Out of the frying pan and into the fire.  Last month Russell Wasendorf, Sr. attempted to commit suicide via asphyxiation by using a hose to funnel the exhaust from his Chevy into the car. A Good Samaritan thwarted his attempt and saved his life.  He is currently in jail awaiting trail where he will be charged with stealing around $200 million dollars from his own clients for the past twenty years.

Within the financial world $200 million is not a particularly large amount of money.  A scandal of this magnitude, although terrible, would not normally ring many alarms, but following the Madoff Ponzi scheme and the collapse of MF Global, it has done so, and with good reason.  This outright theft, along with the more recent LIBOR fixing scandal, has, to a certain extent, confirmed the public fear that the financial industry cannot always be trusted to keep investors’ money safe. This fear is helping to fuel the current economic downturn as investors continue to lose faith and withdraw money from financial markets.  Although this doubt in the system is certainly justified and is clearly an important issue, these recent scandals also beg a more fundamental question:  Can regulators be trusted to regulate?

It is almost laughable how simply Wasendorf was able to fool U.S. regulators as he stole hundreds of millions of dollars through his futures firm Peregrine Financial Group.  The ultimate authority for regulating firms such as Peregrine resides with the U.S. Commodity Futures Trading Commission (CFTC), which, because of its limited resources, delegates most of the oversight, such as regular auditing, to the National Futures Association (NFA).  The NFA, an internal self-regulatory organization, had audited Peregrine three times since 2010 and failed to pick up on the fraud.  Even more shocking is the fact that Wasendorf was able to frustrate the NFA’s attempts to verify Peregrine’s bank statements simply by sending them forgeries.  Instead of picking up the phone or contacting the bank electronically, the NFA relied on written mail to reach Peregrine’s bank.  The only problem was that Wasendorf had provided his own P.O. box as the bank’s address.  Receiving these letters himself, Wasendorf was easily able to falsify records.  He wrote, “Using a combination of Photoshop, Excel, scanners, and both laser and ink jet printers I was able to make very convincing forgeries of nearly every document that came from the Bank.”  When the NFA finally gained enough sense to contact the bank for electronic records, they stumbled upon nearly twenty years of fraud.

Although it is clear that regulators at the CFTC and NFA cannot be blamed for this scandal, it is rather astounding just how incompetent they were at detecting it.  When this failure is seen in aggregate with the several other scandals around the financial world, doubts quickly begin to arise about nearly all regulators’ abilities to provide oversight.  They are clearly struggling to do their jobs effectively.  Blame, however, should not fall solely on their shoulders, for they are playing at a natural disadvantage, which can be seen if we consider the massive disparity in resources between the financial services industry and those organizations that regulate them.  The CFTC for example, which is one of the largest regulatory agencies in the United States, employs roughly 700 people and has a budget of about $200 million.  Goldman Sachs, on the other hand—a single bank that participates in the futures trading regulated by the CFTC—employs about 47 times as many people and has about 22 times as much spending money, with 33,000 workers and $ 4.4 billion in net income for 2011.  With this absurd discrepancy of resources in mind, it should come as no shock that regulators struggle to keep up with financial firms’ attempts to skirt regulations (both legally and illegally).

The problem is exacerbated by the fact that there is no clear solution.   Adding more resources does not seem to be a possible remedy, because of the government’s limited funds.  The U.S. cannot afford to simply throw money at this problem. Attempts to find and incentivize better regulators also run into problems because of the nature of the job.  In addition to being understaffed, regulators are also underpaid compared to those working in the financial sector. Considering this, it is not surprising that the financial industry attracts a much larger array of talented people who can do their work at a much higher level.  Even when people are at their jobs on these opposite sides of the industry, their incentives are vastly different.  A banker who exploits some sort of regulatory loophole or flat-out breaks the law stands to make millions of dollars, while a regulator who manages to do his or her work exceptionally well and stops the banker merely gets a “job well done.”

It seems obvious that regulators are struggling to do their job and provide the policing that the financial industry needs, even if it is not entirely their fault.  Although this may not be the main problem behind financial scandals, it is certainly present and fueling the flames of fraud.  If we wish to change the industry that has caused so much grief though its greed, changing the organizations that are meant to prevent this fraud may be a good place to start.

By definition, fear and  greed mark periods of irrationality. These evil twins of speculation signal a move away from investment and into a world in which rumors, gossip, and irrational behavior rule the landscape. In the current market, a whisper of a potentially undesirable German Parliament vote could send markets down 3%.

History and psychology indicate that this is simply a bear market strung along by fear, an irrational decline that, although troublesome, will eventually return to “normal” levels. But even though the current stretch of fear is prolonged, intense, and volatile, the sobering backdrop of global financial crises and an extended recession continue to loom over the market.

Then perhaps the fear isn’t fear at all, but a justified symptom of a changing financial system.

Domestic macroeconomic issues include lagging unemployment numbers, slow GDP growth and a tremendous decrease in investment. On top of that, the housing market has begun to decline once again, corporate profits have taken another beating, and banks again are rumored to be undercapitalized. “There are issues about the weakness of banks and uncertainty about how the government will respond to another banking crisis,” says Professor Zitzewitz, an economics professor at Dartmouth College.

Even bigger issues lie overseas – the prolonged Greek debt crisis, and concerns over the solvency of Italy, Spain, and Portugal, threaten to send the Eurozone into a financial crisis of epic proportions.

With all of these potentially disastrous domestic and international issues, Thomas Flexner, Global Head of Real Estate at Citibank, believes that the market is behaving somewhat rationally. “This is reasonable fear based on the uncertainty of the markets,” he says. “Irrational implies that the fear is misplaced or unfounded.”

If, indeed, the fear is rational, then the consequences are severe. It suggests that the incredible world economic growth over the past several decades has been inflated.

“In the past twenty years, global markets were magnified by credit creation – easy central bank policies and easy leveraging created credit that turned into purchasing power, propelling global GDP,” says Flexner.

The debt owed to the creditors has to be paid back, slowly and painfully. This paying down of debt could drastically limit the advance of the global economy for many years. If our fears come true, then we could be entering a new economic reality of shrinking credit and a diminished financial  system.

At the same time, some investors continue to make big bets on our financial system, confident that the American economy can come out of the recession unscathed and unchanged. Some might argue that the bear market has been exaggerated, that although some of the concerns are real, the sharp decline in the equities market has been intensified by fear and rumor-mongering.

On August 18th, 2011, the Dow declined a whopping 415 points based on a “trio of disappointing economic readings” and a Morgan Stanley report that the US and Europe may be heading for another recession.

Those losses were erased a few days later as the Dow posted consecutive gains of 322 and 145 points based on an “FDIC report that the number of US banks in trouble is declining.” The Dow slipped 388 points on September 22nd, 2011, for a 3.48% loss based on “several reports…warning of the dangers of another global recession.”

Again, the losses were erased by a 272 point rise two days later on rumors that the German Parliament would vote to expand the bailout fund for Greece.

From this, it seems that the extreme upswings and downswings in stock prices can be attributed to only a few economic reports. To a rational observer, a few poor (but far from disastrous) economic readings should not lead to a 3.48% decline in the blue-chip stock index of the most financially powerful nation in the world.

The tremendous attention that investors are paying to small,  insignificant data points may be evidence that the levels of fear currently exceed market rationality. “The market is moving around more than justified by the news,” Professor Zitzewitz says.

The fear could be stemming from group psychology. The closeness of the financial community, in which relationships rule all, could potentially lead to prolonged bouts of groupthink in which traders and investors move together in herd behavior, acquiring information only from those already within the circle and of the same mindset.

As a result, the effects of a single, unfounded rumor is intensified as it moves through the collective conscious of the financial markets, unchallenged by outside analysis.

Prospect theory also suggests that people who have already achieved gains would be risk-averse, while those who have suffered losses become risk-loving.

It’s possible that as investors received overwhelmingly favorable returns in 2009 and 2010 have now become risk-averse, and even the slightest tremor in the financial bedrock would lead them to quickly shift their investments to less risky instruments.

Ironically, it is the very fear that leads investors to take their money out of stocks that makes the stock market decline. The actions of the investors are a self-fulfilling prophecy.

The fear, volatility, and global decline in financial markets may not be justified, but by their very existence, create an environment that reaffirms their fear.

As Flexner states, “Fear, unfortunately, becomes self-fulfilling. It’s investor’s fear that creates redemptions, forces hedge funds to sell their liquid assets, and eventually decreases the values of those very assets. That’s the biggest problem with fear. Fear in the financial markets transmutes itself into  reality.”

With the nadir of the recession behind them, the biggest private equity (PE) firms, since early 2010, have made numerous strategic shifts in their business. Since its emergence as a high-profile asset class, private equity has evolved in direct response to discovering new means of creating value: financial engineering in the 1980s and operational enhancement in the 1990s. Today, these approaches are standard across all the best firms and no longer offer the competitive advantage they once did. Moreover, gone are the days when top tier PE firms were returning in excess of 20 percent through their traditional core business, the leveraged buyout (LBO). In fact, buyout returns are down, have been (even before the financial crisis), and seem unlikely to rebound anytime soon. Given Blackstone, KKR, and Apollo Management’s recent shift toward public ownership of their PE Firms as well as portfolio diversification away from the LBO and into credit investing, real estate, advisory services, and proprietary trading, PE firms have apparently noticed…but the question remains: What necessary innovation in private equity’s value creation model is next?

In the 1980s, private equity developed its first innovation: financial engineering, or the idea of buying companies with debt, taking them private, and then, in theory, reselling them after a few years with a rate of return enhanced by leverage. According to Henry Silverman, chief operating officer of Apollo Management, this strategy can be explained simply: “If I have 10 cents, borrow 90 cents, buy your tie for a dollar, and sell it to Joe for $1.05, I didn’t make a nickel; I made a 50 percent return on my investment.” By the 1990s, however, financial engineering had become commonplace across competent PE firms; as a result, PE firms looked for another innovation and found operational enhancement. This strategy seeks to increase the value of portfolio companies by reducing cost in any form, whether that involves process improvements, outsourcing, or restructuring.

Success in private equity hinges on a firm’s capabilities in fund raising, deal making, and adding value to its investments. These capabilities are inextricably linked such that the strength of each depends on that of the other two. That is, if a firm has more ways to add value, it will naturally discover more investment opportunities. Winning more investments means a better track record, which, in turn, helps in fund raising. As firms have matched each other’s ability to add value via the two aforementioned innovations, the question remains, “What’s next?” The answer, though seemingly apparent, will distinguish the winners from the losers in the near future: PE firms must be able to spur organic growth in their portfolio companies—that is, the ability to systematically expand or increase the revenue of companies they already own (using internal resources) through increasing their customer base, output per customer, etc. Indeed, this requires PE firms to hold a deeply rooted knowledge of the customers, their behavior, and their wants and needs per industry.

The next critical question then, is how PE firms can improve their ability to engineer organic growth without changing the firm’s structure and limiting flexibility. The answer comes in three parts: adding new growth capabilities, making growth in their portfolio companies the primary focus, and finding ways to make this growth net free.

Adding growth capabilities involves enhancing pricing ability as well as improving sales-force practices. According to the McKinsey Quarterly’s article “Freeing up the sales force for selling,” “Most sales reps spend less than half of their time actually selling.” KKR’s acquisition of Dollar General, a chain of variety stores, illustrates just how PE Firms can add these growth capabilities. When KKR helped take Dollar General private in 2007, its enterprise value stood at $7.3 billion; today, now public, Dollar General has an enterprise value in excess of $12 billion. What changed? When KKR first acquired Dollar General, its management based its decision about which products to put on shelves by simply looking at the profit margin of individual items. Although their logic aligns with common sensical thought, KKR suggested that, given Dollar General’s niche as a place to pick up a few small items (not to do major shopping), management should instead look at dollars of margin per linear foot, “a common measure in food retailing that takes into account not only how much profit a given product generates per dollar of sales, but how quickly the product sells.” This strategy prompted Dollar General to start carrying milk and other basic products as well as offering Coca-Cola in addition to the Pepsi they once were limited to. Ultimately, the “right” products maximized foot traffic among customers and increased revenue exponentially.

With constant attention to eliminating costs, how can PE firms make growth in their portfolio companies a primary focus? One way is to keep in mind the concept of “headroom” as a structure for determining available growth in a market. Headroom equals the market share that a company does NOT have minus the market share that it will NOT get. Headroom essentially outlines which customers can be targeted to switch from rival companies to their own, and what it would take to have those customers make the switch. Thinking along these lines will naturally improve coordination within the company. The last challenging aspect of this innovation involves adding growth capabilities and making growth a primary focus net free—cash invested in these initiatives must come from internal resources of the portfolio company. Doing so, will further align incentives throughout this process of spurring organic growth.

Still, as organic growth increasingly becomes important in private equity, the previous means of value creation will undoubtedly remain important. Nevertheless, as this third innovation truly makes headway, without a strategy for spurring organic growth in portfolio companies, PE firms will become less and less competitive in fund raising and deal making. Ultimately, this means returning to their role of being in the solutions business—promoting growth through real improvements in portfolio companies and increasing overall profitability in the process.

Staying Afloat

Today’s headlines are dominated with news of the collapsed housing market, an auto industry in shambles, and the death of some of Wall Street’s most famous investment banks. Investors have grown nervous, with a mass sell‐off of assets as a result, causing the stock market to take a record‐breaking plunge. Even institutions with large endowments, such as Dartmouth College, are feeling the impact of this crisis, and are cutting spending where possible. With so many large companies and banks failing, there is one sector that has been almost completely neglected in the media: small businesses.

Small businesses, by definition, have fewer than five hundred employees, but represent approximately 99% of all employer firms and create more than half of nonfarm private gross domestic product. Such small companies are also responsible for paying nearly 45% of the total U.S. private payroll. With over 27 million small businesses in this country, their importance to our economy is critical, but right now many are teetering on the verge of bankruptcy.

Due to their extreme abundance, the failure of a single small business rarely makes headlines. However, the financial crisis is having an enormous impact on the way that they operate. These businesses rely heavily on bank loans for financing, and have therefore suffered deeply as credit has tightened severely. Many of these banks have failed, or are in danger of failing, making it much harder for business owners to acquire the capital they need to grow. Banks have grown hesitant to extend credit to such small customers due to heightened risks, which makes it very difficult for small businesses to pay existing loans.

If small businesses do not have sufficient funds to operate, they may be forced to operate on low profit margins, and may eventually fail. The $700 billion bailout and the subsequent lowering of interest rates was expected to stimulate lending and increase liquidity but so far has failed to achieve those goals. John Hole, the 32‐year owner of John’s Tile Center, is worried that he may have to use his personal savings to keep his business from failing. “At my age, the last thing that I want is to be injecting funds into my business,” he said. He hopes to keep his four staff members, but says “I’m taking it day by day.” Banks have used bailout money to bail themselves out but have been unsuccessful thus far at using that money to rejuvenate small businesses.

The financial problem that small businesses face has been further exacerbated by the $700 billion bailout. Although the bailout was intended to stimulate banks into granting new loans, it has largely failed to do so. For small businesses that are not able to attain necessary loans, any increased taxes on the businesses’ existing assets are remarkably painful. For example, a developer may have bought several pieces of land before the financial crisis with the intention of building homes or a mall. Now, with the economy in recession, banks won’t give money to fund the building projects on the land because they know that fewer people will be spending on new homes and luxury items. This presents the developer with a significant problem: he or she cannot develop the investment, but at the same time must pay significant property taxes on the land. Instead of the land generating profits, it now faces taxation and thus negative cash flow. Eventually, the developer may choose to sell his land at a loss and close his small business to avoid losing more money.

A development firm is just one example of a small business type strained by the current financial crisis. Restaurants, retail stores, architecture firms, hotels, and entertainment venues are all suffering, or even failing, due to the severe drop in consumer spending. Nick Economos, owner of the Fishbone Grille in Fort Mill, NC had to close his restaurant because, “People just quit coming.” He said, “People just got scared with their 401(k), and during that time it was just bad news… [the] stock market dropped like a rock and here we couldn’t get gas. That was everyone’s first priority. It added to the anxiety.”

Because small businesses employ so many people and are responsible for such a large percentage of our GDP, the failure of these companies will only continue to hurt the economy. Until consumer confidence returns, many small businesses will continue to spiral downward toward bankruptcy.