Financial Times Exposes McKinsey’s Secret, Conflict-Ridden In-House Hedge Fund

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The Financial Times’ is on a heretofore well-hidden McKinsey internal fund which invests on behalf of current and former partners (both pension funds and additional contributions). The fact that McKinsey has an in-house investment business is in many respects old news; the firm since the early 1980s run its pension investments for both partners and non-partners as mini-family office, selecting outside managers and letting participants choose once a year what percentage of their funds in which category. And there’s nothing that should be controversial about that. And one gets the impression that a large chunk of the funds are invested via other managers. :

MIO’s flagship fund is the Compass Special Situations Fund, a fund of hedge funds that is described by one client as the “crown jewel” in the investment office and a “great benefit” for McKinsey partners. He said Compass closely guards the names of the hedge funds in which it invests and will not even disclose these names to clients of Compass.

The part that is new, and disturbing, is that the firm is also engaged in making active investments in house. It has an 80 person investment team and manages $9.5 billion, which as the article notes, .

Critically, the article was unable to parse how much of the total was unproblematic investments in other fund managers, versus direct investments or co-investments, which can represent conflicts of interest with McKinsey clients. Moreover, McKinsey asserts that the internal fund, called MIO for McKinsey Investment Office, is independent when it isn’t. Unlike Bain Capital, which is organizationally separate from Bain the consulting firm, but uses Bain as a preferred vendor, the investment operation, as was the case in my day, :

MIO is overseen by a board of 12 current and former McKinsey partners, including Vik Malhotra, head of McKinsey’s practice in the Americas and the co-heads of its energy, private equity and investment banking practices. The McKinsey partners serving on the board do not mention their role on their official company biographies.

The firm tries to argue that this is kosher by :

A McKinsey spokesman says the firm takes “ethics extremely seriously”. He added that MIO “operates on a ‘blind trust’ basis, with MIO’s investment managers being unaware of the firm’s clients, and consultants being unaware of MIO’s underlying investments.”….

An MIO spokesman said that the board delegated investment decisions to MIO’s managers, and had a “rigorous policy to avoid conflicts of interest”.

First, the idea that the investment unit doss not know the identity of at least some McKinsey clients is hogwash. Again, in my day, firm members were extremely circumspect about mentioning who McKinsey clients were to outsiders. But even so, the identities of some core clients were well known, like Citigroup, Merrill, American Express, and General Motors.

Moreover, the head of the private equity practice gets intelligence across a broad range of industries. Perhaps the firm has cleaned up its practices since the later 1990s, but I was told flat out by the head of one of the biggest private equity firms, a former McKinsey partner who had also done a stint on Wall Street, that the reason that firms like his hired McKinsey, Bain, and BCG, was that the private equity firms expected the consultants to provide the industry insights they’d gained working for corporate clients to the private equity firms. Since private equity firms often compete with “strategic” buyers on acquisition bids, and portfolio companies often compete directly with divisions of McKinsey clients, this is as rank as conflicts of interest get.

In other words, if NcKinsey of the 1990s (the Rajat Gupta era) was willing to sell out industry intelligence to direct competitors, it’s not hard to imagine that the segregation of information was less tidy than one would think. And that attitude represented a big change from the traditional McKinsey. In my day (mid 1980s), the client teams working on big banks regarded the teams working for competing banks with considerable suspicion. Indeed, the partners on those accounts were fierce rivals and competitively valuable information was most assuredly not transmitted.

The article also fails to consider that McKinsey regularly advises governments, as when it advised both the Treasury and the Fed during the financial crisis. Understanding the mindset of the Obama Administration early on would have been extremely valuable from a trading perspective.

Put it another way: the role of the board has to involve at least some high level oversight of investments. And we are to believe that the current McKinsey partners on that board are able to erect Chinese walls in their brains? And the unit’s results are so implausibly good (profitable in 24 years out of 25, which meant between the crisis and the dot-bomb era, it had only one down year, and it earned 14% in 2014 when the average hedge fund returned a mere 3%) that the commentors at the Financial Times found it hard to believe that McKinsey was not taking advantage of privileged information.

In addition, it is troubling that the firm has kept this secret from clients and has minimized disclosure even to firm partners. Again from the article:

MIO Partners has existed inside McKinsey for three decades, yet until now the workings of its operations have remained little known on Wall Street or in the City of London…

No current or former partner was willing to be quoted by name about the activities of MIO Partners. However, based on conversations with clients and a review of investor documents and filings with the SEC, the Financial Times can shed light on MIO and its investment process…

Other details remain sparse. Even McKinsey’s internal history, published in 2011 and distributed privately to partners, includes just one page explaining MIO’s origins and activities.

It provides a brief description of how the creation of the investment fund in 1985 by Ron Daniel, a long-time senior partner, was driven by a need to attract and retain employees who were being tempted by the financial rewards on offer in banking and private equity.

“Given what the firm invested in knowledge and people development, [McKinsey] was hard-pressed to match what prospective associates, or even veterans, might earn in investment banking and other financially lucrative fields,” the document said.
Mr Daniel set MIO up as a family investment office that could provide McKinsey partners with a range of investments.

This history may be technically accurate but is not complete. McKinsey already had an investment operation that was supervised by Roger Kline, a partner who had Citibank as his major account. As mentions above, it selected the managers who would run the pension fund for the partner and junior staff. That activity was apparently expanded to give the partner more discretionary investment opportunities.

The top of the article give an idea why firm clients were kept in the dark:

In 2012 a group of elite hedge fund managers were about to see a complicated trade finally pay off. Funds run by prominent Wall Street financiers Paul Singer, Louis Bacon and John Paulson had backed a private company that was buying up small American banks. Known as National Bank Holdings, it was about to list its shares , allowing early investors to pocket a healthy profit.

Listed alongside these high-profile investors on NBH’s shareholder register was a less recognisable name: “Barfield Nominees Limited A/C CSC01”. The ultimate owner of the Barfield account was an organisation even more famous than the billionaire hedge fund managers, and more anxious to keep a low profile — McKinsey, the world’s most prestigious management consultancy.

Due to the pressure of needing to get daily posts out, I must confess to not having investigated the focus of National Bank Holdings. However, McKinsey has an extremely large financial services practice, and serves both large and mid-sized banks. It’s thus pretty likely that this venture competed with at least some of its clients’ businesses.

And it’s misleading to present this as “a trade”. Even though the investors were hedge funds, the line between hedge funds and private equity is blurry. This reads as a classic private equity rollup, meaning consolidation play, where the aim is to for the whole to be greater than the sum of the parts by virtue of greater pricing power and/or improved operating efficiencies.

In the law business, major firms often have conflicts of interest. They disclose them and get waivers. The failure to do so here does not pass the smell test. I’m surprised that the experts focused on the involvement of alumni as a source of conflict of interest, since the role of current employees in an operation that is not fully separate, as with Bain Capital, looks sus. From the story:

The fact that former partners continue to have financial ties to an internal investment firm raises questions about potential conflicts of interest, experts say.

“I’ve never heard of that arrangement in a consultancy before,” says Dr Joe O’Mahoney, a reader at Cardiff Business School and former management consultant. “It ties in with the McKinsey philosophy, which is to use their alumni network as an asset. This is the financial aspect to that and it raises the question of conflicts of interest.”

But McKinsey is fortunate that this story did not come out earlier. There would have been pushback from some clients even as late as the 1990s. And as one comment on the story pointed out, Marvin Bower, who singlehandedly made McKinsey an elite organization and wtook ethics and propriety seriously, would be spinning in his grave. But with everyone on the top of the food chain out to maximize his personal take, this revelation is unlikely to elicit the tough questions from clients that it ought to.

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10 comments

  1. James Levy

    My guess is that in good times everyone gets a ladle of the cream, so nobody minds if a few are double-dipping. Like so much else in the system, the real problem is that under stress you have a multi-tiered exodus to the exits where the littlest doll in the center gets away first and everyone else will be left holding the bag. With all these tranches, tiers, and secrets, those at the center are bound to bolt to protect their wealth and leave all their clients to ruination. But again like so much else in our culture, the clients refuse to believe that anything bad can happen or that these conflicts of interest will come back to bite them on the arse (subprime redux). Yet another recipe for disaster.

  2. tegnost

    “Understanding the mindset of the Obama Administration early on would have been extremely valuable from a trading perspective.”
    Ain’t that the truth

  3. Ivy

    As a client participant in, and survivor of, various McKinsey engagements, I share your concerns. I would add that there is likely much more extra-curricular interaction with I-Banks as it is a pretty small world with overlapping alumni associations.

    Re Martin Bower: I wonder if McK still requires men to wear the over-the-calf socks. Our teams said that the organization was quite conservative socially, and the socks mandate was in part to to reinforce that image by preventing any flashing of shin or the embarrassment of lousy elastic. No word on anyone wearing garters.

    1. Paul Greenwood

      Having met Marvin Bower I know how he took the Chicago accounting professor’s consulting entity and fashioned it on Jones Day but I also know it tried to merge with DLJ and access the money vault long before Marvin died.

  4. MLS

    While other consulting firms may not have the insight and expertise that McKinsey has, I think it’s fair to wonder if their peers are engaged in something similar.

    There’s never just one cockroach.

  5. Paul Greenwood

    I do wonder just how much McKinsey spent dissociating itself from Enron fallout considering it was created by McKinsey merging HNG and InterNorth both of whom were McKinsey clients with HNG being the client of Jeff Skilling from the Houston Office. The conflicts of interest within McKinsey are huge and considering how its alums and strategy destroyed Swissair and how it practically lived within Citibank like a bacterial infection, it is very hard to imagine Chinese walls as anything other than capilliary membranes

    1. nothing but the truth

      the american dream now seems to be to be a govt crony and then lard it up by leaving service and becoming a goldman crony.

      goldman being used in a loose sense for wall st sinecures.

  6. Billy Costigan

    The funny thing which I think you hint at but fail to elucidate clearly, is that many times competitors *want* to share information — this is the very reason why consulting firms are hired as middleman. This is especially true in Oligipoly like markets where price collusion benefits all firms rather than competition.

    McKinsey, Bain etc. are hired by both firms. McKinsey does a bunch of research and “recommends” very similar pricing points, go-to-markets etc. to both companies.

    What has happened is in effect price collusion, but on the surface looks like two companies taking “independent” advice from the same consulting company which happens to give them the same recommendation. Why else would they pay big bucks to a bunch of suits?

    1. Yves Smith Post author

      I worked for McKinsey and it does not do that sort of work. Moreover, I have never heard of a case where firms hire both McKinsey and Bain at anything resembling the same time frame. Bain sends in very large teams and quasi manages the firm. It precludes having anything but a very narrow specialist or a firm on a very narrow spec doing the work. The exception would be a sprawling multinational in very different products or geographic markets. The high price tags of both firms also work against hiring both in a major capacity.

      Finally, firms that want competitive pricing data can get it much more cheaply from “channel checkers” like Gershon Lehrman.

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