The Great Deformation (105 page)

The magic wand, however, came in the pro forma “adjustments” to earnings. The company had actually reported 1995 operating earnings of a scant $1.5 million and a net loss after interest and taxes, but in a five-page bridge table which was a wonder to behold, the offering prospectus detailed several dozen pro forma “adjustments” that envisaged the newly minted amalgamation of companies, Ampad-Williamhouse-Globe-Weis-Niagara, as a gusher of profits. Its interest costs had tripled, but thanks to “synergies,” cost savings, and future operating improvements the $1.5 million of actual 1995 earnings were to be viewed as $57 million of pro forma operating income.

This $57 million result included a lot of chickens which had not yet hatched. For example, $8.5 million of higher operating income was to be from the Niagara Envelope acquisition that had not actually finalized as of the IPO prospectus. Likewise, a savings of $4.5 million was cited from closing Williamhouse's New York City headquarters, even though rent and severance costs several times greater were buried in purchase accounting and would be paid for years to come.

Yet by July 1996, the Greenspan stock market bubble had a goodly head of steam. This meant that Ampad had no trouble selling nearly $250 million of stock based on a prospectus riddled with pro forma adjustments to the point of incomprehensibility, and a “growth” story that strained
credulity. Bain Capital was able to sell to credulous IPO punters another $50 million of its stock, bringing its return to over $100 million and the fabled twenty-bagger. Meanwhile, the hedge fund speculators pumped the company's stock to a peak of $26 per share by late summer of 1996, making all the more evident that the Ampad deal was really about speculative mania on Wall Street, not a revival of “old yeller” from the bits and pieces of a dying industry.

The company's combined debt and equity was then being valued at $1.1 billion, or a fantastic 35X the $30 million of operating free cash flow (EBITDA less Capital Expenditure) that Ampad actually posted during 1997. However, within weeks of the IPO and a profits warning, the fast money smelled the rat and followed Bain in scampering off the listing ship. Margins were being squeezed by the superstores faster than the promised synergies could be realized. By early 1999, the stock was delisted and when the company was finally liquidated in bankruptcy shortly thereafter, secured lenders recovered about $100 million and other creditors got zero; that is, the company was worth about 10 percent of its peak valuation.

Once again, the moral of the story is about the ill effects of bad public policy, not just that smarter speculators like Bain bagged the slower-witted. In fact, LBOs are just another way for speculators to make money, but they are dangerous because when they fail they leave needless economic disruption and job losses in their wake. That's why LBOs would be rare in an honest free market; it's only cheap debt, interest deductions, and ludicrously low capital gains taxes which artificially fuel them.

BAIN'S $165 MILLION SCORE ON EXPERIAN:

LEVERAGED SPECULATION WITHOUT BREAKING A SWEAT

In September 1996, Bain Capital and some partners bought Experian, the consumer credit reporting division of TRW Inc. for $1.1 billion, but Bain ponied up only $88 million in equity along with a similar amount from partners; all the rest of the funding came from junk bonds and bank loans.
Seven weeks later
they sold it to a British conglomerate for $1.7 billion, producing a $600 million profit on their slim layer of equity capital and after not even enduring the inconvenience of unpacking their brief cases.

Quite obviously, Bain Capital generated zero value before it flipped the property. So the fact that it scalped a sudden and spectacular $165 million windfall gain has nothing to do with investment skill or even trading prowess. Instead, the Experian corporation's $600 million valuation gain in just fifty days smelled like an Inside Job.

That explains how a division put on the auction block by one of the nation's most prominent deal makers, CEO Joseph Gorman, could have been
so badly mispriced in the initial sale to Bain Capital and its partners; that is, how they got it for just 65 percent of what the property fetched only months later.

In fact, the original auction had been run by Bear Stearns, and it became evident in March 2008 that Bear Stearns had never been in the client service business; it had been in the brass-knuckled trading business where it used its balance sheet to underwrite and trade immensely profitable “risk assets.” Not surprisingly, the private equity houses were the premier source of profits for its trading and capital markets desks, so its “investment bankers” needed little encouragement about where to steer corporate divestiture deals.

In that endeavor they got plenty of help from the inside management of spun-off divisions, who were usually marketed as a “key asset” of the business and eager to participate in the prospective LBO. Thus, Experian's CEO D. Van Skilling and his lieutenants reaped millions from this Wall Street–orchestrated windfall almost before they got new business cards. Oblivious to the irony, however, Skilling defended Bain's instant $165 million profit by insisting “there was never a hint of financial chicanery at all.”

He had that upside down. The deal was pure chicanery, but not because the private equity investors were underhanded. It was because they were artificially enabled by the central banking and taxing branches of the state, the true source of this kind of rent-a-company speculation.

THE WESLEY JESSEN HOME RUN:

FAR LESS THAN MEETS THE EYE

Wesley Jessen was a small specialist firm that did reasonably well in cosmetic eye-color lenses and toric lenses to correct astigmatism. In mid-1995, when Schering-Plough Corp put it on the block, Bain Capital bought it for $6 million and reaped a $300 million profit for itself by 1999; that is, it made nearly 50X its investment in the same number of months. On an apples-to-apples basis, however, the company's operating income rose by only 2X during the same period: all the rest of the gain, $275 million to be exact, was due to massive leverage, the Greenspan bubble, and accounting maneuvers that can fairly be called myopic.

Bain employed a hoary old dodge: having its accountants write off every dime of plant, equipment, and intangible know-how, reassigning roughly $40 million to the inventory accounts, and then charging it to income in the immediate two or three quarters. This trick eliminated all future depreciation, thereby magically adding $14 million to the pro forma operating income on Wesley Jessen's $100 million of sales.

Investors were promptly told to ignore the resulting losses, of course, since these inventory charges were “nonrecurring”! In fact, savings from pre-deal “restructuring” actions by the seller plus the accounting magic generated $24 million of freshly minted “operating income” before Bain's turnaround squad even showed up at the company's Des Plaines, Illinois, headquarters. The alleged “turnaround” of Wesley Jessen was thus largely an artifact of Bain's PR machine.

In the fourth quarter of 1996, the company borrowed $70 million to acquire a competitor, Barnes-Hind, from Pilkington plc. Before the ink was dry on the merger contract, Bain filed an IPO prospectus. While Barnes-Hind had an operating loss of $17 million the year before the merger, its results for that period were improved by $23 million owing to Bain's pro forma adjustments, creating the appearance of another dramatic turnaround.

During the twelve months ending at the merger date, the combined companies had actually incurred a net loss of $27 million, but it vanished with the help of $50 million in pre-tax adjustments for merger accounting and prospective savings. So its pro forma earnings took on a decisively improved aura; that is, it would have booked a $14 million profit, or about $0.73 per share.

Not surprisingly, the stock market eagerly scooped up $45 million of new shares at $15, or twenty times these gussied-up earnings, just in time for the Fed to begin a new round of stock market goosing in March 1997. And that proved propitious for Bain. Almost to the day on which its 180-day IPO lockup expired, it sold its first batch of shares in a secondary offering in a now red-hot stock market at a red-hot price that was up 60 percent from the IPO.

Wesley Jessen had not then filed financial statements with even $1 of GAAP net income, but when Bain's underwriters wired the proceeds in August 1997 the selling price was $23.50 per share. That's 52X the $0.43 per share it had paid for the stock twenty-five months earlier. At the end of the day, massive leverage, fancy accounting, and bubble finance, not entrepreneurial prowess, were the source of Bain's fifty-bagger.

THE GREATEST WINDFALL EVER: THE ITALIAN JOB

In November 1997, Bain Capital pulled off a veritable capitalist heist in the socialist redoubts of the Italian yellow pages. On a $17 million investment in the Italian phone book, it took out a profit of $375 million. This was not only a twenty-two-bagger, but for Mitt Romney it was the ultimate in no-sweat riches. According to the company's CEO, Romney's sole involvement was a cameo appearance during a due diligence session: “He came into the
room, asked a couple of very sharp questions immediately, shook hands and left.” Twenty-eight months later in February 2000, Romney's former colleagues at Bain located him during his tour of duty in Salt Lake City, where they wired his share of the winnings, a reputed $50 million.

Bain and a syndicate of private equity houses were originally brought in as a stalking horse to validate the government's “privatization” machinations. At the time, the key Italian treasury official was one Mario Draghi. His assignment was to get the nation's huge deficit down to a Maastricht treaty–compliant 3 percent, and he elected to do so by means of a rent-a-balance sheet ploy of the type then in favor.

The short story is that Bain and the other investors paid 5X the company's operating income for their shares, and were paid 100X operating income to leave when local circumstances obviated the need for the rental deal. That preposterous multiple expansion accounted for virtually all of Bain's twenty-two-bagger.

In the interim, the dot-com bubble reached it fevered peak, so Italy's lumbering phone book publisher had puffed itself up as a fleet-footed Internet company, claiming to be the next AOL. In the fog of 1999's worldwide financial bubbles, a group of corporate raiders who did not have two nickels to rub together then got control of Italy's storied typewriter maker, Olivetti, and parleyed massive borrowings through that vehicle into control of the Italian phone company.

Now hoist atop a stupendous house of cards, the raiders next went after Italy's gussied-up yellow pages, paying $24 billion, or 180X net income, for a business that was slithering into the sunset. In fact, the exit value reaped by Bain top-ticked Greenspan's NASDAQ bubble in February 2000 and since then has shriveled to the vanishing point. Never have a group of private equity men laughed more heartily on the way to the bank.

The Bain Capital investments here reviewed accounted for $1.4 billion, or 60 percent, of the fund's profits over fifteen years. Four of them ended in bankruptcy; one was an inside job and fast flip; one (Wesley Jessen) was essentially a massive M&A brokerage fee; and the seventh and largest gain, the Italian Job, amounted to a veritable freak of financial nature.

In short, this is a record about a dangerous form of leveraged gambling that has been enabled by the failed central banking and taxing policies of the state. That it had been offered as evidence that Mitt Romney was a deeply experienced capitalist entrepreneur and job creator is surely a testament to the financial deformations of our times.

It is also proof of why 2012 was the sundown election. Mitt Romney was the very apotheosis of bubble finance. By embracing his candidacy and proffering his Bain Capital record as that of a “job creator,” the conservative
party demonstrated that it no longer had a clue about the cause of the accumulating ills afflicting the nation's economy and deeply unsettling its electorate.

The Republican Party needed to be against everything which made Romney possible; that is, the whole machinery of bubble finance. It needed to denounce the Fed's lunatic bond buying, its destruction of interest rate pricing signals, its pegging and propping of risk assets, its provision of free overnight money to the carry trades, and its trashing of the dollar's external value. Likewise, instead of yammering about tax cuts for the job creators, it needed to attack the deep tax subsidies for debt and capital gains and the false prosperity flowing from massive federal deficits, even if it took new taxes such as on energy or consumption to close the gap.

Finally, it needed to acknowledge that the vast overfinancialization of the American economy and the rampant speculation embodied in Wall Street's financial engineering games were not the natural outcome of the free market. Instead, they are the spoiled fruits of printing press money and chronic fiscal profligacy. These deformations, in turn, had resulted in massive windfalls that had accrued to the top of the income ladder, and most especially to the 1 percent at the very top.

In short, the bubble of opulence at the top of the nation's failing Main Street economy was neither natural nor defensible. Obama sensed it, and offered demagoguery. The Republicans denied it, and offered Romney.

INSIDE THE FINANCIAL BUBBLE: LESSONS LEARNED LATE

I learned these truths the hard way, staring at the prospect of spending my remaining years as a guest in one of Uncle Sam's cell blocks. It turns out that my fraud indictment had been a case of a prosecutor gone wild and all charges were dropped by the government “in the interest of justice.” But I had gotten into this pickle not for violating any statute or accounting rule, but because I had plied an LBO trade right to the very edge of sanity.