A New Year for Private Equity

By Rob McCreary

Turning the page on a great year is always bittersweet. While the future is exciting, the status quo is also mighty inviting. For private equity, 2016 will go down with Dickensian hyperbole as “The Best of Times”.

Our business model turns on six or seven main ingredients, the absence of any one of which can make a great cake unremarkable.

  • Low Interest Rates
  • Plentiful Liquidity
  • Low Tax Rates
  • Willing Sellers
  • Efficient M&A Markets
  • Favorable Taxation of Carried Interest
  • Stable Macro Economic Environment

Our industry has matured to a point where our bench of service providers, industry experts, operational consultants, and pricing specialists is prolific. By comparison, in 1999 when we founded CapitalWorks, the Christmas party was eight people, six of whom were creditors! The market for buying and selling was choppy. The providers of senior and mezzanine debt changed their appetite for providing liquidity more often than my teenage granddaughter changes outfits. While lawyers and accountants were skilled at most aspects of the M&A process, there were few diligence providers for mainstream services like Quality of Earnings, Environmental Due Diligence, Market Surveys, Customer Satisfaction Surveys, Operational Improvement, Pricing Analysis, HR Consultation, and Benefits and Insurance Review.

The employment multiplier from the Private Equity Business Model has become simply HUGE. You can prove it by attending any annual chapter meeting of the Association for Corporate Growth. What used to be 150 guys (very few women) swapping lies over beers and, sometimes, something a little stronger, now is close to 900-1100 men and women still swapping lies and drinking more prosperous brands.

The largest change from 1999 is  our industry now suffers from constant media and political injustice; I guess it is our fault. If you are not creating your own message in the marketplace, your competitors and detractors will do it for you. We should become less private about claiming GDP and employment credit. I regret that Mitt Romney had a perfect chance to educate and exonerate when he was running for President but he never delivered the counter punch. We are all the worse for his passivity.

The most interesting aspect of our industry’s poor image is we may simply be a business abstraction to most people in political life. If you ask most politicians what the private equity industry does, they will quickly confuse you with Venture Capital. My favorite insight about how politicians view us came years ago when I talked to one of our County Commissioners about engaging the private equity industry in a discussion of Cuyahoga County’s regional economic development plan for which he was responsible. He asked me with all seriousness “What is private equity?” I fear the political class has a similar abstract view of PE importance to GDP or our value added on important political subjects like jobs.

There is little recognition of how private equity has brought credit stability to the lower middle market of companies with less than $100 million in revenues. Formerly, many of these companies were owned by entrepreneurs who supplied personal guarantees to the banks, but were generally reluctant to invest fresh capital into the business, especially when it was in trouble. Today, most banks expect private equity owners to provide “support” when a company breaks covenants or uses bank funding to support cash losses. That support usually means additional equity in return for time to remedy the problem. There are a whole group of lower middle market lenders who want to bank PE owned firms for just this reason.

As we enter 2017 we remain bullish on our business model and our ability to make a meaningful contribution to the health and prosperity of businesses in the lower middle market, especially job preservation and creation. Now we have PE attribution for supporting a large and growing group of taxpayers and that is not an abstraction.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

January 11, 2017

Rob McCrearyA New Year for Private Equity

Build On What Unites Us

By Rob McCreary

You can get a pulse of America by paying attention to the TV shows acceptable for hospital waiting rooms where comfort, tranquility and hope are cultivated among those patients and family waiting for judgment or healing. Based on my recent pre election waiting room experiences there are only 4 acceptable channels:

  • Judge Judy
  • HGTV
  • The Cooking Channel
  • Weather Channel

As hopeless as this list sounds, I think we can build on all four.

Judge Judy is the easiest. She has a kind of frontier justice devoid of legal niceties and fancy Latin phrases that gets right down to who is right. She quickly undresses the fakers, the con artists, the family leaches and the liars. She dispenses an incontrovertible homeland justice just like Wyatt Earp and Andy Griffith. As such she recalls our roots in the rule of law and administers justice without regard to political sway. We can all get behind her kind of JUSTICE, right?

HGTV is a marvel. How Property Brothers, Flip or Flop, Love It or List It and Fixer Upper are uniting us is obvious. This country loves to buy homes and loves a deal. The concept of a makeover in life, looks, love or finances is part of the American Dream. I am absolutely smitten by Chip and Joana in Fixer Upper. He is the typical guy; broad shoulders, ex-jock, good with his hands, a problem solver, a little bit insensitive and always there in the pinch for Joana. For her part Joana is hot, creative, problem solving and communicative. She handles the goofy couples who are always making those stupid interior design decisions that are either unaffordable or unbuildable. Together they are awesome. If they are faking their genuine love and affection, then strike me down. Their kids are cool too along with the goats, chickens, dogs and cats. I admire mom and dad as self made entrepreneurs. Most of all I share their values even though the Bible is a little out of print for the PC crowd. They represent Family Values and Entrepreneurship.

The Cooking Channel is my North Star. “Chopped” is simply the best TV Show in America. It takes talented chefs who serve up great food and makes gladiators out of them, especially when they get a bad basket of say rattlesnake, brussel sprouts, fruit loops and seaweed. How someone could turn that into a yummy appetizer just blows my mind. The Chefs don’t mind telling you that they really need the money and want to beat the other chefs. This is not tee ball or all “participants are winners” but instead a pretty cut throat race for the crown and the cash. Sort of like real life and the pursuit of happiness. The quirky judges remind me of real life, too, where you encounter people with complete power over you who are difficult. What is refreshing about the interplay is radishes and rhubarb don’t have political views and can live together in a contestant’s basket. It seems to me the judges put professional palate above all else. There is an objective, higher standard. And they reach consensus despite differences and favorites. The chefs are the governed and the judges are those who govern. They are a metaphor for our REPUBLIC and its system of representative democracy.

Finally, there is The Weather Channel.  Who doesn’t like a Cat 5 Hurricane, a Tsunami, a tornado or 12 state ice storm that shuts down the interstate system? This channel is so popular that people in Florida convene for Northern Calamity Cocktails whenever an ice storm cripples the eastern seaboard or the upper Midwest. Without really acknowledging it we are all “channeling” a primal belief in that higher power. As such the weather channel is really our proxy for religion-GOD.

So what unites us is waiting room TV. The reason we like it is pretty much the reasons we love our country and our unique and exceptional experiment in representative democracy. Think about the unconscious waiting room consensus around these core values: JUSTICE, FAMILY VALUES, ENTREPRENEURSHIP, A REPUBLIC, A HIGHER POWER, CONSENT OF THE GOVERNED, PURSUIT OF HAPPINESS. Do these shows have an antecedent in anything faintly familiar?

We hold these truths to be self evident- that all men are created equal, that they are endowed by their Creator with certain inalienable Rights that among these are Life, Liberty and the pursuit of Happiness. That to secure these rights, Governments are instituted among men deriving their just powers from the consent of the governed

During this holiday season we should remember what unites us and bless this great country that alone among great civilizations is grounded in ascendant, revolutionary principles. Those who tell us otherwise are protecting jobs, careers, status or stock prices. They are not broadcasting in the waiting room of our hearts.

Merry Christmas, Happy Holidays and Have A Healthy and Prosperous New Year.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

December 21, 2016

Rob McCrearyBuild On What Unites Us

“The Economist” Weighs In On Private Equity

By Rob McCreary

It seems like the whole world is now fascinated by a business model that has been around for more than 40 years. In the October 22nd issue of The Economist an editorial panel took a look at Private Equity. Entitled “The Barbarian Establishment” the article is mostly complimentary: “Private Equity has prospered while almost every other approach to business has stumbled. That is both good and disturbing.” It reviews the ingredients for successful economic returns as a layer cake of available leverage, low interest rates, and tax shields from deductible interest, large uncommitted equity pools, long term capital commitments and lack of competition from the public markets. Interestingly, the stock market performance of the big four public PE firms – Blackstone (2007 IPO), KKR (2010), Apollo (2011) and Carlyle (2012) – have all lagged the S&P500. In fact, all four are trading at or below their IPO price. Those lackluster returns only apply to the stream of profits from the management companies, not the returns to the limited partners of the multiple underlying funds. It would be surprising, indeed, for Steve Schwarzman and Leon Black to have made a bad trade in monetizing their own profit stream. When they are sellers, the public should be wary.

The article reviews the paltry returns available today from almost every other asset class and concludes “private equity’s current appeal rests not on whether it can repeat the absolute returns achieved in the past…but on whether it has a plausible chance of doing better than lackluster alternatives”. It takes the authors several thousand words, however, to zero in on PE distinctiveness as being the freedom its managers have to ignore the pressures of “quarterly capitalism” meaning impatient investors.” There is recognition of less taxation, less legal vulnerability and fewer operating constraints that allow private equity managers to focus as owners on managing their assets to provide the greatest returns in a short period of time. By contrast, public companies face a mountain of often incomprehensible or conflicting regulatory demands that are not relevant to performance.

A great example is the agenda for our private equity meetings. We try to start (not end) with an executive session that often includes only the CEO of the portfolio company during which the advisory board members ask the CEO to focus on particular issues that are raised by the volumes of financial and operating statistics included in the board package. This allows the PE owners to prioritize and focus on value creation to the exclusion of all else. My public board experience, especially for the 2-3 years after Sarbanes Oxley was enacted, was exactly the opposite. We usually started with an excruciatingly boring review of Sarbanes Oxley compliance conducted by our general counsel or outside lawyers. Only after 50 pages of PowerPoint persuasion that we were, in fact, complying were we allowed to turn to the purpose of the meeting- creation of shareholder value. By that time you were eating lunch and quickly slipping into carbo overload from the cookies and potato chips. With all your blood in your stomach, the public shareholders often competed with the desperate need for a nap.

The authors are also enamored with an attribute that is lacking in the more constipated public company process, SPEED. Management can be changed quickly. Tuck in acquisitions can be accomplished in a matter of months. Divestitures of non performing units do not need lengthy and cumbersome public disclosure. My experience in the public markets with change in management was illustrative. The Governance Committee of the Board would often have “hypothetical” conversations about changing key managers because regulation FD required immediate disclosure if a serious discussion was joined or a real decision was made. It also always took at least two and sometimes three governance meetings to reach a conclusion that a private equity firm will accomplish in a week.

Speed is also important when a window of opportunity is about to close. I had a discussion with the CEO of a telecom company who feared that the “new economy” telecom bubble was about to burst and telecom valuations would soon crash. He said he knew the end was inevitable when in early 1999 all of his customers had infinity growth plans for their respective markets. He shared his concern with the large PE firm that owned his operation and was told they would have a plane pick him up that afternoon. Two weeks later a “Selling Memorandum” was on the street and eight weeks later the company was sold for cash to a large multi-national telecom company. One year later the telecom market was faltering and two years later industry stalwarts like Global Crossing and WorldCom were filing for bankruptcy. The acquirer is still alive but it never regained its mojo.

You have to love an asset class that can move with this kind of speed in a world of red tape and numbing process.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

December 7, 2016

Rob McCreary“The Economist” Weighs In On Private Equity

Winners, Losers and Reigned Out

By Rob McCreary

The 2016 presidential election results were surprising and the aftermath is sure to bring more surprises. There appears to be premature celebration in many camps as business interprets the Trump victory in a most positive light. There are, however, a few bedrock changes coming that will set a business, legal and tax foundation for the next 20 years.

Effects on Private Equity

This election will have a positive effect on the PE asset class but may fall short of positive for its managers. The tsunami of regulation that occurred during President Obama’s last term was real and unprecedented. In our annual summit meeting last spring we brought in an expert on labor matters to speak to our portfolio company CEO’s and CFO’s. He painted a picture of Orwellian doom where the Department of Labor had become its own rule making body under the leadership of the ambitious Thomas Perez. Wage and hour rules including overtime pay and minimum wage were significant issues for our portfolio companies. The classification of workers as “employees” or “contractors” was also a significant risk to many business models that utilize part time or seasonal workers. An expansive “class action” right allowed workers, past and present, to jump into a single dispute and aggregate their grievances. In several cases a wage and hour dispute for less than $5,000.00 became magnified by contingent fee lawyers who earned 30% of their settlements for a class of workers who had nothing to do with the original dispute. In a few cases the settlements were 20x the original amount in controversy and covered hundreds of employees.

There appears to be a general consensus that President-Elect Donald Trump and U.S. Speaker Paul Ryan agree on rolling back government regulation, especially where there is a clear causal connection with small business. Maybe the “wolf pack” within DOL will stop taking down businessmen and capitalists in the name of protecting labor? Maybe harassing successful small business will no longer be the game.

Carried Interest at Risk

While our businesses may be able to breathe better and spend less time each day dealing with regulation and regulators, managers of PE firms may find Trump’s tax policies do not favor them. Both he and Hillary Clinton pledged to end the favorable taxation of carried interest. I have argued in the past about the PE asset class attracting talent because after-tax rewards on wealth creation are significantly greater than many other compensation regimes. For example, appreciated stock options, restricted stock, stock appreciation rights, deferred compensation and stock bonuses are almost always taxed as ordinary income while the gain sharing for PE managers is almost always a “capital transaction” with taxes at capital rather than ordinary income levels. The difference in taxes over a career is meaningful. I do not hear loud voices of protest from the leaders in our industry like Carlyle Partners, Blackstone or KKR. Maybe that is because they already converted their management fee and carried interest streams into a capital asset by going public over the last decade? Without an organized effort to protect our business model it is likely to change soon.

Losers Are Pretty Obvious

The biggest loser is the media. Their business model has changed in my lifetime from journalism based on fact finding (think Ben Bradlee and “All The President’s Men”) to sponsored political content based on celebrity status and inside access. I have noticed in the days after the Trump Trounce the media does not know what to do with itself. ABC, CBS, CNN, NBC news will all struggle for relevance and viewership as they are denied access to a Trump Whitehouse. With a press secretary like Laura Ingraham who is old school enough to expect the media to “do their work”, press conferences may be less like fraternity and sorority mixers and much more like a business of journalism. The big winner, of course, is FOX, especially if Laura Ingraham gets the top media job. Maybe the liberal media can rehabilitate itself with hard core journalism? I would take bet, however, that the taste of stardom and narcissistic fascination with their own reflection will make most of them bitter and mean and eventually cause them to drown in a pool of self-pity.

Reigned Out – It Is About Time

A trifecta is Hillary Clinton, Nancy Pelosi and Harry Reid all getting fired in the same year. There is a real good chance we will see this occur in the next 6 months. That ushers in Elizabeth Warren and Bernie Sanders as the opposition voice.  I doubt incumbent Democrats will see their socialist ideas as currency for a reelection campaign. There are 10 more Senate seats up in 2018 and they are mostly in states that went for Donald Trump. One thing you can count on in politics is self-interest. Democratic incumbents are going to ride whatever train drops them off at Union Station and I doubt it will have a conductor or engineer named Warren or Sanders.

A close second in my lifetime wish list for personnel change is Ruth Baeder Ginsberg. She will never quit the Supreme Court but her influence as a jurist is done. I actually believe that the Supreme Court is guided by principle and legal precedent. As a former lawyer, I have immense respect for the Supreme Court as an institution. It conserves the rule of law. In a smothering political climate where huge political pressure imperils the Court as an institution, the Justices will make sure the institution survives even if there is some bad law created from time to time. Now there is a chance for open and free dialogue around the nuances of legal precedent without the threat from Pennsylvania Avenue. A Justice who has already declared herself has neither the objectivity nor the dexterity to remain relevant in a minority position where persuasion, intellectual fortitude and collegiality matter.

The least likely reign out will be James Comey. Trump may owe him a few years in office. However, like Loretta Lynch, the Clintons have soiled him and he cannot have any support from anyone inside the FBI who actually cares about the rule of law. He will go soon on his own.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

November 21, 2016

Rob McCrearyWinners, Losers and Reigned Out

Indians in Six Because…

By Rob McCreary

Writing a blog about The World Series when your home team is a participant would seem as natural as blonde hair at a hair dressers convention. But I was resisting (jinx concerns) until I read a column by Jared Diamond in Monday’s edition of the Wall Street Journal “How the Cubs Overpowered October”.  Like most of the media, Mr. Diamond is certainly not an Indians fan. While he acknowledges that the October prize often goes to the team with momentum (the Indians are 7-1 in post season), he goes on to state; “Cubs President Theo Epstein- already enshrined in baseball lore for his curse-breaking stint with the Boston Red Sox- has built a roster so loaded with talent that it transcends the crapshoot nature of October.” Well, it is not just about October anymore and there is a real chance that the Champs will emerge from the gales of November off Lake Erie on either November 1st or November 2nd this year. More importantly, I can remember a team that was so loaded with talent that it should have transcended any crapshoot, the 1995 Cleveland Indians. Guess what? They lost.

’95 Tribe and ’16 Cubbies Are Loaded

Mr. Diamond is really enamored with the Cubbies winning 103 games in a 162 game season pronouncing the feat as “rarified air”. Maybe Mr. Diamond should recall that the 1995 Indians won 100 games in a strike shortened season of only 144 games. So the Cubs 63% winning percentage may be rare but the 1995 Indians with a 69% percentage must certainly be Olympian. If the ’95 Tribe had just won half of their remaining games they would have had 109 victories. If he wants blood rare he might bite into the 2001 Seattle Mariners who won 116 games and lost in the first round of the playoffs to the Yankees 4-1.

That 1995 Tribe team certainly matches up well with the Cubbies at the plate. Remember who the #7 hitter was? That would be a right fielder by the name of Manny Ramirez who at age 23 had 31 home runs and 107 RBI’s in a season with 18 less games than the Cubbies just completed. He had 119 fewer at bats than Kris Bryant! By comparison Kris Brant who plays 3B and bats 4th hit 39 home runs with 107 RBI’s in 603 At bats. Manny had 484 Abs. On top of Manny being a better hitter than Bryant the Club also had Albert Belle who at age 28 in 546 plate appearances had 52 home runs, 50 doubles and 126 RBI’s. I guess you have to compare him to Cub’s Anthony Rizzo age 26 who has 583 at bats with 32 dingers and 102 RBI’s. You are left with the rest of the mighty Cubbies getting 95 RBI’s from Addison Russell and 76 from Ben Zobrist. In my book “Rarefied” should mean Baerga with 90, Eddie Murray with 82, Thome with 73, Vizquel with 56, Lofton with 53 and Sandy Alomar with 35. In stark relief, the new WSJ boys of November did not have another hitter with more than 50 RBI’s. By the way the Cubbies strike out a ton and the starters only had 47 stolen bases. Kenny Lofton alone had 54 and the Cleveland starters in 1995 had 117 swipes.

There might be a slight advantage to the Cubs in the pitching department. Lester was 19-5, Arieta was 18-8 and Kyle Hendricks was 16-8. Dennis Martinez for the Tribe was 12-5, Charlie Nagy was 16-6 and Orel Hershiser was 16-6 but all with four fewer starts. The Cubs have a flamer in Aroldis Chapman who routinely throws over 100 MPH and the Tribe had (break my heart) Jose Mesa who lost his way in ‘95 but lost the World Series in 1997 to the Marlins. His name is not spoken in our home.

To keep the comparison going, the 1995 Indians never lost more than 3 games in a row. The 2016 Cubs had a swoon and lost 15-20 games midway through the season. The Cubs skipper is Joe Maddon who has a lifetime 103-58 record while the Tribe in 1995 was skippered by Mike Hargrove who was 100-44. The ‘95 Tribe and the ‘16 Cubs seem to me pretty equal.

Lake Erie Breezes Blow In a Championship

So I have an idea for why the Tribe will win in 6. It will be the weather. Game time is 8pm. Two of the nights will likely have rain. The game time temp for game 1 and game 2 is said to be 45 and 46 respectively followed by 56, 49, 49, 50 and 53. A team built for home runs with lots of strike outs will be feeling it in batting practice. Getting a grip on the baseball will be like trying to hold onto a greased watermelon. Trevor Bauer’s pinkie will be frozen and no blood will flow. A team of mutts that gets on base and advances the runners will have an edge. Tribe stole 2x the bases and neither Lester nor Arieta can hold runners. In fact, Lester has the yips about throwing to first base. Good defense will trump hitting (Indians ranked 11th and Cubs 22nd) and managerial experience will tip it in favor of the Tribe.

I consulted a definitive source on the matter of cold weather outcomes, The Hardball Times. In an article by Chris Constancio written October 2006, Mr. Constancio dropped a few pearls of wisdom.

  1. Pitchers strike out a higher proportion of batters in cold weather and stay warmer on the mound
  2. Pitchers also walk more batters in cold weather
  3. Home runs are relatively rare in cold weather
  4. Batted balls in play are less likely to be hits in cold weather
  5. Patient hitting teams have an edge
  6. Teams that are built on fast balls have an edge over teams with breaking balls

Not all of these factors favor the Tribe. Kluber, Tomlin, Merrit, Shaw and Miller rely on nasty breaking balls for their “out” pitches. In the post season the Tribe has also grabbed leads off the long ball. However, I do like the patient hitting edge and the legion of guys the Tribe can throw at you from the bullpen. Am I am sounding like a Yankees fan or a BoSox fan to you? I am still humble but practicing to become en-“titled” just like them.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

October 25, 2016

Rob McCrearyIndians in Six Because…

McKinsey Report Applauds PE Model

By Rob McCreary

One of our portfolio company CEOs sent me a really interesting comparison of the PE business model with the public company business model. “What private-equity strategy planners can teach public companies” By Matt Fitzpatrick, Karl Keliner, and Ron Williams (Link Here) is a ringing endorsement for several value creation techniques that PE managers employ. Matt Fitzpatrick is a partner in McKinsey’s New York office, where Karl Keliner is a senior partner. Ron Williams is the former chairman and CEO of Aetna; a Director on the boards of American Express, Boeing, and Johnson & Johnson and an adviser to private equity firm Clayton, Dubilier & Rice.

The authors point out those PE managers cannot afford to underperform or else they lose access to follow on funding. This is contrasted to the public markets where it seems like the managers are often paid handsomely for failing and then leaving to “spend more time with their families. The authors also see PE firms pursuing distinctly different value creation strategies. The public managers have to adopt strategies that will work quarter by quarter to appease institutional investors and support stock prices. PE managers have to adopt strategies that will enhance value over a 7-10 year period. One thing the article does not say but is also a distinctive difference is the alignment of rewards. PE managers usually invest meaningful capital at closing which is augmented by option programs tied to an exit and realization at a multiple of the original investment. It is not unusual for that option program not to kick in until the limited partners have received 2.0-2.5x cash on cash return at which point the management team’s options accrue. In a public company the strike price for the option is usually trading price at time of grant. Misalignment should not occur in the PE model but it is fairly common for public managers to exercise options and sell the underlying stock based on short term achievements even though the long term trend may be otherwise.

PE Professional Are Good Strategists

The authors like the 100 day planning process that almost all PE firms employ immediately after they have acquired a company. Here is their contrast: “During the 100-day planning process, private-equity firms are more active than public companies in considering the furthest horizons of strategic planning. Public companies often focus on nearer-term objectives, including existing baseline products and emerging product lines, though longer-term bets can help to create significant longer-term value. Typically, private equity firms more actively identify and emphasize strategic planning’s third horizon, including new markets and products and diligently makes tactical bets on it. For example, when PE firm Clayton Dubilier & Rice (CD&R) acquired PharMEDium for $900 million, in 2014, it hadn’t previously invested in outpatient care. But managers identified this as a major growth opportunity and made a calculated bet that paid off handsomely. CD&R ultimately sold the business for $2.6 billion.”

PE Managers May Have More Freedom to Allocate Capital

The authors also point out that Public Companies face more intense competition for capital. Managing EPS often means using cash for stock buy backs and shareholders seeking yield are highly focused on the public company dividend policy. The PE managers often look at capital allocation at the Fund level and tend to feed winners and starve losers without third party influence. In fact, most PE organizational documents limit the concentration of capital in any one investment to not more than 15-20% of the portfolio. The governance model for PE portfolio companies also helps rational capital allocation because each business unit has its own advisory board comprised of PE professionals and outsiders who can bring industry knowledge and tactical experience on matters like pricing and operational excellence. These Advisors usually invest a meaningful amount of their own capital at closing and are highly aligned to the performance of the portfolio company. There is often no comparable governance model in the public sphere even in cases where the company has unrelated business units.

PE Managers Are Highly Skilled at M&A

The McKinsey report also notes that Private Equity focuses its people on making M&A a competitive advantage. The ability to conceive and execute a value enhancing acquisition is difficult and fraught with “first time” risks. When you are buying and integrating across a portfolio of companies with the same PE teams leading all the deals and supporting management you tend to see better outcomes than the public model where a business unit manager is supported by internal corporate development teams and outside advisors who are often not aligned in their compensation to the final outcomes. The authors also make the point that PE managers are not just good at buying but they are often excellent sellers as well.

It is pretty typical for PE managers to collaborate with portfolio company managers plan during the first 100 days for how they are going to add value and enhance the attractiveness of a portfolio company in the M&A markets. While exit strategy does not trump business strategy, it often compliments it. The selling part of the PE model is also where management and the PE owners align. A realization, cash on cash return above target thresholds, gives both owner and manager the same pay day. The PE model also allows leveraged dividends when cash generators can refinance at low interest rates. There are many times when the market is not right for a sale because there is improvement in process but a leveraged dividend could make complete sense. The low interest rate environment encourages our industry to look at returning capital when it can.

The PE Model Focuses On Cash Flow

While it seems to be a distinction without a difference, there is a huge contrast between a business model where you maximize cash flow to pay down debt and a model where you manage to create earnings. It is true that it is usually hard to have cash flow without earnings but it is almost impossible to convert earnings to cash flow when the shareholders want it all back. By having a guillotine of debt hanging over your head each day, you learn to maximize cash flow by managing working capital, watching expenses and augmenting earnings through pricing and vendor management. As I have written in the past, debt is an insistent mistress and quite jealous of attention to anything other than her needs which means covenant compliance and speedy amortization.

While our public markets are the bedrock of American capitalism, the private equity industry is making a strong statement for why its business model may be better suited to longer term value creation.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

October 20, 2016

Rob McCrearyMcKinsey Report Applauds PE Model

Honey, I Just LBO’ed the SPX

By Rob McCreary

On the back of the predicted sixth consecutive quarterly decline in the earnings per share of the S&P 500 I decided to see how we would have done if we had done a leveraged buyout of the S&P 500 in 2014 and then again in 2015. I did two separate fictional LBOs of the SPX at 11.5x its trailing twelve month (TTM) EBITDA as of December 31, 2013 and then again at 12x TTM EBITDA for December 31, 2014. The nosebleed multiples of EBITDA at which the S&P 500 trades today are not significantly greater than the typical large company buy out, but they are nonetheless historic for the public markets during this last decade. According to data compiled by the Wall Street Daily in an article by Alan Gula dated Feb 1, 2016 the following was the data set for the S&P 500:

10-11-16

You can see that in 2012 the multiple was slightly less than 8x but that in 2014 and 2015 it had reached and exceeded 12x. It is also instructive to see how the SPX- the ETF for the S&P traded during that period. It increased from 1500 to 2200 as shown below and the PE multiple based on TTM earnings increased during that period from 14.87x to an estimated 25x through Q3 of 2016.

capture

It Is All About Earnings in a LBO

I was actually quite surprised to see that if I did a complete buyout in 2014 based on TTM EBITDA for the year ended December 31, 2013 and sold at the end of 2016  I would have returned $1.34 for every $1.00 invested for a 10% compounded return on equity over that 3 year period. Conversely, if I waited one year to do the LBO I would have returned slightly less than $1.00 for each dollar invested, in essence I just got my money back.

The LBO model is highly sensitive to the big variables like entry price, earnings, interest rates, taxes and capital expenditures. For my analysis the only big mover was earnings. My first buyout of the SPX in 2014 had 11 quarters of earnings above the level at which I priced the buyout. The second buyout was done at peak earnings and the earnings have only declined since then. In fact, the S&P 500’s earnings per share for Q3 2013 ($88.97) is almost identical to the estimated $86.96 for Q3 2016.

Possible Arbitrage between Markets

One of the reasons the EBITDA multiple in the public markets is so high is that public earnings and EBITDA are falling. This is remarkable given the record number of share buy backs which typically boost EPS by lowering the shares outstanding.  One question an investor should be asking is whether the liquidity of owning the S&P 500 is worth the sky high entry price? Likewise, is that liquidity premium likely to go away when central bank monetary policy becomes less favorable?

Without permanent liquidity, the entry opportunity in the lower quadrant of the private markets is significantly better because the median entry price is 6.5-7.0x EV/EBITDA. The smaller companies have also demonstrated an ability to grow, albeit slowly. A good trade might be to lighten up on the expensive, but temporarily liquid, large company market and trade into the private markets where the return possibilities should be better, but illiquid. I raise the question of liquidity because many other trading markets have experienced declining liquidity as the commercial banks no longer lend their balance sheets to most trading markets after Dodd Frank. At some point central bank accommodation may stop at which point the liquidity premium could evaporate like it did in 2008. At that point you will be happy to have traded out of a market whose only sustaining momentum may be the promise of liquidity.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

October 11, 2016

Rob McCrearyHoney, I Just LBO’ed the SPX

Governmentis Interruptus

By Rob McCreary

The President announced last week that it is time to regulate driverless cars. This usually means finding a way to tax the new technology or strangle it while a more nimble and less regulated country steals the technology or copies it. But in the heat of a quest for Presidential legacy and scant time to discover it,  President Obama’s administration is calling on the technical staffs of the manufacturers like Uber, Google, Ford, GM, Tesla and Apple to share with the government how those cars work and why they can fail. I guess they are convening a science fair for 15% of the world’s GDP?

Why Not Trust Market Competition

I might trust the forces of market competition among giants of technology like Google, Ford, GM, Uber, Tesla, Microsoft and Apple to fight this one out when 10-12%% of Worldwide GDP is at play. But I also understand that this is a disruptive moment and the government’s first instinct is to help.

According to Digital Industry Insider, in an article reported out by Reuters on September 20, 2016 the National Highway Traffic Safety Administration is calling on the driverless car industry to voluntarily submit a 15 point “safety assessment”.  NHTSA is aiming to make that voluntary submission mandatory through the “regulatory process”. The administration also hopes for a kumbaya moment where someone like Elon Musk, leads a sharing session where Google and Uber will exchange IP and best practices with Tesla and Ford as well as data about problems they have encountered with their own beta tests.  According to Digital Industry Insider, “The proposals touch an array of issues, from the ethics of robot guided vehicles- should an automated car hit a pedestrian or protect the occupants of the vehicle in a case where a crash is unavoidable- to whether self-driving cars should be allowed to speed”.

This was all precipitated when Uber recently unleashed robot cars in the Pittsburgh test market. No longer safely contained as an abstraction on the Google campus in Moutainview California where Google robot cars have been running for many years, the Pittsburgh Uber cars are actually circulating in public and the government wants to know how they work and how they can fail. Gee, I would think that the government would be more interested in how they can succeed given most of the technology leaders are American and the worldwide auto industry is many trillion dollars.

Late Night Hosts Can Give You the Top Fifteen Failures

I am also trying to understand what the government is going to do with the failure information. Any late night host can come up with a list of the top 15 reasons why driverless cars may fail and pose a safety threat to our transportation network:

  1. The Autonomous Flux Capacitor Stops Working
  2. China’s Death Star takes out the Uber and Google satellites
  3. Driverless cars stop at yellow lights and are rammed by old tech cars
  4. Many states still have toll booth operators who only accept cash
  5. Woman riders mutiny and short circuit the flux capacitor so they can sit in the driver’s seat and apply make up at stop signs and text in traffic jams
  6. The software is “improved” by the government.
  7. Driverless cars are organized by a transportation union and go on strike
  8. The Solar Engine is manufactured by Solyndra
  9. Orange Barrels are confused with waiting passengers
  10. They don’t have steering wheels, brakes or gas pedals
  11. They run out of gas in a traffic jam
  12. RAIN.FOG,SMOG blind the eyesight
  13. Valets can’t disable them
  14. Car Ferries let them off early
  15. Hal the computer takes over the system

As far as I can tell there is no need to give the tort industry an advance playbook. If Jimmy Kimmel can name 15 possible failures that is good enough for me.  It should also be satisfactory for most Americans and presumptive President Clinton’s only interest should be a financial one. If I were Elon Musk I might see if President Obama blinks on this one and wait for a President who is looking for a financial legacy.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

September 28, 2016

Rob McCrearyGovernmentis Interruptus

What’s Up with Libor?

By Rob McCreary

Most PE firms borrow on a variable rate basis from banks. The pricing is based on LIBOR which is the acronym for London Interbank Offered Rate which is the rate at which banks are willing to lend to each other. LIBOR has often been the bellwether for real costs of credit because it is peer to peer lending and is not directly influenced by central banks. Here are the comparable statistics for 3, 6 and 12 month LIBOR at September 9, 2016. You can see that 12 month LIBOR has almost doubled over the last year and overnight LIBOR has almost quadrupled. This is a dramatic increase in the cost of short term debt.

52-WEEK (Source;WSJ)

Libor Rates (USD) Latest Wk ago High Low
Libor Overnight 0.42211 0.41611 0.42211 0.11620
Libor 1 Week 0.44522 0.44300 0.44610 0.15115
Libor 1 Month 0.51822 0.52294 0.52572 0.18830
Libor 2 Month 0.66467 0.66522 0.66522 0.24625
Libor 3 Month 0.84544 0.83567 0.84544 0.31515
Libor 6 Month 1.23472 1.25122 1.25122 0.51590
Libor 1 Year 1.54033 1.56556 1.56556 0.81640

Against this metric, however, we read every day about the threat of negative interest rates where banks and corporate issuers charge their customers to hold deposits. European bonds are being issued with negative yields where the owner of the bond gets no current yield and also takes a haircut on par value at maturity. In essence, the owner is saying “All I want is most of my money back.” Likewise depositors are paying Swiss banks to hold their cash (negative interest) but that same Swiss bank can loan its reserves overnight to another bank at more than four times the rate it could have in September of 2015. Is something rotten in Denmark? Not really, it may all come home to the US and the new money market rules that “guarantee” par on government money market funds (Won’t Break the Buck). Money market funds whose portfolio is comprised of short term corporate paper will not be guaranteed at par (They Can Break the Buck) and they also can be subject to redemption fees and gates on the amount and timing of their liquidity. Short term treasuries are rallying and short term commercial paper is oversold and quite cheap. Corporate borrowers like Home Depot are issuing 40 year bonds and then using the proceeds to arrange shorter duration portfolios to handle their expected working capital needs. I assume they see an arbitrage advantage as they expect the oversold position in short term corporates to rebalance after the money market migration to government funds is finished later this fall?

The chart shown below is from Aurum Wealth Management’s most recent report on the new world of money market instruments. It shows a dramatic shift to the government funds:

chart

Blame It on Lehman Brothers

The money market rules trace their origin to Lehman Brothers bankruptcy in 2009 and the pressure money market funds that held its commercial paper felt to hold the $1.00 per share value (Don’t Break the Buck) when the underlying portfolio was actually worth less than par. Eventually those money market funds recovered up to 98 cents of each dollar invested but the risk to ordinary investors who believed their principal was safe was highlighted as unacceptable.

The law of unintended consequences may be at work once again. The typical PE firm cannot borrow like Home Depot and if it has not completely hedged, its portfolio has seen its bank interest rates move from 2.5-3.5% to 3.5-4.5% in just 12 months. This is great for bank profits but bad for leveraged portfolio companies. It is also a complete aberration from the rest of the commercial world where issuers are testing negative interest rates. It is unclear how long LIBOR will be influenced by the great sell off of short term, non-governmental debt. It is also unclear whether this migration will permanently affect the liquidity of the short term fixed income markets. In essence, by lending its guarantee to governmental money markets, the US Treasury is altering the highly liquid and quite dependable short term debt market. I am not so sure anyone thought about it?

Short Term Working Capital Financing

My final concern is how corporations that rely on commercial paper to finance their working capital will react to the precipitous increase in their cost of capital. While I am not an expert on fixed income and really do not know all the alternative available to corporate treasurers, I do know that the US capital markets worked quite well when there was a constant demand for short term non-governmental debt to comprise all or a portion of money market portfolios. That demand also promoted liquidity. Without constant demand and the competition with governmental money markets I can foresee a huge shift in how corporations finance their short term cash needs. Right now it looks like the government has crowded out an amazingly efficient and liquid debt market. The cost of private capital is rising and the US taxpayer is underwriting yet another government guarantee. My only question is how can I get my checkbook back?

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

September 15, 2016

Rob McCrearyWhat’s Up with Libor?

The Generational Divide Comes Together Around Mentoring

By Rob McCreary

I have been introduced to a new concept in the work place called “reverse mentoring”. It was supposedly first introduced by Jack Welch to bridge the technology chasm between older and younger GE workers. Techopedia.com defines it as follows:

Reverse mentoring refers to an initiative in which older executives are paired with and mentored by younger employees on topics such as technology, social media and current trends. In the tech industry or other businesses that rely heavily on technology, reverse-mentoring is seen as a way to bring older employees up to speed in areas that are often second nature to 20-something employees, whose lives have been more deeply integrated with computers and the Web.”

A number of our younger portfolio company managers are happily mentoring the older managers about Facebook, Linked In, GoToMeeting, Amazon and Twitter

This new workplace trend comes as a complete relief to me because I am getting all my tech help these days from my grandkids and they don’t know beans about EBITDA but can go on for hours about Elsa and Kristoff. I am never allowed to assume a meaningful character role in whatever version of Frozen we are playing so I naturally assume the role of Sven the reindeer. Right now the television remote, changing my greeting on my new iPhone, picking ringtones for texts and email, creating playlists,  watching You Tube videos on my phone, “friending” someone and initiating and accepting Face Time are daily interventions by kids aging from 4-14. Curious George reruns, Paw Patrol, transformers, princess costumes, homework, and soccer practices make their reliability iffy, but I have been well prepared to accept the total dependency on grandkids that reverse mentoring may mean.

There is only one problem with this reverse mentoring business model; it assumes that the younger generation is really prepared for some trade-offs. Hard to understand why a millennial will see value in my grammar lessons like “him and I” can never go together. It is either “he and I” or “him and me” in exchange for how to reprogram my android phone to use my Outlook calendar when the factory default is the Google calendar? It is also unlikely that a younger office colleague is likely to see reciprocity in my advice that a business problem might be better resolved by a cup of coffee or a phone call than a text or email when he knows how to type emails and texts with both thumbs and can scroll through emails with one hand without dropping the phone while simultaneously drinking a cup of coffee. I also doubt that the next gen will find any value whatsoever in my weekly takeaways from the Peggy Noonan Columns when he knows how to find Pokémon in a rain forest.

Maybe the reverse mentoring does not have to be based on reciprocity at all and is an Adam Smith experiment in self-interest. The younger colleague has a high self interest in making his boss look techno savvy so the boss doesn’t care when he wants to “collaborate” from home on Mondays and Fridays. I may have missed my golden opportunity last week to get my own techno Sherpa had I been willing to promise Friday work from home to a person interviewing for an Associate position. Self-interest might also dictate that the month of November be declared “Take Your Boss to the Apple Store” for employers whose bonus pool is determined and paid in December. There is nothing like showing your boss how to get a new user name and password for a web site in 30 seconds with one thumb while monitoring the status of the Uber car you ordered with the other.

There are a couple of existential technology mysteries that could be solved by the reverse mentoring as well:

  • What is a RSS feed?
  • How can you reverse the lens on your camera phone to take a selfie?
  • Why do people take selfies?
  • Do you win something for finding Pokémon’s?
  • How do you forward a text?
  • Why are songs that I have listened to for years suddenly blocked from play in my Apple music library?

Jack Welch was a visionary and I love the idea of reverse mentoring especially for the daily struggles with passwords and user names but I fear that he was talking about managerial mentoring like large company IT strategies, systems rationalization, productivity enhancers and using social media for consumer branding. For now I will just have to accept my role as Sven the reindeer in exchange for having the grandkids unlock the mysteries of the internet of things.

Your Insights Are Welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemail’s, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Rob McCreary, Chairman
CapitalWorks, LLC

September 6, 2016

Rob McCrearyThe Generational Divide Comes Together Around Mentoring