Jason Hartman: Welcome to the Creating Wealth Show. This is episode number 284. I’m your host, Jason Hartman. Thanks for joining me today. Last episode, I was talking with Steve during the intro portion of that episode and we covered a lot of things but we still have a few things we meant to cover that we did not cover including Fannie Mae, Freddie Mac, Warren Buffett, and our referral program that we just wanted you to know a little bit more about. Steve, welcome back. How are you?
Steve: Hey, I’m doing great. Thanks for having me.
Jason Hartman: Good. So, we went so long last time and what do you want to talk about today. We got to do a whole conversation about Hedge Funds and Oxif and the smoke and mirrors fake economy versus the real economy and income property being a fragmented market but that’s really the benefit of it. You had a couple articles and things that you wanted to cover.
Steve: Yeah but we went all over the place that’s for sure. We’re going to try to not do that again.
Jason Hartman: Come on, you know we will.
Steve: Okay, fine. Well, there was an interesting article I mean in the news titled Fannie and Freddie Becoming Words of the State which they certainly are. A word of the state under the traditional sense meaning somebody who is unable or unwilling to take care of themselves, sometimes even a prisoner and the states just completely in charge of them, they belong to them and we’ve all been told all Fannie Mae and Freddie Mac or private companies but anybody who is paying attention – there the US post office a private company. I mean all know it’s not true with all the funding that they get and so they are essentially on life support with the federal government that guarantees and the backing by the fed that they received allow them to do what they would able to do. I think what’s most important to mention here is if Fannie Mae wasn’t in, I’ll just call it cahoots that’s how I see it, with the federal government, the business practices that they’ve implemented would never, not in a million years, have allowed them to survive in the general marketplace, not a chance.
Jason Hartman: Yeah not a chance. I remember, who was it Franklin Raines? He just ripped that company off, left with a huge golden pair of shoe and during the day he was revered to some genius who was just creating a homeownership for so many people and doing all this wonderful things and I remembered going to a meeting of the Mortgage Bankers Association and it almost like reminds me of like Lance Armstrong. All you got to do folks and I don’t even know if the Lance Armstrong thing is really _____ [0:03:27] and seems like it because he gave up and stopped fighting it and he fell from grace and a lot of these people that are just like these revered people. This is why I never really put my stock in a single person. I believe in a political philosophy but I’m not going to believe in a person because I’ve just been led down too many times, I’m sorry if I’m so cynical, but I’m not going to say, “Oh, Romney, Romney, Romney”. I’m going to say, “no, I’m going with the philosophy.” Romney is a turnaround specialist. He is still a globalist just like Obama. I don’t think we’re ever going to get a real choice but given the choice, I mean, he is easily the better candidate. The country is a business and I want a businessman and they’re not a guy with no resumes, never done anything real in his life who has this past shrouded in secrecy. Where is his college records, all this kind of stuff right, enough of that. But the point being is that when you look at Fannie Mae and Freddie Mac they may become nationalize – the better thing would be to just let them go under and so many of our investors have said, “Jason, what if Fannie and Freddie go away and the mortgage market dries up and people don’t have access to all these great low interest straight mortgages, won’t that cause housing prices to decline?” Well, my answer is yeah probably. They probably will decline at least initially. They’ll decline I think so but guess what folks there’s always a counter balance to everything in life.
So say housing prices plummet and why did they plummet, well they plummet because people don’t have access to cheap mortgages with low down payments then the population is still increasing, people still need to place to live so what they enforce to do, another four letter word I really like rent. So, they are forced to rent. They only have three choices – they rent, buy or be homeless, and so rents the counterbalance to purchasing when I teach the three dimensions of real estate, this is part of it. If you see the housing market is fuelled by cheap mortgage money and low down payment mortgage money and ease of qualifying and so if you don’t have those three things then people can’t buy. If you do have those three things, they can buy like crazy and prices tend to go up and they create above all. We’ve been through that way too many times. We’ve seen those bubbles inflate. In fact, we see a bubble starting to inflate again now, it’s not that severe yet but I still think it has a long way to go but there are signs that a bubble is being blown up right now as we speak in the midst of this terrible economy and this fake recovery, but if people can’t buy they got to rent so Fannie Mae and Freddie Mac went out of business. I mean I would welcome that because rents would skyrocket and remember we’re cash flow investors. Our clients our cash flow investors. We’re not gamblers. One of the 10 commandments of successful investing is though shall not gamble. We buy properties that make sense the day we buy them and the way they make sense is from a cash flow perspective and I think if you see a republican congress and you see a republican president, you would just have a lot of pressure for no more bail outs, no more nationalization, no more bail outs to these criminals that basically run the banking system and so the likelihood of Fannie and Freddie being cast aside would be greater. Now if you have Obama and you have more democrats in congress, well the likelihood of kicking the can down the road and propping up these entities that don’t work and that are insolvent that will be higher, so then what do you have, well you’ll have a likelihood of a greater bubble being inflated. The rents won’t go up so much – rentals just do their normal thing. They all escalate as they always have throughout history but they’re not going to skyrocket like they would if Fannie and Freddie went away. If cheap mortgage money went away and then, ultimately a couple of years later the private market would start to come in and fill the needs. And instead of getting the mortgage for 3 or 4% well you pay 6 or 8 or 9% and prices would maybe adjust downward to compensate for the mortgage rates but rents would be much, much higher. So, if you like investing for cap rate, cash on cash return or overall return on investment not considering appreciation especially cash on cash, that’s the major one here. If you like investing for cash on cash return, you just better hope that Fannie Mae and Freddie Mac go under because that’s where you really going to be benefit. Steve, your thoughts?
Steve: Yeah. All very good points and kind of bringing it all around. We’re very close to the presidential election here and I was watching the news here and President Obama was out on the stump and it’s that point in the election where no matter what political party you belong to, you’re kind of nauseated with everything and hearing the same talking points over and over again and when the President Obama is more popular ones is, do we want to go forward or do we want to return to the failed policies of the past?
Jason Hartman: Yeah, I heard that one.
Steve: And he’s making illusions to Wall Street and policies of the previous administration and things and that statement always makes my blood boil because the failed policies in the past are well they’re from much further in the past going back to Fannie Mae and Freddie Mac like I said at the beginning of this. Fannie Mae and Freddie Mac have not had to behave like a business. They’ve had the government there to prop them up. We go back to these mortgage bank securities and these derivatives and that kind of things, if these investment banks and these people had to deal with true organic risk like we do as investors. They would have never made all those subprime loans. They would have never done all that crazy speculation but because Fannie Mae and Freddie Mac who are now words of the state where there to prop them up, they were free to run wild. I mean it’s like saying Wall Street just got greedy back in 2006, before they never were, right. I got news for you, Wall Street has always been greedy. Greed has always been around since the beginning of time and you put that big pile of money on the plate in front of them, that’s what they’re going to go for, that’s what they’re going to do and so we don’t ultimately what’s going to happen to Fannie and Freddie but like you said you make a very good point. In any case whatever happens to them, we’ve got to be opportunistic here and we’ve got to take advantage of this bogus monetary policy and the crony capitalism that continues to be spread.
Jason Hartman: What we have now the Obama regime is probably the most facetious regime we’ve had because they are so imbed with corporate American. Listen, George Bush wasn’t much better, he was slightly better but not much and so I’m not defending him either.
Steve: Well you have to qualify that because many times if you come out negatively against Obama you’re by default assumed be a rabbit George Bush supporter.
Jason Hartman: Yes of course. I support main street, I support small business and I know, look at folks, if we want to have cool iPhones, small businesses can’t make things like that. Small businesses can’t make automobiles or spaceships but we need major capital formation in some industries, there’s no question about it. Intel who has a plant here in Arizona and many others around the world, you can’t be a small mom and pop business and make integrated chips and circuitry. Those are things that require clean rooms and teams of brilliant people and very sophisticated software and incredibly complex manufacturing processes and all that. I get that, of course, but the thing you have is you have the situation where when the government picks winners and losers they never picked the little guy to be the winner. They picked Solyndra. They picked a big guy. They picked crony capitalism. They picked Fisker. They picked Tesla. They picked Solyndra. They picked that battery company that just went under, nobody is buying stupid batteries for the electric car, what a surprise. It’s like here you have all these, it’s just fascism. Crony capitalism and fascism are the same thing basically and that’s the problem. So, Wall Street has purchased the government, the government is bed with Wall Street and the whole thing is crony. People like to portray Wall Street as a republican and the environmental movement is democrat, that’s not true at all. I mean Wall Street likes big government. They love democrats. I mean there have been studies done showing that they support the parties about equally but the parties are just two sides of the same coin. I mean the only guy that was really any different was Ron Paul or Ralph Nader or Ross Perot. They really want a change but they were kept out of the system, out of the debates. It’s a scam.
Steve: Yes sir.
Jason Hartman: All things are scam, but anyway that’s what it is. Did we cover the Fannie-Freddie thing enough?
Steve: Yeah, I’ve think we’ve got that covered.
Jason Hartman: Alright, let’s talk about Warren Buffett. You just got to love this hypocrite. I’m looking at a thing here that says, “Buffett calls for taxing the rich while he sues IRS to avoid paying taxes” and it says, “Billionaire Warren Buffet knows how to separate his social activism from his business management. Over the past several months, as advisor to President Obama, Buffett has been calling for additional taxes on the rich and telling Americans he also would like to pay more to the government. However, on November 19th, I guess this is last year November 19th obviously, the true side of Warren Buffett, that of the business mogul, came to light as he is now suing the IRS to avoid paying more than $600 million in taxes levied upon Berkshire Hathaway subsidiary NetJets”. So, here he’s got a private jet company that Berkshire, his fund owns, and he is suing the IRS to keep them from paying $600 million in taxes, okay, total hypocrisy. Pot calling the kettle black, right?
Steve: I don’t even know what to say. I mean we were talking about Wall Street, it’s republican but this guy is a poster child on a Wall Street – it’s Warren Buffett, right? And everything that he’s doing leans so far to the left right now and he’s lying that I found to be just maddening about how his secretary pays a higher income tax rate than he does and this has been a big thing in the political campaign too. People saying I meant Romney doesn’t pay enough in taxes, what’s capital gains. You already paid tax on the money, you already paid the regular rate and Buffett’s not explaining that and then hoping that nobody has accessed to court records or press releases to see he’s suing the IRS and not to have to pay these taxes for like you’ve said of all things private jets. I mean it stinks to high heaven.
Jason Hartman: Yeah totally. It’s mind boggling. It really is.
Steve: People like Warren Buffett are very eager to give other people’s money to the government to spend. I had a friend who posts on Facebook today and he is very conservative guy and really likes to get a rise out of people. He said that he went and he gave blood on his own freewill and on his own choice and it felt great to do charity and I joke with mine and said you mean a bureaucrat didn’t write you a letter telling you that it was the right thing to do and by the way threatening you with civil and criminal penalties if you didn’t do the right thing?
Jason Hartman: You’re right.
Steve: And this went off on a whole tangent but that’s the fact. He is talking about more taxes, more taxes and he’s going to flush million of dollars and legal fees down the toilet, fighting with the IRS, why don’t you just send the IRS a check Warren?
Jason Hartman: I’m sure the IRS will be happy to take Warren Buffett’s check if he wants to pay more taxes. It is total bladed hypocrisy but here’s what we’re getting into. I mean I just filed a September well not the 15th but depends when the Monday falls but I don’t know September 17th or 18th whatever it was this year, was the final extension date for corporate tax returns. So, I have several entities so I filed hundreds of pages of tax returns on the last extension day. It seems like every year I want to get my taxes done early and it never quite happens that way but anyway and then on the last extension day, the following month just a little over week ago, in October, I filed my personal taxes, hundreds of pages long also. All these complicated tax returns. I mean the bills to the CPA are in the thousands and thousands and thousands of dollars, cost a ton of money but I got to tell you what meant Romney said during that second debate was so true because he talked about eliminating the loopholes and making the tax code flatter and Steve Forbes with his flat tax. Look out folks understand, I am benefiting from the system as it is. I don’t know why I’m complaining and railing against it because really I’m winning the game. I mean I hardly pay any tax at all. I make a great living by the way and I don’t pay much at all, I got to tell you, because I have so many deductions. I’ve got all these businesses, I got all these real estates and the non-cash write-off from depreciation on real estate is nothing short of a gift from God. I mean it is the best write-off if you can qualifies a real estate professional and take advantage of all those pass of loses, it’s phenomenal. It’s just unbelievable. I pay almost nothing. I mean it’s amazing because the other reason I pay so little in tax is because I do what I think Robert Kiyosaki really illustrated the best where he has those squares and rectangles and he talks about like the way the money comes in to your life – you make an income. Okay say you’re an employee, you make an income and then you pay taxes and then what’s left over you could spend money and pay for your life. Now, entrepreneurs and keep in mind if you don’t own a business but you’re just a real estate investor that is a business and you will have some nice deductions from that business. There are travel deductions available to you possibly, there are business expenses, there are educational expenses, what if you fly out to Miami and meet the master’s event from Europe, okay well now you have a different tax code if you’re in Europe, well you might be an American moving to Europe, anyway too complicated, but say you’re in New York and you fly to Southern California to go to meet the master’s event and that education and if you’re real estate investor you can start deducting a lot of these things, meals and entertainment, cellphone bill, a whole bunch of things, even a home office might be available to you. I don’t know I’m not a tax advisor. Check with your tax advisor, I’m not qualified and legal stuff. People you got to stop asking me about LLCs and all this kind of stuff. I’m not a lawyer so check with the lawyer.
Steve: Well, it’s very interesting on this state. It’s popular politically, well at least with approximately half of the country to say we need to increase taxes on the rich. I mean you could do that I guess but there’s a reason that they’re rich. Taxes are life biggest expense and they didn’t get rich by paying through the nose on taxes and the funny thing is, the congressman and the senators and all these people who write the tax code, they don’t want to pay higher taxes either, you know that they are putting those loopholes and those deductions in there for them to use so you raise taxes on the rich, you end up punishing the people who are none the wiser, end up punishing the middle class. Rich aren’t going more pay taxes. They’re not going to do it and there are too many ways to get around it. I mean it’s clear that taxes can get to a point where people will take evasive action. They will do anything that they can to get out of that. We could argue about whether that’s more role are, what’s their obligation so society is, we do that but that’s beside the point. People will try to get out of paying more taxes and that’s what in Warren Buffett’s bones here despite all of his rhetoric about people needs to pay more well when it comes to get out the checkbook now, I’d rather sue the IRS.
Jason Hartman: Yeah. Hey, it’s the old don’t do what I do, do what I say hypocrisy, but I just want to finish that example I was giving those, Steve, because it’s really instructive. So when you’re an employee and you don’t have real estate as a business and you don’t have a business of your own, if you’re an employee you should definitely have some kind of business on the side, I’ve always said that, the place where you can gain some tax benefits and deductions and so you get to pay for your life based on the net but as a business owner and/or a real estate investor or blend of both, you get to pay for your life after you get the income but before you pay government on many of that items because many of those items are business expenses that you can legitimize in to your business and then you only pay tax on the net not the gross. It is an incredible, incredible difference and taxes are life’s largest expense and then we don’t even need to explain depreciation and pass of lost write-offs I mean those are the biggest give ever because that’s a totally non-cash write-offs so nothing could be better than that.
Steve: Right.
Jason Hartman: But yeah Warren Buffet ridiculousness and the other thing to say, Steve, is he’s an insider like remember when the financial crisis was really bad and he went put like $5 million dollars in to Bank of America stock or something and bragged about those who’s buying stock in Bank of America, well he didn’t pay the same price, you were paying on the open market. This is just – it’s cronyism to the max folks. It’s just you can’t trust these people – trust yourself, that’s who to trust. Enough on his berating Buffett.
Steve: Yeah, we’ve beat him pretty good.
Jason Hartman: So, I hope I don’t get a phone call on that but if I do I would love to have him on my show but I hear that he only does interviews with good-looking female reporters or you buy his lunch with Warren at charity event, pay $200,000 to have lunch with him.
Steve: Well, if he calls you conference me because I have some questions.
Jason Hartman: Okay good. I’ll do that. But the other thing I want to just remind everybody, before we go to today’s guest is that and I’ve mentioned this a few times but not much we have a referral program and if you hold a real estate license or if you’re in a country where a real estate license is not required, we can pay you referral fees on business you referred to us and Randy, a financial planner that I’ve had on the show before in RIA, a registered investment adviser I should say, he wrote me an email recently and he was talking about one of the clients he referred to us and he said, “Jason I just got off the phone with another financial planning client who is going to buy some real estate, some properties”. They referred to me by and this is one of our clients whose name is I won’t mention by the way and he says, “I’m writing you this email to let you know how much fun this is for me seriously. As an RIA, I’m able to offer my clients literally every financial product traditionally available. That said, there are quite a few RIAs out there that can provide all or most all of these things as well. However, it’s a huge differentiator to be able to incorporate real estate investments in to my client’s financial plan. Thank you for creating such a great system for me to help my clients”. And that’s Randy Luebke, who’s probably going to listen to the show who doesn’t even know I’m reading that email but I’m sure he won’t mind. I hope he won’t mind, but folks we have a fantastic referral programs. So, if you have clients and you’re in the real estate business, I know we’ve got lots of real estate and financial people and the financial people by the way listening to the show when I say financial people I mean RIAs, registered investment advisors, financial planners, people working and selling various Wall Street investments and so forth, I just want to give you a shot out to say, hey appreciate you still listening to my show because you’re pretty tolerant of my Wall Street bashing. I must give you a credit for that but I know frankly a lot of you kind of go to work and kind of bite your tongue and you know Wall Street is a big scam but you’re working within that environment and you look for the best products you can for your clients and so forth and income properties isn’t for everybody that’s why I think hard money lending or private lending is so good because it’s so simple, so much simpler than properties. The return is not quite as good but 12-12.5% isn’t bad. There are some great opportunities there too but if you have anything to mention on our referral program, I know you’ve got a couple of clients who are licensed, who are starting to refer business to you and you’re their investment counselor. I know Sarah, Molly, and Ari and Terry and Dave, investment counselors have all benefited from this, any thoughts on it that you wanted to share?
Steve: Well, first of all. You don’t have to any other work, that’s what we do, that’s what we’re here for and we go through a lot of effort to work with our clients. I’m aware of a couple competitors to the company that don’t really do anything. They just say here’s your property good luck. I mean we go through a lot to help these clients out and you can pass them off to us with confidence, we’re going to take care of them, answer their questions and go to bat for them when necessary. So, it’s pretty easy for you to do.
Jason Hartman: Yeah good stuff. Keep that in mind if you have – you can earn some nice extra income referring people us and this is all totally above board, you have to have a license to do it and we can do broker to broker referrals. So, keep that in mind and make sure you get registered for our Meet the Masters event coming up and Steve, thanks for joining me again today and let’s go to our guest. We’ll be right back with our guest in just a moment.
Female: Sometimes I think of Jason Hartman is a walking encyclopedia on the subject of creating wealth.
Male: Well, you’re probably not far off from the truth Penny because Jason actually has his free book set on Creating Wealth that comes with 60 digital download audios.
Female: Yes, Jason has that unique ability to make you understand investing the way it should be. It’s a world where anything less than 26% annual return is disappointing.
Male: I love how he actually shows this how we can be excited about these scary times and exploit the incredible opportunities to this present economy as for this.
Female: We can pick local markets untouched by the economic downturn exploit package commodities investing and achieve exceptional returns safely and securely.
Male: I also like how he teaches you to protect the equity in your home before it disappears and how to outsource your debt obligations to the government.
Female: And the entire set of advance strategies for wealth creation is being offered at a savings of $94.
Male: That’s right and to get your Creating Wealth Encyclopedia Series complete with over 60 hours of audio and three books just go to jasonhartman.com/store.
Female: If you want to be able to sit back and collect checks every month just like a banker, Jason’s Creating Wealth Encyclopedia Series is for you.
Jason Hartman: It’s my pleasure to welcome, David Carey to the show. He’s a senior writer for The Deal, which is senior writer for The Deal, a news service and magazine covering private-equity and mergers and acquisitions. Before joining The Deal, he was the editor of Corporate Finance magazine and wrote for Adweek, Fortune, Institutional Investor, and Financial World. He also has appeared often on CNBC and it’s a great pleasure to have him here today. David, how are you?
David Carey: I’m fine. I’m delighted to be on your show.
Jason Hartman: Well, the pleasures all mine. So, private equity it’s been something that’s come to the forefront lately with Mitt Romney and Bain Capital and of course, what’s going with the election and sometimes ridiculous childish attacks but explain to the listeners if you would. First of all, what is private equity?
David Carey: This is something we attempted to convey in the book I wrote which is King of Capital with John Morris and it’s tell the story of Blackstone group and the creation of the firm and also we talked about the Evolution of the Industry and we also tried to explain to light readers how private equity works and how private equity firms make their money in the impact they have on the economy. Private equity is a type of investing where you deploy capital in companies privately rather than in the public market and it can take various forms from injecting money into healthy companies for them to grow faster or infusing equity to shore up troubled companies and get them back on their feet. The most common form of private equity is what called the leverage buyout or LBO and these are corporate takeovers done by firms like Bain Capital which Mitt Romney founded, where you buyout a business from an existing shareholders using large amount of debts and of course leverage is so synonym for debt. These types of deals got a lot of press during the boom years leading up to the financial crisis when you had a string of record shuttering 20 billion, 30 billion, 40 billion dollar buyouts of very big corporations like _____ [0:29:52], the casino operator, Hilton Hotels and HCA the country’s biggest hospital group and Dunkin Donuts and Burger King were also gabbled up and leverage buyouts and by leveraging the purchase, borrowed money, the buyer puts up only a fraction of the purchase pricing equity and that magnifies the backing profit on your sale. It’s similar to buying stock on margin or buying a house with the mortgage definitely flipping it for a gain on your equity. One big difference though is the private equity firms aren’t responsible for paying down the debt the way a homeowner pays off a mortgage instead the company that’s being acquired takes on the debt and takes the debt on to its balance sheet and retires the debt overtime using its own cash flow.
Jason Hartman: So, it’s basically all leverage buyouts then? Is that the way all private equity deals a structure?
David Carey: No as I said initially there are a lot of leverage buyouts, the most common form of private equity.
Jason Hartman: Right.
David Carey: It can also involved on leverage deals and as I’ve said injecting capital where you actually putting equity and takeout debt. It can be the opposite of it. But for mostly they are debt funded buyouts and I also wanted to say that the best private equity firms out perform stock and bonds by wide margin and that’s not just for the use of leverage as I described. It’s also get high returns by stream lining, improving, growing and improving the profitability of the companies lead by and these are big funds of the large pools of money from outside sources and they get their money from financial institutions. It’s interesting in spite of the image private equity has of being at least with the democrats, being a job destroyer and the enemy-looking man, the biggest single outside source with private equity is public pension funds so that’s union money.
Jason Hartman: Right.
David Carey: It’s kind of interesting.
Jason Hartman: Well, that is kind of interesting actually in light of the Obama attacks on Romney and Bain Capital because you accused them of shipping jobs offshore and so forth and oddly he’s investing with union money at times, right. That’s sort of a paradox.
David Carey: Exactly.
Jason Hartman: He’s getting the union a good return on their money.
David Carey: He’s asking private equity executives to contribute to his campaign.
Jason Hartman: That’s strange. That tells us in politics, for sure huh?
David Carey: Yeah
Jason Hartman: Let’s kind of drill down a little dipper on the attacks on private equity and Bain Capital and Mitt Romney if we could since it’s so topical right now, your thoughts about them.
David Carey: Well, it’s rather pretty heated and it’s not just coming from Obama, you recalled it during the republican primaries, Governor Rick Perry, and being _____ [0:32:44] Romney of ultra-capitalist and the popular character of private equity hardest since that they’re kind of scorched earth financier _____ [0:32:56] companies and leave a trail of lost jobs and ruined lives when they are awake. I’ve been covering the industry for how many years and I think them on balance. Private equity does far more good than harm. It’s true that private equity firms focus first foremost on their own profits but the most effective means to generating profit is to nurture and regenerate companies not to destroy them and sometimes involves replacing managements or genociding unprofitable operations or reducing bloated costs and head count, firing people but these are the kinds of moves that all successful corporations sometimes must make in order to remain competitive. Successful companies constantly redefine and reinvent themselves to get ahead. And it’s interesting in private equity that cost job cuts often substage for future growth and future job creation. Its interesting, studies have shown that private equity firms frequently do tend to cut more jobs in similar companies that aren’t private equity on their first year or two after they buy them. Then they add jobs back at a faster rate and the difference is even heard after four or five years. So buyouts have gone day and this is some of the deals of Bain’s that have been front center in the press this can happen when buyers pile on too much debt unless what Bain did in four cases that has been written about extensively, either way the companies initially did well and Bain loaded them with more debt to finance, awarded itself a dividend and the companies, fortune savored and tripped into bankruptcy. These are troubling cases of course and it is only natural that the Obama campaign would blast away at them. And there’s also the exception of the rule when Romney led Bain the firm made around 80 investments and the vast majority haven’t kind of expanded and the companies grew and prospered.
Let me throw out another statistic despite the risk of default and bankruptcy becomes with the territory because you’re buying a large amount of debt by these companies, the failure rate for LBOs is actually quite low. A recent study showed that on average just 1.2% of private equity on businesses defaulted every year from 1970 to 2007 or 37 years and when included three recessions and the failure rate of companies that have debt funded dividends like the Bain deals in fact it’s even lower on average and I think lenders have to put up the money for these and they gotten very cautious about the kinds of companies that they are willing to do this with and typically these are companies that have already paid off a lot of debt. They have very healthy cash flows and very sturdy and those are actually the kinds of business that private equity firms prefer to buy although Bain actually initially specialize in turnaround cases which by companies really need to be fixed up and most tend to have a higher failure rate.
Jason Hartman: And they’ve probably have failed anyway if the company like Bain didn’t come along and rescue them.
David Carey: That is very true.
Jason Hartman: Right.
David Carey: Yes absolutely.
Jason Hartman: It’s sort of impossible to address a question like that. They say well some of these companies failed, well all of them probably would have failed if someone didn’t come along and help them out, but when you look at private equity, I mean is there sort of an average deal size in the private equity world?
David Carey: They range all over the map. I mean the top end in 2006-2007, there was one deal that grand out of them all was the Texas Utility Company (TFC) and that was a $48 billion buyout by KKR and TPG. There are thousands of private equity firms that invest in all size businesses and they could end in million dollar investments or less, sort of the middle tear of the market which is deals up to billion dollars in size that’s called the middle market and then you have the large cup market which is above a billion and then you have the lower middle market and small cap, it’s kind like the stock market. It runs a spectrum.
Jason Hartman: Would some of these private equity deals that are so large, I mean you mentioned the big granddaddy deal, the Texas Utility Company for $48 billion, a large deal size, I mean why aren’t these IPOs, why are they using private equity instead?
David Carey: Well, a lot of these companies were troubled like at that time. If they were acquired by the private equity funds and their stocks had created down the hill, some operating problems maybe a few couple of quarters of bad results, shareholders got restless, the board may need to figure out a way to maximize shareholder value and so then the private equity firm comes in and places a bid that’s in a significant premium to the existing share price.
Jason Hartman: Right. That’s the example of the reverse deal, but are there companies that just want to stay private with private equity and not go to the public markets at all that have never been public?
David Carey: Absolutely and sometimes if you know, if you want to change in ownership, there are a lot of family run businesses that would prefer not to sell a stake in to the public equity markets because they want to maintain a greater role on the business. This is a prime example of one thing — and the private equity can be of more palatable alternative to the public markets for like entrepreneur who’s reached retirement age, he wants to leave the business in the family, he does not want to sell it to competitor and he doesn’t want it to take it public. So the private equity can come in and buy a majority or minority stake so the family can maintain its presence and activity in the business and that’s type of deal actually was kind of the way that private equity started out. It’s an alternative capital market, it’s an alternative way of reaching liquidity and that’s something that a lot of business owners just prefer.
Jason Hartman: I would thing though that the business owners would maybe be getting a lower valuation because there’s so much money in the public markets. I mean there’s a lot in private equity too but the public markets are obviously larger and do you think some of them actually make the decision that are going to take possibly a lower valuation that they could do better in an IPO scenario than they could do in private equity?
David Carey: Well, sometimes they do. I mean in the case I was talking about where they keep some grip on the business that maybe willing to take a lower valuation but I will tell you there something if the private equity firm comes along and wants to buy the majority, there is something called a control premium that they pay. So, typically they are willing to bid more than what the valuation of the company might receive in the public market because the private equity firm can come in, call the shots, make the changes and not be a passive investor and realize more value that wait for itself and is willing to pay up to do that. So a private market valuations are extremely high and a lot of these companies are scowled in very heated auctions with lots of private equity bidders. I followed these things all the time and DuPont just divested its car paint business to a private equity firm called Carlyle Group and they are like seven or eight bidders and they paid a pretty higher multiple for it. You’d be surprised the valuations that privately sold…
Jason Hartman: It’s kind of interesting because I don’t ever remember really hearing the term private equity before say I don’t later maybe 10 years ago, where was it, I mean obviously there were private companies buying other private companies I mean that’s not a new thing. How long it has been around or it’s just sort of a new term in a Lexicon really?
David Carey: Well, I tell you it’s private equity sort of appeared on the horizon around 1991 or 1992, that’s when I first heard. It’s originally people on the business were called LBO artist. I think LBO artist got a little bit of tarnish in the late 80s because a lot of them were funded by the guy controlled the leverage debt and jumped on markets was, Michael Milken and so a lot of these guys were funded by this chap who ended up going to prison and it’s part of the late 80s insider trading scandals. And it was partly – kind of added a little more luster to the image I think they calling themselves private equity. I think it’s kind of public relations.
Jason Hartman: Well, I have to say that the name LBO artist does not – it’s sort of strikes me as a con-artist. I don’t think that’s a very good name.
David Carey: Right, that’s what they were typically called the corporate raiders.
Jason Hartman: The Carl Icahn and T. Boone Pickens that was a sort of fascinating time in history. So, all of that stuff…
David Carey: And now Carl Icahn, by the way calls himself a shareholder activist who is no longer a corporate raiders.
Jason Hartman: Well, I bet he’s mostly an activist for himself when he’s a shareholder.
David Carey: Exactly.
Jason Hartman: I mean that’s very interesting. But you know all of that stuff really that was such sort of corporate folklore in the 80s and there so much coolness around it with the movie Wall Street, of course, and just all the stuff you heard back then, all of that same stuff really still goes on now a days, right? I mean there are corporate raiders who buy companies because they can split up the assets and sell them off piecemeal for more than they can buy the whole thing for and they still do all the same things right?
David Carey: I think the split-up scenarios you don’t see them much anymore. For one thing, there aren’t any inviting targets out there. You don’t see too many huge corporate conglomerates because a lot of the conglomerates, the individual pieces didn’t match up well in the stocks trade. They did a ridiculously low valuations so the companies, the conglomerates starting with RCA or Wickes or all the big conglomerates that had been built in the 60s, they all kind of dismantled themselves in the 70s and 80s. I wouldn’t say that is the most common scenario you have seen in buyouts. You usually see companies doing the opposite though by small private equity firms will do, a build up where they’ll buy a small core business and then they’ll extend it territorially on to other products, complimentary products until forth through add-on acquisitions. So actually being an inquisitive mode in building up and not looking – the break-up scenario was not very common these days at all although that’s certainly which I read about in the 1980s.
Jason Hartman: Well, I think the reason it got so much negative PR is because it always involved mass layoffs, right?
David Carey: Not always. I think it’s just the whole idea of buying a company and busting it up just – there’s kind of a superficial, it’s kind of very appealing or nice idea but the fact is that a lot of these companies have been benefited from being sold off. I mean a lot of individual pieces of a large conglomerate like RCA, they were kind of orphan businesses. They weren’t really paid a proper attention too but had offers, they were underfunded and in fact instead of private equity firms that coming in and buying out these large let’s say a company but you see big companies kind of falling off pieces non-core businesses which private equity firms then buy up. I mean a lot of so-called busting up or dismantling is undertaken by the conglomerates themselves. Their hand isn’t necessarily forced…
Jason Hartman: Right, it’s not forced to do.
David Carey: By some corporate raider. I mean some of these stereotypes of a bust-up, they kind of worked to go in to the popular consciousness and yes they can and it’s the same thing about the caricature of the Mitt Romney. I mean there’s only the grain and fruit and some of these stereotypes are very small.
Jason Hartman: What I asked is, what’s the alternative? For example and let’s just talk about Mitt then will wrap up here but one of these Obama commercials that I continued to see is the one about a deal Mitt did and how the factories were empty, in other words there were no workers there because he shut them down and Obama is claiming he shipped the jobs offshore but what they don’t tell you is that maybe those jobs would have been lost anyway, maybe that company would have closed and all of the consumers that are buying those products are getting them at lower prices and they’re getting more choice. It’s such a misnomer the way they characterized then of course well you said to your point earlier in the interview which was that many of these union groups that support Obama are the ones who invested with private equity companies like Bain Capital, like Romney’s company. So, aren’t they the profiteers? Aren’t they the evil ones?
David Carey: They’re certainly the enablers and there’s a certain amount of hypocrisy involved but its funny some firms actually kind of – some private equity firms have very good relations with unions and others that dismiss the unions and the unions attack. It’s all – I mean there’s nothing is what it seems and everyone have some kind of agenda and the practices Mitt Romney is blamed for I mean as I said it’s American capitalism – it’s not a European style of capitalism which has more safety nets and stuff. It’s really peer-free market capitalism and I think private equity is the ultimate expression of that and I don’t think that’s bad. I think you make a company stronger and improve its bottom line. It will have all kinds of insular benefits. You will have a stronger competitive position and in turn it will be able to grow and hire more people too. I mean a stronger company is a company that can employ more people. If you are burdened with bloated workforce, you’re going to suffer competitively, you’re going lose revenues, you’re going to be forced make layoffs. I mean I think the free-market model is really the one that creates the most wealth for the most people.
Jason Hartman: Yeah, well obviously it does. It’s not perfect, it’s just better than everything else, I think Churchill had said. One last thing for you before you go, at the republican national convention we saw one of Romney’s business partners in Bain Capital talked about how they started that firm and I think it made a lot of people curious. How does one start a private equity firm, like what happens? They just hang out a shingle and then they go to investors and try and raise money and then they go to businesses and say, hey do you need money? Can we rescue you? I mean…
David Carey: Yeah. It was Blackstone, the early chapter in the book was about the money raising. It was almost comical _____ [0:49:35] Pete Peterson who was a former commerce secretary under Nixon and Steve Schwarzman, they had both worked at Lehman Brothers and they have star power on Wall Street but private equity was in the business. They had rich experience investing and so they just went out and kind of hat in hands. They are going to raise a fund and some of the stories they told about the slides they receive I mean they took a trip to Boston to MIT to talk to pension fund to see if they can raise some money. And the person that they totally forgotten _____[0:50:13] and so they were turned away in the afternoon and they had to walk back, they were caught in downpour and hard time catching, they were totally swapped before they finally got back to the airport. They suffered a lot of indignities and private equity – it was a new industry and you go out hat in hand and they had a very tough time making their case. I don’t know – I mean Romney himself has said that Bain Capital had kind of a tough time, of course, that business was sprung out of Bain and company which is a really well known and respected consulting business founded by Brooke Bain. And they just decided, they will bring over all their managerial expertise to improve in business and they thought, hey we’re doing this for other people, maybe we can make some money for ourselves as investors and that was the idea behind Bain but Romney himself – he was pretty tough slogging in the first few years. If you’re interested in hearing about the genesis of Blackstone which today’s the biggest part of equity firm on earth. We had some stories on that and next would be pretty interesting and entertaining reading.
Jason Hartman: Very interesting. Sure does, well tell people where they can get the book.
David Carey: Well, last I saw it was still in bookstores. The original hard cover edition was published in October of 2012 and then came out with the paperback edition this year in February. It’s certainly available on Amazon, if you want to order it there. It’s called King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone and the publisher is Crown Publishing and those who preferred reading it in Japanese, Korean and Chinese, it’s been translated in those languages and I understand it’s in fourth printing in Japan.
Jason Hartman: Fantastic. Well, David Carey, thank you so much for joint us today. The book is the King of Capital and learning more about private equity. We often talk about the public markets and the various Wall Street scandals on the show but it’s interesting to hear about the private sides. So, thank you for telling us all about it.
David Carey: Well, thanks for having me.
The Jason Hartman Team
Transcribed by: Renee
