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.

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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:


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.


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.

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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

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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:


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. 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

A Blind Man Driving a Ferrari

By Rob McCreary

American business is like a Ferrari. It purrs at 140 mph, corners well at half that speed and is coveted by everyone. The US dollar, our capital markets, the US banking system, our rule of law, easy capital flows, startup successes, invention, innovation and orderly corporate governance all come together with a throaty purr just like a Ferrari. As President Calvin Coolidge said “The business of America is business”.

Hollywood Provides an Analogy

So, when I had the great luck last weekend to stumble into a classic old movie starring Al Pacino called “Scent of a Woman” about a blind Army veteran who has lost his will to live, I immediately wondered whether there is an analogy?

Recall that Lt. Frank Slade hires a prep school kid, Charlie Simms, (played by Chris O’Donnell) to be his assistant on a final trip to New York City. There is a memorable scene when Frank  talks a Ferrari salesman in Manhattan into letting Frank’s assistant, Charlie, test drive the $107,000 (1992 prices) car. Charlie drives the Ferrari to a deserted part of Manhattan and then Frank takes over. He gets the car up to 70 mph and then says, “Charlie I want to feel how she corners”. Of course, he is suicidal anyway so Frank really does not care how well he executes a blind man turn in a Ferrari at 70 mph.

This is Hollywood so everything ends well with a friendly New York cop pulling Frank over for speeding. The cop never notices that Frank is blind, and the officer lets Frank off with a warning; not for driving blind but simply for excessive speed.

A Bureaucrat Test Driving Your Business

I could not pass up the opportunity to connect the dots between the Ferrari business world and the blind political class many of whom have no business experience. Someone from SEC, DOL, Justice, EEOC, EPA, and IRS is taking the keys from business owners every day. The old concept of checks and balances insured, at least in a Presidential election year, a healthy partnership between politician and business people who controlled the funding. However, in 2016 Trump bypassed the business community by financing his own primary and the Clinton Foundation supplied a “magic carpet” to the White House. Both candidates have done an end run on business. This portends an unchecked reign for the political class. Frank Slade is not giving up the wheel any time soon.

The aggressive overreach by Obama bureaucrats in all the three letter agencies is also changing accountability. “How does she corner at 70 MPH?” is not the first question you want to hear when a blind politician decides it can test drive American business.

Businessman’s Bluff

Until I read Peggy Noonan’s article last week in The WSJ “A Dramatic Lesson about Political Actors” about Borgen, a miniseries cast in Denmark, I believed that business leaders in the United States could hold the politicians in check. Borgen portrays an ambitious woman president against a business scion who threatens to move his company out of Denmark if the president does not revoke a mandate that all corporate boards have 50 % females. The Denmark president calls the business leader’s bluff because the business leader is a patriot and can’t leave the country. Likewise, US corporate leaders cannot leave the system. Where else will they go? There are no other reliable alternatives.  A number of big names have already sold out and those that resist are being targeted and punished. There is no greater proof than Goldman Sachs agreeing to become a commercial bank.

The next act will be a blind man with a comb over or a blind woman in pant suits test driving the Ferrari. It reminds me of Nancy Pelosi’s equally blind faith appeal about regulating 16% of GDP by enacting Obama Care: “We have to pass the bill so you can find out what is in it.”

I also wonder who is going to ticket our political leaders for driving blind? It certainly won’t be the FBI, or Justice. They have already shown that they can’t tell the difference between an “extreme recklessness” and a blind driver. It won’t be Jamie Dimon or Lloyd Blankenship either because their bonus pools are regulated by the Comptroller of the Currency. Maybe some ingénue like Charlie- a young man of character and integrity who has been raised like old school Americans to make tough choices and stand for something- can grab the keys to the Ferrari before some blind politico drives it into a wall?

Nope. This isn’t Hollywood. There is no happy ending and the Ferrari’s keep getting smashed until there are no more Ferrari’s. Only then will someone from the FBI notice that the politicians have been driving blind without a license.

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

August 29, 2016

Rob McCrearyA Blind Man Driving a Ferrari

Private Equity Firms Seen As Broker Dealers

By Rob McCreary

A recent article in the June 30, 2016 edition of The Wall Street Journal by Norm Champ titled “An Iniquitous Raid on Private Equity” highlights the latest intrusion by the SEC on the freedom of private equity managers to arrange their relationships with their portfolio companies. In an enforcement action against a private equity firm called Blackstreet, the SEC sought restitution, interest and penalties for charging a transaction fees in connection with the buying and selling of portfolio companies. The SEC characterized part of the problem in its own press release as follows: “Blackstreet operated outside of the funds’ documents by using fund assets to make political and charitable contributions and pay entertainment expenses.” The enforcement action was settled for $3.1 million. It was not enough that Blackstreet was registered with SEC as an investment advisor under new rules spawned by Dodd Frank. The enforcement action claimed that Blackstreet had acted as a broker dealer in connection with the buying and selling of portfolio companies and as such needed to be registered with SEC as a broker dealer.

This logic is so flawed that you have to ask what is the political motivation? Did Blackstreet principals say something bad about our President? Did they contribute to conservative causes? Did they finance the Benghazi movie? One thing is for sure in Chevy Chase, these guys did not contribute to the right political party? Had they made charitable contributions to the Clinton Foundation from Fund assets we may have had a different view of entertainment expenses?

Business Model for Private Equity                                                                      

The business of private equity is buying, improving and selling its portfolio companies. The private equity firm serves as the general partner and exclusive manager of a limited partnership that owns the portfolio company.  GPs act for the passive owners who risk general liability if they engage in management activities. So the GP is really the owner’s representative and the exclusive party to exercise all of the functions of ownership including buying and selling. Under this logic a private condo developer who pays himself a commission for selling a condo unit instead of hiring a real estate broker should be a broker dealer.

Transaction Fees Are Common

Transaction fees are often assessed by a General Partner when the resources of the private equity firm are devoted to the buy or sell effort. For example, the creation, supervision and updating of a data room is often a collaboration between the managers of the portfolio company and employees of the General Partner. Depending on who does what, it may be appropriate to outsource many one-time services incident to a sale to the private equity firm rather than having a management team do it for the first time. It is not unusual for the GP to charge a fee for the avoided costs to the portfolio company. It is rare, however, for the GP to act as a financial advisor in the purchase or sale. It is a principal and a surrogate for the owner not an agent. If it is charging a transaction fee in connection with a buy or sell it would most often be in the context of providing outsourced services that are not within the expertise of the management team or the case where a preemptive, unsolicited offer is too good to pass by and an intermediary is not required.

The best example is tuck in acquisitions where the transaction was sourced by the GP and the transaction size is too small to engage an investment banker to sift through the selling memorandum, due diligence materials, legal documents, escrows and post-closing responsibilities. Most of our portfolio company managers have little or no experience with acquisitions and they completely outsource the heavy lifting to us. If we charge a transaction fee, it would usually be significantly less than an investment banker would charge for many times more work than they are trained to do. This is not a broker dealer activity but rather additional work by the GP that is an avoided cost to the portfolio company and its owners in the limited partnership.

Bad Actor Creates Bad Precedent

The fund formation documents typically permit the GP in its capacity as a fiduciary (investor interest first) to charge reasonable transactional and portfolio monitoring fees whenever it is providing outsourced services to the portfolio company that they cannot provide themselves. Those outsourced functions are numerous: treasury, corporate development (inbound and outbound), financial reorganization, financial modeling and feasibility analysis, quarterly governance preparation, litigation management, administration of escrows and post-closing working capital, exit preparedness, stock option plan administration, organizing and oversight of committees of the advisory boards, CEO performance reviews, and  hiring and supervision of recruiters for key personnel. None of these functions are broker dealer functions. I know because I worked for a broker dealer and owned a broker dealer. Broker dealers do not act as management surrogates nor do they serve as the fiduciary representatives of the limited partner owners who are prohibited from acting for themselves.

The SEC is run by a woman who understands these things. Mary Jo White is well respected for the work she did in the private sector. For 10 years, she was chair of the litigation department at Debevoise & Plimpton, whose “core practices” and expertise are focused on the success of Wall Street financial firms. The fact that Senator Elizabeth Warren thinks she is doing a lousy job is an endorsement of her leadership effectiveness. Giving her the benefit of the doubt, you must ask if something else is motivating a bad legal intrusion. The answer is found by investigating the reputation of Murry Gunty who is the general partner of Blackstreet. He was alleged to have rigged the balloting for the prestigious Harvard Business School Finance Club in his favor and might be on the SEC’s ten “most wanted” list because of subsequent ethical slips. This decision may be more about a bad man than the bad activity, but it certainly does not warrant bad legal precedent.

And there is always the most logical explanation in Washington DC- politics as usual.

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

August 11, 2016


Rob McCrearyPrivate Equity Firms Seen As Broker Dealers

Pollsters and Politics Are Great Bedfellows

By Rob McCreary

Early in my career I read great advice for surviving the world of financial prediction: “Give them a date and give them a number, but never give them both at the same time”. The profession of making business predictions is a graveyard for professionals who almost got it right.  The business world demands reliability and creates high accountability for paid prophets. Most do not survive their sophomore year.

Political Prophets Have another Standard

I simply cannot understand how the whole industry of political prediction can thrive when its recent batting average on major events like the surprise conservative victory for David Cameron in 2015, Trump 2016, Brexit 2016, Romney’s Presidential campaign in 2012, and almost all global warming predictions is hovering around the Mendoza line or what Miguel Cabrera is batting against Indians’ pitching this year, around .155. How can these highly credentialed university academics and pollsters with every resource on the planet including social media, the internet, robocalls, exit polls, snail mail and endless algorithms get it wrong so often when so much is riding on their predictions?

I can only answer that question with another three questions:

  1. Who is interpreting the prediction?
  2. Who is benefiting from the prediction?
  3. Who is paying for the prediction?

Academics and the British Tote Board

Take Brexit; The pollsters and the bookies diverged in the weeks leading up to the vote. The media was fixated on the bookies expecting that the tote board, how people are betting their money, was a better indication of the result than what people told the pollsters they were going to do. In turn, financial markets sided with the bookies and signaled ironclad confidence in a “STAY” outcome. So the capital flows measured by bookies and brokers prophesied a certainty of NO Exit. That was good enough for academic experts like Stephen Fisher and Rosalind Shorrocks from Oxford University who predicted only a 39% chance of EXIT one week before the polls and 11% as the polls closed one week later. The Washington Post in an article by Chris Hanretty on June 24 reports them being blindsided.

According to Chris Hanretty’s article “Here’s Why Pollsters and Pundits Got Brexit Wrong”, various factions saw the vote unfolding differently: “None of these methods saw a Leave outcome as the most likely outcome. Ordinary citizens came closest, putting the probability of ‘Brexit’ at 55.2 percent, closely followed by an average of polls at 55.6 percent. The least accurate forecasting method was to infer probabilities from betting markets. Fisher and Horrocks, on their morning of poll update, reported an implied probability of just 23 percent. Ninety minutes after the close of poll, this market-derived probability had fallen to just 11.3 percent.”

So the people and the pollsters said that there was a greater than 55% chance that Britain would EXIT the EU.  That needed to be re-interpreted by Oxford academics, Stephen Fisher and Rosalind Shorrocks, by divining the British tote board and the financial markets. Mr. Hanretty suggests that academic pros were relying on tracking referendum forecasts that were a special brew of people, pollsters and betting markets. Two of those three said go and only one, the bookies, said stay. The academics went with the tote board which turned out to be as accurate as my childhood Ouija Board that predicted I would be a priest.

The rest of The Washington Post article talks about the academics learning something new about campaign dynamics in referendums called “status quo reversion” which is the well supported tendency that undecided voters are more likely to choose the status quo (REMAIN) than the uncertain future (EXIT) and that was proved by the betting book and the financial markets.

Hedge Funds Probably Made a Killing

I have another suggestion for The Washington Post. The real smart guys (think George Soros) might have encouraged wholesale media endorsement of the REMAIN outcome because they had a big bet on the more likely EXIT result. Soros would believe the people and pollsters and he could easily manipulate the academics’ Ouija Board.

Think about a multi-billion hedge fund with currency trading skills that is making small, but timely and influential, bets for REMAIN on all the tote boards in London but large last minute (market timing) Exit bets in the currency markets when the odds start to become really good. The pollsters are saying EXIT, the people are saying EXIT but the betting line is 10:1 for REMAIN based on The Washington Post’s and media’s ringing endorsements (backed by Oxford Academics) of the betting markets belief in status quo reversion? Seems to me some hedge fund (think George Soros again) made a small fortune. The reason I suggest George Soros is because his voice was loudest at polling time (after he may have shorted the Sterling) about what would happen if Britain exited the EU. My explanation, while pure conjecture, is just as plausible as the “status quo reversion theory” not working in close referendums?

Support for my hedge fund theory comes from an article published by The Economist on June 24th as well. Among other things, that article investigated the composition of the Ladbrokes betting book on Brexit: How did the wisdom of crowds fail so spectacularly? One theory holds that the Brexit market was swayed by a small number of big bets by optimistic “remain” voters, who tended to be richer than those who supported “leave” (indeed, Ladbrokes, a bookmaker, has said that the majority of individual wagers were placed for “leave”). But while political-betting markets could conceivably be small enough to demonstrate such inefficiencies, currency markets most certainly are not, and they displayed the same pattern as the bookies.” Maybe “richer”, in this case means institutional money that was trying to manipulate the tote book to influence the currency markets?

Going back to pollsters and predictions and remembering my three questions, you have to be pretty skeptical about political predictions:

  1. Who is giving the prediction or interpretations of the prediction? It is usually some branch of media or independent research sponsored by some venerable institution of higher learning.
  2. Who is benefitting from the prediction? Some branch of media is usually incented to predict close elections because it leads to massive ad campaigns.
  3. Who is paying for the prediction? Usually one or more affiliates of a political organization who have commissioned a study or the media itself who simply views it as an investment in creating future ad inventory?

Based on my three questions I think the 2016 Presidential election poll right now is either 60/40 for Hillary or 60/40 for Trump, but you will not hear that from the pollsters because a dead heat (within the margin for error) encourages fundraising that buys advertising. I only wish the pollsters would call it straight and avert the pain of the endless media onslaught that will start soon.

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

July 26, 2016

Rob McCrearyPollsters and Politics Are Great Bedfellows

No Hands on the Wheel

By Rob McCreary

Coming back from Ft. Wayne Indiana last week I drove for 1 ½ hours in my Subaru Outback without touching the accelerator or brake! I actually went for almost ½ mile with no hands on the steering wheel. That experiment ended when a red warning light started to flash a message on my navigation screen, “Please Put Your Hands Back on the Steering Wheel”. This is a Subaru, not a Mercedes or Lexus. It has a vision system with two cameras located at the top of your windshield on either side of the rear-view mirror. The salesman for Subaru claims that the vision system will stop the car if a collision is imminent. So far, I have not had the guts to check that promise.

The vision system called Eyesight calibrates an assured clear distance for the speed at which you are traveling. If I set the cruise control for 65 mph and someone pulls into my lane, the car will break down to an assured clear distance until the car in front of me moves out of my way. It will then speed up to 65 mph. The vision system also keeps my car from moving out of its lane without the blinker having first been engaged. This feature is a little clunky.  If there is a curve in the road the car will lurch back toward the middle, sort of the way my daughters over steered when they had their temporary license.

The only apparent flaw in the Eyesight system is rain and snow. Moisture can block the cameras and the system will not operate. The other flaw is human override. There are times you forget you tapped the brakes which disconnects the cruise control. Those lanes get pretty hard to navigate with no hands on the wheel and no Eyesight when the system is not engaged.

The business implications of the driverless car are potentially devastating for the auto industry. Your car sits in a garage or parking lot for most of its life. If you take the cost of a car and divide it by the time you drive it versus the time you own it, the math for variable cost Uber or a car on demand is pretty compelling.

Take the case of an empty nester couple who both lease a car for 36 month that has a MSRP of $39,000, have a one hour round trip commute and drive to work and park in a garage. Assume they drive them an average of 15,000 miles each year. Assume the garage costs $100 per month. Also assume they can surrender their leased vehicle at the end of 36 months without any additional payments or credits. Assume insurance is $800 per car, the car gets 25 MPG and gas costs $2.50 per gallon. The couple gets an oil change for $40 every 3000 miles.

The leased car costs $8,248 per year and the Uber or driverless car at $0.15 per mile is $2,225 per year, entirely variable.

Here is how the leased versus driverless car might compare:

Leased Driverless
Miles 15,000 15,000
Oil Change $200 0
Insurance $800 0
Parking $1,200 0
Gas $1,500 0
Lease Cost $4,548 0
Variable Cost 0 $2,225
Total $8,248 $2,225

According to my research, the consumer price of Uber per mile is $0.12-$0.15 cents per mile depending on your city and time of day. When you consider how close we are to a driverless car, the cost per mile may only go down as you eliminate the driver.

I had never understood the disruptive effect of driverless cars until I had the Indiana driving experience. If these driverless cars can circulate without a driver and are available on demand, I may not own two cars.

Of course, when you have an athletic closet in your trunk and 75 pound chocolate lab, the driverless car is not an option. Soccer moms and multi-sport hackers like me will always default to the minivan and the SUV. However, we are likely to give up the car for commuting and that could be a big game changer for the auto industry.

Also, if you go to any car wash you realize that people love their cars and want to own great makes and models. The driverless car won’t stop auto enthusiasts or collectors. In fact, the capital freed up by the variable cost, driverless car may go for that Maserati, Ferrari or Tesla. I am looking forward to the “no hands” experience in my Maserati at full throttle in first and second gear!

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

July 15, 2016

Rob McCrearyNo Hands on the Wheel

When You Have $100 Billion in Cash You Buy LinkedIn

By Rob McCreary

I don’t get why this $26 billion deal makes sense. I guess it is like buying Facebook or You Tube but without any retail consumers. I use Twitter solely to receive business and sports information and “follow” people and organizations whose opinion I admire. I do not use Facebook because I want to be private and don’t need new friends. I love You Tube because it makes me look smart on home improvement projects like how to charge a car battery without shocking yourself or how to replace a faucet washer without stripping the reverse threading. To the contrary, I don’t use LinkedIn for anything.

Luckily, before I posted this blog I met with a young man who is looking to change his career from investment banking to private equity and he explained to me that LinkedIn is an important resource and community for younger people who are trying to create new, and utilize existing, professional networks. Other younger people in our office roll their eyes and give me that “you are a caveman” look. Our office manager suggests that this is a valuable network because it is mostly professionals who already know how to use the Microsoft suite of products and find LinkedIn a safe environment for networking without fear of commercial solicitation. Obviously, this is a generational thing and I should stick to what I know which is the analog form of networking that involved shaking hands and looking people in the eye.

According to the WSJ Microsoft’s CEO explains that the deal is “the coming together of the professional cloud and the professional network.” I am not sure what that means but the WSJ thinks it involves toggling between our productivity software and our social networks. In my case I am a pretty shabby user of productivity tools and an even dumber user of social networks but I get why using Outlook is immensely helpful. It allows me to enter addresses on the Outlook calendar that I can then click from my car during a thunderstorm to launch Google maps for my destination without much risk of running into those orange barrels that are more prevalent than locusts. It allows me to invite a group of people to a meeting and to manage changes to that meeting. Of course it allows me to send and receive email and thousands of junk mail solicitations. My new favorite feature is “clutter” where all my golf invitations go and where I can search for music, vintage wines and Russian Brides. If you want to send someone an important email that you really don’t want them to read just include some vague reference to the  things no network administrator will allow-sex, drugs and rock n roll.

Back to LinkedIn, I get friended on LinkedIn all the time even though it is not called that. I usually accept the invitation to join because it does not require me do anything. I also am rated by the people who friended me but it is amazing how little they know about what I really do because I am always getting endorsements for venture capital? In short I am not sure what to do with LinkedIn.

I also don’t understand why this database on 400 million users is really valuable. Google can take me anywhere in the world both through Google Earth and also on my calendar and it can also track me like the CIA and NSA. Twitter can give me alerts when Indians relievers give up walk off home runs and then Terry Pluto can interpret the perils of grooving a fastball at 0-2. Amazon knows that I like Asics sports shoes and will buy whenever there is free shipping. You Tube saves my marriage by empowering me to execute plumbing and electrical miracles. For me, LinkedIn lets people I already know “friend me” so I can accept and then see a list of people I don’t know who want to be linked in to me. I had not realized that this is really not about me. All this activity is really about my networks and a quick and easy way for business people who don’t know each other to connect with my validation.

Obviously I missed the $26 Billion opportunity which by all accounts is a big miss! I am also sure that toggling between productivity tools and professional networks will drive MSFT’s revenues and profits. One of my partners told me that the merger really creates a 3 dimensional customer relationship software product by cross connecting each of your Outlook contacts to their Linked In networks. Another 1+1=3 deal.

I am beginning to get it, but now better identify with my parents confusion after we all watched the Beatles on the Ed Sullivan show and two weeks later my brothers and I had wigs, guitars and knew all the lyrics to “Meet the Beatles”. Microsoft and LinkedIn are probably as compelling as the Beatles but I just don’t know it yet.

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

June 29, 2016

Rob McCrearyWhen You Have $100 Billion in Cash You Buy LinkedIn