Jason Hartman starts this Flashback Friday episode by continuing a conversation with Steve, as they discuss Fannie Mae, Freddie Mac, and Warren Buffett. Afterward, Jason hosts David Carey, author of King of Capital, and senior writer for “The Deal.” They talk about private equity and its various forms, including injecting money into companies and leveraging buyout (LBO).
This show is produced by the Hartman media company. For more information and links to all our great podcasts visit Hartman media.com.
Welcome to this week’s edition of flashback Friday, your opportunity to get some good review by listening to episodes from the past that Jason is hand picked to help you today in the present, and propel you into the future. Enjoy.
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Jason Hartman 1:16
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Last episode, I was talking with Steve during the intro portion of that episode. And you know, we covered a lot of things, but we still had a few things we meant to cover that we did not cover, including Fannie Mae, Freddie Mac, Warren Buffett, and our referral program that we just wanted you to know a little bit more about. Steve, welcome back. How are you?
Hey, doing great. Thanks for having me.
Jason Hartman 2:29
Good. So hey, we went so long last time. What do you want to talk about today? We got into that whole conversation about hedge funds and you know, ox Ziff and, and the the smoke and mirrors fake economy versus the real economy and income property being a fragmented market, but that’s really the benefit of it. You had a couple articles and things that you wanted to cover.
Yeah, yeah. Well, we went all over the place, that’s for sure. We’re gonna try to not do that again.
Jason Hartman 2:54
Oh, come on, you know, we will.
Okay, fine. Well, there was an interesting article on Inman news. titled Fannie and Freddie becoming Ward’s of the state, which they certainly are, you know, a ward of the state under the traditional sense meaning somebody who is unable or unwilling to take care of themselves, sometimes even a prisoner in the states just completely in charge of them. They belong to them. And you know, we’ve we’ve all been told, oh, Fannie, Fannie Mae, Freddie Mac, those are private companies. But anybody who’s paying attention there, the US post office, a private companies, I mean, we all know it’s not true with all the funding that they get. And so yeah, they are essentially on life support with the federal government, the guarantees and the backing by the Fed that they receive, allow them to do what they would be able to do. I think, what’s most important to mention here is if Fannie Mae wasn’t in, I’ll just call it Cahoots. That’s how I see it with the federal government. The business practices that they’ve implemented, would never Not in a million years have allowed them to survive and The general marketplace Not a chance.
Jason Hartman 4:02
Oh, yeah, Not a chance. I remember who was it Franklin Raines. He just ripped that company off left with a huge golden parachute. And during the day he was revered as some genius who was just creating homeownership for so many people and doing all these wonderful things. And I remember going to a meeting of the Mortgage Bankers Association. And you know, it’s it’ll it almost like reminds me of like Lance Armstrong, all you got to do folks and I don’t even know if the lance armstrong thing is really was he doping? It seems like it because he gave up and stopped fighting it and, you know, so he fell from grace. And a lot of these a lot of these people that are just like these revered people, this is why I never really put my stock in a single person. I’ll believe in a political philosophy, but I’m not gonna believe in a person because I just been led down too many times. I’m sorry if I’m so cynical, but you know, I’m not gonna say Oh, Romney romney Romney, you know, I’m gonna say Say No, I’m gonna go with the philosophy. Ramiz, a turnaround specialist. He’s still a globalist just like Obama, I don’t think we’re ever going to get a real choice. But you know, given the choice, I mean, he’s easily the better candidate. The country is a business, okay? And you know, I want a businessman in there not a guy with no resume who’s never done anything real in his life. Who has this past Troutman shrouded in secrecy? Where’s his college records, all this kind of stuff, right? Enough of that. But the point being, is that when you look at Fannie Mae and Freddie Mac, okay, they may become nationalized, the better thing would be to just let them go under. And so many of our investors have said, Jason, what if Fannie and Freddie go away, and the mortgage market dries up? And people don’t have access to all these great low interest rate mortgages? Won’t that cause housing prices decline? Well, my answer is Yeah, probably they probably will decline at least initially. they’ll they’ll decline, I think so. But guess what, folks, there’s always a counterbalance to everything in life. So say housing prices plummet, and why do they plummet? Well, they plummet because people don’t have access to cheap mortgages with low down payments, okay? Then the population is still increasing, people still need a place to live. So what are they forced to do? another four letter word I really like rent, so they’re forced to rent they only have three choices. They rent, buy or be homeless, and so rents the counterbalance to purchasing. When I teach the three dimensions of real estate, this is part of it. If you see the housing market is fueled by cheap mortgage money and low downpayment, mortgage money and ease of qualifying, so if you don’t have those three things, then people can’t buy if you do have those three things they can buy like crazy and prices tend to go up and they creates Bubble. You know, we’ve been through that way too many times we’ve seen those bubbles inflate. In fact, we see a bubble starting to inflate again. Now, it’s not that severe yet, but I still think it has a long way to go. But there are signs that a bubble is being blown up right now as we speak, in the midst of this terrible economy and this fake recovery, but if people can’t buy, they gotta rent. So Fannie Mae and Freddie Mac went out of business. I mean, I would welcome that, because rents would skyrocket. And remember, we were cash flow investors. Our clients are cash flow investors, we’re not gamblers. One of the 10 commandments of successful investing is Thou shalt not gamble. We buy properties that makes sense the day we buy them, and the way they make sense from a cash flow perspective. And I think if you see a Republican Congress, and you see a republican president, you would just have a lot of pressure for no more people. allows no more no more nationalization and no more bailouts to these criminals that basically run the banking system. And so the likelihood of Fannie and Freddie being cast aside would be greater. Now, if you have Obama and you have more Democrats in Congress, well, the likelihood of kicking the can down the road and propping up these entities that don’t work, and that are insolvent, that’ll be higher. So then what do you have? Well, you’ll have a likelihood of a greater bubble being inflated, the rents won’t go up so much rents will just do their normal thing. They will escalate, as they always have throughout history, but they’re not going to skyrocket like they would if Fannie and Freddie went away of cheap mortgage money went away. And you know that ultimately, a couple years later, the private market would start to come in and fill the needs and instead of getting a mortgage for three or 4%, while you’d pay six or eight or 9%, and prices would maybe adjust downwards To compensate for the mortgage rates, but rents would be much much higher. So if you like investing for cap rate, cash on cash return, or overall return on investment, not considering appreciation, hey, especially cash on cash, that’s the major one here. If you like investing for cash on cash return, you just better hope that Fannie Mae and Freddie Mac go under, because that’s where you’re really gonna benefit. Remember, you’re listening to flashback Friday. Our new episodes are published every Monday and Wednesday.
Yeah, all very good points and kind of bringing it to all around. You know, we’re very close to the presidential election here and I was watching the news this morning. And President Obama was out on the stump and you know, it’s that point in the election where no matter what political party you belong to your you’re kind of nauseated with everything you know, and hearing the same talk talking points over and over again. And, and one of President Obama’s more popular ones is, do we want to go forward? Or do we want to return to the failed policies of the past? I heard that one and, you know, he’s making allusions to, to Wall Street and policies of the previous administration and things. And that statement always makes my blood boil, because the failed policies of the past are well, there, they’re from much further in the past, going back to Fannie Mae and Freddie Mac, like I said, at the beginning of this fanime and Freddie Mac have not had to behave like a business. They’ve had the government there to prop them up. We go back to these mortgage backed securities and these derivatives and these kinds of things. If these investment banks and these people had to deal with true, organic risk, like we do, as investors, they would have never made all those subprime loans. They would have never done all that crazy speculation. But because Fannie Mae and Freddie Mac who are now Ward’s of the state were there to prop them up, they were free to run wild. I mean, it’s like saying Wall Street just got greedy back in 2006. Before that they never were. Right, I got news for you, Wall Street has always been greedy Greed has always been around since the beginning of time. And you know, you put that big pile of money on the plate in front of them and that’s what they’re gonna go for. That’s what they’re gonna do. And so we don’t know ultimately what’s going to happen to to Fannie and Freddie, but like you said, you make a very good point. In any case, whatever happens to them, we’ve got to be opportunistic here. And we’ve got to take advantage of, of this bogus monetary policy and the crony capitalism that continues to be spread
Jason Hartman 11:37
What we have now, the Obama regime is probably the most fascist regime we’ve had, because they are so in bed with corporate America. Now listen, George Bush wasn’t much better. He was slightly better, but not much. Okay. So I’m not defending him either. Right?
Well, you have to qualify that because many times if you come out negatively against Obama, you’re by default assumed to be a rabid george bush supporter.
Jason Hartman 12:04
Yes, of course. Of course. I support Main Street. I support small business. And I know you look at folks, if we want to have cool iPhones, you know, small businesses can’t make things like that small businesses can’t make automobiles or spaceships. Okay. But you know, we need major capital formation in some industries. There’s no question about it. Intel, who has a plant here in Arizona and many others around the world, you can be a small mom and pop business and make integrated chips, okay, and circuitry. Those are things that require clean rooms and teams of brilliant people and very sophisticated software and incredibly complex manufacturing processes and all that. You know, I get that of course, but the thing you have is you have this situation where when the government picks winners and losers, they never pick the little guy to be the winner. They pick Solyndra, they pick a big guy. They pick a crony capitalism. They pick Fisker. They pick Tesla. They pick Solyndra. They pick that battery company that just went under nobody’s buying the stupid batteries for the electric car. What a surprise. It’s like here you have all this. It’s just fascism. crony capitalism and fascism are the same thing, basically. And that’s the problem. So Wall Street is it has purchased the government, the government is in bed with Wall Street. And the whole thing is crony people like to portray Wall Street is republican and the environmental movement is Democrat. That’s not true at all. I mean, Wall Street is Wall Street likes big government. They love Democrats. I mean, they there have been studies done showing that they support the parties about equally but the parties are just two sides of the same coin. I mean, the only guy that was really any different was Ron Paul, or Ralph Nader or ross perot. They really want to change But they were kept out of the system out of the debates. It’s a scam.
Jason Hartman 14:06
Yes, sir. Things a big scam. But anyway, that’s what it is. Did we cover the Fannie Freddie thing enough?
Yeah, I think we’ve got that covered.
Jason Hartman 14:14
All right. Let’s talk about Warren Buffett. You know, I just gotta love this hypocrite. I’m looking at a thing here that says Buffett calls for taxing the rich while he sues the IRS to avoid paying taxes. And it says billionaire Warren Buffett knows how to separate his social activism from his business management. Over the past several months as Advisor to President Obama, Buffett has been calling for additional taxes on the rich and telling Americans he also would like to pay more to the government. However, on November 19, I guess this is last year, November 19. Obviously, the true side of Warren Buffett, that of the business mogul came to light as he is now suing the IRS to avoid paying more than 600 million dollars in taxes levied upon Berkshire Hathaway subsidiary net jets. So here he’s got a private jet company that Berkshire his fund owns. And he’s suing the IRS to keep them from paying $600 million in taxes. Okay, total hypocrisy pot calling the kettle black. Right.
I don’t even know what to say. I mean, we were talking about Wall Street and oh, it’s Republican. But you know, this guy’s the poster child of Wall Street. It’s Warren Buffett. Yeah. Right. And everything that he’s doing lean so far to the left right now. And you know, he’s his line that I found to be just maddening about how his secretary pays a higher income tax rate than he does. And this has been a big thing in the political campaign to people saying Mitt Romney doesn’t pay enough in taxes, what’s capital gains, he already paid tax on the money you already paid the regular rate, and Buffett’s Not, not explaining that and then hope That nobody has access to court records or press releases to see he’s suing the IRS to not have to pay these taxes for like you said of all things, private jets. I mean, it stinks to high heaven.
Jason Hartman 16:11
Yeah, totally. It’s it’s mind boggling. It really is.
People like Warren Buffett are very eager to give other people’s money to the government to spend I, I had a friend post on Facebook today, you know, and he’s very conservative guy and really likes to get a rise out of people. He said that he went and he gave blood on his own freewill and on his own choice, and it felt great to do charity and I, I joked with him, I said, You mean, a bureaucrat didn’t write you a letter telling you that it was the right thing to do. And by the way, threatening you with civil and criminal penalties if you didn’t do the right thing. Right, right. And, and this went off on a whole tangent but that’s the fact is, you know, he’s talking about Oh, more taxes, more taxes, and he’s gonna flush millions of dollars in legal fees down the toilet fight. With the IRS, why don’t you just send the IRS a check? Warren,
Jason Hartman 17:03
I’m sure the IRS will be happy to take Warren Buffett’s check if he wants to pay more taxes. It is total blatant hypocrisy. But you know, see, here’s what we get into. I mean, look, I just I just filed September, well, not the 15th. But depends on the Monday falls, but like, I don’t know, September 17 or 18th, whatever it was this year was the final extension date for corporate tax returns. So I have several entities so I filed hundreds of pages of tax returns on the last extension day seems like every year I want to get my taxes done early and it never quite happens that way. But anyway, and then on the last extension day, the following month, just a little over a week ago, in October, I filed my personal taxes hundreds of pages long also okay. All of these complicated tax returns. I mean, the bills to the CPA are in the thousands and thousands and thousands of dollars. Okay, cost a ton of money. But I got to tell you what Mitt Romney said during that second debate was so true, because he talked about eliminating the loopholes and making the tax code flatter. And you know, Steve Forbes with his flat tax, I mean, look at folks understand I am benefiting from the system as it is. I don’t know why I’m complaining, you know, and railing against it. Because really, I’m winning the game. I mean, I hardly pay any tax at all. I make a great living, by the way. And I don’t pay much at all, I gotta tell you, because I have so many deductions, I’ve got all these businesses. I’ve got all this real estate, and the non cash write off from depreciation on real estate, is nothing short of a gift from God. I mean, it is it is the best write off if you can qualify as a real estate professional and take advantage of all those passive losses. It’s phenomenal. It’s just unbelievable. I pay almost nothing. I mean, it’s it’s amazing because the other reasons I pay so little in tax is because I do what I think Robert Kiyosaki really illustrated the best where he has those squares and rectangles. And he talks about like the way that money comes into your life, you make an income, okay? So say you’re an employee, you make an income, and then you pay taxes and then what’s left over, you get to spend money and pay for your life now, entrepreneurs and keep in mind, if you don’t own a business, but you’re just a real estate investor, that is a business and you will have some nice deductions from that business. There are travel deductions available to you possibly there are business expenses, their educational expenses Yeah, what if you fly out to my meet the Masters event from from Europe Okay, well, no, you have a different tax code if you’re in Europe, or you might be an American living in Europe anyway. too complicated. But But you know, say you’re in New York. You fly to Southern California to go to the meet the Masters event. And in that education, if you’re a real estate investor, you can start deducting a lot of these things, meals and entertainment cell phone bill, a whole bunch of things. You know, even a home office might be available to you. I don’t know, I’m not a tax advisor, check with your tax advisor. I’m not qualified, okay. And legal stuff. People, you got to stop asking me about LLCs and all this kind of stuff. I’m not a lawyer. Okay. So check with a lawyer. All right.
Yeah. Well, it’s very interesting on this, they, you know, it’s popular politically Well, at least with approximately half of the country to say we need to increase taxes on the rich. I mean, you could do that, I guess. But there’s a reason that they’re rich. Taxes are life’s biggest expense, and they didn’t get rich, by paying through the nose on taxes. And the funny thing is, is the congressman and the senators and all these people who write the tax code, they don’t want to pay higher taxes either. You know that they’re putting those loops polls and those deductions in there for them to use. So you raise taxes on the rich, he end up punishing the people who are none the wiser, you end up punishing the middle class, the rich aren’t going to pay more taxes, they’re not going to do it. There’s too many ways to get around it. I mean, it’s it’s clear that taxes can get to a point where people will take evasive action, they will do anything that they can to get out of them. We could argue about whether that’s moral or what their obligation to society is. We do that but that’s beside the point. People will try to get out of paying more taxes. And that’s what is in Warren Buffett’s bones here, right, despite all of his rhetoric about people need to pay more. Well, when it comes to get out the checkbook. Now I’d rather sue the IRS. Yeah,
Jason Hartman 21:42
Hey, it’s the old don’t do what I do. Do what I say hypocrisy, but I just wanted to finish that example. I was giving those Steve because it’s really instructive. So when you’re an employee, and you don’t have real estate as a business, and you don’t have a business of your You know, if you’re an employee you should definitely have some kind of business on the side. I’ve always said that that place where you can gain some tax benefits and deductions and so you get to pay for your life based on the net but as a business owner and a real or and or a real estate investor or a blend of both you get to pay for your life after you get the income but before you pay the government on many of the items, because many of those items are business expenses that you can legitimize into your business and then you only pay tax on the net, not the gross it is a an incredible, incredible difference. And taxes are life’s largest expense and then you know we don’t even need to explain depreciation and passive loss write offs. I mean, those are the biggest gift ever because that’s a totally non cash write off so nothing could be better than that. But But yeah, Warren Buffett and ridiculousness and you know the other thing to say Steve is He’s an insider. Like remember when the financial crisis was really bad. And he went put like, I don’t know $5 million into Bank of America stock or something and bragged about how he was buying stock in Bank of America. Well, he didn’t pay the same price you were paying on the open market. This is just it’s cronyism to the max, folks. You just can’t trust these people trust yourself. That’s who to trust. Hey, now on this be rating buffer.
Yeah, we’ve been in pretty good. Okay, good.
Jason Hartman 23:29
So I hope I don’t get a phone call on that. But if I do, you know, I’d love to have him on my show. But I hear that he only does interviews with good looking female reporters, or you buy his lunch with Warren at a charity event pay $200,000 to have lunch with him.
Well, if he calls the conference, man, because I have some questions.
Jason Hartman 23:49
Okay, good. All right. I’ll do that. But the other thing I want to just remind everybody of before we go to these guests, is that and I’ve mentioned this a few times, but not much. We have a referral program. Graham, if you hold a real estate license or if you’re in a country where a real estate license is not required, we can pay you referral fees on business you refer to us and Randy, a financial planner that I’ve had on the show before and ri a registered investment advisor, I should say, he wrote me an email recently and he said, he was talking about one of the clients he referred to us. And he said, Jason, I just got off the phone with another financial planning client who’s going to buy some real estate, some properties they referred to me by and this is one of our clients whose name is I won’t mention, by the way, and he says I’m writing you this email to let you know how much fun this is for me seriously. As an RA I am able to offer my clients literally every financial product traditionally available. That said there are quite a few ri A’s out there that can provide all or most all of these things as well. However, it’s a huge differentiator to be able to incorporate real estate investments into my clients financial Plan. Thank you for creating such a great system for me to help my clients. And that’s Randy looky who’s probably gonna listen to the show who doesn’t even know I’m reading that email, but I’m sure he won’t mind. I hope he won’t mind. But folks, we have a fantastic referral program. So if you have clients, and you’re in the real estate business, I know we’ve got lots of real estate and financial people who in the financial people, by the way, listening to the show, and when I say financial people, I mean, ri A’s registered investment advisors, financial planners, people working in selling various Wall Street investments and so forth. I just want to give you a shout out to say hey, I appreciate you still listening to my show, because you’re pretty tolerant of my wall street bashing. I must I must give you a credit for that. But I I know frankly, a lot of you, you kind of go to work and kind of bite your tongue and you know, Wall Street’s a big scam, but you’re working within that environment and you you know, you look for the best products you For your clients and so forth, and income properties and for everybody, that’s why I think hard money lending or private lending is so, so good because it’s so simple, so much simpler than properties, the returns not quite as good. But hey, 1212 and a half percent isn’t bad. There’s there’s some great opportunities there, too. But Steve, anything to mention on our referral program, I know you’ve got a couple of clients who are licensed who are starting to refer business to you, and you’re their investment counselor. I know Sarah, Molly and Laurie, and Terry and Dave, you know, other investment counselors have all benefited from this. Any thoughts on it that you want to share?
Well, first of all, you don’t have to do any of the work. That’s what we do. That’s what we’re here for. And we go through a lot of a lot of effort to work with our clients. You know, I’m aware of a couple of competitors to the company that don’t really do anything. They just say, here’s a property Good luck. I mean, we go through a lot to help these clients out. And you can pass them off to us with confidence that we’re going to take care of them answer their questions. Go to Bat for them when necessary. So it’s it’s pretty easy, easy for you to do.
Jason Hartman 27:05
Yeah, yeah, good stuff. So keep that in mind. If you have, you can earn some nice extra income referring people to us. And this is all totally aboveboard, you have to have a license to do it. And we can do broker to broker referrals. So keep that in mind. And make sure you get registered for our meet the Masters event coming up. And Steve, thanks for joining me again today. And let’s go to our guests. We’ll be right back with our guest in just a moment.
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Jason Hartman 28:43
Just a reminder, you’re listening to flashback Friday. Our new episodes are published every Monday and every Wednesday. It’s my pleasure to welcome David Carey to the show. He’s a senior writer for the deal which is a new service and magazine covering price Equity and mergers and acquisitions. Before joining the deal, he was editor of corporate finance magazine, and wrote for Adweek, fortune institutional investor and financial world. He’s often appeared on CNBC, and it’s a great pleasure to have him here today. David, how are you?
David Carey 29:15
I’m fine. Delighted to be on your show.
Jason Hartman 29:18
Well, the pleasure is all mine. So private equity. It’s been something that’s come to the forefront lately with mitt romney and Bain Capital. And of course, what’s going on with the election and sometimes ridiculous, childish attacks, but explain to the listeners if you would, first of all, what is private equity?
David Carey 29:33
Well, it’s a something and this is something we attempted to convey in the book I wrote, which is a king of capital, which I co authored with john Morris, and that’s that tells the story of Blackstone Group and the creation of a firm and also we talked about the evolution of the industry. And we also further explained to light raters, how private equity works and how private equity firms make their money and the impact they have on the economy. Private equity is a type of investing where you deploy capital in companies privately rather than in the public market. And it can take various forms from injecting money into healthy companies for them to grow faster or infusing equity to shore up troubled companies and get them back on their feet. The most common form of private equity is what’s called a leveraged buyout or an LBO. And these are corporate takeovers done by firms like Bain Capital, which, where you buy out a business from existing shareholders using large amounts of debt. And of course, leverage is a synonym for that these types of deals got a lot of press during the boom years leading up to the financial crisis, when you had a string of like record shattering 20,000,000,030 billion $40 billion buyouts of very big corporations like Kara’s The casino operator, Hilton Hotels and HCA the country’s biggest hospital group. And Dunkin Donuts and Burger King were also gobbled up in leveraged buyouts. And by leveraging the purchase of borrowed money, the buyer puts up only a fraction of the purchase price in equity. And that magnifies the back end profit when you sell. It’s similar to buying stock on margin, buying a house with a mortgage debt and flipping it for a gain on equity. One big difference though, is that private equity firms aren’t responsible for paying down the debt the way a homeowner pays off the mortgage. Instead, the company that’s being acquired, takes on the debt and takes it down onto its balance sheet and retires the debt over time using its own cash flow.
Jason Hartman 31:45
So it’s basically all leveraged buyouts then is that the way all private equity deals are structured?
David Carey 31:49
No, I’m saying I, as I said initially, there are a lot of leveraged buyout is the most common form right? But it can also involve on leverage deals. And as I say, injecting capital where you actually put in equity and take out debt, it can be the opposite of, but for mostly their detriment of buyouts. And I also wanted to say that the best private equity firms outperform stock and bonds wide by a wide margin. And that’s not just through the use of leverage, as I’ve described, they also get high returns by streamlining and proving growing and improving the profit profitability of the companies they buy. And these are big funds with large pools of money from outside sources, they get their money from financial institutions. And it’s interesting, you know, in spite of the image private equity has been, at least with the democrats kind of thing, a job destroyer and the enemy of the working man. The biggest single outside source of private equity money is public pension funds. So that’s union money. Right? Right. To so it’s kind of interesting.
Jason Hartman 32:58
Yeah. Well, that is kind of interesting. Actually in light of the Obama attacks on Romney and Bain Capital, because you’ve accused them of shipping jobs offshore and so forth, and oddly, he’s investing with union money at times. Sort of a paradox.
David Carey 33:14
He’s getting, he’s getting the union a
David Carey 33:16
Good return on their money asking private equity executives to contribute to this campaign.
Jason Hartman 33:22
Strange bedfellows and politics for sure, huh.
David Carey 33:25
Jason Hartman 33:26
Well, let’s kind of drill down a little deeper on the attacks on private equity and bain capital and Mitt Romney, if we could, since it’s so topical right now. Your thoughts about them?
David Carey 33:37
Well, you know, it’s the rhetoric is pretty heated and it’s not just coming from Obama You’ll recall that during the republican primaries, Governor Rick Perry, the new being rich and branded romney of vulture capitalists and you know, the popular caricature a private equity artists isn’t that their kind of scorched earth finance ears. slash and burn companies leave a trail of lost jobs and balloon lives and they’re like, you know, I’ve been covering the industry for many years. And I think that unbalanced private equity does far more good than harm. You know, it’s true that private equity firms focus first and foremost on their own profits. But the, you know, the means that the most effective means to generating profits is to nurture and regenerate companies not to destroy and pillage. And, you know, that sometimes involves replacing management or jettison jettisoning profitable operations or reducing bloated bloated costs and headcount firing people. But you know, these are the kinds of moves that all successful corporations sometimes must make, in order to remain competitive, you know, sort of successful companies constantly redefining reinvent themselves to get ahead and it’s interesting in private equity To cost them job cuts often set the stage for future growth and future job creation. You know, it’s interesting studies have shown that private equity firms frequently do tend to cut more jobs and similar companies that are private equity on in the first year or two after they buy them. But then they add jobs back at a faster rate. And the differences even add after four or five years so you know we’re buyouts have gone awry. And this is some of the deals. Cobain’s in the front center in the press is this can happen when buyers pile on too much debt unless we’ve been dead and like four cases that have been written about extensively. These are where the companies initially did well and then loaded them with more debt to finance a war itself a dividend financed dividend for itself and then the company’s fortune soured in the US. Canada Tifton under bankruptcy. And, you know, these are troubling cases, of course. And it’s only natural that the Obama campaign would blast away at them. But they’re also the exception, not the rule. You know, when romney led Bain, the firm made around 80 investments, and the vast majority of it turned out splendidly. And companies grow and prosper. And let me throw out another statistic despite the you know, the risk of default and bankruptcy that comes with the territory because your mind you know, you use large amounts of debt to buy these companies. The failure rate for lbos is actually quite low. A recent study showed that on average, just 1.2% of private equity on businesses defaulted every year from 1970 to 2007 37 years and then included three recessions and the failure rate for companies here. Determine the dividends like the bane deals on it. even lower on average. And I think you know, lenders have to put up the money for these defense. And they’re gotten very cautious about the kinds of companies that they’re willing to do this with. And these do Typically, these are companies that have already paid off a lot of debt, they have very healthy cash flows. They’re very sturdy. And those are actually the kinds of businesses the private equity firms prefer to buy. Although Bain actually initially specialized in turnaround cases, which by companies really need to be fixed up, and those tend to have a higher failure rate.
Jason Hartman 37:36
Yeah. And they’d probably have failed anyway, if a company like Bane didn’t come along and rescue them.
David Carey 37:41
That is very true. Right, right. Absolutely. It’s sort of impossible to address a question like that.
Jason Hartman 37:46
They’ll they’ll say, Well, some of these companies failed. Well, all of them probably would have failed if someone didn’t come along and help them out. But when you look at private equity, I mean, is there sort of an average deal size in the private Equity world.
David Carey 38:00
Oh, they range all over the map. I mean, at the top end, and you know, there’s 2006 2007 there was one deal, the granddaddy of them all was a Texas utility complex, even that was a $48 billion buyout, KKR and TPG. But now they run the gamut. They run. I mean, you know, there are thousands of private equity firms that invest in all sized businesses, and they can, you know, get down to, you know, you know, million dollar investments or less the, sort of the middle tier of the market, which is deals up to maybe a billion dollars in size. That’s called the middle market. And then you have a large cap market, which is above a billion and and then you have lower middle market and, you know, small cap, it’s just kind of like the stock market that runs a spectrum.
Jason Hartman 38:49
What some of these private equity deals that are so large, I mean, you mentioned the big granddaddy deal with the Texas utility company for $48 billion, billion with a B Large deal sizes. I mean, why are these IPOs? Why are they Why are they using private equity instead?
David Carey 39:06
Well, they don’t. A lot of these companies were public at the time that they were acquired by the private equity firms and their stocks and traded down. They had, you know, some operating problems, maybe a few, a couple of quarters of bad results, shareholders, got restless on the board nets, may need to figure out a way to maximize shareholder value. And so then the private equity firm comes in and places a bid that’s of a significant premium to, to the existing share price,
Jason Hartman 39:39
Right? That’s the example of the reverse deal. But are there companies that just want to stay private with private equity and not go to the public markets at all that have never been public?
David Carey 39:51
Oh, absolutely. And sometimes, you know, you want to have a change in ownership. There are a lot of family owned businesses that would prefer not To sell a stake to the public equity markets because we want to maintain a greater role in the business. And then this is a prime example of one thing or an area where private equity can be a more palatable alternative to the public markets for like an entrepreneur who’s reached retirement age. He wants to leave the business and the family, he doesn’t want to sell it to a competitor. And he doesn’t want to take it public. So the private equity firm can come in and buy a majority of minority stake the family can, you know, maintain its its presence and activity in the business. And that type of deal actually was kind of the way the private equity started out. So it’s an alternative capital market. It’s an alternative way of reaching liquidity, and it’s something that a lot of business owners just prefer.
Jason Hartman 40:54
I would think, though, that the business owners would maybe be getting a lower valuation. Because there’s so much money in the public markets, I mean, there’s a lot in private equity too. But the public markets are obviously larger. And do you think some of them actually make the decision that they that are going to
David Carey 41:12
take possibly a lower valuation that they could do better in an IPO scenario than they could and sometimes they do is I mean, in the case I was talking about where the keep some grip on the business, they may be willing to take a lower valuation, but I will tell you, there was something if a private equity firm comes along and wants to buy a majority, there is something called them control premium that they pay. So typically, they’re willing to bid more than what the company the valuation the company might receive in the public market, because the private equity firm can come in and call the shots make the changes and seize or not be a passive investor and realize more value that way for itself and is willing to pay up to do that. So private market valuations are extremely high and a lot of these companies are sold in very auctions with lots of private equity betters I follow these things all the time. And DuPont just divested its car paint business, to a private equity firm called Carlyle Group. And now like, you know, seven or eight veterans, and they pay the a pretty high multiple float. So yeah, don’t be surprised when valuations privately sold.
Jason Hartman 42:29
You know, it’s kind of interesting because I don’t ever remember really hearing the term private equity before say, I don’t know, eight or 10, maybe 10 years ago. Where was it? I mean, obviously, there were private companies buying other private companies. I mean, that’s not a new thing. How long has it been around? Or is it just sort of a new term in the lexicon Really?
David Carey 42:47
Well, I’ll tell you, it’s private equity was sort of appeared on the horizon around 1991 92. That’s when I first heard it’s originally people In the business, we’re called LBO artists. And I think lbr has got a little bit of a tarnish in the late 80s, because a lot of them were funded by the guy who control the leverage dead and jumped on markets was Michael Walker. And so a lot of these guys were funded by this chap who ended up going to prison as part of the late 80s insider trading scandals, and it was partly to kind of add a little more luster to the image, I think, calling themselves private equity. I think it’s kind of a public public relations. Well, well, I have to say that the the name LBO artist does not it sort of strikes me as a con or
Jason Hartman 43:49
I don’t think that’s a very good name.
David Carey 43:51
Right. Well, that’s what they Yeah, that was. They were typically called a corporate raiders, right.
Jason Hartman 43:57
The Carl icons and then Boone Pickens. You Yeah, yeah, right, right. That was a sort of a fascinating time in history.
David Carey 44:04
So all of that now now Carl Icahn, by the way, calls himself a shareholder activist who is no longer.
Jason Hartman 44:12
Well, I bet he’s mostly an activist for himself when he’s a shareholder. Exactly. That’s very, very interesting. But you know, all of that stuff really, that was such sort of corporate folklore in the 80s. And there was so much coolness around it with the movie Wall Street Of course, and, and, and just all the stuff you heard back and all that same stuff really still goes on nowadays, right? I mean, there are corporate raiders who buy companies because they can split up the assets and sell them off piecemeal for more than they can buy the whole thing for and they’d still do all the same things, right.
David Carey 44:46
Well, I think these split up scenarios, you don’t see them much anymore. For one thing. There aren’t any. No inviting targets out there. You don’t see too many huge corporate conglomerates because a lot of conglomerates, you know, the individual pieces didn’t match up well and the stocks traded at ridiculously low valuations. So the company’s just the conglomerates, you know, starting with, you know, RCA or, or Wix, or um, you know, kind of all the big conglomerates that have been built up in the 60s, they all kind of dismantled themselves in the 70s and 80s. So there and I wouldn’t say that is the most common scenario, you’ve seen a buy, I usually see companies doing the opposite go buy a small private equity firms will do a build up where they’ll buy a small core business, and then they’ll expand it territorially or into other products, you know, complimentary products and so forth through add on acquisitions and actually being an acquisitive mode and build it up and not looking. The breakup scenario is not very common these days. Well, although that was that’s certainly what you read about in the 1980s. Yeah,
Jason Hartman 45:58
Yeah. Well, I think the reason you know We’ve got so much negative VR is because it always involves mass layoffs. Right?
David Carey 46:04
Not always, I think is just the whole idea of buying a company and busting it up. Just, you know, there’s kind of superficial or very appealing or, or nice idea, you know, but the fact is that a lot of these, you know, companies benefited from being sold off to have, you know, a lot of the individual pieces of the companies of a large conglomerate like RCA, they were kind of orphaned businesses, they weren’t really paid the proper attention to but the head office, they were underfunded. And in fact, you know, instead of private equity firms coming in and buying out these large mosaic companies what you see big companies kind of falling off pieces of non core businesses, which private equity firms then by up I mean a lot, a lot of the so called a bye Upper dismantling is undertaken by the conglomerates themselves it’s not for their hand isn’t necessarily forced, right? It’s not forced by some corporate writer I mean, some of these, you know the some of the stereotypes about bust up artists, they kind of work their way into the pocket of consciousness and they say it means the same thing about the character caricature of money in scorched earth, you know, finance your dance, just, you know that I mean, there’s not you know, there’s only a grain of truth in some of these stereotypes is very small.
Jason Hartman 47:36
What I ask is, what’s the alternative, for example, and let’s just talk about net for a moment, then we’ll wrap up here. But one of these Obama commercials that I continue to see is the one about a deal MIT did and how the factories or empty In other words, there were no workers there because he shut them down and Obama’s claiming he shipped the jobs offshore. But what they don’t tell you is that Maybe those jobs would have been lost anyway, maybe that company would have closed. And all of the consumers that are buying those products are getting them at lower prices. And they’re getting more choice. It’s just such a misnomer the way they characterize that. And, of course, what you said to your point earlier in the interview, which was that many of these union groups that support Obama are the ones who invested with private equity companies like Bain Capital like romney’s company, so Aren’t they the profit tiers? Aren’t they the evil ones?
David Carey 48:32
You know, they’re they’re certainly the enablers, and there’s a certain amount of hypocrisy involved. It’s funny, some farms actually, kind of some private equity firms have very good relations with unions, and others that are a little more dismissive of unions unions attack, you know, it’s all you know, I mean, there’s nothing is what it seems and everyone has some kind of agenda. Yeah, I mean, and you know, the practice When Mitt Romney is blamed for I mean, as I said, it’s, you know, American capitalism is you know that you don’t have established a European style of capitalism, which has more safety nets and stuff. It’s really free, pure free market capitalism. And I think private equity is the ultimate expression of that. And I don’t think that’s bad. I think you make a you make a company stronger and improve its bottom line, it will have all kinds of ancillary benefits, you’re gonna it’ll have a stronger competitive position that will sell more products and in turn, it will be able to grow and hire more people to I mean, a stronger company is a company that can employ more people and it’s, you know, you’re burdened with a bloated workforce. You’re not you’re going to suffer competitively, you’re going to lose revenues, you’re going to be forced to make layoffs. I mean, it’s just, you know, I think the free market model was, you know, really the, the one that creates the most wealth for the most people. Yeah,
Jason Hartman 49:58
Yeah, well, obviously, it does. It’s not perfect. It’s just better than everything else. As I think Churchill said, One last thing for you before you go at the Republican National Convention, we saw one of romney’s business partners and Bain Capital, talk about how they started that firm. And I think it made a lot of people curious, how does one start a private equity firm? You know, like, what happens they just hang out a shingle and then they go to investors and try and raise money and then they go to businesses and say, Hey, do you need money? Can we rescue you? I mean, there’s some that’s what happened was Blackstone, we the only chapter in the book was about the money worries and it was almost comical. I mean, these are two like stupid names Pete Peterson, who was a former Commerce Secretary under Nixon and Steve Schwarzman, who was a they both worked at Lehman Brothers. And yeah, they they were pet starpower on wall street that private equity was in a business they didn’t have much experience investing and so they just one outcome Patent hands, they were gonna raise a fund and some of the stories they told about,
David Carey 51:06
about the slides they received. They they took a trip to Boston and MIT to talk to the pension fund to see if they could raise some money and the person there, totally forgotten that they had appointment to see them in Sylvania. They were turned away in the afternoon and they had to walk back. They were caught in the right in a torrential downpour, and they had a hard time catching a they were totally stopped. When they finally got back to the airport. They suffered a lot, a lot of indignities and you know, private equity was not it was a new industry. And yeah, you go out hat in hand, and they had to they had a very tough time making a case. And I think, I don’t know that. I mean, long names Office of bain capital and kind of a tough time. Of course, that business was spun out of Bain and Company, which is like a really well known and respected consulting business, founded by Bob bang, and they just decided, you know, they They bring all their managerial expertise to improving businesses. And I thought, Hey, you know, we’re doing this for other people, maybe we can, you know, make some money for ourselves as investors. And that was the idea behind game but in the long game, so so that was pretty tough sledding in the first few years. And yeah, so yeah. If you you know, you’re interested in hearing about the genesis of Blackstone, which today is the biggest private equity firm on Earth. Yeah, we have some stories on that. And then next, we’re pretty interesting. Very interesting. Yeah. very entertaining reading.
Jason Hartman 52:35
Sure does. Well tell people where they can get the book.
David Carey 52:37
Well, last time I saw it was stolen bookstores we’ve had it was the original hardcover edition was published in October of 2010. And then we came out with a paperback edition this year. It’s certainly available on Amazon if you want to order it there. It’s called king of capital. The remarkable waters fallen wise, again, of Steve Schwarzman, Blackstone, and the publisher was crumb publishing, and those who prefer reading it in Japanese, Korean and Chinese. It’s been translated into all those languages. And I understand it’s in its fourth printing in Japan. So
Jason Hartman 53:15
Fantastic. Well, David Kerry, thank you so much for joining us today. The book is the king of capital, and learning more about private equity. We often talk about the public markets and the various Wall Street scandals on the show, but it’s interesting to hear about the private side. So thank you for telling us all about it.
David Carey 53:31
Well, thanks for having me on Jason.
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