Money Stuff: Anti-Private Equity Is Good Business

A possibly good business niche would be “private equity front.” That is: 

1. These days, “private equity” has some pretty negative connotations in many places, and customers and employees and politicians would prefer for local businesses to be owned by the third generation of the founding family rather than by some Wall Street behemoth.
2. But private equity has lots of money, and also useful scale and skills; it is in many cases the highest bidder for, and most efficient operator of, all sorts of local businesses. And the third generation of the founding family might prefer to get out of the pest control business and get into documentary filmmaking; selling to private equity could fund that transition.
3. The widespread public preference for family ownership is a bit vague and fuzzy, and there are lots of contractual ways to transfer economic interest and operating control that do not quite count as “ownership.” 

We talked a few years ago about variable interest entities for US-listed Chinese companies:

The idea is that, under Chinese law, it is somewhere between “complicated” and “forbidden” for foreigners to own certain big important Chinese tech companies. This is a problem for those companies if they want to raise capital from foreign investors and list their stocks on foreign stock exchanges. But there is a solution. “Ownership” of a company is a complicated notion, a vague jumble of rights to elect directors and approve mergers and claim a residual interest in the company’s cash flows. You could break those things up and sell them separately. Write a profit-sharing contract that says “A will pay B all of A’s profits after expenses for the next 100 years, renewable at B’s option,” and hey that’s a residual claim on cash flows. (Or something vaguer: “A will pay B an annual consulting fee that B decides in its total discretion based on the economic value of the relationship,” etc.; not technically a residual claim but what else is it?) “B will provide management services to A and A will follow B’s instructions,” hey that’s basically control. “B will have the right to appoint a majority of A’s board of directors,” put it in a contract, it’s not actually stock ownership. Etc. Write some contracts that, bundled together, look like ownership, but aren’t ownership.

So, you know, a private equity firm wants to spend $100 million buying a regional pest control chain, and the grandson of the founder wants to sell, but everyone knows that Private Equity Is Bad. So a Private Equity Concealment Consultant comes in to structure a deal: The founder-grandson sells the private equity firm a prepaid total return swap on his shares and enters into a software supply contract, or he enters into a management services agreement with the PE firm that gives it certain control rights and a variable claim on the company’s cash flows, etc. etc. etc., but he still “owns” the “shares” and has his picture on the billboards. He gets cashed out and doesn’t have to come to the office much, the company gets the various modern efficiencies and ruthless optimization and software contracting of a PE portfolio company, and the customers get to see the grandson’s picture on the billboards. There are price increases and layoffs, yes, but the business is still family-owned, in a certain technical sense. This seems like it would create a lot of value, somebody should do it, and I know I am going to get emails saying that somebody did. [1]

Anyway Bloomberg’s Michael Sasso and Saijel Kishan report:

For at least a decade, private equity has been encroaching on America’s mom and pop businesses, the backbone of the US economy, scooping up independent roofing contractors, veterinary practices, health clinics and other operators at a rapid clip. Now a PE pushback is brewing among small-business owners such as [plumber Jay] Cunningham, who are increasingly refusing to take part—and making sure everybody knows it, loudly touting their antibuyout stances and locally owned credentials.

Yeah no but what if they could keep doing that while also cashing out? 

Cunningham’s Superior Plumbing, for instance, has been advertising on electronic billboards across metro Atlanta that it’s “Still Locally Owned & Operated.” (It might as well read, “We’re Not Private Equity.”) In central Florida, Next Dimension Construction & Roofing posted a sleek video on social media warning about PE-owned businesses “run by investors who’ve never set foot in your neighborhood.” Some smaller-scale financiers see an opportunity in the backlash. Mark Peterson, a self-described “anti-PE” investor, buys minority stakes in small landscape and heavy construction businesses to help them stay independent without needed backing from new-to-the-sector investors who parachute in from faraway finance hubs, wearing suits to the worksite. “Boots before spreadsheets,” says Peterson, owner of Blue Collar CFOs in Idaho.

Okay that’s getting closer. Also, plumbing and pest control are my go-to examples of unglamorous local businesses that tend to get rolled up by private equity, but the story has an even better example:

For instance, traffic-flagging companies, which help wave motorists through road projects, are seeing a surge of PE interest in the past two years. “We get notices every week that another firm has been acquired,” says Stacy Tetschner, chief executive officer of the American Traffic Safety Services Association, a Virginia-based trade group. 

Obviously it’s important that your local traffic-flagging company be family-owned.

Also! In recent years, the concern has been the “PE rollup,” where a private equity firm buys a bunch of pest-control businesses and combines them to create economies of scale and/or market power. But we’re already moving into the world of the “AI rollup,” where a venture capital firm or an artificial intelligence lab or a joint venture between a PE firm and an AI lab or Jeff Bezos buys a bunch of pest-control businesses and automates them using AI. In the world of the AI rollup, putting the grandson’s face on the billboard will be even more important: If people don’t want to buy their pest-control services from private equity suits, surely they won’t want to buy them from an omniscient profit-maximizing robot. But if the omniscient robot was running quietly in the background … ?

If you are trying to beat the market — to earn returns from your investments that are better than you could get from just buying the index — you are competing with everyone else who is also trying to do that. A lot of people are trying very hard to do that, because that’s where the money is. You can’t all win; every dollar that you make above the market return comes from someone else getting a dollar less than the market return. You are competing against extremely smart people and their smart computers to digest all of the world’s potentially relevant information to produce investing signals. The chances that you will reliably beat the market, if you’re just investing your own money in your spare time, aren’t great.

In some ways, your chances are better if you are a sophisticated professional investment manager: You can hire your own smart people, get your own smart computers, spend all day thinking about markets, digest more of the world’s information. But it is still a fierce competition, and in other ways your chances are worse: To earn your keep as a professional investment manager, and to pay your fees, you need to make many millions of dollars more than the market return, so you are competing in the big leagues, and it is hard to make many millions of dollars by being smarter than the very best hedge funds.

If you are trying to reduce your taxes, though, the scope of the problem is considerably smaller:

1. You do not have to digest all of the world’s information to produce useful trades. Just the tax code.
2. You are not competing against the world’s very best hedge funds. Just the Internal Revenue Service. And they’re great, you know. But if the IRS extracts $100 million of taxes from you, it’s not like the IRS agents who extracted those taxes get a $30 million bonus. So.

A possible conclusion here is that if you are any sort of investment professional, financial adviser, fund manager, amateur day trader, whatever, you’d be better off spending 5% more of your time thinking about taxes and 5% less of your time thinking about beating the market. Not tax advice, not investing advice, just an interesting little heuristic.

Bloomberg’s Justina Lee and Denitsa Tsekova have a story about “tax alpha,” which is when investment managers spend more time thinking about taxes and less time thinking about beating the market:

David Hauser loves index investing and has little confidence that professional money managers can make winning bets with his cash. But he absolutely believes they can make some losing ones, and has just handed roughly $5 million over to a quantitative stock picker pledging to do exactly that.

Unlike most active strategies, the goal of the one picked by Hauser is not just alpha, or a return in excess of the broad market. It’s also “tax alpha,” a reduction in his tax bill that could prove even more valuable. By going long and short various shares, it aims not only to make money overall but also to generate losses along the way that can be offset against capital gains, thereby reducing what the entrepreneur owes the government. …

“Tax alpha is the most consistent source of outperformance that you can deliver,” says Samuel Harnisch, the founder of Quantitative Financial Strategies, a Denver-based firm focused on taxable wealthy investors.

There is a charming epistemic modesty here; it is very hard to know ex ante if you can beat the market, but the tax code is reasonably deterministic and you can be pretty sure if you’ve got it beat. We have talked previously about the tax-aware long-short strategy described above, and it is a sort of side effect of academic efficient-markets research: If you kind of figure that all of the stocks are the same and will have random returns, then (1) it is hard to beat the market but (2) it is easy to construct a portfolio that earns the market return and also generates a lot of tax losses, so just do that.

Of course eventually you will be competing against the world’s best hedge funds in this business too:

The pursuit of tax alpha has reached its zenith at hedge funds, which didn’t historically focus on taxes because typical major clients like pensions and endowments aren’t taxable. But amid booming demand from other investors, many are tailoring their long-standing strategies for this new market.

AQR Capital Management is setting the pace, having grown assets in its tax-aware long-short strategies 10-fold in two years to about $57 billion. Fellow quant shops Two Sigma Investments and WorldQuant are introducing their own offerings. Man Group, the world’s largest listed hedge fund with $228 billion under management, is also building out tax-aware long-short solutions as well as trying to make some other strategies more tax-efficient, according to Paul Kamenski, co-head of fixed income at the Man Numeric unit.  …

“Tax-aware strategies must be built on credible pre-tax alpha and that should be the primary draw for investors,” an AQR spokesperson says in an email. “But delivering strong after-tax outcomes requires more than just time-tested alpha — it demands sophisticated tax-aware resources and infrastructure, which we’ve built into every facet of AQR.”

I feel like the obvious lesson here is that tax-aware strategies don’t have to be built on credible pre-tax alpha? [2] I mean, pre-tax alpha is nice, but getting the broad market index return and not paying taxes on it would be great, probably better than the alpha most hedge funds can achieve, [3] and also probably easier.

Elsewhere in alpha, you could have a crude simple model in which some people have investing skill, but each person’s investing skill works only over a particular time scale. Some people can buy the stocks that will go up in the next second, others can buy the stocks that will go up in the next hour, others the next week, others the next decade. There is a smooth continuum, but for practical purposes people get sorted into maybe four discrete buckets:

1. If you are good at making investment decisions over time scales of milliseconds, seconds, minutes, hours or maybe a few days, you can work at “proprietary trading firms,” the Jane Streets and Citadel Securities (not Citadel) and Hudson Rivers of the world.
2. If you have skill over days or weeks, you can work at “multistrategy hedge funds” or “pod shops,” the Millenniums and Point72s and Citadels (not Citadel Securities) of the world. There is some overlap between this and the previous category, and we have talked about Millennium poaching traders from Jane Street. If your skill is in, like, 36-hour increments, you could go either way.
3. If you have skill over time scales of years, you can work in private equity or private credit or venture capital. 
4. If you have skill over time scales like “forever,” maybe you can go work at Berkshire Hathaway Inc., but there are not a ton of openings. It is for fairly intuitive reasons hard to get a job when your skill set is buying stocks and holding them for 40 years. How can anyone tell if you’re any good? Wait 40 years?

The bucket that is missing from that list is “months.” Some people are very good at making investment decisions over time scales of several months, but “months” doesn’t really fit in anywhere. [4] The big prop firms and pod shops have a quantitative and scientific approach to talent evaluation and management; they want to measure your performance with fairly high-frequency data points, not a few trades a year. And obviously holding an investment for six months doesn’t work for private equity, which puts a lot of expense and effort into buying and revamping whole businesses. So if you’re really good at generating alpha over a period of a few months, you might have to just hang out your own shingle and tell potential clients “hey I have this weird niche skill, I’ll buy the stocks that go up over the next six months, I don’t fit in in polite financial society but I can make you some money.”

This model is somewhere between “exaggerated” and “joking,” and I don’t really mean months precisely, but there is probably something to it. The giant investing institutions tend to prioritize either quantifiable short-term factor-neutral repeatability (prop shops, pod shops) or long-term fundamental commitments (PE, VC), and there is perhaps a gap in between. Bloomberg’s Nishant Kumar, Liza Tetley and Katherine Burton report on portfolio managers who don’t work at pod shops:

A growing number of traders are leaving or eschewing the mercenary life of working for so-called pod shops despite vigorous efforts to lure or retain their talent, with pay packages in the millions of dollars mere table stakes. Some traders say they’re finding more fulfillment by cultivating their own clients, gaining wider latitude and more time to see bets through, even if that means leaving behind easy access to billions of dollars of investing firepower.

And:

Sean Gambino, a veteran stock-picker who coined the term “pod exhaustion,” ran his own fund that earned an annualized return of 18.6% before trying out a stint at now shuttered Eisler Capital. He left to run his own shop again in 2024, where the focus is on long-term fundamental calls, rather than quick punts.

“I ran my own fund, tried a pod and left again. That tells you everything,” said Gambino, who runs Stamford, Connecticut-based Baypointe Partners. “Pod exhaustion is real — if your edge isn’t short-term and repeatable, the model grinds it down.”

We talked last month about pod shops as “alpha factories,” which are increasingly optimized to produce certain sorts of reliable trading edges. If you want to produce slow artisanal edge you might look elsewhere.

The basic idea of a digital asset treasury company is that you sell stock to buy Bitcoin. For a while people liked this idea, so you could sell stock at a premium to net asset value to buy more Bitcoin, which was accretive. This was a good trade but has mostly stopped working, and now most DATs don’t trade at much of a premium. The original DAT, Strategy Inc., trades at about 1.19x NAV, which isn’t bad, but is down from more than 2x in the glory days. Many DATs are closer to 1x, and some DATs trade at discounts and attract activists trying to shut them down.

A variation on the DAT idea, also pioneered by Strategy, is that you borrow money to buy Bitcoin. This borrowing normally takes the form of preferred stock, which has the advantages that (1) you never have to pay it back and (2) if you are short on cash, you can stop paying the coupon on the preferred without going into bankruptcy. Because of those advantages, it has the offsetting disadvantage that you have to pay a very high coupon. [5] Strategy, for instance, has a weird floating-rate preferred stock called Stretch, which currently pays an 11.5% coupon. Last week it sold about $1.2 billion of Stretch to buy more Bitcoin.

Borrowing money at 11.5% to buy Bitcoin is a good trade as long as Bitcoin goes up by more than 11.5% a year, which, you know. (Last year it did not.) But even when it is a good trade, it doesn’t carry: You need money to pay that 11.5% coupon, [6] and Bitcoin doesn’t have any cash flow. If you sell billions of dollars of high-coupon preferred to buy Bitcoin, you will need hundreds of millions of dollars of cash every quarter to pay the coupons. How will you get it? There are really only three answers [7] :

1. Sell more preferred. If your Bitcoin stash is growing, you will keep getting bigger and you will have more preferred capacity, so you can sell more preferred stock to raise cash to pay the interest on your previous preferred stock. But this does sort of compound the problem.
2. Sell common stock. If your Bitcoin stash is growing, your stock price will presumably go up, so you can sell some common stock to raise cash to pay the interest on the preferred. But if your stock price is not going up this is less pleasant. Plus, if you sell common stock and don’t buy Bitcoin with the proceeds, you are not doing the fun accretive trade that DAT investors want.
3. Sell Bitcoin. This is, for DATs, not allowed? I mean, it’s allowed, but it’s frowned upon in DAT culture. The point is to buy Bitcoin.

Answers 1 and 2 are fine, in a world where everything is going up; you can sell a lot of common and preferred stock, use most of the proceeds to buy Bitcoin, use a little to pay coupons, and nobody will pay much attention. But in a less ebullient DAT world, neither is great.

Ideally what you would do is raise money (by selling common stock or preferred or even Bitcoin) to buy an asset that:

• is Bitcoin but
• pays a 12% yield.

Is there such an asset? Well. There is definitely a market for Bitcoin lending, and if you told me “I get 12% for lending out my Bitcoins” I would not be especially surprised. I might be, given the history, nervous. Will you get your Bitcoins back? 

On the other hand, if you run a DAT and are paying like 12% on your preferred stock, and I run a DAT and am paying like 12% on my preferred stock, you could raise some money to buy some of my preferred stock? Which would pay you a 12% yield? And give you some cash flow? Obviously my preferred stock is not Bitcoin — if Bitcoin goes up a lot, my preferred stock probably won’t — but it’s Bitcoin-esque. Bitcoin-flavored. Maybe it will make your shareholders happy? Bloomberg’s Melos Ambaye reports:

[Last] Wednesday, Strategy announced an unlikely taker for its perpetual preferred shares: another company whose balance sheet hinges on Bitcoin’s price. Bitcoin treasury company Strive Inc. — co-founded by former Republican presidential candidate Vivek Ramaswamy - announced that it allocated $50 million, or more than one-third of its corporate treasury, to the securities.

Strive, which owns about 13,300 Bitcoin, is already heavily exposed to the token’s price swings. It’s turning to Stretch to earn a double-digit yield on capital set aside to meet its own preferred dividend obligations.

“Instead of holding idle cash earning low yields in money market funds, we believe it makes sense to allocate a portion of those reserves to instruments like Stretch that provide strong yield dynamics while maintaining stable price behavior with deep liquidity,” Matt Cole, chief executive officer of Strive, said at the time.

The firm issues its own preferred shares with a 12.75% dividend and uses most of the proceeds to buy Bitcoin. It keeps cash in reserve to cover the fixed dividends of the preferreds. By putting some of its reserve cash into Stretch, which has an 11.5% yield, instead of treasury bills yielding about 3.7%, Strive increases the income it earns on that cash.

Sure, whatever! I feel like we’re due for some weird DAT M&A.

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