A cynic is someone who knows the price of everything and the value of nothing. The world’s cynics, (the hedge fund managers) are gleefully wringing every nickel out of a market they helped remake in their own image, meanwhile rendering it incapable of supporting real growth.
“Hedge funds are cashing in on these markets. It’s the buy and hold investors who are suffering.”
So say Leda Braga, Tomasz Tunguz and Eric Siegel in a provocative new study of how the market has been hijacked by these financial engineers. The report is called: “What Ever Happened to Long-Term Investing?” It appeared on Wednesday and is a stunning indictment of the short-termism that has infected our financial system.
Early investors like Warren Buffett and public pension funds, which are supposed to manage money on behalf of future generations, have been pushed aside by hedge funds with their quick buck culture and insatiable demand for liquidity. This shift, say Braga, Tunguz and Siegel, could not have been possible without the rise of quant investing and the proliferation of ETFs.
The authors say ETFs are a form of mutual fund that give big investors an easy way to pummel markets with huge orders. The result is “persistent downward pressure on security prices,” which in turn forces market makers to pass along their losses to small fry like you and me who are stuck holding shares at the wrong time.
“Stock prices swing more widely than they used to, leaving most public company shareholders losers as short-term traders take profits by selling shares after price run-ups.”
But the real culprit behind this market turbulence has become obvious: Private equity firms seeking to cash out through IPOs and LBOs. They are what Braga, Tunguz and Siegel call “a central force of market dysfunction.”
“Every one of the 100 largest stock market-listed companies ranked by private equity ownership is today less valuable than it would have been if pre-takeover governance had remained in place,” they say.
The rot set in during the 1980s when Michael Milken’s junk bonds were used to finance a series of LBOs including RJR Nabisco and Beatrice Foods. It was such an obvious disaster that Congress passed the Private Securities Litigation Reform Act (PSLRA) in 1995 to shield CEOs from shareholder lawsuits for material misstatements around IPOs or mergers and acquisitions transactions involving more than $10 million.
LBOs, though, continued to flourish at the big banks that were not covered by the PSLRA legislation. Then came the buyout of Toys “R” Us in 2005 by Kohlberg Kravis Roberts & Co., Bain Capital, and Vornado Realty Trust.
The bankruptcy of Toys “R” Us last week shows just how badly private equity can screw up a once-proud retail brand. It was also an unwitting metaphor for what has happened to our financial markets: The three private equity firms quickly set about taking out all kinds of cash for themselves — but ended up destroying the very value they promised to add.
“The company’s debt spiraled from $2 billion to over $5 billion as these three firms drained the company of $470 million in annual interest payments, siphoning hundreds of millions more into fees for themselves.”
Toys “R” Us might have been a one-off case if private equity owners hadn’t moved on to devour other retail brands with similar effects. Sports Authority and Gymboree followed Toys “R” Us into bankruptcy. Payless ShoeSource is not far behind and could jeopardize the survival of its 3,500 stores.
All together, this carnage accounts for 35% of all US retail store closings so far this year — even though these are only 2% of the nation’s retailers. But it gets worse: Because these companies were loaded up with debt by their private equity overlords, they are now under pressure to sell off assets at fire-sale prices just to make payments on their debt.
“As a result, the private equity cycle of extracting value then destroying it continues,” says Braga, Tunguz and Siegel. “Once thriving physical stores are vacant and sold for pennies on the dollar.”
The worst side effect may be that these companies no longer contribute much in the way of taxes. Without tax receipts, states will have less money for roads and schools — though not for funding pensions or public health care programs funded by state taxes either. That’s what happens when hedge funds rule the market instead of long-term investors like Warren Buffett or your favorite pension fund.
“Recall that Toys “R” Us went bankrupt less than three years after going public,” says Braga, Tunguz and Siegel. “Now that’s what we call a short-term investment.”
