Sunday, August 10, 2014

A Cure Worse Than the Disease

Here be dragons. Who do you want in your corner?
Messenger: “I see, lady, the gentleman is not in your books.”
Beatrice: “No; an he were, I would burn my study. But, I pray you, who is his companion? Is there no young squarer now that will make a voyage with him to the devil?”
Messenger: “He is most in the company of the right noble Claudio.”
Beatrice: “O Lord, he will hang upon him like a disease: he is sooner caught than the pestilence, and the taker runs presently mad. God help the noble Claudio! if he have caught the Benedick, it will cost him a thousand pound ere a’ be cured.”

— William Shakespeare, Much Ado About Nothing

I suppose it does little harm to admit, O Dearly Beloved and Long-Suffering Readers, that this site is shot through and through with what my colleagues across the gaping divide in Sales & Trading would call “talking your book.” Notwithstanding the slings and arrows sent this way by those who can see no redeeming social or economic benefit to my profession, I am proud of what I do, and I firmly believe I offer real value to my clients in return for the shiny simoleons which they so graciously bestow on me, however so (and too) infrequently. This should not really be that surprising. I think there must be few human beings who do not find some sustaining or redeeming value in their daily occupation, even if only as a sop to their self esteem or a dodge against despair, and despite all your protestations I continue to aver that investment bankers are human, too.
If you prick us, do we not bleed?

That being said, I think I have been pretty honest in these pages (and in the conduct of my daily duties, too) that M&A advisory services are not for everyone. There are many reasons a client might consider in deciding whether to employ someone like me, and not all of them make sense or can be justified by any honest calculus. While there are plenty of dissembling shysters roaming my industry intent on imposing their services and extravagant fees on anyone they can convince to write a check, I have always been of the opinion that you make a client happy in the long run by only recommending what is truly beneficial for them, rather than yourself. And often, hiring an M&A advisor is not the best course of action. At least not yet.

* * *

So I am pleased to take this opportunity to respond to an article on private equity and venture capital shill site peHUB, written by a corporate attorney, about things to consider when you are selling a private company. As advertised, it is geared towards the owners of private companies, who generally face a simpler and less complicated set of constraints and obligations than the Boards of publicly held ones. Of its type, it is a reasonably comprehensive and useful guide.1

In it, Mr. Stewart offers the following considerations concerning whether you should hire a flesh-eating investment banker like me when you are selling your private company:

*Do You Need an Investment Banker? Investment bankers can add significant value in an M&A process, but they are expensive. Investment banker fees typically range from 1 percent to 2 percent of the deal value, although the fees vary by deal size and profile. Typical benefits of having a banker in an M&A process include having an agent to (1) advise on market trends and valuation, (2) approach potential acquirers with which the target’s executive management would not otherwise have contact, (3) take the difficult, “bad cop” negotiating positions, and (4) co-manage the sale process with the target’s legal counsel.

Now this is fine advice, as far as it goes, but it omits some pretty important content and nuance that I, your reliable guide to all things overpriced and intermediary, will be happy to impart herewith.

Deferring our discussion on whether M&A advisory fees are in fact “expensive” and if so how for later (I promise), I can first address Mr. Stewart’s itemized reasons for hiring a banker by contrasting them with what corporate lawyers typically do in deal contexts. On the first two points the author is correct by implication: rare (and professionally worrisome) is the lawyer who is concerned with markets and valuation, and even rarer (and in likely violation of her professional ethics) is the lawyer who spends time and energy soliciting buyers for her client. These are tasks for which lawyers are unsuited by training, focus, and predilection, and if the client wants someone other than himself to weigh in on such matters and perform such heavy lifting he needs to hire someone for whom they are suited. The third task is more nuanced, as lawyers are perfectly capable of acting (and often quite happy to act) as “bad cop” (read flaming asshole) in matters properly considered legal, but it is true that bankers adopt this role more naturally and properly in matters business.

The fourth task is generally a bone of contention for lawyers and bankers on a deal, as each usually considers the other an interfering nuisance who focuses on the wrong things at the wrong times. Nevertheless, it is true that a properly run deal process usually starts with the banker running things until definitive negotiations begin between the seller and the potential buyer, at which point the seller’s attorney takes over to control the legal minutiae of drafting purchase agreements and other such trivia. While I am convinced many if not most deal attorneys would be delighted if they never had to deal with another investment banker again, bankers are more than pleased to have lawyers around to handle the boring scut work of transaction documentation and risk mitigation. After all, somebody has to stay behind to argue over semicolons while the banker takes her client off for a nice, celebratory bottle of Échezeaux.

* * *

But Mr. Stewart misses three very important reasons why it usually makes sense for a private company, in particular, to hire an investment banker to sell itself. The first is the fact—evident if an attentive reader were to consider the range and complexity of the tasks Mr. Stewart himself recommends the seller perform—that selling a company is long, complex, and difficult work. A typical sale process, depending on its structure and the number of potential buyers it involves approaching, can last anywhere from four to six months or longer, and that is if all goes well. During that time, company management and owners (usually the same people) must continue to run the firm with the same level of intensity and focus they do normally, otherwise things being things and people being people results will start to wobble or decline, and the intrinsic value and earning power of the business will erode. Yet pre-deal preparation, internal due diligence, and identification and potential communication with selected potential buyers all take a substantial amount of time, and once the deal is launched keeping it humming along and tending to its myriad details and interruptions requires constant daily attention. Virtually no private company of normal size has the extra personnel or dedicated, trained professionals to handle this properly, and, frankly, few private company CEOs or CFOs have the skill or training either, even if they did have the time. (And they don’t. Or shouldn’t.) A skilled sell-side advisor will manage this entire process, and she will arrange things so company management spends as little time as necessary providing the input, attention, and personal presence they must so they can continue to focus on their day jobs. Lawyers just don’t do this sort of thing.

Second, a good2 M&A advisor will bring market intelligence to bear on a sell-side assignment which nobody else—not even a dedicated internal M&A functionary at a large private company—can come close to providing. This is detailed, intimate knowledge of a firm’s potential buyers, based on comprehensive discussions and extensive deal experience and interaction with all of them. As I’ve written before,

You might think that a participant in a particular industry should know the strategic intentions and capabilities of its direct competitors well, but normally you would be wrong. Competitors do not talk to each other directly about strategy because—wait for it—they are competitors. On the other hand, it is the job and practice of any good investment banker not only to develop an informed opinion about how each significant competitor in a space thinks about strategy but also to have done so by talking directly with them, frequently if possible. This is simply not practical for most corporations. Investment bankers are normally far better informed about the strategic landscape of an industry than any one of its participants.

And this knowledge is not limited to other companies, either. A good advisor will also know the likely, potential, and just-barely-possible buyers of her client among the financial sponsor (private equity) community, too. Not only will such a banker know these parties and their own acquisition appetites and capabilities well, she will know which ones of them are complete and utter assholes, which ones tend to fire the management teams they acquire with companies within the first year of purchase, which ones like to bait and switch sale processes by bidding high then whittling down their offer during exclusive negotiations, and which ones are irredeemable bottom feeders.3 This is invaluable information which even the best informed private company in the most incestuous industry has very little of, if any.

Knowing the likely buyers in the private equity world and being able to bring them to the table is critical in virtually every industry sale process nowadays. Not only are sponsors often the best capitalized and most aggressive buyers, they are almost always faster and more professional than the strategic buyers in an industry, because unlike the latter the former do deals for a living. Incorporating this type of determined, fast-moving buyer into a sale process is very helpful even if the seller and his banker think the most likely buyer is a competitor in the same business, because it helps the banker keep time pressure and process discipline on the strategic buyer which might otherwise dissipate. They also usually offer a very different purchase alternative to a private company seller: sell us your business, then come work with us as a (junior) partner to build it bigger so we can sell it to the next guy, and you will get a second bite at the apple. This, in contrast, to the typical offer from a strategic competitor: sell us your business, then either join us as a salaried employee or go away. Many private company owners prefer selling to private equity firms for this very reason nowadays, but they are babes in the woods when it comes to knowing those buyers. A skilled investment banker can offer crucial guidance in this area.

Third and last, surprisingly enough—given the regular beatings good sell-side advisors give potential buyers in M&A deals—most serious buyers prefer private companies to have professional sell-side help engaged. This is for all the reasons cited above: they know most private companies do not have the time, M&A experience and discipline, or negotiating skill to run a tight, efficient transaction process. Buyers want to know the person sitting across the table from them is not procrastinating, flip-flopping on deal provisions or objectives midstream, or negotiating in a disingenuous or irrational manner. Being a buyer of companies is expensive and time-consuming, too, and buyers who are serious don’t like to suspect their time is being wasted. Having a professional investment banker across the table gives them some confidence, because everybody knows no investment banker would allow herself to be hired by a client who wasn’t serious themselves.

And this, at the last, is probably the most compelling reason a private company should hire a financial advisor to sell itself: because that banker will make sure to keep her client disciplined and focused on accomplishing the sale. Privately held companies—for all sorts of good, bad, and indifferent reasons—can often be pretty squirrelly, and nothing will kill a deal faster than a squirrelly seller. After keeping buyers in line, a good sell-side advisor’s principal role is to keep her own client’s eyes on the prize.

* * *

Which brings us to the matter of expense. It is true that, for most deals, the check a seller writes to his investment banker is usually the biggest one crossing the closing table other than the purchase price itself. Even so, one or two percent of the transaction value is arguably a pretty small price4 to pay for someone who has broadened the potential universe of buyers, guided and directed the sale to achieve the highest price and best non-price terms available given the seller’s other objectives, and performed all the tiresome, dirty work of managing a complex sales process for upwards of six months or more. Even more compelling, except for the occasional nominal retainer, the success fee a banker earns upon her client’s sale is just that: a success fee. If the sale fails, or her client withdraws his company from the process for whatever reason, she does not earn anything. Her risks and incentives are completely aligned with those of her client, assuming of course her client really wants to sell.

And that is the real answer: if you’re not really sure you want to sell your company, don’t hire an investment banker. It is our job and embedded in the way you pay us to do everything in our power to close your transaction, including beating you up if you’re backsliding, procrastinating, or otherwise doing anything unreasonable and likely to derail a potential sale. Other bad reasons—like you’d like to play investment banker yourself, no matter how much it costs you in distraction from your core business, diminished transaction value, and fruitless legal and accounting expense—are also good arguments for not hiring a banker, but presumably you are too intelligent to need me to tell you that.

Of course, any good corporate law firm would be more than happy to accommodate you in such circumstances. After all, they charge by the hour.

Related reading:
Matt Stewart, Things to consider when selling a private company (peHUB, July 28, 2014)
Eight Reasons Not to Hire an M&A Advisor. And One Reason to Do So (May 14, 2011)
A Good Start (January 19, 2011)

1 If I’m being honest, as I claim, I think the author is a little lackadaisical about describing the necessary structure and elements of the sale process for a private company. While he gets the major elements right, he is a little slapdash in describing how they all fit together. It has been my experience that a robust and disciplined process is absolutely necessary to keep deals moving at an appropriate pace, to encourage potential buyers to play nicely, and to keep the seller focused on what needs to be done. Without a firm hand on the tiller (and an eagle eye on the clock), there is a tendency for all deals to fritter away into time- and money-wasting nonsense. Given the fact that, of all the players involved in these little dramas, lawyers are usually the only ones paid by the hour, I will leave it to the cynics in the audience to conclude whether this omission was intentional.
2 The perceptive among you will note that my use of “good” here is definitely normative, if not prescriptive. The type of knowledge which informs nuanced, deep understanding of the strategic landscape of an industry is normally only collected by investment bankers focused on and active in that industry. This means if you value and want such knowledge you should search for an advisor from among those who actually have it, rather than the generalist sell-side firms who market themselves as one size fits all. They are prolific sausage factories, it is true, but all the sausages tend to come out the other end looking the same. Just sayin’.
3 Yes, we know who you are. All of you. You, too.
4 Unless you are paying 2% for a billion dollar deal or greater, in which case your banker is a shyster and you are a fool. Or neither one of you cares how much of your public shareholders’ money you waste.

© 2014 The Epicurean Dealmaker. All rights reserved.

Saturday, August 2, 2014

Where Did He Learn to Negotiate Like That?

Anybody else want to negotiate?
Korbin Dallas: “We need to find the leader. Mangalores won’t fight without the leader.”
Mangalore Leader: “One more shot, we start killing hostages.”
Korbin Dallas: “That’s the leader.”
Mangalore Leader: “Send someone to negotiate.”
Security Chief: [to Dallas] “I I I I I’ve never negotiated I…”
Korbin Dallas: “Mind if I… try?”
Security Chief: “No, no, sure, sure. Sure. [to Mangalores] We’re sending somebody in to negotiate!”
Korbin Dallas: [walks into room, shoots Mangalore leader between the eyes] “Anybody else want to negotiate?”
Security Chief: “Wh-wh-wh-where’d he learn to negotiate like that?”

The Fifth Element

Unlike many of you, O Dearly Beloved, I am old enough to remember a time when air travel did not offer wireless internet in flight. As a result, when junior bankers like me did not have work papers to review or spreadsheet modeling or presentation editing to do on our laptops,1 we were thrown back on our own devices when it came to entertaining ourselves with something other than the crappy movies playing on low res CRT screens hanging from the ceiling. Normally I would bring some combination of newspapers, magazines, equity research reports, and a book or two to occupy my time, but occasionally said distractions would fail to engage me or I would simply run out of material to read before the flight ended. On those occasions, in desperation for something to distract me from the grim environs of a 30-year-old narrow body aluminum tube stuffed with sweaty tourists and bedraggled business travelers, I would sometimes stoop to leafing through the airline magazine jammed conveniently in the seat back pocket in front of me.

This rarely offered much relief, but I do recall frequently encountering the same stiff, glossy multipage ad for a well-dressed chap named Chester Karras, who generously offered to teach the ambitious road warrior the secrets to becoming a master negotiator, for a hefty price. “You don’t get what you deserve,” his tagline warned, “You get what you negotiate.” Putting aside the wisdom of advertising such services to the rumpled middle manager wedged into the middle seat of aisle 32 on the 9:18 pm flight from Dallas to Abilene, these ads always reminded me that true negotiating skill is surprisingly rare among most businesspeople.

* * *

For spectacular anecdotal proof of this observation, we need only turn to last week’s article in DealBook about the nasty bollocking mustachioed technology advisor extraordinaire Frank Quattrone’s firm Qatalyst Partners delivered to its erstwhile client, Trulia, in the latter’s recently announced sale to competitor Zillow. To an aficionado of the dark arts of M&A, there are many odd and interesting nuggets to be gleaned from this brief article about the behavior of Trulia and Qatalyst, which I thought you kindly people would find amusing to review with me on a languid Saturday afternoon.

First, there is the apparent fact that, after hiring Qatalyst three years ago to sell itself to (presumably) Zillow and perhaps one or more other potential buyers, Trulia apparently never terminated the engagement when it failed to lead to a sale. This, as we technically describe it in the trade, was Just Fucking Stupid. Engagement letters between clients and financial advisors are normally open-ended contracts which describe reciprocal duties and obligations which do not expire until the transaction contracted for occurs or one or both of the parties explicitly terminate them. The notion that Trulia could hire Qatalyst to sell itself, have that process fail, and subsequently move on to an initial public offering and other activities for three years without bothering to terminate an open-ended sale contract is just ludicrous. For this mistake alone, somebody in the executive suite of Trulia—the General Counsel or Chief Financial Officer are the most likely candidates—should have their head handed to them.

Second, there is the matter of Qatalyst’s original fee, which the DealBook article describes as “about 2 percent.” Now, I don’t know (or care) what Trulia’s purported enterprise value was three years ago when it first engaged Quattrone’s merry band, but I would be surprised if it was much below a billion dollars. (Remember, they just got sold for $3.5 billion this past week.) Now I understand that the technology world operates in its own reality distortion field, but I have to confess I was stunned by that fee percentage. In the normal business world, where industrial logic and economic pressures operate in place of the moonbeams and unicorn piss of tech land, a billion dollar sale mandate should earn the sell-side advisor flogging it significantly less than one percent of transaction value. Advisor success fees are heavily negotiated on a deal-by-deal basis, but they normally have some relation to normal fees normally earned by normal advisors normally. This one looks like Trulia’s CEO just hiked up his skirts and asked his Qatalyst banker how far he wanted him to bend over the barrel.

Third, there is the matter of the fee Trulia negotiated with JPMorgan for the current mandate which resulted in its sale to Zillow. This DealBook reported as about 1.5 percent. You might think JPMorgan was mighty gentlemanly to accept a lower percentage fee for the higher sale amount, until I inform you it is somewhere between four to five times the normal fee for a three billion plus dollar transaction outside tech land. The rack rates which investment banks try to achieve in M&A transactions are based on advisory fee schedules which in turn are based on competitive fees earned by them and their competitors in hundreds of transactions annually. In other words, a market. These fees decline as a percentage of transaction value as the size of the transaction increases, and most financial advisory firms’ fee schedules show transaction fees of fractions of a percent at these levels.

* * *

Now perhaps Qatalyst Partners’ and JPMorgan’s technology bankers really are the sort of special snowflakes who can deliver $50 to $70 million of advisory value to Trulia. Perhaps Frank Quattrone and his colleagues use secret photos of every Silicon Valley founder, CEO, and venture capitalist engaged in unnatural acts with scrofulous barnyard animals to boost their negotiating leverage when it comes to striking terms on engagement letters and actual transactions. Barring that, however, I am skeptical, as a technology outsider, that any of these clowns can offer anything special enough to merit fees which are many multiples of the fees which highly talented M&A advisors outside the technology bubble would be delighted to work for. Especially if both transactions were targeted primarily or solely at one buyer, Zillow, which makes many of the deal dynamics and negotiating complexities much less burdensome. After all, it’s not like the companies involved are particularly technical or require particularly specialized skills from their advisors.

I take this as yet more proof that the denizens of Silicon Valley think they are special, and the normal rules of gravity and economic interactions do not apply to them. Perhaps the executives and owners of technology firms are delighted to spread higher than normal fees around to their pals and enablers in the banking world in exchange for extracting ridiculous sums from the pockets of widows, orphans, and idiot venture capitalists to fund their fantasy business models in the first place. I’m not sure I would be so happy to pay an extra $40 million in success fees to bankers who sold my company because my CEO and his staff were too inept to negotiate their way out of a paper bag with a map and a blowtorch, but then again I am not Silicon Valley’s demographic.

And this, in the end, has clearly been my mistake. Effective immediately, I am rebranding myself as an M&A advisor for technology companies, offering skilled buy- and sell-side services at a mere 300% of retail.

Shit, I use Twitter and Blogger.com. I’m a friggin’ natural.

Related reading:
David Gelles, Old Attempt to Sell Real Estate Website Trulia Rewards Ex-Adviser Qatalyst Now (DealBook, July 29, 2014)
Killing People Is a Bad Habit (August 28, 2009)

1 You might think plane flights would be an excellent time to get tasks like this done: no interruptions by clients or superiors, relative quiet, and few distractions of interest. In actual fact, bankers often forgo catching up on pressing work due to the risk competitors or strangers on the plane might look over their shoulder and get a glimpse of confidential information. Quarters are close in economy class, and unless your immediate neighbor is a co-worker who can shield you from prying glances, most serious work should be deferred until you get back into the office. So, once again, junior bankers are screwed.

© 2014 The Epicurean Dealmaker. All rights reserved.

Sunday, July 27, 2014

Improve Yourself

Improve yourself
Liberal Education makes not the Christian, not the Catholic, but the gentleman. It is well to be a gentleman, it is well to have a cultivated intellect, a delicate taste, a candid, equitable, dispassionate mind, a noble and courteous bearing in the conduct of life.

— John Henry Cardinal Newman, The Idea of a University

Last week, former Yale professor and current essayist and writer William Deriesiewicz penned a jeremiad against elite higher education in this country which not only excoriated his former employer but also all such cognate institutions of higher learning which aspire to the top of the annual listing of “best” colleges and universities put out by U.S. News & World Report. He has many criticisms to offer, including the fact that colleges like Yale do not in fact teach their students to think, but rather to be timid, anxious careerists following blindly in the well-worn ruts of privilege their parents, peers, and society have picked out for them:
Our system of elite education manufactures young people who are smart and talented and driven, yes, but also anxious, timid, and lost, with little intellectual curiosity and a stunted sense of purpose: trapped in a bubble of privilege, heading meekly in the same direction, great at what they’re doing but with no idea why they’re doing it.

Contrary to their carefully maintained public image and stated mission, Deriesiewicz also denies that these institutions’ educational curricula are as intellectually demanding or their student bodies are as truly diverse as they like to claim. Instead, he blasts them as bastions of existing privilege which train and credentialize a blinkered socioeconomic elite to reproduce itself.

Allowing for some artistic license and the exaggeration natural to a magazine article writer intent on drumming up advance sales of his book, I have to say I cannot materially disagree with Mr. Deriesiewicz. The only question I have is why it has taken him, a college professor with a decade at least in the very belly of the beast, so long to discover what everybody else has known for approximately ever.

* * *

Mr. Deriesiewicz seems shocked, shocked to discover that 250+-year-old institutions charging rack rates north of $60,000 per year to convey some tangled Latin prose on sheepskin to spotty youngsters at the end of four or more years—institutions for which the combined endowments exceed the gross national products of several small countries—should be complicit in the perpetuation and justification of entrenched socioeconomic power structures. Whence, exactly, did Mr. D think these universities’ wealth, status, and prestige come from? Whence the demand for their services? From whom?

From the dimmest reaches of time on, Most Patient and Attractive of Readers, elite educational institutions have been founded, mirabile dictu, to educate the elite: to inculcate and train the ruling class in those arts, preferences, and temperaments which would be conducive to their wielding of power and privilege (q.v. Cardinal Newman supra) and to introduce them to their peers and future colleagues in business, government, and society. In the earliest days, such institutions mostly served as high class finishing schools for the sons [sic] of the rich, as well as training grounds for a limited class of administrators and functionaries the rich relied on to manage their affairs, such as politicians, military officers, and the clergy. Over time, these institutions widened their reach beyond the landed gentry and wealthy merchants to encompass the growing ranks of the striving administrative classes, including, most importantly, the vast numbers of middle class merchants, businessmen, and professionals who would comprise the bulk of the modern market-based economy. Eventually—much later—the doors were opened to women; first as a sop to the daughters of the rich who wished to enrich their unemployed adult lives, and later to those female coequals who began to invade and swell the numbers of the workforce. Along the way, elite institutions began to admit increasing numbers of “outsiders” such as Jews, men and women of color, and other more marginal ethnic, racial, and socioeconomic groups.

But each and every time they added more groups to the circus tent, elite educational institutions remained focused firmly and irrevocably on serving the elite: legitimizing, justifying, and expanding the elite, but serving the elite nonetheless. It’s like The Preppy Handbook joked about Princeton in the 1980s: only 20% of freshmen entered as preppies, but 80% of graduating seniors exited as such. Just so, the Ivy League may admit 12 to 15% of their incoming classes from households where the student is the first person in her family to attend college, but by the time she graduates she will have been anointed—and will have fully internalized her right and privilege to become—a fully fledged member of those citizens credentialed to enter the ruling class. In addition to replenishing their ranks, this suits the elite just fine, since the meritocratic myth that at least a few outsiders can join their ranks via hard work and talent is an excellent way to keep the rest of them docile. Besides, they can always admit a small number of international students who pay full freight in order to subsidize the scholarship kids.

So Mr. Deriesiewicz’s outrage that the Ivy League helps perpetuate the dominance of elites and contributes to socioeconomic inequality seems to miss the point. That is what they have always done. That is their primary purpose.

* * *

Likewise, the ex-professor’s disappointment that so many students at elite universities demonstrate so little interest in the opportunities such institutions offer to expand their minds, take risks, and learn to connect with themselves is misplaced. Surely these are admirable goals for some, but it is the height of presumption to insist they should be the goals of every student who attends college. For in my experience, the diversity which Mr. Deriesiewicz pooh-poohs on the basis of class exists in full force when it comes to the intellectual curiosity, interests, and objectives which students bring to elite colleges. There are future businesspeople, politicians, lawyers, medical doctors, athletes, and the like at Yale and every other similar college. The portion of true scholars, future PhDs or college professors, and restless seekers after knowledge in a top flight university is not much different than that of the general population: small. Many future non-scholars do indeed take the opportunity to stretch themselves here and there, and perhaps a few reconsider their life goals upon encountering Spinoza or Cervantes, but the unfettered life of the mind is a true calling for very few.

Being a former, current, and future paying customer of these institutions, I can personally attest they actually do a reasonably good job exposing their students to opportunities to challenge their assumptions, broaden their knowledge, and get in touch with their inner selves. They do this by requiring students to fulfill distribution requirements across disciplines, offering a staggering breadth of classes to choose from, and enabling them to interact with dozens if not hundreds of professors and other students just as smart or smarter than they are who do not believe or think the same as they do. The colleges Mr. Deriesiewicz derides are often the first places where these talented, driven children have a real opportunity to spread their wings and take the kind of risks he admires. That being said, if a kid attends Princeton with the monomaniacal goal of becoming a Goldman Sachs investment banker for life, there is nothing any university can do to make him drink deep from the font of self- or other-knowledge. This is not Princeton’s problem, either. Cherchez la mère et le père.

* * *

In fact, an alternate reading of the professor’s complaint could leave a perceptive reader with a substantially more sanguine opinion of the state of higher education in America than the one he offers. First, the mere fact that prestige magnets like Harvard and Yale—which attracted 34,295 and 29,610 applications from all over the world for 1,662 and 1,359 spots in the Classes of 2018, respectively—actually do not fill their classes entirely with the moneyed careerist offspring of high-status alumni is a positive thing. The student diversity such colleges actively promote actually means lots more “pointy” (unusually talented, not well-rounded) candidates finally get in than one might otherwise suspect. Sure, this may benefit the technocratic elite and the current socioeconomic power structure as a whole (and usually does), but tell that to Buffy Witherspoon, IV’s parents when she is declined for admission in favor of a low-income genius from Compton who wants to study Catalan poetry and neurochemistry.

Second, the fresh blood which these elite systems suck into the power structure not only legitimizes it via promoting the oversold myth of equal opportunity and meritocracy, it also strengthens it by bringing new perspectives, different backgrounds, and unconventional ambitions to the party. Sure, the ruling class co-opts its potential enemies by making them one of the club, but this is good both for the ruling class and for the revolutionaries it co-opts. This may not make the Marxists in the audience happy, but it enables socioeconomic evolution and change in ways that may, at the end of the day, be significantly more than trivial.

Finally, the staggering rise in the number of kids who go to college in America over the past few decades1 has not only made admission to the top ranked universities insanely competitive, it has also improved the quality of dozens if not hundreds of second, third, and fourth tier colleges. The colleges where top quality students can get an outstanding education—practical, theoretical, or both—are far more numerous than they used to be, simply because the demand for spaces and the quality of applicants have both risen dramatically. What parents, students, and, yes, critics like William Deriesiewicz have to realize is a bright, ambitious student has far more than seven or eight acceptable colleges to apply to nowadays. And not getting into Yale, Harvard, Stanford, or Princeton is not the life-ending tragedy the neurotically competitive parents of the private school set might think it is.

* * *

Like many academics before him, I fear Professor D has confused the mission, purpose, and legitimacy of our higher education system with the mission, purpose, and legitimacy of the ivory tower. The latter is and always has been servant to the former, not its master. And the former likes the way things are just fine, thank you.

Besides, nobody’s forcing you to apply to Harvard.

Related reading:
William Deriesiewicz, Don’t Send Your Kid to the Ivy League: The nation’s top colleges are turning our kids into zombies (The New Republic, July 21, 2014)
Sovereign Triviality (November 19, 2011)
In the Nation’s Service (December 29, 2011)
The Standard Model (February 18, 2012)
No Country for Young Children (October 21, 2012)

1 Your Forgetful Bloggist remembers reading not long ago from a source he cannot recall that whereas approximately 48% of the high school graduates eligible for college actually attended college in 1980, by 2010 that percentage had risen to 68%. Combined with general population growth over those decades, that means the college admissions pool has increased in both size and quality spectacularly since YFB graced the leafy groves. I maintain, for what it is worth, that there is no way in hell I could get into the college which accepted me when I was a mere sprout today. Sadly, nobody who knows me personally disagrees when I say this.

© 2014 The Epicurean Dealmaker. All rights reserved.

Sunday, July 13, 2014

Shine On, You Crazy Diamond

Quick. What do you see?
Claudio: “Benedick, didst thou note the daughter of Signior Leonato?”
Benedick: “I noted her not; but I looked on her.”
Claudio: “Is she not a modest young lady?”
Benedick: “Do you question me, as an honest man should do, for my simple true judgment; or would you have me speak after my custom, as being a professed tyrant to their sex?”
Claudio: “No; I pray thee speak in sober judgment.”
Benedick: “Why, i’ faith, methinks she’s too low for a high praise, too brown for a fair praise, and too little for a great praise; only this commendation I can afford her, that were she other than she is, she were unhandsome, and being no other but as she is, I do not like her.”
Claudio: “Thou thinkest I am in sport: I pray thee tell me truly how thou likest her.”
Benedick: “Would you buy her, that you enquire after her?”
Claudio: “Can the world buy such a jewel?”
Benedick: “Yea, and a case to put it into.”

— William Shakespeare, Much Ado About Nothing

Matt Levine put an instructive and amusing post up at Bloomberg View two days ago on the nonsensical phenomenon which is CYNK that is worth your attention, Dearest of Readers, if only for a slow news Friday leading into a World Cup finals weekend. I recommend you enjoy it as an all-too-rare example of a financial journalist who actually tends to know what he is talking about trying to explain arcane and confusing epiphenomena of the financial markets to plebeians with wit and style. Levine, of course, is a former Goldman Sachs banker, which means, inter alia, that 1) he tends to know whereof he speaks (writes) and 2) you are free to disregard everything he writes as the sophistic outpourings of a confirmed agent of Satan sent to Earth to separate you and your orphaned, widowed Mother-in-law from any semblance of financial wherewithal and pin money. (These two things, by the way, are not necessarily mutually exclusive.)

Anyway, I have no particular interest in glossing Mr. Levine’s more than adequate gloss of this financial chicanery other than to point to a by-product of the CYNK story which features briefly in his story and which lesser mortals have been making quite the to-do about as this little passion play makes the rounds of Cialis-financed stock market news programs; namely, the purported market cap of this fraud professional short squeeze piece of shit security. As the Squid alumnus states,
Something about a company with no revenues and a brilliant but undeveloped business model (buy friends on the Internet! friends not included) having a $4, 5, 6, whatever billion dollar market cap struck me as fishy.
No shit.

* * *
In fact, if you segue on over to the font of all financial market wisdom, Yahoo! Finance,1 you will find that venerable market oracle calculates the market capitalization of this special snowflake without apparent substance or reason for being to be a delightful and highly substantive $4.05 billion as of Thursday’s “market” closing “price.” This is, of course, prima facie ridiculous, and it has been cited ad nauseam by every journalist and sundry whose secret brief and deeply held belief is that everything to do with the mysterious financial markets is bizarre, impenetrably obscure and opaque, and just plain dumb. On its surface, it is plain dumb, and, I am here to tell you, Delightful Readers, as your Guide to All Things Valuation, that the surface is all there is.

For a delicate glissade of the mouse over to CYNK’s historical price page on Yahoo! reveals that CYNK’s trading on Thursday (the last day of trading before exchange officials woke up from their bureaucratic pay scale-induced comas to ponder that something might not be quite right) occurred in a range of $9.80 to $21.95 per share for a total volume of 386,100 shares. Yes, that’s right, children, you read that right: 386 thousand shares. In other words, the blowout day of trading in a four billion dollar public company involved somewhere in the neighborhood of six million dollars2 of stock trading hands. Do you see the problem? Of course you do.

Imputing a “market value” to a public company on the price which obtains when 0.13% of its total shares outstanding actually trade is a dubious business, especially when it is clear that the supply of available shares is, as in this case, severely constrained. It would be another thing entirely if everyone holding CYNK’s 291 million other freely tradable shares looked at their Quotrons and said, “Huh. $21.95 per share. Yeah, that seems totally reasonable. I think I’ll hold my current position for future price appreciation potential.” But when supply is artificially constrained from meeting demand, the price which obtains in a market is not the equilibrium price, and the value which that price imputes is not the equilibrium value of the asset.

Microeconomics and common sense tell us that not everyone in the market for any asset must have the same individual supply and demand preference for that asset. There is some portion of buyers who are willing to pay more than the current market price, some sellers who are willing to sell below the current price, and many on each side of the market who are not. This is neatly illustrated by the following diagram of a hypothetical market operation, familiar to many a student who did not sleep through the first month of Micro 101:



The point is that there is a “market,” of sorts, at almost every quantity of asset supplied, and if the supply of willing sellers is abnormally constrained or abnormally bolstered, one should expect sales to occur along the buyers’ demand curve until a local “equilibrium” is found. That being said, a sensible person would not view such an abnormal market as a good indicator of the normalized value of the underlying asset in question.

So, therefore, one should firmly embed notions such as the “market capitalization” of short squeeze scams such as CYNK in pulsating neon scare quotes, so the great unwashed and their blinkered guides in the media do not take them as anything other than arithmetic exercises. So, also, one should not take reported implied market values from the technology economy, such as Series D or pre-IPO round investments by professional investors in vaporware startups, as anything other than the revealed price preferences of that particular investor in that particular company. The fact that Fidelity invested $100 million for a 1% stake in the illiquid equity of Doofr-rama does not make a strong case that Doofr-rama’s “value” is $10 billion. All it really tells you is Fidelity desperately wanted 1% of Doofr-rama. If you want to know why, you better go ask Fidelity.

* * *

Value is a highly subjective and evanescent thing, O Dearly Beloved, a fact which I have addressed in these pages before. Perhaps the greatest proof we have of this in the financial world is the unpredictable and often fraught process whereby private companies enter into the public agora via initial public offerings. What makes the rest of us take some comfort in the reliability of seasoned publicly traded stocks is that they are traded freely by and among hundreds if not thousands of individual investors daily, all of whom can express their wacky, idiosyncratic notions of value to the limit of their appetites and checkbooks, in competition and cooperation with other lunatics with contrasting notions, to their hearts’ content or distress during market hours. If there is some constraint or check on fully free trading, such as artificially constrained supply (e.g., CYNK) or a dangerous mix of newly released limited supply supported by underwriters’ legal stabilization techniques (e.g., every new IPO), the wise judge of value should look at any arithmetic calculation which purports to give such an entity’s worth with a gimlet and highly jaundiced eye.

The wisdom of crowds in the market, as everywhere else, does not arise from the wisdom of each and every member of the mob. It comes from the diversity of idiotic, ill-considered, and just plain dumb opinions held by everybody, which, by some thankful magic of human nature, usually tend to cancel each other out and supply a workable if not entirely transparent answer. It’s when we have only one lunatic, or a small handful, making value decisions that we tend to get the silly answers.

Of course, if you find that one special snowflake whose worth has no price, feel free to dive in headfirst. I won’t judge you: it’s your funeral. Just don’t expect the rest of us to follow.

Related reading:
Matt Levine, Cynk Makes the Case for Buying Friends, Naked Short Selling (Bloomberg, July 11, 2014)
Go Ask Alice (September 14, 2013)

1 Yes, I am aware that such a citation perhaps does not give you a great deal of confidence you are dealing with a professional’s considered opinion, but 1) it’s probably close enough, and 2) you don’t really think I’m going to spill my special secret top quality financial data sources into this pig trough, do you?
2 Based on the clearly incorrect assumption all 386,100 shares traded at the average of the high and low prices of the day. The correct calculation would involve what is know as the volume-weighted average price, or VWAP, of shares traded. But in order to get that, you would have to subscribe to a real market data service, for which you are definitely not paying me in your current subscription price. My ballpark estimate is close enough.

© 2014 The Epicurean Dealmaker. All rights reserved.

Monday, July 7, 2014

You Go First

A busy analyst is a happy analyst
Don’t shit where you eat.

— Anonymous

Way back in the Dark Ages of Investment Banking, O Dearly Beloved—say in the 1970s or 1980s, before Your Humble Correspondent embedded himself in the front lines of global financial conflict—somebody or other decided in their infinite wisdom that new recruits to my industry out of college should, as a matter of policy, be hired for two-year stints only. After this period expired, they were thanked for their troubles, given a celebratory fruit basket or somesuch, and politely shown the door. A tiny minority of very strong promise were sometimes buttonholed by higher ups, slipped a tenner or two, and persuaded in whispered tones to stay on as regular employees, but virtually everyone else was gently or not so gently ushered out the door. Talented leavers were encouraged to reapply for admission after a stint at a recognized institution of higher networking obfuscation learning where they could bolster their professional credentials and familiarity with the latest corporate buzzwords. Talentless cannon fodder—as revealed ex post via mediocre or worse job performance—were graced with fixed grins and sotto voce imprecations muttered between gritted teeth. Almost everybody left.

The reasons for this odd system may be lost in the mists of time (or your Professionally Nonchalant Bloggist’s lack of interest in substantive historical research, which for all intents and purposes is the same thing), but it has obtained in my line of work for many a waxing and waning moon. As such, investment banks and college graduates—clueless children educated to within an inch of their lives in disciplines useful perhaps 300 years ago and no later—found a symbiotic relationship in which this program served each of their interests and predilections. College students found a well-organized, (then-)prestigious, (then-)well-paying industry with slick recruiting materials willing to take on their confused and ill-directed selves for a limited period of two years, in which the banks promised to provide very good money, an impressive notch on their virgin résumés, and all the Seamless food they could eat, with a free Get Out of Jail card tacked on at the end. In exchange, the investment banks got swarms of smart, eager young beavers willing to learn how to create and maintain 50 page spreadsheets and 100 page presentation books and generally make themselves available 24-7-365 for all manner of scut work while they figured out what they wanted to do with their lives. Lots of directionless college graduates got jobs which paid terrifically well and offered prestige far beyond their deserts, and investment banks got access to a much larger group of intelligent, ambitious youngsters than they deserved. It all worked out pretty well.

Back in these prelapsarian times, when majestic investment bank dinosaurs still trod the Earth, a cozy symbiosis developed between the much smaller private equity industry—small, nimble, clever mammals and clients of the dinosaurs, to boot—and big investment banks. Private equity firms were always looking for a few highly trained, intelligent, and motivated finance geeks to join their organizations at the bottom every year to both support the Schwarzmans, Blacks, and Kravises of the world and eventually succeed them. Naturally, they looked to the giant investment banks as farm teams for their junior recruits, and they cultivated a close relationship with promising young investment bankers they met on live transactions and found through industry gossip. They also pumped their counterparts and salespeople at the banks for information as to who was the best, fastest, and most ambitious among their large Financial Analyst classes in order to target their recruiting appropriately. Senior bankers were happy to cooperate, since 1) it made some of their best, highest paying clients happy, and 2) top junior bankers were likely to leave after their two year stint was up anyway. PE firms were free to recruit these tyro plutocrats and, since their recruiting tended to be focused near the end of the analysts’ two year terms and did not materially interfere with their duties, any minor inconveniences could be comfortably overlooked.

* * *

But now we live in much different times, Most Patient and Understanding of Readers, as many of you may indeed be aware. Banks face life-altering threats from Dodd-Frank lava flows and Volcker Rule asteroids, and the tiny, nimble private equity mammals of yore have evolved into lumbering colossi of hair, tooth, and tusk which are assuming the role of apex herbivores and predators in the global financial ecosystem. Financial Analyst positions at investment banks are nowhere near as numerous as they used to be, and those that still exist no longer carry the socioeconomic prestige or promise of outsize pay they used to. On the other hand, the largest of private equity firms have evolved into very large firms indeed, with a consequently magnified demand for cannon fodder of their own, and they have been joined by legions of small and mid-sized private equity firms with their own need for junior weenies. The tables, so to speak, have decisively turned.

And yet the private equity industry still chooses to recruit its junior personnel from the same place: the most talented among the junior ranks of investment banks. Except they are no longer following the old gentleman’s agreement of letting young bankers mature and learn in situ before they harvest them: they are recruiting them practically before the ink dries on the little buggers’ bank business cards. This, as you might imagine, is beginning to irritate investment banks, who spend a great deal of time and money recruiting, selecting, and training young bankers into useful employees. It is one thing to recruit and train a top Financial Analyst who will give you a solid two years of work and then depart, a friend of the firm, to an important client where he or she might eventually direct more business to you. It is another entirely for your new analysts to start receiving frantic recruiting efforts six months after they start their jobs and sign acceptance letters at new employers 18 months before they are supposed to leave. In addition to distracting them from time-sensitive duties for which we pay them ridiculously high wages and diminishing their incentive to work hard for the rest of their contracted stint (because they have guaranteed jobs waiting at the end), recruiting and hiring by private equity firms can introduce serious potential conflicts.

Notwithstanding their position at the very bottom of the investment banking totem pole—or in fact exactly because of it—Financial Analysts are privy to highly sensitive confidential information about many clients’ businesses and lots of live and potential transactions. This is especially true of those analysts who work in corporate transaction-intensive parts of investment banks like mergers & acquisitions, leveraged finance, and financial sponsor coverage. These are the very analysts which private equity firms are most interested in hiring, since their training, talents, and daily work resembles their own most closely (as opposed to, say, corporate financiers focused on capital raising, capital markets bankers, or sales and trading assistants). For one of these analysts to have divided loyalties, or an open information channel to a private equity firm which has already hired him effective 18 months from now, is a serious potential breach of confidentiality and maybe even a source of direct conflict. Even if one presumes there are no private equity professionals who would be tempted to pressure an investment bank analyst to share confidential deal or client information via friendly persuasion or even a threat of rescinding an outstanding future job offer—a towering assumption of dubious validity, I assure you—knowledge that a junior employee has a signed job offer from a particular client is going to make any investment bank compliance officer extremely uncomfortable. It is also going to cause more relaxed banks serious client management problems if KKR discovers the analyst working on their $10 billion proprietary buyout is going to work for Apollo in ten months.

* * *

And, if we’re being honest here, the suboptimal equilibrium falling out of this vicious prisoner’s dilemma is doing nobody any good. Because too many private equity firms are competing for too few analysts1, they have begun recruiting them earlier and earlier, and they are signing them to offers before they are even halfway done with their two-year apprenticeships. This is a problem for PE firms for two reasons. First, it really isn’t that easy to determine who are the best (most competent and adept) financial analysts after only six months, because such competence is developed not only through training but also through sheer bloody volume of experience. Private equity firms like to think they have the interviewing skills to figure this out in advance of actual proof, but in this, as in so many other things, the PE firms are massively overestimating their own knowledge and skill. The only thing they can determine with certainty this early in a novice investment banker’s career is whether he or she is a hardcore finance junkie (see footnote 1, below), but these do not always turn out to be the best analysts.

Second, and more importantly, if a bank discovers their first year analyst has an offer of employment 12 to 18 months hence at a private equity firm, they may do one or more things to seriously diminish the value of said analyst to his future employer. Harsher banks may simply fire such analysts, on the not-too-ridiculous theory that it’s just too much trouble to manage an employee with potentially serious conflicts of interest (q.v. supra) whose motivation to work insanely hard and try to become the best analyst she can be is seriously undermined by having a guaranteed exit to what she sees as a better job in the future. Other banks, suspicious about such shenanigans, may ask employees outright if they have accepted offers from other firms. If the analyst lies and the bank finds out (and Wall Street and the private equity industry are very small worlds indeed), the bank may fire said analyst for cause, thereby simultaneously cutting short the apprenticeship her future employer was counting on to train her appropriately as well as tarnishing her employment history.

Still other banks, unwilling to can employees they have sunk serious time and money into training and developing to be investment bank analysts, may decide out of reasonable caution to reassign such juniors to areas where their future employment status will not create the reality or appearance of potential conflicts. But this means these analysts will likely be rotated out of areas such as M&A, leveraged finance, or sponsor coverage where they would have otherwise received the intensive hands-on experience their future employers were counting on to make them valuable hires. Even less draconian measures along such lines, such as reassigning compromised analysts to only work with corporate clients or relocating them to overseas posts where geography can provide some measure of conflict insulation, will have the same effect of rendering these prize recruits that much less experienced and valuable to their future private equity overlords.

And in all such outcomes, the entity screwed the hardest is, of course, the financial analyst him- or herself. If he or she dodges the bullet of summary firing for cause (or not for cause), they may still limp along in another position within the bank they have less interest in, have their training and experience gathering significantly curtailed or redirected, and/or work under a cloud of suspicion as to their motivation and team spirit (with consequent negative implications for performance reviews and pay) for the remainder of their employment in banking. Plus, it would be the rare and lucky analyst indeed who suffered any one or more of these fates who did not see his magical “guaranteed” offer of employment at Private Equity Megabucks, LLC evaporate like a fetid mist over the Bayonne Marshes once PEM, LLC finds out. Trust me here: private equity firms are not charitable organizations. They don’t give a shit about you.

* * *

The solution to this dilemma, of course, is simple. Private equity firms have become large and rich enough that they should do their own damn recruiting at colleges to hire junior personnel, rather than relying on investment banks to provide a pre-screened, pre-qualified employee pool to poach from. Given their focus on hiring the elite of the elite and hardcore finance junkies, this should not be too much of a burden, since PE firms almost uniformly insist on hiring recruits from the Wharton School and maybe five or six other top-name universities anyway. It’s not like they’re going to have to visit 100 colleges around the country. Of course, they would have to train these new graduates themselves, which will involve time, money, and effort they are normally loath to expend. But the time has come for private equity firms to realize they are too big individually and in aggregate to slipstream off the shoulders of investment banks anymore. The parasite-host burden has become too large.

The other solution, of course, is to chill the fuck out and go back to the old system of waiting to recruit IB analysts later. This would be better for private equity, better for investment banks, and better for junior professionals. It is a difficult collective action problem, which would require discipline on the part of PE firms and potential recruits, as well as support from investment banks, but it is not impossible to foresee.2

Private equity takes extreme pride in being disciplined investors, and they broadcast this message loud and long to anyone who will listen. The time has come for them to demonstrate they can be disciplined recruiters and employers, too.

And to stop taking dumps in the community watering hole.

Related reading:
William Alden, A Mad Scramble for Young Bankers: Wall Street Banks and Private Equity Firms Compete for Young Talent (The New York Times, July 5, 2014)
Curriculum Vitae (March 10, 2013)


1 Private equity firms like to style themselves as even more selective than investment banks. At least in the past, when their relative numbers could support it, they preferred to hire only the top five or ten percent of IB analysts (as so ranked and paid by their bank employers) into their firms. The notion is that they are the elite of the elite, and they want 24-year-olds who can program 50-page LBO models in their sleep using Visicalc and chewing gum, as well as pure hardcore finance junkies whose every waking dream since kindergarten has been to have a bigger 60th birthday party than Steve Schwarzman. These are the kids who tape stock tables from The Wall Street Journal and glossy pictures of Warren Buffett on their bedroom walls in high school, enroll in the Wharton School as double finance and econ majors, and who viciously haze any coworker who cannot navigate a spreadsheet without a mouse. These are the kids who have summer jobs in college teaching Training the Street classes in basic accounting and financial modeling to liberal arts majors who want to apply to Goldman Sachs too. They have always wanted to be private equity professionals. In the past, they only applied to investment banks out of college because that was the only way to get into PE.
2 Surprisingly enough, the junior recruits might be the best positioned of anyone to enforce such a return to sanity. If they were courageous enough to forgo immediate recruiting by private equity as soon as they get their sea legs, they could build their skills and experience at their bank employers for the full two years of their employment. I find it hard to believe such candidates, battle tested and thoroughly trained, would not find an eager audience of potential employers among the best private equity firms once they’re ready. They are certainly superior candidates to wet-behind-the-ears tyros six months out of college. But this, of course, requires wisdom and courage from 22-year-olds in a fevered and desperate job environment. That may be too much to expect from the poor lambs.

© 2014 The Epicurean Dealmaker. All rights reserved.