Michael Lewis ("Liar's Poker," "Moneyball") examines Wall Street's "class system without class resentment"

December 12th, 2006

Stocks — Coach Class of Capitalism: Michael Lewis

By Michael Lewis

Dec. 11 (Bloomberg) — One of the miracles of Wall Street is its ability to create a class system without class resentment.

At any given time in the capital markets there are at least two sets of rules–one for the rich and well-connected, another for the middle class, the Wall Street proletariat. The upper class rides in the front of the plane with their venture capitalists and hedge-fund managers; the proles ride in the back, with the mutual-fund managers.

There is, you might think, a war waiting to happen between the Haves and the Have-Mores. And yet no one much complains. One group of people simply expects to earn 20 percent or more per annum on their capital, the other is more or less content when their mutual fund underperforms the market only slightly.

That's not to say that the proles from time to time don't work themselves into a tizzy. When some Wall Street analyst is getting caught speaking ill in private of a company he has promoted in public–especially if he is caught immediately after a general stock market collapse–the proles take to the streets with their pitchforks and torches.

But they don't seem to be disturbed by the inequality inherent in the financial markets in good times. So long as common stocks are rising and their money isn't obviously stolen–that is, so long as the proletariat enjoys steady, if unspectacular, returns on its capital — the investment lower class is surprisingly docile. It's as if the pleasure of any return at all has distracted investors from a comparatively low rate.

Reshaped Markets

But it's going to be hard to keep them distracted. In the past few years the financial markets have reshaped themselves in the most extraordinary ways, and put an even finer point than usual on the class distinctions inside them. The upper class is now serviced by a vast and growing industry, loosely called Private Equity.

The job of the private-equity investor is–again, speaking loosely–to exploit the idiocy of the ordinary investor, and the corporate executives and mutual-fund managers who purport to serve him. Private Equity Intelligence says this year private-equity firms have raised $300 billion, up from $283 billion for all of last year–which is up from an ignorable $10 billion or so 10 years ago.

Even those gargantuan numbers fail to do justice to this peculiar financial event. Private equity is not served up without piles of debt–the typical debt-to-equity ratio of a company after it has been bought by a private-equity firm is 2-to-1 — and so the actual purchasing power in the hands of private equity fund managers is something like three times as much as they have in their bank accounts. It's as if a giant and especially successful new stock market has been created alongside the old one. But to invest in this new market you must already be rich, and well-connected.

A New Field

What's odd about this is that so much of the financial drama of the past five years–the rise of Eliot Spitzer, the Sarbanes-Oxley law, the muckraking in the financial press — has been staged, ostensibly, to level the playing field on Wall Street. But the players have responded by building a new field, apart from the old one.

The regulation, by raising the cost of doing business to public companies, has had the perverse effect of reducing the value of a company simply because it IS public, and thereby creating further incentive to take it private. Sarbanes-Oxley has done many things, but one of them is to create a lot of cheap assets for private-equity firms to buy.

It has also helped to make the relationship between the upper class and the proles more explicitly parasitical than it usually is.

Sorry Souls

The recent deal to buy, and then sell, the car-rental company Hertz Global Holdings Corp. nicely illustrates the current state of play in that relationship. In December 2005, a pair of private-equity firms, Clayton Dubilier & Rice Inc. and the Carlyle Group, bought Hertz from the Ford Motor Co. — which is to say they bought it from the sorry souls who own shares of Ford. Eleven months later, in November 2006, they turned around and sold Hertz back to the proles in an initial public offering.

In buying the company they put up $2.3 billion in equity capital. By the time they sold it they had gotten $1.3 billion of their money back, and held shares–which they no doubt plan to get rid of as soon as they can — valued at another $3.5 billion or so. In less than a year they had netted a fairly clean $2.5 billion profit.

I suppose one might argue that it isn't as simple as that–for instance, that it is riskier to invest money through a private-equity firm than it is to invest in common stocks, and so the private-equity investor is merely being paid for the added risk. But it's hard to see how Hertz is a riskier investment simply because it is owned by the Carlyle Group and not by Ford.

Buy Cheap, Sell Dear

In effect, the smartest, best-connected money has separated itself from the rest of the stock market, and has gone into the business of trading against that market. It seeks to buy from the stock market cheap, and sell to the stock market dear, and if you need evidence that this is possible you need only look to the returns on private equity, which have been running three times the returns of the public stock market.

With the shrewdest and most sophisticated investors armed with essentially unlimited capital, any company that is available to the public is almost by definition an inferior asset, i.e., an asset that the private-equity people have no interest in. We may not have arrived at the point where the publicly traded shares in a company are a sure sign that those shares are a poor investment. But that's the obvious, ultimate destination.

Which raises the question: Why do the proles continue to invest in publicly traded companies? And the obvious answer is: They have no choice.

One day the private-equity markets may expand to the point where even proles are offered a little piece of the action. That will be the day the action is no longer worth having. Trust me. The ordinary investor is now and forever cast in the role of the peasant at the king's banquet. He's so happy to have any food at all that he fails to notice that bone between his teeth isn't the meal. It's the scraps.

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