Wednesday, December 19, 2012

Private Equity's Dirty Little Secret?

Daniel Gross of the Daily Best reports, Cerberus to Sell Stake in Gunmaker Freedom Group:
It took a while, but the owner of Freedom Group, the weapons conglomerate that makes the Bushmaster weapon used in last Friday’s assault in Newtown, Connecticut, finally said something.

At 1 a.m. on Tuesday morning, more than 80 hours after the event, Cerberus Capital, the high-profile private-equity firm that owns Freedom Group, issued a statement. Cerberus expressed sadness and attempted to distance itself from the assault, noting that Freedom Group “does not sell weapons or ammunition directly to consumers, through gun shows or otherwise.” It continued: “We do not believe that Freedom Group or any single company or individual can prevent senseless violence or the illegal use or procurement of firearms and ammunition.”

But you don’t need a weatherman to know which way the wind blows. Cerberus recognizes that the Sandy Hook even was a “watershed event that has raised the national debate on gun control to an unprecedented level.” And this higher level of public debate is making Cerberus uncomfortable. “As a Firm, we are investors, not statesmen or policy makers.” So rather than get involved in a messy debate, it is cutting Freedom Group loose.

“We have determined to immediately engage in a formal process to sell our investment in Freedom Group.” That way, Cerberus can give the money back to its investors, and go about its business “without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so.”

While welcome, the statement is troubling. And while it is tempting, even satisfying, to lash out at a secretive private-equity firm that profits from the sale of automatic weapons, a deeper look should cause us to pose questions to others, and to ourselves. The rich guys in New York weren’t the only beneficiaries of Freedom Group’s growth. In fact, many of the indirect beneficiaries are people of much more humble means.

Let’s start with the obvious. Cerberus claims that “as a firm, we are investors, not statesmen or policy makers.” But of course, Cerberus’s small leadership team includes statesmen and former policymakers like Dan Quayle, a former vice president of the United States, and John Snow, a former Treasury secretary. In recent years, Cerberus has purposely become involved with companies that benefit from, and rely on, public policy. One of its more successful investments has been in Air Canada, for example.

Private-equity executives, including the folks at Cerberus, have very strong opinions on matters of public policy when it comes to tax rates, the treatment of carried interest, and entitlement spending. Cerberus executives, including its founder, Stephen Feinberg, have given heavily to political campaigns (virtually all of it to Republicans). For people who chose to operate in regulated industries, who choose to invest in government contractors, and who participate in the political process at a high level to suddenly plead a lack of interest and competency in such areas now that there’s a national debate on gun control is highly convenient.

Cerberus is now going to have to dump Freedom Group at a fire-sale price. Who will buy a company that is the target of public opprobrium and likely new regulation—especially one that is now laboring under a higher debt load? At the end of the third quarter, Freedom Group had $646.8 million in debt, up from $487 million the year before. That’s a manageable load for a company whose sales are clocking upwards at a 20 percent annual rate. But the interest payments can quickly become problematic if the business suffers some setbacks, or if it is exposed to expensive litigation.

Of course, Cerberus has already extracted a few hundred million dollars on behalf of its investors from Freedom Group, by having the company issue debt and buy back shares. And this brings up a larger issue.

The dirty little secret of private equity is that many billionaires owe their fortunes and ability to conduct swashbuckling takeovers to civil servants. From its inception, the industry has raised money from public-employee pension funds—taxpayer-funded retirement-savings programs for teachers, DMV clerks, bureaucrats, sanitation workers, and police officers. Huge institutional investors like the New York State Common Retirement Fund, CALPERS (the California Public Employees Retirement System), and CALSTRS, which invests on behalf of California teachers, possess hundreds of billions of dollars in assets and are mainstays of the private-equity business. When Cerberus, and the Blackstone Group, or Bain Capital use debt to boost returns, and use the bankruptcy code to shuck obligations, a big chunk of the benefit goes to civil servants.

In its statement, Cerberus noted that “Our role is to make investments on behalf of our clients who are comprised of the pension plans of firemen, teachers, policemen and other municipal workers and unions, endowments, and other institutions and individuals.” Many of these funds are in turn controlled by publicly elected officials. And events like Newtown put them in a tough spot. The Financial Times reported that CALSTRS had expressed concern with Cerberus about the investment. Private-equity firms are much more responsive to questions from their investors than they are to questions from the public. If Cerberus, or other private-equity firms, invest in toxic companies that embarrass them, the big institutional investors may be less likely to participate in the next fund. Until recently, these large public funds were looking the other way, too.

The bottom line is that we are much more implicated in the search for profits than we like to think. Andrew Ross Sorkin reports in the New York Times on other gun companies that are owned by private-equity firms, which in turn invest on behalf of such pension funds. Other companies, like Smith & Wesson and Ruger Sturm, are publicly held, which means they may reside in index funds, ETFs, or mutual funds. If we were all to do a deep archeological dive into our portfolios, many of us would find some connection to a gun company.
The bottom line is that guns are big business in the United States and any talk of regulations stemming from the Sandy Hook tragedy only serves to boost gun sales. As gun owners flock to stores fearing a crackdown, FBI data indicates that gun sales are on target to set another record.

And both pension funds and retail investors are invested in gun manufacturers through private equity or public markets. But some pension funds are divesting from guns. Reuters reports that NYC pension funds may sell $18 million in gun-related stocks, no doubt spurred on by Mayor Bloomberg, a leading advocate for gun control.

California state treasurer, Bill Lockyer, has ordered a review of state pension fund investments connected to a company that manufactures firearms after learning one of its guns was used in the Connecticut school shootings. Lockyer has asked CalPERS and CalSTRS staff to review all the funds’ investments in the wake of the shooting on Dec. 14 at Sandy Hook Elementary School in Newtown.

While I understand the reaction, divesting from guns or defense companies is a slippery slope. A month ago, I covered why bcIMC got slammed over unethical investments, stating the accusations were baseless and that "ethical investing" is a slippery slope which opens a Pandora's box. 

The truth is it doesn't matter what New York or California do because other large investors (maybe Texas where they love their guns) will step in and gladly invest in gun manufacturers. Also, what's next, divesting out of Wal Mart which just sold out of guns?

But for private equity, all the attention and public spotlight was too much. It seems like Eliot Spitzer's Slate article targeting Cerberus succeeded in shaming them into action. The question is for how long?

And while I think there is a real need for America to have a conversation on gun control, the issue isn't as easy  as pro gun rights or pro gun control advocates make it out to be. 

Below, California Treasurer Bill Lockyer speaks with Yahoo's Aaron Task on why he's proposing that the state’s two public pension funds divest themselves of gun makers, and putting Credit Suisse, Blackrock and others on notice. 

CBS Los Angeles also reports on how California is reviewing its investments in gun manufacturers. Interestingly, it turns out one of the reasons behind the sale of Freedom Group is that Stephen Feinberg's father lives in Newtown. That's what you call the ultimate alignment of interests.

Finally, the Wonkblog’s Brad Plumer stops by to give us the ins and outs of the U.S. assault weapons ban that was in place from 1994 to 2004 and explains how effective it really was.