Is Still a Conflict

JP Morgan sold credit default insurance and a mutual fund managed by JP Morgan’s Asset Management Group bought the insurance.   That’s a conflict of interest.  No way around it. See, As One JPMorgan Trader Sold Risky Contracts, And One Bought Them.

Surprisingly, however, the article by Azam Ahmed implicitly condones, and even praises the transaction.   Rather than finding any criticism of this transaction, Ahmed quotes a researcher at the Brookings Institute who states,  “the lesson is that the asset management firms really do act like different different bodies”.  Apparently this is a good thing.

I disagree.

Conflicts of interest undermine the trust upon which our financial system is built.  Simply put:  one party/individual cannot represent both sides of a transaction.  Or, to put it more colloquially, no one can serve two masters.

In the context of the JP Morgan trade, the credit default swap is a contract.  This contract imposes rights and obligations on each of the parties. These are obligations “with teeth”.  Remember when Goldman and AIG were fighting over collateral which needed to be segregated to support similar derivative-type contracts?.

Suppose similar conflicts arose with respect to the JP Morgan trade.   Would the Asset Management Group, on behalf of the mutual fund and its investors, sue the bank to enforce the credit default swap?   Imagine all of the judgments which would have to be made in this context.   Are the investors in the mutual fund confident that the Asset Management Group would have represented them (the Investors) aggressively against their (the Asset Management Group’s)  employer?

To further highlight this conflict, imagine if the trade had gone the other way.  Assume that JP Morgan Bank earned a huge profit and the mutual fund lost $2 billion on its investments.  In that scenario the Bank would have earned a huge profit at the expense of its clients.  I suspect very different articles and columns would be written.

The most disturbing aspect of the Article, however, is the absolute lack of sensitivity to the conflict issue.  Reflecting the approach of an adolescent kid beseeching her parent “but everyone does it!”, Ahmed explains “That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog-world of Wall Street”.  I guess if “everyone does it”, its OK.

The fact of the matter is, it is not OK.  The very foundation of the financial system depends on trust.  One element of this trust is that advisors (or rather agents) will act for exclusively for the benefit of investors (principals), that they will avoid conflicts of interest. While transactions can be structured to meet various legal requirements (and I’ve done tons of “structuring” in my career) and possibly fall within various exemptions or special rules, the reality is that, a conflict is a conflict is a conflict.

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Let’s Remember Who Owns the Assets

“At base, having a small elite with vast wealth is good for the poor and middle class”, explains Edward Conard, former partner of Mitt Romney and author of the soon-to-be published, Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong. Conard’s views are explored in an article in yesterday’s Magazine Section of the New York Times, by Adam Davidson, The Purpose of Spectacular Wealth, According to a Spectacularly Wealthy Guy.

As befits a private equity guy, and a graduate of an Ivy League business school, Conard’s argument is simply that the rich are smarter than you and me, and the “poor and middle class” would be in a better place if they, the elite, were left alone to run it.

Let’s for a moment assume that Mr. Conard and his various colleagues in the super elite are very smart,  there is, however, one glaring factual inaccuracy which woefully undermines his argument.

Davidson, after illustrating Conard’s enthusiasm about the virtues of eliminating a fraction of a penny on the cost of every can of soda, further explains that according to Conrad there are other investor looking to make similar “micro improvements”; “They are also wealthy investors like him who are willing to risk their own money to finance improvements that may or may not work.”

Wait a second.  “Willing to to risk their own money.”  Let’s stop and pause.  I would venture a guess that Mr. Conard never risks his own money in his deals and potential improvements.   Or, as I’ll explain in a minute, if he invests his own money, then likely it is all the “house’s” money anyway.  So, it is not really much of a risk.

I’ve never met Mr. Conard, but I’m going to assume for a moment that Mr. Conrad is an archetype of a prevalent, albeit elite, cohort pounding the streets of New York in the early 1980’s.  Armed with a business degree from Harvard, but probably not much capital of his own, he first landed a job at Bain & Company, then moved along to a stint at Wassserstein Perella, and then landed back at Bain Capital.  While I’m sure that he made a very good salary and received good bonuses in his pre-Bain Capital days, the odds are pretty slim that he would have amassed a large enough fortune to become an “investor willing to risk [their] own money to improvements that may or may not work.”

Instead, he became a hard working, no doubt diligent private equity guy in the early days of the private equity bonanza.  Eventually, he made a fortune, not by putting his money at risk, but rather by putting other people’s money at risk.  The classic OPM game.

Private equity typically works as follows.  A Private Equity Firm (PEF) creates a partnership, it raises money from investors as Limited Partners, and then typically creates an entity to serve as the General Partner.  The General Partner is usually thinly capitalized (at least compared to the size of the entire fund), and its stake holders are typically insiders at PEF.  As a last step, the General Partner, on behalf of the fund, enters into a management agreement with PEF.  Included within these inter-locking relationships are various fee structures which compensate  PEF and the General Partner.  This compensation consists of the holy grail of all fees, the “2 & 20”, a 2% management fee and a 20% carried interest.  This is how fortunes are built in private equity.

Once the capital is raised from investors, the fund then goes out and borrows additional capital, usually multiples of the original equity investments.  That’s why these transactions use to be called leveraged buyouts.  In fact, most of the money “put at risk to finance improvements that may or may not work” is borrowed money …. and, the investors, including the General Partners are not on the hook if they lose it.

With Mitt Romney’s presidential bid, the whole discipline of private equity has come under scrutiny and no doubt will be dissected under a microscope in the coming months.  I’m not interested in getting into the argument as to whether private equity is good thing.  That is a subject for another time.

However, I am objecting to the notion that professionals such as Mr. Conard create a false narrative suggesting that they are great investors putting their money at risk.  No doubt, after 15 years of managing private equity deals in a wild bull market, private equity professionals have likely amassed great fortunes.   And, no doubt, they do re-invest in their own deals.  However, as I said above, they are essentially investing with “house money”… it’s easy to double-down, once you’ve assured yourself a nest egg (with multiple homes and private planes), to leave money in the deals.

The real investors are not the Ivy League MBA’s.  Instead, the real investors are you and me.  A significant portion of the capital for private equity comes from pension plans, both public and private.  In fact, public pension plans tend to be some of the most coveted clients for private equity firms.

The reality is that the true investors, people with money at risk, are not an elite group of risk assessing and risk taking investors.  Instead, they are hard working employees of large corporations and public entities.  These are the same employees who stand by helplessly as their jobs are eliminated or they learn that their pension plans are underfunded by staggering amounts.

These are the real investors in “improvements that may or may not work”.  And, these are the real investors who have funded the private equity industry.

Don’t get me wrong, some of my best friends are private equity professionals.  They are hard working, some of them are charitable and they are good citizens.  And, some firms have generated significant returns for their investors.  This is good and beneficial.  But, let’s not glorify them into a power wielding elite who “know” best for American.

I am further skeptical about an elite which potentially doesn’t understand  the distinction between personal assets and client assets.  In my judgment it is enough to disqualify someone from the elite.

Warren Buffet, arguably the greatest allocator of capital ever, always acknowledges that he invests capital on behalf of the Berkshire shareholders.   Go back to his oldest shareholder letters and he refers to shareholders as his partners.  He means this not in a legal sense, but it an ethical sense.

If Mr. Conard is hell bent on supporting an elite of master investors, then lets make sure that this elite embraces the proper values and behavior which in fact would be best for the poor and middle class. Let’s create an elite of financial experts who also understand and abide by fiduciary principles.  Professionals who at all times know that they work for plan participants and beneficiaries, and subordinate their self-interests to the interests of the clients.  Professionals who tolerate no conflicts of interest, and importantly, who don’t rig the game for outsized profits for their own benefit.  Yes, we may need an elite, but let’s have an elite of ethical and prudent behavior.

As a fiduciary, I recognize that my prescription may be viewed as self-serving, but one can only wonder if certainly elements of the Financial Crisis may have been avoided or tempered, if the leadership of the financial community took their roles as fiduciaries seriously.

Let’s judge the elite by their values and ethics, not by the size of their assets.

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