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SOME NEWS STORIES are unusual in ways that it’s hard to know what to make of them. Such is the case with the recent collapse of a relatively unknown company called First Brands.
On the surface, it might seem like a mundane story. First Brands is an auto parts supplier, making commodity items like brake pads and windshield wipers. The company was founded in 2013 by a fellow named Patrick James, who built it up over the years by acquiring several other, smaller companies. It ultimately reached billions in revenue.
Earlier this year, however, First Brands began paying some of its bills more slowly, and lenders started asking questions. What came to light was that First Brands had been engaged in what’s known as invoice “factoring.” This is a strategy whereby a company sells its open invoices to a third party in exchange for immediate cash. This is an attractive option for companies that are short on cash because it allows them to raise money without taking on new debt. That makes them appear stronger financially than they actually are. It’s entirely legal but often kept under the radar.
In mid-September, as investors pressed for more information on First Brands, further issues came to light. Among them: It was revealed that the method the company was using to factor its invoices was different—and more risky—than what the public had assumed. Of more concern was that the company couldn’t account for approximately $2 billion of cash, and that led to a bankruptcy filing on September 29th. As one of the company’s unhappy lenders put it, the $2 billion “simply vanished,” and the Justice Department has since initiated a criminal inquiry.
First Brands is a private company, and ordinarily, a story like this wouldn’t have been such big news. It got more attention, though, when it turned out that its bad debts were concentrated among a small number of Wall Street lenders, including the financial firms Jefferies and UBS.
Jefferies revealed that it has more than $700 million of exposure to First Brands. Through a fund it manages, it turns out that it was First Brands’s largest lender. Jefferies had also been helping the company to issue new bonds, and there are questions now about whether it had been forthright in portraying First Brands’s existing debt level as it worked to promote those new bonds. This caused a 10% one-day drop in Jefferies’s share price.
UBS estimates that it has about $500 million in exposure to First Brands and has seen its share price decline as well.
What can we learn from this story? I see a few potential lessons.
First, this episode helps us to appreciate the difference between public and private markets. This is important because in recent years, there’s been growing interest in private equity and private debt, and Wall Street has lobbied to allow them into everyday Americans’ 401(k) plans. Disappointingly, in my opinion, even Vanguard, the pioneer of low-cost investing, is now promoting private funds.
It’s well known that private fund fees are high. But as I described a while back, in some cases, it’s difficult to even know what those fees are. That gets at the second issue: Because private funds aren’t subject to the same level of auditing and oversight as standard, publicly-traded funds, they’re more susceptible to mischief. At the very least, they’re often opaque, and that makes them inherently more risky.
Consider what happened in the First Brands case: A Jefferies subsidiary known as Leucadia had set up a private fund called Point Bonita, which, in turn, was lending to First Brands. As customers paid invoices, those funds were routed through First Brands and back to Point Bonita. From the perspective of an outside investor in a structure like this, it would have been nearly impossible to assess the risk.
In its fundraising presentation earlier this year, Jefferies did disclose the factoring arrangement but downplayed it: “First Brands does not view factoring as debt-like given it is a true non-recourse sale.”
If this sounds complicated, that’s the problem. When it comes to private funds, most of them are probably just fine. But because of the complexity, even the most sophisticated investors can have a hard time assessing the risk.
That’s why, in my view, they should be avoided. While public companies certainly aren’t immune to problems, the nature of private funds makes them much more susceptible to issues like this.
Another key point: For years, there has been debate over whether the stock market is “efficient.” According to this theory, the collective wisdom of investors ensures that stock prices accurately reflect the value of underlying companies. Episodes like this, however, help us see that the notion of market efficiency is just that—a notion. Because no one can be sure precisely what is going on in any given business, we should never put too much faith in the commentaries of market observers.
Another question about First Brands: Is its failure a canary in the coal mine, telling us something about the state of the economy? It would be easy to compare it to an early warning sign of the 2008 downturn, when two Bear Stearns funds unexpectedly failed in June 2007. Some are drawing that parallel.
Jim Chanos, a hedge fund manager who is recognized as one of the only investors to have predicted the 2001 failure of Enron, commented on today’s lax lending standards: “As long as everything works, nobody asks questions,” he said. “It isn’t until something stumbles, or the markets stumble, that people say, ‘Wait a minute, what are we doing here? This doesn’t make any sense.’”
Echoing that point, and noting another recent bankruptcy, Jamie Dimon, the CEO of JPMorgan Chase, made this observation: “I probably shouldn’t say this, but when you see one cockroach, there are probably more. Everyone should be forewarned on this one.”
That brings us to the final lesson we might learn from this story: When it comes to making judgments about the economy or financial markets, we should never be too sure. It’s possible that this is a sign, and that there are more “cockroaches” that might undo the current economic prosperity. But I’m not convinced. It’s very possible that this was a company-specific issue. For that reason, I wouldn’t be alarmed and would be careful not to overreact.
As I mentioned last week, investors’ best defense is to diversify, keeping a close eye on asset allocation.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
It will be interesting to see how the Vanguard private equity fund does over the next 10 years.
Thanks for another excellent and thoughtful article. Keep them coming, we appreciate your fine efforts. For me, I am just sticking with the S&P 500, which has served me very well for many years. At 80, I have NO need or desire for Private Equity. Thanks Again.
Thank you Adam for another insightful article.
I’ve been an accredited investor in real estate, but it was with people I knew and who had good reputations. Even then, there were a couple of surprises, though the investment was ultimately profitable. However, you will never see me put money into today’s private equity offerings. I’ve always looked at public company financials as reflecting “the best that a company could justify”. The finance people in these companies have to be willing to prove that their numbers are supported by real money and good decisionmaking. But sometimes even that decisionmaking can be suspect or wrong, or just over-optimistic, and thus the actual financial status of these companies might actually be worse than reported. Private equity doesn’t have even that “governor” required by the securities laws. And, like it or not, that old Willie Sutton saying “I rob banks because that’s where the money is”, sometimes applies to investing, too. “I rob individual investors because that’s where the money is.” Dishonesty can be well hidden until the damage is done.
I invested in Starwood’s SREIT a few years back on the recommendation of a trusted former colleague and friend. Never again. It will take me 5+ years to withdraw my investment due to the tollgates they imposed during Covid. Buyer beware!
My concern is the rule change that allows private equity to be part of IRA accounts. It’s ill advised in my opinion. It used to be only “qualified investors” who presumably understood the complexity or could absorb the downside risk. Now it’s anybody and everybody can have some private equity.
Thank you for this timely article and related links below….pretty scary stuff when you consider the parallels with previous financial crisis in our recent past. Sadly this is yet another reminder of the short term thinking that is rewarded by financial services firms. Just think about the recognition, rewards, closing dinners and bonuses that were paid out when these loans were made. None of that money will be recovered and as a result, people will continue to be encouraged to ignore the long term implications of their actions.
More news of alleged fraud in this morning’s local paper:
Miami investor used fraud to buy dozens of Boeing 737s, FBI says
https://www.seattletimes.com/business/boeing-aerospace/miami-investor-used-fraud-to-buy-dozens-of-boeing-737s-fbi-says/
I chuckled when I saw that cockroach comment reported. But I’m making sure my plan is sound enough to withstand the shock when all the lights come on.
Like the “Black Box” at Long Term Capital Management no one knows what was going on – even the people running sometimes. Being susceptible to bias confirmation I’m sticking with index funds. My father used to talk about the new deodorant they came out with. It didn’t get rid of the smell, but it spread it around so much no one could tell where the odor was coming from. Maybe index funds help in that way.
I’ve been thinking a lot about the deodorant analogy regarding AI. There are so many AI companies out there with high valuations (and many that are still private but flying high with predicted value). A lot of the AI hype has caused our index funds to rise. I don’t doubt that AI is going to change our economy, but I highly doubt that many of these companies will survive. We just have to hope that the ones that do continue with the crazy high valuations (or at that time maybe deserved crazy high valuations) so that they keep the average value (our index funds) up.
Private companies, like a marriage-only the people who are intimately involved know what is really going on.
I always find it amazing that these companies fool the “experts” at places like Jeffries and Black Rock–see Nick’s link below. I hope there are no bailouts coming in private equity.
Another fascinating anecdote from Adam. It seems that the higher the stakes, the less likely the cream rises to the top. It’s the used car salesmen that run the show. (apologies to used car salesmen, drunken sailors, etc.)
Of the two loans mentioned, the Jefferies loan occurred first at an effective rate (with fees) of about 30%. That’s a whiskey rate. An other people’s money while I fly around on a private jet with a stay-out-of-jail card rate.
The nominal UBS rate was about the same as the Jefferies at 10%, but without the fees, thus was the effective rate as well. They jumped into the whirlpool for less cause after watching Jefferies do it.
Amazing.
This is another reason the Fed needs to tread very carefully going forward. Overly cheap money gives cockroaches more places to hide.
And Tricolor too?
https://www.wsj.com/articles/collapse-of-subprime-lender-tricolor-kicks-off-scramble-for-100-000-car-loans-c1606f7c?st=S6eeM6&reflink=article_copyURL_share
The missing $2 billion causes me to think that this was just fraud, not a canary in the coal mine. If it were just a case of a failing company the financials and other records should reveal the losses and the causes of the losses. Thanks for this article. As a commercial credit officer, I’m very interested in post mortem analyses like this.
here is another cockroach:
https://www.wsj.com/finance/blackrock-stung-by-loans-to-businesses-accused-of-breathtaking-fraud-6de5c3a7?st=kaVyJY&reflink=desktopwebshare_permalink
I find amusing the statements in the articles that people went to the official offices and found them closed or vacant. Of course they were. Everyone now works from home or a table at their favorite coffee shop.