The Private Equity for Families Blog

The Case for Paying Fees

The cost of an education in Chicago is going up. In its weekly fixed income update Wasmer Schroeder, a fixed income manager with offices in Cleveland and Florida, announced a failed financing:

The Chicago Board of Education attempted to bring $874 million in bonds to market last week, with most of the proceeds earmarked towards refinancing existing debt. Despite initial price talk of 7.75% for tax exempt maturities and 9.75% for the taxable portion, the underwriter was unable to bring the bonds to market due to a perceived lack of demand for one of the lowest rated new issues in recent memory. The deal is now day-to-day with timing uncertain.”

Evidently, the Chicago Board of Education is considered a bad credit. This highlights disconnect between the private credit markets and the political world that governs our children’s’ public education. Bond investors are really sharp and highly interested in getting repaid. They don’t listen to promises or rhetoric. They are inflow managers and look at balance sheets, including footnotes, municipal revenues and cash flows. Not surprisingly, most politicians are outflow managers because spending other people’s money is much more popular than austerity and saying NO to spending. The two groups have trouble crossing trades.

Rahm Emmanuel is probably hoping his former boss will issue an executive order that will make those Chicago Board of Education Bonds more appealing. Possibly, a federal governmental agency will guarantee those bonds? Maybe Chicago can find someone at a “too big to fail” financial institution to guarantee the bonds in return for a political favor from the White House?

The breakdown in private funding for public debt is likely to become a pervasive story over the remainder of this decade. When you think about the magnitude of underfunded political promises to children, veterans, pensioners and retirees the Chicago story may be playing soon in your own hometown. This is where it pays to have a credit manager on your side. I fear that Chicago is not the only municipality that has an insolvent education system. There will be significant crony capitalism at play as the politicians work to finance the deficits they have either created or inherited. It will take smart people to read the footnotes or look behind the guarantees presented by equally insolvent third parties.

The 2008 real estate disaster taught us all something about counterparty risk. The smart money does not keep drek on its balance sheets. They repackage and pass it along to people like us, directly or indirectly.

Whenever the asset or its repayment is derivative, meaning it relies on a third party to make it happen, you have to ask WHY?  If smart bond investors will not buy the bonds directly, why should you buy them with someone else’s guarantee? I guess there will always be exceptions like the case where Warren Buffet personally guarantees the repayment of the Chicago bonds? In general, however, the derivative asset is unlikely worth more than the primary asset. Wasn’t that the lesson of Collateralized Mortgage Backed Securities? You take a huge pool of C mortgages and split them into tranches where the first tranche get first call on all repayments and is statistically AAA according to an accommodative credit agency. In some cases the AAA tranche was guaranteed by a third party. Guess what, they all defaulted like the “F” credits they really were and the counterparty guarantors went out of business.

The disinformation machine will work overtime to rehabilitate poor credits like Chicago and spin straw into gold. Count on greed and the search for yield to make it so. I predict that Chicago bonds will be underwritten, just not in a form you will not recognize.

The case for having smart managers who are highly compensated has never been stronger. While I love the low fees that come with aggregated buying power from people like Vanguard, I  believe that smart people who can charge for their expertise will outperform in asset classes like municipal bonds as long as America is massively overleveraged. When you are only making 2% on the good bonds, you cannot afford any defaults!

The same is true for private equity. It is not what you pay in fees. It is what you keep. I am a big believer that there has never been a better time to have a motivated and aligned manager by your side.

Your insights are welcome

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

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