Review – Restrepo

I watched a NatGeo documentary last night called “Restrepo.” It’s about the conditions and objectives of a small US Army platoon in the mountainous wilderness of Afghanistan.

Very little happens in this movie over its 1.5hr runtime. There is a lot of buildup and talk about how often the base is attacked, and this is depicted several times, but overall nothing happens. I don’t know if this was an intentional part of the plot (“the futility of the Restrepo mission”) or if it’s bad editing or belies a fraud about the claims being made in the film about what it is like for these troops, but it is not entertaining. And by that I don’t mean, “Gee, I wish there were more poor, dumb soldiers getting wasted in this real life documentary” but rather, “Gee, what am I getting out of watching this film?”

That being said, this is not good propaganda for the US government’s desire to nation-build overseas. Why does the military allow journalists and documentarians to embed with their troops? Restrepo is an offshoot of a slightly larger but still insignificant base tasked with enlarging the “security bubble” in the area so that a road can be safely built connecting two hapless economic regions into one, which is supposed to bring jobs, incomes and peace and happiness to the land. Every bit of tactical maneuver in war seems really stupid when studied by itself — “50 men gave their lives for a bridge that was ultimately destroyed by the enemy anyway, why did 50 men die for a bridge?” — but the Restrepo mission seems especially stupid not because these men are fighting and dying and accidentally murdering local civilians for an unbuilt road, but because the premise behind building the road is itself very stupid. Do the local Afghans even WANT this road? If they did, why didn’t they build it before the US Army showed up?

Is military Keynesianism a viable structure for developing foreign economies? Keynesianism doesn’t seem to work to develop domestic economies. And the military, professional murderers and demolishers, don’t seem to be the right people to task with building things, let alone people’s economies. Wouldn’t it make more sense to send overwhelming military force through the area, wipe out/expel the organized Taliban elements and then let civilian diplomats and construction contractors come through and negotiate new power structures and infrastructure plans?

The Korengal Valley itself, where the drama unfolds, is truly magnificent geography. It reminds me of the valleys I hiked on the Inca Trail in Peru on my way up to Macchu Picchu. In fact, the remoteness, the terraced cultivation and the “primitive” lifestyle and social organization of the Afghans looked nearly identical to what I saw in Peru. It seems like a perfectly nice place for the locals to live and you get the insane idea watching the movie that they never asked for the US Army to invade their territory and murder their wives and children in helicopter gunship assaults, and they’re not all that thankful for their service now that they’ve shown up. Would it be unpatriotic, dare I say even treasonous, to suggest that the Afghans are getting a raw deal here and it’s hard to wonder why they wouldn’t want to overtly or covertly support the Taliban in these circumstances?

That old quip about “I’m from the government, and I’m here to help you” runs hard through the film’s narrative. We see again and again the way the local commander makes big promises and doesn’t follow through– he murders a guy’s cow and offers no agreeable compensation, he disappears a local who he suspects of being an accomplice of the Taliban and then offers the vague assurance that he’s being treated nicely and will soon return though he doesn’t, and he responds to an attack by calling in a fire mission on a neighboring village that kills and maims several women and small children. I don’t care who someone is fighting for, if I had to hold the charred body of my innocent two year old in my arms and watch a bunch of crude monkeys rifle through the smoking remains of my home looking for contraband after such an incident, I think I’d lose my shit.

And what IS the best solution to murdering someone’s cow, anyway? If you could get your higher-ups to release the $400-500 cash to pay the guy back (I think the village elders took the US Army for a ride on that request, by the way, there is no way a cow is worth half a grand in the mountains of Afghanistan) doesn’t that incentivize them to let more of their cattle wander into your concertina wire whenever they lack liquidity? And if you can’t get that cash released, aren’t you guaranteed to keep pissing off the locals while insisting you’re there to win hearts and minds?

The long and the short of it is that imperialism is a terrible idea in the first place, but the United States government isn’t even good at imperialism. It is very half-hearted and half-assed in its attempts to brutalize and control foreign peoples and spends more time apologizing and groveling about its numerous mistakes than making any meaningful progress in terms of rapine and pillage. It makes you wonder the whole time how such a pointless and ineffectual system can sustain itself, until you realize that the people who are really getting mulcted in this process are the guileless American people “back home.”

And the poor, dumb US foot soldier is the tool used to tug at those people’s heart strings while picking their pockets clean. “Thank you for your service,” indeed.

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Supporting Causes With Integrity

Introduction

I am a skeptic when it comes to charity– I believe most charity efforts are inefficient ways to make the desired impact, misunderstand the nature of the problem they seek to address and are doomed to treat symptoms rather than causes or, at worst, create more problems than they solve. I believe that this is partly due to the incentivizes and mechanisms of philanthropic activities versus monetary/commercial exchange activities, and partly (mostly) due to the fact that most people interested in charity do not spend much time thinking philosophically about what they’re doing, how they’re doing it and why they’re doing it.

As I do intend to contribute to (or even create) some philanthropic entities over the course of my life and I do not wish to be a hypocrite, I have attempted to identify and outline some important tradeoffs which must be considered before engaging in charitable activities.

Spectra of tradeoffs

Short-term vision vs. Long-term vision

This tradeoff involves the consideration of looking at problems which are immediate, present or developed in nature versus looking at problems which are distant, in the future and developing or potentially could develop based on a particular trend playing out. This tradeoff also has implications for questions of fund-raising and financing methodology and the construction of a strategy to meet the problem (ie, building a strategy which is active in the coming year versus a strategy which may only become active many years from now). This tradeoff has a generational component– looking at one’s own generation or the immediately following generation, the generation of one’s grandchildren or even more distant successors, or looking at the general inheritance of mankind for all time.

Physical issues vs. World of ideas

This tradeoff involves considering problems related to things that affect the material well-being versus predominant ideas, values, culture, etc. An example would be providing books to schools, versus influencing what is in the books in schools.

Treat symptoms vs. Prevent problems

This tradeoff is one of both urgency and quantity. It implies a certain metaphysical reality for the tradeoff to exist, that is, that a smaller good can be had now at the expense of a larger good later. The tradeoff demands that we consider which is more important: ending present suffering or ending the the cause of suffering. An example is providing malaria medication, versus providing mosquito nets.

Act locally vs. Act globally

This tradeoff involves the radius of impact and the desire to improve one’s own community versus the potential to affect a more desperate community further afield. An example would be trying to end homelessness in your own city, versus trying to provide clean drinking water to everyone on the planet.

General application vs. Specific application

This tradeoff is similar to the impact radius consideration but the question asked is more precise: “Given that resources are limited, do you seek to relieve the problem as it affects one specific group, or as it affects all groups?” A person may choose a specific group far away or a specific group they know familiarly, that is why this is not a question of acting locally or globally. An example might be seeking cures for childhood cancer, versus seeking cures for all cancers.

Verifiable impact vs. Difficult to measure

This tradeoff involves considerations of the empirical measurement of philanthropic influence. You may decide only to support a cause which has a clear and objective metric to indicate the influence your contribution is making, or you may decide to support a cause where the impact is subjective, mixed up with other independent variables or is simply on too vast of a scale to easily measure. An example is delivering computers to third world classrooms, versus improving the happiness of a community.

DIY vs. Pay to fund others

This tradeoff is a question of agency and considers whether one will serve as the agent of change himself, or whether he will hire others to do the work for him. It is not just a question of leveraging the efforts of others through the division of labor– it is about whether it is personally desirable to be involved as an agent oneself or whether it is preferable to provide things like ideas, organization and money while leaving others to actually execute on the plan. An example is going on a mission trip and building houses for the poor, versus making a donation to the Bill & Melinda Gates Foundation.

Change the system vs. Work within it

This tradeoff involves an analysis of the contribution the social system (rules, laws, cultural customs, traditions, economy, etc.) makes to the existence of the problem in question. You might see the problem as a necessary outcome of the system itself, necessitating a “revolution” to resolve it, or you might see the system as largely disinterested in or detached from the problem meaning it’s possible to use the system, or channel its energy differently, to resolve the problem. An example is abolishing the tax code, versus seeking a privileged status within it such as 501(c)3 designation.

For-profit vs. Non-profit (Self-sustaining vs. Dependency)

This tradeoff examines the proper method of financing a charitable activity. It signifies an awareness of the way that the existence of a charitable resource might influence the supply or stickiness of a social problem. It also provides consideration for the likelihood of strategically resolving a social problem with a potentially uncertain, inconsistent or mismatched method of finance. It understands that the design of economic systems and the consideration of incentives is often background for the existence of certain social problems. An example is a business that purposefully hires various “at risk” demographics to keep them out of trouble, versus a charity which spends significant time and energy ensuring its continued financing by others; a corrolary example is a charity with a substantial endowment which is intelligently invested over a long-period of time allowing it to grow, versus a charity which comes hat in hand every year asking for new donations to continue its operations.

Individuals vs. Families/communities

This tradeoff involves the philosophy of “If you can change the life of just one person, you’ve made a difference” as opposed to “It takes a village” or “Only together may we truly prosper.” It asks one to focus their consideration on whether the problem is truly being solved if only some are relieved or whether a wholesale solution must be put into affect to feel a sense of accomplishment. An example is a scholarship for a talented student, versus constructing a school for an “underserved” community.

One causes vs. Many causes

This tradeoff considers whether one can do the most good by having many plates spinning and doing a little good in a lot of places, or if it’s better to dig deeply and do a lot of good on just one issue. An example is putting all your effort and resources into diabetes research, versus supporting the local children’s hospital, a charity sports league, providing scholarships to handicapped students and funding a legal defense fund.

One project vs. Many projects

This tradeoff is similar to the one immediately preceding it. The difference is simply that one could have one project at each of many causes, or many projects at one and only one cause, or some other combination of the two. It is partly a question of finishing what you started before going on to something else. An example is just feeding the poor, versus feeding the poor, providing job training for the poor and organizing community awareness seminars about the challenges of the poor.

Mankind vs. Other Organisms

This tradeoff is self-explanatory– do you seek to resolve human issues, or ecological issues (including issues related to the state of the environment, the welfare of non-human animals, the prevalence of plant species, etc.) An example is building a church, versus saving a species of river smelt from extinction.

Conclusion

When it comes to philanthropy, I believe the most important epistemic principle is that you should have a rational, deeply contemplated answer to the question, “How do you know you aren’t making it worse?”

Getting More Out Of Venture Capital

In “We Have Met The Enemy, And He Is Us” (PDF), the Kauffman Foundation gets radically honest about the world of institutional venture capital investing and their own experiences with the asset class:

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.

Specifically, they found that:

  • The average VC fund fails to return investor capital after fees.
  • Many VC funds last longer than ten years—up to fifteen years or more. We have eight VC funds in our portfolio that are more than fifteen years old.
  • Investors are afraid to contest GP terms for fear of “rocking the boat” with General Partners who use scarcity and limited access as marketing strategies.
  • The typical GP commits only 1 percent of partner dollars to a new fund while LPs commit 99 percent. These economics insulate GPs from personal income effects of poor fund returns and encourages them to focus on generating short-term, high IRRs by “flipping” companies rather than committing to long-term, scale growth of a startup.

And who is to blame? As hinted at in the title, the authors believe the cause is primarily a fundamental misalignment of incentives and weak governance structures allowed by the LPs:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

Their conclusion is utterly damning:

There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.

The Dismal Asset Class

Is the average VC fund manager earning their keep? According to the Kauffman report, “since 1995 it is improbable that a venture fund will deliver better net returns than an investment in the public markets.” The “mandate” for most VCs in terms of investment returns that justify their existence is that they return 3-5% per annum over a typical benchmark like the S&P 500 as a proxy for public financial market returns. But in reality:

Investors are still attracted to the ‘lottery ticket’ potential VC offers, where one lucky ‘hit’ investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns.

VC is a proxy for gambling and the average fund is consistently not justifying its fees.

3 Ideas For Improving The VC Investing Experience

I took away three ideas for improving the VC investing experience based on the report. I think these three ideas have applicability outside of VC and speak to the need for improved corporate governance in any investment situation:

  1. transparency; eliminate the black box of VC firm economics
  2. incentives; pay for performance, not empire building
  3. accountability; measure fund performance against the “Public Market Equivalent” concept

A venture capitalist considering an investment for his portfolio will demand to know the internal economics of the business he is investing in as a normal part of due diligence. He wants to know this to ensure the business is being operated in a safe and sustainable manner so his investment will be secure. In particular, he puts emphasis on the incentives of managers and other owners of the business as indicated by their ownership stakes and decision-making structure and their compensation agreements. While an LP investor is not technically an investor or owner in the GP that manages the fund, the arrangements and incentives predominating at the management company level WILL have an influence on the way the portfolio is operated. Rather than argue for a right to know, LPs should ask their GPs to defend their right to privacy. If they’re to be business partners and in a relationship of joint risk taking, why shouldn’t their be sufficient trust to share information such as the following?

  • Partner capital contributions (by partner), partnership ownership
  • Partner comp amounts and structure– salary, bonus amounts and structure, and the allocation of carry, management company agreement
  • Quarterly firm financials– balance sheet, income statement, cash flow
  • Full-year firm projected financials, annual budget
  • Partner track records, investment cash flow data for public market equivalent (PME) analysis

Further, LPs should have other value-adds besides the cash they bring to the fund. Often this comes in the form of specific industry or personal experience which could be useful to the GPs in evaluating investments for the portfolio. But active agency in a corporate governance structure is another important value-add, missing in too many firms of all sizes, types and industries. Additional transparency could be achieved by involving LPs in the following:

  • The right to elect LP representatives to fund Advisory Boards
  • Information rights to detailed firm quarterly and annual financials
  • Right to review and approve annual firm budgets

According to the Kauffman report, almost two thirds of VC fund revenues come from management fees, NOT carry on performance generated. This means that most funds are incentivized to maximize assets under management by continually building new funds rather than to maximize performance by making outstanding investments while minimizing losses. Why should VC managers get rich regardless of the performance of their investments? The owner of a wholly-owned business only makes money when his business is profitable. He can’t pay himself a big paycheck forever just because he put a lot of capital at risk.

Instead of the standard “2 and 20” model, a VC could manage under an operating budget and a sliding carry system. Under this system, rather than charging a fixed 2% on all AUM regardless of how much or how little it is (and regardless of how many funds paying 2% have been raised historically), the GP tries to estimate its operating expenses needed to manage various levels of scale in advance, including office, support and vendor expense, travel and reasonable salaried compensation for the investment professionals in the firm. This budgeted expense would be spread across all funds and would likely decrease as a percentage of total AUM over time. To enhance the incentive and reward for strong performance, a sliding carry could be instituted in which the GPs are compensated at higher levels of total profits generated as they achieve increasing levels of outperformance against Public Market Equivalent hurdles. (Of course, this system could also employ hurdles such as returning some minimum multiple of invested capital net of fees before performance carry participation, ie, 1x, 1.1x, etc.) An additional recommendation for aligning incentives from the Kauffman report was constructing the VC fund as an “evergreen” fund:

Evergreen funds are open-ended and therefore not subject to the fixed timeframe of a ten-year fund life or the pressure and distraction of fundraising every four to five years. Without the pressure of regular fundraising, evergreen funds can adopt a longer timeframe, be more patient investors, and focus entirely on cash-on-cash returns, rather than generating IRRs to market and raising the next fund.

The final idea is to utilize the Public Market Equivalent (PME) concept to gauge investment performance, versus an indicator such as Net IRR or Net Multiple. The PME is calculated as a ratio of the value of capital in the strategy to the value of capital in a public market equivalent (such as the S&P 500, Russell 2000 or other comparable index based on risk, market cap, volatility, etc.) For example, if an investment was worth $15M at the end of the fund’s life, but would’ve been worth $10M in the Russell 2000 over the same time period, the PME is 1.5, or a 50% out performance. This is useful because it can reveal relative underperformance even when the VC fund achieves a high IRR or other performance metric but the public markets achieve a growth rate still higher. It is also useful because it can put a loss of capital in perspective when the public markets lose even more. The PME measures investment skill relative to the market environment. For Kauffman, “we have used PME to prioritize our best-performing funds, and to concentrate our investment activity and increase our investment amounts in those partnerships.”

Closing Thoughts

After their grand survey, the Kauffman fund managers have become more skeptical about VC as an asset class:

If they are not top-tier VCs, you are very unlikely to generate top-tier returns… Being a better investor in VC for most LPs will translate into being a much more selective investor.

Kauffman suggests there may be as few as 10 (!) such funds worthy of investment in the entire VC universe.

Part of that selectivity involves choosing to invest only with the most talented managers. Another part of the selectivity is sticking to funds whose total committed capital is not so enormous as to make them unwieldy and unsuited for the initially small, risky ventures they’re supposed to back:

Big VC funds fail to deliver big returns; we earned an investment multiple of two times our invested capital only from venture funds whose commitment size was less than $500 million.

According to a study conducted by Silicon Valley Bank, having a discipline about relatively small size is an important determinant of future investment returns:

  • The majority (51 percent) of funds larger than $250 million fail to return investor capital, after fees;
  • Almost all (93 percent) of large funds fail to return a “venture capital rate of return” of more than twice the invested capital, after fees.
  • Small funds under $250m return more than two times invested capital 34 percent of the time; a rate almost six times greater than the rate for large funds.

Incentives matter, and rather than serving as a failed example of economic and investment theory, the VC industry is efficiently responding to the incentives created by LPs who lack the discipline or data to make informed investment decisions.

Notes – The Great Deformation – Part I, The Blackberry Panic Of 2008

The Great Deformation: The Corruption of Capitalism in America

by David A. Stockman, published 2013

I received a copy of David Stockman’s 2013 analysis of the mechanics of the 2008 financial crisis and its aftermath as a gift from a friend and sat down to read the first 50 pages, Part I.

I think Stockman attempts to make several key points as a set up to the remainder of this lengthy tome:
-the mainstream/regime narrative of an incipient economic crisis catalyzed by a financial collapse originating in Wall Street credit markets controlled by major Wall Street institutions (such as Morgan Stanley and Goldman Sachs) is one part baseless lie and one part clueless ignorance of facts on the ground at the time
-there was a crisis, for these particular institutions, which was a result of years of non-value adding financial and accounting chicanery enabled by Fed Chairman Greenspan’s infamous “put” and the crisis would’ve resulted in the liquidation of these firms assets (and the termination of their managers) into abler hands which would’ve been a good thing for competitive financial markets and the capitalist economy as a whole
-this crisis was not only averted by the frantic lobbying of connected officials in Congress, the Treasury and other regulatory agencies by crony executives in the affected firms, but these same executives and officials worked in concert to turn the bailout moment into a massive payday/profit opportunity; most of the people making decisions about this in the government, particularly in the Treasury and the Fed, were inexperienced, miseducated or otherwise rank amateurs with little understanding of the context of their decisions or their consequences beyond the immediate moment
-the scale of the bailouts in terms of pure dollars was completely without precedent or connection to actual costs and risks present in the system at the time
-memoirs of officials and executives involves in the bailout discussions published extemporaneously do not make a substantial case for their decisions based off of data available about the period years later
-much of the decision-making at the time, by concerned executives as well as captured officials, seems to be dominated by the twin desire to avoid taking responsibility for mistakes made in the past (thereby looking foolish) and to continue the illusion of the viability of the system based on these mistakes going forward

“All the rest,” as it has been said, “is illustration.”

There were parts of the narrative I found confusing to follow at times. Its possible I didn’t read clearly, but in several instances it seemed like on one page or at the beginning of a chapter Stockman would be arguing that the potential capital losses of a particular company were small enough relative to their total balance sheet that they could easily sweat the loss from a survival standpoint and then on the next page or at the end of the chapter, he seemed to suggest the same loss was so sizable that it would threaten the viability of the enterprise itself.

I think there was a lot of question-begging in the narrative as well. Stockman builds a decent logical case for why there was no “contagion” that could spread from Wall Street (the financial markets) to Main Street (the rest of the economy) that would result in a general economic depression. But his argument always rests on the costs being shifted to various government backstop agencies and funding sources which could make things like commercial lending and payroll finance markets “money good”. It isn’t explained where these institutions would come by the required funds necessary to remain in operation without a bout of money printing (bailouts) and how this is different than the bailouts Wall Street received.

That leads to another concern I have with the overall thesis, which is that somehow, what happens on Wall Street is arbitrary and doesn’t affect greater economic outcomes. While I agree with the notion that purging the financial system of bad debts and bad business models during periods of crisis is a process of economic health rather than economic illness, I so far fail to see how the repricing and reorganization of economic capital taking place in these markets would not result in similar repricings and reorganizations of capital investment throughout the economy as a whole. Stockman details several multi billion dollar examples of ” predatory financial practices” in which members of Main Street America were able to finance lifestyles they couldn’t prudently afford the costs of and it seems like these are prime (or subprime, as it were) examples of assets that would need to be repriced and reorganized into abler hands. The gutters of both Streets would be filled with the purged excess, and it would eventually drain.

Annoyingly, Stockman repeatedly exalts “our political democracy” and even conflates its goodness and functioning with free market capitalism. For me, this is a fundamental flaw in reasoning and defining terms that throws his entire analysis into suspicion, at least from the standpoint of his analytical framework operant and his own agenda in terms of desired social outcomes. I don’t think Stockman and I are on the same page, in other words.

So far, Stockman’s book expects a lot of prior knowledge on behalf of the reader. He doesn’t begin the book outlining his economic or financial theories, nor his concept of the purpose of government. We intuit bits and pieces of it as he proclaims this bad, that person good, this event horrid, etc. But he never really says “I’m from the School of X” or gives a summary of the key principles necessary to follow his analysis. Therefore, it comes off as strenuously assertive rather than rigorously logical. And I think part of Stockman’s goal is to spread blame in a bipartisan fashion, while building bridges and giving accolades in an “independent” manner. So far, though, it seems arbitrary due to this lack of explanation about his framework.

On Conspiracy

I’ve spoken to a lot of people who deny the existence of various conspiracies behind well-known human events because they believe it’d be too hard to keep a secret with the assumedly large number of people who would have to be in on it to pull off the original act.

I want to ignore the possibility, which I’ve raised, that secrecy isn’t even necessary because many times people will ignore or not recognize criminality right in front of their face (ie, the ongoing, millenia-long fraud of the State).

Instead, I want to reflect on the following current events. Nearly every week for the past several months, new information about global national “security” apparatus spying has come to light thanks to the efforts of Edward Snowden and his allies. Each one of these stories are billed as surprising revelations not previously known.

I don’t think there has been any specific disclosure of how many people at the various agencies fingered are involved in each of these various schemes but it seems safe to say they are “numerous.” I don’t know what kind of upper bounds a person would put on the number of members of a conspiracy required to keep a secret but I’d have to believe, given that these agencies occupy fairly large office buildings and other campuses around the country and the world, that the number of operatives exceed those thresholds.

How, then, did these programs manage to remain a secret?

To take this further, how do “intelligence communities” manage to operate at all given that they, too, are “numerous” and their entire model operates on the assumption that secrets can be kept despite their numerousness?

If I were to venture a guess, I’d say the answer lies with recognition of the fact that people have strong incentives to keep secrets concerning criminal or otherwise socially-reprehensible activity they’re engaged in. Especially when such activity constitutes their “job” which provides food for their families, or, even more powerfully, when such activities line up with their ideological beliefs, whose faithful following gives their lives purpose and meaning.

I think it unwise to overly discount the economic likelihood of conspiracy.

The Long War: Changing Ownership, Management Incentives & Reporting Practices

Ian Cassel, founder of MicroCapClub.com, made a comment on Twitter today which grabbed my attention:

If a company is over $25m market cap they should have to have earnings conference calls w/ Q/A. Coalition Against Private Public Companies.

Shortly thereafter, he was asked by Jeff Moore of the Ragnar Is A Pirate blog:

How about if they have more than 100 shareholders?

To which Ian replied:

yes another good idea

At this point, I asked:

so you guys are for imprisoning and fining people because they won’t give you info you want?

Ian considered it and responded:

do I think every public company should, Yes. Force probably not, but cld be part of a tiered listing standard

I think this whole idea is worth a comment so I’m now going to give it one.

The first angle with which to approach Ian’s compulsory conference call proposal is the moral one and concerns the question, “Should managers of public companies, whatever their size, be compelled by force of law (ie, threat of fines or imprisonment for non-compliance) to provide the investing public conference calls regarding their earnings releases?”

The answer to such a question would hinge on whether or not, by refusing to hold such calls, these managers were committing an act of violent aggression against the investing public, such as theft, assault or fraud. If refusing to hold an earnings call is an act of theft, assault or fraud, clearly there is justification for compelling such behavior in order to remedy this affront to the rights of the individual members of the public and the answer would be “Yes”; similarly, if refusing to hold an earnings call does not represent the initiation of the use of force against members of the public, the answer to this question is clearly “No”.

I don’t want to waste anyone’s time going into a lengthy exploration of the facts on hand. I think it’s obvious that refusing to hold an earnings call is not an act of aggressive force and I don’t think Ian provided or attempted to provide any evidence that it was. In fact, he suggested this was not an issue to be handled by the law at all. I elaborated as much as I did, anyway, because there may be people reading this who did not understand the issue in this way and may have been confused prior to reading it. For their benefit, I state plainly now, the answer to the question is “NO”.

The second angle of approach is institutional. As Ian suggested in his final comment, the solution to this perceived problem could be handled at an institutional level (in this case, the voluntarily adopted rules and internal regulations of the listing exchanges) by adopting Ian’s preference for mandatory earnings calls at a certain market cap threshold as an observed “best practice” or condition of doing business on the exchange. If a company doesn’t want to follow it, they have the option of not being listed on the exchange observing such a rule. From a moral standpoint, there is no issue as there is no coercion, and compared to the alternative of creating a top-down, one-size-fits-all-companies-and-exchanges external regulation backed by force of law by government, this solution is indeed preferable because it at least allows for the possibility that some companies would not follow this practice and would find other avenues for listing their shares and allowing for equity exchange.

This leads to the third angle which, for lack of a better term, I’ll simply refer to as the “practical” considerations, of which there are several. For starters, I wonder if this is really an issue? In Ian Cassel’s (and Jeff Moore’s, perhaps?) world, it certainly seems to be. Ian Cassel’s world would be a happier place if all the public companies whose market caps were $25M or greater provided the public (of which he is a member and would stand to benefit) an earnings call upon release of each earnings statement. But embedded in such a proposal seems to be the belief that the world should reflect Ian Cassel’s preferences, and everyone else should bear the cost and expense of preparing and providing this information to Ian Cassel (and others of like mind).

Is this reasonable? If having better earnings communications from small companies is important to Ian, and if dialoging with management is a valuable commodity, Ian already has a course of action available to him to pursue such goals: he can make his own independent effort to email, write, call or visit in person the management of these companies and create a relationship whereby they would provide him answers to some of the questions he has in mind; or, he could acquire a sufficient number of shares of the company such that he is the owner of the company and the management is now fully responsible to him and he can have any and all information about the company that he pleases.

Neither of these actions require anyone being compelled to change their current practices. Both require nothing more than the expenditure of Ian’s own effort, time and wealth. If certain companies prefer not to establish such relationships or provide such information to people like Ian, Ian always has the option of walking away from them. And if he doesn’t have the financial resources to acquire such an ownership stake so as to make them more responsive to his inquiries, that would be a problem for him to solve by finding ways to produce more wealth for himself he could exchange with others for the privilege – it is not the responsibility of the company, its shareholders or anyone else.

Another practical consideration is the arbitrariness of the threshold for compliance. There’s nothing magic about a $25M market cap (nor a 100+ member shareholder base). The first number seems to be an attempt at defining “resourcefulness”, implying that a company with a certain sized market cap “should be able to afford” such accommodations. But market caps are not determined by managements and company resources, they are determined by the passions and dispositions of the investing public. It’s entirely conceivable that a company of truly inadequate resources (say, a book value of $50,000, just to harshly illustrate the point) could be bid up to a market cap of $25M in some bizarre turn of events. The fact that it has been so valued doesn’t make it more able to provide additional clarity about its business– and even if it did, it still doesn’t have an obligation to provide anyone anything like this. The shareholder base threshold is simple populism and the democratic principle– 99 of the shareholders could own one share at a penny a piece, with the remaining shareholder holding substantial control of the rest of the shares, making them truly insignificant in the ownership structure. But by creating arbitrary rules like this these individuals would create for the company sudden obligations simply by their existence.

Another practical concern is why a person, operating in the microcap space where an edge is often gained specifically because of the lack of consistent, clear information about these companies, would want to see measures taken which would serve to increase the “efficiency” of the market and thereby eliminate a lot of these mispricings and the opportunity to cheaply invest along with them. Sure, once you’ve put your money in you might have a self-interested reason to see everyone else suddenly figure out what a great company you’ve invested in because they have these wonderfully translucent earnings calls, but before that point you’d want to see opacity. Such a rule (compulsory earnings calls) would work to eliminate those opportunities before one could make their initial investment, not just after. As microcap investors, what we’re getting “paid to do”, essentially, is to find these opaque opportunities, get in there, agitate for change company-by-company and work to clear the dirt and smudges off the glass, so to speak. We want that to happen AFTER we get involved and BECAUSE we got involved, not before and regardless.

My final issue is with the cutely-named imaginary organization “Coalition Against Private Public Companies”. The implication is that public companies run like private companies constitute some kind of social ill. But if we look at the facts, it is often the owner-operator/private companies of the world which are most efficiently managed and whose business is best looked after compared to the alternative of entrenched, professional managers and disconnected, alienated and disinterested public shareholders (see this outstanding research piece by Murray Stahl [PDF] for a convincing argument, for instance). Indeed, it is often the public companies which are most dysfunctional– how is it preferable to have a management team obsessed with short-term earnings results, attempts to influence and gain the approval of Wall Street analysts, etc.? It’s perhaps syntactically confusing but what is really worth rebelling against is public private companies, not private public companies.

A public private is a company that SHOULD be private, but is in fact publicly traded and as a result the minority partners in the business, that is, the various outsider shareholders from the investing public, are treated like nuisances or smurfs whose capital is to be dissipated at the insider owners’ discretion. Such managers have no incentive to responsibly steward the outside shareholders’ capital because it doesn’t belong to the insiders and the outsiders are, in most cases, afforded an ambiguous and difficult, if not impossible, legal process to attempt to assert their equal status as capital owners. The most benefit they can receive from the capital is to issue some of it to themselves as generous salary or bonus payments, to use it as a tool for conducting ego-gratifying acquisition strategies or by sitting on it as a kind of future retirement/pension package to ensure they can care for themselves even in old age by remitting it to themselves as needed.

A private public company, on the other hand, is a company whose capital ownership is diversified and constituted by numerous members of the investing public, but which is managed and operated with the efficiency, passion, dedication and noble conservatism such as one would expect from a competent family dynasty or other limited, owner-operator control group or person. This is a company that treats capital as a precious commodity and always seeks to maximize the returns on its use which all members of the investing public so involved stand to benefit because they are treated as equals even though they have minority status. The fact that this company is publicly traded does not influence the decisions of the management and serves only to benefit all shareholders in the instances in which the management can buy back undervalued shares or issue significantly overvalued shares to raise cheap capital.

Truly, there are very few enterprises on all of planet earth that really provide their owners (shareholders) with outstanding additional benefits by virtue of their being publicly owned and exchanged. The more I think about the issue, the more I wonder why most public companies are public in the first place. Almost every IPO seems to represent an opportunity to cash in on delusional hopes and ignorant dreams rather than a genuine opportunity to “share the wealth” in exchange for some long-term capital necessary to fund profitable growth.

If I were to join a group agitating for change, I’d like to imagine it’d be called the “Coalition To Privatize Public Companies.” But honestly, I have no use for imagination, nor for agitation. I don’t seek to have others bear my cross, even as a joke or a day-dream. No, this is in fact a principle (one of several) of my efforts as a private, individual investor in the public market place and I intend to pursue it throughout my career.

It’s part of my long war.

Fees, Firepower & Funds: The Incentives Faced By Private Equity

I know very little about the private equity world, mindset, incentive structure and investment strategy, but I am eager to understand it better. I found a recent post, “Too Much Is Never Enough” at the Epicurean Dealmaker blog, to be informative reading, assuming the author knows what he is talking about. Plus, it came chock full of Seven Samurai quotes, which is pretty awesome:

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.