Thursday, May 23, 2019

There is a new Tariff in Town is the perfect epitaph for the past year of private equity investing. Threats of tariffs, imposing of tariffs, rollbacks of tariffs and increases in tariffs have created an atmosphere of commercial whiplash along the supply chains from China to the U.S. and back. Setting aside the arguments for leveling the playing field on intellectual property, quotas, and market accessibility, the frequency of moving the cost of goods has created a Marxist like, Groucho not Karl, world of chaos in commerce. Imagine asking the price of a chicken sandwich at a restaurant being told the following “$10 or $11 or $12.50.” That is the answer to ordering goods in the last six months that customers receive from vendors as answers are couched with no tariff or tariff rolled back, or with 10% tariff or with 25% tariff modifiers. The challenge of negotiating customer price increases and vendor “tariff burden” sharing is made trickier not only by the multiple changes in the tariff percentage, but also by the perception the tariffs may disappear in the near future. It has become the Brigadoon tariff for which some customers refuse to pay.

The agonizing way the tariffs and the trade negotiations are being handled begs the question “What comedians are in charge of this?” A quick scan of the world stage reveals that comedians seem to be a rising global power. Slovenia elected Marjan Sarec, a satirist, as Prime Minister in 2018. Last month, the Ukraine elected Volodymyr Zelensky, a professional comedian, as President. For years, Beppe Grillo, an Italian comedian, has led the largest party in its parliament. Guatamala elected Jimmy Morales, a comedian as President. Lifelong fears of “clowns running our countries” has come to fruition. Various comedians have led to the shutdown of the U.S. government for several weeks, in part over a $3 Billion funding disagreement, which was less money than Congress agreed to pay the government employees for not working those several weeks. Vital services were stopped, the safety nets for the vulnerable were impaired, government employees were forced to live hand to mouth, and national parks were closed for the government to spend more money than it would have spent to stay open. Other comedians have led Britain to the Brexit standoff where multiple votes are taken on the same plan by the same people on the mystifying hope the results will change. Millions of jobs are put at risk or removed from countries while rhetoric trumps common sense.

The same sort of pious decision making by soundbite rather than by analysis has penetrated the institutional investment world at the state level. The mantra “fees are too high” becomes a guiding principal ¬¬¬¬¬similar to the former New York State gubernatorial candidate Jimmy McMillan, whose platform was “The rent is too damn high.” Jimmy, it turns out, has lived rent free in Flatbush for a decade, but his slogan was remembered. If a state treasurer candidate ran on a slogan of “Our pension performance is below actuarial assumptions and the funding gap is growing”, she would run out of cardboard to print the slogan and not attract the press. A more simple “Fees are too high” chant, of course, ignores what net result the high level of fees might create.

Dale Folwell campaigned on this thesis to be elected treasurer of North Carolina and head of its pension fund. Upon election and over staff objections, in 2017 he fired several equity managers and reduced fees by $60MM and broadly declared victory. In the same period, North Carolina missed out on $400MM of gains due to the movement of the underlying assets from more expensive equity managers to lower fee burdened cash and bonds. Net losers on the “fees are too high” campaign were the pensioners and the NC taxpayers who will have to absorb the $340MM opportunity cost. To his credit, as the size of the net cost grew, NC has now quietly reversed some of these changes, but no public acknowledgement by Dale similar to his early anti fee campaign has followed.

We met with the CIO of a large municipal pension fund in the recent past who asked us the question “Do you think we should look at fees?” to which we responded, “Yes, but not to the exclusion of net performance.” We asked the CIO: If we had two candidates for CEO of one of our portfolio companies where one requested a $250K salary and had run one prior company with fair results and the other required $500K, but had doubled investor’s money in each of the two prior companies she had run, which would he choose? His response is lost to the mists of time, but the need for analysis to prevail over slogans is clear.

I’m Rob Morris and I approved this blog.

There is a New Tariff in Town