“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.

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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:


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.

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:


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

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