Angst in America, Part 6: Middle Class Blues


“We of the sinking middle class may sink without further struggles into the working class where we belong, and probably when we get there it will not be so dreadful as we feared; for, after all, we have nothing to lose.”

– George Orwell
 

“A strong, educated middle class is what made America the greatest country in the world.”

– Lincoln Chafee


As we continue our tour of the widespread angst afflicting investors large and small today, I want to ask a more fundamental question: Is the angst all in our heads?

The quick answer: No, it’s not. The economic challenges we face are real. Fear, or angst, is often a perfectly reasonable response. I’ve said that, with one exception, we can muddle through the coming crises. But “we” doesn’t mean every single one of us. The nation will survive the next recession, but some of its citizens may not, at least not with the same financial security that they currently enjoy and expect. The coming pension crisis will put quite a dent in expectations. Economic strain can lead directly to sickness, disability, and sometimes suicide or fatal illness. It happens. I don’t want to minimize that risk.

It’s precisely the risk that we will find ourselves among those who can’t muddle through that creates so much angst. Worse, we know the risks aren’t randomly distributed. We have classes of Protected and Unprotected citizens, to use Peggy Noonan’s terms. But even the Protected are afraid they may slide down the scale into economic oblivion.

Actually, they probably wouldn’t slide much farther than the middle class – but they may find the middle class hollowed out when they get there. The middle class is a fairly new development in economics. Up until the last century or two, most societies had a tiny wealthy elite and great masses of common laborers. We now regard having this group in the middle, not wealthy but with their own assets and spending power, as a great achievement. We don’t want to lose it, but some people fear we will.

If you delve into the economic and social-psychological literature, and if you can put up with the academic language that does its best to obscure what’s actually being said, you will find that there is a general consensus around the idea that having a lot of money does not make us happy, once our basic needs are fulfilled. There is, however, some research – and it’s controversial – which indicates that relative income is important. A majority of respondents would rather have more relative income than more absolute income, especially if they are relatively lower-income than everybody else. On the surface of it, that proposition doesn’t make sense to many people; but we’re dealing with human emotions and feelings, which often don’t make sense. We just seem to be wired to want to keep up with – or do better than – the Joneses, and now many people suspect they are doing worse. (Remember, these studies measure only the average propensity, not what you and I might as individuals think or believe or feel.)

So, given the uncertainty of the times (and the data I will present here), there is reason for concern that the middle class is really under pressure. It’s not just in their heads; it’s an everyday, real-world situation.

With that in mind, we’ll look at some new income data and see if it can help us control our angst.

All of this angst – no matter your current circumstances – makes it more difficult to make decisions now than it is in more confident times. Those of us in the publishing business, as well as in the money management business, know that it is in times of high anxiety that is the most difficult to get our clients and readers to actually respond. The best time to elicit a response is in a boom period, and the next best time is, ironically, just after a bust, when people are ready to figure out what to do. I say ironically, because it is precisely when we have an economic and political situation like the one we have today, when there is actually time to make proactive decisions, that it appears to be the most psychologically difficult to do so. We procrastinate; we become like Wilkins Micawber from Charles Dickens’ novel David Copperfield, who was famously noted for saying repeatedly, “Something will turn up.”

Let me suggest that now is the time you should be thinking hardest about taking action to have your house in order when we hit the next rough patch. Next week I’m going to start writing about what I am calling “The Great Reset.” I think we are approaching that moment when the two greatest bubbles in human history – sovereign debt and government promises (which are conflated in many people’s minds) – will burst, and politicians and central banks will be forced to take actions that are unthinkable today.

One way you can help yourself is by taking one of the few remaining spots at my Strategic Investment Conference, May 22–25 in Orlando. I have assembled an all-star cast of some of the finest analysts, economists, and geopolitical thinkers for a 2½ day deep dive into how the world will change over the coming 1–5–10 years. My full intention is for you to be able to walk away with the tools to create or enhance your own game plan. But if you can’t make it to the conference, we will soon be offering a full set of the speeches. They won’t give you the valuable interactions you would have at the conference with the speakers and other attendees; but that said, the recordings are the next best thing.

And now, having urged you to make sure you have the strategies to “batten down the hatches,” let’s see why the middle class is under so much pressure.

Poverty Going Extinct

We’ll begin with some good news. Despite all our problems, on a global basis the number of people trapped in extreme poverty has plummeted this century. That trend doesn’t mean everyone everywhere is living comfortably. Many millions still endure terrible conditions. But their number is shrinking.

The reason for the improvement, I believe, is that technology and free trade brought economic growth to formerly stagnant economies. Yes, corruption and inefficiency diverted much of the growth into the wrong hands, but there has still been a general increase in living standards and incomes.

We can see this decline in extreme poverty in the following chart from Max Rosen’s Our World in Data site. The chart plots the share of a country’s population living in extreme poverty vs. growth in per capita GDP. “Extreme poverty” means living on less than the equivalent of $1.90 per day. The lines illustrate the change in that balance over time. You can see a nifty animated version of the chart here.


 
What we see here is that many countries began in the top left quadrant or close to it, with a high percentage of the population in extreme poverty and with low GDP per capita. Over time, countries slide to the lower right, meaning higher per capita GDP and a lower percentage of the population in extreme poverty.

So, it appears that a general increase in national income correlates with fewer people living in dire poverty. Correlation isn’t causation, of course, nor does this mean that all is well in these countries now. But there is at least an association between economic growth and reduced poverty. The rising tide seems to lift most boats.

That’s great news – something we should all celebrate. We in the developed world can’t truly comprehend what extreme poverty is like. $1.90 a day? Americans spend more than that on coffee and junk food. I don’t know how people buy food, shelter, and everything else with such a small amount.

I suppose extreme poverty seems normal if you have known nothing else. But increasingly, we all do know (or think we know) how the other half lives. That’s part of our problem, as we’ll see below.

My point here is simple: If you are reading this letter, you are already far ahead of most human beings in terms of wealth, health, education, leisure time, and more.
 
Gratefully recognizing that fact helps with the angst. It’s not the complete answer by any means, but it helps.
 
The Great Middle

Now let’s consider some related data from Europe and the US, courtesy of Pew Research Center. In this case, we’ll look at the middle class.

First question: What’s “middle class?” Pew defines it as adults living in households with disposable incomes ranging from two-thirds to twice the national median disposable income. In the US, that means a 2010 after-tax income between $35,294 and $105,881.

Pew found that from 1991 through 2010, the percentage of adults living in middle-class households in the US shrank from 62% to 59%.


More significantly, perhaps, the US has the smallest percentage of middle class adults of any of the advanced economies Pew studied. Notably, during this period the middle class expanded in the UK, Ireland, France, and the Netherlands.

The percentages in themselves don’t tell us much. A shrinking middle class might be good if it means that more people are moving into the upper strata. Of course, it’s not possible for everyone to be above the median. That’s what median means: half above, half below. But income-distribution curves can have different shapes. In 2010, 59% of US adults were in the middle class, 15% above it, and 26% below it. Not exactly the shape of curve you want to see.

(Incidentally, I know the word class isn’t exactly right in this context. We are talking strictly about income. Usually, class considers other identifiers, like education. Pew uses middle income and middle class interchangeably but acknowledges the terms can be ambiguous.)

Now let’s look at a different data point: the median income that lies at the center of these distinctions. The chart below shows how the median changed from the beginning to the end of the study period. US median household income rose from an inflation-adjusted $48,343 in 1991 to $52,941 in 2010. That’s a 9.5% increase over 19 years. That’s pretty feeble, in my opinion, and indeed lower than in some European countries. Luxembourg’s median household income jumped almost 35% in the same period. But the trend was flat or even negative in Germany, Finland, Italy, and Spain. (More on US median income below.)


 
Another thing that strikes me here is the wide variation within Europe. In 2010, median income for a three-person household ranged from $31,885 in Spain to $65,466 in Luxembourg. You could say Luxembourg is small and unique; but Norway isn’t small, and at $52,304 its median household income is 64% higher than Spain’s. I suspect these differences have a lot to do with the European Union’s present travails – and its rising populist movements.

The US stands out in another way, which Pew illustrates with this scatterplot:


Comparing the size of each country’s middle class with its median income, we see that the US is a distinct outlier. Our middle class is smaller, but its income is higher than those of the middle classes in the other countries studied. Pew attributes the difference to another factor: The US has larger portions of its population in both the lower-income and upper-income categories than any of the other countries studied.


I don’t think these figures are a great mystery on the upper end. European countries have higher taxes, so they have relatively fewer wealthy people. Ditto on the lower-income end: It’s harder to be poor when your government has generous welfare programs. But these differences at the top and bottom ends are greater than I would have expected.
 
Measuring Relative Income

If the average person in this country feels as though they are going nowhere fast, there is a real reason for it. The next chart, from the St. Louis Federal Reserve FRED database, shows that median income in the US is actually down over the last 17 years and is only 3% higher now than it was 30 years ago. Those are inflation-adjusted numbers. But the reality is that, for the average person, inflation has been much higher than the average of 2% per year over that time, because the things that the average person actually buys, like housing and education and healthcare and all the other necessities of life, are rising at a much faster rate than 2%. So this chart reflects the fact that life has gotten much more difficult for average Americans. If people’s income hasn’t grown beyond what it was 30 years ago, they struggle just to make ends meet and to maintain the lifestyle they had. Can we say angst?


The Census Bureau updates its income figures about once a year, and the last real update we had was last fall, taking us through 2015. Doug Short did an analysis of those numbers, and I am going to borrow three graphs from him. (He does fabulous charts!)

He breaks the country into quintiles, calculates the average household income for each quintile, and then also shows the top 5%. Notice that the average income for the top 5% is $350,000. We will come back to that figure in a momento.


It looks like everybody’s income is rising, especially those in the top 20% and 5%. But if we inflation-adjust those numbers, the illusion of growth goes away. What we see is that there has been almost no movement for the bottom 60%, while the middle quintile has grown somewhat, and – this won’t surprise anyone – the top 20% and 5% have done very well.


The next chart shows what that growth looks like in percentage terms. We find that the bottom quintile saw their income grow by only 25% over the last 49 years, less than ½% per year. Interestingly, the fourth quintile grew even less than the bottom one, at around 19%, mainly because of government programs that supported those in the lowest 20%.


But what about the 1%, I hear you asking? Investopedia conveniently gives us that answer:

To be certified as a one-percenter, you needed to bring home an adjusted gross income of $465,626 more for the 2014 tax year, according to data from the IRS. The Washington Center for Equitable Growth put the average household income for this group at $1,260,508 for 2014.

But as the saying goes, your mileage may vary. It turns out there is quite a lot of variation among counties around the US as to what it takes to qualify for the top 1%. To make the grade in New York, you will need about $8 million in annual income. But that amount wouldn’t help you very much in Teton County, Wyoming (we’re talking Jackson Hole here), where you will need a tidy $28 million per year to make it into the top 1%. On the other hand, there are many counties around the country where the top 1% take in less than $200,000; and in Quitman County, Georgia, you only need $127,000 a year to be elite. I found it odd that in LaSalle County, Texas, you had to make $6 million to land in the top 1%. Now, that county has only about 6000 residents, and the median income is quite low. It turns out there are many rural counties in America with a similar pattern, either because some of their residents “fly in” or because there is oil fracking involved. If you are interested in that phenomenon, you can check out this story in the Washington Post.


Crossing Classes

My gut feeling as I travel around the country and read a lot, is that more people are worried about staying where they are or not sliding down than are trying to figure out how to get up to the next level. It’s just the times we are living in. We are also seeing fewer new companies being started than ever before. I don’t think we can attribute that fact to generational differences – there is just a great deal of nervousness about being entrepreneurial.

The possibility that we might slide down the class scale is the source of much angst. Upper-income people worry they will decline to mere upper-middle-class status, while the middle class doesn’t want to join the ranks of the lower class.

It’s not so much that those upper-income people are worried about being middle class, it’s that they have created expenses and lifestyles around a certain level of income. If that income falls, they will have to change the lifestyle they have become used to. That is remarkably difficult for many of us to do. Our sense of self-esteem and emotional well-being are, it seems, tied into our lifestyle.

A little personal revelation: I am no exception. I could certainly live a less expensive lifestyle. To some extent, I simply tell myself to enjoy life as I find it and work hard to try to maintain my businesses and to grow them if possible. That is more difficult than you might imagine when the very foundations of the industries that I choose to work in seem to be shifting underneath my feet in directions I can’t control. You just have to adapt. I have had to downshift my lifestyle on three occasions in my life; and while that’s not fun, I seem to adjust. Maybe there’s a little bit of Wilkins Micawber in me. In those lean periods, something always does seem to turn up. Then again, my great goal in life is not to have to make that hard adjustment yet one more time. In a real sense, I’ve created my own personal angst. It’s kind of silly, really. But it does tend to drive me. I’m sure the psychologists among you can hav e a field day with that.

Whether your worries are groundless or real, those fears are greater if you know you’re at the lower end of your peer group. The wealthiest .001% don’t have to worry – they’ll be fine in just about any scenario. But people in the 85–95th percentiles are in danger of taking a fall in the next big market and economic upheaval.

And of course, the lower middle in the 25–50th percentiles are very vulnerable to downward mobility. A New York Times report on the Pew study starts with one of their usual personal vignettes:

Mike McCabe’s neighbors in rural Gillespie, Ill., consider him lucky. After being out of work for a year, he landed a job in January making cardboard boxes at a nearby Georgia-Pacific plant for $19.60 an hour.

He would agree with them, were it not for the fact that his previous job in a steel mill near St. Louis paid $28 an hour. “I’ve had to rethink my whole life to make ends meet on what I’m now making,” Mr. McCabe said. “The middle class is struggling for sure, and almost anybody in my position will tell you that.”

That short passage actually says a lot about angst in America. Let’s unpack it.

Your neighbors will consider you lucky if you stay unemployed for a year and then find work for 30% less money than you made before. Maybe so, but you’ll still be hurting. The statistics suggest that people in situations like this probably had little savings and burned through whatever they had while unemployed. They may have gone deeply into debt to survive.

“I’ve had to rethink my whole life to make ends meet on what I’m now making.”

That’s haunting because I think we can all imagine ourselves in that spot, no matter where we are now. What if you had to (a) go a full year with no income and (b) return to work at only 70% of your former earnings? Would you have to adjust your lifestyle? I sure would. My dad taught me that you do what you have to do, but fear of having to do it is the source of much of our angst.

At the same time, if his neighbors consider this guy to be “lucky,” there must be many others in far worse straits. Remember the Maine guide I talked about last summer, who lost his job due to a plant closure and is now having to work through his retirement savings, 10 years before he turns 65? That kind of puts my angst and maybe the angst of most of my readers in real perspective.

Lucky Days

Part of our angst is that we feel captive to forces beyond our control. We suspect the bad luck that might push us downscale is more prevalent than the good luck that might propel us higher.

I think we also worry that it’s not luck that will hurt us but rather our own weaknesses. My friend Barry Ritholtz made an interesting point in his Bloomberg column recently.

A surprising thing I learned from interviewing some of the most successful people in finance is how frequently they credit good luck. Indeed, in most of the almost 150 Masters in Business interviews I have done, our guests mention – unprompted by me – the crucial role of serendipity. This isn’t false modesty or humility, but rather, an honest acknowledgment that chance can make a significant difference in people’s lives.

Note that the role of chance doesn’t imply successful people don’t need to be educated, smart and diligent. Rather, it recognizes that lots of insightful, intelligent, hard-working people may not achieve the same level of success as other folks with the exact same qualities – and that those who are more successful may have had lucky breaks that others didn’t get.

I think part of this is ego. It feels good to blame bad news on things we can’t control while taking full credit for whatever successes we have. But there’s more to it. Luck does indeed cut both ways.

In the US we have a cultural imprint that I think traces back to our Puritan origins. It tells us that everyone gets what they deserve. If you’re wealthy, you must be smart and hardworking. Conversely, the poor are poor because they’re lazy and make bad choices.

Both of those things are true in many cases, but not always. I have known many brilliant, hardworking people who have struggled financially. I’ve also known some very wealthy people who were, shall we say, less than genius-level intellects and whose work habits were suspect. The fact that there are exceptions proves that the rule isn’t absolute.

Nonetheless, our Puritanical attitude is widespread and is even built into our laws. If your net worth is above a certain threshold, you’re an “accredited investor” and presumed to be sophisticated enough not to need certain consumer protections and disclosures. And if your net worth falls below a certain threshold, you are “protected” from investments that might offer higher returns to those who are better off than you are, presumably because your current economic circumstances suggest you wouldn’t understand the investments, regardless of your education and experience. Both of those assumptions by the government are nonsense.

Whatever our income or class, we all face challenges over which we have some influence, yet we may find ourselves subject to a fate that we can’t control. The challenge that we have today is to recognize that the political, economic, and investment forces that we have become used to dealing with over the last 70 years, through all their ups and downs, are getting ready to shift more radically than we have yet seen or can even imagine. We will have to think more deeply and creatively than ever about how to prepare for the changes – the transformation – coming to our lives.

Orlando and SIC

If I haven’t missed putting anything else on my calendar, my next trip will be to the Strategic Investment Conference, May 22–25 in Orlando. Then on the 26th Shane and I fly up to Washington DC to be with Neil Howe and bride Gisela at their wedding. 

I know I mentioned the Strategic Investment Conference at the beginning of the letter, but let me offer you some new reasons why you should attend. My friend Marc Faber has now agreed to speak and serve on a few panels. The last day will be a panel composed of George Friedman, Mark Yusko, Neil Howe, and Matt Ridley. George needs no introduction to my readers. Mark Yusko is a renowned investor who is the founder and chief investment officer of Morgan Creek Capital Management. Neil Howe wrote The Fourth Turning, which was the driver for Steve Bannon’s documentary, Generation Zero. Neil will be telling us what the next 10 years are likely to hold as we enter the latter half of this Fourth Turning). Matt Ridley is the brilliant Libertarian thinker/philosopher and prolific author who wrote The Rational Optimist and The Evolution of Everything, which I think is one o f the best books of the last five years.

I’m going to moderate the panel and engage them in a discussion about how the next 10 years will unfold. I can’t imagine anything more exciting. Well, except the rest of the conference, where Ian Bremmer and Pippa and Harald Malmgren will not only make their own presentations but then sit down with George Friedman in a no-holds-barred panel on current geopolitics. Lacy Hunt, David Rosenberg, Raoul Pal, Grant Williams, Martin Barnes, some of the most noted cutting-edge biotech scientists, and an energy panel with two billionaires who actually know how to pull oil out of the ground and tap energy from the sun. They are not just investors; they have built their own “mini-empires” from scratch and have an extraordinary view on the future of energy and natural resources. And the list goes on and on and on.

You really do want to figure out how to get Orlando May 22–25, if you haven’t already made arrangements. This is where you can get the information you need to make the course adjustments that will be required for The Great Reset. Make sure your spot is reserved.

Now, I mentioned that next week I’m going to write about The Great Reset and talk specifically about how I think we need to adjust our core portfolios. But in the meantime, as part of the launch of my new portfolio management company, I will be hosting, on May 17 at my home, a chili and prime dinner for independent brokers and advisers, where we will share with you the specifics of how we are going about changing the way you manage the core of your portfolio. As I keep saying, the key is to diversify trading strategies, not just asset classes. Technology has allowed us to do some marvelous new things, and portfolio diversification that smoothes out the ride is one of them. One of my goals is to be able to help brokers and advisers get their clients through the storms that we all know are coming as the world struggles to figure out how to deal with the massive amounts of debt and government obligations that are building up. Maybe not this year, but at some point there has to be a Great Reset, and you need to be able to get your clients through it. If you’re interested in attending to learn more about what we’re doing, drop a note to me at business@mauldinsolutions.com. Give me your name and your firm, and we’ll get back to you ASAP.

I actually played nine holes while in Sonoma, and I only lost two balls! And I reminded myself that I need to get out more and relax. It was just good for the soul. Shane and I went to a charity event last night, and after the requisite live auction and money raising, we settled back to listen to some badass Texas blues the way the good Lord intended them to be played. Matt Tedder and Paul Harrington teased more sound from a guitar and harmonica than I have ever heard before. There is a reason why many think Paul Harrington is the best harmonica player in Texas. You probably don’t recognize the name, but you have heard him play on a lot of famous musicians’ recordings. If you want to have a fun evening, start with this link and then just start clicking on more links and Google the names that come up. 

And with that I will hit the send button. You have a great week, and if Texas blues isn’t your thing, then spend some time with your own favorite music. It’s good for the soul.

Your wishing I could play the harmonica analyst,

John Mauldin


Private equity bets big on software

A new wave of funds thinks it can win with aggressive investments in tech businesses

by: Tom Braithwaite
  

For someone who prefers a low profile, Robert Smith has a knack for attracting attention.

Mr Smith, who rarely gives interviews, held his wedding in 2015 at an inaccessible Italian villa, in theory far from the gazing eye. But given that his bride Hope Dworaczyk was a former Playboy Playmate of the Year and the entertainment was provided by John Legend and Seal, photos of the ceremony made the tabloids anyway.

While many finance executives in Silicon Valley try to blend in by driving Tesla electric cars and wearing jeans to work, the employees at the San Francisco office of Mr Smith’s Vista Equity Partners opt for sports cars and three-piece suits — a reflection of the tastes of their Texas-based boss.

And for the past couple of years, Vista has been making a splash through a series of eye-catching deals in the software industry — an area that private equity firms have long been wary of.





A former Goldman Sachs banker, Mr Smith set up Vista in 2000. Its record of buying, improving and selling software companies recently allowed it to raise $10.6bn for the biggest ever technology-focused private equity fund. The money is going out the door just as fast: in the past 12 months, Vista has bought four companies for more than $1bn each.

“We are very disciplined buyers,” says Mr Smith, who complains that he, a rare black man at the helm of a large financial institution, is often unfairly targeted by the police when he is at the wheel of his McLaren car. “We manage money for teachers and firemen and municipal workers. We have never lost money on any buyout investment. The last thing they want us to do is be irresponsible with capital and we take our fiduciary responsibilities very seriously.”

Glitzy consumer internet companies, such as Snap, Uber and Airbnb, have monopolised attention in the tech industry, stoking a debate over whether Silicon Valley is inflating a new bubble.

Along with groups such as San Francisco-based Thoma Bravo, Vista is at the forefront of a parallel trend of aggressive private equity investments that has the capacity to reshape the software industry. Many of the recent rapidly negotiated deals have been concluded with less due diligence than is typical, and have involved companies with higher growth but lower profits than those normally targeted by private equity firms.

The flurry of private equity investments raises important questions for the tech sector. On the one hand, it could indicate that this new brand of specialist firms has developed a secret sauce that allows it to generate reliable returns from software. Vista’s funds have typically made returns of more than 20 per cent, according to investment data provider PitchBook. However, the investments could simply be contributing to a new bubble that will inevitably lead to a lot of bad debt and failed companies.

Anthony Armstrong, head of technology mergers at Morgan Stanley who has helped sell a number of companies to the young private equity groups, believes they are blazing a new trail.

“It’s like the Golden State Warriors,” he says, comparing them to the highly successful Bay Area basketball team, which has revolutionised the sport with its mixture of pace and aggressive shot-taking. “Smaller players, moving quickly, making three-pointers.”

Vista is by no means alone. Indeed, it will soon relinquish its record as the largest tech-focused fund. Silver Lake, the Silicon Valley-based private equity firm responsible for the biggest ever tech deals such as the buyout of Dell in 2013 and Dell’s $67bn acquisition of EMC in 2015, is raising a $15bn fund. And the Japanese telecoms group SoftBank, primed with money from Saudi Arabia and Apple, is raising the Vision tech fund whose $100bn target size would trump anything that has come before.

A bid backed by Silver Lake is the frontrunner in an $18bn-plus auction for Toshiba’s flash memory business.

Thoma Bravo, which specialises in enterprise software, is also on a buying spree, paying $3bn for Qlik Technologies last year, a company that made just $13m in core earnings and recorded a net loss in the 12 months before the deal.“

There is a lot of capital in the category and more will come,” says Orlando Bravo, 46, the managing partner, who took the reins at the then Chicago-based firm and reoriented it geographically and philosophically to the west coast. Working from the Transamerica Pyramid, San Francisco’s tallest building, he last year raised a $7.6bn fund.




"When we were raising our fund, investors were asking, ‘Are there enough targets for all the money?’, and that’s when [SoftBank’s fund] was announced and my answer to that was, ‘There is way enough’,” Mr Bravo says. “We are, in hindsight, conservative because this is the first time that you have the large-scale tech software assets available to private equity.”

Mixed fortunes

When the private equity industry was in its infancy in the 1980s, the tech sector was barely on its radar. Gradually, this changed. First hardware assets became tolerable for debt providers.

Then came the realisation that software, although lacking hard assets to lend against, could offer reliable recurring revenues. “

The lenders originally were sceptical of the sector because the assets walk out the door every night and there was nothing that they felt they could lend against,” says an asset manager who invests in Thoma Bravo’s funds. “What has been proven is the stickiness of the sales in software. The renewal rates in the best businesses are well above 98 per cent.”

Tech is now attracting all types of private equity firms, with the sector representing almost 40.1 per cent of buyouts last year, according to Dealogic data. That is the highest proportion on record and up from around 10 per cent in 2010. Established generalists such as KKR and Carlyle have been joined by tech-focused firms such as Golden Gate Capital and the newer Siris Capital.


Dealmaking



$3bn Price paid last year for Qlik Technologies by Thoma Bravo — about 200 times its core earnings

$3.6bn Price Vista paid for Canada’s DH Corp to combine it with Misys after the latter’s IPO failed to be launched


The old guard has had a mixed record in the sector. In 2006, Freescale Semiconductor was taken private by a consortium of Blackstone, Carlyle, Permira and Texas Pacific Group for $17.6bn, just before its orders plummeted. Stephen Schwarzman, Blackstone chief executive, described it as a deal “where literally everything goes wrong”. More recently, Carlyle ended up cutting from $8bn to $7.4bn the price paid to Symantec for Veritas, a data storage provider, after banks struggled to finance the deal. Avaya, a networking company, bought for $8.3bn in 2007 by Silver Lake and TPG, filed for bankruptcy in January. In a sign of its changeable approach to the sector, Carlyle has opened, closed and reopened a Silicon Valley operation all within the past 10 years.

Perhaps their experience plays a part, but the larger firms are raising eyebrows at the prices and aggression of the younger pretenders such as Vista and Thoma Bravo. “They are prepared to pay an ebitda multiple that is almost ridiculous,” says a partner at a rival firm, referring to the standard valuation that considers the price paid as a multiple of earnings before interest, tax, depreciation and amortisation.

But Mr Smith is critical of some of the other funds for failing to understand the software market. “The world is awash with capital and ambition which has led more PE tourists to invest in the highly specialised area of software,” he says. “Many have already lost money in the space. I expect to see a few more lose money in their software investments in years to come.”

Ensuring returns

Vista believes that it can make money, even at these high multiples, by exerting an unusual amount of control on its acquired companies. It expects them to follow 100 best practices it has developed. It also requires an unusual amount of sharing between its portfolio. At monthly meetings, the top 300 managers across the companies gather to swap experiences. Everything is done to eke out revenue and margin gain.“

They can produce more code faster with fewer bugs, expand their markets more effectively and frankly enhance the customer experience,” says Mr Smith of companies that have submitted themselves to the programme.

Thoma Bravo does not impose as much control but Mr Bravo says there are always straightforward margin gains to be made because tech companies are reliably inefficient. “Silicon Valley thinks the same way they have since inception — singularly focused on top-line revenue growth,” he says.

This does not mean that the private equity model of slashing costs would work. Margins need to be improved but if that is achieved by cutting too many salespeople or too far into research spending, then growth will lag.

Vista can also be ruthless in the selection of managers. In some cases, it will decide to replace a newly acquired company’s executives. But Mr Smith will also go to extreme lengths to keep executives he values. Vista sold P2 Energy Solutions, which makes software for the oil industry, to its rival Advent International in 2013. Advent, understandably, assumed the management would be part of the deal. But after signing, Vista rehired the chief executive and chief financial officer and installed them at other companies.

Given the target companies often have little in the way of cash flows, the amount of debt used in the deals can seem worryingly large. Yet from another perspective, it can seem too small. Private equity firms like to use as little of their investors’ money as possible, typically borrowing three-quarters of a deal’s price. That allows them to capture more profit when they sell. But lenders will not write a blank cheque to buy companies with such meagre cash flows, forcing the funds to use more equity, which reduces risk but limits the potential returns.

Even Mr Bravo concedes the boom could still blow up — he just does not think his firm would suffer. “The thing I don’t like about the whole asset class is I haven’t seen other groups sell that much,” says Mr Bravo. “Where is the money on the table, guys? I’d like to see how much is stuck.” In the past few months, Thoma Bravo has sold three of its bigger bets, including Deltek, which it bought for $1bn in 2012 and sold on to Roper Technologies for $2.8bn.

Vista did get stuck on one recent deal, abandoning a planned initial public offering of Misys, the UK-based software company, after being unimpressed with what fund managers in London were prepared to pay. Mr Smith’s reaction was, true to form, aggressive. He pulled the listing and doubled down, buying Canada’s DH Corp, a financial technology group, for C$4.8bn ($3.6bn) last month, to combine it with Misys.

The market for selling such companies may evaporate altogether. The Nasdaq Composite surpassed its dotcom bubble peak in 2015 and valuations have kept rising. Another tech sector crash is not inconceivable. On the face of it, that might not seem to matter to the likes of Vista, which has never sold a company through an IPO. But with private equity firms commonly buying and selling the companies between each other, the music could stop at any time.

The McLarens of Silicon Valley would then really start to stand out.


Elliott: Activist investor lays path for tech deals

At 4:30am Lars Björk was disturbed by the ping of a text message. He was more disturbed when he saw the sender. Jesse Cohn of Elliott Management, the activist New York hedge fund, was writing to say he had bought shares in Mr Björk’s company.

For Elliott, which once impounded an Argentine ship during a dispute with the Buenos Aires government, the pre-dawn text sent in March last year counts as a token of affection. “I don’t take it personally,” says Mr Björk, a Swede who runs Qlik Technologies, a maker of data analytics software.

Technology used to be regarded as too complex for activist investors, but Mr Cohn was a trailblazer. He began taking on Silicon Valley companies in 2006 aged just 26, earning a reputation for a thorough understanding of the industry and a bracingly foul mouth. “He’s hard work but he’s not trying to be an asshole,” says one banker who advises the companies that Mr Cohn targets.

Less than three months after his rude awakening, Mr Björk and Qlik were in private equity hands. Thoma Bravo had agreed to pay $3bn. That was 73 per cent higher than Qlik’s value during a sudden dip in February, though only in line with where it was trading at the start of the year. It was a rich price for such an acquisition. A normal buyout might be done at 10 times a target’s core earnings. Qlik was done at 200 times.

Thoma Bravo has spent billions of dollars scooping up software companies. Three of the biggest — Qlik, Compuware at $2.4bn and Riverbed Technology for $3.6bn — were first smoked out by Elliott. Boards do not like to give in too easily to a potential bidder — and private equity firms tend to avoid hostile bids — but when an activist turns up, threatening to oust the board, deals can get done. Orlando Bravo (left), managing partner of Thoma Bravo, says that wooing companies will get easier: “Many are choosing to partner with private equity before the activists even show up.”

If public company boards do start waving the white flag without activists having to fire a shot, that might be bad news for Elliott. But the firm has a hedge: it has set up its own Silicon Valley private equity firm. And whether he is phoning to rattle a cage or launch a takeover bid, Mr Cohn has everyone’s number.


Calling the Protectionists’ Bluff

Daniel Gros
. Chinese factory workers



BRUSSELS – Most reports about globalization in recent years have focused on its problems, such as declining levels of trade and the abandonment of “mega-regional” trade agreements.

Indeed, US President Donald Trump has now terminated the Trans-Pacific Partnership (TPP) – a trade deal among a dozen Pacific-rim countries, including the United States and Japan; and negotiations on the Transatlantic Trade and Investment Partnership (TTIP) between the US and the European Union have come to a halt.
 
But headlines can be misleading. Although new trade deals can spark controversy, it is highly unlikely that protectionism will prevail. This is true even in the US, where Trump was elected on the promise of getting tough with major trading partners such as Mexico and China. So far, the Trump administration has taken no action suggesting that a new era of protectionism is at hand. And in Europe, the benefits of economic openness have been widely acknowledged, and negotiations on a free-trade agreement with Japan are currently underway.
 
Most developed countries remain fairly open today, and this pattern will likely continue. A new surge of support for protectionist policies would require a coalition of powerful interest groups to organize a campaign aimed at changing the status quo. With average tariff rates at negligible levels (below 3% for both the US and the EU), who would support a push for higher barriers?
 
In the past, coalitions of workers and capitalists from the same industry would lobby for protection. Their interests were aligned, because higher tariffs allowed workers to demand higher wages, while capitalists could still make higher profits in the absence of foreign competition. The infamous 1930 Smoot-Hawley Tariff, which many believe helped precipitate the Great Depression, was the result of such lobbying.
 
Today, however, the interests of workers and capitalists are no longer aligned. Most manufacturing is now dominated by multinational firms that operate production facilities in many countries. This is particularly evident in China, where US and European companies have made huge investments. Any policy that hurts the Chinese economy will hurt them, too.
 
Foreign-owned enterprises account for about half of China’s exports; and US firms are the biggest investors in the country. So, if Trump followed through on his campaign promise to impose a 45% import tariff on Chinese goods (most likely in violation of World Trade Organization rules), he would strike a major blow to US multinationals’ profits. This may explain why most of the administration’s protectionist rhetoric comes from Trump and some of his academic advisers, and not from the experienced CEOs who occupy key cabinet positions.
 
Another major difference today is that many firms are a part of global value chains, whereby goods are assembled in countries like Mexico or China from imported components, the most sophisticated of which often come from the US. If these countries imposed tit-for-tat measures on US imports, the US companies that export those components would suffer, as would companies that collect royalties on intellectual property used abroad.
 
Those who want to “get tough” on China or Mexico claim that their goal is to persuade US companies to make their products entirely in the US. But assembly is usually a low-skill, low-wage activity at the bottom of the value chain. So, slapping a tariff on goods made in China would only push assembly operations to other low-wage countries, not back to the US.
 
The same can be said with respect to Mexico. Withdrawing the US from the North American Free Trade Agreement would do little to create high-paying jobs in the US. It is worth noting that US labor unions that opposed NAFTA 20 years ago have not rallied behind Trump’s threats against Mexico.
 
To be sure, the presidency grants Trump considerable power to shape trade policy, so one cannot ignore the possibility that he will pursue protectionist measures to appease his supporters. But, ultimately, there is no broad-based support in the US for a return to closed borders.
 
Europe, meanwhile, has been moving in the opposite direction. European multinationals also have large stakes in the Chinese economy, and EU manufacturing exports to China and other emerging markets are now almost double those of the US. Many Europeans see trade as an opportunity, rather than as a threat to jobs; and even Europe’s staunchest anti-globalizers show little appetite for more protectionism.
 
Still, if there is little support for reversing free trade nowadays, why is there such vocal opposition to major trade deals? In the US, manufacturing workers’ wages have long been stagnant, and job opportunities in the sector have fallen rapidly. As these trends coincided with high trade deficits, the two issues became politically intertwined, even though most studies show that automation has been a much more important factor in the decline of manufacturing as a share of overall employment.
 
Manufacturing in Europe is doing better than in the US. But there are still protests against the TTIP – and, to a lesser extent, against the EU’s recent trade deal with Canada – because some object to “new” deals that supposedly subordinate local standards and regulations to those of trading partners.
 
Large trade deals often introduce new health and safety requirements that become much more politically charged than cuts to already-low tariffs. Northern European countries, in particular, cherish their local standards and spurn the thought of eating chlorine-disinfected chicken or genetically modified fruits and vegetables, even if there is no scientific evidence that these production methods pose a health threat.
 
But the unpopularity of mega-regional trade deals in advanced economies does not imply broad-based support for a return to protectionism. The “bicycle theory” of trade liberalization – that it will collapse unless it keeps moving forward – is wrong. European policymakers should ignore the protectionist noises coming from Trump’s administration, and concentrate on defending the current global trading system and the liberal international order.
 
 


Trump’s Weak-Dollar Temptation

Reagan and Clinton presided over a strong currency—and success.
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Donald Trump doesn’t have many firm policy convictions, but one of them seems to be a mercantile faith in the virtue of a weak currency. The U.S. dollar “is getting too strong,” Mr. Trump told our Journal colleagues on Wednesday. “That’s hurting—that will hurt ultimately.”

Someone should tell him that weak-currency politicians tend to be losers.

One irony of his comments is that for weeks Mr. Trump had been celebrating the boost in economic confidence since his election, which has included a rise in the dollar. When investors have confidence in a country, they tend to put money into assets denominated in that country’s currency. The “Trump reflation” in the dollar and stocks, which has since ebbed as the prospects for pro-growth reform seem more uncertain, was a good economic sign.

Mr. Trump’s dollar-bashing is also highly unusual because even Presidents who favor dollar devaluation typically say the opposite. Or they say nothing at all, leaving the dollar commentary to the Treasury Secretary, whose mantra usually is “a strong dollar.” And that makes sense. Why talk down the purchasing power of Americans?

A dollar-bashing President can also disrupt financial markets, as Mr. Trump’s comments initially did on Wednesday. The greenback recovered, but currency markets are volatile and sharp movements can do serious harm at delicate financial times or take firms under if they’ve made the wrong currency bet.

Above all, dollar bashing can complicate the Federal Reserve’s monetary policy. The Fed is currently in a tightening phase, which tends to support a stronger dollar, so Mr. Trump’s comments are counter-cyclical.

But Mr. Trump also told the Journal that he might reappoint Fed Chair Janet Yellen when her term expires early next year. Ms. Yellen is known as a monetary dove who kept interest rates low throughout President Obama’s second term. Most analysts interpreted that Yellen mention as a declaration that Mr. Trump wants the same treatment. But if Mr. Trump’s policies succeed, growth will be faster and the Fed might have to raise rates more rapidly. The Fed and financial markets don’t need a monetary kibbitzer on Twitter .

If economics doesn’t persuade Mr. Trump, perhaps modern presidential history will. Going back to Richard Nixon, the most economically successful Presidents have presided over strong-dollar eras.

Ronald Reagan’s pro-growth policies attracted capital from around the world, and the greenback soared along with U.S. growth. Bill Clinton also saw rapid growth and a rising dollar that sent commodity prices like oil that are traded in dollars crashing. Gasoline at 90 cents a gallon might have saved him after impeachment.

On the other hand, Richard Nixon encouraged an easy-money Fed and took the U.S. off the Bretton-Woods gold standard. One result was rising inflation and an explosion in oil prices. Jimmy Carter’s Treasury tried to talk down the dollar, and inflation grew worse.

George W. Bush didn’t seek a weak dollar but he did preside over one as the Alan Greenspan-Ben Bernanke Fed kept rates too low for too long. Oil and commodity prices rose, making for meager gains in real incomes, while runaway housing prices set the stage for the financial mania, panic and crash.

Much of Barack Obama’s tenure was also marked by a weak dollar as the Fed tried to steal economic demand from the rest of the world. But that policy never did raise growth much above 2% a year. The public’s frustrations with slow growth and stagnant incomes set the stage for the rise of Bernie Sanders and Donald Trump in 2016.

We aren’t saying that a strong dollar is the primary goal of economic policy. That goal is broad prosperity from strong and sustainable economic growth. Monetary policy should seek a stable dollar not “king dollar.” But the byproduct of better policies and faster growth might be a flood of capital into the U.S. and a stronger dollar. This isn’t to be feared. If a strong dollar were politically damaging, both Reagan and Mr. Clinton would have been one-term Presidents.

Mr. Trump’s policy challenge is coaxing faster growth from an economic expansion that is already long at nearly eight years and with relatively tight labor markets. The only way to lift growth above 3% for an extended period is by lifting business and capital investment. That requires deregulation and tax reform that boost supply-side incentives. Worry about that, not the dollar.


The American Government’s Secret Plan for Surviving the End of the World

Newly declassified CIA files offer a glimpse of the playbook the Trump administration will reach for if it stumbles into a nuclear war.

By Marc Ambinder
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Among the greatest foreign-policy dilemmas faced by former President Jimmy Carter is one that has never been publicly aired but is gaining new relevance. It concerns nuclear war, and how the U.S. government would survive it. Carter’s decisions remain classified, but documents newly declassified by the CIA, along with the archives at several presidential libraries, provide a new window into the White House’s preparations for an imminent apocalypse.

Today, such an apocalypse could be triggered by any number of nuclear-armed states, including North Korea and Pakistan. During Carter’s presidency, such anxieties were focused squarely on the Soviet Union. It was during that period that military planners in both the Soviet Union and United States began to grapple with what until then had been an unthinkable heresy: abandoning the Mutually Assured Destruction catechism that had governed global order since the 1950s and preparing for surviving an all-out nuclear war.

Carter and his White House were interested in more specific questions. If the presidency could survive after a nuclear war, what exactly would it do afterward? How could the surviving commander in chief be identified? Who would identify him? How would he fulfill the three main functions of the presidency: to be the chief executive of the government, the head of state, and the commander in chief of its armed forces?

Carter’s answers came in the form of Presidential Directive 58, which was issued in the final months of his presidency; Ronald Reagan amended those plans with his own presidential directive in 1983. Their contents inform the continuity of government plans that remain in effect for the Trump administration. They have been the object of a multibillion-dollar pastiche of programs and a magnet for conspiracy theorists around the world.

What follows is a glimpse at how the government developed some of its most closely held national-security secrets — and how the Trump administration, or any of its successors, might rely on them to survive the end of the world as we know it.
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Pages from "Survival Under Atomic Attack," a U.S. government booklet released across the country in 1950. (Photo credit: City of Boston archives) 

                      
When Carter took office, the Soviet Union had a head start on preparing for nuclear war. It had an expensive civil preparedness program; hundreds, perhaps thousands, of underground bunkers; and extensive continuity of government programs.

The United States, for its part, had Ray Derby. Born in Iowa in 1935, Derby became one of the Defense Department’s premier experts on emergency preparedness and disaster response. In Europe, he led noncombatant evacuation drills across NATO, training the trainers who evaluated each unit’s ability to absorb and withstand an attack. In the United States, he led numerous governmentwide task forces on civil defense for nuclear, biological, and chemical accidents. He also developed the standard plan that America’s nuclear bases would use in a disaster. By the time of Carter’s inauguration in 1977, he was in charge of training and operations at the West Virginia Operations Office in the General Services Administration’s Federal Preparedness Agency (FPA).

At the time, the principal federal plan for catastrophic disasters like nuclear war — Federal Emergency Plan D — called for each federal agency to design, develop, and build its own hardened, underground facility. In an emergency, the government would be run from the bunkers. Most agencies did not take the responsibility too seriously.

The FPA tasked Derby with evaluating the implementation of Plan D. The first thing he noticed was that agencies rarely, if ever, rehearsed their respective plans. Few had made any provisions for maintaining vital records — even the laws, regulations, and directives that agencies used in their daily work. Many agency employees didn’t even know whether they were part of the teams that were supposed to evacuate during a disaster.

These failures were the product of systemic neglect since the dawn of the nuclear age. Aside from a brief boom after the Cuban Missile Crisis, during which six federal government relocation centers were built around the nation, the United States did not treat civil defense as a part of its strategic deterrence. The federal government proved eager to spend money to upgrade weapons, not to protect the population or help them survive a nuclear attack. In the 1970s, many government agencies gave up planning post-disaster operations, assuming that the various federal organizations that had the word “preparedness” or “mobilization” in their titles were taking care of it.

Derby thought the problem was larger than funding. The American public said in polls that they wanted a civil defense program. But they lived in peace and didn’t pay attention to its development. They might have assumed that a big program existed somewhere out there, ready to be used in a Soviet attack. By the 1970s, the “duck and cover” years had given way to the comforting dulcet tones of détente. There was no urgency. And presidents were not insisting on any.

There was one other complication: to effectively save the country during a nuclear war, the military had to cross one of its red lines by getting involved in domestic security. After nuclear war, martial law would almost certainly have to be declared, and the military given extraordinary powers to manage resource distribution. But the government also assumed that some sort of martial law would be required before the start of the actual war. As soon as it believed a war might be imminent, the government planned to move significant parts of the population, specifically those who lived near significant strategic military targets, and policymakers knew this might require a degree of coercion, even force. The military did not like to talk about this scenario, and neither did politicians. Plans were therefore developed in secret and classified, ensuring less visibility and public accountability.

And what about members of the government themselves? In an emergency, or a changing of the Defense Condition status, the Joint Chiefs of Staff would order 60 officials to primary relocation sites. The government operated a so-called special facility atop Mount Weather in Berryville, Virginia, where a cadre of top executive branch officials would ride out a nuclear war. Other standby relocation sites were near Hagerstown, Maryland, and Martinsburg, West Virginia, at the Marine base near Quantico, Virginia (for the FBI), and Front Royal, Virginia, near a facility where the State Department was supposed to reconstitute. Still others were hidden at colleges inside or near the Beltway.

But the Army and Air Force had enough helicopters to transport only about a third as many officials as would be required — assuming that aboveground transportation was possible. (Instructions called for them to make their way there in some other unspecified fashion if the helicopters were not available.) And for any top American leaders who managed to make it to Mount Weather, their ability to communicate with federal agencies, other governments, and the American people was questionable, at best, not least because the sites were generally minimally staffed.

Many political leaders disdained suggestions that they practice for war or the very idea they would voluntarily hide themselves in secret bunkers away from the public and their families. (Dick Cheney, a congressman in the 1970s, was one such skeptic.) The assumption in the U.S. government was that the Soviets knew everything anyway. They had even bought land at the base of Mount Weather solely to monitor the comings and goings of emergency personnel. If the apocalypse was coming, warding it off was considered a fool’s errand.
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A 1991 bird's-eye view of the above-ground Mount Weather complex. (Photo credit: WILLIAM F. CAMPBELL/The LIFE Images Collection/Getty Images)
 
                      
By the time Jimmy Carter became president, the country was spending less than $100 million a year on civil defense, compared with more than $30 billion a year to keep its nuclear weapons from becoming obsolete. Congress had identified the value of a unified civil defense program but hadn’t done much to fund it. Carter became the first president since John F. Kennedy to pay significant attention. In September 1978, he declared that civil defense was part of the country’s strategic deterrence, because a population, or government, vulnerable to nuclear attack was more vulnerable to being coerced by threats of an attack. A short presidential decision directive, which was classified at the time, said as much — and little else.

America’s civil defense budget rose modestly at first. But a series of studies acknowledged how weak the country’s civil defenses had become. Fallout shelters built in the 1950s were obsolete and needed to be refurbished or replaced. Executive orders assigning functions to different agencies were widely ignored. There were no federal provisions for evacuating large populations, the lynchpin of any civil defense program. Military exercises all but ignored the hypothetical scenario. These studies also set the path for a whole new policy.

Over the objections of the Pentagon, Carter eventually endorsed a consolidation of the government’s civil defense and continuity programs into one agency and set an ambitious goal. During an all-out nuclear war, the government would aim to have 80 percent of the country survive — and it should prepare to do so on a budget of less than $250 million per year.

On June 19, 1979, the Federal Emergency Management Agency (FEMA) was written into existence. Carter elevated the importance of the agency’s director, assigning to the National Security Council and the Pentagon the task of overseeing civil preparedness. It was now inextricably linked to national security — and strategic nuclear policy. A secret CIA memo said that “trans-attack planning” — how the presidency could function during a nuclear war — was now a part of a national security strategy.

This was sweet music for Ray Derby. FEMA would take charge of the FPA’s Continuity of Government program Derby had been working on, but he would be tasked by FEMA with taking control of the special facility at Mount Weather, becoming, for all intents and purposes, its mayor. Its secrecy would increase, as would its budget and footprint. It would be responsible for the official survival items list, the stockpile of resources that would be needed to rebuild the government after nuclear war.

Meanwhile, the White House was focusing on the hardest challenge of all — providing a mechanism for presidential successors to execute nuclear war orders during and after a nuclear exchange. Early in Carter’s presidency, the director of the White House Military Office, Hugh Carter, convened a small working group to review the White House Emergency Plan, the top secret document that set out how the Secret Service would evacuate the president — and how the White House Military Office would instantiate successors if the president were killed.

The basic blueprint was contained in a series of proposed PEADS — presidential emergency action documents — which National Security Advisor Zbigniew Brzezinski’s military aide Col. Bill Odom then reviewed and revised. Odom, as he wrote in a memoir, found the proposed procedures conspicuously lacking in both imagination and a connection to reality.

One White House memo noted that day-to-day communications between the Pentagon and presidential emergency facilities at Mount Weather, Camp David, and the White House were “satisfactory” under normal conditions. But during a civil disorder, or “uncoordinated sabotage,” it was obvious that satisfactory wouldn’t suffice. And in a conventional or nuclear war, it was determined that the facilities would provide “little protection” — in other words, whichever survivors were stashed there probably wouldn’t survive for long before being targeted themselves.


A seating chart for the special facility atop Mount Weather in Berryville, Va., where a cadre of executive branch officials would ride out a nuclear war.
                 

This meant, in practice, that fixed command posts would not work. A mobile command post was a theoretical option. But the White House couldn’t depend on getting the president or a successor to an emergency escape aircraft in a surprise nuclear attack. Even if they managed to do so, it was impossible to know what kind of staff they would have around them.

Meanwhile, because only Carter and Vice President Walter Mondale had “presidential emergency satchels” — the famed nuclear footballs that verified their identities as commanders in chief — the country’s nuclear command-and-control system would risk coming to a halt if both men were incapacitated or had died, unless there was some other way of identifying presidential successors to the military.

The original solution offered by the White House Military Office were code names uttered by their designees. So if Speaker of the House Thomas P. “Tip” O’Neill Jr. found himself the only surviving successor, all he would need to acquire complete control of the government and its nuclear arsenal would be to offer the surviving Pentagon command center’s emergency action officer a vocal verification of his identity by using the term FLAG DAY. The president pro tempore of the Senate, next in line, was FOUR FINGER. Secretary of State Cyrus Vance would authenticate his identity by calling himself FADE AWAY.

In reality, the Pentagon’s emergency action officer would try to ensure that a survivor was who he said he was. But if Soviet missiles were on the way, the designers of this fragile system had little doubt that the shortcuts would be used, with untold risks for the efficiency of the country’s military response and its basic security.

In light of these challenges, the White House task force tried to conceive of a more flexible, and de-centralized, idea of what it meant for the government to survive. In defining the presidency’s continuity, the task force found itself coming back to three central, if decidedly bureaucratic, concepts: survivability (the president and his basic support team had to ride out a war), connectivity (they had to communicate with one another, the country, and other heads of state), and supportability (people needed other people elsewhere in the country to help them).

This led to a key recommendation: five 50-person “interagency cadres” that would be pre-positioned or pre-deployed during emergencies to support would-be presidential successors.

These “presidential successor support teams,” codenamed TREETOP cadres by the Pentagon, would deploy randomly to any one of “several hundred sites, perhaps 2-3 thousand, that would be pre-selected,” allowing for a relocation of institutional knowledge that was “highly flexible and adaptive.”


A hand-drawn schematic of how the governments-in-transit might operate found unredacted in Odom’s notes.
 
                 
Odom’s team drew up a list of requirements for these teams. The first thing that a deployed team would do was to identify and authenticate the actual president — the ranking successor.

The details of the system they developed remain highly classified, but as it was described to me, it involved what might be the first example of “tracking chips” embedded in presidential successor support cards, which would be amplified by radio frequency repeaters. The signals would be collected by FEMA and the National Military Command Center. Other critical technology that would be deployed to assist the would-be presidents would also be tagged and tracked, which might offer a layer of protection against spoofing. (The plan, however, flew ahead of the technology available to make this work. It wasn’t until the George W. Bush administration that the government could passively and electronically track some presidential successors by satellites and the cellular phone system.)

Second: Each team would have to, on its own, help the successor carry out the three main presidential functions: commander in chief, chief of state, chief executive. The team would have to talk to other deployed teams that had survived and securely identify themselves. It would have to talk to the Pentagon, or its surviving elements, to execute the nuclear war plan. It would have to receive intelligence and damage assessments. It would have to talk to state and local governments, too. More prosaically, the 50 people on each team would have to be prepared to function as a stand-alone executive branch without outside help for at least six months.

Odom’s review proceeded slowly. Agencies were asked to weigh in on whether they could carry out a series of secret executive orders. These orders remain classified to this day, but certain public documents offer scraps of information. The Carter White House eventually issued at least 29 PEADs.

PEAD 2 dealt with the reconstitution of Congress, a touchy issue for the executive branch, much less mentioned in open correspondence. PEAD 5 was titled “Providing for the Mobilization of the Nation’s Resources.” PEAD 6 dealt with calling an emergency civilian reserve force.

How would Congress be reconstituted? What resources would be mobilized? Who would be drafted? We still don’t know.

People watch a television showing file footage of a North Korean missile launch at a railway station in Seoul on April 5. (Photo credit: JUNG YEON-JE/AFP/Getty Images)
 
        
We do know this. When Carter’s presidential directive codifying these changes went into effect in late 1980, the CIA set up its own secret agency, the National Intelligence Emergency Support Office, which would be headquartered in Virginia, receive input from all CIA directorates, and deploy three-person successor support teams to randomly chosen TREETOP locations at a moment’s notice.

We also know, from budget documents, that agencies began to request more money to fund successor support teams. We know that the Pentagon began to test hardened mobile command centers. We know that the Air Force developed plans to add electromagnetic bandwidth devoted to continuity of government to its latest satellites. We know that a designated presidential successor would start being brought to Mount Weather during events that gathered all the branches of government together, like the State of the Union address.

We also know that Reagan found the system inadequate. He was briefed on it before his presidency, but his participation in the 1982 Ivy League war games convinced him that a survivable presidency was untenable and a major gap in the defenses of the country. One of his top aides, Thomas Reed — along with a Marine attached to the National Security Council by the name of Oliver North — persuaded Reagan to permit some modifications to Carter’s system, rather than abandon it.

Flash-forward 35 years. Russia has taken Crimea by force, and an under-resourced NATO worries that an invasion of the Baltic States could bring the alliance to the brink of war. The United States worries that North Korea is on the verge of mating nuclear warheads to intercontinental ballistic missiles that could reach portions of the Unites States. President Donald Trump can still be baited with tweets, has resorted to military force against a sovereign nation backed by Russia after seeing television images of children dying from exposure to sarin gas, has spoken of building a bigger (and not just better) nuclear arsenal, and has not (yet) demonstrated the temperament to respond to a crisis with tact.

Emergency survival plans have evolved since the era of Jimmy Carter. We can safely assume that presidential successors will be authenticated by something more than a whispered code name. But the threats that might prompt their use are still nearer than we all would hope.