Monday, June 3, 2013

THE PROBLEM WITH MONOPOLIES...


MRSA and Private Equity

For both there is a cure!

By J.M. Hamilton (11-7-10)

Several interesting titles came to mind for this week’s editorial, among them:  Private Equity, the Killer Whales of Capitalism, or Private Equity & Saturated Fat, Clogging the Arteries of Commerce and the Economic Recovery.  But hey, I have nothing against Killer Whales, who are only acting out their role in nature by culling out the weak and infirm from the seal population.  And saturated fat is absolutely benign compared to private equity.   At least with a little will power we can avoid saturated fat.  Private equity, on the other hand, is more pernicious, insidious and prevalent in our society; that is to say, private equity is much more analogous to the super-bug, MRSA or methicillin-resistant staphylococcus aureus.  Besides, the government’s concern about MRSA, and required intervention into market place, nearly completes the hook, and allows this piece to run full circle.

Government Intervention into the Market Place: Democrats, Republicans and Bears!  Oh My!

The Times ran a story this week, Antibiotics Research Subsidies Weighed by U.S., where for once, we may actually have both Democrats and Republicans coming to agreement that government intervention into the market place might be a positive thing.  Its seems as though MRSA, and assorted superbugs, are overthrowing and growing beyond the reach of medicine; and Big Pharma has more profitable endeavors to pursue (like adding vitamins to medicines, so that patents and monopolistic profits can be extended), than developing new antibiotics to fight MRSA and his deadly friends.  Funny how the most ardent Laissez Faire Capitalist becomes all “lovey” about government, when the market falls on its ass, and there’s a life threatening crisis at hand.

Seems as though both Democrats and Republicans want to throw all kinds of financial incentives, tax breaks, and other assorted financial goodies, Big Pharma’s  way (on top of the multitude of breaks Big Pharma already receives), so what would transpire in a more perfectly capitalist system, can now happen through government intervention into a oligopolistic market place.  Unfortunately, as usual, government is attacking the symptom of the problem (Big Pharma intransigence and greed), instead of the problem (Monopolies authorized by our government), essentially applying a band aid to the boil on the skin instead of addressing and attacking the MRSA that lurks beneath the boil. 

Adam Smith and an “Absurd Tax”

We’ll eventually get to private equity, but first a quick visit to our friend Adam Smith.  Mr. Smith warned about the pernicious tendency of capitalism to metastasize into monopoly, when he wrote:

(The interests)… “in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public.   To widen the market and narrow the competition, is always in the interests of the dealers… and can serve only to enable dealers, by raising their profits above what they would naturally be, to levy, for their own benefit, an absurd tax upon the rest of their fellow citizens.  The proposal of any new law or regulation of commerce which comes from this order (Merchants, Dealers, Monopolies), ought always to be listened to with great precaution, and ought never be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention.”

No way.   Adam Smith, a free market deity, nearly 235 years ago warned that monopolistic profits are a tax on society, and warned about capitalism’s tendency toward combination?  And as this blog has written about (see Monopolies and Double Standards, Et Al.) monopoly can only occur by the grant and authority of the government.   And hence, the market place failure we are now witnessing:  Having created the oligopoly, Big Pharma, the government now has to go begging this oppressive power for core and fundamental medicine.   Had the government not allowed Big Pharma to consolidate and grow so powerful, there would be many varied entities and entrants in the pharmaceutical market place, each seeking out their own niche, presumably one of these would have been antibiotics to keep up with superbugs.  Instead, we have a few powerful actors, Big Pharma, who can hold out for compounded government largess, at the expense of the tax payer and general welfare of society, before developing drugs that would otherwise, most likely, be developed in a less monopolistic market sector.

“This is market place failure,” states California Democrat Mr. Waxman in the Times article.   Indeed, Mr. Waxman, but rather than throw yet more tax payer money at Big Pharma (in the form of financial incentives and tax breaks), perhaps the real solution is the break up the pharmaceutical cartel, so that there are more players to address life threatening disease and illness?

How the Game is Played

Enter private equity…. Shadow banking’s co-evil twin.  Private Equity makes its money by acquiring, merging, leveraging up perfectly healthy companies and corporations with colossal amounts of debt, front loading profits, extracting huge management fees, of course taking a portion of the profits (if any) from the targeted company, tax deductibility on the massive debt, and even enjoys the kicker of special tax break, under the guise of “carry forward.”  Private equity further guarantees profitability by sealing itself off from loss by creating LLC funds and holding companies; hence, profits can flow up, but losses and bankruptcy may stay below with the LLC.  But the really big pay off occurs when the private equity company takes the acquired firm and flips it, by taking it public (IPO), merging it with another company (M&A), or tossing said company to another private equity firm (to be leveraged up and “debted up” all the more), much as a pack of Orcas does with baby seals.  Of course, private equity, like MRSA, goes barely unnoticed when things are going along swimmingly; but when the economy heads south or the bubble bursts, all that leverage, and the debt service load, tends to tear a company apart at the seams, to the detriment of:  society, management, investors, employees, bond or debt holders, vendors of the bankrupt company, and the tax base.

Witness a record number of business failures in this country in the last couple of years, possibly half of them pushed over the edge by their recent, or present liaison, with private equity.  From the NY Times story, Profits for Buyout Firms as Company Debt Soared (10-5-09), we get the following:

“A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s. Among them are household names like Harrah’s Entertainment and Six Flags, the theme park operator.”

Gee… all those tax breaks and special considerations, do you think private equity has some ties to the Federal Government?  You bet.  Why look no further than the occupations of our recent Treasury Secretaries: 

*Mr. Henry Paulson (Bush Administration) former Goldman Sachs, CEO and creator of TARP.  Say no more. 
*John W. Snow (Bush Administration) now a member of Cerberus Capital Management Groups, private equity, and the fine folks who helped bring Chrysler down.
*Larry Summers (Clinton Administration), lieutenant of Robert Rubin, and a key player in the deregulation of the derivatives industry.  The derivatives industry will and does, undoubtedly, play a significant role in private equity, and yet another round of M&A activity to come.
*Robert Rubin (Clinton Administration): Goldman Sachs, Citigroup, both of which ran and supported private equity operations.

Alone, of our recent Treasury Secretaries, Paul O’Neill (Bush Administration) stands out as a man of fiscal integrity, a man who bucked the Bush tax cuts and the neo-cons, and a man who did not come from, or return to, investment banking and private equity.  Perhaps that’s why Mr. O’Neill was let go?  As for Mr. Summers, the derivatives he has championed over the years play a unique role in private equity, by allowing investments banks, and private equity, itself, to hedge their bets against targets for acquisition.  Derivatives can secure profits for debt holders, if a takeover target fails, so that, depending upon the deal, and the subsequent financial results, the investors, private equity, banks and bondholder, may actually have an incentive to see the target fail or enter into bankruptcy.  As we can see in our on-going financial crisis, Wall Street makes money coming and going (lose, win or draw), and if the system blows up, well there’s always Uncle Sam ready to offer a bailout.

Fed Reserve and QE2:

The mother’s milk of private equity is cheap liquidity.  We are talking tons of money sloshing around, like the kind we see right now under QE 1 and QE2.  Private Equity has enjoyed peak periods, during bubbles, and massive monetary easing, like that seen in the mid to late eighties courtesy of Fed Chairman Alan Greenspan, and the earlier part of this decade, again under the auspices of the Fed, commanded yet again, by Mr. Alan Greenspan.  During these periods private equity awash with easy money, courtesy of investors and friends in the banking industry, runs around preying upon companies, leveraging them, merging them, and most stock analyst’s favorite, creating “synergy” and “economies of scale”…. All code for down-sizing, layoffs, and organizational restructuring. 

At a macro level, as companies merge or fall prey to their massive debt load, private equity plays a critical role in the consolidation of industry and markets, that is to say, the creation of monopolies and oligopolies, not unlike what we see with Big Pharma, and problems associated with Big Pharma, like MRSA.

These monolithic business entities have tremendous problems with risk management, as we saw with B.P. earlier this year, and often end up performing poorly for their stockholders and society. 

And the Fed’s and Treasury’s role in all this?  Well presently, the Treasury finds itself in the ownership of a car company, and several financial institutions.  What better way for the Fed and Treasury to divest themselves of these entities, than to print money, flood the market with cheap liquidity, drive down bond yields and treasury yields, and drive unwilling participants back into the stock market…. So that the Fed can exit, stage left, from its forays into the private sector.  TARP might, officially, then be proclaimed an economic/government success, and the preeminence of “Too Big to Fail,” as a government policy, upheld. 

Of course, an intended or unintended consequence of massive liquidity, and lower bond yields, is to drive investors into junk bonds, and riskier investment vehicles, such as hedge and private equity funds.  Again, all the mother's milk of private equity….so that at a time of record unemployment in this country, and with the Fed printed money so fast that the printing presses are beginning to smoke, we can reasonably expect more job killing raids by private equity in the market place.  Merger and acquisition activity should soar.

The Bottom Line:

Merger and acquisition activity, as well as, the taxation and regulation of private equity, like monopolies themselves, all fall under government purview.  One quick way for government to arrest rising unemployment is to slow merger and acquisition activity (via Justice, SEC and the FTC), and tax private equity at the appropriate rate all businesses face, and eliminate the tax deductibility of debt; all the better for the government to address unemployment, MRSA and intransigent industries, such as Big Pharma, who are literally holding public health hostage, so that they can, possibly, extract further financial concessions from our government.

Private equity, too, has a role to play.  Perhaps instead of becoming a contractionary force in our economy, it can be a force for good, by deploying its capital toward new ventures and start-ups that create jobs and opportunity, instead of the elimination of same.

At the end of the day, MRSA is a growing life taker and a threat to the nation’s health; likewise, private equity, in its present incarnation, is a threat to society, business, the consumer, management and employees, and our nation’s economic health.  For both there is a cure.

 Copyright JM Hamilton Publishing 2013

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