Gabriel’s scarcity rent - it’s management stupid!

It supposedly began with a bubble. Just another bubble like the one I described on The South Sea Company (or how Sir Isaac Newton spurned the dismal science). The bubble was fuelled by an excess of liquidity. It had to end someday. We learned the word subprimes. We knew it had to mean trouble.

Liquidity injections were administered and succeeded. But they were just patches for a bigger problem. And then they asymmetrised the risk: there were institutions willing to provide liquidity when needed, to reward higher risks, to stimulate the economy further up and away from reality. Until the moral hazard was too huge.

And then it ended too abruptly. The wells of money simply drained and, those whose business was to ensure the efficient distribution of liquidity between the different players just became inefficient. From excess to world wide scarcity, even for sound projects. It became a financial crises.

Few crises have been so focused on the financial system like this one. Because that’s what’s really in trouble here, the whole financial system. I began in the UK with Northern Rock, now nationalised thanks to Alistair Darling. In the meantime Daniel Bouton from Societe Generale didn’t know what was happening in his bank until he lost more than his reputation. And the Swiss face value is also in an all-time-low: just take a look at UBS and Credit Suisse (also First Boston).

But where really is too darn hot is in the US. Bearn Sterns is in flames, expiring his final breath. Bought by $270 million, it was valued about $20.000 million one year ago. A 85-year-old Wall Street institution simply died.

And those that bought companies using leveraging, namely private equity, now see the liabilities piling on top of the roof. Take a look at Blackstone: their profit for the last quarter was less than a half of what was expected, and dropping. Of course its value is dropping too.

We gave it complete freedom. They took it. They invested again and again in the same risky assets, albeit chopped and transformed so they didn’t look like they were the same: collateralised debt, mortgage insurances, mortgage reinsurances, credit swaps and all kinds of derivatives that were the same dog, different collar.

And when the system was in trouble: more liquidity. Await for some more in the next days. New bolts and flashes from the Fed to try to contain it all. But no regulations… in any case it would be too late for that. And always paying a huge price in inflation… until that game is not longer possible.
The dollar’s dropping. The safe heaven for savings all over the world that financed the US debt has ended. If you add up the soaring energy prices, and the huge public deficits, the US credibility is under minimum. The country risk is dangerously rising… no more overspending, no more cheap financing, the party is over.

Daimler no more. Finally Cerberus got their way. (Remember the post Cerberus Capital Management: another style for private equity). One icon buys another. In those five months, thousands of hours spent at the negotiating table as well as more than $7,400 million.

So it seems the time has come for Cerberus to get their chance to manage Crysler in their own way. Chrysler needs it badly. Chrysler needs to retake the profitability path and that will mean some additional leaning or, probably, even severe downsizing.

The ones to decide will be the new management team: 150 professionals brought by Cerberus. Headed by Robert L. Nardelli.

Ex-chief of Home-Depot, his eyes should add a new and fresh perspective to the Chrysler problem. Star in GE energy division, he lost the race to replace Jack  Welch. Then he was controversial at Home Depot because his earnings and his conflicts with shareholders that finally ousted him.

Now we will be able to see the difference in management between a long established and experienced firm such as Daimler Benz and Cerberus’ own style. In these days of increased capital costs it’s very important for the market to perceive the value added by private-equity management. That value can be proved in Cerberus in the forthcoming months… or not.

There are many unanswered questions. This time, they swear, there are no plans to chop the company to pieces and sell them, but some days ago the unions  threatened for a strike avoided at the last minute. Cerberus had also sworn to keep the previous managers but promises are just that… promises. Now they say it is reasonable to change management when facing new challenges. And the auto industry is amid turbulences right now, as Toyota, Ford or Honda can witness too.

Next questions only time will answer: can Cerberus provide the right management for Chrysler? Is Nardelli the right man for the job?

My readers (thank you for being there) already know that Blackstone is a private equity firm that I like and I’ve been following lately (See China and Blackstone: bad news for capital markets, good news for private equity).

I’ve always visualised private equity firms as a way to avoid the market’s constraints, and the firm’s constraints also, to be able to make longer term moves in order to ensure efficiency and the emergence of sunk benefits inside the firm (See Defensive strategies from private equity).

The funny thing is to see how a private equity firm just decides to go public. In any case, makes a lot of sense to me. At least the market recovers part of what has been taken off it. ($4.13 billion are a nice prodigal son to welcome home)

And Blackstone decided to do just that and went public last Friday.

Graph source Yahoo Finance

This graph is from IPO-day. If you read the news, it was a success, as the PR guys and gals are saying: biggest US IPO in the last four years, executives going mega-rich and all that stuff.

And I concur that it was a success. But not a wild success: a mild one.

In the picture, the trade for Friday: the share ended up at $35.06, far higher than the initial price of $31, a 13% more… of course it went up, it was already over-subscribed. But, take a second look, it didn’t go that far up. The Fortress Investment Group went 33% up in its IPO last February, and it wasn’t as sexy or hyped as Blackstone.

Things are changing. As I have also written before, cheap money is going scarce. (see Rates keep raising: is this the end of cheap money?) And maybe we’ve reached the peak. Bond’s yields are going up too.

Let’s take a peek at the market:

Graph source Yahoo Finance

The graph is the Dow Jones Industrial Average Index over the last year. The two curves below are the Relative Strength (RSI) and the Money Flow (MFI).

The RSI measures the internal strength, the momentum, and it’s indicative when the security reaches a high and the signal fails to reach one. It’s not as low as it was in March’s crisis, but it’s in the second lowest for the last year.

The MFI also measures momentum but takes into account volume as well as price. In this case it has shown repeatedly how the market was loosing strength, thus slowing the slope, so there is a divergence there. In any case it would be worrying if this signal went below 20%, which has not happened.

But my point is that things are not as bright as they were before. And probably things will be harder from now on. If these guys were discounting new highs, they could have waited for a better moment. But they decided to go in now. There must be a reason for that. Behind the curve probably we will find a bumpier road, not the accustomed highway they’ve enjoyed until now.

And, just another thought, another interpretation from a different perspective: is it sustainable that private equity firms enjoy a 15% tax rate while public companies are at 35%? Doesn’t seem quite fair. There’s a hard debate on this and proposed changes on legislation on the way… is Blackstone equity already discounting the conclusion of the debate? (or at least the uncertainty)

Last food for thought today: KKR has also announced it will go public. (yummy, yummy)

Those of you who read me know my ideas about private equity and how it has become an increasingly efficient way to invest the “big bucks”. I wrote about this in China and Blackstone: bad news for capital markets, good news for private equity.

I have to confess I like the concept of private equity. Although private equity firms probably wouldn’t considering hiring me, I’d hire them to increase efficiency. Their whole business is about efficiency gains: buy some under-performing firm, use your credibility to increase debt to pay the buy-out, make it perform again. If the gains are similar to the costs, the company is yours… *for free*.

Of course I’m exagerating. That’s a simplification, but, for comparing purposes, what happens if you compare their strategy to the diversification strategies undertaken by big companies? We have extra resources, we are not really interested in giving them away to our investors, or owners, so we are going to buy some business out of our core knowledge and know-how to have less risk and at the same time less yields.

Why should anyone do that? Well, managers would say there are synergies to be gained, but, as you know, sometimes those synergies never make it out of the power-point file.

The real reason to do that is that the managers need to keep busy, and need content to present in their next shareholders meeting, probably speaking about another business they don’t know anything about. (Fortunately, neither the shareholders)

Are they paid to do this? Are they suitable to do this? Hell, no!

Not so long ago, they were pretty relaxed and calm because nobody would object anything to that strategy. Even shareholders didn’t see that it was easy to reduce their risk just diversifying investments in different companies instead of diversifying core businesses.

If the investor can diversify by himself, companies shouldn’t try ventures alien to their business.

Then, why were the big companies so unperturbed just doing that? Because they were huge. Or at least too big for hostile takeovers.

And then came KKR with RJR Nabisco (See article about KKR here), and Cerberus with Chrysler (See article about Cerberus here), starting a series that could end with ABN Amro or who knows what. Being huge is not safe anymore.

A new signal emerges from markets. It’s the end of diversification. It’s time to concentrate on your core business. For public companies there’s only one protection strategy for private equity. And it’s no longer to be huge, now you need to be efficient instead.

Barbam propinqui radere, heus, cum videris, praebe lavandos barbulae prudens pilos
(in latin, if you neighbour is being shaven, do get your beard ready)

*Efficiency will save you from private equity*

Got an interesting non core business? Let it go. Otherwise private equity will come for you, and spin it off you.

Inside the non-efficient companies lie a lot of unused resources that justify the gains private equity need as an excuse to assault them. If only those companies could use those same resources for protection…

But that would mean being efficient again. That would mean ruthless reestructuring. That would mean hard and painful decisions. That would mean having to face change, sometimes radical change. That would mean challenging established authority. In short that would mean working more and better.

One last problem about leaning and trimming yourself: why do it yourself when private equity can do it more efficiently than you? (And market seeks efficiency, somehow)

A few days ago I wrote about KKR and the three men behind that acronym. Now it’s the time for another company that lies in the private equity niche too, but, as you will see, plays its cards quite differently. In this article I’ll focus on the difference between them.

the original Greek Cerberus, a dog with three heads that guards the world of the dead and won’t let you in

Cerberus Capital Management was news just three weeks ago, when they announced they’d buy Daimler’s 80.1% stake in Chrysler for $7,400 million. Three months before the company had announced the laying off of 13,000 employees, after the red tape exceeded $1,500 million for 2006.

Not very good times for Daimler and Crysler. That was the end of a transatlantic marriage that lasted since 1998 and cost $36,000 million.

As you know, good times for private equity, bad times for inefficiencies and for corporate social responsibility: more laying offs ahead. More trouble in the Motor City: Detroit. And of course unions abhorring of letting private equity in, unions such as the United Automotive Workers and their leader: Ron Gettlefingers, warning about the dangers.

worried about the takeover? when this man speaks, Motor City listens

But something strange happened. Ron Gettlefingers, after some months sending the leave-Chrysler-alone message decided to back up the take over. Why? Who convinced him and how?

this is the man from Cerberus that convinced Gettlefingers: John W. Snow

What did Snow promise? Three things: to keep the same management team (I’m not sure that is a good idea after $36 billion having gone down the drain), to keep his three brands (well, without further analysis, looks sensible to think about consolidating the strongest only), and no further lay-offs and contract negotiations to be held this summer with the unions (which doesn’t mean that they’ll succeed either).

Will they be able to deliver? who knows.But that’s not the point.

They have credibility or, at least, they have a very different style. Cerberus managers are not perceived as elitist billionaires -and that’s a difference with KKR. Cerberus founder Steve Feinberg was son for a steel’s salesman, graduated in politics in Princeton while playing a lot of tennis. It has been said of him: “While other hedge-fund managers are collecting fine French wines and flying around in private planes, he drives a Ford truck and drinks Budweiser.” (Follow this link to a Businessweek article for the source)

most appreciated piece of art in Cerberus headquarters

It is said that the most valuable piece of art that is stored in Cerberus headquarters is a poster by the Fugees. Feinberg himself drives a pickup and wants no personal publicity. Half of their staff are ex-managers, a big number when compared to other companies that heavily relay on consultancies.

remember the one on the left? from US vice-president to Cerberus vice-president

Dan Quayle is also in Cerberu’s team as vicepresident. Not famous for his literacy or his perfect spelling, but close to the people. The same style that has made George W. president twice.

So, which are the main differences between the way of doing business of KKR and Cerberus?

• Cerberus are perceived as peacemakers, not as hard negotiators. Got nervous union leaders? they just hop on a plane and talk face to face plain conversations, making trust, opening bridges. As Buzz Hargrove, president of the Canadian Auto Workers (CAW) said on Feinman, “He gave us all letters that said there will be no job losses. He was very genuine, not some highfalutin billionaire. It was real talk.”
• And a financial difference: they don’t use leveraged buy-outs. That way the cost of borrowing money keeps lower. And, guess what, they talk to creditors too, giving them a lot of information and letting them participate. That makes trust too, and the more the trust, the less the borrowing costs also.
• Not worried about quick returns either. Let things take their time.

So, money is not everything, is it?

As you probably know, private equity firms are hot. And as they get more and more funds (remember how the Chinese government decided to invest in Blackstone) they become even more desirable.

KKR used to be the Holy Grail of private equity. KKR stands for Kohlberg, Kravis & Roberts and was founded in 1976 by Jerome Kohlberg, Henry Kravis and George Roberts. KKR specialised in leveraged buyouts and starred with the buy of RJR Nabisco in 1988 for $31.4 billion. There’s a must-read book about this buyout: Barbarians at the gate, by Bryan Burrough and John Helyar. And a movie too.

Blackstone has broken that record this year- yes 2007- and gone from princess to queen, but that’s a story for another day.

You could say that they used junk bonds to buy underperforming companies, reworked their balance sheets, and sold them for profit, maybe as a whole, maybe not.

But who where those entrepreneurs that decided to create KKR? Where are they now?

The first, Jerome Kohlberg, was born in 1926. Unsurprisingly, he was working with Roberts and Kravis in Bear Stearns, worldwide investment banking and securities trading and brokerage firm. He left KKR in 1987 –that is one year before the Nabisco takeover- but he didn’t retire until 1994 when he created the Kohlberg Foundation. His wife has a restaurant, the Flying Pig, in Mount Kisco, NY. His fortune is approximately $1.2 billion.

Henry Kravis was born in 1944. Economist and Columbia MBA, in KKR he was the key to developing the LBO, leveraged buyout, concept, acquiring corporations they thought were under their potential, putting 10% of the price and financing the rest through junk bonds. (At that moment the concept of junk bond was still undefined, they were just high-yield bonds). The concept included selling whatever assets that could be valuable and leaning the company to a maximum before selling again with huge profits. He directed the Nabisco takeover after Kohlberg’s parting, creating the legend for KKR. He also participated in buying huge brands like HCA Inc., Texaco, Gillette, Playtex, Beatrice, Safeway, Borden and Samsonite. He is a prominent Republican and a strong supporter of G. W. Bush. (What a coincidence: Nabisco also began donating great amounts to the Republicans after the takeover) His fortune is approximately $1.5 billion.

George Roberts was born in 1945. Cousin of Henry Kravis, Law Graduate. Mentored too by Jerome Kohlberg in Bear Sterns, he cofounded KKR, participated in the Nabisco takeover –he is one of the main characters of Barbarians at the gate- until he exited in 1987. He’s been active ever since, participating in the Toys’r'us takeover by $6.6 billion with Bain Capital this year and SunGard Data Systems for $10.6 billion with Blackstone. His fortune is approximately $2.5 billion.

Well, he is the richest of all three so maybe he has something to tell. This text is from his acceptance speech at the 1998 Man of the Year’s award from the Culver Military Academy:

“I’m often asked by people, especially younger people, what do you have to do to be successful. And I assume they’re asking not what you have to do to make money, but what do you have to do to be a successful individual. Coming out here, I jotted down several examples that I’d like to share with you.

“You’ve got to work hard at whatever you do. So if you’re going to work hard and put everything you have into what you’re doing, you better find a job and a career that you love to do, because if you don’t you have no chance.

“Set your goals. Set goals that are unrealistic in some cases. Be prepared to be disappointed. One of the goals I set for myself when I came to Culver was to get into Yale. I got turned down. One of the goals I set for myself when I graduated from CMC was to get into either Stanford Law School or Stanford Business School. I got turned down. Set your goals high; reach, that way you improve our muscle tone. Don’t be afraid to fail. Our society won’t penalize you if you fail honorably, and by that I mean with integrity and honesty. Everyone who has done anything in life has failed at something. And there will be nobody in this room who is any different.

“Keep a sense of humor, that’s probably the most important thing. Be prepared to laugh at yourself a little bit, your mistakes. And when things really get tight and tense and everything else, laugh a little bit.

“Keep a perspective of what’s really important. For me, that’s been my health, the health of my family, and those intangible things that don’t involve material objects.

“Raise a family, because that’s the only way you’re going to learn to love somebody or some group more than yourself.

“Rely on yourself with both your brain and your heart. Don’t blame others for the mistakes that happen. Learn from them yourself and go on.

“And lastly, help others that are less strong and less fortunate than yourself, because you will get back many, many, many fold what you have done for yourself.”