PureVC

The Biggest Ponzi Scheme You've Never Heard Of

By now we have all heard of Bernard Madoff. It is reported that his Ponzi scheme of $50+ billion dollars is the largest of all time. I've found one that may top Madoff's Ponzi scheme that may occur under the everyone's radar.

As you may know, several states in this country continue to have budget shortfalls. In a typical year, many of these local governments run a bit in the red and borrow money until tax revenues come in. Given the current state of world financial affairs, the projected tax revenue shortfall will likely bankrupt these governments. New York is facing a big shortfall, so is California.

CNBC reported today that in response to California's budget shortfall the state may be taking desperate measures to make sure it keeps running. Among those under consideration is the state simply writing I Owe You's to vendors. However, the state finance guy indicates that he is not likely to do that because it would affect the state's ability to borrow in the future. Thus, his solution is to simply delay the payments of people's tax refunds.

Does this sound a little bit like robbing Peter to pay Paul? Does this sound a little bit like the big hedge funds that have lowered the gates on redemptions? Perhaps this is so Bernard Madoff that people do not realize it. I am amazed that the world wants to send Madoff to jail, wants to demonize hedge funds for not allowing withdrawals, and wants to crucify anybody who runs a Ponzi scheme - yet when California wants to do something as preposterous as "delaying" tax refunds because of a budget shortfall, this goes unnoticed.

I am not an attorney, but this situation is akin to a clearing company utilizing clients' account assets for operating expenses. It is illegal and gets you a fine from the SEC and possibly shut down.

Thus in our great country, not only do you have to prepay your taxes and essentially pay for something ahead of time before your bill is due, you actually may have to pay for something that you don't actually owe. You pay your taxes ahead of time and then when there is no tax due, you don't get it back until it is convenient for the government. It is the taxpayers that should charge interest to the government who does this, not the other way around. It is once again the taxpayer who is bailing out the government.

Is it any wonder why people in this country try and hide their assets offshore?

The Hurdle

It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.

Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.

I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my money in a mutual fund or buy a piece of commercial real estate and get a good cap rate. When I invest, I want the manager to make big returns and be rewarded on the back end for the great return.

It is sort of analogous to investing in public equity for dividends. I am not a dividend investor and would never invest in a stock for its dividends but more for its appreciation. Additionally, in a private venture type investment, taking a dividend in a startup does not make sense to me because you want the cash to stay in the company to add value to the equity. An LBO is a different scenario because the company is cash flow rich and taking a dividend should not weaken the company materially.

Thus to me the hurdle rate should be a non-issue and in a private deal where I am looking for a good return, I do not want the manager to focus on the hurdle. I would rather that it be clean and simple. I want to be able to calculate the return and fees that I paid to the manager in my head or on the back of a napkin, not through a complicated spreadsheet.

If I am investing in a fund, I am looking to build a relationship is someone who can earn good returns over any cycle. I may negotiate some terms or fees, but the hurdle certainly is not one of them. I would rather go with a talented manager with a low hurdle than a first-timer with a high preferred return.