Notes – Original Issue Discount (OID) Tax Implications, Lessons Learned (#taxes, #investing)

In the process of carrying out the KV Pharmaceuticals capital structure arbitrage trade of 2012, I got caught with my pants down a bit as I didn’t think to sell the convertible notes before they stopped trading. As a result, I missed an opportunity to lock in a capital loss for tax purposes at the time, which would’ve helped shield some of the income I made on the puts and thus made the trade as a whole more tax efficient.

Instead, I got a double-whammy of tax inefficiency for my ignorance, a chicken that finally came home to roost in tax FY2013 as the CPA assisting me with my tax preparation informed me that I ended up owing an additional sum beyond amounts withheld in prior periods due to Original Issue Discount (OID) interest income related to my defunct KV Pharmaceuticals play!

At first I was shocked and dismayed– the company went into bankruptcy and the securities were eventually removed from my account entirely earlier this year. How could I owe taxes when I never earned any cash interest and will never get back even a penny from the securities I stupidly held onto?

I talked about it with my CPA (who double-checked with his partner) and then spoke to a rep at TD Ameritrade and the matter is decisively not going to turn out in my favor. I learned that when a bond goes into default it often switches from cash interest basis to accrual interest basis in the eyes of the IRS, and like any good group of thugs they want their blood now, not later. In other words, I owe federal income tax on “accrued interest” I not only never received but never will receive. Because the securities were removed from my account in 2014 and not 2013, it looks like I accrued interest income due to me even though we clearly know right now that I’ll never get it.

Instead, I get a stepped up cost basis on the securities (in the amount equal to the accrued interest not received) so when I finally report the loss for FY2014 taxes, it’ll be a total loss of X + Y instead of just X. I get to shield additional future income with the X + Y amount but I paid real cash up front for the privilege.

If I had known better, I would’ve executed this trade such that the gains and losses all occurred in the same period in 2012. I also probably wouldn’t have gotten into a trade in the first place whose money-making mechanics I generally understood but about whose technical execution and tax implications I was grossly ignorant.

Another expensive lesson learned!

Quotes – Anti-Fraud Ethics (@nntaleb, #ethics, #fraud)

If you see fraud and don’t shout fraud, you are a fraud.

~Nassim N. Taleb, “Ethics

On Conspiracy (#conspiracy, #snowden, #NSA)

I’ve spoken to a lot of people who deny the existence of various conspiracies behind well-known human events because they believe it’d be too hard to keep a secret with the assumedly large number of people who would have to be in on it to pull off the original act.

I want to ignore the possibility, which I’ve raised, that secrecy isn’t even necessary because many times people will ignore or not recognize criminality right in front of their face (ie, the ongoing, millenia-long fraud of the State).

Instead, I want to reflect on the following current events. Nearly every week for the past several months, new information about global national “security” apparatus spying has come to light thanks to the efforts of Edward Snowden and his allies. Each one of these stories are billed as surprising revelations not previously known.

I don’t think there has been any specific disclosure of how many people at the various agencies fingered are involved in each of these various schemes but it seems safe to say they are “numerous.” I don’t know what kind of upper bounds a person would put on the number of members of a conspiracy required to keep a secret but I’d have to believe, given that these agencies occupy fairly large office buildings and other campuses around the country and the world, that the number of operatives exceed those thresholds.

How, then, did these programs manage to remain a secret?

To take this further, how do “intelligence communities” manage to operate at all given that they, too, are “numerous” and their entire model operates on the assumption that secrets can be kept despite their numerosity?

If I were to venture a guess, I’d say the answer lies with recognition of the fact that people have strong incentives to keep secrets concerning criminal or otherwise socially-reprehensible activity they’re engaged in. Especially when such activity constitutes their “job” which provides food for their families, or, even more powerfully, when such activities line up with their ideological beliefs, whose faithful following gives their lives purpose and meaning.

I think it unwise to overly discount the economic likelihood of conspiracy.

Notes – Stanford Graduate School of Business Search Fund Primer (#searchfund, #business, #investing)

Notes on “A Primer On Search Funds” produced by the Stanford Graduate School of Business

“The Search Fund”

  • Greater than 20% of search funds have not acquired a company
  • Stages of the Search Fund model:
  • Raise initial capital (2-6mos)
  • Search for acquisition (1-30mos)
  • Raise acquisition capital and close transaction (6mos)
  • Operation and value creation (4-7+ years)
  • Exit (6mos)
  • SFs target industries not subject to rapid tech change, easy to understand, fragmented geographic or product markets, growing
  • Highest quality deals are found outside broker network/open market due to lack of auction dynamics
  • Research shows that partnerships are more likely to complete an acquisition and have a successful outcome than solo searchers (71% yielded positive return, 15 of top 20 performing funds were partnerships)
  • Principals budget a salary of $80,000-120,000 per year w/ median amount raised per principal $300,000~
  • Majority of the economic benefit of SF comes through principal’s earned equity; entrepreneur/partners receive 15-30% equity stake in acquired company in three tranches
  • Investors typically receive preference over the SFer, ensuring investment is repaid, with return attached, before SFer receives equity value
  • Individual IRR from 2003-2011 median was not meaningful, heavily skewed toward 75th percentile where median was 26% in 2011; 57% of individual IRRs were not meaningful in 2011; the median fund destroyed capital in 2009 (0.5x) and 2011 (0.8x); 58% in 2011 broke even or lost money
  • Half of the funds that represent a total or partial loss were funds that did not acquire a company; biggest risk is in not acquiring a company at all
  • Median acquisition multiples: 1.1x revenues; 5.1x EBITDA
  • Median deal size, $8.5M

“Raising a Fund”

  • Search fund capital should come from investors with the ability and willingness to participate in the acquisition round of capital raising

“Search Fund Economics”

  • Search fund investors often participate at a stepped up rate of 150% of original investment in acquired company securities

“Setting Criteria and Evaluating Industries”

  • Desirable characteristics for a target industry: fragmented, growing, sizable in terms of revenues and number of companies, straightforward operations, early in industry lifecycle, high number of companies in target size range
  • Desirable characteristics for a target company: healthy and sustainable profit margins (>15% EBIT), competitive advantage, recurring revenue model, history of cash flow generation, motivated seller for non-business reasons, fits financial criteria ($10-30M in revs, >$1.5M EBITDA), multiple avenues for growth, solid middle management, available financing, reasonable valuation, realistic liquidity options in 3-6 years
  • Key challenge is “know when to take the train” lest a SF never leaves the station waiting for the perfect opportunity
  • Ideally, seller is ready to transition out of the business for retirement or personal circumstances or has something else they’d like to do professionally
  • Experience shows it is better to pay full price for a good company than a “bargain” for a bad one
  • Idea generation: SIC and NAICS codes, Yahoo! Finance, Thomson Financial industry listings, Inc. 5000 companies, public stock OTC and NASDAQ lists and even the Yellow Pages; generate a list of 75 potential industries to start
  • Target industries buoyed by a mega-trend
  • Can also target an industry in which the SFer has worked and possesses an established knowledge base and network
  • Some focus on 2-3 “super priority” industry criteria (eg, recurring revenues, ability to scale, min # of potential targets, etc.)
  • Objective is to pare down the industry target list to 5-10 most promising
  • Basic industry analysis (Porter’s five forces, etc.) is then used to narrow from 10 to 3; SFers use public equity research and annual reports for market size, growth, margin benchmarks; also Capital IQ, Hoover’s, Dun & Bradstreet and One Source
  • Industry insiders (business owners, trade association members, sales or business development professionals) and industry trade associations or affiliated ibanks and advisory firms are primary methods of research and often have general industry research or white papers available
  • Next step is to create a thesis to codify accumulated knowledge and compare opportunities across common metric set in order to make go/no-go decision
  • In order to become an industry insider, SFers typically attend tradeshows, meet with business owners, interview customers and suppliers and develop “River Guides”

“The Search”

  • Median # of months spent searching, 19
  • 54% spend less than 20 months searching, 25% spend 21-30 months, 21% spend 30+ months
  • Track acquisition targets with CRM software such as Salesforce, Zoho, Sugar CRM
  • Bring up financial criteria and valuation ranges as early as possible when speaking to potential acquisition targets to save everyone time
  • A company that is too large or too small as an acquisition target may still be worth talking to for information
  • You must immediately sound useful, credible or relevant to the owner; deep industry analysis should already have been performed at this stage
  • Tradeshows can be a critical source of dealflow
  • If a particular owner is not willing to sell, ask if he knows others who are
  • “River Guides” are typically compensated with a deal success fee, usually .5-1% of total deal size
  • Boutique investment banks, accounting firms and legal practices specializing in the industry in question are also a good source of deals
  • The business broker community itself is extremely large and fragmented; could be a good rollup target?
  • Often, brokered deals are only shown if a private equity investor with committed capital has already passed on the deal, presenting an adverse selection problem
  • Involve your financing sources (such as lenders and investors) early in the deal process to ensure their commitment and familiarity

“Evaluating Target Businesses”

  • Principles of time management: clarify goals of each stage of evaluation and structure work to meet those goals; recognize that perfect information is an unrealistic goal; keep a list of prioritized items impacting the go/no-go decision
  • Stages: first pass, valuation/LOI, comprehensive due diligence
  • It is in the best interest of the SFer to tackle core business issues personally during due diligence as it is the best way to learn the details of the business being taken over
  • Adding back the expenses of a failed product launch rewards the seller for a bad business decision; adding back growth expenses gives the seller the double benefit of capturing the growth without reflecting its true cost
  • Due diligence may also uncover deductions to EBITDA or unrealized expenses that reduce the “normalized” level of earnings (undermarket rents, inadequate insurance coverage, costs to upgrade existing systems, etc.)

“Transitioning Ownership and Management”

  • Create a detailed “Transition Services Agreement” with the seller, a legal contract where specific roles, responsibilities, defined time commitments and compensation are agreed prior to the transaction close
  • The first 100 days should be dedicated to learning the business
  • Businesses consist of people, and people need communication; great leaders are always great communicators
  • “Don’t listen to complaints about your predecessor, this can lead to a swamp and you don’t want to be mired there.”
  • The goal is to learn, not to make immediate changes
  • Outwork everyone; be the first person in and the last to leave
  • Many SFers insert themselves into the cash management process during the transition period by reviewing daily sales, invoices and receipts and signing every check/payment made by the company
  • The company’s board should be a mix of deep operational experience, specific industry or business model experience and financial expertise
  • The seeds of destruction for new senior leaders are often sown in the first 100 days

Quotes – Configuration & Rearrangement (#philosophy, #physics)

All unhappiness is configuration, all happiness is rearrangement. Your life lacks nothing, the universe contains within it everything, you need only order it as you like.

~Anonymous