.  There’s just too many dollars being spent out there for the economy to tank.

And so far I’ve been right; we haven’t had a recession yet.  But there is a huge fly in the ointment; all the adjustable rate and sub-prime mortgages out there beginning to default because interest rates are rising and folks can’t afford to pay for their houses anymore.  Won’t that send the economy into oblivion?  Well, not really:

“The downturn in the US housing sector, which has sparked market jitters, is of serious concern but poses no major risk of an overall US financial meltdown, the ratings agency Moody’s said Wednesday.

Moody’s has a heavy duty reference on their side:

 ”US Federal Reserve Chairman Ben Bernanke said last week that he expected “significant financial losses” from failed sub-prime real estate loans but only a limited effect on the economy.”

I’m somewhat surprised that even Bernanke is downplaying the ultimate effect of the sub-prime storm that has yet to reach full gale.  Because it’s going to get uglier before it gets better.

It seems we’re weathering the storm ok though, and by 2008 should be seeing solid growth again.  So for those of you waiting for some huge tsunami of collapse reminiscent of the S&L crisis some years ago, well, that isn’t going to happen.  The world isn’t built like that anymore.  More importantly, the banks aren’t built like that anymore; they’re diversified, riskified, derivafied and webified.  They’re so technified nobody knows where the risk is anymore.  So it seems the magic of the inverted yield curve will fail again, but only for the third time in fifty or sixty years; still a great run.  And this will be the second time that it was government spending that put the lie to the rule, so I don’t like to think that counts.

Now, it does mean that you should add your banker to the list of people you can’t trust anymore; chances are his morals can no longer be distinguished from the used car salesman down the street.  Enforcing the meaning of fiduciary duty (please no more laws) would give mortgage bankers the slap upside the head they’ve been asking for. 

And it doesn’t mean that the dollar will stop sliding, and sliding.  The illness of our dollar is far more structural and pathological than a bunch of greedy, amoral bankers; all they’ve done is screw up the housing industry and make life immeasurably more difficult for thousands of hard working folks who didn’t know what they were signing.  No, the dollar symptoms bear witness to a chronic sickness about to be worsened by a decade long triple inflation wave front of commodities, food and energy.  It’s going to be quite a sickbed for awhile, and there aren’t any doctors in sight.  So grab your Maker’s Mark, or Nyquil, or whatever your favorite tonic is, because we’re in for a ten year ride here.

But we’ll leave those thoughts for another article.

Here’s an unsurprising poll by the Financial Times:

It appears clear that the western world’s citizens are unimpressed by the benefits of globalization, whether it has provided increased choice, lower costs or more value to their lives.  So much for free markets.  People are losing their jobs, especially at the lower levels.  And everyone knows that a lot of that free market theory is just a load of malarkey anyway, designed to give fat cat owners and managers of big companies a good reason to go take advantage of the bare-foot Chinese at $2.00 a week.  And all at our expense.  Right?

What does globalization, corporate governance, pay caps and the like all have in common, other than an “Us vs. Them” or “Capital vs. Labor” kind of Marxian perspective of the world.  Isn’t that the way we’re taught to think?  Isn’t that the only way to see it?  After all, the Man is out to get you and this really is a zero sum game, just like Marx and Engels said it was.  Clearly most folks agree in every country that these people need to be reigned in.  They are taking it all, and at our expense. 

It appears the only hope for the free market proponents is the last question, in that about half the people sort of support the general idea of free competition.

But let’s come at this from a little different perspective.

1. What’s the largest and freest market in the world?
2. What market has the highest standard of living?
3. What are some of more closed markets in the world?
4. What are their standards of living?

“So,” you say, “I understand USA is much richer than North Korea, buy I still don’t cognitively appreciate the theoretical connection between free markets and high standards of living.”  Then consider this example:

Let’s say you live in Chicago.  And I tell you that you can not buy anything from anyone who didn’t go to your highschool.  What kind of life do you think you’d have, compared to the one you have now?  What about if you could just buy things from Chicagoans, or better yet, people who live in Illinois?  What kind of life would you have now?  But wouldn’t you prefer to be able to buy things from all over the world?  That’s the inherent power of globablization.  You must have faith in free trade.

Still not convinced?  Hmmm.  I’m beginning to doubt your sincerity.  But here’s another example.  What countries are getting richer the fastest?  Forget the rich people.  They are in every country, and there will always be rich people.  I mean for the average, everyday Joe.  Who’s getting richer fastest?  The answer is obvious; the countries that have embraced globalization.  Countries like Ireland, China, India, Chile and the USA.  By the way, the opposite is true also (just go visit Venezuela).

On a subtler note, compare the EU with the States of the USA.  Compare size of markets, populations, educations, culture, freedom of speech, etc.  One might argue that the biggest difference between the two markets is that the USA is one large, free market, unlike the EU where the barriers between neighboring countries is comparatively large.

Now compare the standard of living between EU countries and the USA.  Go on.  Ignore the western press and its often  prejudiced opinion.  For your average, middle class guy, who’s better off?  Where is life just pretty darn good and getting better, not worse?  Forget what you hear in the press.  What does your gut say?

If the answer to the question is not absolutely, positively, clear, ask yourself this question: “What country does everyone want to move to?”

Maybe our corporate business managers should get a big lesson in fiduciary duty.  OK.  I heartily agree.  But does that mean we want government bureaucrats playing games with their wages?  Not OK.  And what does any of this have to do with globalization?  I do not have a clue.

But back to the matter at hand, which is the power of free markets to raise the standards of living in the country where you live, and generally help make you richer.  Forget the fact that globalization is literally pulling 2 billion people (1B each in China and India) up into the middle class (as defined by indoor plumbing, no longer worried about food and clothing).  Forget that stores like Walmart make everything more inexpensive for you to buy. 

Just consider whether in the last twenty years, life is getting better for you or not.  And if you’re too young to answer that question, but you’re working, ask yourself if you’d rather be in your shoes, or your parents when they started out.

So, do you still want free markets?