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When I was a boy and an avid reader of Superman Comics there was an occasional Superman encounter with the Bizarro World where that society’s objective was the opposite of Earth. For example, beauty was bad and ugly was good. Investments that made money were bad and those that lost money were good. People who were mean were liked and people who were kind were unpopular. The Bizarro people looked grey, chiseled, and goofy and acted even stranger than they looked. Even my boyhood fantasies of a date with Supergirl were corrupted by the Bizarro Supergirl who was erratic, dangerous, scary and brutish. After even brief encounters with the Bizarro World, it was always refreshing to return to colorful comic book earth with Jimmy Olson and Lois Lane.

Forget About Foundational Values

Fast forward 50 years and I now feel like I am living in that Bizarro World. Every day there is another news item, blog, tweet or Facebook post to confirm that the reported “mainstream” is the antithesis of everything I was brought up by parents, teachers, priests, mentors and coaches to believe in:

• Former men’s Olympic decathlon champion in 1976 now is a woman and has her own reality TV show.
• Former Secretary of State and Presidential hopeful ran the entire United States foreign policy for 6 years off a personal server in her basement but never compromised national security.
• Front runner for RNC Presidential nomination is Donald Trump.
• The President of the United States is giving Iran and their crazy Ayatollahs a path to nuclear arms because he needs a legacy.
• The United States has Trillions of dollars of debt it can never repay.
• The IRS Director responsible for denying tax exempt status to conservative not for profits has an unexplained server crash. No one cares.
• The SEC appoints its own judges because it can’t win any cases in the normal judicial process we have been using for several centuries.
• The NLRB is simply abandoning legal precedent and imposing its own view of workers’ rights.
• Drugs and prostitution are legal in several states.
• Detroit is bankrupt; Chicago is next.
• Members of Congress make more money than 95% of America and that is before they retire.
• Members of Congress are exempt from insider trading laws while Martha Stewart goes to jail.
• Cops are presumed guilty until proven innocent.
• The media creates news rather than reporting about it.
• CEO’s get paid hundreds of millions of dollars to pretend they weren’t fired.
• Students can borrow all the money they want to go to college with the realistic expectation that they will never have to repay any of that debt.
• Your 27 year old dependent son or daughter is entitled to healthcare coverage on your employer’s health care plan.
• People of the same sex can get married.
• The Cubs, Pirates, Mets, Astros and Royals all have good baseball teams.

There is more media attention paid to “toe tappers”, deflated balls, inflated egos, the “red carpet” and Reality TV than pervasive worldwide poverty, genocide, ethnic cleansing, be-headings and European immigrants.

Bizarro Investment Policies Abound

When you are living in a Bizarro World, you better be pretty careful about your investments as well. Risk is good and caution is bad. Leverage is good and equity is bad. Consumption is good and saving is bad.  Stocks and bonds are good and real assets are bad. Solar is good and coal is bad. Apple Pay is good and cash is bad.

This migrates into the popular thinking about Private Equity. The regulators are good and the managers, profits, fees, taxation, business building and employment are bad. Pretty soon the highly competent managers that run the best performing funds will decide that they, too, are living in a Bizarro World and they will get tired of the persecution and take their talents to other opportunities. The Bizarro people will get what they want and spoil a beautiful business model that balances the needs of many constituents- employees, suppliers, customers, competitors, financiers, lawyers, accountants, consultants and service providers.

Normal People Are Outcasts

The other thing about the Bizarro World that I remember from the comics was that anyone who expressed even one scintilla of “normal” earth like behavior was immediately an outcast with no chance of redemption. A kind person was physically abused forever. A truthful person was ridiculed forever. An honest person’s reputation was ruined forever. A spiritual person was condemned forever. In our Bizarro World honest and thoughtful opinions by normal people are being diminished as racist, sexist, or discriminatory.

Who changed the rules to permit these Bizarro people to run our country? Where is Superman when I need him and how can I find my way back to the colorful comic book earth of my youth?

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.

The public market meltdown that started last Friday and continued into Monday morning was met with expected bullish and bearish commentary. What was new for me was the New York Stock Exchange announcing that it would impose “time outs” if the meltdown exceeded certain benchmarks. Those “circuit breaker” benchmarks were revised in May 2012 by lowering the panic thresholds and switching the measuring index from DJIA to S&P 500. The Bloomberg news announcement follows:

If losses in the U.S. stock market worsen, keep in mind there might be a 15-minute break.

The New York Stock Exchange said it will halt trading for 15 minutes if the Standard & Poor’s 500 Index drops 7 percent.

The stock exchange will pause trading if the benchmark for U.S. equities slumps to 1,832.92 before 3:25 p.m. New York time, Sara Rich, a NYSE spokeswoman said in an e-mail.

The S&P 500 slid 3.9 percent to 1,894.93 at 9:42 a.m. in New York as markets were convulsed by a surge in selling.

Trading will stop for a second time if the gauge extends its losses to 13 percent before 3:25 p.m. If the plunge reaches 20 percent at any point during today’s session, NYSE will shut the market for the rest of the day.

Even though I have a vague recollection of circuit breakers imposed after the 1987 ‘Black Monday” crash, I cannot recall the New York Stock Exchange ever preconditioning trading hours for steep losses in the S&P 500? In fact, there have been two such interventions-one in 2008 and one in 2010. There have also been times when trading in a stock or exchange is suspended because of a technical glitch or illegal manipulation, but I have never seen a preannounced set of recesses and then a shut down if losses exceed 20%. Here is a summary of the rule now in effect:

In conjunction with all U.S. equity exchanges, the NASDAQ Stock Markets filed a rule change with the Securities and Exchange Commission (SEC) to modify the existing Market-Wide Circuit Breakers (MWCB) in order to address extraordinary market volatility. When triggered, these circuit breakers halt trading in all exchange listed securities throughout the U.S. markets. The rule was approved on May 31, 2012. This revised rule made a reduction in the market declines percentages threshold necessary to trigger a circuit from 10, 20 and 30 percent to 7, 13 and 20 percent from the previous day’s close. It shortened the duration of the halts from 30, 60 or 120 minutes to 15 minutes. Finally, the revision changed the pricing reference to measure the market decline from the DJIA to the S&P 500 Index.

In my opinion, these circuit breakers defeat the whole concept of a market and access to liquidity. Are we entering a new phase of public markets where the bidders can only sell off the market until certain benchmarks are met? The unintended consequences are what scare me? Will this guide short sellers to cover early because a “time out” might rob them of the opportunity to let their profits run? What does a 15 minute delay do for unfilled orders? What does the prospect of a shutdown do for potential sellers who might fear no liquidity when they need the cash today?

The reason I like the Private Equity asset class at moments like this is valuation stability. My private investment in a motor business, automotive supplier, aerospace equipment business or precision machining shop is worth the same today as it will be tomorrow. What someone will pay for it in a full sale process may change (and I may hold rather than sell low) but its fundamental worth as a store of value does not change. It seems like the stock market is now beginning to offer a different value proposition: My stock is worth only what I can trade it for when the market is operating.  Since it only represents an infinitesimal minority ownership and a digital entry on the books of the Depositary Trust Company, its worth relies entirely on participants’ confidence in the marketplace where it trades. If you start conditioning liquidity and people understand what it means, I wonder whether that marketplace will continue to attract the same group of participants?

The one way nature of these time-outs bothers me too. I did not observe NYSE preannouncing trading suspensions or shut downs when Quantitative Easing was in full bloom and Central Bank “money printing” was finding its way into the S&P 500. The credibility of a market that has unlimited liquidity  going up but regulated liquidity when the markets are going down is not a real market and certainly not the public equity market I have watched for most of my life. I simply cannot understand how the mutual fund industry can deal with this regulated approach unless it responds by imposing “gates” like those being implemented for certain “non-governmental” money market funds? All I know is that the rules are increasingly complex and rigged in favor of those sophisticated participants on the inside.

It is also no coincidence that after the NYSE announcement, the markets rebounded. Were the shorts covering because they feared suspension or shut down? All I know is that the market is being conditioned under the guise of “safety and soundness”. The more fundamental question is whose safety and soundness is the NYSE really looking after?

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

The Financial Times had an interesting article on July 12 about Calpers admitting that it had not tracked the fees it had paid to private equity managers over the last 25 years. Given the SEC crackdown on excessive and hidden fees from some of the largest PE funds in America, the call for Calpers self-examination is not surprising. What does surprise me is the increasingly popular implication that high fees hurt relative returns.

The PE asset class has outperformed most public and private asset classes over the long haul measured by 10, 15, 20, and 25 years. The cumulative fees paid to managers that produced those outsized returns were probably “astronomical” as a Calpers official has speculated. But shouldn’t the question be “Is the manager fairly compensated for the skill he brings to the outlier investment result?” I think we could have a pretty interesting debate about the relative value of returns in products like life insurance, annuities and “high load” mutual funds that carry heavy up-front fees. They are accrued and often paid even before the product experience begins and in many cases are a higher percentage of total returns than the traditional “2% and 20%” private equity compensation scheme.

It also should be noted that the 2% annual management fees that are paid to PE managers are really a reimbursable expense (working capital advance by investors) repaid out of the first tier of future realizations. The only time you fail to recoup the annual management fee is if your fund profits and “fund offsets” are less than the cumulative annual fees. This is rare and I do not believe it is an area of scrutiny for the SEC or consultants who score the managers. Rather it is the 20% “carried interest” that is catching everyone’s attention. The amount of fees is staggering but so is the outperformance of the asset class over a long period of time. The way I was taught to do the investor math is to compare all products net of fees on a pre-tax basis and, if you have the information and sophistication, net of taxes as well.

What is most surprising to me is that the PE Industry has not banded together to defend itself and its track record. Maybe it is because the largest firms are public already and have their hands full with daily compliance? Or maybe it is the hope for privacy and anonymity- flying below the radar- that keeps spokesmen on the sidelines? As shown in the chart below Cambridge Associates shows in its March 2015 report on U.S. Private Equity and Venture Capital Funds that private equity and venture capital have both outperformed publicly traded securities of all types over the long run (the last 10, 15, 20 and 25 year test period) and, in many cases, over the short term as well (1, 3, 5 years). Note the bold numbers show the outperformer:

U.S. Private Equity and Venture Capital Index Returns (%)

March 2015	Qtr.	1Year	3Years	5Years	10Years	15Years	20Years	25Years
USPE	0.8	11.2	15.6	15.8	12.9	10.9	13.5	13.5
USVC	9.9	21.5	18.0	16.1	10.3	4.8	25.4	22.1
NASDAQ Composite*	5.4	13.4	22.1	15.9	8.1	1.0	9.6	9.8
Russell 2000 Composite	9.7	4.9	19.2	15.6	7.8	7.4	9.6	9.8
S&P 500	4.9	13.7	20.4	15.5	7.7	4.2	9.9	9.6

Sources: Cambridge Associates LLC, Frank Russell Company, Standard and Poor’s, and Thomson Datastream. * Capital Changes Only

The consultants can challenge these returns because they include a “survivorship bias” inasmuch as the PE firms that failed are no longer reporting to Cambridge. But I also imagine (but have not been able to confirm) that the returns for the public indices are gross and not net of fees for the products that try to mimic them? In any event, there is a remarkable outperformance by Private Equity over a 25 year period of already dramatic wealth creation in the US Capital Markets.

The problem with Private Equity is not the fees. It is the reluctance of a small group of extremely private and successful people to defend themselves. I understand their frustration. In some cases it is simply better to fade away and retire than end up in a shouting match with the SEC, the populist media or, even worse, a member of Congress. Maybe our industry needs a political PR machine? There could be some excess capacity in that industry soon.

Your insights are welcome

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

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

Whenever I am getting my sports information from the Wall Street Journal I know I am too busy. There have to be more informed sources like ESPN, Bill James Baseball Abstracts or even Topps baseball cards? But I got an inspiration from the Friday July 17 WSJ article on baseball “The Underdogs: Are These Teams For Real?” by Matthew Futterman.

Mr. Futterman’s thesis is that analytics have leveled the playing field in major league baseball to a point where the Houston Astros, New York Mets, Minnesota Twins and Pittsburgh Pirates have a better chance at the 2015 playoffs than the Red Sox or Yankees. While I agree that all baseball managers possess the tools today to slice and dice statistics like Billy Beane, the star manager of the Oakland Athletics who was popularized by “Moneyball”, I think Mr. Futterman has missed a nuance. The managers of these “small market” teams have small budgets so they must choose their players wisely and with inspiration about achievement potential beyond statistics. Clearly the Yankees and the Red Sox have all the statistical and financial resources to get any player they want. So the Yankees have expensive players in their line-ups like Mark Texiera, Carlos Beltan and Alex Rodriguez and the Twins, Astros Mets and Pirates have low salary unknown hitters and pitchers like Brian Dozier, Trevor Plouffe,  George Springer, Evan Gattis, Jacob deGrom,  Josh Harrison, Neil Walker and Starling Marte.

I would argue that it is all about the money. When you have lots of it to spread around you have to buy big names to appease the ego of your owner, put fans in the seats and grab the national limelight for TV revenues. When you are in short supply of money and you want to be successful you have to choose your few stars wisely and your high potential players even more wisely because you have to win to put fans in the seats and grab important TV revenues. So for the big market teams it seems to be all about the entertainment value of their teams and for the rest of the MLB it is about proving yourself by winning.

I believe there are striking similarities between large and small market PE managers. The large market managers have venerable names like Blackstone, KKR, Apollo, impressive roman numerals in their fund history, and highly reputable managers who are the founders and true “rock stars” of our industry. They have a lot of money to pass around because their public shareholders are often buying on reputation, and pension fund, endowment and public retirement system owners have career risk in manager selection and gravitate to proven stars. So just like the Yankees with “AROD “the Tigers with “Miggy”, the Red Sox with “Pappy” and the Dodgers with Clayton Kershaw, the large fund manager roster is based on historic track record and iconic stature. In fact, 10 private equity firms account for 55% of the money managed by all PE firms and 7 of those 10 are publicly traded. Appollo Fund VIII alone has $17.5 billion.

The resurgence of the small market baseball teams is based, principally, on smart managers who are largely unknown and want to establish their pedigree. So you find GM Terry Ryan and Coach Paul Molitor turning around the moribund Twins, and Neal Huntington and Clint Hurdle leading the Pirates, and Jeff Luhnow and A.J. Hinch leading the Astros and Sandy Alderson and Terry Collins directing the Mets. These are not household names even for veterans of fantasy baseball like me and certainly not the kind of managers who are going to direct $200 million dollar payrolls. They can only afford a few established stars like Andrew McCuthcheon, Jose Altuve, and Joe Mauer and fill their rosters with many unknown players like Dallas Keuchel, Brian Dozier, Gerrit Cole and Carlos Correria. In fact the Twins are #18, the Mets #21, the Pirates #25 and the Astros # 29 in 2015 payroll and the Mets, Pirates and Astros combined have a smaller 2015 payroll than the Los Angeles Dodgers.

If you need support for my small market, small fund manager bias you need to go no further than Clayton Kershaw who is the ace of the Los Angeles Dodgers. Mr. Kershaw is getting $31 million in 2015 under a five year arrangement. If he doesn’t opt out he can earn $65 million over the two remaining years of a seven year $215 million contract. He is currently 6-6. By contrast, Gerrit Cole who is the ace for Pittsburg is getting paid $510,000 under a one year contract (no mistake with the decimal point- that is $510 THOUSAND!!!!). So who has the incentive? And who has the entertainment value? Gerrit Cole is a free agent and he is proving his worth with a performance for the ages. He is 13-3 at the All Star break. Kershaw is also doing his job by putting fans in the seats and getting national TV attention; he is an All Star and solid entertainer. But the real question for the owner and management is who would you bet on?

If I was motivated by career risk and track record and had the money to pay up I would take Kershaw. However, if I had something to prove like a recovering alcoholic (Clint Hurdle) and a graduate of a tiny liberal arts college in New England (Neal Huntington) I would take Gerrit Cole.

So should you choose your PE managers like small market owners? It probably depends on whose money you are investing. If it is your own, I would look for mangers with good credentials that have something to prove through performance. The PE Fund with $10 Billion under management is like Clayton Kershaw. The partners start each year of a 10 year contract with a range of $100 million of $200 million to cover annual salaries and overhead. The small fund team starts with $2.0 million in a $100 million fund and is much more motivated to produce aligning returns upon exit. It is also particularly gratifying for the small PE Fund manager to find a few Gerrit Coles in his portfolio even though long term Mr. Cole will probably end up in a larger market (larger fund).

Either way you are probably a winner unless your fund manager has the kind of luck you find with the Chicago Cubs or the Cleveland Indians both of which have been cursed and defy any normal thesis about business, life or baseball.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

I recall a conversation I had with one of my law partners at Calfee, Halter in the early 1980’s about private companies “trading” on an exchange. He was an older and smarter securities lawyer who understood many of the nuances that were lost on his junior partner. In those days the liquidity path for a private company was a one way street-IPO your company or remain illiquid.

Better Than The IPO

Fast forward 30 years and the idea of a robust exchange for change of control for even the smallest private companies has become a reality: no need for partial IPOs, no lock ups; no S-1s; no SEC comment letters; no nights at the printers; no investor conferences; no “Qs” or” Ks” or form 4s; no worries about relational investors; and no quarterly earnings pressures. The M&A market has become a much more efficient, more liquid and less cumbersome exchange for trading control of a privately held company than the public markets.

Even more remarkable is the evolution of a host of products and markets that give liquidity to owners and creditors without transferring control. Banks, hedge funds, mezzanine funds, business development companies and family offices are all participating in minority debt and equity hybrid products where influence is contractual and not based on governance control. It is like a partial IPO without any of the infrastructure and baggage.

Systemic Risks May Be Greater In Public Markets

As I have written in other blogs, we are constantly doing a sanity check on valuation by comparing private company valuations with publicly traded peer companies. I have argued in the past that conventional valuation theory suggests a pricing disconnect between the liquid public market with endless transparency and thousands of owners and the private markets with a concentration of ownership, murky transparency and questionable franchise values. Valuation theory says that the private markets should trade at a discount for lack of marketability.

Now that I am the age of my Calfee mentor, I, too, am seeing some things differently. Like many other investors I am disillusioned by the public markets. While I have incredible respect for the discipline and rigor of public company life and the thousands of managers and service organizations that cooperate in making the US stock market the eighth wonder of the modern world, I am concerned about a few things like central bank influence, concentrated ownership in pooled vehicles like mutual funds and ETFs and illusory liquidity in times of market turbulence. It also dawns on me that the hold period for a huge swath of the accumulated wealth is getting shorter and shorter as retirements loom and savings are spent which may create some volatility. Most troubling, however, is something we know very little about—The Depository Trust Company (“DTC”) and its parent company, The Depository Trust & Clearing Company (“DTCC”).

Depositary Trust Corporation Is Not A Household Name

You know you are researching a pretty obscure topic when Wikipedia only has 4 paragraphs written about it. Normally, I would not care about DTC except that 100% of the US stock market investments exist only in book entry form (an electronic blip) with an affiliate of DTC called Cede & Company. The aggregate volume of securities that cleared through DTC and its sister companies in 2014 was 1.6 Quadrillion trades and some experts estimate that the safekeeping values at DTCC and its subsidiaries exceed $ 60 trillion. DTCC subsidiaries handle bonds, municipal securities, ETFs and money market funds. It does not appear that DTC has any domestic competitors in its expansive role of safekeeping, recordkeeping, clearing, dividend posting and collection, and proxy services.  DTC is a member of The Federal Reserve System and its parent company, The Depository Trust & Clearing Corporation which owns 100% of its voting stock is owned by the NYSE and 300 companies in the financial services industry. DTCC IS A USER OWNED MONOPOLY THAT HAS NO KNOWN DOMESTIC COMPETITOR.

DTCC guarantees the trading activities of its 300 participants and, in essence, provides its own balance sheet on a short term basis to facilitate and settle the trading activity of its members. Participants must keep liquid reserves with DTC to cover problems like customer defaults and the participants have certain cross guaranty agreements which act to provide a cooperative strength to weaker participants. For example, when Lehman and MF Global failed and their assets were liquidated under supervision of a trustee, DTCC underwrote the customer accounts for which its subsidiaries were providing custody services. DTCC’s 2014 audited statements claim that there will be no losses to DTCC or its participants on account of MF Global and Lehman’s collapse but it does disclose that the magnitude of the securities that it has recovered for Lehman and MF Global exceeds $500 Billion against a DTCC net worth of $980 million at December 31, 2014. At some point in time it probably had contingent liabilities from Lehman and MF Global that were many times its net worth.

A bigger scare was Superstorm Sandy which flooded DTCC’s vaults at 55 Water Street and caused the evacuation of its 2,300 employees and suspension of operations at that site. DTCC disclosed that there was significant damage to physical securities in its vaults and DTCC issued its own IOU in the form of indemnification certificates (DTCC IOUs) to serve in the interim while the damaged securities were replaced. There were almost 100,000 of those indemnification certificates issued in 2012 which by the end of 2014 had fallen to 1,500 representing $584.0 million in lost certificates. Assuming each certificate had equal value, DTCC peak exposure for securities damaged in the flood could have been $30.84 Billion against a DTCC net worth of $980 mil for the same period.

User Owned, Undercapitalized And Systemically Important

DTCC is a Systemically Important Financial Market Utility and its regulators have determined that it is undercapitalized. It is currently in the process of raising $400 million in equity capital to shore up the inadequacies in its balance sheet. Considering it clears and custodies ALL the market activities of the US Capital Markets representing at least $60 trillion of securities (not including the notional value of derivatives which are estimated at 500 Trillion), this doesn’t seem like enough extra capital for me? Thinking about investor security reminds me that if you do not have a break wall, how can we be certain you have a firewall?

Maybe Valuation Theory Is Changing?

So returning to the PE model and the private markets, maybe this is just one more reason we are seeing institutions and families more comfortable owning an asset that manufactures something or provides an invaluable service in a less cumbersome private market with efficient pricing and vast liquidity than a market where the only trading linchpin was literally flooded out of business. They call it “Water Street” for a reason.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

In a June 2 Wall Street Journal Opinion article, “How to Rein In the SEC”, the authors explored the current trend by the SEC to act as prosecutor, judge and appellate court under its own rules for matters where it has brought the charges against a person or corporation. The authors were former employees of the SEC. Mr. McLucas was the director of the SEC’s Division of Enforcement from 1989-98 and the co-author, Mr. Martens was the SEC’s chief litigation counsel from 2010-2013.

The authors are quick to point out that administrative proceedings have been supported by the Supreme Court for more than 40 years as legitimate venues for adjudication of proceedings stemming from a federal agency’s own rule making or legal authority. What is troubling here is the timing. SEC has shifted its docket from the federal courts to its own in house judges after a series of notable setbacks like the Mark Cuban insider trading case, a public company accounting fraud acquittal and other insider trading charges that were dismissed before trial or ultimately rejected by a jury. The SEC defends this trend to inside judges as an extension of powers granted by Dodd Frank, but the authors suggest that those powers were conferred in 2010 and the new policy only began with a new Chairman after a string of big losses in 2013.

So why the switch? It must be about winning!!! In a May 7 Wall Street Journal article “SEC Wins With In House Judges” the reporter, Jean Eaglesham,  showed that from 2010-2014 the SEC won 90% of the administrative actions that it adjudicated in house versus a 69% win rate in federal courts. The edge goes to the SEC because its internal process does not follow many of the fairness protocols that a defendant in the federal courts might expect like having adequate time to prepare a defense (only 120 days for hiring experts and review of millions of pages of evidence based on investigations spanning years and opportunities for deposing witnesses that SEC had already contacted and interviewed during that comprehensive investigation). Additionally, the SEC appeals process is to commissioners of the SEC and allows those commissioners to make findings and impose penalties that the independent Administrative Law Judge did not find or impose at trial. Those same commissioners must approve the original investigation of the defendant and, unlike the independent administrative law judge who has no involvement in authorizing the investigation and prosecution, might be seen as having a strong bias for proving themselves right.

The Commissioners of the SEC are appointed by the President, are confirmed by the Senate and serve for five year terms. President Obama has appointed 4 of the 5 sitting Commissioners and reappointed one Commissioner who was appointed by President Bush in 2008.

In fact, Ms. Eaglesham’s research shows that the SEC prevails in 95 % of the appeals to its own commissioners who authorized the prosecution in the first place. And be careful about appealing because in only one instance was the penalty reduced and in seven cases the Commissioners increased it!  This is contrasted to an 84% success rate in federal courts where appeals judges do not have the authority to impose new penalties. Given this edge, it is no wonder that the SEC has decided to use its own in house process in four out of five prosecutions since 2010. Before then the docket was split 50/50 between federal courts and internal judges.

Finally, the SEC administrative judges have much different profiles even within their group. For example, Judge Cameron Elliot has found 100% of those coming before him on contested charges guilty of at least part of the complaint. That contrasts with other administrative judges who find fault 85% of the time. Remember that the SEC hires these judges and pays their wages.  By contrast, in the federal courts a judge will quickly recues himself if he has any money connection to the lawyers or parties in a proceeding that comes to his docket. If he does not, a mistrial is the likely outcome.

Now consider a private equity manager that is investigated under Dodd Frank for failing to inform its investors of hidden fees and charges. An innocent manager with its reputation and livelihood at stake will undoubtedly hire his best defense and fight the charges. But if the SEC can steer its most difficult and highest profile political cases to its own kangaroo court where it has a 90% success rate and the commissioners who authorized the prosecution sit as the appeals court, I predict you will see wholesale capitulation and settlement. SEC begins to create law just like the “hanging judges” of frontier justice.

The concept of a Kangaroo court goes back to frontier justice where travelling judges were paid for outcomes- good or bad- and were thus accused of  “hopping” from venue to venue to increase their pay. Their justice was an illusion and the outcome was often decided before the trial began. Even someone as pugnacious as Mark Cuban might not have had a chance in a Kangaroo court. It is hard to believe any defendant would end up much better in today’s SEC perversion of a fair trial. 90% certainty at trial and 95% certainty on appeal where the appeals court hires the trial court and the appeals court are political appointees certainly gives the government an edge.

More recent criticism of the trend for aggressive enforcement comes from a court decision on May 21, 2015 regarding the failure of Caledonian Bank (SEC v. Caledonian Bank Ltd., et al, 15 Civ 894 (S.D.N.Y) where Judge William H. Pauley criticized the SEC for causing the Bank’s collapse by refusing to release $50 million of depositor funds above the bank’s net equity:

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“THE COURT: Was the SEC aware at the time that it came before me with its ex parte application that Caledonian Bank’s net equity was only $25 million and that anything above that amount represented depositors’ money?

SIMPSON: No, you’re Honor.

THE COURT: When did you learn that?

SIMPSON: I believe we learned that over the weekend after the filing of the complaint.

THE COURT: When you learned that, did you bring that to the Court’s attention or seek a reduction in the assets that were being frozen?

SIMPSON: We did not, your Honor.

THE COURT: Why not?

SIMPSON: We were negotiating with Caledonian and I believe they requested a reduction in the freeze amount. We took that to a very high level within the commission and decided that we were not going to agree to that.

THE COURT: How could the commission think that they are entitled to a freeze of seizing moneys that belong to depositors?

SIMPSON: Your Honor, I believe that we were negotiating with Caledonian on that issue and we did not specifically address that issue.

THE COURT: The bank collapsed because of your actions, didn’t it?

SIMPSON: Yes, you’re Honor.

THE COURT: It’s stunning. Its incredible government overreach.”

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The Court then took the extraordinary step of ordering the SEC to submit an affidavit explaining among other things, who at the SEC made the decision that the asset freeze should not be lowered to $25 million.

Normally, a repentant government would question its own activities but recently Andrew Ceresney, the head of the SEC’s Division of Enforcement, announced that the SEC would start filing more insider trading and complex cases within its own administrative courts instead of federal courts. I fear the power of the Kangaroo court will prevail and everyone will be presumed guilty until a lesser plea bargain is exacted.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

It took me most of my investment banking career (1986-1998) to realize that the best private  investors were those who had a margin of safety baked into their investment thesis. For example the leaders were able to mitigate risk by uncovering balance sheet benefits like mispriced real estate, deferred tax upside or poorly managed working capital. In some cases margin of safety came from liquidation value of the property, plant and equipment exceeding the purchase price. There were also circumstances where a company had pricing power but lacked the courage to capture it. Value investors often found significant earnings improvements from replacing people with productivity tools. Even growth investors who were buying a future stream of cash flow and earnings at high valuations often saw a margin of safety in barriers to entry, protected markets, patent protections, trade secrets, intangible assets or undocumented know how. These guys saw sustainable advantage and margin of safety that allowed them to pay a market price and still buy the business for a bargain.

It certainly feels like the margin of safety in any investment in almost any asset class in 2015 is hard to find. For most of us the cost of entry for good businesses in the lower middle market has risen dramatically over the last 10 years. This is especially true for value investors like CapitalWorks who have typically viewed visibility on management teams and entry price as the greatest determinants of investment performance.

So how can you build a portfolio and safely put money to work when the asking prices are rising and access to management is limited?

In two recent acquisitions we employed different strategies to pay a winning price without sacrificing the bedrock margin of safety.

In the first we looked at a holding company that had three unrelated businesses and saw the opportunity to combine them in a way that would create two businesses each of which could be a platform for tuck in investments. In the second we saw a services business at an inflection point in a changing industry with opportunities to carve out market share from dominant competitors for whom certain niche markets were increasingly unattractive. The investment thesis in each case meant meaningful business model and cultural change and in both cases the execution risk was extremely high. Our pre-closing exposure to management was constrained by the highly choreographed and controlled investment banking process so we were not sure what our inherited management group could really do.

In both of these portfolios company acquisitions that margin of safety came from an interesting intangible advantage we have over some other lower middle market private equity buyers. We have a bench of proven wealth creators with relevant industry experience who give us the courage to overcome the uncertainty of limited access to management in the investment due diligence process. Without knowing whether or not your inherited management can execute your investment thesis, you better have a backup plan in case they can’t.

That plan first involves coaching. Our LPs are comfortable with what they have accomplished in their own careers and are eager to share it with our management teams. Beyond coaching, these LPs bring their networks of industry relationships to help us replace retiring executives. Beyond networks, these LPs bring their peers and colleagues who are interested in investing and lending their wealth creation reputations to ours. Finally, the profile of these LPs changes the profile and market perception of the acquired company. Employees, suppliers, customers and even competitors often look at the new team differently when industry legends begin to play a more visible role.

Even more interesting is the reaction of tuck in sellers to a group of industry veterans playing a visible governance role. The selling patriarch often wants to leave his company legacy in their hands and often is more willing to rollover equity to better align our post-closing objectives. The patriarch’s ongoing involvement in the “second bite of the apple” helps us mitigate key man and customer relationship risks. We often observe a dramatic transformation of the tuck in company from a market participant that struggles with recruiting, pricing, strategy and execution into a more important market leader.

Company building also is enhanced by management teams’ willingness to trust industry legends and we have seen a remarkable receptivity to coaching when the “PE GUYS” are in the background. All of this is a way of saying that CapitalWorks’ business model has evolved from being a value investor who makes his money on the buy to a value investor who perceives a sustainable advantage- a margin of safety- in its ability to improve portfolio companies by executing change strategies. Our talented LPs are at the heart of it all.

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.

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My daughter is a Managing Director at Cambridge Associates (CA) in Boston and she told me about a study that CA had recently completed for its clients on  strategies to leverage relationships with PE sponsors for “no fee, no carry” co-investment opportunities.

CA’s study shows a dramatic outperformance of “all in” co-investment strategies over the base fund performance in a majority of the vintage years they studied. This makes sense because almost all co-investment rights are free of fees and carried interest and should dramatically boost the host fund’s performance, but some of the other results of that study were surprising.

By way of background, LP’s can pursue co-investments with 4 separate approaches. You can invest in a Fund of Funds that has a small percentage of its investments in co-investments. FOF’s have low management fees and carried interest because they pay the host fund a full set of fees as well. You can also invest in funds whose sole strategy is to invest only in co-investment opportunities. These funds usually reveal a strong relationship between the fund manager and the PE sponsors. CA demonstrates that these strategies lag (not exceed) the host fund in 75% of the cases. The third strategy is to leverage an investment in a PE fund for the right to pick and choose co-investments in that same fund. Finally, some LPs leverage a PE sponsor relationship for direct investment chances.

All these strategies have predictable risk/return characteristics with the direct investment approach having the highest variability. The CA study confirms that the objective of eliminating “fee drag” quickly diverges from actual investment performance the more the LP exercises discretion. Accordingly, if a LP co-invests in all the sponsor deals it typically does better than when it cherry picks. When LP’s pursue direct investment opportunities they often experience a bad result.

Another interesting observation by CA is that the SEC may be ready to spoil a perfectly good thing for the most sophisticated LPs by mandating co-investment rights be available to all LPs. This sounds good, but somehow I do not see a $1.0 million LP investor picking the right opportunity as well as the $25.0 million institutional investor, especially an institution with industry or deal specific experience or an experienced advisor.

The search for yield/performance is causing everyone to look for an edge.  Like every sure thing, the co-investment strategy comes with nuances and Cambridge Associates demonstrates for its families and institutions that there are few “sweet spots” in a popular and growing investment strategy.

We have seen a similar trend and a similar result. In 2004 we had a hybrid fund where certain family LPs committed to co-invest in ALL our transactions and other family LPs paid a larger management fee for the right to choose where they invested. What we observed was quite similar to the CA empirical analysis. Those who did all our deals in that 2004 fund did quite well and those who chose underperformed the committed group. As the GPs of that fund, we underwrote the non-participants, and we learned that, if you believe in the sponsor, as a co-investor you should be like a great Texas Hold’em player –ALL IN.

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Dick and I have been working on a transaction for the last two months that involves a service business. One of its most critical assets is relationships between the provider and its customers. We have utilized a third party marketing firm with technical expertise in financial services to help us validate the strength of the customer and supplier relationships. That exercise resulted in a comprehensive report that gives us in depth feedback on 18 customers and suppliers.

For many private equity firms this would be sufficient due diligence. The sample size is large. The reports are detailed and the interviews were recorded so that transcripts could be reviewed for nuances and inflections. However, we chose to make this our starting place and we are glad we did.

Business Is a Contact Sport

We decided to follow up in person or by telephone with 8-10 of the parties who were interviewed and 2 who were not. What we found was that the problems were greater than the audio transcripts have revealed but that the relationships and opportunities were stronger than we had appreciated. Face to face we were able to read body language. On the phone we, in our role as prospective owners, were able to lay the foundation of a future relationship better than our third party service provider.

The picture of the problems and opportunities also became much clearer. The customers clearly want us to succeed and because they like the current relationship managers, they are unafraid to tell us where we need to improve. The message we got was crisp. We needed to invest in people and inventory to keep their business. More importantly, they told us how to succeed with them. Our competitors were equally under invested in people and parts and often did not have the same long time managerial relationships. The body language convinced us that the opportunity was great but we had to be focused and responsive. We were going to get a chance to demonstrate new habits and deliver on new promises.

99% of Success Is Just Showing Up

Most importantly, we showed up. While this seems elementary for business relationships, I am convinced that the internet is displacing the old way of forming relationships. It is way too easy to relegate a business problem to an endless email chain where it languishes unresolved. Providing emotional context with something as simple as a smile or as enduring as a firm handshake is impossible. For a new owner it is critical that the customer form an opinion. By showing up we are signaling his importance and a genuine desire to listen and communicate. That customer is important enough that the new owner will brave two connecting flights and several snow storms to elicit a scorecard. It gives us an opportunity to demonstrate the owners’ voice in support of our employees but it also says you can contact us if your relationship manager is not delivering on expectations.

We ended our three days of face to face and phone due diligence having had a few belly laughs and more than one discussion about the price/value equation. But we were optimistic about our future because in every case the customers and suppliers repaid our effort with engagement and constructive dialogue which is something unhappy customers rarely do. It is a good test to show up and see if your customers will meet with you. Those that are hiding are often on their way to another destination.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

In a recent Wall Street Journal article by Andy Kessler dated March 29, 2015 entitled “The Glory Days of Private Equity Are Over” (read here) Mr. Kessler, an accomplished author, investment banker, research analyst, venture capitalist and hedge fund manager, makes an impassioned case for why macro trends will bury the private equity business model. His assumptions, however, may be too simplistic and his prediction- “Stick a fork in it “- may be premature.

Caveman Business Model

First of all Mr. Kessler thinks the private equity model is pretty simple. You buy a company mostly with leverage and run it for its cash flows with enough left over to pay interest, fees and dividends. Then you take it public or sell it to someone else. If it were that simple I am sure that accomplished venture capitalists and hedge fund managers, like Mr. Kessler, would be doing it themselves?

Caveman Cash Flows

Mr. Kessler believes that you generate cash flow, not by expanding the company, but rather by slashing costs, closing divisions, cutting staff, curtailing marketing, eliminating research and development and “more”. Maybe the biggest Neanderthals among us are still clinging to that “caveman” business model,  but I have found that most private equity owners look for operational improvements, pricing opportunities, systems improvements, customer and supplier rationalization, compensation alignment, principal amortization, growth capital expenditures, management accountability and inclusionary governance. This is real company building based on people management, rational capital allocation, prudent capitalization, tuck-in acquisitions and attainable business strategies. At least that is what we attempt to do with all of our portfolio companies in the lower middle market.

Four Trends and A Funeral

Mr. Kessler then points to four obvious trends that will kill private equity and one that is the “killer”.

Trend #1: “Interest rates are going up”: Not according to our capital introduction expert, John Corrigan, who has been working with our middle market financing sources since 2010. During John’s tenure with us senior debt in the lower middle market has fallen from 5.25% to 3.25% for quality credits and mezzanine debt has fallen from 18% to 13%. Recently, he has seen a slight increase in mezzanine interest rates but he finds the senior debt market to be as “competitive as ever”. Mr. Kessler believes in the Stark family model from the “Game of Thrones” that winter is coming and that, inevitably, interest rates will rise and kill the private equity model. By the way almost all the Starks got killed by the end of the first book and their arch nemesis, the Lannister family, no doubt the earliest capitalists, ruled the world with gold.

Trend #2: “Banks are slowing lending for leveraged deals”: Mr. Kessler cites the Wall Street Journal as his source for regulators discouraging leverage structures more than 6x EBITDA. In the middle market and the lower middle market where the highest volume of M&A deals are occurring, the price for the whole company rarely exceeds 7x and the equity capital is usually 35-40% of the transaction. This means the debt capital structure is usually less than 5x and the bank portion rarely exceeds 4x. Our experience is that the middle tier banks are more aggressive today than any time since 2007. In fact, unlike the “too big to fail” banks, just recently the regulators have been easing up on them for the first time in years.

Trend #3: “Tax reform is in the air”: Mr. Kessler points to Lee-Rubio tax reform which could call for the end of the interest deduction on certain debt as a sure sign that the foundation of the PE model will shake and fall. He calls the interest rate deduction the “air that filled the private equity balloon for years”. I can think of a few more notable Hidenburgs who are many times more leveraged who have remained airborne due to the interest deduction like the US Housing Industry, the US Banking Industry, Fannie Mae, Freddie Mac. And on the tax point, there are at least 5 tax attributes that are equally or more important to most private equity partners: (a) the deductibility of goodwill; (b) the limited liability structure that eliminates double taxation of corporate profits;(c) the taxation of profits interests as capital;(d) the taxation of capital gains at a significantly lower rate than dividends and ordinary income and (e) deferral of tax on unrealized appreciation. Mr. Kessler is also crazy to believe that a debtor central government with debtor states and municipalities and debtor pension funds supported by a debtor populace will voluntarily vote in favor of raising their cost of borrowing by eliminating the interest deduction.

Trend #4: “Private equity is holding back the economy”: Since Mr. Kessler believes in the caveman approach to private equity he cannot believe that the prudent use of debt capital in a buyout model can lead to productivity, job growth or innovation. He believes that is possible only with venture capital because VC’s do not utilize debt in their investment structures. He bashes the derivative industry. He blames PE for a ½%-1.0% lower gross domestic product. But where is the evidence? Our experience is completely opposite. We buy companies and grow revenues through a combination of strategic and tactical management and operational improvements. We raise prices where we can. We invest in systems to give us better information for running our businesses. We hire sales people to boost revenues. We consolidate buying power to lower our costs from suppliers. We tuck in product lines to leverage our existing expense structures. Our employees get matches to their 401k plans and annual raises. Our management teams get bonuses when we achieve our annual budgets. This is not voodoo economics. It is old fashioned business based on perspiration, purpose and people.

Our Imminent Demise Is Highly Exaggerated

Mr. Kessler ends his article by saying that the first four trends are nothing compared to the last trend which is the scarcity of good investment opportunities other than mattress companies and food companies which he must believe are the safety trade for PE cavemen. Now this is something I can acknowledge is a fact; no, not the mattress and food company thesis but rather the scarcity of good investment opportunities. We have to work harder than ever and employ more investment discipline than in 1999 to find good opportunities and continue to meet our promised IRR hurdles. But we have found a perfectly good way to do that- actually invest in and improve the businesses you buy and raise smaller pools of capital with sidecar families who are willing to co-invest in larger transactions. We are adapting to changing circumstances with a business model that continues to work for us and our investors. We know that the PE asset class is highly Darwinian and that, as good stewards of capital, we have to evolve or perish. Our early demise has been highly exaggerated.

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.

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In our last blog I wrote about the mutual fund industry creating two kinds of funds; retail and prime and non-prime institutional. Institutional funds would have a fluctuating NAV and could carry liquidity constraints called “gates” unless the underlying assets were government or agency securities.

Now Deposits May Require Fees

Last week the Wall Street Journal reported that JP Morgan was going to begin charging fees to certain institutional clients for bank deposits. Characterizing those institutions as private equity funds, foreign banks and hedge funds, the article suggests that these types of deposits create systemic risk and are most likely to flee major banks in periods of financial insecurity. (Click for WSJ link)

I knew right away that this was a propaganda piece because private equity firms and hedge funds do not carry material cash deposits at banks. So the genesis of these new rules is the EVIL EMPIRE creating systemic risk of liquidity meltdowns? Highly improbable but the WSJ was just passing on someone’s message.

A New Approach to Bank Funding?

Short term bank deposits have always served as a cheap source of funding for financial institutions. Now, thanks to the long reach of Dodd-Frank, banks must reserve against deposits most likely to exit the banking system in a financial meltdown. In some cases depositors will be charged fees for the privilege of utilizing the US Banking System. At least in my lifetime, this is a new phenomenon and a major change in the way banks fund themselves. It is also interesting that the banks are following the leaders in the mutual fund industry by shaking up the savers.

Where to Stash Your Cash?

My question is where the money will go when the real depositors (think corporations and pension funds not private equity funds and hedge funds), decide they don’t want to pay fees? They can’t put cash in non-government institutional money market funds without agreeing to significant limitations like a floating NAV and gates and fees. So, if you are a corporation with $100 million of cash on its balance sheet you either throw in the towel and fund the government or you manage your own fixed income portfolio? The WSJ article suggests that there may be exceptions based on historical customer relationships.

Dodd Frank Hijacked By Fiscal Policy?

Is this really about systemic risk or forcing cash to work in the economy? I could argue that the recent changes to how institutional cash is treated by banks and mutual funds are really a validation of perceived deflationary risk. By forcing the cash to move out of comfortable, time tested products there is the added benefit that it might get invested in the general economy.

If you are really serious about keeping that cash as a security blanket or for corporate opportunities or for general working capital and you want to access that cash when you need it, it looks like you are going to be buying government and agency securities. It will be interesting to see what the banks do to keep deposits?

Chances are high that the new form of bank “deposits” will have a government wrapper of some sort, just like the money market industry.

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.

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Over the years I have learned that the real news begins in the back pages of every newspaper, especially The Wall Street Journal. Therefore, I was not surprised to find on page C8 of the February 6, 2015 Wall Street Journal an article about how changes in money market mutual funds will be bad for Banks (Click here for link).

The SEC is changing the landscape of the mutual fund industry through powers granted under Dodd Frank to “reduce systemic risk”. Fidelity Investments has announced that they will accept the new regime (Click here for link) by splitting their offering into retail and institutional money market funds.

The retail fund will be available to individuals and will offer the current suite of choices including government, non-government and municipal portfolios and their NAV will be fixed at $1.00. The institutional fund, however, that buys non-government or municipal assets will have a floating NAV and, in some circumstances, its liquidity will be subject to redemption fees and gates (limitations on redemption’s to sustain orderly markets). The rest of the article talks about why this is bad for banks because it takes away a funding source. Evidently, short term bank paper is an important money market investment class.

This Will Be Great For Private Equity

What the article is not saying, however, is what is likely to happen to savers and retirees who have accumulated enough wealth to be in the “institutional” pool. Either they get in the government pool or they get penalized by owning a private pool with scary attributes like a floating NAV that can drop below dollar parity (break the buck) and redemption fees and gates that allow the mutual fund to charge for and/or delay redemption’s.

Now don’t think for a minute that this isn’t good for Fidelity because its biggest fear is liquidity. Also absorbing losses by honoring a $1.00 NAV when it has to meet redemption’s in a choppy or turbulent market is not good business. And, of course, it is good for the government securities market because it assures funds flow into short term government instruments and agencies like Fannie and Freddie. So a grand bargain has been struck and the only losers are people who want to sit on an “institutional pile” of cash in non-governmental or municipal money market funds and, possibly banks, corporations and municipalities who may see their cost of short term funding rise as the pools of capital migrate to the government funds.

There are very few institutions who will want their cash value to float below zero or be subject to limitations on when they can get their cash so they will do exactly what the Fed wants – they may stop concentrating savings in money markets and put the money into other assets classes like real estate, venture capital and  private equity.

Shaking Up The Savers – Deflation Fighter

It also may be an intentional move to avoid Japanese style persistent deflation by shaking up the savers and causing the money to get back to work in the economy? This shake up has apparently worked already by inflating financial assets like the stock market, real estate and private equity. The Fed’s policy target of 2% annual inflation has not been met for a long time and debtor nations like the U.S. need inflation to make their business model work. The interesting question for all of us is where does this influence and manipulation end? It seems like almost every asset class is influenced by a central bank or governmental plan or policy. For my money I want to own a business that manufactures an important product or provides an essential service and, in both cases provides employment.

The new money market rules could drive even more cash into private equity.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Private Equity firms fashion themselves as pretty good students of relative value. While managers may have different investment styles from deep value and relative value, to growth at a reasonable price and straight growth, they all understand the nuances of valuation. For example, as a value investor we have set our benchmarks to tell us when we should be aggressive buyers, when we should be aggressive sellers and when we should sit on the sidelines until a trend emerges. One of those benchmarks is the historic relationship between public company and private company valuations.

Valuation theory has almost always suggested that private businesses should trade at a discount to publicly traded peers because the latter are predictable earners with access to cheap capital. In addition, there is often a liquid trading market for their shares and, in the large cap universe, institutions with huge dollar positions can move in or out of a position without affecting value. Valuation convention would suggest that the private company discount should be 20-30%.

Sanity Check For PE Professionals

Whenever we are wondering if the valuation we are willing to pay for a private company is sound, we look at the choice we have of buying the leading public company in the same industry. This is a sanity check and an IQ test for our analysts and associates who are crunching the numbers and providing opinions on bid strategy and capital structures.

Occasionally the old guys in the firm, like me, look at this equation just to get a perspective on valuations trends. Yesterday, our friends at Key Banc Capital Markets sent around their 2014 Merger and Acquisition Review. We are particularly interested in their data because they have a strong industrial focus and are one of the leaders in the country relating to middle market industrial M&A. It came as a surprise to me that Key Banc showed the median Enterprise Value/EBITDA multiple for 2014 reported middle market industrial transactions being 9.8x. That is up from 6.8x in 2009 and 7.7x in 2013. Key Banc also reported that the number of transaction with PE firms had increased 27% from 2013 with almost 1000 deals in 2014. Even more surprising was the leverage multiples. Bank debt represented 5.1x of transaction value, almost reaching the record of 5.2x recorded in 2007.

ALL EBITDA Is Becoming Equal

These statistics were so provocative that I talked my friend and former colleague, Raj Trikha, Head of Industrial and Energy Groups at Key Banc Capital Markets for a little perspective. Raj said: “We are seeing a compression of multiples. Whereas traditionally there were distinct bands based on size, we are seeing a convergence of purchase price multiples into a single band.” According to Raj, the largest EBITDA companies(above $40 million) historically commanded the top multiple. The middle band from $20-40 million were a step down and industrial companies under $20 million were another step down. There also was a quality of earnings scrutiny within each band with industrial companies that had exceptional EBITDA margins commanding premiums. Today Raj is finding “ that differential significantly compressed.”

10X Gets Your Attention

The 2014 EV/EBITDA valuation multiple of 9.8x suggested to me that industrial public peers should be trading 20% – 30% higher, but what I found was not what I expected:

None of the best and largest capitalization industrial companies was trading at a 20% premium to the MIDDLE MARKET M&A Exit Values. In fact, you could buy both Emerson Electric and Parker Hannifin at a discount to the valuations in the middle market!!!!

And….Industrials Are The Relative Value Play

Even more interesting was Key Banc’s data that showed private industrials as the cheapest middle market sector with Consumer at 11.1x , Healthcare at 13.7x and Technology at 10.7x . By comparison public leaders in those three sectors, Apple, Merck and Google, trade at 9.99x, 12.7x and 14.76x EV/EBITDA respectively.

What makes me think of the Bubble, Bubble idea is that the private markets derive their liquidity in large measure from one source-U.S. BANKS. Unlike the millions of independent actors in the stock market, the liquidity that is putting middle market private companies at valuation parity with the best public companies is a highly regulated, government controlled marketplace comprised of domestic banks which are all influenced by the same master, the Federal Reserve. That master can end the valuation game by raising interest rates, discounting collateral or raising tier 1 and tier 2 capital requirements like it did in 2008 and 2009 when the bank portion of M&A capital structures fell to  less than half what it is today. It can remove M&A  liquidity with the vote of  seven men and women.

Valuations Will Follow The Fed

For the moment, an accommodative Fed is fueling historic valuations in the M&A markets. This is not a time to be on the sidelines. These windows close abruptly and the catalyst is often unforeseen. When that happens you can expect that trading ranges for private companies will revert to a 20-30% discount to public peers.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Happy New Year! PE4Fams has not been slacking in the New Year … just busy with multiple opportunities to grow our portfolio companies and acquire some new platforms.

Over the last 30 days our team has been conducting all kinds of due diligence from quality of earnings to customer interviews and market surveys. In varying degrees as part of our diligence process we often get access to senior management (CEO, CFO and VP of Sales) but we rarely meet middle management before we own the company. That is really too bad because we have learned with experience that many small businesses thrive or fail because of the strength of the middle management. We were lucky enough in a recent opportunity to meet all the middle managers and they were committed, intelligent, energetic, and heroic. They were powering the target business and helping it thrive.

Promote The Middle Managers

This lesson has been reinforced for us in crisis situations. One of our most experienced and battle tested advisors, Mark Bronstein, has spent his career dealing with middle market companies under duress. Whether it is a receivership assignment, a turnaround management role or a straight forward liquidation of assets for creditors, Mark has a simple formula for testing whether the business is viable. He replaces the senior leadership with middle management.

His experience is that senior leadership is often responsible for the crisis. It is often their failure of leadership that has put the business in jeopardy, not the business model, the customers, suppliers or creditors. He is quite confident in the tenured middle managers who understand how the business runs, what customers expect, how to cut costs and how to create confidence with suppliers and vendors.

Much to our dismay he proved this to be true in a turnaround assignment for us in a small portfolio company. That company was distressed when we bought it and more distressed after the first six months of operation under a CEO we had recruited to run the business. That CEO was not suited to the turnaround task , so we parted ways in favor of another CEO who came from the same industry and who had numerous sales and marketing contacts. He compounded our misery by assessing the problem to be revenues.

Revenues Are Not Always A Solution

Revenues come in many flavors and a few of them are simply awful. In this case the prices at which the CEO added revenue were below our cost of goods sold. Six months later we were losing money and hemorrhaging cash.

We brought Mark in to save our investment. The first thing he did was assess the capability of the middle managers. He concluded that there were numerous centurions who could run the business without involvement of the current senior management team. So, without promotions or fancy titles he simply passed the management responsibility to the plant manager and the operating leaders. He worked with the new team to assess true profitability by customer and he terminated those relationships that lost money. He managed this process remotely with complete confidence in the new team to achieve our objective of generating free cash flow, albeit at a much lower level of revenue.

Today that business is recovering nicely without any senior management. Mark was right. The middle management knew how to run the company.

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 voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

As lifelong Cleveland Browns fans, the private equity team at CapitalWorks has shared the collective angst of the City regarding the demotion of Brian Hoyer and the fumbled handoff to Johnny Manzel. We have seen this play before – 18 times before – and we all know how it ends. Bernie Kosar has taken some heat for calling it a “Head Ache”, meaning that there continues to be a void in leadership from the owner. Subordinates are caught in the middle as the owner and his general manager strip authority from the coaches. This is what the military affectionately refers to as FUBAR.

What Can the Cleveland Browns Learn from Private Equity?

Private Equity has many of the same management challenges as professional football. As owner you have responsibility for all your portfolio companies, their management teams, their customers and suppliers and their extended communities like lenders, co-investors and advisors. Likewise you are competing with other businesses who relish the thought of taking market share, ruining a pricing advantage, recruiting your best people and putting you out of business. It is a highly competitive environment and, increasingly, an international game.

We actually devoted a 15 minute discussion last Monday to the lessons we have learned from the Browns. Dick Hollington made two observations that apply to success in the private equity environment. First, you have to be committed every day to a culture of excellence for its own sake and an unswerving dedication to, and faith in, your system and process. No Exceptions! Second, you have to have a team with deep character. The traits he admires most are hard work, team play, humility, toughness without being mean or cheap, discipline to control your emotion in the face of adversity or insult and genuine fairness. I commented that I liked Jimmy Jones’ (ex Dallas Coach) assessment at the half time of the Browns – Cinci game that success for Johnny Football in the NFL, unlike high school and college, is more about avoiding the big mistake than it is the big play.

It Is All About Culture, Process and Humility

We have a process. It is boring, disciplined, frustrating, painful and often unsatisfying. We lose most of our skirmishes and devote thousands of hours to transactions that never become portfolio companies. We lose deals on price, fit, flare and relationships. But we have a winning culture and have maintained a good record for over 15 years. We support our QB’s, wide receivers, centers and safeties as long as we possibly can without jeopardizing the overall team. When we change a manager, he is rarely surprised. When we fail, we fail as a team. We rarely pin the blame on anyone other than ourselves as owner. We aspire to be New England, Green Bay, San Francisco and Seattle (hard to say Pittsburgh) with a commitment to the same process every day. Like Midwestern plow horses, we have an endless energy for excellence and achievement content to return to the barn without any narcissistic celebration dances in our end zones. The Browns have a lot to learn from Private Equity.

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