Private Equity Is Destroying Roads, Schools and Hospitals

Posted by guest, Apr 17, 2008 8:23AM

When does the "farm aid" version come out?

Posted by Novice, Apr 17, 2008 8:46AM

Each night, EP cackles as she inscribes into her little black book the names of elementary schools and emergency rooms that she has forced into penury that day.

It's the perqs of the job that really make it.

Posted by guest, Apr 17, 2008 9:15AM

I love how they make it seem that these evil PE guys are "skimping" on their taxes, as if they are cutting back room deals with the IRS or something. honestly, what do they expect/want? that Kravitz & Co. will voluntarily pay more taxes than they are required to by law? Get real people. and get a real job, because you're cheap-ass cartoons aren't fooling anyone (well, maybe Joe and Jo Public)...

Posted by guest, Apr 17, 2008 9:29AM

Joe and Jo Public are bitter, and will be fighting in Nyack soon.

Posted by guest, Apr 17, 2008 10:01AM

@9.15 - Looks like somebody "skimped" on your education.

Posted by guest, Apr 17, 2008 11:00AM

At first I thought something was wrong with this, but then I put on my 3D-demagogueles and reality-cancelling headphones.

Posted by onetwo , Apr 17, 2008 11:12AM

God I hate commies.

Posted by guest, Apr 17, 2008 11:38AM

11:00,

Then I guess you havent seen Michael Moore's version of American History? (Or Michael Moore's version of ANYTHING)

Oh, and all the Dems here - Michael Moore forms the CORE of the Democratic Party. Just thought youd like to know.

Posted by guest, Apr 17, 2008 11:42AM

@11:38 Yeah, like Jerry Falwell forms the core of the Repub

Posted by guest, Apr 17, 2008 11:48AM

@ 1-2:

Any thought on my proposal at top? What if the debt tax shield was eliminated? any other repercussions on the world?

Really it is an accident by which wealth is transfered from tax payers to equity investors. There's no fundamental principal of economics that says that interest has to be tax deductible. Anyway, I just wonder what the world would be like if remittances to debt investors (interest) were treated the same as remittances to equity investors (dividends)

Posted by guest, Apr 17, 2008 11:56AM

@11:48 One reason interest is deductible to the borrower is that its counted as income to the lender. Tax code tends to be that way. Another example: medical expenses: deductible for the employer, income to the doctor. Before you jump, dividends are an exception - income to the investor, no deduction for the borrower. Dividends though are a return of capital. A logical way to treat them would be to allow the investor to reduce his basis in the underlying investment by the amount of dividends received.

Posted by guest, Apr 17, 2008 11:59AM

@11:56 here. To clarify, I mean REQUIRE the investor to reduce his basis by any dividends received, thereby increasing the amount of cap gains taxes collected upon disposition of the investment.

Posted by guest, Apr 17, 2008 12:01PM

Dividends are no more a return of capital than interest is.

Posted by guest, Apr 17, 2008 12:04PM

@11:42, Falwell comes in for a fair bit of criticism from many mainstream Repubs (eg. agents of intolerance?)

Ok. Lets see. When was the last time some leading Dem called Michael Moore out. ??

Posted by guest, Apr 17, 2008 12:04PM

@12:01 Why do you say that? Dividends are accounted for like a return of capital. Essentially the same treatment as a stock buyback. Think that's a return of capital?

Posted by guest, Apr 17, 2008 12:06PM

@12:04 I call bullshit on that. They're all kissing his ass, cause they have to. McCain was the exception, and he even capitulated and made a visit to Bob Jones U land.

Posted by guest, Apr 17, 2008 12:10PM

@12:04 The reality is that the R's are an uneasy coalition of hard right social conservatives, libertarians and the strong military crowd. These three disparite coalitions have just learned to get along better than their counterparts on the D side. But that could change fast.

Posted by guest, Apr 17, 2008 12:22PM

That's just 2/3 of the R's. There are some moderates left in the party, although they were frozen out in the last eight miserable years.

Posted by guest, Apr 17, 2008 12:27PM

@Top proposal-- what if, as some have suggested, we eliminated the debt tax shield past some metric such as 50% D/TC or 3xInterest Earned, to curb the incentive to lever-up companies to their breaking point, while protecting PE's role in secondary markets. Any thoughts?

@11:38-- Does anyone know if there is any truth to the rumor that MM was fired as editor of Mother Jones back in the day for striking an anti-communist remark from an article? I saw this somewhere a few years back and did an internet search on it recently, but came up empty.

Posted by guest, Apr 17, 2008 12:27PM

@ 12:10

And racists.

Posted by guest, Apr 17, 2008 12:31PM

@12:22 Frozen out, but I bet they still voted for Bush. That's the genius of the R party. I'm sensing your type is a Rockfeller Republican. You read Christie Whitman's book, its my party too. Understood how she nailed a blue state. Sort of embarassed at the other 2/3 but not embarassed enough to be pulling levers for Gore or Kerry. And not Hillary or Obama either. In fact you're probably very satisfied with McCain. Glad that Huckabee, Thompson are long gone. Don't even mention Giuliani. Maybe liked Romney's businesslike ways, but your heart sank when he started flip flopping all over the place. Plus, youd hate to admit it, but felt a little funny about all that Mormon stuff.

Posted by guest, Apr 17, 2008 12:45PM

@12:27: Fuck that the last thin we need is some arbitrary limit that will be gamed invariably. Just change the treatment and have PE firm earn their returns based on operation improvements rather than financial engineering. I mean this doesn't really penalize PE firms it just removes artificially value creation subsidized by the tax payers.

Posted by guest, Apr 17, 2008 1:06PM

The point is that there ARE still people on the R side who do speak out against the craziness of the religious right wind. Yes, McCain has had to grudgingly kiss and make up with Falwell but it is all to clear that there isn't much love between them. Similarly there were voices both for and against illegal immigration within the party.

On the other hand, when EVER did ANYONE on the dem side take a stand against big labor and the teacher's unions? The supposedly pro business R nominee railed against CEO salaries and opposed the tax cuts at one point of time. What was the one instance where the huge parade of D candidates managed to even utter the slightest ctiticism of ANY union? Are unions really the chosen ones and infallible?

Posted by guest, Apr 17, 2008 1:33PM

I am generally supportive of labor unions but the labor union movement lost my unconditional support when I sent my child through NYC public schools. You've never lived until you've met a schizophrenic teacher who takes kids (including your kid) to shopping malls during school hours, can't average test scores, awards grades on random vibes, doesn't know beans about the subject matter, and whose job has been protected by years by the UFT.

Some of the worst take leadership positions in the UFT.

No, you'll never meet an ambitious Democratic candidate for national office who doesn't publicly love unions.

Posted by guest, Apr 17, 2008 1:40PM

as long as i get my money i could give 2 shits about joe public.

Posted by bernoulli, Apr 17, 2008 2:52PM

... what about the roads and schools? bahahaha

Posted by guest, Apr 17, 2008 2:58PM

Not sure what yr trying to say, but R's love roads (prisons too), but hate schools. Being able to drive around in your SUV, filled with cheep gas, is your god given right as an American.

Posted by bernoulli, Apr 17, 2008 3:03PM

Either sarcasm doesn't go well on the internet or you didn't watch the video.

Posted by guest, Apr 17, 2008 3:43PM

Right, because that whole mortgage payment tax deduction doesn't count just like the corporate debt tax shield

Posted by guest, Apr 17, 2008 3:51PM

@3:43 Actually, mortgage int is deductible (and consumer interest isn't -although it once was) as a means for encouraging home ownership. Two sides to this. Good: people who own things take care of them. Results in stronger communities. Bad: why do we have to keep using the tax code, which is like a gazillion pages, for social engineering.

Posted by diablo, Apr 17, 2008 4:42PM

@3:51

The tax code is used for social engineering because that's a convenient way to introduce loopholes for your contributors. So keep the money flowing fellas.

One little thing about home ownership. When your LTV is close to or higher than 100% you are renting, not owning. And when people realize that they are really renters, they become like lemon juice. That number is growing fast and furious.

Posted by guest, Apr 17, 2008 4:58PM

Shut up diablo. These people are not renters. They are poor ingorant illiterate (but equal) folks who were tricked into thinking that buying a house worth 50 times your salary - when you are a single parent of 3 children with a temp job - was a good idea. THEY NEED TO BE BAILED OUT. You are a stupid banker who just became so by dumb luck and hence you should move into a studio somewhere in Harlem and 90% of your salary should go into letting these people stay in their houses.

And you are getting a good deal. 100% of you salary is based on dumb luck - we are asking back for only 90% ot it!

- Ghost of Random Banker

Posted by guest, Apr 17, 2008 8:41PM

@9:15am. Did you mean Henry Kravis? All day long, I kept thinking "Kravitz? Kravitz? Who does he mean?" but the only Kravitz I could come up with was Lenny Kravitz.

Posted by guest, Apr 17, 2008 8:55PM

diablo, what do you mean when you say people become like lemon juice? Invisible? Sticky? Lemony?

I think there were a lot of people fooling one another in the mortgage debacle. Lenders fooling credulous people by persuading them that they could always refinance or sell, small-time real estate speculators fudging mortgage applications to make a quick buck.

It's pretty clear to me that a number of people didn't grasp the consequences of signing an ARM.

I'm not sure how the credulous could be helped now, because many of them simply can't afford their houses under the most lenient of terms. I don't support any changes that reward irresponsibility when the prudent stayed renters and didn't get into trouble.

I think that lenders are going to be required to disclose more during the loan process, particularly if they're selling an ARM. No-documentation loans are a thing of the past and should never have been allowed.

The speculators don't deserve any help and should be prosecuted for fraud if evidence supports it.

Posted by guest, Apr 17, 2008 10:44PM

As one of the main film makers working on this project, I find the knee jerk 'commie' arguments interesting because it's a a pretty clear example of ideological blinders. The video itself is very clear about the legal loopholes that make PE and LBOs lucrative - and that ain't free market capitalism.

- Lee Stranahan, stranahan.com

Posted by ep, Apr 18, 2008 2:33AM

"The video itself is very clear about the legal loopholes that make PE and LBOs lucrative - and that ain't free market capitalism."

Mr. Stranahan:

I am glad you took the time to join us.

The video is a pandering propaganda piece worthy of little but a sort of stunned awe; amazement that such malignant dishonesty is still possible among such unabashedly wealthy people as those in the Western world.

What's more- you know it.

You are clearly intelligent and older than 20, so your pieces loose connection with the facts can only be explained by some combination of willful ignorance or malicious deception.

Stirring up resentment by intimating that buyouts destroy jobs, universally bankrupt companies and destroy roads, schools and hospitals is at such variance with the facts behind LBOs (I will suggest that you should endeavor to research them, on the very unlikely possibility that you don't actually know already) that its is painful for those of us with even a passing familiarity with finance to endure the dripping voice-over.

You and your ilk are an agitator of the worst kind. You offer equality, justice and comfort, but you do so by inflaming class warfare- and in the end all you can offer is the cold, gray hopelessness (albeit cloaked in the burlap blanket of 'security and equality') of socialism, except, of course, for the political classes- who enjoy the comforts of intellectual superiority, and power.

I can only hope that the wanton and unbridled dishonesty that characterizes your approach to the world visits upon you but a fraction of the suffering and desperation the other victims of centralized planning have endured over the decades.

Best Regards,

-ep

Posted by guest, Apr 18, 2008 9:43AM

"it's a a pretty clear example of ideological blinders." - some Stranahan

Coming from a move-on and michael moore cohort - that statement is intensely rich in its irony.

It was not a 'project', it was a smear job. You analyzed no issues - you just played your part to perfection - the elitist explaining 'evil and greedy capitalism' to the dumb masses. At least read up a little bit on finance and economics. But then again - maybe you have and simply chose to ignore it! Karl Marx was also a very learned man - didn't necessarily mean awesomeness for USSR and the rest of the communist countries though.

Posted by guest, Apr 18, 2008 9:52AM

Lee Stranahan works at NBC (big greedy corporation - oh my god the travesty!) and made a living for the longest time making 'high quality corporate videos' - God damned evil corporations again! I would love to know what kinds of evil corporations Mr. Stranahan derived his livelihood from. Does he invest in stock? Does his 401k invest in stock?

Oh and for your next project here is an idea. Did you know that CA (the state you live in) and othermiscellaneous union and state run pension funds are the BIGGEST beneficiaries of PE funds? They make multiples of what Kravitz makes. So why dont you expose their hypocrisy and force them to invest their money where there mouth is. I think Calpers should invest in GE and Ford and all the poor little factories being closed due to the ill-effects.

Come on Mr. Stranahan - you could ACTUALLY make an impact if you did that!

Posted by guest, Apr 18, 2008 9:59AM

I love the second rate "erotic photography" he produces. True, I don't find women copulating with riding crops attractive, but maybe I am not cultured enough for this particular brand of eroticism.

The only thing better than that is the fact that, since his website is broken, you can just browse through it all.

http://www.intimatearts.com/m/

NOT safe for work. Seriously not safe. Trust me. Really.

Posted by guest, Apr 18, 2008 1:52PM

Stranahan,

What you are portraying as "very clear... loopholes" are really just extensions of the laws and opportunities that everyone in this country enjoys. Corporate debt is tax deductible? So is personal mortgage debt. KKR isn't responsible for paying back the debt? Well, if they don't pay back the debt, they certainly aren't making any equity returns, and thus aren't benefiting from the capital gains tax you so abhor.

Private equity makes companies better. Period. That may result in some initial layoffs, but what company in this country isnt overloaded with unmotivated, overcompensated people? Have you never worked in a large organization and realized that the business could make the "same product, in the same factory" with fewer people standing around the water cooler? Your statement is socialistic because it is based on the fallacy that people are fundamentally owed a job - people are owed nothing. They must work hard, learn their trade and outperform their competition (other workers) in order to be paid anything. The end result is a better community, smarter people and cheaper products for everyone. Productivity. Not just "employment."

Finally, the dirty assaults on Kravis are embarrassing. So, he makes money? Is that evil? How about the 40 years he has been working at 2-3 times a "normal" 40-hour work week, while being smart and making prudent decisions along the way? Don't begrudge a man his hard-earned success, especially when he gives so much money back to CHARITY. Entire wings of hospitals and museums, anyone? Not to mention how many "roads and schools" his $150k+ of tax each day finance. How many hospitals did you build last year?

Entitlement is worse than greed.

EP, you're amazing.

Posted by guest, Apr 19, 2008 3:35PM

Edgeonsite speaking here, please refer to me by this name and not time of post.

The Corporate Debt Tax Shield is an integral piece to firm Valuation. AS it has not been mentioned anywhere in the comments above, I would suggest that everyone here go read Modigliani-Miller "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review (June 1958). Both are Nobel Laureates for their work on Capital Budgeting. I will cover this in great detail, but first, store the thoughts you may have on corporate tax shield and PE operations in the back of your mind.

MM Proposition I (no taxes): The value of the levered firm is the same as the value of the unlevered firm.

MM proved that a company cannot increase its value by playing shell games with its capital structure (debt versus equity). IE: Should a firm be 50/50 debt/equity or 60/40 debt/equity? In other words, the value of the firm is always the same under different capital structures.

MM Proposition II (no Taxes):

Because levered equity has greater risk, it should have a greater expected return as compensation. This type of reasoning develops the MM Prop II. MM argue that the expected return on equity is positively related to leverage b/c the risk to equity holders increases with leverage. To develop this position, recall that a firm's weighted average cost of capital (Rwacc) can be written as:

Rwacc = S/S+B)*Rs + B/S+B)*Rb

Where
Rb is the cost of Debt
Rs is the expected return on equity or stock
Rwacc is the firms weighted average cost of capital.
B is the value of the firms debt or bonds
S is the value of the firms stock or equity

This simply states that a firm's weighted average cost of capital is a weighted average of its cost of debt and its cost of equity. An implication of MM Prop I is that Rwacc is constant for a given firm, regardless of cap structure, in a world of no taxes (this does not hold true in a world with taxes).

Lets now define R0 (zero) to be the 'cost of capital for an all-equity firm'

R0 = Expected earnings to unlevered firm/unlevered equity

Rwacc must ALWAYS equal R0 in a world without corporate taxes. Prop II states the expected return of equity, Rs, in terms of leverage. The exact relationship, derived by setting Rwacc = R0 and then rearranging is MM Prop II (no taxes):

Rs = R0 + (B/S)*(R0 - Rb).

This implies that the required return on equity is a linear function of the firm's debt-equity ratio. It can be shown that if R0 exceeds the cost of debt, Rb, then the cost of equity rises with increases in the debt-equity ratio, B/S (no, not bullshit). What we see is the effect of leverage on the cost of equity. As the firm raises the debt-equity ratios, each dollar of equity is levered with additional debt. This raises the risk of equity and therefore the required return, Rs, on the equity.

This was where the firm operated in a no tax environment. Granted, there were many more exemptions, but taxes are the biggest lynch pin. Modigliani-Miller were roundly criticized and discredited for excluding taxes. So they came out with Proposition I & II (with taxes) which assumed a firm existed in a Taxed environment.

MM show that due to a quirk in U.S. tax law, the proportion of the total value of the firm allocated to taxes is less for a levered firm than it is for the unlevered firm: interest on debt is a tax write off! (Larry the Loophole illustrated this correctly). Thus, this interest write-off is held within the firm and increases its overall value. As a result, managers should select leverage.

Algebraically, the reduction in corporate taxes is Tc*(Rb*B), where Tc is the corporate tax rate. This is often referred to as the 'Tax Shield'. Assuming that the cash flows are perpetual, the present value of the tax shield is

(Tc*Rb*B)/Rb = TcB

Next step is to calculate the value of the levered firm. The annual aftertax cash flow of an unlevered firm is

EBIT*(1-Tc)

Where EBIT is earnings before interest and taxes. The value of the unlevered firm is the present value of EBIT*(1-Tc).:

Vu = (EBIT*(1-Tc)/R0

Where
Vu = Present Value of an unlevered firm
EBIT*(1-Tc) = Firm cash flows after corporate taxes
Tc = Corporate tax rate
R0 = Cost of capital to all equity firm. Note: R0 now discounts AFTERTAX cash flows.

As show, leverage increases the value of the firm by the tax shield, which is TcB for perpetual debt. Thus, add the tax shield to the value of the unlevered firm to get the value of the levered firm. Algebracically, this is:

MM Prop I (Corporate Taxes)

Vl = ((EBIT*(1-Tc)/R0) + ((Tc*Rb*B)/Rb)
Or
Vl = Vu + TcB

This relationship holds when the debt level is assumed to be constant through time. A different formula would apply if the Debt-equity ratio was assumed to be a nonconstant over time.

Because the tax shield increases with the amount of debt, the firm can raise its total cash flow and its value by substituting debt for equity. Note, companies report two books each year: Financial and Tax. The Financial books are reported to investors, Tax are reported to the IRS. Both are different. The Tax aims to bring earnings to 0 to reduce the tax burden whereas the Financial books aim to maximize firm value.

MM Prop II under no taxes posits a positive relationship between the expected return on equity and leverage. This result occurs because the risk of equity increases with leverage. The same intuition holds in a world of corporate taxes. The exact formula ina world of corporate taxes is:

MM Prop II (corporate Taxes)

Rs = R0 + (B/S)*(1-Tc)*(R0-Rb)

Whenever R0 . Rb, Rs increases with leverage, a result that is also found in the no-tax case btw.

The end of MM.

So what does this mean? Firms will lever up to increase firm value. But there is one hidden thing to this that will bite you in the arse: Bankruptcy. Basically, imagine two points on a graph, one is firm value with no debt (Vu) and the other is firm value with debt (Vl). Vl is always higher at an increasing rate, up to a certain inflexion point, to which any additional debt brings down firm value. The cause? Increase debt burden costs: Risk of bankruptcy.

A world application. Remember the first portable computer??? It was the Osborne 1 by the Osborne computer corporation. At it's height, they were selling 10K units a month. The company was highly levered to support growth in manuf. and inventory. Investors priced in a ridiculous multiple to the stock. Then, the company announced that its inventory was growing , indicating it had a sales/demand fall off and may be at bankruptcy risk if it cannot sell its units. Back in that time, consumers were dependent on computer manufacturers to service their computers (not the case today). If the company failed then their product would be useless without a repairman. As a result, consumers panicked and sales further plummeted. Within three months of the announcement, the company filed Bankruptcy. Thus illustrating bankruptcy risk.

Moral of the story: There is a limit to the amount of leverage a company can take on in terms of increasing firm value.

The idea of a PE group is to find a company that has undervalued assets and buy it. Once the targeted company was acquired, the PE firm would help restructure the company, usually selling off certain underperforming assets and implementing a series of cost-cutting measures. The new "leaner and more efficient" company could then be resold, often at significant return on investment.

Buying the company is done with debt. The company is saddled with it. Selling off underperforming assets is where job losses come. The company's employees are then forced to make the company more leaner and efficient to service its own debt. The company is then resold at a higher market price.

Does this have any benefit? Most research indicates that it does not. Within 1-3 years of IPO, the company will usually be operating like every other public company and thus be a potential buyout candidate. Thus feeding the cycle of LBO,IPO,LBO,IPO.

Posted by ep, Apr 20, 2008 2:20AM

Amusing, that you would type, or copy-paste, Modigliani-Miller only to blow it with:

"Does this have any benefit? Most research indicates that it does not."

You don't cite evidence for this case, primarily, I suspect, because it is at such variance with the facts that there isn't much. (See e.g, Kaplan, Smith, Lichtenberg, Siegel, all of which find evidence to the contrary. They are but a few among many).

You also fail to note the positive effects of default risk (distinct from bankruptcy risk) on incentives, and the consummate operational improvements this creates. But then, this might illuminate your worldview (man is basically good, needs to be insulated from bad-luck rather than incentivized to excel) for us. Good luck with that. Let us know how it goes.

I notice that you fail to apply the same analysis to the homeowner with a mortgage who rents out the apartment below to pay their lender. Dirty rich landowners! Put them up against the wall!

Finally, your LBO/IPO cycle comment ignores a few basic facts which present an alternative to your anti-capitalist view.

1. Almost by definition IPOs from formerly LBO'd firms have higher valuations than the firm was bought for (and it was probably bought at a premium to the public share price, so this is instructive). This puts a bit of a hole in your poorly applied interpretation of M-M, since the company has de-levered quite a bit by this point- why isn't it worth less given its debt light capital structure? Hint: Even adjusted for the firm's return on equity when public, there are abnormal DELEVERED returns to shareholders in these IPOs. (It's not enough to cite big theories, dear friend, they have to be properly applied too. Can you spot your error in applying MM? I leave it as an exercise for the student).

2. "Within 1-3 years of IPO, the company will usually be operating like every other public company and thus be a potential buyout candidate."

You pretty much admit here that the public markets destroy value that LBO's created. (I agree, by the way, and so do most studies on the topic- see my above citations). That it is right in front of your face and you STILL cannot see it is instructive.

Please don't make me come in here at 2:15am on a Sunday again to correct your stupid mistakes. It might be relevant to their strength (or lack thereof) that I can disabuse them with little effort even after three martinis. -hic-

Posted by guest, Apr 20, 2008 11:56PM

Ep,

Amusing, that you would type, or copy-paste, Modigliani-Miller only to blow it with:

"Does this have any benefit? Most research indicates that it does not."

It is my understanding that you interpret my statement to state that there is no benefit in MM research. That is not the case. I meant to state that there was little benefit to the cycle of LBO/IPO to investors. While I do not have specific citation on hand, I will try to get that for you. Kindly, would your please provide specific research that I can pull that indicates there are benefits to the LBO/IPO process? And no, I did not mean to say that public markets destroy value, I meant to say the managers themselves do.

My citing of MM was for the individual who was inquiring about the corporate tax shield and asking whether it should exist. I should have been more clear on that.

See the post: "Posted by guest, Apr 17, 2008 11:48AM: 'Any thought on my proposal at top? What if the debt tax shield was eliminated? any other repercussions on the world?'"

As a result of MM research, it can be proven that the Corporate tax shield adds to firm value while also reducing risk. The reasoning for the reducing risk part is that it can be shown that leverage increases the equity beta less rapidly under corporate taxes. This occurs because, under taxes, leverage creates a riskless tax shield, thereby lowering the risk of the entire firm. As a result, the tax shield increases firm value while lowering the overall risk of the firm. One must account for bankruptcy risks though, this does put an upper limit on the debt loads. Which brings me to your next point..

You state that I failed to note the positive effects of default risk on incentives, and the consummate operational improvements this creates. I am intrigued to know if you have a formula that can quantify this?

However, I will pre-empt a response from you stating that I did not cite anything on financial distress costs. I would refer you to the following:

Altman (Think: Altman Z-Score) estimates that both direct and indirect costs of financial distress are frequently greater than 20 percent of firm value. E.I. Altman, "A Further Empirical Investigation of the Bankruptcy Cost Questions," Journal of Finance.(September 1984).

Andrade and Kaplan estimate total distress costs to be between 10 percent and 20 percent of firm value. Gregor Andrade and Steven N. Kaplan, "How Costly Is Financial (Not Ecnomic) Distress?" Journal of Finance (October 1998)

Bar-Or estimates expected future distress costs for firms that are currently healthy to be 8 to 10 percent of operating value, a number below the estimates of either Altman or Andrade and Kaplan. However, unlike Bar-Or, these authors consider distress costs for firms already in distress, not expected costs for currently healthy firms.
Yuval Bar-Or, "An Investigation of Expected Financial Distress Costs," unpublished paper, Wharton School, University of Pennsylvania (March 2000).

So, I have covered financial distress costs in greater detail for firms that are both in financial distress and firms that are not in financial distress.Does any of your referenced positive effects of financial distress offset these huge financial distress costs? Are they even material?

In regards to your next statement:
'I notice that you fail to apply the same analysis to the homeowner with a mortgage who rents out the apartment below to pay their lender. Dirty rich landowners! Put them up against the wall!'

I did not consider homeowners because they have nothing to do with firm value. Homeowners are not something that can be bought and sold on the capital markets, so there is no need for analyzing them. To further illustrate this point, and to demonstrate your ignorance, if a homeowner goes over their debt limit and defaults, and they do!, then the primary difference between a homeowner and a company is that homeowners will not disappear as a result of the seizure and liquidation of any assets that are put up as collateral. Firms on the other hand, disappear when they fall under their debt loads and cease to exist as a legal entity. I understand there are many bankruptcy's, but I am assuming worst of the worst: Chapter 7. To qualify for relief under chapter 7 of the Bankruptcy Code, the debtor may be an individual, a partnership, or a corporation or other business entity. 11 U.S.C. §§ 101(41), 109(b). One of the primary purposes of bankruptcy is to discharge certain debts to give an honest individual debtor a "fresh start." The debtor has no liability for discharged debts. In a chapter 7 case, however, a discharge is only available to individual debtors, not to partnerships or corporations. 11 U.S.C. § 727(a)(1) (www.uscourts.gov). Remember KB Homes and Carlyle Group? I don't see them walking down the street as I would John and Jane Debtor.

But while we are on the subject of the individual human/homeowner/land lord, personal taxes do affect capital structure from an investor standpoint(maybe your homeowner/land lord takes his profits and invests). A firm should select the capital structure that gets the most cash into the hands of its investors. Stockholders receive (1-Tc)*(1-Ts) and bondholders receive (1-Tb).

Where
Ts is the personal tax rate on stock dividends
Tb is the personal tax rate on interest

If dividends and interest are taxed at the same personal tax rate, Ts=Tb, then you can see that bondholders receive more than stockholders due to the double taxing of corporate earnings and dividends. Thus, firms should issue debt, not equity, in this situation.

In a world without personal taxes, stockholders receive 1-Tc whereas bondholders receive $1. Thus, firms should issue debt in a world without personal taxes. You are probably figuring it out by now that a firm will be indifferent between issuing equity or debt when cash flow to bondholders and stockholders is equal. Algebraically, this is:

(1-Tc)*(1-Ts) = 1-Tb

Bonds have the tax advantage today although it is somewhat diluted in a world with personal income taxes than in a world without them (Can you discover why this statement is true? I leave this as an exercise for my fellow arrogant student). However, the tax advantage is limited by the financial distress costs. Consequently, the optimal amount of debt will be lower in a world with personal taxes than in a world without.

And, finally, I would like to address your derogatory and unfounded statements about my world view and your arrogant claim that I am an anti-capitalist. My world view is irrelevant to the facts at hand. While I am in the minority, I believe that regulation is bad for the economy. Regulation is usually the source of the problem, not the cure. Free market capitalism should be allowed to continue un-abated by ill advised politicians who know nothing about the economy, only to pander to the electorate to get votes. And I am anti-tax to the core. With this, and the two long reply's that I have posted, I don't even know how you could come to the idea that I am anti-capitalistic. Is it because I stated that the LBO, IPO process is not beneficial? Regardless of the facts, if it does not benefit shareholders then I do not support an LBO, but if it does then I do support it. Call me anti-capitalistic and your dead wrong. With that being said, it leaves me only to conclude that you stated such derogatory comments in order to dis-credit my original post, which was mostly founded on pro-capitalistic and academic research. This is a logical fallacy of course and I will not submit to it. In addition to your pursuit to discredit me you have only provided a few names and not actual research papers that can be referenced where as I have. I suggest that next time you want to take a swipe at that, you put your martini glass down and clear your swill filled head so that you can be more logical and more cordial in your response. Your disagreeing with me is fine, but without the need for you being a jerk.

Have a nice day.

Posted by ep, Apr 21, 2008 4:47AM

"While I do not have specific citation on hand, I will try to get that for you. Kindly, would your please provide specific research that I can pull that indicates there are benefits to the LBO/IPO process?"

Of course, it is somewhat annoying to be your research assistant in this. It helps some that the research is so trivial that it takes little of my time. Then again, that it was so trivial highlights how shameless you are about approaching an intellectual discussion unarmed, and, in fact, making bald assertions (which turn out to be false) about, e.g., the evils of a "LBO/IPO cycle."

Perhaps in future you might at the very least avail yourself of Google Scholar before posting under the guise of certainties your disparate and varied claims.

Also, I notice you have avoided addressing my criticism of your M-M application.

As to the benefits of IPOs from LBOd firms, Lerner and Cao are going to be the best recent source, and also the most comprehensive- but no less than 4 major and 3 minor studies support similar contentions. I am unaware of major studies which support opposing positions, with the possible exception of Felder. Considering Felder was booted from his department for academic fraud related to data fabrication in three of his studies, I believe we will let that one go.

Meanwhile:

Lerner, Cao: “The Performance of Reverse Leveraged Buyouts,” Journal of Financial Economics

http://www.people.hbs.edu/jlerner/RLBOPerformance.pdf

"We collect a comprehensive sample of 496 RLBOs between 1980 and 2002 and examine three- and five-year stock performance of these offerings. RLBOs appear to consistently outperform other IPOs and the stock market as a whole, with economically and statistically meaningful positive returns. There is no evidence of a deterioration of returns over time, despite the growth of the buyout market: RLBOs performed strongly in the late 1980s, the mid-1990s, and the 2000s. Large RLBOs that are backed by private equity firms with more capital under management perform better. We also find the so-called quick flips—when private equity firms sell off an investment within a year after acquisition—underperform."

Their initial bibliography is both fairly comprehensive and instructive. To wit:

"Muscarella and Vetsuypens (1990) examined 72 RLBOs between 1983 and 1987, and documented substantial increases in profitability and temporary increases in leverage when compared to the same firms prior to the LBO. DeGeorge and Zeckhauser (1993), examining 62 RLBOs between 1983 and 1987 (though much of the analysis is based on a smaller sample), find that the accounting performance of these firms exceeds their peers prior to going public, and then deteriorates thereafter. They find no evidence, however, that these offerings’ stock prices underperform the market. Holthausen and Larcker (1996) examine 90 RLBOs between 1983 and 1988, and argue that there is no evidence of either poor performance when either accounting or stock market measures are employed. Chou, Gombola and Liu study the earning management around RLBOs and find positive and significant discretionary current accruals coincident with offerings of RLBOs. Finally, Mian and Rosenfeld (1993) examine 85 RLBOs over roughly the same period and find that the offerings slightly outperform their stock market peers."

Also see: Gompers, Kovner, Lerner, Scharfstein "Venture Capital Investment Cycles: The Impact of Public Markets," Journal of Financial Economics.

These are the most basic materials.

This culture and market economies in general are faced with a serious challenge in the form of class warfare tempered by the darkest of ignorance. You, sir, do a great disservice to the same markets you claim to support when you, without basis other than what seems ill-formed opinion, make staunch claims about the benefits (or lack thereof) of complex financial transactions without the slightest connection to accepted fact. (Further, I notice- without surprise- you failed to provide citations to the many "studies" you claimed supported your initial position).

I make no apologies for being coarse with those intelligent enough to be knowledgeable, but to lazy or beleaguered with social agenda to be bothered. In this connection I also make no apology for calling your ilk as I see it- nor that fact that I do it with martini in hand. Coping with this sort of deliberate friction from the socially arrogant, intellectually brilliant and hopelessly complacent is a constant, taxing, upstream swim.