Breaking the Bankers: Part 1 - Private Equity

by Wholesome Rage | 4 July 2018

[Transcript follows]

For more than a year now I’ve been reading into financial journalism, economics. And one thing that always confused me was… what separated a crime from market forces?

I’m going to assume you’re bored by the news that banks routinely engage in predatory practices because the money they make from embezzling and defrauding their customers is more than the money they make from paying fines when, if, they get caught doing it. So let’s talk about Anchorage Capital instead, their takeover of the Australian electronics retailer Dick Smith, and break down how a hedge fund can destroy a brand, eradicate an entire chain of brick-and-mortar stores on a continent, and it all be perfectly kosher in the eyes of the law.

To do that, first I want to describe a kind of crime that is illegal. A horse crime. There’s been a crime described in the horse racing world where you have two identical race horses… except one is much better. A real champion. Real champion horses are extremely rare though, so you want to make as much money off him as possible… so you enter the worse horse into a race under his name, bet against him, and make some money that way.

Then, after that’s made his odds much lower, next time you switch the horses back around and bet on your horse, and you win big. So big, in fact, that you’ve now got an opportunity to sell him for stud.

But you rather like your good horse, don’t you? Champions are rare. So, once again, you sell the worse horse off under the champion’s name…

It’s the perfect horse crime. It’s such a good crime because it’s so hard to catch. But, if you do get caught doing it, you can bet that’s some major jail time heading your way.

But what if, instead of race horses you did this with, it was a major national retail outlet? Then the issue isn’t worrying about getting caught. Nothing you’re about to do is illegal. No, the trick is how to buy the horse cheap, sell it as a champion, and only hand over the cheap horse… when it’s all the same horse this time.

So in 2012 Anchorage Capital buys Dick Smith from Woolworths for around $115 million. Anchorage Capital is a private equity firm, and Dr John Vaz, of Monash University, summarizes it beautifully with this line:

The objective [of a private equity] is not to acquire a business with the objective of investing for the longer term, but purely with a view to exiting at a point where the return for risk relation is maximized. This means that an exit is planned from day one to the extent return is not compromised.

The plan, when entering the worse horse into the first race, was never for it to win. It was to set expectations for betting on it.

But Anchorage couldn’t switch it out for a better horse. Instead, it had to create the illusion that they made this one a champion.

Anchorage Capital stopped purchasing inventory for Dick Smith, stopped restocking, cut staff, and moved some numbers around. For that year they only sold previously stocked inventory. Profits, as a ratio of income to expenditure, shot up, credited to Anchorage’s amazing market skills and managerial performance.

They then floated the company for $520 million dollars, as a company’s valuation is also a factor of expected performance. It wasn’t just how well they were doing then, but the fact that they could advertise the growth was consistent. Anchorage Capital cashes out, leaving other investors to hold the bag.

The horse wasn’t lean because it had been exercised, but because it had been starved. There’s another difference between the comparison to the horse crime. In the horse crime, you keep the better horse. In the financial crime, the better horse never existed, there isn’t even anything to repossess.

Without the money to pay its bills or outstanding debts, to recoup inventory, Dick Smith folded. Thousands lost their jobs, and Australia lost a previously iconic brand. Yet what Anchorage Capital did wasn’t illegal.

Hang on, what debt?

Again, from Dr John Vaz:

The private equity firm and management will contribute the minimum equity required[…] Tax benefits will also be maximised to the extent that interest is tax deductible, a huge benefit given the degree of debt. Furthermore the tax paid on such gains is capital gain, taxed at a lower rate. Private equity firms will use very smart tax lawyers and accountants to structure the deal so that taxes paid will be well minimised.

Not only did they kill the company, but they did so by borrowing as heavily as possible, writing off the interest on that borrowing as tax deductible, and minimizing the tax they paid on profits as much as possible.

This is still legal. It’s a practice known as ‘negative gearing’ and it’s not only common, but encouraged by many economies around the world as a means to stimulate investment. Not only was the case of Dick Smith’s gutting legal, but it was state subsidized. The Australian government paid for this.

There was a Senate inquiry to see what crimes, if any, Anchorage Capital had committed. It’s five years later and nothing seems to have come of it. Anchorage continues to invest in Australian companies, most recently TJS Services, under its same managing director Phil Cave. When asked by journalists for comment on the inquiries he declined to comment, leaving the Australian Private Equity and Venture Capital Association (AVCAL) to do the talking.

AVCAL said the inquiry was a “unique opportunity for the community to better understand the the important role that private equity plays within our community.”

I think it was a fantastic illustration of the role it plays.

That brings me back to my initial question. What makes a financial crime a crime. I think I’ve found the answer; If the money is taken from large investors, or directly from individuals, then it is a crime. If the money is taken from the broader marketplace, even though it is composed of individuals, then it is just seen as shrewdness or market forces. It doesn’t matter how unethical a practice is found to be, so long as it is to the benefit of shareholders.

This may sound flippant, but I want to get into a three part series where I found this to be true. This would be the first part, focusing on things you really think should be criminal, and yet…

Dick Smith Electronics in Australia, worth $96 million in November of 2012, soared to a valuation of $520 million by December of 2013, only to be insolvent by December of 2015. In 2016, Valeant Pharmaceuticals is investigated for its predatory practices, which include charging for their drugs 10,000% more than what they’re sold for in Europe, and acquiring smaller companies to cut their research and development from 20% of revenue to 3%. 33,000 people are losing their jobs at Toys R Us as hedge funds pull $470 million from their own horse-heist.

If you or I had done what these people had, we would be charged with grand larceny, theft, fraud, embezzlement. But across every case mentioned above am I aware of even a single person seeing a single day of prison time.

Anchorage Capital, which bought and floated Dick Smith in that time period, faced a senate inquiry in Australia. No criminal prosecutions.

In Valeant Pharmaceuticals 2015 annual report they admitted to being the subject of investigations by the Securities and Exchange Commission, the U.S. Attorney’s Offices in Massachusetts and New York, the state of Texas, the North Carolina Department of Justice, the Senate’s Special Committee on Aging and the House’s Committee on Oversight and Reform, and had received document requests from the Autorite de Marches Financiers in Canada and the New Jersey State Bureau of Securities. No criminal prosecutions.

Toys R Us is just being blamed on being uncompetitive, and the finger is pointed at Amazon while private equity runs off with the money.

At this point it’s important to ask; What is the purpose of investment? It is to make money for the investor. While investment as a practice can be extremely beneficial to the invested, that is ancillary to the investor’s aim. If destroying the company, and thousands of people’s lives in the process, is more profitable to the investor, then that is what they do.

And it is legal to do so.

Now we can certainly agree it’s unethical. However, the capitalist system assumes that profit is the only efficient means of motivating and organizing labour and capital. Under that assumption, there exists no way to legislate to prevent profit optimization without contradicting the core belief of the underlying system.

In short, the pursuit of profit cannot be criminalized even when it is damaging or disadvantageous to society as a whole.

No matter how egregious, or deleterious, all laws and regulations are just playing catchup with the kind of people whose day job it is to find out that there’s no rule that says dogs can’t play basketball.

After that there is usually an investigation period, and the rules are written: Okay, dogs can’t play basketball.

Alright, but that doesn’t specify water buffalo.

New investigations after, this time, a few NBA all-stars get trampled and gored: No non-human mammals.

But how great is it to have a rattlesnake on point guard?

And so on and so forth.

Let’s take Valeant Pharmaceuticals again. Its modus operandi, its method of operation, is to buy up smaller companies and make them more profitable. There’s two ways you can do that; Increasing revenue and decreasing expenses. Considering that they are a pharmaceutical company, they can’t market their product better or create new customers…

I mean, God, I hope not.

So there are instead two options available to them. Raise prices, and cut research and development — something Valeant says is an unacceptable financial risk. Again, the purpose of private equity is to minimize risk to the shareholder, not maximize benefit or viability of the company, as we already covered. It is more efficient to purchase companies that have already succeeded in their research than it is to gamble on your own.

Alright, but say that’s not egregious enough. This is just Martin Shkreli and EpiPen stuff. So what Valeant then also does is work with an online distributor, Philidor, to use Valeant products instead of generic alternatives when filling prescriptions. This way they can sell their drugs at four times market rates, and forcing insurers to take the hit when cheaper alternatives were available. Valeant invested over $100 million into Philidor.

Unethical? Certainly, they couldn’t justify it to a Senate ethics committee. But not illegal.

There is some small justice here, in that after the Senate inquiry, Valeant’s stock price plummeted 90%. But its CEO, J. Michael Pearson, would see no prosecution. The hedge fund manager behind much of Valeant, Bill Ackman, still holds a net worth of $1.1 billion dollars.

Again, you’re seeing this happen in real time with Toys R Us. Exactly what I described with Dick Smith is happening to the United States’ largest brick-and-mortar toy chain. KKR investment and Bain Capital have put the company into $5 billion of debt, but personally walked away with at least $470 million.

Private equity is involved, while the employees, shareholders and customers are committed. In a bacon-and-egg breakfast, the chicken is involved, but the pig is committed.

A problem, if you want to call it that, is that you can’t outlaw the practice of investment. Investment is an important, beneficial practice. It keeps as much money as possible in the economy being used, in a similar way that banks using deposits to give people loans does. You also can’t criminalize profit motivation.

So, in the free market, what laws can you make that prevent these crimes? And the answer is… shockingly little. All you can effectively enforce is; “Did this company provide accurate information about its dealings”? That is, you make these actions more difficult by relying on a certain degree of transparency. They can ruin you as much as they like so much as they’re honest about it.

The unfortunate side effect of this is that, as I said before, it means financial laws can only exist to protect investors, in most cases. We can only meaningly enforce availability of information, but that only matters to people who have the power to act on that information.

For the employees of Dick Smith and Toys R Us, for the customers of Valeant medication, the knowledge of what was happening would do them as good as knowing a meteor was going to hit the Earth in a month. And even then, that information doesn’t need to be broadcast to them. It might mean having to drive out to an observatory and checking their bulletin board.

When we do see criminal prosecutions happen, it’s almost always because someone was caught lying to move money about and pay the bills, and they ran out of money, which is what Martin Shkreli actuallywas arrested for. In all these other cases that you see on the news, where you see a company destroyed, or bankrupted… odds are high someone knew exactly what they were doing, and did it well.

And they have made more money for doing it then you, or your children, or your children’s children, will all cumulatively see in your lifetimes.

Next week, in part 2, I’m going to be covering the LIBOR scandal, the greatest financial crime you’ve never heard of, and the only trader who went to jail for it, Tom Hayes.

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