A Gutsy Call on Interest Rates

By Rob McCreary

I guess I am just a sucker for contrarian thinkers, but when I first read Stephanie Pomboy’s investment guidance in an article by Barron’s Leslie Norton on March 22, 2018, I was a little skeptical about her thesis. In the face of a new Fed Chairman’s committed interest rate increases for 2018, Stephanie was telling her clients to buy 10 year treasury bonds as her best investment idea???

This is a single direction trade with no place to hide. The only way you get any increase in bond value is dramatically lower interest rates than anyone could foresee at that point.

Stephanie Pomboy is the founder of MacroMavens and she is a frequent contributor to Barron’s. In February of 2018, when she was interviewed by Leslie Norton of Barron’s. She was then a lone voice on the subject of interest rates:

I know everyone thinks the 10 year is going to 4% or 3.5% or whatever, but we are more leveraged today than ever; our threshold for pain is lower than the market recognizes, so I would be overweight long dated treasuries and underweight the dollar. Those four rate hikes will be chopped to three and then two, and people will actually start to talk about maybe they have to pause quantitative tightening.”

Ms. Pomboy’s call has proved to be prescient. She had the correct view of the consumer being “tapped out” and more likely to save the Trump tax cuts than spend them. She also showed a keen appreciation of the costs associated with debt-based prosperity.

The Fed blinked in November 2018, when the 10 Year Treasury rate touched 3.2% and since then the yield on the 10yr treasury has fallen to 2.3% in March 2019, and now stands at 2.58%. The S&P 500 has rallied from a low on December 24, of 2,351 to 2,905 on April 15, for a YTD gain of 23% and all is well again.

The elephant in the room, however, is still the consumer as well as underfunded public and private pension promises. The Wall Street Journal highlights the extent of the pension problem in its April 10, 2019 edition in an article by Heather Gillers.

Ms. Gillers looked at state and city underfunding and concludes that even though there has been a phenomenal recovery in the stock market since 2008, the investment returns did not keep pace with the increase in liabilities; “Liabilities of major U.S. public pensions are up 64% since 2007 while assets are up 30%, according to recent data from Boston College’s Center For Retirement Research.” For example, in 2010 the assets were valued at $1.78 Trillion and the liabilities were $2.75 Trillion – about a $1 Trillion underfunding. Today the assets are $2.91 Trillion and the liabilities are $3.82 Trillion- about the same $1 Trillion underfunding. These charts show the math problem and why the Fed must continue to provide liquidity induced stock market returns:

A logical question to ask is how we can ever close the $ 1 Trillion gap?  We have had perfect conditions for a decade and now most of the variables are turning against any further reduction.

  • Return assumptions for the future are dramatically lower.
  •  Fewer workers support more retirees who are living longer.
  •  Future stock market returns cannot replicate the last 10 years without consumer spending
  • Cutting pension promises is political suicide.
  • Yields on risk free assets are miniscule.
  • Many states cannot afford their current promises.
  • Infrastructure everywhere needs attention.
  •  Millennials are sitting on their wallets

Pomboy was prescient to see a strong relationship between the economic welfare of the U.S. consumer and the growth of GDP. Just by looking at unfunded public retiree pensions you can predict they are likely to get about 1/4 less in promised pensions than they expect and that may fall even more if the stock market starts to trade on future growth prospects, not momentary liquidity. When it is clear that spenders must become savers to survive retirement what will sustain a 25x PE multiple?

Rob McCrearyA Gutsy Call on Interest Rates

What Baseball Teaches You About Talent Recognition and Retention

By Rob McCreary

When pitchers and catchers report for spring training the winter of my mind officially ends. My seasonal affective disorder of endless nights fades to a new dawn of clarity and understanding. I begin to see baseball as a metaphor for business.

There is a significant problem in baseball right now with team owners not giving really great stars like Bryce Harper and Manny Machado long-term, big money contracts. The union is calling it collusion. The owners are mum.

2014 Detroit Tigers….

The Miguel Cabrera experience still has owners twitching. In 2008 at age 25 a future Hall of Famer was paid $152 million for 8 years to play for the Detroit Tigers. Moving forward to 2014 the Tigers decided Cabrera was their franchise player and awarded him a contract extension of 8 years for $248 million. Including the 2 years left on his 2007 contract this became a 10-year commitment for $292 million through 2024 at which time Miggy would be 41.

The interesting dilemma for Mike Ilitch, the Tigers owner and Dave Dombroski, Tigers general manager was the cohort of Tiger superstars on that 2014 team that were not given the big contract:

  • Max Scherzer, RHP won 3 NL Cy Young Awards and 6x All Star selections and has a combined win/loss of 159-82 for the Washington Nationals.
  • Justin Verlander, RHP- won 1 Cy Young, a World Series ring with Houston in 2017, MVP of World Series and has a combined win/ loss record of 204-123 for Detroit and Houston.
  • David Price LHP- 1 Cy Young in 2012, won a World Series ring for Boston in 2018 and has a lifetime win/loss of 142-75.
  • Rick Porcello, RHP – 1 Cy Young Award, World Series ring for Boston in 2018 and lifetime 135-106 win/loss record.
  • JD Martinez- World Series ring in 2018, AL RBI leader in 2018 and 2x All Star

Became The 2018 Boston Red Sox

Dave Dombroski left Detroit to become the General Manager of the Red Sox in 2016 and promptly signed the nucleus of the 2014 Detroit Tigers- Price, Porcello and Martinez. They won a World Series in 2018.

General Electric in 2001

In a parallel universe another fabled franchise, General Electric, had just finished a world series parade of Jack Welch successes spanning 20 years and succession was almost an afterthought.  The investment community was convinced Welch had set things on autopilot and long-term property for GE shareholders was similarly linear. Insert GE stock chart from 1980 to 2001.

Should I Wish Upon A Star?

I wonder if Miguel Cabrerea has ever met Jeff Immelt. They bear little resemblance other than being internal, “can’t miss” superstars each of whom got big contracts and proceeded to lead their franchises to the basement. In GE’s case they lost Gary Wendt who ran GE Finance and whom Jack Welch feared would overshadow other CEO aspirants who went into private investing, James McNerney who then became CEO of 3M and later Boeing, Robert Nardelli who became CEO of Home Depot and then Chrysler.

For the Tigers, the eventual loss of Verlander, JD  Martinez and  David Price without a world series trophy doomed a great American east franchise to perpetual rebuilding.

Maybe the “Moneyball” educated baseball owners are getting the message about giving long term contracts to can’t miss candidates. I am sure Board of Directors all over America are thinking about the Immelt effect as well.

When the star culture overtakes a team culture you get GE and the Tigers. Good stewardship often means having many high achievers under one roof. It is equally important for company Boards and baseball leadership to find a process for recognizing talent and then retaining it.

Rob McCrearyWhat Baseball Teaches You About Talent Recognition and Retention

Experts Looking At Corporate Balance Sheets

By Rob McCreary

Barron’s recently invited 10 leading financial minds to look into their crystal balls and predict how capital markets may fare in 2019. This round table is always interesting, but you have to remember panelists’ perspectives are usually tied to the industry that pays their salary. Abby Joseph Cohen is still representing Goldman Sachs.

This year a few of the panelists broke rank and gave a sobering look at the issues corporate America is facing on account of debt based tactics to goose earnings at the expense of balance sheets. Debt based prosperity is suddenly a significant concern.

By way of background, The Daily Shot also rang the same bad weather bell when it showed this surprising capitalization factoid:

It is hard to believe that 36% of small publicly traded stocks do not have earnings but this is consistent with a blog I published earlier about the noticeable rise in so called Zombie stocks (“Zombie Stocks Look Pretty Lively” and also a blog I wrote in October (“You Know It Is A Top When”) suggesting the equity market was peaking as management teams leveraged their companies to buy back their stock.

Those two themes were also voiced by a number of Barron’s’ panelists:

Jeff Gunlach, CEO and CIO DoubleLine Capital: “ The biggest risk is in the corporate bond market…A Morgan Stanley research report suggests that, based on leverage ratios alone, 45% of investment grade corporate bonds would be rated “junk” right now. The report further suggests that around 60% of corporate bonds currently rated BBB would be rated junk right now.”  This situation arises as Central banks around the world are removing liquidity, and in the US, raising rates.

William Priest, CEO and co-CIO of Epoch Investment Partners:” Quantitative tightening, or QT, impact will be profound. In my view, quantitative easing was necessary after the financial crisis to offset liquidity and solvency issues. We probably should have stopped QE in 2011, but that’s hindsight. QE artificially drew down the discount rate for all financial assets and was a fantastic stimulus to the stock market.”

Rupal Bhansali, Chief Investment Officer, Ariel Investments “Cash will no longer be a four-letter word. Debt will be a four letter word. The thing to bet on the coming years is net-cash companies”…Investing is ultimately about figuring out the unexpected because the expected is already in the price. That’s why corporate leverage isn’t just a problem for fixed income markets, but is a bigger one for equity markets. Equity investors need to remind themselves of their status in the corporate structure.”

Fixed Income Manager Sounds same Warning

Piling on with its own warning, the fixed income experts at Wasmer Schroeder & Company published a year-end review of corporate debt markets. Here is what Christopher Sheehan, Vice President, Senior Portfolio Manager wrote about the proliferation of BBB rated debt in almost all indices:


I have to admit that it is rare to see so many panelists pointing to the same unrecognized risk factors.  I also can’t recall anyone talking about corporation balance sheets this much since I started investing in the early 1970s. Maybe deep value, active investment will be back in style soon?








Rob McCrearyExperts Looking At Corporate Balance Sheets

Opportunity Zones- Gimmick or Gamechanger?  

By Rob McCreary

A little-known provision of the Trump Tax Reform Act of 2017 was bipartisan support for an interesting tax incentive around investments in Opportunity Zones. This is the hottest tax dodge since tax shelters in the 1980’s, but whether it will serve its purpose of distressed community development is uncertain.

Here are a few Q&A clarifications from a recent IRS publication explaining how the tax regimen will work:

Q – What is an Opportunity Zone?

A – An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service. Click here to search your geography https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml (the box to type the address into is up in the top right corner).  You will need to have or download flash for the link to work correctly.  

Q – How do Opportunity Zones spur economic development?

A – Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.   If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.  If held for more than 7 years, the 10% becomes 15%.  Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that investment is realized (emphasis added)

Q- I sold some stock for a gain in 2018, and, during the 180-day period beginning on the date of the sale, I invested the amount of the gain in a Qualified Opportunity Fund.  Can I defer paying tax on that gain?

A – Yes, you may elect to defer the tax on the amount of the gain invested in a Qualified Opportunity Fund. Therefore, if you only invest part of your gain in a Qualified Opportunity Fund(s), you can elect to defer tax on only the part of the gain which was invested.

What Does This Mean For Qualified Opportunity Zones?

Interestingly, investments in real estate as well as businesses located in those designated communities could qualify for tax deferral on the source of the investment capital as well as tax forgiveness on the gain from the new investment. The applicability to real estate development is clear, but the rules for business investment are quite tricky.

Let’s take the example of an apartment development in Tremont, a trendy neighborhood just south of Cleveland, Ohio. A developer owns a property which he has permitted for a 5 Floor Apartment Building with construction planned for 2019. His project construction costs are $7.5 million of which $2.0 million is equity. The developer forms an Ohio limited partnership “QOF Fund I, LP.” to invest in the Tremont apartment building project and, possibly, a follow-on project across the street.

Luckily, the developer has a relationship with the Gotrocks family who just sold their family business in early 2019 for a substantial gain. The developer suggests the Gotrocks invest $1.0 million in QOF Fund I. He then makes the same proposal to several other families with a similar capital gains and cash to invest. They pool their resources and fund all $2.0 million of equity. Non-rollover investors can participate in the investment but they will not get any of the tax benefits.

Gotrocks family has a good accounting firm, Counter, Beans and Sheets. They advise Gotrocks to claim a deferral of $1.0 mil of the large gain from the sale of the family business on their 2018 1040 tax return even though that event was late 2018 and the QOF investment was early in 2019. Counter Beans explains that any capital gain is eligible for deferral if the QOF investment is made within 180 days after the date of sale (for pass through entities it is year end regardless of transaction date).

Counter Beans also explains to Gotrocks that the $1.0 million deferral is until 2026 (or earlier if the replacement project is realized) and, if the apartment investment is held for 5 years Gotrocks can also exclude 10% of the $1.0 million family business gain and 15% if they hold the apartment project for 7 years (2026)!

The Real Tax Benefit

That is just the icing on the cake. Gotrocks can also exclude 100% of its share of the gain on the sale of the apartment building project if it is held for 10 years (2029). Not surprisingly, it looks like the developer (think Trump Enterprises) can also exclude 100% of his gain from a carried interest even though he would have made only a nominal capital investment.

Counter Beans says IRS is still developing rules on whether debt is included in tax basis for purposes of calculating gain on the sale of the projects. There should also be clarification about the tax treatment for promoters.

What About Small Businesses?

The rules are more complicated. For a business investment to qualify its revenues and income must be “principally” generated within the boundaries of the Opportunity Zone. According to recent IRS clarifications, “Principally” means 70% of 90% or 63%. So, if a yoga studio had three locations inside the Zone and one outside the Zone and each had similar revenue, the QOF could invest in all four and, if those 4 studios were held for 10 years,  still write up the QOF tax basis in all four to fair market upon realization in a sale transaction.

Many Unanswered Questions

There are still interesting questions. If a QOF project or a business distributes capital gain profits before selling in year 11, do those profits qualify for a tax refund? How can a high growth business with sales mostly outside the Opportunity Zone qualify? Will this tax break really stimulate community redevelopment?

This tax change has stimulated a significant buzz at holiday gatherings, especially because many investors have taken gains in the stock market. While the motivation is tax savings, it may turn out that some good community redevelopment work also takes place?



Rob McCrearyOpportunity Zones- Gimmick or Gamechanger?  

Zombie Stocks Are Alive And Well

By Rob McCreary

The zombie motif was popularized by the horror movie “Night of the Living Dead” where zombies and vampires morphed into aggressive and deadly undead preying on humans. The zombie concept  moved into finance with the advent of Zombie Banks in Japan in the “lost decade” of the 1990s. Those Zombie Banks were kept alive by accommodative central banks ,even though a majority of their assets were often non-performing.

Recently, the Zombie Bank discussion has focused on Chinese financial institutions who are insolvent because they have financed “see through” apartment complexes and also participated in shadow banking activities.

In all these cases it is accommodation from a government or central bank as part of monetary policy that keeps these undead institutions going. However, I never would have expected similar support for undead corporations from supposedly Darwinian capital markets around the world.

US Capital Markets Have Many Zombie Companies

The number of undead public companies trading in the US capital markets surprised me. According to The Wall Street Journal “Daily Shot” and an article by Nicolas Rabener from Factor Research more than 10% of publicly traded stocks in 14 advanced economies with market caps in excess of $500 million have higher interest costs than operating earnings . In the US capital markets that number is 8%, matching the Zombie percentages from 2006.

In these studies by the Bank of International Settlements (BIS) a public corporation is a Zombie if its interest coverage ratio (ICR) has been less than one for at least three consecutive years and if it is at least 10 years old. By comparison, healthy public companies have a worldwide ICR of 4x and a US ICR of 9.7x. This chart shows the general rise of indebtedness of non-financial publicly traded companies in the US. Notice the almost 50% increase from 2008.


In fact, these “Zombie public companies” which are functionally insolvent are actually trading at a surprisingly small discount to the S&P 500:


The BIS and Rabener research conclude that a persistent falling interest rate from 1986 to 2016 has actually made these zombie companies look like they are improving because, even though they are not paying down principal, their ratios improve as their interest burden falls. The research also concludes that weak banks do not demand restructurings and bankruptcies in periods of low interest rates. The Zombie banks are keeping the Zombie corporations alive.

By Comparison PE Banks Are Quick To Act

This is a major divergence from the banking world we live in.. In the private equity world if you have a small company with an EBITDA to interest ratio of less than 1:1 you are on your way to a special assets group where the bank’s work out people will direct cash flows to debt retirement by shrinking available leverage. You have to wonder how these Zombie companies in the public realm avoid similar treatment, especially in a period of rising interest rates where their ratios are now deteriorating?

One piece of useful research would be debt prices on public debt issued by Zombie corps. The debt markets always focus on repayment so their trading prices usually assess survival risk in the right way. How many of these Zombies have public debt that trades at a discount to par?

Is There An” ETF Effect” Lifting Zombie Prices?

I also wonder whether it is the ETF effect? With the shrinking number of publicly traded companies and the proliferation of financial products that attempt to mimic an index, is it conceivable that ETF managers mimic the indexes by buying undead companies in their tracking portfolio. If Zombies are 8% of the market above $500 million market cap, does the ETF portfolio intentionally include Zombies to make the ETF a true proxy? Without price discovery on an individual basis, these undead may just be pulled along by a tide of capital inflows?

If this is what is happening, maybe the ETF prospectus should warn: “The manager will buy securities of ZOMBIE publicly traded companies that have the inability to generate operating profits in excess of their annual interest expense”

In any event, keeping Zombies alive might be important enough monetary policy for full employment , retirement funding and bank health that  Jerome Powell and the FED have another reason to think about getting to the neutral rate fast and showing accommodation rather than tightening?

Rob McCrearyZombie Stocks Are Alive And Well

China Debt- Opportunity or Contagion

By Rob McCreary

Remember when a Japanese investment group bought Pebble Beach Golf Blub September 1990? It seemed like every important asset was being gobbled up by an ascendant Japanese economy. Soon thereafter in 1992 the Japanese real estate market crashed and then, in a great imitation of a kamikaze, the Nikeii followed suit  Now, more than 25 years later, the Japanese economy is just starting to shake off the chains of asset deflation.

In the rearview mirror,the miracle of Japan was really a debt financed bubble and Bank of Japan’s monetary policy of keeping bad investments alive and preserving “zombie” banks spawned 4 decades of decay.

Murky As The Yangtzee

No one knows for sure how much debt is now supporting the China miracle? In his book on the subject, “China’s Great Wall of Debt” Dinny McMahon, a financial journalist with the Wall Street Journal specializing in China, will not speculate about the debt burden (government, banks, shadow banks and private debt). Other sources like Wikipedia speculate the debt burden (on and off-balance sheet) could be $11 Trillion or about 90% of China’s GDP. This may not capture the funding for China’s Belt and Road infrastructure initiatives for which there is virtually no reported financial information.

Shadow Banking Products Are The Wild Card

Mr. Mc Mahon is especially concerned about the shadow banking system where banks sell their own “wealth management products” (WMPs) to customers where the holder is completely unsecured and bears the complete risk of loss. The US analogy might be a special purpose off balance sheet investment vehicle that is selling annuities (promises to pay) but has no assets. The difference in China is the state has always made good on bad debts, especially if generated by the banking system, and citizens trust the state’s implicit guarantee. But according to McMahon the enormity of WMPs is staggering:

“ In 2008, the future pillars of China’s shadow banking barely existed. At the end of 2014, the amount of credit that had been generated by the shadow banking system was about 40% of China’s GDP. By mid 2016, that had doubled to about 80%.

A recent factoid from Wall Street Journal’s “The Daily Shot” was also pretty alarming. Apparently, business owners have been pledging listed shares for personal loans, and defaults are accelerating. The analogous situation is 1929 in the US. Once there is a default on the bank loan, the value of the collateral disappears quickly because there is no orderly downside market for stocks being liquidated in distress. If the securities cannot be liquidated, the banks will try to make a distressed sale of the underlying companies. The deflationary spiral is hard to stop. Just ask the Bank of Japan. Here is the information. The blue line is the percentage of listed firms where more than 50% of a company’s shares are pledged.

The Shanghai Stock Exchange has lost almost 30% of its value since the beginning of the year which puts even more strain on the credit system which is increasingly secured by pledges of stock collateral in material decline.



Luckily most of China’s creditors are its own banks and citizens.  As long as they have confidence that China will provide, the moment of financial truth may never arrive. Unfortunately, recent experience suggests that all financial bubbles eventually burst and miracles turn to contagion overnight.

Rob McCrearyChina Debt- Opportunity or Contagion

You Know It Is A Market Top When????

By Rob McCreary

Investors all have sure signs for market tops. Lately, the equity crowd is watching an inverted yield curve as a harbinger of recession and the inevitable market correction. Other savants point to the disconnection between the market movements of Facebook, Amazon, Apple, Netflix and Google and the rest of the stocks in all three equity markets. Private investors look at the excessive debt to capital ratios in private capital structures and the resulting spike in valuation multiples. Debt guys are spooked by a US central bank that is pulling liquidity out of the system by raising rates and shrinking the Fed’s balance sheet. Free traders bemoan the effect of tariffs on globalization and the possible return to trade cartels among regional trade allies. All of these are signs of something big, but they are too theoretical for me. I need something much simpler and closer to someone’s wallet to convince me it portends a certain market reversal.

Directors Are Buying, But Not With Their Own Money

A recent snippet in Barron’s, however, identifies a trend that I think is foolproof advice about the market top. US public companies have announced $835 Billion of stock buy backs so far this year after $810 Billion in all of 2017. Barron’s thinks the buy backs could exceed $1 Trillion before the year is over. By itself the buy backs are bullish– the Boards of Directors think their stocks are enough of a bargain to use their corporate cash and debt (their liquidity) to buy up their own shares thereby, in many cases, substituting debt for equity in their capital structure. That is a bold bet and one that smart people won’t make without either huge conviction or else they are using other people’s money.

So what if I also told you that Barron’s believes that executives at those very same companies are selling their shares and options into those massive buy backs approved by directors and financed with shareholders’money? This may be a better indication of a market top because managers are doing just the opposite from the company directors – they are liquidating equities and options and putting shareholders’ money in their wallets. Here is how Barron’s sees it in their October 8, 2018 edition:

“ In light of the big jump in corporate stock purchases, it is notable that executives at those companies are doing the exact opposite: dumping their shares at a record clip. Again, according to TrimTabs, corporate insiders sold $10.3 Billion worth of stock in August. That is the highest amount of selling in the month of August over the past 10 years…The previous high was $9.3 Billion in August of 2017.

I have always thought it was a better measure of conviction to see how someone is betting his wallet than how he is betting his reputation. Should we call a market top?


Rob McCrearyYou Know It Is A Market Top When????

Insurers Underwrite LBO Risk

By Rob McCreary

Five years ago, when a private equity firm sold a business the buyer would require the seller to establish a funded escrow account (5-10% of the purchase price) with an independent bank as a convenient source of indemnification for representations and warranties. Until recently, in the lower middle market, it was highly unusual for a third-party insurer to underwrite and insure that indemnification obligation.  In a recent survey by GF Data (September 2018) the prevalence of representation and warranty insurance is notable:

“Use of an insurance product continued to rise, from 43 percent of all deals in 2017 to 47.3% in the first half of 2018. At $50-250 million TEV, the jump was from 66.7% to 69.7%.”

” Valuations remained at historically elevated levels on deals utilizing insurance – maintaining an average mark of 7.7x. The average multiple fell, however, on deals completed without insurance – from 7.1x to 6.4x. Average indemnification caps rose slightly across the board in the first six months of this year.”

Data Rooms Become The Underwriters’ File

We utilized our first indemnification insurance product in a sale in December 2013. At that time the number of insurers who were willing to underwrite a smaller transaction was limited. Today there is competitive interest from many insurers in transaction sizes $20 million and larger. It shows the maturation of the private equity industry and the comfort underwriters have for PE due diligence. Partly this is attributable to data rooms where 100% of the due diligence information for a transaction is posted to a data repository that, in essence, then becomes the insurance company’s underwriting file. Sellers and buyers often split the costs of this insurance policy and the retention, which works like a deductible on your homeowner’s policy, is usually also split. In the competitive M&A markets right now, it is also becoming more common for the policy to be structured so there is zero recourse against the seller in competitive auctions.

In addition to underwriting the data room file, the insurer looks at the reputation of the parties to the transaction, the quality of their advisors and the independence of the various “experts” who report on quality of earnings, environmental matters, human resources, health and safety and wage and benefits. Because the insurer is stepping into the shoes of the seller for any major indemnification claims, there are often specific matters where there is known risk that are excluded from the policy. That might mean that a known environmental cleanup responsibility remains 100% with the seller or responsibility for existing litigation is not insured.

Third Party Insurance Fits The PE Model

The nature of private equity with finite fund lives and relatively short investment periods lends itself to a third-party stepping in. There was always a great temptation for a disappointed buyer to invent a series of claims against the indemnity escrow after the closing simply to reduce the purchase price. Now the insurer bears a large portion of that post closing responsibility and has both the time and infrastructure to dispute buyer claims. A private equity firm was more likely to compromise a bogus claim because of time, legal costs and fund life considerations.

According to Jeff Phillips, Vice President and Practice Leader of Transactional Risk for Oswald Companies  who were early advocates of “reps and warranty insurance” for the lower middle market, the claims administration process has also been professional and reliable:

 “Twenty percent of Reps and Warranties polices are going on claim with issues arising most frequently from Financial, Tax, Compliance with Laws and Material Contracts.  Generally, our clients have been pleased with the claims administration process and the insurers understand that for this product to be viewed as an attractive alternative to traditional seller indemnification, valid documented claims must be paid promptly.”

These Policies Are Affordable

The other surprise about this insurance product is affordability. The typical premium for $5.0 million of coverage in a clean $50 million transaction with a deductible of 1% of the purchase price might only be $150,000-175,000 depending on the industry. This suits a private equity firm that can then operate with certainty about its ongoing contingent liabilities for portfolio companies that have been sold. This usually means quicker distributions to fund investors and general partners.

The ultimate test of this product will come when there is the next recession. Highly indebted companies with shrinking cash flows and earnings may look to insurers for help through indemnification claims. It will be interesting to see how well the insurance industry has really underwritten its risks. My prediction is this product will do better than the underwriters expect largely because the reps and warranties made by sellers get diluted by the auction environment in which each buyer has to operate today.

In any event, the next time a politician tries to convince you that private equity is bad for business just recall all the companion industries are thriving due to its model. The latest winner may be the insurers who are underwriting a majority of these deals.

Rob McCrearyInsurers Underwrite LBO Risk

Rock Star Candidates May Disappoint

By Rob McCreary

In the lower middle market our management teams are the biggest contributors to investment returns. When you are lucky enough to inherit a great management team you can usually count on sustained growth and sequential profitability. Good managers immediately understand the vital few objectives and are typically honest about organizational capacity and risk mitigation.

Spam or Fritos?

However, when you have to recruit new managers you often enter an employment lottery where your chances decline dramatically, especially in a full employment economy. I talked to a friend who has worked in management recruiting for his entire career and he admits recruiting   for the lower middle market is tough, but he believes careful and skillful recruiters can usually spot a problem in the interview process. So far that has not been my experience.

One of my colleagues referred me an interesting study from Harvard Business School conducted by Rakesh Khurana, the Marvin Bower Professor of Leadership. He asked the question over the last 5 years did Pepsico or Hormel create more value for shareholders? In a head to head competition between Spam and Fritos,  Spam not only won on saturated fats but Hormel ($21.73-$41.40) also won by lapping Pepsi ($84.09-$112.35) in stock performance. Here are their 5 year stock charts.

Professor Khurana thinks the secret is not the Spam, but rather how the two organizations hire. Pepsi has a reputation for hiring leaders who look the part. If you are 6’2”” and have flashy credentials you are a great candidate at Pepsi. In the recruiting industry they call it “Pepsi pretty”. Also, if you happen to have worked at McKinsey, Bain or BCG you are what Professor Khurana would call “central castings”.

Hormel is Midwestern in its attitudes and hiring practices. Its CEOs are not flashy and they don’t come with either stage presence or management consulting backgrounds. The current CEO, Jim Snee, is also the Chairman and President. Jim has worked at Hormel for 28 years after getting a BA at New Mexico State and an MBA from the University of St Thomas in St. Paul Minnesota. Hormel has had only 10 leaders in 125 years. The rest of the management team also has humble origins with only Jim Snee and Jeff Baker having attended Harvard and Wharton’s executive programs. By contrast Pepsico’s management team is not only highly degreed but they are also from “central casting” for public company management teams.


Neutralize Good Presenters

I often find I am drawn to articulate candidates.  Good presentation skills often shift the energy of the interview process from the recruiter who is trying to get honest answers to the presenter who wants to answer questions with his spin.  Mike Miles, the former chairman and CEO of Kraft, Inc. and Phillip Morris Cos realized early in his career that most of his information came from people presenting to him and his understanding of facts and circumstances was greatly colored by people’s presentation skills. Miles knew he was influenced by “stage presence” so he standardized the format to neutralize good talkers.  In a similar way we have talked internally about putting our emphasis on what a candidate’s peers and direct reports say about him or her.  Some candidates do a great job of managing up, but fail to motivate their direct and indirect reports. The trick is getting these people to share their experience.

Quirky Leaders May Outperform

As one of our recruiting firms put it;” Everybody wants a team player. Rockstar leaders seduce us with their congeniality, but the highest performing CEOs actually tend not to be great team players. Research on European “mittlestand” businesses- less than 500 employees- shows these small company leaders are not great cultural fits. The terrible fits get fired. The perfect fits thrive by becoming “one of the gang”. The leaders who are just a little bit off tend to perform the best.”

What This Means For Small Business

Maybe you can compete for talent after all. You just have to look for “mutts” which I define as leaders who have a good following but not deep friendships with their employees. While they lack that leadership “look” and their presentation skills may lag, they can energize and inspire with their sense of the possible. They don’t bounce around jobs every 3-4 years.  They often graduate from state universities and local business schools at night. They succeed through grit, determination, and a solid grasp of what their team can accomplish. Since they rarely had the benefit of a central castings head start, they tend to prove themselves with performance. More than anything they also tend to make their teams successful and never forget to share the Spam with high performing team members.




Rob McCrearyRock Star Candidates May Disappoint

Binge Watching Hallmark Channel Is Bad For Your Health…

By Rob McCreary

The last time I went for a physical examination the nurse who was taking blood samples and updating my medical record was shocked when I reported I was not taking any prescription medications other than an oral inhaler for seasonal asthma. Aside from being a medical freak, I got the feeling from her there were many opportunities for improving my health just by getting on a few popular prescription drugs like Lipitor and Coumadin.

The Hallmark Channel

If you think you are healthy all you have to do is start binge watching episodes on The Hallmark Channel. You will quickly discover that your aches and pains may be rheumatoid arthritis or that “frequent urge to go” might be an enlarged prostate. Have trouble sleeping or chasing your grandchildren around the yard?  You may be candidates for Ambien which comes with butterflies and Symbicort for your COPD.

Ironically, our symptoms often aren’t half as bad as the side effects. Here is a list of side effects from some heavily marketed drugs

  • Lyrica – Diabetic Nerve Pain: “Lyrica is not for everyone. It may cause serious allergic reactions or suicidal thoughts or actions.”
  • Abilify – Depression for dementia patients: “Elderly dementia patients taking Abilify have an increased risk of death or stroke.”
  • Bellsomra – Creepy Pet cartoons made out of fuzzy letters- the sleep cat and the wake dog:  “Walking, eating, driving or engaging in other activities while asleep, without remembering it the next day, have been reported.”
  • AstraZeneca drug Movantik – Opioid induced constipation: Drug created to deal with side effects of another drug.  So many people are addicted to opioids AstraZeneca acctually spent the money to play this ad during the Super Bowl.   US Market for drugs treating opioid related constipation expected to be $500 million by 2019.
  • Symbicort – COPD: Grandfather used to huff and puff (big bad wolf cartoon) before he took Symbicort.  “Side effects – increased death in Asthma patients; increase of lung infections etc.”

US Drug Industry Dwarfs The World

Remember this is big business. The Pharmaceutical industry is making a handsome living by supplying endless pharma solutions to any perceived medical condition even when the cure may be worse than the condition:

My Mother’s Little Helpers

My mother resisted the medical industry. She put doctors in the same category as big banks and the IRS. Accordingly, our childhood medicine cabinet was comprised of four solutions to any medical problem. Milk of Magnesia solved any problem of the digestive track. Vicks VapoRub was the go to prescription for the chest congestion and the common cold. Bayer Aspirin took care of everything else internal, and all skin problems were cured with Keri Lotion. If all else failed, there was always a few sips of whiskey which would always have an expected cleansing effect and also made you sleepy.

Today a mere sniffle has an arsenal of cure weapons ranging from a derringer to a howitzer.

Nyquil Theraflu Mucinex
Tamiflu Relenza Rapivab
Peramivir Afrin Zyrtec
Allegra Claritin Chlor-Trimeton

Something more serious like a gastrointestinal problem has thousands of pharmacological solutions. For example, common “gas” which my mother would have treated with Milk of Magnesia now has 56 separate solutions.

Aches and Pains (including mental and emotional versions) have so many different solutions I literally lost count.  For example, “Frozen Shoulder” defined as “an inflammatory condition that restricts motion in the shoulder” alone has 49 separate drugs.  Silly me to think, since old age is creating shoulder tightness, I could alleviate the problem by stretching. Had I known I could get a prescription for Naproxen, Voltaire or Diclofenac (most popular), I would have cancelled the yoga class.

Next time you want to watch The Hallmark Channel just remember how our parents made it through most of their lives with just two or three all purpose medical solutions of which exercise (other than bowling night) was a pretty low priority. Maybe you should abstain from reruns of “Pride and Prejudice” and try 6 months on Bayer aspirin alone?

Rob McCrearyBinge Watching Hallmark Channel Is Bad For Your Health…