How to Make $ Through Investment

The answer is there is no easy answer. If you are a financially disciplined cheap ass and you put your $ in a tax sheltered diversified, dollar cost averaged index fund and hold for 40 years, you are almost guaranteed to be a millionaire (short of some crazy catastrophe or collapse of a system) by the time you are in your 60s (after working and investing for 40 years).

Unfortunately, the best evidence (I have been led to believe) shows that actively moving $ around (as opposed to throwing it in funds that track the big 3 indexes) doesn’t work. As Ben Stein once said (I’m paraphrasing): “Unless your name is Warren Buffett, you can’t pick stocks.”

But if I were to break from this prudent advice and invest in ideas about the future, I’d listen to what James Altucher & Peter Thiel are saying. As is quoted, “Thiel said, ‘Ideas have more value than money.’”

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66 thoughts on “How to Make $ Through Investment

  1. The best use I got out of any of the individual stocks I ever bought was the year I was partially employed and due to a merger one of my bought-during-tech-bubble internet stocks sold at enough of a loss to offset my entire tax burden for the year.

    If you sit down at a poker table and don’t realize within a couple of minutes who the mark is, the mark is you.

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  2. Not only can people not pick individual stocks, but hedge funds are pointless, and private equity is a scam.

    To clarify, hedge funds didn’t *used* to be pointless, they used to pay okay, but they did so via means they can’t do anymore because those means were blatantly absurd and now illegal. They don’t even manage to outperform the market anymore.

    Private equities, meanwhile, have *always* been scams, that mostly exist hoping people don’t do the basic math of ‘how much money did I put into this vs. how much did I get out of it, and did that do better than an index fund’. They like to constantly over-value assets until they can’t anymore, and come up with some lame excuse as to why they sold it so cheap. And they like to constantly hide how much they are paying *themselves*. (And like to use the ‘carried interest’ loophole in a blatantly illegal way.)

    I actually got in a weird discussion about this a while back, with someone talking about CalPERS, before I learned much about private equity. All I knew was that CalPERS was paying fucktons of money to have their ‘money managed’, and didn’t *actually* seem to be doing better than index fund. (Hell, CalPERS is big enough they don’t need an ‘index fund’…there’s no reason they can’t just buy all the stock of the Dow individually, in a vaguely-even pattern, just sorta cycling between who they buy each month.)

    Since then I’ve learned, yeah, the whole ‘not doing better than an index fund’ is not some weird fluke.

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    • ‘how much money did I put into this vs. how much did I get out of it, and did that do better than an index fund’

      Of course, I probably should make the point that private equity should do *significantly better* than an index fund to justify the lack of liquidity and additional risk. Like 5% or more better. If your PE is averaging only 2% better than the market, it’s, uh, not worth it.

      I’m just saying that, after fees, PE sometimes end up *below* index funds, or at least pretty close to them, which makes them such obviously stupid investment choices it’s amazing. (And apparently, often, no one seems to actually *know* how well their PE investment is doing. Which is another ‘so stupid it’s amazing’ concept.)

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    • David,
      Most people don’t know jack shit about anything, let ALONE about hedge funds.
      Knowing a bit about hedge funds is how you turn $500 into $50000 in under a year.
      Well, that and watching the entire market crash and burn around your ears.

      Picking investments when things are going completely crazy is not only doable, it’s often wiser than going conservative.

      I know investors who picked up on China’s collapse, and a ton of other decent bets.

      But to invest, and invest well, involves knowing as much as possible about how the entire world works.

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    • And like to use the ‘carried interest’ loophole in a blatantly illegal way.

      This seems unlikely. Prosecuting a Wall Street executive for tax fraud is a dream-come-true for a prosecutor with political ambitions, especially in this political climate. It’s hard to believe that nobody wants to grab that particular brass ring, if it’s such an open-and-shut case.

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          • http://www.investopedia.com/terms/c/carriedinterest.asp

            One way to look at is this – you and I are in a real estate deal. You are the 5% partner, I am the 95% partner. If I I agree to give you 20% of the excess proceeds after all my capital is returned plus some return on that capital, that 15% of the proceeds (20% less the 5% attributed to your capital contribution) represents the carried interest. Another term for it a promoted interest.

            Carried interest is associated with a return on investor capital and usually (most of the time at least) requires a capital event in order to trigger it.

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            • It’s a capital event associated with somebody else’s capital, which is then transferred to somebody to reward them for something other than their capital investment, though. Getting capital gains treatment for it is a pretty unusual situation.

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            • We’ve had this discussion before and that’s exactly why even I of House Slytherin thinks the rule is BS. If you put up a 5% stake your return on capital should be proportional to that 5% stake. If you’re getting back double or triple what the other capital owners are getting as a proportion of their stakes, you are obviously getting a return on labor, not just capital. Or you’re getting a gift, which iirc is taxed like labor at high enough levels to close that potential loophole.

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              • And the problem is, often, there *isn’t* a 5% stake in the first place with PE. It’s an imaginary investment, created by the contract. The actual investors pay 100%, the manager gets to *pretend* he put in another 2% or whatever, and take his cut…which is only supposed to happen after everyone else gets paid a certain amount…except everyone else has all these *fees* they keep mysteriously having to pay, which he, for some reason, has no share of. (Shouldn’t the guy you are literally paying to manage a corporation have to pay for subcontractors himself?)

                Although it’s much more complicated than that. Because *everything* about this entire setup is deliberately ‘much more complicated’ than human beings can figure out.

                Dave is, I think, stuck in real estate thinking, where there’s a lot more transparency, the process normally makes sense, and the entire thing is not, generally, a scam.

                But, as you point out, ‘carried interest’ is *still* a tax scam, even over there. We can argue whether or not capital gains should be taxed at a different rate, but things that are clearly ‘payment for services rendered’ are *not* capital gains. Period, the end.

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                • Dave is, I think, stuck in real estate thinking, where there’s a lot more transparency, the process normally makes sense, and the entire thing is not, generally, a scam.

                  I am, and this is why I can write a really awesome post defending carried interest. I thank both you and for making something that I should have seen much much sooner very obvious. I’m almost embarrassed that I didn’t see it sooner.

                  Thank you. Thank you. Thank you. Thank you. This made my OT day.

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              • There are a couple of reasons to tax investment income at a different rate from wage income (or not at all):

                1. Supply of capital is more elastic with respect to post-tax returns than supply of labor is to post-tax returns.

                2. The Chamley-Judd result: Taxing investment income distorts the choice between present and future consumption in a way that privileges present consumption over future consumption, thus discouraging saving and investment.

                3. Somewhat related: Investment income has already been diminished by the rate at which the principal was taxed when it was originally earned as wage income.

                4. Double-taxation from the corporate income tax.

                I’m not entirely sure which of these apply to carried interest, and to what degree. 4 does, of course, and maybe that alone justifies it.

                3…maybe? If investors had more capital to invest due to not having had to pay taxes on the principal, would that mean each fund manager would manage that much more money, and earn proportionally higher fees, or that there would be more fund managers? Or maybe somewhere in the middle.

                I don’t think Chamley-Judd applies. The fund managers never have the option to consume their carried interest before it’s taxed, so the initial tax rate doesn’t matter, as far as present vs. future consumption is concerned.

                I don’t think the elasticity is an issue, but I haven’t fully thought that through.

                Honestly, I’m not even sure what the ostensible justification for the investment income tax rate we actually have is. Is it just double taxation, or the elasticity thing, or just a compromise between economic logic and populist pandering?

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                • 3. Somewhat related: Investment income has already been diminished by the rate at which the principal was taxed when it was originally earned as wage income.

                  Which, really, is the way you can figure out it’s tax fraud with PE managers.

                  They weren’t taxed on the money before they put that money into the fund…because they didn’t put any money into that fund. They just got to *pretend* they did.

                  But, hey, if someone gets handed a 2% share of a huge fund…that’s a taxable *gift*. (Or it’s a taxable payment for services rendered.) Sure, the actual *gain* on that is capital gains, but the rest isn’t.

                  And, sure, it’s actually imaginary, they don’t get that 2% back, just the profit *from* ‘it’…but if they want us to treat their share of the fund as real for tax purposes WRT capital gains, we have to, you know, treat it as real for tax purposes for income! Which means they should have paid some damn taxes on their giant ‘2% of a few billion dollars’ windfall!

                  They’re trying to have it both ways, paying capital gains rate on the increase in money they never had, and hence *never paid any income taxes on*.

                  Honestly, I’m not even sure what the ostensible justification for the investment income tax rate we actually have is. Is it just double taxation, or the elasticity thing, or just a compromise between economic logic and populist pandering?

                  Who the hell knows? I keep hearing it’s to encourage investment, and I keep wondering ‘As opposed to what? If people don’t invest it, wouldn’t it, uh, sit in a bank, where it would be loaned out?’

                  Frankly, considering the absolute failure of corporate income taxes, I think it might be reasonable to stop taxing that, and just start taxing cap gains at the normal rate. (And also raise the tax rate at higher brackets.)

                  The problem, of course, becomes how to work losses and gains across multiple years, but it’s not insurmountable.

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        • Basically, managers of PE are trying to claim that some of their money is not ‘pay’, it’s profit from the PE, which would allow it to be taxed at the lower cap gains rate.

          This is due to a ‘loophole’ that allows them to claim an investment stake without actually investing, as part of their compensation, rather like stock options, and *would* legally be under capital gains…if that amount was actually treated as a real market return and actually carried any risk.

          However, it *doesn’t* carry any risk. Even when the PE performs poorly, somehow the *manager’s* profits always get paid, in full.

          Which makes it pretty obvious these ‘profits’ are just a *paycheck*, and hence it is not, and has never been, legal to classify them as capital gains.

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          • Basically, managers of PE are trying to claim that some of their money is not ‘pay’, it’s profit from the PE, which would allow it to be taxed at the lower cap gains rate.

            Good for the IRS to pay attention to that. They’ll already do well enough on the carried interest if the investments they make are successful.

            Still, it doesn’t mean that all carried interest is illegal nor does it mean that legitimate carried interest should be taxed at ordinary income rates, despite the creative attempts by some to associate labor with capital-markets-based value creation.

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              • If I play by your rules, I see two outcomes –

                1) We lower income taxes to capital gains levels.
                2) We increase capital gains taxes to the level of top tax brackets.

                (1) will most likely be seen as a tax cut for the wealthy, something that’s not only politically unpopular on the left (rightly so) but fiscally reckless.

                (2) is something I strongly oppose not necessarily on ideological grounds but on the belief that cheap capital helps fund investment and high capital gains rates incentivizes people to defer taxable gains if and when they can. I saw a lot more of this in my business prior to the Bush tax cuts than after, especially with respect to real estate dispositions.

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                • But taking a casual glance around the ole’ American economy (the world economy, in fact) it’s pretty obvious that we have a massive glut of capital.

                  Why shouldn’t we remove some of the incentives to invest right now?

                  15% is not some figure written in stone – it’s quite possibly too low, creating incentives to make bad investments. I wouldn’t kick it from 15% to the top income tax rate in one go, but something staggered over a number of years would be worth trying. If it goes too high, it’s not like there’s ever a problem cutting taxes.

                  I admit to some interest in HRC’s proposed changes, which leaves a low rate for long-term investments but a much higher one for short ones. The devil is, of course, in the details but if I’m going to give out incentives for investment I’d prefer long-term to short.

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                  • Morat20: I admit to some interest in HRC’s proposed changes, which leaves a low rate for long-term investments but a much higher one for short ones. The devil is, of course, in the details but if I’m going to give out incentives for investment I’d prefer long-term to short.

                    The way I would do it would be to tax CG as ordinary income but adjust the basis to account for inflation.

                    So say you invested $100 which you later sold for $200. If “later” was a year and inflation was 5% then you would be taxed on $200 – 1.05 x $100 = $95. If “later” was 10 years and cumulative inflation was 50% then you pay taxes on $200 – 1.50 x $100 = $50.

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                  • But taking a casual glance around the ole’ American economy (the world economy, in fact) it’s pretty obvious that we have a massive glut of capital.

                    I work in healthcare real estate. Holy crap is this case and the amount of capital coming into this country to invest in commercial real estate is staggering.

                    Why shouldn’t we remove some of the incentives to invest right now?

                    The Fed is hesitant to raise interest rates. I think that would probably help, at least in my corner of the world. Capital gains? I’m not so sure.

                    15% is not some figure written in stone – it’s quite possibly too low, creating incentives to make bad investments.

                    I think low interest rates are a bigger liability when it comes to creating an environment for making poor investments. It’s not a coincidence that the demand for subprime-backed mortgages rose after the Fed cut rates to record low levels in 2003-2004 driving down bond yields on fixed income investments across the board. The need for yield drove investors to subprime.

                    I don’t like capital gains taxes at all so 0 would work for me, but since that won’t happen and since capital gains taxes have historically been at higher levels, I don’t think we put ourselves in a bad position if we raise them incrementally. I think 20% is the max now and I probably wouldn’t lose much sleep if they were increased incrementally to 30% over a few years. I highly doubt that we’re at a point where this kind of tax increase is going to negatively impact revenues (if I may cite my crude interpretation of the Laffer Curve). I may see an increase in tax deferrals in real estate, but it may not happen.

                    I admit to some interest in HRC’s proposed changes, which leaves a low rate for long-term investments but a much higher one for short ones.

                    I’ll admit to being intrigued myself, and I think it’s appropriate that short-term investments are taxed at a higher rate (I’d argue that there’s a stronger labor component than in a shorter term transaction although I need to work that out with at some point).

                    A two-to-three year capital gains rate at 36% declining every year by 4% until 20% is reached is an interesting compromise. Typically, developers in my space build to a 2 to 3 year hold period so if they’re selling out at a 32% capital gains rate, it’s higher than where it was before but most likely manageable. Sure, they can hold the asset longer for the lower capital gains rate, but that will be a bad idea because time value of money works against developers after deals are stabilized.

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                    • The Fed is trying to assess how much we’re recovered from our very own Lost Decade. I think they’re pretty bullish on American and a bit skittish on external countries.

                      A 20% tax rate for long term capital gains doesn’t sound that crazy to me. [Are we still keeping the 0% for poor folks?]

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              • Wouldn’t the most effective way to do that simply be to eliminate the corporate tax entirely and simply tax all capital gains as normal income. It’d certainly make a ton of dough and eliminate quite a bit of distortion though I gather a lot of economists get the vapors at the latter idea.

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                • That has always been my preference. Corporations are nasty shapeshifters that are hard to tax anyway. Just tax the owners when they take money out. Has the added side benefit that Grandma pays Grandma’s rate on corporate earnings on the Microsoft stock in her retirement account and Bill Gates pays his rate, instead of Grandma and Bill paying the same corporate rate.

                  I’m also wondering if we could further reduce weird behavior by setting capital gains rates to zero and making up for it by fiddling with the estate tax. Just let people do whatever they want with their money and property while their alive. No reason to do anything with your money just for tax reasons. We’ll settle up accounts when you die.

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                  • The main objection I’ve heard that isn’t “evil corporations need to pay their fair share!11!oneone!!” is that individuals would incorporate and thus avoid taxation. That strikes me as infinitely too cute and that the IRS would have no difficulty slapping that one down.

                    The problem with depending on the estate tax, as a practical matter, is that you then have to basically police all the transferring of assets from parents to children for their entire lives. Otherwise they’d just quietly or sneakily engineer transfers of wealth from one generation to the next to avoid the tax and die below the taxation threshold. That strikes me as a fundamentally insurmountable practical flaw with the idea even as I’m sympathetic to the foundational principle.

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                • There’s a lot of competition, but I think the corporate income tax is a pretty solid candidate for America’s most ill-considered tax, at least at the federal level. I won’t rule out the possibility that one of our thousands of state and local jurisdictions has managed to cook up something even worse.

                  I’m not sure why you think this change would “make a ton of dough,” though. US corporate income tax revenues in the US were $273B in 2013. Looking at the IRS’s aggregate tax data for the same year, it looks to me less than a trillion dollars worth of income was subject to the lower rate. $158B in qualified dividends and $500B in capital gains on capital assets. $350B in “business or profession” profits. I assume that’s already taxed as ordinary income, but let’s go nuts and throw that in, too. Assume the rate every last penny goes from 20% to 39.6%, although a surprising amount of it goes to people making under $200k per year. Even throwing in the extra $350B in business income and making heroic assumptions about the marginal rate, we’re still looking at a max yield of $200B per year, for a net loss of $70B.

                  Or are you talking about increased revenues from the economic growth that’s being suppressed by the corporate income tax?

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            • Well, whether or not capital gains should be taxed at a different rate is a different matter altogether.

              I’m just saying, and the IRS appears agrees with me, that someone who gets paid a salary to do a job doesn’t get to call it capital gains merely because they work managing money and have decided to pay themselves their salary via the ‘investment return’ system, even if a) they didn’t pay a dime *into* said investment, and b) they mysteriously always get paid even when the investment doesn’t pay any other ‘investor’.

              That’s just, blatantly, straight up tax fraud. Tax fraud it has taken the damn government *years* to notice, and people keep calling it a ‘loophole’ instead of what it is and asserting we need to change the law. No, it isn’t, and no, we don’t. We just need to start arresting people.

              Actually, what appears to be *real* crime here is the fact all these PEs are scams. None on of them follow the waterfall model that is supposed to control the distribution of fund. The investors (aka, limited partners) are supposed to be paid first, and the general partner, (aka, the management), are supposed to be paid last.

              But when the returns are low, it turns out the contracts were set up where the limited partners have to pay all sorts of additional fees (In addition to the *actual management fee they are already paying the firm to manage the damn thing*.) and costs, so, tada, when the return is low, it turns out the general partner is the only one who gets handed any money, somehow, despite that being literally the opposite of how the system is supposed to work.

              It’s theft/fraud of the investors *and* tax fraud, all rolled into one. Like I said, PEs seem actually *designed* as scams.

              And ‘carried interest’ is the term for just this, so, yeah, pretty much no ‘carried interest’ is legally capital gains, as far as anyone can tell. (Of course, ‘as far as anyone can tell’ is almost completely meaningless in PE…no one seems to actually know *anything* about what’s going on or why people end up with what money, including the damn investors.)

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    • Index funds and passively managed target-date retirement stuff is my 401k strategy. I ignore it, checking in once a year to make sure my company match (stock, of course) hasn’t broken 10%. (If it has, I diversify it).

      My ‘risky’ investment is my sole outside-of-401k investment, which is a DRIP based on a large stock grant I was given way back when. Since I work for (ultimately. It’s one of those wholly owned subsidiaries things) a Fortune 500 company, I toss 150 bucks a month at their stock and set the dividends to reinvest and then ignore it.

      I occasionally raid it for cash.

      But actively managed stuff is for the birds. I’m not paying out the nose for someone to lose to an index fund. The closest I’ll get the is the target-date retirement, and the ‘management’ there consists of slowly changing the mix of investments as I approach retirement.

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        • Pretty much. If I recall, one has to be considered an accredited investor per the SEC regulations. Limited partnership interests like the ones sold by private equity funds aren’t sold to the public but rather through private placements.

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        • Technically, I think the private comes from the fact it’s basically investing in a privately-owned company, which the PE firm just bought.

          However, not only can you not invest in one without an invitation, you invest via custom contract. You don’t ‘buy something’, you sign a contract and give them some cash, and they, supposedly, give you some cash back later. This makes it extremely hard, if not impossible, to sell.

          And, like I said above, this extreme illiquidity *should*, in return, be paying quite a lot better than the market to be worth it. And…it isn’t.

          The fact it’s a *contract* means they can also pull all sorts of insane crap like billing *you* for consultants *they* hire to manage the place (Weren’t you *already* paying a management fee?), or constantly rate the owner assets higher than they are worth (Not publicly traded, so not illegal to do that.) until they come up with some excuse they had to sell them for cheap.

          PE is, from top to bottom, custom-designed as a scam.

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          • PE is, from top to bottom, custom-designed as a scam.

            Do you have a background in finance, the capital markets or investment banking?

            Things you are saying are so spectacularly wrong that I’m starting to consider you the finance equivalent of Robert Greer, and heaven forbid we get him going on nutrition.

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            • Do you want me to start *listing* the industry-wide practices of PEs scamming their clients?

              Okay, let me pick one at random: http://www.nytimes.com/2015/06/14/business/retirement/when-private-equity-firms-give-retirees-the-short-end.html

              Basically, the story is PEs management firms getting sweatheart deals on *their* legal representation because they direct the PE’s legal needs to the same law firm, which charges *above* market rate…and it’s worth pointing out this doesn’t even come out of the PE’s profits, which would be bad enough. No, it’s the limited partners that are billed.

              To recap: I pay someone money to manage a company. That company ‘needs’ legal services, so the manager of that company goes to a law firm and pays full freight or *above* full freight to the law firm, which then comes directly out of *my* profits for some reason. Not out of the general profits of the PE, not paid for by people who are *being paid* to manage the firm…out of *just my* my profits.

              These people then turn around, and, because they’re directing so much profitable business towards the law firm, get a discount on *their own* legal work from those places. This is, uh, clearly illegal kickbacks and breach of fiduciary duties. Or, as it is commonly known, ‘private equity’.

              This is…literally one example of how PEs scam their customers.

              But, hey, don’t take my word for it. Take the SEC’s:

              ‘When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time.’

              http://www.sec.gov/News/Speech/Detail/Speech/1370541735361#.U3BqsK1dVEY

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              • Seriously, folks, read that speech by the SEC guy…and then realize he doesn’t even mention *all* the various scams. He didn’t mention the lawyer kickback one, and he didn’t mention that clawbacks don’t work either:

                http://www.nakedcapitalism.com/2014/09/another-private-equity-scam-clawback-language-work-advertised.html

                And he didn’t mention the tax fraud either. (Which is more IRS than SEC.) Or ‘tax receivable agreements’, which I don’t actually understand, but sounds rather dubious to me.

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                • This is the money quote in the article:

                  Now of course, if the limited partners had any spine, they’d dispense with this arrangement and insist that the managers receive no incentive compensation until the funds were wound up, or that the distributions were so large that even if the remaining deals were total losses, the managers would still be entitled to a profit participation.

                  I’m not going to defend the fee practices of private equity shops, but if they’re getting away with bloody murder, it’s easy to see why. Seriously, how the fish are the limited partners not seeing any of this? Fees aren’t the only problem here.

                  Oh, here’s another perspective on the Morgensen piece, one that kind of puts the facts in the right perspective, something Morgensen did in her own sort of special sneaky way:

                  http://fortune.com/2015/06/24/is-private-equity-ripping-off-retirees/

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                  • I’m not going to defend the fee practices of private equity shops, but if they’re getting away with bloody murder, it’s easy to see why. Seriously, how the fish are the limited partners not seeing any of this? Fees aren’t the only problem here.

                    It’s because limited partners are almost always managing *someone else’s* money. Why does someone who works for the state managing a pension care about the *actual* growth of the fund?

                    And if you read up on what’s going on with CalPERS, it becomes clear the board knows *nothing* about how PEs work, and that the actual staff doing the management just believe whatever the PE tells them. PEs are, as I said, quite deliberately set up so the investors have no idea what’s going on. But, hey, ‘private capital’ is where all the smart people invest, isn’t it? So let’s throw all this money (which isn’t ours) in there.

                    And, incidentally, responding to my ‘They are complete scams’ with ‘No they aren’t. Well, okay, they probably are, but the people being scammed should be more careful.’ is, uh, sorta goofy.

                    Yes, obviously, the people being scammed should pay more attention. I don’t think anyone was disputing that. Hell, the second that PE firms started saying that their *contracts* with limited partners were trade secrets and they wanted to exempted them from FOIAs…well, someone in the government should have said, ‘Uh, no. That’s absurdly stupid.’

                    …do you see my *designed as a scam* yet? Private equity, in theory, could be some reasonable investment thing. Private equity, as it is *practiced*, is a deliberate black box, constructed in such a way that no one can see or argue with their returns. Which is, uh, a little suspicious. Just a bit.

                    Oh, here’s another perspective on the Morgensen piece, one that kind of puts the facts in the right perspective, something Morgensen did in her own sort of special sneaky way:

                    See, the real issue here is that we literally have no idea if there are quid pro quo arrangements. With anyone else, we could find out, but because PEs are insanely, impossibly, opaque as to what is actually going on with the money, we cannot. And the only reason we see inside them *at all* is the 2012 law.

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  4. Matt Y and Vox have a thing where they show people would be better off just putting all their money into index funds.

    I suspect the big problem for a lot of people is something you mention above. A lot of people (including myself) have trouble being cheap-asses with their money when alive. It is no fun being a parsimonious miser when especially when making a good income. People want to have fun, go to good restaurants, nice vacations, etc. If Keynes is right, everyone being a cheap ass might be bad for the economy overall because it leads to the paradox of thrift.

    Planet Money once interviewed a woman on savings who did have the cheap ass philosophy as you mentioned. She said “You don’t have to buy new clothes, new furniture, eat at restaurants, buy new furniture, and go on vacations/travel, etc.”

    I gotta admit that my reaction to hearing this was two-fold:

    1. She didn’t sound very fun.

    2. Doesn’t someone have to buy new furniture and clothes for their to be second-hand stuff? If everyone stopped buying new stuff, the market would collapse from a lack of demand.

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    • Well, do it in moderation then. Eat at home most of the time. Go on vacations only some times and buy new clothes only sometimes. Also, watch what you eat, then you won’t have to go buy new clothes that often.

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    • It is no fun being a parsimonious miser when especially when making a good income.

      Sadly, this is the only alternative to spending every last penny you make as soon as it comes in. If only there were some middle ground!

      Joking aside, I’m used to hearing about how the poor can’t save because small luxuries are their only joy in life. This is the first time I’ve heard a rationalization for why the well-off can’t save.

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        • I thought I responded to this earlier. My sense was that he was saying that it was unreasonable to expect people to save, even if they have a significant surplus over basic living expenses. Mostly I thought it was odd that he said that this especially applies to people with “good incomes,” since I usually hear the exact same claim being made about people with low incomes.

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      • What MDrew said. After all the necessities are paid for, most middle and upper income people have a choice of either spending what is left on non-necessities or saving it for the most part.

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      • @brandon-berg

        I don’t think I was disputing anything about the importance of saving or saying that people should cut back on their fun. There are probably people (including myself) who do spend money unwisely. It is a pretty human thing to do.

        I was thinking about Rowe’s comment on being a cheap-ass. There is probably a lot of truth. Perhaps people who make 85,000 (before taxes) should live like they make 40,000-50,000 (before taxes) as an example.

        But humans are also social creatures and we want to have fun. It isn’t very fun to work long and hard and then just eat bland food or never go out or on vacation, etc. Nor are most person likely to keep friends (or psychological health) if they don’t go out or always decline.

        There are also philosophical questions. Everyone should have money saved for retirement, contingencies, emergencies, etc. But how much? What is the purpose of saving if it turns one into a miser?

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    • That is the myth that you have to be cheap. Just scrap together the min to open an index fund account, then do a minimal direct deposit every month and let the fund work over time. Or if your corp does IRA matching take them up on it.

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      • This is exactly the right advice. Automatically deduct a bit more than you think you can (ideally every paycheck rather than monthly) and you’ll naturally adapt to the checks you’re getting. Plus, if you save enough, it’s fun to get significantly bigger checks late in the year after you’ve maxed out.

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      • This is entirely correct. Also if you don’t do matching with any employer that offers it you’re literally abandoning money. Even if the market declines during that period you’re personally starting out at 200% return and the market would have to absolutely plummet (and you’d have to sell out at the bottom) for you to come out behind.

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        • The matching thing absolutely can’t be stressed enough. If I knew with 100% certainty that IBM stock was going to double tomorrow and I could by $1000 worth today as long as I put it in a retirement account, I’d be pretty crazy not to find some way to scratch together as much of that $1000 as I could and jump on the opportunity. But people leave that money on the table all the time.

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          • Seriously, or the contrast.. if you knew IBM was going to drop by 25% by tomorrow but you had a matching option to buy stock today you would still do it. You put in a grand, the company matches you a grand, it goes down 25% and you’re still 500 bucks ahead. And that was assuming that you sold the stock after it declined.

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  5. I’ll bring it down here since my response will probably be long. First:

    And, incidentally, responding to my ‘They are complete scams’ with ‘No they aren’t. Well, okay, they probably are, but the people being scammed should be more careful.’ is, uh, sorta goofy.

    I interact with private equity firms in my professional career and have a far broader view of what constitutes private equity. The general fee structure (management fee + promote/profits interest over a return threshold) is the same. Most of the private equity funds we encounter are much smaller than the Blackstones/KKRs of the world and are capitalized using far fewer sources and sources where the relationships matter to the point where sponsors don’t screw with them (that and real estate private equity is far more transparent).

    I’m happy to take note of bad acts and recognize them for what they are, but I won’t broadly dismiss a segment of the capital markets that plays a significant role as a “scam” because of it. This isn’t the libertarian in me speaking but rather the professional.

    Why does someone who works for the state managing a pension care about the *actual* growth of the fund?

    Well, I would have to think that the actuaries are projecting the pension obligations expected to be paid out into the future and want to make sure that the pension fund’s investment strategy is such to both grow the fund and produce enough investment income to meet those obligations. The states that are dealing with pension shortfalls (especially NJ and IL last I checked) may be in for a world of trouble.

    That, and the people that work for the state in this capacity are paid to make sure that the state pension fund grows to its maximum potential based on its various investment strategies, asset allocations, etc. and may by law have a fiduciary obligation to do so. If they are failing to do their jobs, they should be fired and replaced.

    And if you read up on what’s going on with CalPERS, it becomes clear the board knows *nothing* about how PEs work…

    Yet, people like Morgensen hem and haw about how it’s the private equity funds that are fleecing retirees when the people that are paid directly by the state to manage the money and protect the interests of the retirees have no idea what the hell they’re doing. That’s not a private equity problem. That’s old-fashioned incompetence.

    …and that the actual staff doing the management just believe whatever the PE tells them.

    This is worse than anything the private equity firms are doing, and that is saying quite a lot because the private equity firms aren’t on their best behavior in some cases, especially the bigger ones.

    PEs are, as I said, quite deliberately set up so the investors have no idea what’s going on.

    Yet journalists, bloggers, tax accountants and other investigators are uncovering what’s going on and in some cases are doing so using the same legal documents the limited partners receive when they agree to invest into the funds. The Smith post on clawbacks draws from those very limited partnership agreements. The things that are being “uncovered” should have been noticed not necessarily by the pension fund managers (they won’t have a clue) but by the attorneys that should be reviewing and blessing every legal agreement that these funds enter into.

    I don’t come across limited partnership agreements in my line of work, but I do come across purchase and sale agreements as well as joint venture agreements (like LP agreements, they’ll have waterfall structures involving promote/profits interest). They are heavily negotiated and both parties through their separate counsel review the legal documentation to make sure that the terms of the deal are what they are supposed to be.

    You may be looking at this situation and saying to yourself “Private equity is a scam!!! Look at how they screw over their limited partners!!!”, but I’m sitting over here with the perspective of someone that has been involved in similar-type transactions asking myself “What the hell is going on with the limited partners?” Are they really this oblivious to what’s going on? Are they going to just take it on the chin because of the relationship with the fund operator or the fact that they’ve made a lot of money in the past? Is the problem incompetence or indifference?

    But, hey, ‘private capital’ is where all the smart people invest, isn’t it? So let’s throw all this money (which isn’t ours) in there.

    It appears the smart people are the ones raising all the money.

    Yes, obviously, the people being scammed should pay more attention. I don’t think anyone was disputing that.

    No, but let’s at least focus on why they’re being scammed before we focus on how they’re being scammed.

    Hell, the second that PE firms started saying that their *contracts* with limited partners were trade secrets and they wanted to exempted them from FOIAs…well, someone in the government should have said, ‘Uh, no. That’s absurdly stupid.’

    There could be trade secrets in the contracts, especially if the contracts lay out the fund’s investment strategy (which they should). If I laid out my strategy in detail, I wouldn’t want my competitors filing a FOIA request so they can get the documents and replicate I’m everything I’m doing. By the way, what’s the benefit of making them available anyway?

    …do you see my *designed as a scam* yet?

    Yes, but consider two things. First, if it’s a scam, it’s more detectable than people may think, especially when you consider the way these things are coming to light. Again, we’re back to incompetence vs. indifference.

    Second, and perhaps more important, it appears that the private equity firms that are the likely culprits are the major private equity firms that can raise billions of dollars and have an extraordinarily long list of investors wanting to get in the door with these firms.

    The private equity industry is huge ranging from the multi-billion dollar funds down to funds raising $25 to $50 million in high net worth capital. There is a TON of competition both for capital and for deals, especially in the low-to-middle part of that market (which would explain why returns in the sector have dropped). My suspicion is that the sorts of shenanigans pulled by the larger shops will be less likely done by the smaller firms because 1) the amount of money being generated will be much smaller and 2) there is so much competition for capital in that space that investors can easily take their money and go elsewhere.

    I know I’m making a few generous assumptions here, but I think the competitive landscape for the smaller PE firms is much more intense. That alone could help keep people in line.

    Private equity, in theory, could be some reasonable investment thing.

    It is also reasonable in practice although I won’t get into the gory details.

    Private equity, as it is *practiced*, is a deliberate black box, constructed in such a way that no one can see or argue with their returns. Which is, uh, a little suspicious. Just a bit.

    Except people are seeing issues with the way private equity firms report returns, calculate clawbacks and structure fees in their favor. Unfortunately, the people that are pointing this out are doing so after the people that should have seen it but didn’t signed on the dotted line.

    I’m still wondering where the hell the pension consultants and lawyers were when these documents were getting examined.

    See, the real issue here is that we literally have no idea if there are quid pro quo arrangements.

    There are, but quid quo pro arrangements are common place. What we don’t know is whether or not there are arrangements that are truly detrimental to the interests of the limited partners. I think Morgensen jumped to too many conclusions.

    With anyone else, we could find out, but because PEs are insanely, impossibly, opaque as to what is actually going on with the money, we cannot.

    How would we find this out from privately-held companies that have no obligation to disclose information to you, me or the SEC? Heck, I don’t even know if this information is in the reports submitted by public companies (although it may…haven’t checked).

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    • I interact with private equity firms in my professional career and have a far broader view of what constitutes private equity.

      Is your objection that I was saying ‘private equity is a scam’?

      Okay, let me rephrase: Private equity, itself, is not a scam. There are quite a lot of people making quite a lot of money via the various activities that comprise ‘private equity’. I mean, technically, all ownership of privately owned companies, and all real estate investments, can be considered private equity. But generally people can’t just ‘invest’ in privately owned companies without a lot of work (Venture or growth capital, which are like 90% lawyers figuring things out), and REITS are fairly standardized from what I understand. Those are not scams. (Well, they aren’t scams in how they are structured, at least.)

      It’s the sorta-general-purpose opaque private equity funds that are scams for general investors.

      And, yes, I’m sure there are private equity funds that are look exactly the same that are not scams…but those things are probably pieced together by the *investors*. A group of ten investors might get together to set up a private equity fund to do a LBO of someone, and they’re all limited partners, and everything is fair and reasonable because setup was created by them!

      And it looks, legally, exactly like a Blackstone private equity fund that is ripping investors off, one fee at a time.

      So it’s easy to say ‘They’re not all scams’. But, the things, this post is talking about ‘where to invest’, and from the point of view with someone to put money, the things that already exist and are willing to take their money *are* scams.

      I’m happy to take note of bad acts and recognize them for what they are, but I won’t broadly dismiss a segment of the capital markets that plays a significant role as a “scam” because of it.

      Great, now we’ve apparently reached ‘Too big be a scam’. Why on earth does the *size* something occupies in the capital market have any bearing on whether or not it’s a scam?

      No, but let’s at least focus on why they’re being scammed before we focus on how they’re being scammed.

      …I was just pointing out they *were* being scammed. That was it. You acted like I didn’t know what I was talking about, so I started pointing out examples of scammy behavior.

      If you agree that these large PE funds *are* scams, well, then we’re in a agreement. (And if you want to say ‘Do a lot of really really scammy things’ instead of ‘are scams’, whatever.) You want to talk about how to fix that, I’d have to suggest ‘Not like giant financial institutes control the entire universe so much they can apparently rewrite everyone’s reality.’, but maybe that’s just me.

      There could be trade secrets in the contracts, especially if the contracts lay out the fund’s investment strategy (which they should). If I laid out my strategy in detail, I wouldn’t want my competitors filing a FOIA request so they can get the documents and replicate I’m everything I’m doing. By the way, what’s the benefit of making them available anyway?

      The investment strategy hardly has to be *in* the contract. It’s trivial to have the contract refer to an investment strategy laid out in another document, but still have the contract itself be public, so the public can read it and notice exactly what sort of fees they are paying. The question isn’t ‘How is the money being made?’, which could rightly be a trade secret…the question is ‘Who gets how much of it?’, which is not a secret, and should not, under any circumstances, be kept from the public, which owns that money.

      And the benefit of making them public is that *someone* can read them…because the people being paid to do so sure as hell aren’t. Watchdog groups send in FOIA requests for government contracts all the time, exactly so they can look at them for this sort of stupidity.

      And I point to your statement ‘If they are failing to do their jobs, they should be fired and replaced.’…how would we *know* they are failing to do their job and signing stupid contracts if we can’t see the contracts?

      First, if it’s a scam, it’s more detectable than people may think, especially when you consider the way these things are coming to light.

      Yes, that completely ‘detectable’ scam that has been ripping off the public for a decade and billions of dollars is, uh, at the point where members of the public are calling for an investigation.

      yay?

      The private equity industry is huge ranging from the multi-billion dollar funds down to funds raising $25 to $50 million in high net worth capital. There is a TON of competition both for capital and for deals, especially in the low-to-middle part of that market (which would explain why returns in the sector have dropped). My suspicion is that the sorts of shenanigans pulled by the larger shops will be less likely done by the smaller firms because 1) the amount of money being generated will be much smaller and 2) there is so much competition for capital in that space that investors can easily take their money and go elsewhere.

      Now that *sounds* like a valid point. All the stuff about PE I know is the large stuff.

      However, I will point out that the reverse could easily be true…the big guys are being looked at because *public money* is in them, and because they are so big.

      I’m sure a lot of big private investors have actual competent lawyers that look at some random small PE and go ‘This is a scam’…which just means it will be *incompetent* people who invest in that specific one.

      Except people are seeing issues with the way private equity firms report returns, calculate clawbacks and structure fees in their favor.

      …which only happened because the laws changed.

      How would we find this out from privately-held companies that have no obligation to disclose information to you, me or the SEC?

      Why are you asking me? You’re the person who seems to think private equity funds might be reasonable investments, isn’t it up to *you* to point out how we can be sure they’re not scams?

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  6. I think the crux of our disagreement is here:

    …I was just pointing out they *were* being scammed. That was it. You acted like I didn’t know what I was talking about, so I started pointing out examples of scammy behavior.

    Feel free to browse Naked Capitalism and mine it for examples of bad behavior. I saw plenty of it there and you didn’t even begin to scratch the surface.

    However, and this may be my professional bias speaking, having a reasonable definition of what constitutes a scam, I have a very hard time putting private equity in that category. Even if I think the fees in some cases are absurd if not exorbitant, the lion’s share of the blame should not fall on the private equity firms but rather the pension funds for enabling this behavior. Call it indifference, incompetence or not having a spine for a number of reasons, but I can’t buy off on any narrative that suggests that Wall Street’s predatory behavior is screwing over retirees. The pension funds have access to resources that can uncover this stuff very easily. Also, knowing people that deal with the pension funds and our experiences with those kinds of investors (real estate, private equity and hedge funds), the contacts that evaluate the opportunities ALWAYS asking about fees.

    You want to talk about how to fix that, I’d have to suggest ‘Not like giant financial institutes control the entire universe so much they can apparently rewrite everyone’s reality.’, but maybe that’s just me.

    Sure.

    Let’s start with a point where you and I agree, most likely for different reasons: public pension funds do not belong in the private equity. My belief has nothing to do with the alleged scams but rather that they are not able to achieve returns that beat the market. It’s a supply/demand issue. Pension funds are investing billions into private equity funds so those funds can give them better returns. However, as more and more capital has flowed into the space, given that the kinds of investment opportunities that could achieve these returns (ie buyouts) have not kept pace, there’s more capital competing for a given pool of deals. That pushes up pricing and makes it harder to achieve those returns.

    Public pension funds aren’t the only ones to blame for this, but I’ve heard that at least 20% of the capital in private equity comes from that source.

    On a logistical level, a pension fund like CalPERS that invests billions in private equity has restriction on how much it can invest in any given fund (i.e. no more than 5%) and maybe also with operators (although I’m not sure). Therefore, in order to invest its allocation into private equity, it has to invest in a large number of funds. Given that these funds all compete with each other, pension funds that have private equity investment in 20, 30 or more funds have investments that are in effect competing with one another. I haven’t even gotten to what happens when the private equity investment go unsupervised (which you covered).

    Aside from the fees generated by the industry, I”m not so sure that the private equity industry is worse off without the pension fund money. The best funds will still find investors and the worst of them will close up. Maybe there’s less competition for deals and the remaining investors are better off. Who knows.

    To some of your other suggestions –

    As much as I find the pension funds at fault for what’s been happening, I woiuldn’t object to better disclosure of fees.

    As far as the clawback shenanigans, I would either prohibit clawbacks and mandate that the carried interest be paid only at the fund level (and not the deal level) or require that the clawbacks be fully funded prior to the fund managers receiving their carried interest. I would propose as a penalty for non-compliance that any carried interest payments within a fund where a violation takes place be treated as ordinary income. When I publish my carried interest post, the reasoning will make perfect sense.

    Management fees should be treated as ordinary income and putting them into the fund in order to avoid taxes is something the IRS should deal with and immediately.

    And the benefit of making them public is that *someone* can read them…because the people being paid to do so sure as hell aren’t. Watchdog groups send in FOIA requests for government contracts all the time, exactly so they can look at them for this sort of stupidity.

    If watchdog groups want to look behind the veil and see how the pension funds are allowing the private equity firms to charge such ridiculous fees, have at it. All I ask is that these people bark up the right tree. What if the people being paid to read the documents are reading them, know what’s in them yet go along with it anyway because they feel that these private equity managers are their best bet to beating the market? Right or wrong (mostly the latter), that’s a possibility here.

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    • …I can’t buy off on any narrative that suggests that Wall Street’s predatory behavior is screwing over retirees.

      Yeah, and, no offense, but I think that might say more about what you are willing to accept as true than what is *actually* true.

      Wall Street’s predatory behavior *is* screwing over retirees. Yes, this might be because the administrators of pension funds are idiots who just blindly do whatever Wall Street suggests…but, uh, *that’s* Wall Street’s doing also.

      All scams happen with the ‘consent’ of the scammed (Otherwise they’re thefts.), and happen because the scammed person *does not fully understand what is going on*. Saying ‘They should have worked more to understood’ is all fine and dandy, especially when those people are supposed to be *professionals*…but does not change the fact that there was a scam.

      However, as more and more capital has flowed into the space, given that the kinds of investment opportunities that could achieve these returns (ie buyouts) have not kept pace, there’s more capital competing for a given pool of deals. That pushes up pricing and makes it harder to achieve those returns.

      And let’s not forget that a good portion of private equity is destructive, dismantling companies.

      Now, a little destruction is good, but at some point, with private equity funds running around looking for places to invest, they will (and have) buy and dismantle perfectly functional companies that have hit a bad year, just so they have *something* to do.

      What if the people being paid to read the documents are reading them, know what’s in them yet go along with it anyway because they feel that these private equity managers are their best bet to beating the market?

      Ah, I’ve been reading about the CalPERS mess, and it’s become very clear *those* people, at least, have absolutely no idea what’s going on. The board has no idea, and the staffers think whatever their friends on Wall Street say is 100% true.

      And they’re supposedly ‘leaders’ in this whole thing.

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      • Yeah, and, no offense, but I think that might say more about what you are willing to accept as true than what is *actually* true.

        None taken so long as you apply the same thing to yourself. At least I can say that I’m drawing on my professional experience in this conversation, and unfortunately for the populist types that shit all over the finance sector, this story is a little too messy for that.

        Wall Street’s predatory behavior *is* screwing over retirees. Yes, this might be because the administrators of pension funds are idiots who just blindly do whatever Wall Street suggests…but, uh, *that’s* Wall Street’s doing also.

        So it’s Wall Street’s fault that the pension funds blindly follow their suggestions?

        Look, I am not one to take power imbalances in finance lightly. I understand how much it is of a clusterfish when consumer finance companies market to lower-income consumers and in many cases profit on their ability to trap them in an endless debt cycle (the one reason above all that I despise payday lending).

        This dynamic doesn’t exist here. The staffers at these funds know what’s going on, and the fact that they make poor decisions on behalf of the funds and the retirees says more about this whole story than the private equity business. The staffers give the fox the keys to the hen house and you blame the fox for this?

        All scams happen with the ‘consent’ of the scammed (Otherwise they’re thefts.), and happen because the scammed person *does not fully understand what is going on*. Saying ‘They should have worked more to understood’ is all fine and dandy, especially when those people are supposed to be *professionals*…but does not change the fact that there was a scam.

        All scams happen with the ‘consent’ of the scammed (Otherwise they’re thefts.), and happen because the scammed person *does not fully understand what is going on*.

        This is fine, but my contention is that the blame rests with the pension funds for allowing this to happen. They are the one force that could restore some sanity to things like corporate governance and fee structures if they knew how to get out of their own way, get off their asses and do something.

        Now, a little destruction is good, but at some point, with private equity funds running around looking for places to invest, they will (and have) buy and dismantle perfectly functional companies that have hit a bad year, just so they have *something* to do.

        I recall having a conversation about private equity like this and there were commenters concerned that private equity firms would target “perfectly functional companies”. Rest assured, those companies are too expensive to acquire and have no need for private equity capital. Publicly traded companies that have a bad year may take a hit on the stock price but if the long-term story good, the share values will remain above where private equity would target it.

        I’ve been reading about the CalPERS mess, and it’s become very clear *those* people, at least, have absolutely no idea what’s going on. The board has no idea, and the staffers think whatever their friends on Wall Street say is 100% true.

        They’re doing a hell of a job for their retirees, aren’t they?

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