private_equity_secrets_revealed.pdf

Private Equity Secrets RevealedFrom the Coalface - 2nd Edition

Table of Contents

Introduction 3

Private Equiteers: The Confidantes Behind the Cloak 4

Firm & Fund: The Architecture, Anatomy and Arrangement 22

Theories & Ideas: There’s More Than One Way To Skin a Cat 41

Structuring: The Key to Value Preservation in Private Equity 60

Banks & Debt: The Key to Value Creation in Private Equity 86

Analysis & Due Diligence: Sorting the Plums from the Lemons 95

Valuation: Making Sense of What to Pay 124

Entrepreneur: Donning an Important Hat 143

Dealmaking: The Art of Getting In 167

Anti-PE: Is It Really Magic or Just a Con? 187

Hope you enjoy the book....

Author: The Private Equiteer © 2011

1. Introduction

I worked in a small team, as most private equiteers do, investing many millions of

dollars into seemingly successful businesses. We worked directly for our investors;

not only as advisers or consultants, but as genuine investment partners. That

meant we had carte blanche to buy any business we saw fit, as long as it adhered to

our loose investment mandate and the owner was willing to sell.

Initially, I wrote a journal to articulate my understanding of private equity

concepts and to record my fledgling ideas. But as time passed, my journal entries

became a book-in-the-making, and that book became an act of valediction. I

figured, if I could add even a teaspoon of transparency to this clandestine industry,

I’d be doing the world a good service.

Private Equity Secrets Revealed doesn’t read much like a story, but rather a

chronicle of thoughts, observations, ideas, theories, formulas and critiques of the

private equity industry, its firms, and its people. I wrote down everything I thought

relevant as it happened day-to-day.

Though, if for some reason I could teach only one lesson, it would be that

conventional wisdom in private equity is about 90% convention and 10% wisdom. If

you can somehow ignore the convention and look at issues from their grass roots,

you’ll go far. And that’s essentially what I hope you’ll read from this book, a

breaking of convention and a form of private equity that adds real lasting value to

already great businesses.

One last note, as a collection of journal entries, you can read this book front-to-

back, back-to-front, or anywhere in between. If you find the beginning slow, skip

ahead to something that interests you. In general, the start is high-level, the middle

is technical and the end is more practical. Happy reading and investing.


What Is Private Equity?

The formal definition of private equity is vaguely: the ownership of equity securities in a

business not publicly traded.

As simple and concise as this definition is, it doesn't differentiate between passive

and active investors. This is an important distinction because the private equity

offering contains much more strategic value than the offering of most other private

investors. In this sense, a private equity investment more closely resembles an

investment made by a management team. The primary difference being that the

private equity professionals do not constitute staff and hence, they represent an

extension of management that isn't completely engrossed in the daily operations of

the business. This allows them some independence and a refreshingly different

view of the business from the outside world.

Therefore, my expanded definition of private equity is: the ownership by a value-add

investor of equity securities in a business not publicly traded.

2. Private Equiteers: The Confidantes Behind the Cloak

Do you have what it takes?

I just read a great quote by Jim Rogers, of Adventure Capitalist fame, and thought

you may find it somewhat motivating (or de-motivating, depending on your

situation).

“If you ask a thousand people if they want to be rich, every one except the poet

and the mystic will say yes. When you explain what is needed to become rich,

maybe 600 of that initial 998 will say, "No problem, I can do that." But when push

comes to shove, when they have to sacrifice everything else in their lives--having a

spouse and children, a social life, possibly a spiritual life, maybe every pleasure--to

meet their goal, almost all of them, too, will fall away. Only about six of the original

thousand will continue on the hard path.


Most of us don't have the discipline to stay focused on a single goal for five, ten, or

twenty years, giving up everything to bring it off, but that's what's necessary to

become an Olympic champion, a world-class surgeon, or a Kirov ballerina... Such

goals take complete dedication.”

While Rogers' goal may have been to become rich, and while many of us think

we're after more noble pursuits (though mostly we're just being righteous), it's

hard to deny Jim's truth.

A week in the life of a mid-market private equiteer

A mid-market private equiteer has more than one role. Actually, the typical mid-

market private equiteer has many roles and they differ considerably. What I find is

that although I'm theoretically working many roles each day, for weeks at a time

one particular role receives focus. Rather than just writing about one role though,

I'll list the myriad roles that I have to consider on a weekly basis:

• Fund raising: a fund is not a fund unless it has investors, so the first stage to

getting a fund off the ground is selling the merits of the fund to investors and

raising money.

• Deal origination: this involves finding potential investees and conducting the

initial analysis needed to know whether the deal is worth progressing.

• Due diligence: when a deal progresses beyond the early origination stages, much

more in-depth analysis in conducted to confirm the investment hypotheses.

• Transaction structuring: as a deal becomes more likely, it is important to

collaborate with the business owners to understand the best structure to facilitate

the purchase or investment.

• Settlement: as a deal settles, a lot of work is required to sign documents,

implement contracts, transfer assets, advertise the deal, and most importantly,

execute the day-1 strategy.


• Investee management: at this point, you implement the quick-win strategies and

show the management team what level of effort you expect. After the first six

months, involvement may taper if all is going well, but there will still be bursts of

effort required. These bursts may relate to new acquisitions, poor performance,

new strategies, or anything until the investment is exited.

• Debt management: in deals with debt, a surprisingly large amount of time is

spent dealing with banks. This is especially true of the initial application and

covenant reporting.

• Exit: the exit process is often quite different to the purchase process because it is

a time when you welcome investment bankers into your firm with open arms.

You may first contact potential trade buyers directly, but either way, you want to

focus on securing the best sale price.

• Investor management: the investors in the fund need loving too. After all, you’re

having fun with their money. You should keep in touch with them regularly to

spread the love, but you may also have to deal with them if any capital call

defaults arise.

• Regulation: the dirty part of private equity is dealing with tax, accounting, legals,

etc. related to the fund, the firm and the stakeholders. However, it's essential...

and essentially boring.

The most diverse role within this list would have to be investee management. This

is because you must help with any number of roles within the investee.

For example, human resources, accounts, strategy, operations, insurance,

marketing, computing, management, etc. If you've ever wondered why some mid-

market private equity firms are full of people with non-finance backgrounds, it's

because investees benefit greatly from having access to a wide set of skills in the

private equity firm.


Working for a mega-fund vs. mid-market fund

A reader recently asked me to contrast the human elements of working for a larger

fund versus a smaller fund. The reader specifically asked about differences in

learning curves, compensation, quality of life and hierarchy. It's a great question

because larger funds mean larger deals and larger deals mean a completely

different set of competitors, vendors, deal sources and processes.

Learning Curve

We're not dealing with rocket science here, so the learning curve isn't particularly

steep for private equity; once you're through the door (i.e. you get hired), it

becomes more about your resourcefulness.

For larger funds, the focus is firmly on becoming a confident and polished

dealmaker; this means developing great communication skills and fitting in with

the culture at the big end of town (sounds easier than it is).

For smaller funds, the focus is on becoming an amiable dealmaker and an

articulate consultant; this means personally connecting with business owners

(often “moms and dads”) and learning how to deliver pragmatic advice with

confidence (which can be a challenge for some people).

The other difference relates to structuring; larger deals are more likely to use

complicated instruments, whereas smaller deals often stick to preference equity

and senior debt; but, none of this is too difficult if you apply yourself.

Compensation

Make no mistake, in a large firm you will earn multiples of what your smaller firm

counterparts make, and the gap only increases from the day you start.

Smaller firms will attempt to bridge the gap by offering carry (albeit, a small %),

but don't become blinkered by this; it takes a long time for your carry to fully vest

(10 years+) and there's a lot of fine print that will mean you get much less than

your initial calculations.


With that said, carry is the holy grail for private equiteers, but you need a

relatively large fund to make it meaningful (or great performance, but don't count

on that); of course there are many other variables, but you know what they say

about a bird in the hand (base salary)...

Quality of Life

Private equity isn't investment banking, we work pretty reasonable hours. If

anything, smaller firms will work you a little harder as they often have fewer

people working on more deals.

Irrespective of firm size, before accepting a position at a PE firm, make sure it

doesn't have a PowerPoint culture; this can indicate they work 80+ hours a week

pumping out decks, which as we know, is what most investment bankers do.

You can do the sums to work out the management fee income to work out if they're

running on fumes or flush with cash; there's a lot to be said for frugality, but it can

be downright dispiriting having to pay for your own gas to drive out to investees

(trust me, it happens, especially in single-owner firms).

Above all, you need to be inspired by the people you work with and you need to

feel that you're a part of something big; great teams will make 90-hour weeks

enjoyable, and uninspiring teams will make 35-hour weeks painful.

Hierarchy

You operate much more autonomously at smaller firms and get experience across a

wide range of domains; this is implicit in having fewer people and working on

smaller deals.

At larger firms, you're more likely to have a set of duties that complement the

overall team. If you pick the right mid-market firm, you can grow very quickly,

simply by having complete autonomy to close deals, manage investees and effect

exits; you'll never enter a mega-sized fund as a junior with this level of autonomy.

With that said, you'll quickly feel under-compensated if you're closing all the deals

as a junior and being paid a janitor's salary; you need a different mindset regarding

compensation and duties going into larger vs. smaller firms.Author: The Private Equiteer © 2011

Conclusion

Clearly my experience with mega vs. mid-market firms is limited to a sample that's

nowhere near the entire population of private equity firms. So I'd be interested to

hear thoughts, disagreements, questions, etc.

The human side of private equity teams and dealmaking

Dealmaking may seem to be all financial figures and legal terms, but ask any

experienced dealmaker what the most common cause of failure is and they'll

generally point to people issues. Admittedly, many of these are vendor versus

investor issues, but behind the opaque cloak of private equity, you'll also find many

failures attributed to intra-team issues.

I've found three common intra-team issues that can lead to deal failure:

• Deal Envy - it's not so much the envy that damages the deal, but the actions that

result. Excessive negativity (as a result of envy) can wear down even the most

enthusiastic private equiteer. So, it helps to give your team buy-in as early as

possible: share the idea, ask others to become involved, and try to lead with an

open mind. As soon as you appear evangelical, your team will likely position

themselves to shut you down.

• Deal Disputes - the best way around disputes is to prevent them in the first place.

Ensure your arguments are fact-based and keep an open mind. If you appear to

have made your mind up without sufficient evidence, your team will likely

position themselves to prove you wrong. Also, try not to implicate your team or

their actions in your reasoning. People are naturally defensive. So, try not to put

them in that position in the first place.

• Deal Fatigue - even a deal evangelist suffers from deal fatigue if a deal subsists

long enough. But, deal critics suffer from fatigue much sooner, so it's important to

keep a deal moving if you plan to garner support from the team. Make sure you

respond and gather supporting evidence quickly and meet with your team

regularly and consistently. A quick deal has many other benefits, but mostly it

reduces fatigue.


In summary, there are a few measures you should always take to prevent the above

issues: facilitate buy-in to reduce envy, keep an open mind to prevent disputes and

maintain momentum to close the deal before fatigue sets in. Of course, the

investment has to have merit in the first place, but if you keep one eye on intra-

team issues, at least your deals won't fail for a lack of leadership and skill.

The recipe for success for mid-market private equiteers

The role of a mid-market private equiteer is divided into, 1) Origination, 2)

Analysis, 3) Dealmaking, and 4) Consulting. In simpler terms, 1) you find

investees, 2) analyse them, 3) close deals with them, and 4) improve them. (Of

course, you then need to exit your investments, but I classify that as dealmaking.)

All of this is done to achieve target returns for investors, but more importantly, so

you can take lots of carry home.

To find the recipe for success, we just need to deconstruct each of these roles and

understand what is most important to achieve good outcomes.

Origination

This refers to finding leads that may turn into investments. You can sit back and

wait for bankers to bring you deals, or you can use your resourcefulness to go in

search of good deals. Both work, and both have their ups and downs, so it's best to

keep your nets spread wide and options open.

The main problem we face in proactive deal origination is just getting a few

minutes of a business owner's undivided attention. The recipe for success is to be

amiable and tenacious. That is, be genuinely friendly to everyone (including

receptionists) and try to contact business owners over and over again (not

necessarily the same ones; just keep active). I guarantee, if you are nicer and more

genuine than your colleagues, and you make MANY more calls than them, you'll

trounce your colleagues in terms of lead volume and quality.


Analysis

This refers to appraising a business before making an investment, plus the analysis

required to help improve the investment later. The main problem is boiling the

ocean. What I mean is, spending too much time building pretty (useless) financial

models. The recipe for success is to ask yourself what matters most and just focus

on testing a handful of related hypotheses. Are earnings maintainable and real? Do

earnings translate well to cash flow? Are there any anomalies regarding Capex or

working capital? Are exit opportunities plentiful? Etc. It shouldn't take more than

an hour with the information already at hand.

Keep in mind, great financial models don't make great investments; great

businesses make great investments. And great businesses aren't found using

financial models; they are found by getting away from the computer and

developing your entrepreneurial intuition.

Dealmaking

This refers to turning a lead into an investment. The main problem is losing a deal

due to a gap between your offer and the vendor's expectations. The recipe for

success, well, it really depends on the situation. Your offer doesn't just include a

monetary value. It may include prestige, future returns, profitable ideas, strategic

synergies, and even friendships. If you deconstruct this, you'll realize that a vendor

is influenced by all of these 'soft' offerings, and they may choose a lower price as a

result, but monetary value is always a trump card. Depending which way the wind

is blowing, a vendor can suddenly forget the connection you made and go for the

highest price; that's human irrationality.

But I don't want to sit on the fence with this one. If I had to say there was one

thing that constitutes a 'recipe for success' in dealmaking, I'd say it's transparency.

People are blown away when you're amiable and transparent, especially when

they've been dealing with 'bankers' all day.


Consulting

This refers to giving advice to help improve it your investee. I call this consulting

because that's what it is. You're not employed by the business, you're only on the

board (or not even that in some cases). And the board is there in an advisory

capacity. The main problem is actually making a difference. Too often, private

equiteers mess with the mojo of their investees by trying to implement textbook

McKinsey concepts in a world they've never operated in. The recipe for success is

to acknowledge your relative inexperience in the investee's industry and listen to

what people say (and talk to them). Then, deconstruct the investee's issues by

focusing on what matters most to desired outcomes. It's that easy.

Above all, work with your investees, roll your sleeves up and get your hands dirty.

Become one of them, earn their respect and be diplomatic with ideas; form ideas

together and implement them together. Don't be the private equiteer that drives up

in his/her Porsche and walks around with some superiority chip. You don't effect

change unless you connect.

How to discuss deals within a private equity team

From what I've seen, there are two ways that private equity teams can discuss,

debate, contemplate and decide on deals:

• All-in discussion

• The defensive lead

The all-in method involves everyone contributing to the pros and cons, strengths

and weaknesses, opportunities and threats, of the potential investee. It gives

everyone a bit of buy-in, which is great, but it also abdicates anyone of sole

responsibility, which can be bad.

The defensive lead method involves one person taking the lead on a deal and

becoming its champion. He/she must understand the intricate details of the

business and defend it as other team members barrage him/her with its perceived

shortcomings.


Certain people swear by the defensive lead method because it unleashes emotion

and creates a deeper understanding of the business.

My preference is certainly the all-in method. I find it to be the most respectful, the

most constructive and the most enjoyable. I find that the defensive lead method

creates unnecessary rivalry and tension. The discussions largely become divisive as

they focus solely on negatives. As the name suggests, the team perceives the lead

person as being defensive and the lead person perceives the team as being

argumentative and adversarial.

I'd be interested to know what others think, especially since the defensive lead

method is most prominent in the private equity industry. It's probably a hand-me-

down from the competitive world of investment banking and/or strategic

consulting. I like that we don't work their long hours, and I'd like to think we have

the intelligence not to waste energy on unnecessary internal competition.

Toning it down for the team

If you must live with vendors in the future (as part owners), then it's wise to think

of your future relationship when negotiating. (Even if you don't live with them,

you should still be decent, but that's not nearly as convincing.)

So, with that in mind, I want to comment on negotiations, but in the context of

your internal private equity team. There are a few points to consider here:

• Team members are acutely aware of your negotiation tactics (and most tactics in

general), so when you try to use them internally, it leads to instant contempt

• Your negotiation style becomes a part of you when you're dealing with potential

investees all day, so it's not always easy to turn it off when dealing with your

team

• You are married to your team (you aren't selling them a set of encyclopedias and

then leaving); so, even though you may have superior negotiation skills, your

team will be there tomorrow to resent you if you treat them unfairly


• Your team talks; there are cliques you can't even see; don't treat anyone in a way

you wouldn't want everyone else to know about

• In deals and in life, you often benefit much more from not getting your way

Too often we focus on the tangible and don't acknowledge the potential value in

maintaining good relations. Just food for thought for now.

Show me the carry... or at least most of it

In another post, I talk about the fee structure of the typical private equity fund and

in particular the 20% outperformance fee (also known as carried interest or carry).

Well, people are drawn to working for private equity firms because of the carry,

don't let anyone tell you otherwise. However, it's not as simple as just receiving

20% of cash outperformance; often, people who may not even work for the firm

have a financial interest in the carry. This can come as a disturbing realization for

fledgling private equiteers, so I thought I'd explain it here.

The following list outlines the people and/or companies that often have a stake in

the carry:

• The private equity team, which includes the founders, directors, associates and

analysts (sometimes)

• Previous founders, who aren't active in the firm anymore, but who struck profit

sharing agreements

• Previous team members, who keep the stake of carry that they accrued while

employed (sometimes)

• Overarching parents (banks, etc), which may have a stake in the carry if the fund

is captive

• Early investors, which may have a stake for helping to establish the fund from a

funding perspective

• Legacy parents, which may be entitled to a stake as the result of the fund being

spun out of them


As you can see, the 20% carry can dwindle away quite quickly, depending on

circumstances. Captive funds usually have it the hardest because they're investing

from the parent's balance sheet and have no choice but to satiate their every desire.

In it for more than the carry

Private equiteers live for the carry (carried interest). We get overly qualified at

college, we leave our own profitable ventures, we accept meagre salaries, we work

our glutes off trying to close deals... all for the carry. Some equiteers (admittedly

lower in the hierarchy), do it for the potential of carry (that is, they're not yet

signed up to carry, but one day hope to be).

However, it's important to look at carry with a clear mind, one not too blinkered

by riches. Moreover, in writing this post, I'm hoping that some of you aspiring

private equiteers will enter the industry with carry at the bottom of the priority list.

If you can do this, then you'll be able to self-motivate even if your fund explodes

and theres no carry to go around.

Let's look at a very simple example. Your firm runs a $100m fund with a 20% carry

entitlement. There are four founding executives and eight investment executives.

It's likely that, let's say, 25% of the carry is taken up by anchor investors, parent

companies, previous founders/partners, etc. (Yes, when you leave a fund, often you

are still entitled to accumulated carry on that fund.)

The founders will take a large part of the remaining 75%, a very large part, and

may leave the other eight executives with say 20%. As a newer member of the

investment team, your entitlement is lower, so let's say 1.5%. However, you don't

earn that 1.5% upon joining the team; it will likely be broken up so you earn 0.15%

per year for 10 years.


Now let's say your fund has a 2% management fee. But, management fees are

usually based on committed capital, which reduces as money is distributed back to

investors. So, let's say $15m in fees. That's about $85m invested. If your team

manages to double the investment (which isn't unreasonable in the right

environment), total carry will be $17m. In your first year that you earn 0.15%, that

equals about $25k of carry.

If all goes well and you stay with the fund for 10 years, your total carry will be

$250k. For simplicity, if you get that in five equal repayments in the last five years

of the fund and you use a discount rate of 15%, the PV of your carry is only about

$50k. To be a little less conservative, add the nominal amount of $25k to your

current salary of say $100k (this is PE remember), and your annual earnings,

including carry, are $125k. This is a fairly typical scenario.

So, I'm not trying to dissuade new private equiteers, but rather put carry into

context. My advice is that you make sure you're in private equity for the right

reasons: you like to do deals, deal with business owners, research different

industries, etc. The money will follow if you have the passion for those things, but

you'll be sorely disappointed if you're only entering for the carry. It still takes

10-15 years to run your own fund and make the real money, especially in mid-

market.

Or, with the right background (started and sold a successful business, Ivy League

MBA with summa or magna, etc), you may get a foothold into a large fund and

become entitled to a smaller piece of a much bigger apple pie.

Show me the carry, part II

I received a couple of emails in reference to the last post, “In it for more than the

carry.” Some commented that a $100m fund is a micro fund. Some commented that

they received a bigger percentage of carry in their first few years. And, some

suggested there's nothing wrong with entering private equity with carry at front of

mind.


Those comments are dually agreed and noted. However, when discussing the

average scenario, you have to draw a line somewhere and stick to it. Upon

reflection, I'd say the average fund that many of us are managing is in the range of

$50-500m. While a $1b fund is not necessarily mega, I do think it is a large fund.

Maybe I should have used $200m instead in my example (100 is always such a rice

round number to work with).

On the topic of percentage of carry, many first year private equiteers don't even

get carry. And, you'll really be surprised to see how much carry is transferred

outside of the investment team and/or to the founders. The founders of a fund are

just as diligent with negotiating carry as they are with negotiating investee deals;

don't for a minute think they'll become generous just for your sake.

As for the last point, maybe I was being a little disingenuous with claiming that

real private equiteers should make carry their last priority; it's simply not likely or

reasonable. I guess the message I was looking to convey was carry could actually

end up being a lot less in real terms than fledgling private equiteers expect. They

often dream of numbers and conveniently exclude management fees, external

entitlements and founder avarice. So, I guess the real message is to love the job and

the money will follow.

Human behavior and its affect on private equity

Contrary to what some industry elitists may think, private equity doesn't transcend

the greater finance industry. It is exposed to the same biases, the same aversions,

the same subjectiveness, and the same contradictions. It's foremost a sales game,

but also a game of control and discipline. And with that in mind, I'd like to discuss

a range of human behaviors rarely talked about in the industry. I believe they have

a profound effect on performance and differentiation in the private equity industry.


• Emotional Bias: when emotions related to a potential outcome prematurely affect

the decision, emotional bias is said to exist. In private equity, the emotions of

closing a deal create a bias towards making the deal a success. I spoke indirectly

about this in my recent post, “the superficiality of most due diligence”. In my

opinion, this is the single biggest threat to the objective appraisal of a potential

deal; we tend to want to close deals more than anything.

• Loss Aversion: this occurs because it is human tendency to rank avoiding a loss

higher than receiving a gain. Ask yourself how you would feel if you lost 20% on

your stock portfolio versus missing the a 20% return on an investment. In private

equity, we think it's fine to miss great opportunities, yet sinful to invest poorly.

This has become dogma in the industry because it appears a more conservative

and agreeable argument.

• Congruence Bias: private equiteers love to talk about hypothesis testing, almost

as if everyone else just shoots from the hip. The problem is, most private

equiteers only test hypotheses directly and only reject hypotheses in extreme

cases. For example, a typical hypothesis is “the company's customer base is

sufficiently fragmented?" The subjectivity alone creates bias, but so too does the

use of direct testing (testing the positive case rather than the alternative case).

One solution is to test the alternative case and have to prove "customer base

concentration".

• Framing Bias: framing is about using past experience and other external

information to give something context. Framing makes daily decisions more

efficient; if you consider every decision with a clean slate, you'll go crazy.

However, conventional framing threatens objectivity in private equity.

Conventional framing shows what people want to believe, rather than what's

true. It's important to learn to reframe important information to understand it in

its entirety. For example, if a founder wants to sell a business, it doesn't

automatically mean its bad, he may just want to sail the world or climb Everest.


• Information Bias: when we talk about the competitive advantage of our firms, we

talk about superior information. When we negotiate deals with founders, we talk

about asymmetric information. When we're pressed on an issue, we say we don't

have enough information. We just love information. However, as great as

information may be, it needs to be the right information. Information bias is

about seeking information that has less influence on the target decision. This

occurs in private equity because more information is viewed as better analysis.

But we lose site of the big picture; we get caught up in the process; we often fail

to sit back and ask what the most important information could be.

I'll leave it at those for now, which I think are the most salient cognitive biases that

affect the industry. My suggestion to combating these biases is to acknowledge

them, make them known, discuss them, and try to work around them with your

team. Pull each other up every time they seem to creep back, not in an adversarial

manner, but in a constructive and amiable manner.

Private equiteers and bankers; VCs and entrepreneurs

How do all of these professions/careers/livelihoods fit together? A quick definition

of each is as follows:

• Private equiteers: active financial investors in established businesses that use

gearing to amplify their returns and off-market strategies to grow their portfolio

businesses (typically using M&A)

• Venture capitalists: active financial investors in earlier-stage (growing) businesses

that use their contacts, prestige and experience to help businesses commercialize

and monetize their concepts

• Bankers: deal originators and organizers; often the middlemen between PE deals

and other M&A activity; mostly in the public arena, though some deals involve

private companies exclusively

• Entrepreneurs: the people with the imagination and the risk appetite to pursue

ideas through to concept, then pursue their concept through to commercialization

and profit; the real heros in all of this


I believe there is a closer connection between a) bankers and private equiteers, and

b) venture capitalists and entrepreneurs. I say this because private equiteers spend

a lot of time sourcing deals, just like bankers. Whereas, venture capitalists spend a

lot of time short-listing deals (in which entrepreneurs have approached them) and

are therefore much more concerned with the business concept (rather than sale of

capital).

So what's the implication of this? Well, it potentially explains what the ideal skills

are for PE and VC firms. I'm not saying the best private equiteers are bankers, just

that their skills are more suited to the role of a private equiteer compared to a

venture capitalist. For venture capitalists, I believe it's more important to have

people with real entrepreneurial experience, not only to evaluate deals, but to help

commercialize concepts.

String learning curves together; quit your job every 6-12 months

You join a new firm and immediately think, “Wow, these people are freakin’

geniuses”. And it seems that way because you’ve just entered a different world, a

world in which you’re a newborn. You observe these people, what they do, how

they think, and you accept it all as your new religion. You use the same lingo,

adopt the same mannerisms and start to think the way they think.


Then four, five or six months later, it all slows down. Now, you’re essentially one of

them and they don't seem like geniuses anymore. In edu-speak, you’ve hit a

learning plateau. You’ve learnt 80% of what there is to learn (at that particular

firm) and you’ve realized these geniuses are just like everyone else; they only

seemed like geniuses because they knew something unique at the time.

With sports, music, and other discrete skills, smashing through the learning

plateau separates the hobbyists from the champions. But entrepreneurship isn’t a

discrete skill; its a collection of many discrete skills. And from my observations,

entrepreneurs are rarely specialists; they become masters of many domains, even if

originally they specialized in one. So, what does this mean?

The significance is as follows: The effort to move from 80% to 85% competence for

a particular skill, could reasonably get you from 0% to 80% in a new skill. So,

especially for an entrepreneur, it can be much more fruitful to string learning

curves together (compared to smashing through a plateau). This would suggest

you'd learn much more by joining new companies every 6 to 12 months, unless

your environment (at the same firm) is constantly changing.


This wont be a particularly popular view, but technically I think it has merit. Sure

the process of becoming an expert is educational in itself, but that last 20% of

competency is so easily lost once you change focus (and it requires so much more

effort), that for future entrepreneurship, it rarely paves the road to success.

3. Firm & Fund: The Architecture, Anatomy and Arrangement

Structure of a private equity fund

From a legal perspective, a private equity fund can look like a complicated beast

(see left). However, the structure of a private equity fund is quite easy to

understand once properly explained. Additional complexity can arise from

country-specific legislation, but all funds tend to have a similar premise; that is, to

provide a vehicle whereby a private equity manager can facilitate investment into

investees.

A few objectives lead to the structure being what it is. One major objective is to

provide a flow-through entity for taxation purposes. This is to circumvent double-

taxation, which leads to investors being taxed at the company level and the

personal level if not handled correctly. Another major objective is to qualify for

capital gain taxing on carried interest. In the U.S., this is at a maximum of 15%.


Industry parlance often includes references to limited partners (the investors) and

the general partner (the manager). The limited partners are simply the investors

who provide money to take stakes in the investees (portfolio businesses). The

general partner is the firm (and its staff), which manages the limited partnership

(the investment vehicle) and facilitates investments into the investees. The legal

theory is that the limited partners have limited liability, whereas the general

partner does not.

Different stages of venture capital and private equity funding

Private equiteers typically believe that venture capitalists invest in loss-making

businesses with a view to extraordinary growth (risky). Whereas venture

capitalists typically believe that private equiteers invest in traditional businesses

(boring) with a view to value creation through means other than revenue growth

(over-gearing). In practice though, there can be an overlap between the two.

With that in mind, I thought it would be helpful to explain some of the venture

capital lexicon and the different stages in venture capital investing.

• Pre-seed stage: this is the stage of idea inception. Capital is used to create the

legal business structure, research the market, register patents and initiate

prototyping. Providers of this capital are usually friends, families and fools (the

"3Fs"), or sometimes angel investors.

• Seed stage: this involves the commercialization of products and services. Typical

uses of funds include bolstering the management team and moving from

prototype to production. Investors at this stage are usually angel investors and

incubators.

• First stage: this stage is about establishing real revenue, opposed to revenue from

trials and grants. From a corporate perspective, the business should be fully

operational and able to scale to meet demand. This is where true venture

capitalists enter a business and look to fund subsequent stages as part of a

syndicate.


• Second stage: at this stage, revenue is about to take off. Capital is required to

increase production, fund large marketing campaigns and enter new markets.

Later stage venture capital specialists may invest at this point, or the original

early stage firm will consider a second round of funding.

• Third stage: the business is highly profitable now. Funding for working capital,

increasing plant size, product diversification, more marketing, quality

improvement and further revisions is required. For a high growth business, later

stage venture capitalists will dominate funding. For lower growth and more

traditional businesses, private equity firms will enter the fray.

• Pre-IPO stage: funding at this stage is called mezzanine or bridge finance. It

cleans up the share register, pays down debt, prepares the company for IPO and

ensures top quality management are at the helm. There are specialist funds that

will come in at this stage, but private equity funds will also make an appearance.

Often convertible debt will fund this round as the business will have the income

to support the coupon payments.

The 4 life stages of a private equity fund

The lifespan of a typical private equity fund is ten years, but that ten years

generally doesn't start until the team raises substantial capital and it doesn't end

until all assets are sold. So, the lifespan of a private equity fund may stretch to as

long as 15 years. Below, I discuss each of the stages that attribute to the real

lifespan of a private equity fund.

It's also important to note that these stages overlap and that funds even overlap. As

you raise a new fund, you may be managing and exiting investments from a

previous fund. And, while you may hire new private equiteers to manage the new

fund, invariably there's a labor overlap and old funds create a hindrance.


• Raising capital and building the team (1 to 2+ years) - it can be very difficult to

source capital, which is why most funds don't even get off the ground in the first

place. Private equiteers may spend upwards of two years creating hype and

luring investors until they reach their funding target. If and when the final

funding round closes, the managing company must then build the team to invest

in and manage the portfolio businesses. This is a defining moment because the

lifespan of a private equity fund is longer than many marriages and hence, the

fund's success firmly relies on the people chosen at this point (and specifically

their resourcefulness, aptitude and ability to get along with others).

• Sourcing deals (2 to 5+ years) - most mid-market firms source deals themselves,

though they may entertain bankers and advisers on the odd occasion. This stage

requires a dedicated team willing to sell themselves to C-level executives while

broaching the concept of private equity. It can be tough, it can be dispiriting, but

we're private equiteers, so it's part and parcel. A motivated team can invest an

entire fund in a couple of years, while slower funds may take 5+ years.

• Managing and improving the portfolio (3 to 7 years per investee) - once a team

makes an investment, it needs to work quickly to create a record of exceptional

performance. A team can't just wait until before an exit to make a difference

because potential buyers look at medium-term historic performance when

conducting their valuations. This can be a stressful time in difficult economic

conditions or a blissful times during strong economic growth.


• Exiting the investments (varied time frames) - an exit can occur 6 months after

your investment if the right strategic buyers and economic conditions present.

However, an exit may drag out for 7+ years if the investment underperforms, the

economy teeters, and buyers don't present. The longer an investment remains in a

portfolio, the higher the required exit price to meet target IRRs. If investments

remain at the end of the official ten year term of the fund, there are a range of

options: a) the investment may be sold to a secondary fund, b) the fund may be

extended for anything from 1 to 3+ years, or c) the fund can hold a fire sale. The

best exits are with many potential buyers and when you're not forced to sell, so

private equiteers certainly don't want to hold fire sales. And, since the team likely

raised another fund, extending this fund will only hinder the new fund.

Keeping in mind that the average fund has a real life of 12+ years, most private

equiteers will likely have left the firm before seeing a whole fund through. Food for

thought, especially when calculating your likely carry.

The subtle hierarchy of the private equity structure

Private equity firms have quite flat management structures, especially at the mid-

market level where everyone is responsible for deal origination, negotiations, due

diligence, transacting, monitoring and exiting. But, even with this flat structure,

there is a subtle hierarchy that tenure (and success with deal origination) drives.

Often senior employees in a private equity firm focus on securing limited partner

investments and dealing with high-profile opportunities. The junior employees

engross themselves in financial models, make cold calls to potential investees, and

deal with the dreaded intermediaries. In aggregate though, great deals and great

returns form the basis of incentives.

Without further adieu, the hierarchy of staff from senior to junior is as follows:

• Founding Director

• Managing Director

• Director


• Associate Director

• Associate

• Investment Manager

• Investment Analyst

Although this hierarchy may vary across regions, titles usually correlate quite

closely to this structure. Employees often enter firms from the bottom up after

completing an MBA or other relevant post-graduate study.

There's no way that's private equity

Have you ever asked yourself what qualifies and what doesn't qualify as private

equity? I certainly haven't been ordained to make a claim either way, and it's not

as if it really matters what you label an investment, but let's try to make a

distinction for the same reason Hillary climbed Everest... because we can.

By way of its namesake, private equity should be "private" and involve "equity".

But, what does that mean? The word "private" could refer to the source of capital,

the ownership of the investment or the publishing of financial reports. If you put

the words "private" and "equity" together, then you'd imagine that the "private"

refers to equity from private sources. However, that would rule out listed private

equity (LPE) as genuine private equity, which I don't agree with.

I've previously said that I prefer to think of private equity as a methodology rather

than a class of capital. So, this makes me think of the "private" in private equity as

referring to privately held investees (or very soon to be private, in the case of

Public-to-Private buyouts). Of course, this rules out PIPES (Private Investments

into Public EquitieS), but I'm okay with that because PIPES don't adhere to my

idea of the private equity methodology.


But, private equity is more than just an investment into a private company; we're

still left with the word "equity". Well, I'm a big believer in private equity being

about investments as equity or any instrument with unlimited upside potential.

Sure, some funds invest through mezzanine debt and preferred stock with

liquidation caps, but for me, real private equity has full access to the upside. That's

not to say I think firms shouldn't have any other exposure, just that most of it

should be via real equity with real upside.

Just to summarize, I believe genuine private equity refers to equity investments

into private companies. However, that's still too broad; any old investment fund or

wealthy individual could fit into that definition. To wrap up my definition of

private equity, the investor has to be active in the business and add strategic value

to the business; they must be professional investors and business people. They

must act as directors, managers, staff, investors, stakeholders, and value creators.

For me, this is the essence of private equity.

As for what I think doesn't qualify as private equity; any minority investment into

a public company, any investment as a passive investor, or any investment that

doesn't give the investor enough influence to make a difference. I certainly don't

buy the idea that you're only private equity if you're registered with your local PE

or VC association; if anything, it's more nobel to be an active, long-term, private

portfolio investor without the penchant to be called "private equity" (think Buffett

and Branson, before they listed).

Types of investors in a private equity fund

Someone recently asked me what type of investors we have in our fund; that is, are

they mostly pension funds, institutions, individuals, etc. Although I had a vague

idea, it sparked the idea for this post. So, I went through our investor register,

talked to a few other GPs and LPs, and came up with the following list of potential

investors in a private equity fund:

• Company pension funds: a fund managed by a company to fund pension

payments for its employees.


• Government pension funds: a fund managed by the government and invested in

by various employees.

• Sovereign wealth funds: state-based funds that invest a nation's surplus for long-

term growth.

• Endowment funds & similar: used to support an organization with its financial

growth & income.

• High-net-worth individuals: people with a high personal net wealth.

• Insurance companies: much of their profit is derived from investing the float.

• Investment banks: non-traditional banks that look to outperform through higher

risk activities.

• Non-financial companies: any other business looking to invest a surplus for a

moderate return.

Fund raising is all about contacts, marketing and reputation. The investor

constituency will reflect the areas of capital raising strength in the team. Some

funds benefit from friends at large institutions, some are supported by religious

contacts, some are even just anchored by one major wealthy individual.

The 2/20 rule for private equity funds

The 2/20 rule simply refers to a 2% management fee and a 20% outperformance

fee. That is, investors typically pay 2% of committed capital to the management

company to manage the fund and 20% of returned funds above the initial capital as

an incentive to the fund managers.

I mentioned committed capital, because in most private equity funds, investors

commit capital rather than invest capital. Their capital is called as required by new

investments. So in practice, a firm may not invest a single dollar for two years, but

based on committed capital of say $1b, $20m a year is paid as management fees to

sift through opportunities. This is one of the many beauties of the private equity

model (for private equity firms at least).


I once heard a prominent partner of a large New York private equity firm say,

"There are three certainties in life: death, taxes and a 20% carry." Of course the

monetary value of the carry isn't a certainty, but what he was inferring is that the

private equity industry will stick by its 20% carry rule irrespective of what anyone

else thinks because it is their livelihood.

As for the 2% management fee, it keeps the fund running; it pays the staff, the

lease on the office, the electricity bills, and those infamous lunches that introduce

new investees to the big time. Since the fee is fixed, employees are rarely paid

bonuses in the private equity space; the 20% carry is their incentive. Additionally,

distributed funds from exited investments aren't included when calculating the

management fee (even that would be too audacious for a private equity firm); only

invested or uncalled capital attracts fees.

The 2/20 rule sounds mundane enough, but it really is the lifeblood of the industry.

Some of the best strategic thinkers go to private equity because of the combination

of small teams, large funds and the 20% carry. Equally, the 2% management fee is

vital to facilitate great deals, mainly because the carry is contingent on many

variables and often not paid for five or so years into a fund (until exits occur).

Carried Interest 2.0

Private Equity Online published an amusing piece suggesting an adjustment to the

age-old 20% carried interest formula. I had to double check my calendar to see

whether it was posted on April Fools' Day, but alas, it was the day after.

The preamble pointed out that most GPs strongly believe they're top-quartile

performers and that their funds will deliver 3x or 4x cash returns. It goes on to

suggest they can't all be top-quartile funds and that a 3x return is very rare, hence

unlikely.

The article then suggested we, as an industry, change the performance fee equation

to,

• 30% carry if the GP achieves above 2x cash, but only a 10% carry for below 2x


This idea plays to the outward confidence of GPs while securing better terms for

LPs. It's a novel suggestion, but unfortunately for LPs, it would never fly. You see,

the LPs are the gamblers in this relationship, not the GPs.

GPs are champions of ratchets, earn-outs, stock options and vendor financing;

they're masters of reducing risk first and maximizing return second. That's their

business and they're unlikely to change course at the behest of the LPs who agreed

to the 2/20 terms in the first place. It would go against the grain of the private

equity methodology to take on a likely risk for an unlikely return.

With that said, it would sure make for interesting conversation at a GP investor

meeting. I think the culture of the LP industry instils fear of confrontation with

GPs, when in reality, what do LPs have to fear? A little LP activism would

probably do them some good.

Carried interest, the Buffett way

An interesting tidbit: when Buffett started his Buffett and Associated, Ltd.

Partnership in the late 50s, he quoted his limited partners a 25% carry (although,

I'm sure he didn’t use the term “carry”). By the time the partnership began

investing though, it became a 50% carry above a 4% hurdle and a negative 25%

carry on the downside.

This meant if the partnership made a 20% return, Buffett would keep 50% of the

16% over 4%, which would be 8% of the overall return. However, Buffett didn't

take this payment; he reinvested it back into the partnership to compound upon

itself. If the partnership made 4% for the year, there would be no performance fee.

The surprising bit is if the fund lost 10%, Buffett would personally cover 25% of

the loss below the 4% hurdle. So in this example, he'd pay back 25% of 14%, or

approximately 3.5%.


This downside protection for the partners (or as I referred to earlier, a negative

carry) was unlimited until all capital was lost. Can you imagine a private equity

firm today structuring a fund like that? Buffett's response to this risk was that he

knew he wouldn't lose money over the long term. Somehow, I suspect he

wholeheartedly believed this and didn't just spout it for the sake of fundraising.

Another interesting fact about his partnership is that while he convinced his

friends and family to part with almost $100k, he only contributed $100 to the fund.

A private equity fund would rarely get off the ground with this lack of skin in the

game, but after all, he probably had more than enough skin in the game by

guaranteeing 25% of the downside.

As an aside, understanding the ventures that Buffett thought up and supported, I

would say he's more of a private equiteer than maybe even he would like to admit.

Private equity 101: the J-Curve

Private equity is an illiquid, medium-term investment for a number of reasons.

Firstly, it takes time to turnaround, grow and develop businesses. Secondly, this

process, by its very nature, requires cash up front and then delivers cash much

later in the game; income along the way is just cream.


The term "J-Curve" is the net cumulative cash position of a private equity

investment over the life of the fund. That is, net cash flows are negative in the

formative years and become highly positive in later years, and the net cumulative

position looks like the letter "J" on a chart.

The J-Curve effect intensifies because funds are much more likely to write assets

down than write them up. This is more to do with accounting standards than

conservatism. In most instances, the lower of cost or market value is used in

valuations. On the other hand, an asset's value is rarely written up unless there is a

cash inflow event. This means that unrealized gains could be accruing, but until the

investment is exited, they won't be declared or reported.

Bred in captivity... and looking to escape

Tereza Tykvov penned a paper, almost two years ago, entitled "How Do

Investment Patterns of Independent and Captive Private Equity Funds Differ?

Evidence from Germany". It presents and discusses empirical evidence of

performance differentiation between independent and captive funds. A captive

fund, according to Alt Assets, is:

• A private equity firm that is tied to a larger organization, typically a bank,

insurance company or corporate.

There's been a long-standing debate about the viability, attractiveness,

performance and conflicts of captive funds. In theory, they're setup like traditional

private equity funds, but in practice, they lack the je ne sais quoi that gives private

equity its mystique and appeal. It's a similar argument to whether listed private

equity defeats its purpose (and circumvents the value-add) of traditional private

equity.


Anyway, Tykvov postulated and confirmed that independent funds perform better.

In the broad strokes, his thesis is that the peculiarities of captive funds directly

suppress performance. That is, the principal-agent problem is more at work than in

a traditional fund. I've written previously about the principal-agent problem and

specifically that private equity goes a long way to circumvent the problem. Well,

captive funds go some way to undo the circumvention of the principal-agent

problem because often the edicts from a captive fund's parent (often a bank)

conflict with the value-add of private equity. Here's a list of captive fund

characteristics (as usual though, the list isn't exhaustive):

• Capital flow: when a fund invests directly from the balance sheet of a large

corporate, it doesn't have all of the issues associated with raising a new fund. This

is particularly attractive to private equity teams when capital is tight, like right

now. Most of the time though, the parent will still require some external fund

raising to complement its committed investment.

• Deal flow: if the parent is a bank, accounting firm, advisory firm, etc., then the

team has access to deals from within the greater group. This can mean thousands

of warm leads into businesses deemed fit by other departments within the greater

group. At times, I would give my left arm for access to potential investees like

that.

• Carry: I've written previously about how private equity teams are precious about

their carry and how various external parties can have a stake in the carry. Well,

it's not unusual for parents to take 5-10% of out-performance, meaning 25-50%

of the total carry. Is that worth the additional capital and deal flow? Maybe in

times like this, but it still tests the relationship. For the parent, this portion of the

carry determines whether the private equity business group is profitable, so it is

basically the fund's life-line. Don't deliver profits and you'll have the board

barking down the phone and analysts questioning your existence.


• Reporting: if there's anything that goes against private equity, it is reporting on a

regular short-term basis (often quarterly) to a manager, a board, or even worse,

the public. Exposure to quarterly reporting conflicts directly with the theory of

private equity; that is, building great global companies over a medium term.

Public markets, public investors and the J-curve definitely don't mix.

• Deal competition: this is a pro and a con; personally I see it as a pro. If your

parent is a bank or advisory firm, then other banks and advisories won't bring

you deals, unless they're of inferior quality. If I had to choose between having

access to an intra-company database of thousands of potential investees and

getting regular calls from pesky investment bankers, I wouldn't exactly be torn.

• Interference: private equity teams love autonomy and flexibility; nothing's going

to kill the vibe more than a corporate dictator trying to flex his/her bureaucratic

muscle. Captive funds often have to deal with an executive from the parent on

their investment committee who can't help but toe the company line. This can be

a constant distraction. Other edicts from the top may include exiting investments

at certain times to satisfy analysts and to bolster quarterly reports.

• People: private equity is as much an art as a science and the art is based on

people and culture. The private equity culture is the engine of the private equity

machine; the flexibility, autonomy, creativity, diversity, energy and opacity make

private equity what it is. You add some bad voodoo into the mix (read:

bureaucratic BS) and all of a sudden you've upset the equilibrium. I see this as

the biggest problem with captive funds.

Truth is, I don't think captive funds can compete with independent funds. The

empirical work supports this thesis, the industry trends support this thesis (captive

fund numbers are on a downward spiral) and the anecdotes support this thesis.


Capital calls: who's really in control?

Bottom line: institutions have over-committed to private equity funds and now the

chickens are coming home to roost. Staying with the chicken theme, it seems all of

those celebrations for closing those billion dollar funds were somewhat chicken

before the egg. Okay, no more chicken cliches, but it is a little worrying for private

equity firms, mine included.

The implication of this is not as serious as the media are making out, at least not for

recent vintage funds and not as long as the defaults are limited to a small portion of

committed capital. In practice, it would mean calling extra cash from other

investors and maybe scaling down the fund and reducing future investments. It

doesn't look good making subsequent calls due to defaulting investors, but it's

certainly not the end of the world. What really concerns teams is what they're

always concerned about... the carry. I've written about the 2/20 rule and the

significance of carry before.

More worrying than all of this though, are reports that limited partners are

wearing the pants and demanding that general partners don't make capital calls

until otherwise advised. According to the “Carried Interest” blog, some limited

partners are threatening not to invest in future funds if calls are made without their

approval. This is going to be a real saving face battle as private equity firms and

listed partners fight for power. Unfortunately, for private equity funds, it's a

buyers' market and listed partners, more than ever, already have the power.

Due diligence for LPs

GPs often forget that without LPs, they wouldn't have a fund to manage. No fund

means no carry, and no carry means, well, let's not even go there. But it's a tough

job for an LP to pick which GPs are most likely to succeed. Unlike public markets,

LPs have access to limited information, which most of the time is manufactured to

present the best case anyway.

So how does an LP conduct due diligence on a GP to make their investment

decision?


• Past performance: in public markets you often hear the disclaimer, "past

performance is no indication of future performance." If you watched the men's

snowboarding at the Winter Olympics, you'd probably disagree. Actually, if you

look at most things in life, you'd have to disagree. If a PE firm consistently

outperforms through thick and thin, that's a very good bet. But, people and times

change, so it's important to look at other factors too.

• Team dynamics: I can't overstate how important team dynamics are in a fund.

You need the team committed, engaged and motivated to do its best work. But

more importantly, you want them to care about the success of the fund. LPs

wrongly think that giving GPs equity will make them care. We're not that

rational. People care about whatever the heck they want to care about. Visit the

team, talk to a sample of people, and ask questions that will gauge their emotional

commitment. If GPs aren't excited and engaged, there's probably an underlying

problem that you won't be able to uncover in the time allotted.

• Leadership: any group of people can do amazing work if they're inspired by a

great leader. The group doesn't need to be intelligent by IQ standards, or have

contacts within the industry, or even have a history of performance, as long as

they're inspired. An LPs questioning should test whether the employees think

they work for the best people in the industry. Any indication otherwise is a bad

sign. Apart from the fact people will jump ship, it shows something

fundamentally wrong with leadership at the firm.

You may be wondering why I've concentrated on the "soft" aspects of a firm. Why

haven't I talked about education, qualifications, seats on boards of public

companies, industry lobbying, etc? It's for one simple reason. An uninspired and

unmotivated team is dead wood, no matter how qualified they are.

I've seen it time and time again, qualified people who are absolutely useless

because they aren't engaged. But I've also seen engaged novices originate leads,

close deals and make a difference, without an ounce of finance experience. That's

why I think it's important for LPs to focus on team dynamics, leadership and care

factor.


Of course, I'm not an LP, so I wouldn't know what works best, but that's my take

nonetheless.

Firm-wide financial controllers

My experience is that most investees suffer from a lack of financial discipline. And,

with almost every investment my firm has made, we've had to somehow improve

the financial expertise in each investee. The most obvious in-house alternative to

hiring a new financial controller is to monitor the financials and make regular

process improvements ourselves (as private equiteers). But, this can quickly

become burdensome as the portfolio grows.

A midway solution is to hire a financial controller at the private equity fund level to

oversee and improve financial management across the entire portfolio. The

advantages of this are manifold:

• A single overseer of financial performance can provide the private equity team

with consistent data across all investees (same template, same metrics, same

formulas, same processes, same assumptions, etc.).

• It is much cheaper; hiring a great (opposed to good) financial controller for each

and every investee is very expensive at the mid-market level.

• In many cases, you're spared firing a good financial manager (in exchange for a

great one), who likely has years of experience in the business and is therefore a

wealth of investee-specific knowledge.

• It frees up the investment team from having to deal with minor financial

compliance issues.

The largest disadvantage of hiring a firm-wide financial controller is that if you

hire a dud, they could potentially create issues across your entire portfolio. Other

than that, it's a good idea for firms looking to have more time for strategic value-

add. You can even charge the controller's salary to each of the investees, rather

than have him/her erode your management fees. Win, win.


Sure, let's get married, we've known each other at least 60 minutes

Hiring new staff has always puzzled me. You spend an hour, maybe two, maybe

even three to get to know each other. Then you say "I do", lift the veil, consummate

the relationship (with a handshake in most cases) and that's that. Signed, sealed

and delivered.

But, imagine... just imagine you told your mother (or your best friend) that you

were about to marry someone after knowing them for only a couple of hours. And,

imagine telling them that you didn't just meet this person randomly. You prepped

them on exactly what you were looking for and were truly surprised when they

said things that made you happy.

I hear you. Yes, there's a big difference between employment and marriage. Sure,

you see your husband/wife at least three hours a day, while you see your employees

only between 10 and 12 hours a day. Agreed; big difference.

So, I'm thinking, all of the wisdom you hear about getting to know someone before

marriage should also apply to employment. Moving in with them, enduring their

habits, arguing with them, making up with them (hey, hey)... all of the stuff that is

prattled on about by older learned folk. Of course by this I mean you should trial

them.

Now, I don't mean put them on probation, so if they do something drastic like

defraud you you'll fire them. I mean put them on a fixed contract for a month with

the intent that they'll only be hired temporarily. Naturally, you'll mention the

potential to land a full-time gig, but you'll also explain the uncertainty. Don't even

give them a title; call them a consultant or executive or something equally vague.

During this period, you can work them into the ground, enjoy a cold ale with them,

put them in front of intimidating clients, have at least one heated argument with

them and if you're lucky, you'll be able to tell if they really have what it takes to

work in your esteemed organization. Sure they can put on an act for a month, but

that's much harder than for 60 minutes.


Is venture capital a form of private equity and vice versa?

A recent reader asked, why do I keep differentiating between private equity and

venture capital, especially if venture capital is just a form of private equity. Well, in

the strict sense, venture capital is private and it is often structured as equity, ergo,

venture capital is private equity. (With that same definition, a $100 investment into

a friend's lemonade stall may also qualify as private equity.)

However, when I refer to private equity, I'm referring to a business model of

investment. A few characteristics of this strategy include the following:

• The business is privately owned, not traded on a public stock exchange

• The investor is active in the strategy and management of the business

• The investor is a professional investor employing a pool of funds over a portfolio

of businesses

• The investment is mostly structured as equity, which gives the investor upside

exposure

• The investment is in an established business with existing customers and positive

maintainable cash flow

This definition differentiates private equity from family investments at points 2, 3

and 5. It also differentiates against venture capital at point 5. The implication of

this point 5 is that while venture capital is often linked to research,

commercialization and monetization, private equity is more closely linked to

expansion, succession, buyouts and recaps.

More simply, to me, VC is about building a business, whereas PE is about

expanding a business. The difference may sound subtle, but it completely changes

the model in terms of risk versus reward.


4. Theories & Ideas: There’s More Than One Way To Skin a Cat

The anatomy of an attractive industry in all economic conditions

Let's get a few things straight to begin with. Firstly, the characteristics of an

attractive industry are the same regardless of economic conditions; that is,

prospective industries should always present opportunity and not represent

excessive risk. (Oxymoron you may say, but it doesn't have to be.) Secondly, an

attractive industry today isn't necessarily an attractive industry tomorrow;

fundamentals fora particular industry can change quite quickly. Lastly, an

attractive industry for you should also be an attractive industry for me. Some firms

may specialize, but I'm talking in general terms here.

Here is a list of characteristics that make an industry attractive for private equity

investment:

• Large market: the theory here is that the market needs to be large enough to

support the type of business you are hoping to own at the end of your investment

period without miracles occurring (such as abnormally large market share).

• Low reliance on uncontrollable variables: private equity is about backing a great

management team and helping to drive a great business to abnormally high value

creation. Uncontrollable variables such as the weather, commodity prices,

burgeoning technologies, etc., unnecessarily detract from management's ability to

create value.

• Moderate competitor fragmentation: low fragmentation may lead to fewer

potential investees and a low chance of entering the industry. It may also be

harder to invoke a roll-up strategy or take market share if there are fewer poor

managers. However, if fragmentation is too high, it may be difficult to find a

decent sized player and it may be difficult to gain traction through an acquisition

strategy.


• Low customer and supplier power: if either suppliers or customers have excessive

power, than the pricing of products or services may not be adjustable. The ideal

industry is at the most valuable point in its value chain; that is, the industry adds

the value and the suppliers and customers are simply commodity traders or

middlemen. Therefore, they have control of prices, profits and value.

• Attractive exit options: without a range of exit options, it is difficult to play

potential buyers against each other and therefore secure the best price. There

should always be an honest expectation to be able to list a firm because there's no

rule about a particular industry being un-listable; public markets will always be

interested in a great business with sustainable and reliable cash flows. Similarly,

there should be many potential trade buyers; again, if it's a great business, others

will want it.

What to look for in potential investees in this economic climate?

Especially in the current market, it pays to be discerning with potential investees.

The current under-performance of many funds has been attributed to over-gearing,

high purchase multiples and poor fundamentals, so we don't want to become

caught in the same trap when it's clearly a better time to be buying. The following

list outlines a few characteristics of potential investees that I believe are important

to look out for:

• Potential market size: depending on the size of the fund and the size of the

potential investee, the market for that investee needs to be a certain size to

mitigate a range of risks. A larger market means you need less of a share to

achieve target returns. It also means that competitors have less of an influence

when they get aggressive. For a lower-mid-market fund, I look for markets with a

current size of at least $0.5-$1b and with growth rates that are at least positive

(not as common in our current economic climate).


• Customer/Supplier Fragmentation: the last thing you want in this market (when

it's already tough to grow) is to invest in a business with high customer

concentration. If a major customer is lost, you could lose a significant part of your

business. All of those great strategic plans you had to grow the business will now

only bring the business back to its former glory. The same goes with the supply

side, although there's often less of an impact (unless you are licensing someone

else's brand).

• Counter-cyclical offering: most of the highly defensive industries make for bad

investments. They either don't have the growth prospects or are too risky. I'm

thinking agricultural commodities, certain financial services, natural resources,

etc. But, you can benefit from counter-cyclicality in other industries too by

finding sub-industries that businesses visit in tougher economic conditions due to

cost savings. There's no point going into something like motor yachts with the

expectation that next year's sales will grow upon last year's sales; common sense

in this area will go a long way in saving face (and no, I don't buy that old money

argument).

• Invested management team: we're seeing many business owners looking to sell

out completely while telling us that their businesses would make great

investments even in a downturn. One would think that a mass exodus would

indicate something quite different to a great opportunity. So, beware of business

owners jumping ship, especially if they're not on their deathbeds and are

sufficiently able to continue their businesses. They know more about their

business than you do, so take notice of their behavior. Also, don't let earn-outs

that seem to lock management in fool you; they've often done their numbers and

have accounted for the risk of losing the earn-out.

• Low gearing: a seemingly low risk business with high gearing can become high

risk and virtually non-existent if revenue softens or a refinancing event strikes. A

lowly geared business gives you room, should you need it, if things turn sour. We

are seeing businesses file for insolvency every day due to gearing, so it should

serve as a powerful warning to private equity investors looking to buy in this

market. Again, common sense and looking at deals objectively will save face.


There are many other characteristics to look for in potential investees, but these

are the most prescient for the current economic climate. I say, forget about being a

contrarian investor when you can just use some common sense; look for

fundamentally good businesses, purchase them at reasonable prices, and use

private equity value creation principles to exceed target returns. Why make it more

complicated than it needs to be?

Borrrrrrrrrrring... but we love boring in private equity

Over at the Union Square Ventures blog, Fred Wilson discusses the failure rates

expected in venture capital. He suggests a third of all deals are hit out of the park,

a third are mediocre, and the last third fail (although his own firm's empirical data

suggests more of a 40/40/20 split). He also suggests that the overall cash return on

such a portfolio may be 3-4x, which is pretty good if you can get it.

Private equity is quite different; we expect all deals to do well. Not out-of-the-

park, but well enough to hit target returns (at least 20% IRR or 2x cash). Private

equiteers generally believe this low-risk moderate-return approach is more

successful than the high-risk high-return approach favored by venture capitalists.

Now, although this difference in investment strategy may seem subtle, it actually

means private equity and venture capital are miles apart in execution. Without

decent growth, venture capital is toast. However, even with very low-growth,

private equity can still bear fruit. How? Leverage, deal structure and multiple-

arbitrage.

One of the major implications, especially in mid-market private equity, is that we

don't mind skipping over high-growth businesses. We know there's less

competition for lower-growth businesses and that less competition means lower

purchase multiples. And, with an eye firmly on moderate target returns with very

low-risk, we know paying a lower multiple is a great risk mitigator.


We also know that stable revenues are more conducive to leverage, and leverage

amplifies our returns. While leverage also amplifies our risk, we know particular

deal structures can transfer some of that risk to other investors in exchange for a

taper on our returns above a specified target. This is okay for us, because

remember, we are more concerned about mitigating risks than overshooting our

target by orders of magnitude.

So, as you can see, lower-growth (aka boring) businesses can actually serve our

cause more effectively. You may see larger private equity funds going crazy with

mid-20s purchase multiples in public markets, but down here at the mid-market

level, we have choice. We can invest in the most boring businesses you've ever

seen, conservatively apply debt, structure the deal well, simplify and organize

management, exit when the time is right at a higher multiple, and achieve our

objectives, even without significant increases in revenue. In private equity, we love

boring.

A problem with the 'we love boring businesses' argument

Boring businesses are great for private equiteers because they attract less attention,

ergo less competition during sale, ergo lower earnings multiples. I wrote about this

in a post titled “Borrrrrrrrrrring... but we love boring in private equity”. However,

there's a problem with boring businesses.

A private equiteer's boring business is also an employee's boring business. And

about the only time employees want to work for a boring business is when they

need the money. But, this doesn't nullify the boring business theory, it just poses

considerations.

Anything to do with employees must be considered in a different light. Firstly, in a

business where passion isn't obvious (i.e. boring), you can't expect people to work

80-hour weeks for 40-hour salaries. Secondly, you shouldn't assume anywhere

near as much loyalty. A glue packer will go elsewhere for a 20% pay increase,

whereas an F1-race car engineer may stay even after a 50% pay cut. Lastly, you'll

be limited in terms of the talent pool; a regional GM of Apple won't accept a CEO

role at a glue factory for a 70% pay cut, but they may do so for an internet startup.Author: The Private Equiteer © 2011

However, all is not lost. Focusing on productivity, efficiency and working with

what's available has been a godsend to many a boring business. Oftentimes, you

don't need the big-name CEOs or loads of employee innovation. Sometimes, you

just need a well-oiled machine that supports quick and easy bolt-on acquisitions.

The principal-agent problem... and private equity

According to Wikipedia, the principal-agent problem is as follows:

“the principal-agent problem ... [addresses]the difficulties that arise under

conditions of incomplete and asymmetric information when a principal hires an

agent.”

One of the most encountered real-life examples of the principal-agent problem is

the misalignment of interests within public companies. The primary interest of

shareholders is to realize a favorable return, whereas the primary interest of the

management team isn't necessarily the same. Arguably, their interests should be

the same, but managers may be more interested in working shorter hours, building

a bigger (but not necessarily more profitable) business, or making high-profile (yet

incompatible) acquisitions. This misalignment of interests is the principal-agent

problem.


Public companies have a multitude of strategies to surmount the principal-agent

problem. For example, issuing performance options to the management team

creates more of an alignment with shareholders. However, the other interests still

exist and the shareholders are still limited in their influence over the management

of the company. Shareholders may be able to vote out CEOs and other executives

by majority vote at general meetings, but this is a far cry from the granular

influence that investors would benefit most from.

Logically, private equity represents a real solution to the principal-agent problem

(albeit, still not a perfect solution). Firstly, the principal (private equity firm) has

much more influence over the agent (management team) to the point where they

are an agent. For example, if a private equity firm wants updated debt covenant

data from an investee, they can generally expect a response within the day. Try to

request this from a public company, and in six months' time, you may have a

vague, ambiguous and sugar-coated announcement that doesn't nearly include

enough information. The reduction of information asymmetry is the key to private

equity firms experiencing less of the principal-agent problem.


So what's my point? To most, the principal-agent problem is a distant and clouded

memory from B-school. But, surprisingly, it underpins the entire private equity

value proposition for investors.

Adhocracy: the antithesis of today's corporate strategy

Over time, there have been many distinct management ideas that have shaped the

thinking of corporations and their incumbent management. Corporate strategy, as

one of these ideas, has existed for almost 50 years and formed the basis of many

subsequent ideas. But, has the idea of corporate strategy become something other

than what was originally intended? Have strategic consultants over-bureaucratized

business with their own overly regimented version of corporate strategy? Are

companies even benefiting from all of this centralized instruction?

The father of strategic Management, Igor Anhoff, said that strategy is a "rule for

making decisions". Michael Porter told an American business school that strategy

"has to do with what will make you unique". However, Richard Koch, Mr 80/20,

believes that despite these clear and concise definitions, corporate strategy has

done more harm than good because "the Centre" typically enforces it. That is,

people without real-world experience and by people detached from the coalface

usually run it.

In light of my experience with what I see as new-age corporate strategy, I am

feeling a pull towards the management idea of adhocracy, especially for small,

medium and fast-growing enterprises. While some define adhocracy as the

opposite of bureaucracy, I like to think it's a more responsive structure

underpinned by decentralized strategy. It puts strategy in the hands of business

units, which arguably, best understand what works and what doesn't work. More

importantly, what it doesn't do is put strategy in the hands of external consultants,

fresh out of business school, without a minute's worth of coalface experience.


Unlike what critics may espouse, adhocracy doesn't have to be unfocussed. It

doesn't have to mean the engineering unit only strives to be bleeding edge, that the

marketing unit only works to build the biggest brand, or that the finance unit only

tries to cut costs. An adhocracy should always work towards the greater good

(which is usually market positioning, customer satisfaction and all of those staid

ideas), but mostly by recognizing the benefits of decentralized thinking. Anyway,

after the nonsense I've seen lately (mostly coming from strategic consultants), I

really think adhocracy is worth a second thought.

The four horsemen of the private equity apocalypse

We've all heard the aphorism, “a private equity investment is like a marriage”.

And, it's even more true once you realize the dependence that private equiteers and

managers have on one another. The success of an investment firmly rests on the

shoulders of senior management (they operate the business after all), while senior

managers are often at the mercy of the various legal controls that private equiteers

have over the business (they provided much of the capital).

It is with this thought that I'm relating John Gottman's marital communication

research to private equity. It may sound like an opportunistic and somewhat

tenuous connection, but I've come to realize how heavily private equity success

depends on human factors. What's more, people are irrational; poor relations could

see parties working against each other even if it means working against themselves.

And in private equity, the last scenario we want is managers working against the

interests of the business.

Gottman has suggested four communication styles that predict the destruction of a

relationship (he refers to them as the Four Horsemen of Marital Apocalypse).

• Defensiveness - the destruction starts with defensiveness; it shows a loss of

respect for your wisdom. Symptoms may include investee managers disregarding

your advice, arguing excessively, changing opinions to counter yours, or simply

using excuses to answer general enquiries. A heart-to-heart, face-to-face, honest

and open discussion is all that may be needed to steer the relationship back on

course.Author: The Private Equiteer © 2011

• Criticism - this is about making nonconstructive critical remarks about others. In

private equity, this starts with managers attacking the credibility, integrity,

usefulness, etc. of their private equity investors. You should see this as a positive,

because it means you've caught issues early enough to resolve them. Don't

become too defensive; see it as a sign that you're not managing your relationships

properly. The key is to be open and friendly and show some humility.

• Contempt - this is a visceral feeling of distaste or disdain. And unfortunately, it's

difficult to turn back from a truly contemptuous relationship. Once the sight of

you makes your manager's skin crawl, it's usually too late. Signs of contempt

include lack of contact, cold communications and a general feeling that the

manager wants nothing to do with you. It is resolvable, but it involves taking

large risks and breaking through the cold amour of the contemptuous manager.

• Stonewalling - according to Gottman, stonewalling is the most dangerous stage of

all. It reflects complete apathy, detachment and separation. It's the point where

the manager has already made plans to remove themselves from the situation

(even if years away) and now feels an odd contentment that better times are on

the horizon. Private equiteers can mistakenly view stonewalling as resolved

contempt because the manager seems happier, but this is rarely the case. A

potential resolution (from the perspective of the firm) is to bring another partner

into the investee and cut all ties. Hopefully, the slate will be wiped clean and the

new partner will create a fresh new relationship.

The purpose of talking about these factors is to keep them in mind when making

critical decisions that affect investees. Remember there's much more to success

than numbers and contracts; the introduction of a small fee has the potential to

change the dynamic of your investee relationship forever and ultimately lead to

investment failure. Identifying the four horsemen and having the humility to admit

fault is critical to avoiding irreversible damage between your firm and investees.

We people are complex and it's worth keeping aware of human factors to ensure

investment success.


Appearances are only skin deep in life and private equity

We come into this world as children, bestowed with raw innocence and besotted

with toys, confectionery and attention. But, before we grow into adults and face

life's major decisions, we develop an odd yearning to matter and to be noticed.

And, as we slowly lose that raw innocence and develop this yearning, we develop

our cunning and calculation (which we invariably use to satiate our desire to

matter or be important).

Now, this concept of being noticed isn't always an overtly moral concept; people

engross themselves in rather obscure pursuits such as dancing, stamp collecting,

palm reading, etc. However, even with so many channels to become noticed, the

reality is that many of us will never really matter outside of our circle of family and

friends. We'll never make a dent in global poverty and we'll probably just add to

the raft of existing global challenges and conundrums.

But, there's another way. Why waste our efforts on making a difference (especially

one that will help others), when we can just create the appearance that we matter?

Why bother with impoverished people when we can spend hours a day at the gym

to look like we mean business? Or why bother with environmental conservation

when we can get a boob job to become more desirable? Or why even build robust

businesses that create jobs and support innovation when we can simply spend

thousands of dollars on our attire to create the allusion that we've made a

difference?

Wow, this post sounds really righteous and holier than thou, but that's not my

intention. If anything, I'm just asking myself, “am I trying to make a difference or

trying to appear like I'm making a difference”. Is making a difference even that

noble? Who knows. But what I do know is that in private equity, investment

horizons are long enough to separate those that actually matter and those that just

appear to matter. (And in life, well, I guess that's up to you.)


Mistakes of ambition vs. mistakes of sloth

Quote: “All courses of action are risky, so prudence is not in avoiding danger (it's

impossible), but calculating risk and acting decisively. Make mistakes of ambition

and not mistakes of sloth. Develop the strength to do bold things, not the strength

to suffer”. Niccol Machiavelli

Private equity is a juggling act of many roles, most of which rely on explicit risk

calculation. And as with any juggling act, mistakes are inevitable. But that's okay

because we learn from mistakes and we probably learn more from mistakes than

successes. However, there's a catch.

If I touch a hot plate and burn my hand, I learn that it's hot and that I shouldn't

touch it again. If I touch it again, then the mistake is reinforced. But if I continue

to touch the hot plate, I'm not learning a whole lot more, I'm just getting burned.

We make mistakes of sloth (laziness) every day. We know laziness, contemplation

and apathy are all toxic to progress. So, just like touching a hot plate over and over

again, being slothful loses it's punch pretty quickly. We may get some other benefit

from being slothful (such as relaxation), but an education isn't one of them.

On the other hand, mistakes of ambition are generally different day-to-day. We

tend to learn something profound from each and every ambitious pursuit, even if

it's not immediately obvious.

In the context of private equity, you'll learn nothing from NOT contacting a

potential investee. But at a minimum, you'll fine-tune your get-around-the-

gatekeeper skills if you do call. And more than likely, you'll have a valuable chat

with an industry professional, which may even lead to a successful investment. The

same goes for investee improvement; you'll learn much more from conducting

analysis and making suggestions, compared to doing nothing.

If things aren't going as you planned, is it due to mistakes of ambition or sloth?


Do we need a Magna Carta for the private equity industry?

The earlier English Kings operated their kingdoms mostly untethered. Pre-13th

century, if a king acted against the greater good or in an unethical manner, the

response was more of an "oops" than a judicial hearing. But, as King John of

England increasingly abused his power, the barons challenged him and the Magna

Carta was written.

While there may be more regulation around private equity in the 21st century,

consensus is that they act in a similar invincible manner. Sometimes when they

effect their power, companies collapse, people become unemployed, the banking

system suffers, and the final result is chaos and catastrophe. With this in mind, do

we need a form of Magna Carta for the private equity industry?

Well, with risk comes reward and without risk, companies and people resign

themselves to mediocrity. With risk also comes failure, but it's a failure that's a

byproduct of reaching for the sky. Particularly with venture capital, we wouldn't

see the innovation and advancement that we do if it wasn't for people willing to

take abnormally high risks. This is just a fact of life, but at times when there is

more bad news than good, the scruples of private equity firms come into question.

However, many private and public businesses are collapsing without private equity

influence.

This argument could easily go ‘round in circles indefinitely, but I believe private

equity is just another form of risk capital that inherently has risks (sounds like a

tautology, but it's often forgotten). We should expect failures, but we shouldn't

bring the whole asset class into question as a result of a few. If anything, we need

to learn from these failures and continue to support private equity by creating

lasting value for shareholders, employees, the community and global economies. So

in answer to the headline question: No, I don't believe private equity needs its own

Magna Carta. Well, not yet.


Corporate governance the natural way

What the heck is a Corporate Governance Framework (CGF) anyway? It even

has its own acronym for Pete's sake. According to this acronym, not only does a

corporation need governance, but that governance needs a framework. And, not

only does corporate governance need a framework, but it needs interminable

discussion about what constitutes this framework. Wow, I have a headache

already.

What happened to working towards a greater good and being a part of something

innovative and rewarding? What happened to only acting in a way that you would

be proud to see published and proud to tell your mother? What happened to just

being a decent person who gives, shares and empathizes with others?

Corporate governance somewhat ties into the idea of the principal-agent problem

because it is associated with executives that don't act in the interests of the people

(whether those people are shareholders, members of society or the man on the

moon). I realize it's a necessary evil, mostly for large listed businesses (that have

lost the plot), but what concerns me is talk of a CGF in SMFEs (the F is for fast

growing). If you refer to my previous posts, you'll see I'm a fan of keeping it

simple, especially in times of turmoil. So, my nonconstructive advice regarding

CGFs is to get a grip, be brutal with anyone wavering from the greater good, and

get on with the business of building a great company and spend a lot less time

managing managers.

Correlation vs causation: industry analysis

In one of my previous posts, “apparently everything is counter-cyclical now”, I

talked about approaching potential investees and hearing that almost all of their

businesses were counter-cyclical. Of course I was skeptical, and of course, the

chickens have come home to roost now.

Implicit in this theme is the concept of correlation vs. causation. That is, the

difference between:

• two correlated variables, and Author: The Private Equiteer © 2011

• one variable causing another variable.

Some business owners would see a drop in economic growth and then an increase

in their sales and assume their business was counter-cyclical. This is a simple

correlation test. But thinking along the lines of causation, maybe a drop in GDP

doesn't lead to an increase in motor yacht sales or beach homes. Maybe the

correlation was simply the result of a lag or government deficit spending.

So today's hint (to self and others) is to consider causation rather than correlation.

Moreover, don't be bedazzled by statisticians with regression models claiming

causation. Use some common sense and don't be too afraid of relying on impartial

anecdotal evidence. You may have learned to live and die by facts in B-school, but

we all know the importance of gut feel.

Is listed private equity an oxymoron?

Listed Private Equity (LPE) refers to private equity funds (and sometimes

management companies) traded on public stock exchanges. Like any listed

business, capital for an LPE is first raised through an initial public offer (IPO) and

then shares are traded on an exchange. Since private equity contains the word

private and the equity underpinning an LPE fund is public, at first glance, the term

LPE appears to be an oxymoron.

But, if you consider the term private equity to represent an investment

methodology, rather than the source of the equity, LPE doesn't seem like such an

oxymoron after all. For example, do you think that a wealthy individual investing

$100k into the local boulangerie is “private equity”? The source of the equity is

certainly private, but most of us understand private equity to be something else, a

methodology perhaps. With that said, if the real value of private equity isn't the

source of funds, what difference does it make where the funds come from?


Maybe the more common argument against LPE relates to public reporting. The

idea being that public reporting creates a short-term view and a short-term view is

not always conducive to long-term value creation. That's a valid argument, but

valuation standards for traditional firms (such as the more recent FASB 157) also

impose short-term reporting requirements. The difference is that traditional firms

don't have to report to the public, but is this such a big deal? I think the answer

depends on regulation of LPEs and how managers of LPEs react to public

pressure. If the LPE has equity exposure to its investments and plays an active

management role based on a medium-term outlook, then no, I don't think Listed

Private Equity is an oxymoron.

Should we treat firms that sign up to the UNPRI as suspicious?

What would your first thought be if I told you I signed up to Alcoholics

Anonymous? You would probably think, "Wow, I didn't know you had a drinking

problem." Now, what if I told you I signed up to the UN Principles for

Responsible Investment? That's right, you'd think I have a problem with being a

responsible investor.

Of course I support good people doing good things, but I just can't compute the

UNPRI. There are no concrete rules, there's no stewardship, there's no recourse,

nothing. If we boil it down, it's a vague guide that suggests I shouldn't use child

labour, or slave labour, or ruin the environment, etc.

Here's a thought, Why do I need someone to tell me not to use slaves? Should I

pinch myself; am I really in 2010? Do I need someone to tell me not to be a

monster? Obviously the signatories think so.


I'm not questioning the efforts of the UNPRI team; I'll assume they have good

intentions. What is suspicious, are firms that need to tell the world they aren't

morally corrupt. (And you know what they say about people that harp on about

their own integrity.) If you ask any one of them, they'll say they're supporting the

cause and doing it for the children or whomever, but you and I both know they're

doing it to display a UNPRI logo on their website and, in the process, condemn

others as irresponsible.

It's truly disgusting in the context of these issues. If they really want to make a

difference, they'll donate a % of their carry to these causes (Ha, best joke of the

year). My suggestion: do a little more due diligence on PE firms that are

signatories to the UNPRI.

This won't be a popular view, but it's my view. And it goes for similar treaties or

protocols; stop signing pieces of paper and start acting responsibly on a global

scale.

A new benchmark for the risk-free rate

With all the chaos surrounding bank deposit guarantees, I had a thought. At

school, most of us learnt to use government securities to determine the risk-free

rate for use in models that discounted cash flows. Sure, governments are hardly

risk-free (I'm thinking Russia, Argentina, Iceland, et al), but the theory is that

they're about as close to risk-free as you can get. That is, if the government's in

trouble, then we're all in trouble.

Well, now with government guarantees on bank deposits, we effectively have a

new risk-free rate. That is, if governments are backing bank deposits, then bank

deposits are consequently as safe as government securities. I don't know what this

means for the world outside of academia, but it's an interesting consideration for

anyone who’s discounting cash flows.


The counter argument is, in most countries at least, bank guarantees are limited to

a certain amount (e.g. $100,000). You would think this would apply on a per

person basis, but most reports seem to suggest this is on a per account basis. So, by

creating multiple accounts can circumvent limits. In some countries though,

governments have placed a blanket guarantee across all bank deposits, which

negates the need for multiple accounts. Either way, I stand by the idea of a new

risk-free rate in any country where these guarantees exist. Because personal

deposit rates tend to be significantly higher than government bond rates.

Look, the private equiteer has no clothes

I trust you know the story, The Emperor's New Clothes.

In short, swindlers promised the Emperor the finest suit from the finest cloth. The

cloth was so exquisite it was apparently invisible to those unfit for office or

unpardonably stupid. Not wanting to be categorized as such, the Emperor agreed

the suit was exquisite and accepted it. As the Emperor paraded his new suit, the

townsfolk commended him on his fine choice of loom.

Of course, there was no suit (it was invisible because it didn't exist) and it took a

small child to express this observation before everyone else caught on. The

Emperor ended up short a few pesos for the privilege of running around town

naked and the townsfolk were shown to be so impressionable that they couldn't

distinguish a clothed Emperor from a naked one.

There are plenty of messages in this tale that apply to private equity (and most

other industries). For me, it emphasizes the importance of having a voice, thinking

independently and being unabashed in expressing an opinion.


At the moment, if deals are looking a little naked (high multiples, poor

fundamentals, underperforming industries, high risk, high valuation, etc),

differentiate yourself by opposing the townsfolk (other general partners) and

calling out said nakedness. Make it known you're an independent thinker whom

has learnt from recent events and is sensitive to current conditions. It's the perfect

time to be genuine in exposing your independent thinking; not so much for self-

promotion, but for self-preservation and the preservation of your fund.

The nomadic private equiteer: it's possible in theory

I just finished watching an interview on Mixergy (my new favorite website/blog)

with Kareem Mayan as guest. The interview discussed the viability of digital

nomadism. Without repeating too much, proponents suggest you can reduce your

burn rate, learn more from customers, and generally increase your business

awareness, by going global. Not global in the sense of creating a website, but

global in the sense of physically traveling from city to city, spending 2 to 3 months

in each, while working and/or running a business.

Okay, it's a pretty far-out thought, but there's one thing in particular that attracts

me. I think we learn most from testing our limits, challenging our comfort zones

and meeting new and interesting people. And, that's global travel to a T. Life on

the streets of a foreign city can be life-altering and give you an appreciation of

business that you'd never gain from a pokey office in downtown San Fran.

For startups, there's also the argument that funding in USD or EUR goes much

further when expenses are in some third or second world denomination. Often, all

you need is fast internet, a good supply of beans and a laptop. So if this is all you

need, why operate from the most expensive cities in the world. Sure there may be

strategic value in somewhere like the Valley, but hey, sometimes it's just heads

down. And of course we're blessed with Skype.

One day when globalization advances and more private equity funds invest

globally, maybe we'll all be on the road living nomadically. A scary thought for

some and an exciting thought for others.


5. Structuring: The Key to Value Preservation in Private Equity

The value-based components of a private equity deal

Contrary to popular opinion, private equity firms are interested in risk mitigation

first and value creation second. The structure of most private equity deals reflects

this. In aggregate, the components of the deal should protect the private equity

firm on the downside and incentivize the management team on the upside. This

typically suits the risk profiles and expectations of each party.

Consequently, unlike venture capital, a private equity deal is more than just money

for stake; there's some sauce involved too. The following points discuss some of the

components of a private equity deal that lead to the aforementioned risk and return

profiles:

• Clawback (or ratchet): a clawback involves a condition whereby the private

equity firm's stake in the business increases (and the management's stake

decreases) if the business doesn't meet certain earnings targets. The purpose of

the clawback is to protect the investor against downturns in earnings. Inherently,

this is a protection mechanism for the private equity firm.

• Incentive scheme (or ESOP): an incentive scheme, or employee stock ownership

plan, balances the effect of a clawback. It provides incentives to management to

reach certain earnings targets (or a particular exit price). It often only partly

offsets the effect of a clawback, meaning that the net effect is in favor of the

private equity firm. Inherently, this is an incentive mechanism for the

management team.

• Earn-out: this is a condition whereby a portion of the purchase price is deferred

and conditional upon predetermined targets. While deals involving expansion-

capital use clawbacks, complete buyouts of a business use earn-outs (therefore,

earn-outs are usually mutually exclusive to clawbacks). The purpose of the earn-

out (just like the clawback) is to protect the private equity firm from downside

volatility in earnings and from any unintended consequences to misinformation.

Inherently, this is a protection mechanism for the private equity firm.


• Management Fees: these fees are paid upfront and/or periodically to the private

equity firm in return for help to grow the business. They can range from

reasonable to exorbitant, depending on the perceived value of the firm and the

fragility of the deal and management team. Management fees are another way the

private equity firms can realize a return on their investment prior to exiting.

Inherently, this is a protection mechanism for the private equity firm.

• Coupon or interest payments: although the term "private equity" suggests the

invested capital exists as equity, some firms prefer to invest in hybrid securities

such as convertible notes (which include an equity component). The benefit to

the firm is they receive the upside of equity with the protection of regular interest

or coupon payments. This can seem perverse to potential investees, but it can also

facilitate higher valuations. Inherently, this is a protection mechanism for the


• Preference subordination: private equity firms prefer to invest in preferred stock

so in the case of failure, they rank ahead of ordinary shareholders. A coupon

payment is often included, but even without a coupon the subordination mitigates

some risk for the investor. Inherently, this is a protection mechanism for the


There are many other components and conditions to a typical private equity deal,

but these are the primary tools used to manipulate the risk and return profile of the

deal. They're not always divisive in nature; they can simply make an otherwise

risky deal viable.

Stake with the sizzle

Unlike typical venture capital deals, private equity firms try to take quite

significant stakes in their investees. Expansion deals involve smaller stakes because

the existing (and continuing) owner/manager retains his/her equity. Buyout deals

involve much larger stakes because incoming management aren't wealthy enough

to buy anymore than a few percent. (If they were, they'd probably live-out their

days on the Seine.)


But, there's a reason why the stake owned by a private equity firm sizzles and the

stake of the management team doesn't (or at least not as much). Private equity

firms look to control their risk by commanding strict terms on their invested

equity. To make the deal appear somewhat fair, they provide the management team

with other incentives on the upside. The outcome of this is that if the business

develops lemon-like qualities, the private equity firm won't suffer as much.

Whereas if it ripens into a plum, the management team will benefit a little more.

The underlying objective of this is for the private equity firm to limit the fallout of

a bad investment, while still benefiting from a good one.

In practice, preference equity or hybrid instruments help manage risk. In rocky

times, like we're experiencing now, the higher ranking capital will be returned

before lower ranking capital. So even if you own 50% of an investee and the

current value (determined in the recent round of valuations) is below your initial

investment amount, you will be allocated 100% of the equity if it's on a preferred

basis. This is sizzling for the private equity firm (from a risk control perspective)

and a bad day for the other owners. But, of course it's only a bad day if an exit is

triggered and this situation is realized, which we're all desperately trying to avoid.

And in good times of course, the management team has the ability to realize a

much higher return with their upside incentives.

Preference equity and convertible notes

I hope I've mentioned it before, private equity is firstly about risk mitigation and

secondly about value creation. This is why private equity firms rarely invest cash

as ordinary equity; they want the extra protection that comes with preference

equity. One of the most common points of contention though, is the use of coupons

on preference equity (or interest payments on convertible notes). Vendors often

feel that private equity firms shouldn't get the benefits of a debt instrument while

also enjoying the upsides of equity.


Preference coupon payments mitigate risk by returning cash to the private equity

investor sooner. The returned money can't be lost and it is worth more than money

returned at exit (time value of money). But, this is hardly consolation for the

vendor who is stuck with ordinary equity and no guaranteed periodic payments.

By saying what I'm about to say, I'm probably going to feel the full wrath and

scorn of the private equity industry, but c'est la vie. I believe a coupon is only fair if:

• it is intended to offset an abnormally high top-line valuation; and/or

• there is a mechanism in place to compensate management on the upside.

An example scenario is if the private equity firm values the business at $X, but the

vendor wants to set a precedent for future investments at $X+Y. The private equity

firm could agree to the $X+Y by offsetting the uptick by a preference coupon

payment.

You may note that I'm being a little hypocritical. In a recent post, I lauded the

strategic value of the private equity offering and suggested it was worth more than

any upfront valuation by a trade buyer. However, there needs to be balance. Those

of you too aggressive with coupons should probably weigh the value of these

coupons against the opportunity cost of lost deals. You can try to justify your

coupons a million different ways, but at the end of the day, if it doesn't feel right

for management, then the deal won't fly.

Why do certain investors deserve preference equity?

Short answer, they don't. No one deserves preference equity; it's simply another

lever attached to the deal. If the vendor wants a higher valuation, then maybe I'll

pull this lever and demand my equity have preferred status.

The benefit of preference equity is that it subordinates ordinary equity in the case

of a wind up or if at exit the returned cash is less than the cash invested.


Let's look at an example. I invest $200m for 50% of a business as preferred equity,

while management owns the other 50% as ordinary equity. If the exit equity value

were $500m, I would receive $250m, all else equal. If the exit equity value were

$400m (the same as the entry value), I'd get my $200m returned. However, if the

exit equity value were only $300m, in which case my equity would be worth

$150m if it weren’t preferred, I would actually get my original $200m back due to

the preferred status.

As you can see, this preferred status has real tangible value. No one really deserves

this value by default; it is simply negotiated into a deal. Some people will use all

sorts of baseless arguments to suggest why they "deserve" preference equity, but

it's all bollocks as far as I'm concerned (if they were so special, why aren’t they

putting those special skills to use for themselves?). So, whether it’s a founder

saying they deserve preferred status or other investors saying the same, be sure to

understand the real value of this status and simply build it into the deal and your

valuation.

The other by-product of preferred status is the coupon (interest payment) that

preferred equity often attracts, which is equally contentious.

Bridging the gap with an earn-out

Let's say you're an entrepreneur with a business that has ongoing EBITDA of

$20m and you want to sell your business for 5x EBITDA. However, I'm a private

equiteer and I only want to pay 4x EBITDA for your business. So, how do we

bridge the gap? Or more importantly, how do I create the perception of a bridged

gap?

(By the way, this is hardly deceptive because anyone will see it for what it is. The

reason it works is that it creates a higher top-line figure that appeals to egos and

emotions of both entrepreneurs and advisers.)

Just to recap, you want $100m (5x) for your business and I want to pay $80m

(4x). One method I can use to get to your headline number of $100m is by

constructing an earn-


My offer to you will look something like this:

My firm, Acme Private Equity, proposes to pay up to $100m for 100% of your

business. This includes an upfront payment of $80m and an earn-out of $20m. You

will receive the earn-out if your EBITDA reaches $25m in the next financial year.

What I've done is offered $100m, but with conditions. The main condition being

that your ongoing EBITDA increases from $20m to $25m. So really, I'm offering

to pay $100m for a business with EBITDA of $25m, which is a multiple of 4x; the

multiple I wanted to pay in the first place. If EBITDA stays at $20m, I don't have

to pay the earn-out. So, I've only paid $80m, which is still only 4x EBITDA.

Being honest with ourselves though, if the earn-out is paid, I am actually paying 5x

for the business. This is because the extra $5m of EBITDA was created under my

watch and I shouldn't be paying anyone for earnings created while I owned the

business. So sure, I'm paying you 5x. But, I protected myself on the downside and

I received a guaranteed $5 EBITDA increase (if EBITDA didn't increase, I would

have only paid 4x). Either way you look at it, this scenario is better than me just

flat out paying you $100m on $20m of EBITDA; better for me, not you.

Funding earn-outs... a tip for new players

So, a typical deal may sound like this: “I'll pay you $x for your business, of which

$y is paid now and $z is paid if you meet next year's EBITDA budget”. The $z,

which is predicated on future earnings, represents an earn-out.

That is, the vendor has to earn that additional capital payment by hitting budget.

But, when the time comes and the business has exceeded its EBITDA target,

where does the money come from to pay the vendor for the earn-out? If you're

buying 100% of the business, the vendor doesn't really care where you get the cash

from (as long as it is paid) because they no longer have an interest in the business.

However, if the vendor is retaining a share of the business or if there are other

shareholders remaining in the business then they will certainly care about the

source of funding for the earn-out.


Let's use an example. If I pay you $100m for 50% of your business, but $20m of

that is an earn-out (so $80m up front), you may assume it's all coming from my

own pocket (or the bank's). But, what if I suggest the company's cash flow covers

the earn-out? Well, since you will still own 50% of the business, you will essentially

be paying $10m of your own earn-out.

Now, this isn't necessarily a deceptive term suggested by the buyer; it's simply a

valuation play. Of course this structure would be disclosed upfront for you to

analyze, so all I'm saying here is that it's an interesting way to adjust value in a deal

to meet conflicting expectations. In the above example, you would receive $100m if

the business met budget, but theoretically $90m is from my pocket and $10m is

from your own. As long as you think of it this way, there's no issue.

Are earn-outs fair or just a product of private equity avarice?

Earn-out payments for deals that were settled recently are unlikely to be paid as

vendors see their businesses come under unprecedented pressure from the global

financial crisis. As an indirect result, we're seeing a lot of conjecture around the

fairness of earn-outs. Vendors are asking, why are we carrying your future risk

after we've absolved ourselves of the business's future profits?

The apathetic response is one referring to legal terms, the agreed contract and the

unfairness of life. However, having a remorseful vendor is a terrible outcome for a

multitude of reasons. So, it's important to communicate the concept of earn-outs in

a way that doesn't portray unfettered avarice on the part of your firm. The lucky

part is that earn-outs really do have their place and tend to be quite fair. Here are

the two main reasons:

• Firstly, the purpose of an earn-out is to align interests. We need alignment

because there is significant influence and information asymmetry. That is, the

vendor knows much more about the business and has much more influence on

the business than a new owner has. So, the buyer needs some comfort that the

vendor will help to facilitate a successful hand-over.


• Secondly, earn-outs can increase the value of the deal for the vendor. The

reasoning is that the cost of capital for the average vendor is lower than the cost

of capital for a private equity buyer. This means that a deferred earn-out payment

may allow the private equity firm to pay more for the business, from the

perspective of the vendor, while really paying the same amount from their

perspective. This can help bridge the gap between value expectations, which is

the cause of most problems in private equity deals.

With all of that said, the simplest way to communicate the fairness of earn-outs is

in terms of risk and reward. An earn-out allows a buyer to pay a higher reward by

reducing the risk. (The risk is that the vendor negatively influences the business, or

doesn't drive the business as hard, during the hand-over period.) I don't for a

minute buy the idea that an earn-out should protect the buyer from economic and

market movements. They are risks in any business and the new owner should be

solely responsible for absorbing the outcomes.

The importance of managers investing cold hard cash

The worst principal-agent scenario is one where the agent (management team) has

no equity interest in the investee. The second worst principal-agent scenario is one

where management have an equity interest in the investee, but haven't had to part

with any cash for that interest (e.g. stock option plans). The only principal-agent

scenario that a private equiteer should ever entertain is one in which the

management team invests cold hard cash into the business for an equity share.

Now, you may say the founders have invested enough cash and effort over the

years to excuse them. And, you may find that the founders even want to withdraw

cash from the business in concert with your investment. But, if the founders are at

that stage (i.e. taking money out and winding down), you need another champion

to work alongside the founders. That is, a champion willing to invest cash with

enthusiasm and with the energy to facilitate growth.


The fact is, private equiteers have their interests spread across a portfolio of

investees. So, they really do need someone working within the business on a full-

time basis who feels the same urgency. Stock options without an initial investment

are better than no equity interest, but the human psyche is skewed toward a

potential loss rather than a potential gain. That means, a loss of $1m of equity

value affects people much more than the expiry of options with a potential value of

$1m. So, get as many people writing checks as possible and you'll be able to sleep

just that little bit easier.

The private equiteer toolbox: equity ratchets

So, you're about to invest in Acme Inc., but you're concerned about future under-

performance and you're looking for ways to protect your investment. In the VC

world, you may rely on the ability to dilute the founders in subsequent rounds at a

lower valuation, but in private equity, you have much more in your toolbox.

An equity ratchet triggers when the executive team doesn’t achieve a

predetermined level of earnings (the budget). If they underperform the budget,

you're granted free stock and a higher ownership percentage of the business. If

they perform according to budget, then the equity ratchet expires and everyone

remains happy.

So, let's say you own 75% of Acme Inc. and the executive team owns 25%. Your

original investment terms state by year-end EBIT must be at least $20m, otherwise

your equity will increase by 1 point for every $1m of budget underperformance.

Usually, there's a cap to prevent the private equiteer from taking complete control

in a bad year. So, let's say the cap is at EBIT of $10m. That means if Acme's EBIT

is $10m or below, your firm's ownership increases to a maximum of 85% in 2009. If

it is somewhere in between, your equity increases accordingly.

The idea behind the equity ratchet is to motivate the executive team on the

downside (opposed to motivating on the upside, as option schemes are designed to

do). This is controversial because it goes against the concept of positive

reinforcement.


And, why is it called a ratchet? Because it only goes one way; in favor of you.

The pros and cons of equity ratchets

My last post described how equity ratchets work in private equity. In this post I'd

like to raise a few thoughts on the pros and cons of equity ratchets.

Pros of equity ratchets:

• If the investment doesn't turn out the way you planned, you receive more of the

business for the same original investment. E.g. if you pay 5x for a business with

earnings of $20m, and then earnings drop to $10m, that original 5x multiple is

now a 10x multiple. If you only purchased 20% of the business originally, a

ratchet could increase that to 40%, in which case you've still only paid 5x, all else

equal.

• Often a ratchet can give you a greater share of a business due to short term

hiccups, even if the business outperforms in the long term. So taking the example

above, earnings could have dropped to $10m due to the GFC, but next year they

could return and grow to $25m. Now you own 40% of a business doing $25m

even though you only purchased 20% at an original multiple of 5x.

• A ratchet can motivate managers if they've invested along side you. If they know

they own a lesser class of equity and are at risk of being ratcheted down, they

may work harder to keep earnings up.

Cons of equity ratchets:

• A ratchet creates misalignment with other investors since you're essentially

punishing them for under-performance of which you're partly responsible for. It

makes any pitch about aligned interests weak.

• Once a ratchet is enforced and a private equiteer's ownership is increased, an

adversarial relationship is often born. If the other investors include executives in

the business, it can lead to lasting effects on performance and morale. This is

especially likely if the executives' interests ratchet down to almost nothing.


• Private equiteers talk about their focus on long-term performance and

differentiate themselves from public markets for this reason. However, ratchets

are inherently short- or medium-termed. The idea that other investors (sometimes

executives) are punished for short-term performance doesn't sit too well with

private equity traditionalists.

• The misalignment and short-term focus of ratchets motivates managers to report

higher earnings, which in turn motivates manipulation. While this may sound

fraudulent, in practice it's more about debating normalization adjustments to

reported earnings. You'll find yourself spending days negotiating the timing of

sales, the timing of costs, the cases behind numerous normalizations (transaction

costs, advisory costs, etc.), and a plethora of other things.

Overall, I'm not a fan of ratchets. They motivate on the downside, they create

misalignment and they abdicate private equiteers of their usual responsibilities.

Private equity ratchets in practice

The terms of an equity ratchet predicate its value. Often the terms don't just state

that, for example, "our equity will ratchet up 5% if your EBIT falls below $30m in

2010". Usually, a positive linear scale is used to incrementally ratchet the equity

according to a predetermined range of earnings.

This is best demonstrated with an example. Say we have a 70% stake in an investee

with 2009 EBIT of $30m. We invest with the proviso that a ratchet applies to 2010

earnings, whereby, for every $100k the EBIT drops below $30m in 2010, our

equity ratchets up 0.1%. There is a cap on this to prevent us taking over the entire

company in a bad year. The cap is at a maximum of an extra 15% of equity, which

translates to a range of $15-30m. Therefore, if EBIT in 2010 drops all the way to

$15m, our equity ratchets up 15% to a total of 85%.


The first thing you'll notice here is that in practice, a ratchet rarely achieves a

perfect equilibrium around your original paid multiple. What I mean is, if you

invested $105m for your 70% stake (which equals a 5x EBIT multiple), the ratchet

doesn't help you keep your original 5x multiple. If EBIT did drop to $15m and

your equity ratcheted up to 85%, then you're effectively invested at an 8.2x

multiple (all else equal and no applicable debt).

You may ask, why can't the ratchet maintain our original multiple? Put simply,

other investors just wouldn't go for it because the risk of losing their entire stock-

holding is very likely. Plus, why do you deserve this protection anyway?

There are many ways you can value this ratchet, but in the example above, you can

see with the ratchet your effective multiple is 8.2x if EBIT drops to $15m.

Whereas, without the ratchet, the multiple would be 10x. The enterprise values in

these two instances differ by about $26.5m. Of course, the ratchet isn't worth

$26.5m because one would hope the probability of EBIT dropping by 50% is less

than 100%. If you want to get really technical, you could value the ratchet at each

interval and apply a probability to each scenario and then sum the results. But,

that's way too much work and you can't really use the calculation in negotiations

because it draws attention to the fact that ratchets are evil.

Private equity ratchets in practice II

I've harped on a little (or maybe a lot) about how iniquitous and unscrupulous

equity ratchets are. I've said they misalign interests from the outset and lead to

adversarial relationships when triggered. So, are there any equitable ways to

structure equity ratchets? And, if not, why do we still use them?

Like most things, there are shades of grey. At one end, we have short-term one-

way earnings-based ratchets that go against the mantra of private equity and pin

executives to short-term performance. At the other end, we have long-term two-

way returns-based ratchets that create much better alignment across the entire

stock register.

So, let's check out these characteristics:


• One-way vs. Two-way: a two-way ratchet simply means that executives aren't

only punished for underperformance, but they're rewarded for outperformance.

A two-way ratchet supplants the need for executive option schemes and further

encourages executives to invest their own cold hard cash. The only other

consideration here is the rates at which the ratchet moves in each direction (more

on this later).

• Shorter-term vs. Longer-term: we can link our one-way ratchet to something that

makes more sense for everyone, i.e. the exit. We lament public markets for their

short-termism, so why do the same by using short-term ratchets? If we are going

to align interests and have longer-term investment horizons, then we should use

longer-term ratchets and give executives a chance to make a difference.

• Earnings-based vs. Returns-based: continuing with the concept of aligning

interests, private equiteers are rewarded for returns, not earnings. Higher

earnings certainly help boost returns, but there's much more to a great return,

like higher exit multiples and good leverage. If you want executives to maximize

your exit return, then it makes sense to incentivize them on the return-side via a

ratchet linked to IRR or cash multiple.

There's one more consideration for two-way ratchets, the ratchet rate. Should the

rate be equal for the downside and upside? Well, it depends. In all fairness it

should, but sometimes the ratchet rate is adjusted to bridge valuation gaps.

Managers may opt for a higher ratchet rate in exchange for a higher initial

valuation, or vice versa. Also, the private equiteer must ensure the upside ratchet

rate isn't so aggressive as to eat into their target return (I've seen this happen).

So, it's best to plot out a range of scenarios before agreeing to a ratchet to make

sure that: everyone is sufficiently incentivized, your target returns are possible in

most scenario, and misalignment or adversarial terms are minimized.


Keeping lawyers fed and clothed

Being a litigious world, legal documents (and legal fees) are ubiquitous in private

equity. They may provide comfort for the potential investee, they may protect the

interests of stakeholders, they may mitigate risk on the part of the private equity

firm, or they may achieve any number of other objectives that legalese is designed

for. For the most part, the documents are superfluous to real life needs, but

paranoid and delusional lawyers will try to convince you otherwise.

The following list is a very brief summary of the legalese that graces the desk of a

private equity professional:

• Confidentiality or non-disclosure agreement: used in many other industries, but

in private equity, they're mostly used to provide comfort when providing

sensitive information. So, before sharing competitive secrets or financial

information, investees may insist on this type document being executed by both

parties.

• Offer letter or term sheet: this document presents high-level terms, conditions

and expectations of the proposed deal. Most of it won't be legally binding, but it

will attempt to converge the expectations of each party to decide if there's a deal

to be done. It may also include a clause to sign the potential investee up to a

commitment whereby if he/she pulls out, a break fee will be applicable.

• Transaction documents: this will set the legal framework for the new business

structure and the purchase of shares and/or assets in the existing structure. Many

of the terms in this document will build upon summarized terms that the offer

letter first presented. Negotiation of the transaction documents will occur until

executed and settled upon when cash changes hands.

• Employment and management contracts: as I've said ad nauseum, private equity is

about backing the right people. With this in mind, it is important to get a solid

commitment from your top managers through new employment contracts. These

contracts will have terms that favor the private equity firm (such as non-compete

clauses) and the manager (such as option package details).


There are many other documents that cross tables in the private equity world, but

the fours groups above cover the majority.

Term sheet treatise

A term sheet is a letter of intent provided by a private equity firm to a target

business. The purpose of the term sheet, apart from articulating an interest in the

target, is twofold: 1) to outline the proposed terms of the transaction, and 2) to

apply an indicative value to the transaction. T

he term sheet is rarely legally binding; it acts more as a letter of good faith between

the parties. If all of the terms become agreed, the term sheet forms the basis for

more detailed documentation, such as a redrafted Shareholders Agreement.

It is important to keep cognizant of the affect a term sheet will have on existing

documentation. Generally, if a term within the term sheet differs from an existing

term between shareholders, then the expectation is that the new term from the

term sheet will replace the existing term. Business owners, or other parties

considering the transaction, need to understand that the term sheet becomes the

proxy for the terms of the relationship and may affect their control over the

business in the future.

The process of negotiating a term sheet, like most negotiations, is all about pushing

and pulling. For each clause there will be wording that puts it in favor of the

private equity firm, wording that puts it in favor of the potential investee, and

wording that provides a relatively neutral position. It is rare that all clauses are

written from a neutral position because different parties feel differently about

different issues. So typically, parties will enter negotiations and attempt to have the

issues they are most sensitive to written to favor their cause.


Term sheets have varied degrees of complexity, usually based on the stage of

discussions and agreements already made in principle. Very simple term sheets

where the private equity firm is in a weaker position may only include a few

clauses outlining the valuation, deal structure and exclusivity. More advanced

discussions may result in a term sheet with 15+ clauses and may discuss concepts

such as right of first refusal, drag along rights, conversion rules, etc. In later posts

I'll discuss some of these concepts in more detail.

Term sheets: Indemnification

Indemnification refers to shifting onus and responsibility between parties. If you

borrow my car and indemnify me against your use of my car, if you hit someone,

they can't sue me. In simpler terms, you're offering me protection or insurance

against claims (gratis, of course).

In a private equity term sheet, indemnification most often refers to the company

indemnifying the Board and investors against any cases brought against the

company. This is a standard term that private equiteers will rarely negotiate.

With that said, it's a reasonable term given that directors hold advisory rather than

operational roles. You could debate otherwise, but abolishing the term would mean

you attract far less directorial talent. You'd be hard pressed to find quality

directors willing to join your board without indemnification.

In addition to the indemnity term, private equiteers will often require directors and

officers (D&O) insurance. As with most insurance, it's important that you

understand the nuances of the policy, because you may find you're not covered for

obvious events. And if you're a CEO who is also on the board, then you are also

covered and should be particularly attentive to the policy wording. Just as the

limited liability structure of a company doesn't protect against everything, neither

does a D&O policy.


While indemnification is a standard non-negotiable term, consider how it affects

the rest of your business. Entrepreneurs without legal nous often sign contracts

without understanding the full extent of indemnification. You may think you have

minimal exposure, but you must also consider the exposure of the other party.

That's what's really in play here. And when it comes time for someone to sue, it's

all about the deepest pockets, which hopefully are yours, if all is going well.

Rather than get too obsessed, just keep an eye/ear out for the term “indemnify”. If

it appears in anything you're about to sign, pay particular attention. People have

lost everything by unknowingly (or unconsciously) indemnifying others.

Term sheets: covenant not to compete

A covenant not to compete (CNC), or non-compete clause, places limitations on

vendors competing in the same industry after they sell their business. As you can

imagine, it can be extremely damaging competing against someone whom has spent

many years building (and learning how to build) a business in the same industry.

Not only that, but imagine that this same person knows the strategy, tactics and all

minutia of your new investment. Imagine, how tough a competitor this person

could be.

This scenario is what a CNC attempts to stop. It attempts to restrict the vendors

from competing with the business, in similar regions, over a relatively lengthy time-

frame. However, in certain regions (such as California) there is a CNC prohibition,

and in other regions where a CNC is enforceable, the level of enforceability is open

to debate. In some ways, CNC enforceability is similar to garden leave

enforceability; courts often rule that barring someone from earning a living is not

just. Exceptions exist if there is a blatant intent to operate in competition.

In regions where enforceability can be relied upon, term sheets generally include a

CNC as standard. From the perspective of the private equiteer, the vendor

shouldn't expect fair value if they plan on destroying that value later with

proprietary knowledge. And, from the perspective of the vendor, they shouldn't be

barred from their field if all doesn't go according to plan. However, as with most

terms, it's about balancing preferences.Author: The Private Equiteer © 2011

Term sheets: drag-along rights

A common term in a term sheet is the drag along right. A drag along right allows

the applicable shareholder to drag all other shareholders into a sale of the business

when they choose.

You may ask, why would shareholders disagree on a sale if it makes commercial

sense. Well, there can be all sorts of extenuating circumstances whereby private

equiteers and managers have opposing views. Private equiteers may want to cut

losses if the business is flailing, whereas managers may want to make sacrifices to

save face. Or, managers may not want to sell to a hostile bidder, whereas a private

equiteer may not share the same emotion. Either way, the drag along right

somewhat insures the private equiteer for differences in opinion at exit time.

For founders or managers partnering with private equiteers, they really need to be

ready to leave the business at the behest of the private equiteer. It's an unfortunate

fact of life for founders considering a private equity deal, but it is necessary for

private equiteers to know that they can take advantage of exit opportunities to

achieve target returns.

On the flip-side, if it comes to exit time and the managers strongly disagree, they

can be very disruptive to the exit process. If the potential acquirer needs the

cooperation of management and staff to effect the transaction (very likely), then it

goes without saying that management still have the final voice through their level

of cooperation. So, like many terms in the term sheet, this is one that helps align

interests rather than fully insure against a potential risk.

Term sheets: exclusivity

The purpose of a term sheet is to propose deal terms and value. But, another

underlying purpose of the term sheet (for the private equiteer) is to secure

exclusivity over the deal. The exclusivity clause, which is often the only legally

binding clause in the term sheet, bars the vendor from pimping the deal to other

competitive parties.


In some cases, vendors approach private equiteers to confirm a price offered by

another party. The vendor doesn't intend to proceed with the private equiteer; they

simply want to ensure they're getting a good price from the other party.

Sometimes, this could lead to an actual investment, but sometimes pigs can fly too.

It's relatively safe to say that these situations always waste time; hence, the

exclusivity clause.

Of course, the vendor can do whatever they want in practice, irrespective of what

a piece of paper dictates. And even when the clause is legally binding, the fact is,

there's very little recourse for the private equiteer. However, term sheets are

Darwinian in nature and have evolved to include breach fees within the exclusivity

clause. If the vendor solicits the deal to another party within a predetermined

period (often 45 days), they are asked to pay the fee. The vendor can wait for the

period to lapse, but the fee still works as a great filter.

I say this because it verifies if a party is serious about a deal. And, suffice to say, a

private equiteer only wants to deal with serious vendors. With that said, I also

wonder how many deals fail due to the imposing nature of the breach fee. These

fees can easily get into the millions of dollars, so they can be quite off-putting. But,

you win some, you lose some. As your time in private equity passes and you

become jaded by losing deals that were never deals in the first place, you won't

mind the odd false-positive.

Term sheets: lock-up provisions

Lock-up provisions refer to restricting the sale or transfer of shares post-

transaction. For example, after an IPO, the original owners of the business often

have their shares locked up to stop them from dumping them on the market shortly

after the listing. In this case, it creates alignment with the new shareholders to

facilitate a smooth transition. This also applies to private equity transactions.


However, in private equity transactions, the lock-up period is often for the

duration of the investment. That means, the entrepreneurs cannot sell or transfer

their shares until a planned exit event unless approved by the private equity

investor. In instances where approval is granted, the shares typically have to be

offered to the private equity investor first (this is referred to as Right of First

Refusal). If the private equity investor refuses to participate, they may allow a sale

to an approved investor.

This term may seem overly onerous, but considering the expected investment

horizon, private equity firms want to keep share-register disruption to a minimum.

Allowing shares to be traded freely causes unnecessary overhead and has the

potential of allowing divisive investors onto the register.

Term sheets: preference participation and liquidation preference

These are the juiciest of all term sheet topics because they tend to create the most

misalignment between investors and entrepreneurs. Why? Well, for starters, to

own preferred equity is to have a preference over ordinary equity, which implicitly

creates misalignment. But there's more, much more.

Investors often command preferred equity to gain protection on the downside.

This protection is by way of their equity subordinating ordinary equity. So, if the

company is wound up, the preferred equity holders receive payment before

ordinary equity holders. (In most cases, there's nothing left for ordinary equity

holders.)

In addition to preferred equity subordinating ordinary equity, there are two other

important considerations: preferred participation and liquidation preference.

Preferred participation relates to an exit event where there is upside (it determines

access to newly created value), whereas liquidation preference relates to an exit

where there is downside (it reduces exposure to lost value).


Many publicly listed preferred stocks are non-participating. This means they don't

participate in the upside of ordinary stock. This lack of participation is accepted

because the preferred stock is seen as debt since it includes a fixed periodic

repayment and it subordinates ordinary stock (just like debt). So, like debt, it

doesn’t participate in upside.

However, in private equity, preferred stock is usually fully-participating. That

means that on an exit event (merger, sale, wind up, etc.), the preference equity

converts to ordinary equity and gets full access to the upside. This is in addition to

the fixed preferred dividend and the subordination rights. (Sometimes, the

preferred equity with be partially-participating, which means that preferred equity

holders will receive upside to a certain multiple of their original investment, but

this is rare.)

As for the liquidation preference, it is a multiple that dictates the minimum return

to preferred equity holders at an exit. So if the multiple is 1x (which it is 99% of

the time) and I've invested $20m for 50%, then at exit I will receive at least $20m

(if $20m is available). So, even if the exit event gives equity a value of $21m, I

don't just get 50% of that, but at least $20m. In effect, this creates a value

decelerator for preferred equity; it can still be worth nothing, but it reaches

nothing slower than ordinary equity.

You can clearly see that these preferred terms create significant misalignment with

entrepreneurs whom hold ordinary stock. You often hear entrepreneurs say "why

do you get all of the upside, but none of the downside." The cheeky answer is

"because we're private equity". The measured answer is that there is still downside;

if the company is wound up and there is no equity value, then even the preferred

equity holders are left holding the tip jar. However, that's little consolation for

entrepreneurs that have been taught by public equity markets that preferred equity

is non-participating.


The answer to all of this is that these terms form part of an entire term sheet that

needs to be prodded, poked and pulled in every direction until all parties feel

comfortable. These terms allow investors to focus on certain aspects of a deal and

entrepreneurs on to focus on others. For example, these terms can give

entrepreneurs increased access to upside if they agree to take more exposure on

the downside. Its all about priorities.

Tax: a private equiteer's second best friend

Before you ask (and you shouldn't need to ask), a private equiteer's first best

friend is carry. Coming in a distant second, a very distant second, a private

equiteer's next best friend is tax.

Here are the reasons:

• The typical private equity investment is highly geared, ipso facto, it has high

interest expenses. Those high interest expenses provide a tax shield, which means

private equity investees often don't pay a cent of tax. And not paying tax while

receiving the benefit of others paying tax is a private equiteer-friendly concept.

• Tax gives private equiteers a bargaining chip. All of a sudden, they can justify

paying a lower price because of the tax implications. They can refuse to grant

management options because of the tax implications. They can make a case for

their preferred legal structure because of the tax implications. They can gear the

business up to its eyeballs because of the tax implications. They can justify just

about anything because no sane person understands the Internal Revenue Code

(or whatever applicable tax code) in enough detail to debate it.


• Lastly, a private equiteer's heartfelt campaign to have the vendor pay less tax

creates an alignment of interest. "I want you to pay less tax because it increases

the value of the transaction for you, it helps us both create a better business for

your employees, and no one likes the tax man (chuckle, chuckle)." How could

you turn down a line like that? You'd love it if you were a vendor, wouldn't you?.

Now that we're best buddies with a common enemy, I proceed to show why I

should pay you less for the business, why the strike price on your options should

be higher (so they don't incur tax) and why the business should be geared at 6 x

EBITDA.

So, to recap, private equiteers love tax because they rarely pay it, because it creates

a bargaining chip, and because it helps to show alignment with vendors. I'd be rich

if I were paid a dollar every time I heard a private equiteer raise the strike price on

management options citing tax implications. My advice, just give it to people

straight; it tends to work best in the long run.

The anatomy of the ideal board of directors

The board of directors of an investee may only meet once a month, but they have

the responsibility of driving the business from the top. Being a director or

chairperson may seem like a figurehead role, but it's actually a very influential role,

especially in smaller businesses. The same way that private equity firms say that a

great manager can make any business, a great board should be able to do the same

(they should be hiring the best managers as well as driving the business in the right

direction).

The following points describe the anatomy of the ideal board:

• Make sure the board consists of people who will attend board meetings. Don't

select people who are on 20 other boards or who are overseas often; the board

needs people that will actively add value through their actions, not just their

name.


• Involve senior management for segments of the meeting so the meeting is more

directed and informed. But also make sure there's a period when senior

management are not present so the board can talk frankly.

• Have a reasonably balanced mix of private equity firm reps, founders, executives

and independents. Make sure there's at least one independent with deep industry

experience. The number of private equity firm reps shouldn't out-number the

remainder of board members.

• Keep the total number of board members to a reasonable number; 5-7 is the

maximum number needed for the mid-market. Too many people will create a

bureaucratic mess and will dilute the output of proceedings.

• Ensure a customized agenda is prepared for each board meeting so discussion is

targeted and everyone knows the intended outcomes of the meeting. Start each

meeting with an outline of the agenda and be sure to stay on topic, at least until

the end.

• Send all supporting documentation earlier; at least three days to a week before

the meeting so everyone has time to prepare. You don't want people seeing

information for the first time at the meeting unless it's hot off the press and

relevant to discussions.

• Keep channels of communication open so board members can continue to

provide guidance aside from the meetings. Too many boards leave issues until

meetings and wonder why issues are getting out of control.

Net asset adjustments at transaction settlement

An issue that often arises when bedding down transaction documents is what

happens to a variation in net assets at the time of settlement. That is, what if the

vendors siphon money from the business at the last minute by selling stock,

equipment or just taking cash straight from the bank?


Private equity firms generally value businesses on their forecast maintainable

earnings. So, in theory, they should only be concerned with whether the business

has the assets needed to support the forecast maintainable earnings. In practice

though, this is a very subjective measure and private equity firms don't like the

idea of vendors using such tactics to shift value; it's a matter of saving face.

A remedy is to apply a dollar-for-dollar adjustment to the purchase price based on

any variation to an agreed net asset figure. But creating an additional source of

purchase price uptick creates an additional channel for price manipulation. So, in

typical private equity style, the preference is to limit the adjustment to the

downside (and not reimburse the vendors for any net asset change on the upside).

But, as you can imagine, owners rarely welcome this.

For the sake of fairness, I believe the best solution is to ensure there's an effective

earn-out condition attached to the deal (to align interests at least in the first year)

and include a downside dollar-for-dollar net asset adjustment with a lower trigger

(that allows the business to operate as usual). If the vendors sell assets from the

business at the last minute, they risk lower earnings in the current year and hence

a reduction in their earn-out. Even in this case, the downside net asset adjustment

trigger will limit them. This is a relatively complex solution, but possibly the

fairest.

Receiving a return sooner: fees, glorious fees

Common belief of private equity investments is that the bulk of the return comes

from an exit event. We all know that part of the return may come from secondary

sources, but the real upside seems determined by the value of the exit. This is true

to some extent.

Private equiteers often insist on investing via preferred equity, which includes a

preferred coupon. The preferred coupon creates a return on the investment prior

to the exit event; so, if there are any issues with the exit or the company sinks, the

cumulative preferred coupons can help soften the blow. Some coupons are so high

that they pay back the original investment before an exit occurs.


Another way to create a return is through management fees. The fees are charged

to investees for helping to manage them. These fees are usually in addition to

preferred coupons and can represent millions of dollars a year. The case put

forward to the founders, or other investors, is that the private equiteers need to be

paid a pseudo-salary for their ongoing work. This may also encompass board fees

if they aren't stipulated separately.

Let's try an example. I invest $10m into a business as preferred equity with a 12%

coupon and management fees of $0.25m per quarter. Therefore, I receive $2.2m

per year from the coupon and fees combined. Add to that an initial signup fee of

$0.5m and acquisition fees over the life of the investment of $1m. In the first year,

the return is $2.7m; second year, the cumulative return is $4.9m; third year, $7.1m;

and the last year, $9.3m, plus total acquisition fees of $1m, and we have $10.3m

returned before we've even exited the investment. Plus there are ordinary

dividends earned along the way, depending on the terms.

Compared to ordinary dividends, preferred coupons and management fees shift the

return away from other investors (since they aren't participating in these terms). If

things fall to pieces in say year three of my example, the private equiteer has

received approx. $7m of the original $10m investment back. If there were no

coupon or fees, the entire $10m would have vanished. It's another form of risk

mitigation.

Like many components of a private equity deal, this may seem a little unfair... okay,

very unfair. But, as I've discussed many times, a private equity investment must be

viewed with all of the terms in mind. There's no denying that private equiteers

drive hard bargains, and that founders in the past have resented such deals, but

we're all consenting adults. In many cases, aggressive terms, such as high fees,

offset an unusually high valuation. Often founders, and especially their merchant

bankers (whom receive a commission based on the top-line price), prefer higher

top-line multiples.


6. Banks & Debt: The Key to Value Creation in Private Equity

Borrowing from the bank: asset versus cash flow

When you or I request a loan from a bank, we're faced with secured and

unsecured loans. A secured loan gives the bank a charge over the asset you plan to

purchase. So, if you buy a car using a secured loan, the bank, in effect, owns it

until you repay the loan in full. An unsecured loan (normally at a higher rate) has

no such charge.

Similarly in business, you can apply for funding using your assets or cash flow.

Clearly, an asset-lend is less risky for the bank. However, many businesses don't

have the assets to secure the size of loan they need. Moreover, few businesses have

the assets to back a loan anywhere near the size of what's available if the bank

approves a cash-flow-lend. Regarding what a bank will approve...

• For an asset-lend, banks typically offer a percentage of the total fixed asset value

(an independent market valuation)

• For a cash-flow-lend, banks typically offer a multiple (x) of maintainable cash

flow (FCF) or earnings (EBIT); the multiple depends on volatility and similar

factors

Imagine your EBIT is $10m and, if approved, the bank will lend 4x EBIT. That's

$40m. If the same bank would lend 70% on assets, you would need almost $60m in

assets to raise a similar amount. Sure, certain businesses have those assets (at

market value, not book or cost), but I'd say most don't, and most don't want their

assets encumbered anyway.

One caution, made more apparent by the GFC, is that you shouldn't rely on the

amount a bank approves as a gauge for responsible gearing levels. If you borrow

4x earnings on an earnings figure that you know isn't sustainable, you could easily

end up with negative ownership. That is, the business is worth less than the debt it

owes. Credit teams can be tough, but there's always information asymmetry; you

know much more about the business than they do.


The most common covenants in private equity debt financing

As we all know, senior debt is at the head of the line when we talk about

subordination. That is, if a company is wound up, senior debt lenders receive their

pesos before most other lenders, and certainly before equity holders. Inherent in

this concept, is that providers of debt are mostly concerned with risk rather than

growth prospects. You may read from this that debt providers are typically bitter,

cynical and pessimistic, and you'd mostly be correct.

Debt providers are the source of much value for private equity firms. With the

tight grip they have on a company, we need to do everything we can to maintain

healthy reports and measures against debt covenants.

There are three typical covenants used:

• Debt/Earnings: this provides a multiple or value that suggests how many years of

earnings will pay back the debt principal (this measure is also called the gearing

ratio). The earnings number may be EBIT or EBITDA, depending on the

preferences of the provider. A typical multiple for this covenant is between 2-4x,

although for larger deals a multiple of 5x isn't unusual.

• Earnings/Interest: this provides a multiple that suggests how many times the

current earnings could pay back the interest on the debt (also called interest

cover ratio). The idea being that earnings could fall X% before the business

couldn't pay the interest on its debt. A typical multiple for this covenant is at least

2x, the higher the better.

• Cashflow/Repayment: this is similar to the interest cover ratio, except it uses free

cash flow (FCF) in the numerator to bypass the obvious downfalls of using an

accounting earnings number. It also adds the compulsory principal repayments to

the denominator (so the denominator = interest + principal repayments). The

reason for this is that the expected repayment often contains a principal

component.


There are many other debt covenants in use around the world, but these three are

typical in the US, EU and in Asia. Private equity firms, amongst other consumers

of debt, report on these covenants quarterly, with a more detailed report expected

upon the receipt of audited accounts.

Using EBITDA or FCF in debt covenant calculations

A reader, Nicolas, recently asked the following question:

“While the use of the fixed charge ratio seems to be quite straightforward (FCF /

Debt Service), I was wondering why didn't we also use FCF / Interests Expense

(instead of EBITDA / Interest Expense) when calculating interest coverage.

It seems more natural to use FCF and more logical to be homogeneous in the

numerator used. I might be mistaken on that but these are my thoughts. Do you

have any explanation on that? This could also be applied to EBITDA / Net Debt

no?”

In calculating interest cover, we must make sure we're not double counting interest

by using a numerator that has had interest taken out already. Let's look at an

example.

Say my interest expense is $10 and I have $15 spare to pay the interest. My

interest cover is 1.5x. The problem with using net cash as the numerator, is that it

has already had interest removed (and a tax shield applied and whatever else

affecting the result). So in the example, it would look approximately like ($15-

$10)/$10, which is only 0.5x. This suggests I don't have enough to pay my interest.

With that said, FCF can mean different things. Some people calculate free cash

from an equity holder's perspective, some from the deb holder's perspective, and

others from the firm's perspective. The reason I mention this is that if your "FCF"

is pre-interest, then it's much more suitable for the interest cover calculation than

FCF post-interest. In most textbooks, the method of calculation is indicated by the

acronym, e.g. FCF, FCFE (free cash flow to equity holders) or FCFD (free cash

flow to debt holders), but in practice it's worth checking.


Now back to your question: what about the debt service ratio? Why does it use

FCF rather than EBITDA. Again, it comes down to timing and classification.

Principle repayments and interest expenses are rarely classified in the same

manner. And FCF is often calculated before principle repayments are removed,

making FCF a valid numerator. But it's not perfect when you get into the detail

and when it comes down to it, the banks have all the say and they generally try to

take a conservative view.

Using debtors to secure additional liquidity

Following on from my post on working capital, I want to make a quick mention of

the financing (and factoring) available to businesses to solve working capital

issues. With this type of financing, a company invoices a customer, sends a copy of

the invoice to the finance company, and the finance company extends a loan, which

uses the invoice as security. When the customer pays the invoice, it pays the

finance company to settle the short-term loan against the invoice. The terms of the

financing determine whether the customer pays the financier directly or indirectly

and how much of the invoice will be lent (usually up to 80%).

This type of financing (called trade, debtor or receivable financing) is most suited

to B2B or to B2C transactions in which invoices are used. And, the distinction

between debtor financing and debtor factoring is that the former involves lending

against the debtors, whereas factoring involves the purchase of debtors at a

discount. The discount in factoring represents a financing cost in the same way an

interest charge on debtor financing represents a cost.

In some cases, debtor financing or factoring competes against private equity. The

process of securing financing or factoring is much quicker and less involved than

securing private equity. Both are arguably more expensive than other forms of

capital, but of course, a private equity investment is more than just short-term

funding. So, the decision between the two depends on the objectives of the

business. And, there's no reason you can't have both, which is really the best of

both worlds for most businesses.


An important side note is that debtor financing and factoring is a common source

of business fraud. As you can imagine, it's quite easy to manufacture fake invoices

to have additional funding advanced. These fake invoices are fresh air invoices and

the underlying fraud is fresh air fraud. The other important note is that the focus is

on the creditworthiness of debtors rather than the business itself... for obvious

reasons. So, it can be much easier to secure if you have solid customers, even if you

are having performance issues.

Vendor financing for private equity deals

In deals involving the complete sale of a business, the owner (or vendor) can agree

to a partially deferred payment. For example, if you wanted to buy my business for

$100m, we could come to an arrangement whereby you pay $60m now and another

$40m next year. Depending on who's pulling whose levers, interest may be

charged on the deferred payment. Also, there's no rule to say it has to be paid in

one year; it could be paid in installments over three years, it could be paid in a

lump sum in five years, or it could be paid when the new owner exits.


In private equity, vendor financing is another way to make a deal achieve the

separate goals of the vendor and the investor. For example, if the vendor wants to

sell for $100m, but the buyer thinks that is too much, he/she can suggest a deferred

payment in the form of vendor financing. This isn't because the buyer doesn't have

the cash, it's to reduce the real value of the deal. Remember time value of money?

So, if the vendor finance amount is due in five years, it's obviously not worth as

much as what the same amount would be if paid today.

One other thing to remember is that vendor financing isn't the same as an earn-out.

If the payment is at all contingent on future earnings, it's an earn-out, not vendor

finance. In the other case where interest applies, the rate can be any amount that

the parties agree. The private equity firm will usually insist on a rate that makes

the deal right for them on an economic basis (remember, time value of money).

Vendor financing example

In a previous post, I talked about vendor financing. In this post, I am going to give

a numerical example of how it may work from the point of view from a private

equity firm. Let's start with a few assumptions.

• My private equity firm is interested in buying TPE Healthcare

• TPE Healthcare has FY09 EBIT of $10m

• Based on previous analysis, I decide that the highest multiple I will pay is 7x

• The owner of TPE Health care wants $85m for the business

So, the highest price I can pay (and justify to my investors) is 7x $10m, which is

$70m. However, the owner (or vendor) wants $85m. In preliminary talks I explain

the concept of vendor financing and that it may help to get the deal done. The

vendor wants to retire and I think TPE Healthcare is a great business, so we really

want to come to an agreement.


I start with the idea of paying $50m initially and $35m in three years. The total is

$85m, which the vendor wants, but the deferred $35m is worth less when

considering a dollar today is worth more than a dollar tomorrow. Say I use a 20%

discount rate as the opportunity cost of my funds. (So, I'm inferring that I think I

can invest my money for 20% elsewhere if I had to.) Discounting the $35m back to

today's money results in a present value of 35/(1.2)^3 = $20.25m. So the real value

of the proposed deal is $50m + $20.25m = $70.25m, which is close enough to the

$70m limit that I hoped to pay.

If we agree on this structure, I'll pay $50m upfront with a combination of equity

and debt. Then in three years' time, hopefully the business is performing much

better, and I can decide to pay the $35m in either cash or completely with debt

(since earnings should be much higher). The risk, of course, is that the business

goes backward and I can't afford the $35m. In this case, I'd have to call on equity

from the fund, which would be a very bad outcome. So, there is certainly risk with

vendor financing, but it's important to remember that the present value of the deal

is still $70m, which I was fine with paying (as long as I believe in my discount rate

too).

The credit tick of approval and its hidden value

What women proverbially say about men also applies to private equity firms and

credit providers. That is, you can't live with 'em and you can't live without 'em.

With debt, private equiteers are able to create the returns they've become

accustomed to (we're talking pre-crisis here). But without debt, private equiteers

would also live an extra 10 years from not having the stress related to covenants

and disapprovals.

Getting credit approval for an investee makes the deal much more likely since debt

helps to achieve higher returns (if all goes well). But, there's more value to credit

approval than just funding for the original deal:

• Firstly, getting credit approval somewhat confirms your analysis and optimism

around the deal. We all like to think we're objective, but it's good to get some

confirmation from an independent team.Author: The Private Equiteer © 2011

• Secondly, if a bank is willing to extend credit now (especially post-crisis), then

it's safe to assume that the potential buyer of the investee in 3-7 years will also be

able to get credit. Sure, there are a million and one variables, but it still gives

some comfort around an easier exit or divestment.

• Lastly, getting credit approval now gives comfort around the likelihood of a

recapitalization. So knowing you can get 3 or 4 times EBITDA in debt now will

give you some comfort around recapping out of the investment if all goes well.

The real message in this post is that if you can't get credit approval now, then

maybe the deal isn't the right deal. Current conditions have made debt harder to

get, but at the same time, getting approval now may say something quite positive

about your deal. Maybe you just don't need to be doing those deals that are

borderline with the banks. And, as I've discussed, credit team disapproval has

underlying consequences regarding divestment. Do you really want to be entering

deals that may be hard to exit? The exit crystallizes the value you've created; the

exit directly affects your return; the exit is the Holy Grail.

Banks are destroying small businesses

Most of us are to blame for the recent global economic unpleasantness. We all

overindulged and we all borrowed way too much money. But, rather than use our

collective mistakes to learn from, the banks are using them to punish us. And,

rather than picking on businesses their own size, they're targeting small businesses,

clearly because they're the most vulnerable. Yes, these are the same small

businesses that underpin our economies and give employment to the majority of

people on this planet.

During the period of excessive gearing, we all signed up to relatively strict debt

terms because, a) we had little choice, b) we had high hopes for the future, and c)

these terms still allowed some room for movement. Then, the GFC hit and the

usual multiplier effect of diminishing sales kicked in: sales fell, margins fell,

earnings fell, free cash flow fell, and, we started to breach covenants. As a result,

we all went into panic mode and tried to do everything possible to keep our heads

above water.Author: The Private Equiteer © 2011

So, what are you thinking if you're a bank? How about, "let's look at our lending

book commercially; that is, we're more likely to get our money back if our

customers survive"? Or maybe, "as long as they pay our interest invoices, let's be

reasonable as a sign of good faith for our customer’s loyalty"? No, what they're

actually thinking is, "this is a perfect time to cash in on all of these breaches by

increasing our margins, charging infringement fees and making our terms more

burdensome."

You may be thinking, "what's wrong with that; they're a business with

shareholders and their customers agreed to these terms". Well, that's true, and

technically they're well within their rights to do this, but as I've posted ad

infinitum, there's more to business than the immediate bottom line. What this

stringency is really doing is creating a GFC aftershock of similar magnitude to the

real thing.

Let's say you're running a small business. You're doing absolutely everything you

can to survive. Even, laying off workers, taking short cuts and reducing service

levels; all pretty risky stuff. Then, you get a letter from your banker (many of them

lack the courtesy to call or visit). And, in large letters it mentions the following:

“You've breached your covenants, your margin is doubling, you must pay a fee of

$300k for the breach, you now have to report to the bank monthly until they're

satisfied, and, you must engage an accounting firm of the bank's choice to perform

an exploratory investigation of your accounts. Oh, and if you fail to do any of this,

the entire facility may be called and you'll have 14 days to repay the principal.”

Do you remember that whole notion of just keeping your head above water? Well,

drowning looks like paradise compared to what's on the horizon. The increase in

your interest expense alone is impossible. Then of course there's the penalty fee,

which you simply don't have the spare cash to pay. There's the half a million

dollars (and endless nights) to fund the bank's third-party investigation. There's

the downtime for most of your crew to deal with the new demands. And, there's

the lost sleep from knowing failure is imminent.


If we were all held at gunpoint and made to choose someone to blame for this

whole GFC mess, we'd have to firstly choose ourselves. But, in a very close second

place would come the banks. To think they're instigating this aftershock, well, it

just smacks of the same insanity that caused this mess in the first place.

Then again, how many of you have let an investee off the hook come earn-out or

equity-ratchet time? (Let's just pretend I didn't say that.)

7. Analysis & Due Diligence: Sorting the Plums from the Lemons

Types of due diligence that private equity firms conduct

It is often mused that the success of an investment is directly proportionate to the

rigor of the initial analysis. Whether this is true or not (there's always the risk of

analysis paralysis), private equity firms expend an inordinate amount of effort on

analyzing a potential investment. The following list, although not exhaustive,

describes some of the due diligence (DD) undertaken:

• Commercial: the private equity team conducts this internally. It begins with the

construction of an extensive questionnaire delivered to and completed by the

management team. The questionnaire requests information on structure,

offerings, financials, insurance, employees, etc. The private equity team will then

perform extensive analysis on this data to determine whether they will proceed

with paid analysis.

• Accounting: this analysis attempts to verify the accuracy of accounts and to glean

important financial information that can support the investment decision. The

analysis will discuss margins, working capital, capex, forecasts, trends in

expenses, diversification of revenue streams, etc.

• Tax: this is similar to accounting DD, but focused specifically on statutory

taxation and outstanding tax liabilities. Tax analysis will also uncover ways to

structure the deal and run the business in the future.


• Legal: this is mostly concerned with the structure of the business and its legal

operating entities. The output will discuss charges against assets, property leases,

commercial & employment contracts, intellectual property, and any outstanding

litigation. Often the legal DD team also handles the preparation of the

transaction documentation since it already understands the business.

• Insurance: although often overlooked, insurance DD is an important part of risk

management for a private equity firm. It is mostly concerned with understanding

the ideal level of insurance for a business and comparing that to the current level

of insurance. Another major consideration is the ongoing exposure to potential

claims based on events from the past.

• Industry: the private equity firm or external industry experts will conduct this,

depending on the firm's internal skill set. The purpose is to determine the position

and value of the business from the perspective of an industry professional. It is

especially useful in industries that command a specialized skill set.

• Other: a multitude of other types of DD, such as environmental and ethical, are

considered on a case-by-case basis and in consultation with the team and their

respective skills.

Market due diligence in private equity

Private equiteers conduct due diligence on markets for one simple reason: we want

to understand customer demand for a firm's products and/or services. We become

engrossed in analyzing this demand because it will support future revenue and

drive future growth, which underpins future value and decides our investment

returns.

Understanding customer demand is quite difficult for most investees; it involves a

lot of prodding, poking and probing to gather masses of data, most of which is

useless, to make inferences about what customers may or may not do in the future.

But as long as you understand it's not a perfect science, it won't drive you too

crazy.

There are two main objectives in market due diligence:


• Understanding the market

• Testing hypotheses about the market

Both of these steps require talking to other people, lots of people, and doing a little

textual research on the side. Private equiteers often get too caught up in using

Google to understand a market, when really, you have direct access to someone

who has operated in this market for many years (the investee's founder).

Additionally, you should see customers, suppliers, competitors, regulators,

commentators and anyone else who has first-hand experience in the market. In

comparison to aimless Google searching, you'll be amazed at the info you can

garner from face-to-face encounters with real people.

It's best to start the due diligence by defining the hypotheses for your investment.

Each hypothesis should relate to the question of whether you should invest in the

firm. Once you've decided what will make (or break) the deal, go about

discovering the market while testing the hypotheses. It's important not to focus

solely on the hypotheses, because you'll be left with a couple of answers and no

real understanding of the market. Equally, don't focus just on understanding the

market, because you'll end up with a pile of information and no clear decision on

whether to invest.

During your travels, you'll find a lot of people that rely on Gartner and other

research providers. But, not only shouldn't you rely on others for such critical

tasks, but you don't want to give up the experience (and resultant knowledge) of

rolling up your shirtsleeves, getting your hands dirty, and learning everything

about the industry yourself. To really quantify your research, use a bottom-up

approach to understand demand, the future spend of customers, your market

share, complements and substitutes, opportunities and threats, and then

extrapolate to derive estimates on market size and growth. Even if you're way off,

you'll have at least learned a lot from the experience.

Good luck... and as Steve Blank mentioned in a post today, you can't test

hypotheses from within your building. Get out there!


All financial statements matter in private equity

Private equity firms may act surreptitiously in public, but they expect total

transparency from their investee management teams. In practice, this means

managers must deliver accurate and constant financial information. But, to ensure

coverage of all risks and issues, the information needs to be of the right type.

It is often lamented that managers focus on the P&L way too much. This can

create a range of problems; the most severe being bankruptcy. (Also, the P&L only

represents paper earnings and is therefore somewhat disconnected from reality.)

Therefore, I have titled this post "All financial statements matter" and have

included salient, though not exhaustive, commentary on each statement:

• Profit and loss: revenue will always be important regardless of lectures about top

vs. bottom line. Without revenue, well, there's not much of a business. In saying

this, pay particular attention to profit margins to understand how revenues

convert to value. The gross margin will give insight into the attractiveness of the

offering and indicate how differentiated the offering really is. In comparison, the

operating margin will uncover how efficiently the business is running as an

enterprise; are costs too high or are managers engaging in profligacy? Lastly,

private equity firms rarely acknowledge net profit figures. Net profit is an

accounting construct relevant only to the taxman. All else equal, lower net profit

and lower taxes are best.

• Balance sheet: working capital management is key to most businesses, even if

they don't know it. Confusingly, both increases and decreases in working capital

can indicate issues. If working capital decreases to negative, it reflects an inability

to cover short-term liabilities, which will ultimately lead to insolvency. But, an

increase in working capital can also indicate slower collections, higher debtor

days and increased bad debts. This is especially important in the current

economic climate. Inventory, debtor and creditor management is also very

important as efficiency becomes key when growth slows. The non-current

balance sheets items have uses too, but in times like these, the current sections of

the balance sheet receive the most attention.


• Cash flow: we were all taught in school that a business can post a positive net

profit and still become bankrupt. Well, it's true and it's proving an invaluable

lesson for many public companies that haven't focused enough on cash flow.

Cash is the ultimate measure of performance, so keep attuned to the drivers of it.

Apart from the usual P&L movements and changes in working capital (from the

balance sheet), make sure you control capex with a iron fist. Unbridled capital

expenditure won't show up on a P&L and won't come to the surface of a Balance

Sheet until the end of year, but it will show up on weekly or monthly cash flow

reports. Equally, keep an eye on debt and the ability to meet repayments. Be

vigilant with reporting against covenants on a frequent basis. Unmanaged debt

can put a business into bankruptcy overnight.

Especially in these times, it's important to be diligent and disciplined with financial

management. In a previous post I mentioned that everyone seems to think their

business is counter-cyclical now, but don't fall for it. Be honest with yourself and

plan for rainy days.

Financial profit & loss 101

Part of being diligent with financial management is understanding each and every

line of detail. Understanding each line means you can pinpoint problems and

create surgical solutions. For example, if you find that gross profit is much lower in

one region than the others, you know that you have to investigate COGS in that

region. I realize that this is topic is Financial Accounting 101, but like many things,

it's worth being said for the reminder. So without further adieu, here's how a dollar

of revenue turns into less than a dollar of NPAT:

Revenue (“the top line”)

minus Cost of Goods Sold

= Gross Profit (or GP)

minus Expenses

= Earnings before Interest, Tax, Depreciation & Amortization

minus Depreciation & Amortization

= Operating Profit (or OP)


plus/minus abnormal revenue/costs

= Earnings before Interest & Tax

minus Interest of debt

= Net Profit before Tax (or NPBT)

minus Taxation

= Net Profit after Tax (the "bottom line")

The devil's in the detail

With private equity firms looking to stabilize their investees, they should be

spending an inordinate amount of time on financial analysis. This is more than just

looking for ways to keep costs down; it's about understanding performance for

each segment of the business. This granular approach allows you to attack

problems at their source (and with a more surgical solution), rather than just

applying blanket edicts to the entire business.

When I talk about all levels of performance for each segment, I'm not just referring

to usual segments, such as business units. I'm talking each function, region, sales

team, product, service and account manager. The purpose here is to understand

revenue and profitability for each segment and understand how the latest economic

conditions are affecting the investee.

This may again sound like financial analysis 101, but the fact is that the majority of

businesses don't spend adequate time on this type of differential and detailed

analysis. Anecdotal evidence suggests that businesses are finding their problems

more complex than just decreasing sales. Some businesses are actually reporting

higher revenues, but inefficiencies are dragging them down. Remember that

cultural issues and lower morale can be the cause of just as many issues .

So without trying to save the world overnight, all I'm suggesting is to break down

your revenue, gross profit, operational expenditure, capital expenditure and

margins by the aforementioned segments. Find the underlying cause of any issues

and attack them with precision. Be mindful that this "downturn" is creating

complex problems that require rigorous analysis.


The amplifying effect of diminishing sales

This is quite an elementary topic. Actually, it's very elementary. But, in this

economic climate and with the profligacy of some managers, it's important to keep

front of mind. I'll introduce the topic with a few quick calculations. Consider a

business with sales of $100m, gross margin of 60% and EBITDA of $20m. If sales

drop 20% down to $80m, you're also losing gross profit of $12m. Usually at a

minimum, this will fall directly to the EBITDA line.

So, in this example, EBITDA will now be $8m. This is quite a serious problem for

investees, but made much worse by the continued profligacy of managers and

inflation in fixed expenses.

So what's the implication of this? For starters, you've conceivably just dropped

60% of EBITDA and therefore 60% of value (that is, if the new EBITDA is

deemed the new maintainable EBITDA). That's a BIG problem. The obvious

reaction is to reduce fixed costs so EBITDA doesn't drop by the full GP loss, but

that carries risks too. It obviously creates tension if you have to let people go, but it

also limits your ability to return to previous sales levels if you have to sell off

important equipment.

What are the other options? I'd say one of the better options is to delay cuts to

people and major equipment and put as much effort as possible into taking market

share and boosting sales. Also, make sure that costs don't blow out as a result of

the sales drive. It's just as much about sales as it is financial discipline.

Unprofitable customers

There are two types of unprofitable customers for investees:

• Those you know will be unprofitable, and

• Those you don't know will be unprofitable


The first group is often the result of a "loss leader" approach where you expect to

create future value from sacrificing some current value. The potential future value

may be in the form of increased volume, new synergies, higher prices, better

reputation, etc.

Something as simple as sample paint (that you take home to compare to other

colors in your home) is a loss leader; the paint company loses money on supplying

free paint, but it gains from brand loyalty/awareness, should you like the sample

color and decide to purchase it.

However, the risk with loss leaders is if they continue to lose and don't start to

lead. Imagine if someone took enough sample paint home to paint their entire

house. Or, imagine if potential customers used your sample paint, but bought the

identical color from a competitor at a lower price. So, you really need to keep

abreast of loss leaders and ensure they stop losing and start leading.

The second group of unprofitable customers is generally the result of miss-pricing.

Either your investee didn't estimate costs accurately or they didn't charge the

customer enough at the time of purchase. This is inevitable in most businesses, but

it shouldn't be accepted without action. The loss can be more than just lost profit; it

could set a precedent, it could convey a message of inferior quality, or it could

create a price war.

To prevent customers becoming unprofitable, it is important to monitor investee

profitability by customer (in addition to by product/service, by location and by

salesperson). This granular approach will ensure the sources of losses are found

quickly and rectified effectively. If you're thinking it sounds overly bureaucratic to

take such granular measurements, then you must simplify the process. Get the

investee comfortable with a standard reporting template and ensure the process of

measuring, calculating and reporting data is consistent.


Free cash flow, a primer

We know accountants can be a little delusional at times, but more than that, we

know that accounting profits are delusory all the time. For example, Net Profit

after Tax (NPAT) is an accounting construct; it is based on a range of policy

decisions that don’t reflect reality. These delusory policy decisions determine

revenue recognition, inventory reporting and depreciation scheduling. The

implication of this disconnection from reality is that accounting profits rarely act as

an input to the real value of a business.

With cash, a business can pay dividends, repay debt, invest in assets and absorb

increases in input cost. With accounting profits, all a business can do is calculate its

tax liability (which is important in other ways, but more on that later). So, what's

the purpose of explaining this? Well, a private equiteer will rarely even

acknowledge the NPAT of a potential investee. This is because if a deal goes ahead,

capex, depreciation, interest expense and taxation will all change.

This is where Free Cash Flow (FCF) makes an appearance. FCF attempts to

measure the cash that is free for the business to use for dividends, capex, debt

repayments, etc. I'm certainly not suggesting FCF is the perfect measure, because

it's not, but it is far better than relying on NPAT. There are numerous FCF

calculations, but the most common is as follows:

• Net Profit

• plus Depreciation and Amortization

• less Changes in Working Capital

• less Capital Expenditure

What's happening here, in a practical sense, is that we're taking NPAT, adding

back depreciation and amortization (which are non-cash items), adjusting for

accrued (rather than paid) revenues and expenses, and then taking away capital

expenditure (which is a cash item). In theory, the result is the real cash profit for

the business.


To value the business, FCF may underpin a Discounted Cash Flow (DCF)

analysis or earnings multiple calculation (more on this later).

This is just a primer on FCF; in another post I'll talk about the issues with FCF,

some solutions to these issues, and the caveats of using FCF in business valuations;

there may be a more suitable measure.

What's the deal with capex anyway?

Capital expenditure (capex), which simply means expenditure on assets with long

lives, is a big deal for private equity. Firstly, because it reduces cash flow.

Secondly, because it reduces cash flow. Thirdly, okay, okay, I don't want to harp

on about cash flow, but I do want to talk about the importance of capex in private

equity deals. The following list goes a little further:

• The P&L statement doesn't show expenditure on capital assets. This is because

capital assets are capitalized to the balance sheet and only expensed to the P&L

as they deteriorate (or insofar that accounting standards say when and by how

much they deteriorate). The implication of this is that analysis of the P&L

statement won't show the capital requirements of the business and hence, the

business's real value. For example, you may be considering a great business that

has EBIT of $1m, but if the business requires $2m of capex just to keep operating

each year (fixing machines, buying new equipment, etc.), then it's not such a

great business. You can get an estimate of capex by looking at depreciation on the

P&L, but this is fraught with risk.

• Even the balance sheet doesn't make the capex picture any clearer. You can

calculate the difference in assets between one year and the next, but all you get is

a single number skewed by many variables. For example, if the company sold a

large asset, this would underestimate real capex. Also, if the company only

invests in capex every three years, an analysis of only the last year may show the

business has no capex requirement, which would be wrong. The same goes for

the Cash Flow Statement, which shows a single item for investment in plant,

property and equipment; it's only a single number.


• Most importantly, capex reduces cash flow. This has implications for valuations

and debt reduction. As aforementioned, capex doesn't make it to the P&L

statement. That means any valuation based on EBITDA won't account for it.

Even a valuation on EBIT will only somewhat account for it if you consider

depreciation to be a good proxy for future capex, which it rarely is. But, the big

problem is that if FCF is negative due to high capex requirements, you won't be

able to pay off debt. And, you may not be able to meet debt repayments, which

would quickly lead to insolvency.

So, the message is really to make sure you consider capex in all transactions. You

need to see the detailed budgets of the business and understand how capex affects

cash flow, what capex is required to keep the business operating as per usual, and

what plans show for one-off items in the near future. Then, you may be able to get

a better picture of maintainable earnings and hence value. Above all, don't be

fooled by EBITDA figures.

How to calculate capex from financial statements

The best way to calculate capex is by gaining full access to a company's financial

accounts, its financial staff and its executives. With this combination, you'll be able

to paint a good picture of the capex necessary to keep the business running at its

current levels of cash flow. However, often we must value companies prior to

conducting formal due diligence and in these cases, we typically only have access

to standard financial statements. This post discusses calculating capex with access

only to these statements.

A few basics first:

• Capex is important because it can significantly influence the value of a business

• We can classify capex as either growth or maintenance, but we're mostly

interested in maintenance capex

• Maintenance capex refers to the capex required to keep a business running at

current cash flow levels


• Growth capex refers to capex required to grow the business beyond typical cash

flows (e.g. acquisitions)

• Financial statements do not have a line item titled maintenance capex

• And, no formula exists to calculate maintenance capex from the financial

statements

• Therefore, maintenance capex calculations are mostly estimates

The first place you may think of looking for data to calculate capex is the cash flow

statement (within the investment section). There may be a line item for

Investments in Equipment (or similar), which defines cash flow related to

investments in assets. While this essentially refers to capex, it will likely include

capex related to acquisitions and other growth campaigns. The reason we only

want maintenance capex is because we're valuing the business based on its current

state and current cash flows.

The second place you may look for evidence is the depreciation line on the P&L

statement. Many people use this as a proxy for capex and cite its smoothing effect

as an additional advantage (I wrote about this in a recent post on EBITDA vs.

EBIT). However, this smoothing, which accounts for many years, may reflect the

business as a different beast because it is backward looking. Additionally,

depreciation doesn't account for asset price inflation, which is significant for

certain businesses.

So what else can we refer to? Short answer, nothing. In my opinion, the ideal

method for calculating capex from the financial statements is to analyze investing

cash flows and depreciation over various years to find trends and arrive at an

informed estimate. Also check the supplemental notes for more granular

information on cash flows and depreciation. Here are a few steps I normally

follow:


• Look at the Investment in Equipment line on the cash flow statement, remove

acquisition capex, but make sure to add back an amount that will maintain the

newly acquired assets. Look at previous years too; you may find a year without

growth and with a similar level of profit, hence, evidence of maintenance capex

levels.

• Look at the Depreciation section of the P&L, increase the amount for inflation,

and adjust for structural changes such as acquisitions or major growth into other

areas. Again, compare with previous years to find (and understand)

abnormalities.

• Compare the above figures over various years to establish a trend and to help

make inferences about what capex should be in future years. Avoid suggestions

from management that maintenance capex is some fraction of what you've

calculated; often managers underestimate capex.

• Compare your capex-to-revenue ratios to those of listed businesses in the same

industry. One would expect similar businesses to spend similar amounts on capex

to maintain assets and uphold regular levels of service.

• Test your calculated figures with management and ask them for specific forecasts

on large items. You may find cyclical items that run on a cycle not apparent from

only 3-5 years of historic financials. Again, overestimate and make sure the

investment is viable on those figures because your overestimation will likely

become an underestimation.

Calculating maintenance capex can be time consuming and frustrating, but it is

imperative that you understand it in detail in valuing a business. I've seen many

investments fall short of expectations because private equiteers took management

capex forecasts as gospel.


The free cash flow capex conundrum

I recently posted a primer on Free Cash flow (FCF). In that post I discussed why

FCF was a superior measure of profitability (compared to NPAT), but I also

warned it isn't a perfect measure. Its virtue is that it better reflects reality by

undoing the manipulation of accrual accounting. So, in theory, FCF should more

closely reflect your incremental cash at bank.

While FCF may be a better measure of cash profitability, it still has shortfalls for

the purpose of business valuation. The chief reason is that FCF is calculated on an

ex-post basis; it uses historical data. Business valuations, on the other hand,

implicitly need to be forward looking. The simple solution is to synthesize FCF

based on forward looking assumptions.

One of the major considerations in synthesizing FCF is that the result should be

reflective of the ongoing earnings of the business; that is, excluding abnormal and

one-off items. The beginning profit and working capital figures can be relatively

easy to adjust in this respect, but capex can be more of a red herring. This is

because historical capex figures include expenditure on maintain existing assets,

expenditure on assets to grow, and expenditure implicit in making business

acquisitions. The latter certainly shouldn’t be included in your synthesized FCF

because it isn’t reflective of daily operations.

With this in mind, you need to have a detailed discussion with management

regarding the level of capex that is required for the ongoing operations of the

business. This means reversing out capex from acquisitions and making sure

you've accounted for enough capex to purchase/maintain the assets required for

normal operations. Without this, you cant hope to arrive at a figure that is

reflective of the real ongoing earnings of the business.


Working Capital Series: Introduction

This is the first post in a series that discusses working capital. The purpose of the

series is to deliver a congruent and clear theory on how working capital fits into a

private equiteer's analyses. I plan to make practicable and thoughtful points that

(hopefully) don't regurgitate finance textbooks. So, if deep down, working capital

is still a little bit of a mystery to you, stay tuned.

The series will broadly adhere to the following structure:

• Overview - working capital fundamentals that will provide a foundation for more

complex discussions

• Dealmaking - working capital analysis conducted for valuation and settlement

purposes

• Investees - working capital issues for investees including improvements and

monitoring

• Exiting - working capital considerations when exiting an investee

Although the generic working capital formula is hardly rocket science, it can be

quite difficult to understand its exact dynamics in relation to valuation

methodologies and other private equity topics. In some instances, it is vitally

important to consider working capital, whereas in others it doesn't really matter

(more on that later in the series). Lastly, more than working capital itself, it is

critical to understand its drivers and their influences on value and ongoing

performance.

Working Capital Series: References and calculations

When we talk about working capital in private equity, we may be referring to the

financial monitoring value (current assets - current liabilities) or the financial

analysis value (current assets - cash - current liabilities).


When monitoring a business, we want to know if it is solvent; that is, whether the

business can cover its liabilities. Cash is important in this monitoring because it

makes up for any shortfall between assets and liabilities as they fluctuate somewhat

independently. If working capital turns negative, we immediately know more cash

must be injected to make up the shortfall, otherwise the business is at serious risk

of bankruptcy.

However, when conducting financial analysis (rather than monitoring), we're

interested in understanding how much cash a business needs to support its

operations on an apples-vs-apples basis. That means, we must exclude cash when

looking at movements in historical working capital because we want to gauge how

much cash would have been needed, not how much was actually in the bank. Just

imagine, a company could borrow money, raise equity, sell assets, or any other

number of things that can move cash and skew historic analysis of working capital.

So, we circumvent these aberrations by conducting analysis on an ex-cash basis.

One more point though, an analysis of working capital may only include debtors +

inventory - creditors if the analyst wants to understand working capital on a purely

operational basis. The difference between this and the current assets - cash -

current liabilities method, is that minor current accounts are excluded, such as

current debt, prepayments, deposits, etc. This may be done to ignore capital

structure (current interest due) or if the minor current accounts are insignificant.

So please keep all of this in mind when you hear the term working capital. If an

accountant asks about working capital, it's likely they're talking about CA - CL.

But, if an analyst mentions it, they're likely referring to an ex-cash calculation. One

is to gauge solvency and the other is to understand cash requirements based on

business growth, credit terms and volatility.

Working Capital Series: Drivers

It's quite difficult to understand why working capital is important and why it

influences other analyses without understanding its drivers. By understanding

each driver, you'll gain an appreciation for why a movement in working capital

may indicate a myriad of potential issues or outcomes.Author: The Private Equiteer © 2011

For example, an increase in working capital may refer to revenue growth, stubborn

debtors, stricter creditors, slower inventory, assets sales, or even debt reduction.

The primary drivers of working capital are as follows:

• Debtors (accounts receivable) - this refers to accrued revenue/sales placed on

credit and awaiting to be settled by cash. An increase in debtors may refer to a

growth in revenue, a change in debtor terms or difficulty in collecting cash from

debtors.

• Inventory (stock) - all materials used to create products (or support services) are

considered inventory. Good management of inventory is all about efficiency; how

little has to be held, how quickly we can use it, how best can we store it, and

what's the cheapest way to manage it? An increase in inventory can refer to

revenue growth, slower moving stock, revaluations, increased obsolescence, or

preparations for volatility.

• Creditors (accounts payable) - simply the opposite to debtors; any accrued

expenses for payment in the current period but as yet unsettled for cash. An

increase in creditors may refer to increased creditor terms, an inability to pay,

revenue growth (therefore, increased COGS), increased short-term debt, or

higher unearned revenue (prepayments by customers).

• Cash - as discussed in, “Working Capital Series: References and calculations”, we

exclude cash from our analysis because it is the cash requirement itself that we're

attempting to determine. Just think of cash as the plug. If we estimate that the

worst case shows a shortfall of $1m in cash, then we must arrange to have that

cash on standby or at least have contingencies to deal with the shortfall (such as

renegotiated creditor terms).

• Other - There are other minor drivers of working capital, which include any

current account (on the assets or liabilities side) that isn't included above. If the

business has a large debt burden, the current portion of debt may be a major

working capital driver. Prepayments, unearned revenue, taxes, provisions, etc.

should certainly be considered and included in your analysis if they seem to be

volatile and influential.


The typical strategy with working capital is to decrease debtors terms, decrease

inventory requirements and increase creditors terms in order to manipulate the

working capital profile of the business. If optimized (debtors pay much earlier than

you have to pay creditors), you'll find a cash flow surplus opposed to a shortfall.

So as you can see, it is critical to understand working capital drivers to further

understand how a business operates from a financial perspective. In the next post

of the series, I'll show the different working capital profiles and you'll see why

Buffett was first drawn to insurance companies many years ago.

Working Capital Series: Cash-positive and cash-negative profiles

The working capital profile of a business can either deliver an ongoing surplus of

cash (above earnings) or can cause an ongoing drain of cash (below earnings)

This first diagram shows a situation in which there's a cash drain on the business in

question. If the business is selling its goods for more than it paid for them, then the

cash drain is less than the cash expected to be received, but it's the timing that

we're most concerned with. If the costs must be paid now but revenues are

received in 11 months, an accountant may call this profitable, but the business may

not be viable in a realistic sense.

Especially in a high growth business, it can be difficult to sustain a cash drain, even

for a few days (think millions of dollars for a business that is too early stage for

traditional sources of funding).


The second diagram shows a business with a working capital cash surplus. This

occurs because it receives cash from its customers before it has to pay its suppliers.

This is a nice position to be in, but is difficult to achieve. If a business has a unique

position (usually if it accounts for a large portion of supplier sales) it can enforce

longer creditor days. Sometimes just the nature of a particular market (such as

insurance) will support this type of working capital profile.

A cash-negative working capital position means that money is tied up, which

incurs an interest charge if it's borrowed or an opportunity cost otherwise.

A cash-positive working capital position means that surplus cash is available, for a

short period, which may produce interest income or allow for other profitable

investment.

There are businesses operating right now that have such large negative working

capital positions that the ongoing shortfall is greater than the earnings multiple

valuation of the business. In these cases, you really must question whether the

business is viable in the long term. On the flip-side, businesses that have large

positive working capital positions can continue to create income from non-

operational activities (such as investment), which is the premise behind the float of

insurance companies and arguably a big factor in Buffett's wealth today.


Working Capital Series: Valuation

There are various methods used to value investees, but private equiteers tend to

focus on earnings multiple valuations and discounted cash flow (DCF) valuations.

Working capital affects these valuation methodologies in the following two ways:

1. The earnings or cash flow figures may be influenced by changes in working

capital (delta) across periods

2. The net debt (specifically cash) position may be affected by the operational

working capital requirements of the business

In a discounted cash flow (DCF) valuation, working capital is analyzed to help

calculate free cash flow (FCF) for each period (see right for equation). These free

cash flows are discounted and summed to arrive at a valuation. This is simple

textbook stuff, so I want to concentrate on working capital considerations in

earnings multiple valuations for the remainder of this post.

Unlike a DCF, an earnings multiple valuation is based on maintainable earnings;

that is, the level of earnings that can be maintained indefinitely. If all else is equal,

working capital (from an analyst's point of view, i.e. ex-cash) remains the same

across periods and so there is no cash surplus or shortfall between periods. And so,

there should be no working capital offset in the maintainable earnings calculation.

You may be thinking, "but we don't expect earnings to stay flat and so there will be

working capital consequences and since different businesses are affected

differently as they grow, we need to consider it somewhere." Well, you need to

account for this via the applied price multiple. What does that mean? If the firm's

working capital profile spins off a lot of cash, investors will be willing to pay a

higher multiple, and vice versa.

Remember, even though growth may increase the theoretical cash shortfall, growth

also generates greater earnings and greater value.


So, the verdict is that the earnings figure used in an earnings multiple valuation

should not be adjusted for working capital delta because it is a maintainable

estimate. However, you may account for a firm's working capital profile in the

multiple if it is abnormal or if the multiple is already assuming high growth.

The one exception is where you know of a material change to working capital that

will create a material difference between current and future earnings figures.

Onto point 2 (net debt position): working capital may affect the enterprise value

(EV) because not all cash at bank can be used to repay debt. You may remember

from the basic EV calculation that EV equals equity value plus total debt less cash;

the idea being that cash can pay down debt. However, you shouldn't simply

assume that all cash at bank is excess cash to pay down debt.

There are numerous examples where cash is needed to support a firm's operations

and hence, is part of its earnings multiple valuation. The simpler way to think

about it is, how much cash can I remove from the business without causing

disruption? Since an earnings multiple valuation is theoretically based on future

earnings, I personally believe that enough cash should be left in the business to

support working capital gyrations for the first year.

This doesn't mean that if cash momentarily dips $2m that the vendor should leave

$2m for the new investor. What it does mean is that enough cash should be left to

pay the finance/opportunity costs of supporting that $2m working capital

requirement for the first year. I think this is fair since you're valuing the business

on future earnings and it will take a momentary investment of $2m to create those

earnings.

There are also other scenarios in which vendors should leave cash in the business.

In retail businesses for example, if all cash is taken from the tills (cash registers),

the business won't operate properly. Ipso facto, the money required to adequately

fill the tills is operational and included in the earnings multiple valuation (and

shouldn't be considered excess cash). It may be difficult to agree a number in this

case, but theoretically I believe the reasoning to be sound.


So, the verdict on point 2 is that not all cash at bank should be thought of as excess

cash in a earnings multiple valuation. Any cash required for the operations of the

business and/or to subsidize the opportunity costs of cash shortfalls should be left

in the business. In an EV calculation, this cash should not be used to reduce debt

to arrive at a net debt figure.

This is a long post, but I hope it helps to form your own views on working capital

and valuations. It should be a simple topic, but theories seem to change daily;

depending which side you're on in today's latest deal.

Working Capital Series: What to do at settlement?

An agreement on value doesn't necessarily signal the end of all deal negotiations

and troubles. Unsavory vendors will likely hand the business over with zero

debtors, zero inventory and a mountain of creditors. Oh, and no cash, of course. A

scenario like this may see you paying millions more for a business than you had

originally planned.

As I've discussed in a litany of working capital discourses, working capital goes to

value. But, it's not just the value imputed to the business at a particular point in

time; it drives the value you'll actually get when the business is handed over. And,

the last thing you want is to base your valuation on favorable working capital

terms and receive the business in an opposite state.

The simplest solution is to decide the settlement accounts at the time of valuation.

That is, place a few imaginary stakes in the ground and peg your working capital

drivers (decide a fixed amount for inventory, debtors, creditors, cash, etc). If at

settlement working capital is not equal to the trigger amount, then the purchase

price is adjusted on an equal basis ($1 less in working capital leads to $1

downward adjustment to the price paid). Many private equiteers will try to enforce

a one-way adjustment, but as Sergey and Larry say, don't be evil.


This isn't a perfect solution. But, it is a solution designed to be communicated

upfront with complete transparency. It will avoid resentment later on because

there is a lot less subjectivity. With that said, there will be some subjectivity in

deciding the trigger values for the working capital drivers, but ideally you can

make a case based on rigorous analysis of historic financials.

The simple rule is that you value a business as a going concern and so the business

should be left to you as a going concern (therefore, not requiring extraneous

investment to support working capital after purchase). Make sure you decide early

what constitutes a going concern and then stick to your guns.

Working Capital Series: the locked-box approach

One of the most contentious issues when buying/selling a business is the working

capital adjustment at settlement. This is often a bone of contention because it goes

to value, is easily manipulated, and changes on a daily basis.

My suggestion in a recent post was to draw a line in the sand and agree a working

capital figure so a dollar-for-dollar adjustment could be made at settlement. For

example, we may agree that working capital will be $10m at settlement, with at

least $4m in cash. So at settlement, if working capital is different, we can make a

dollar-for-dollar adjustment to the purchase price. The problem with this method is

deciding the level and dealing with all of the variables in the interim period.

A few comments from readers suggested I consider the locked-box approach. I

have seen this used previously, but my initial thought was the settlement date

would need to closely follow the receipt of audited statements. Otherwise, you'd be

getting the upside of a business that you don't legally own (you're not exposed to

the full risks yet). However, there's a solution, which I'll mention after explaining

how the locked-box approach works.


In the broad strokes, the locked-box approach uses the most recent financial

accounts to lock working capital drivers and hand economic interest of the

business to the vendor. In simpler terms, the vendor cannot take a cent from the

business after the accounts are locked, and the investor bases his/her valuation on

this scenario. Of course, working capital won't be the same at settlement, but any

movements will offset net debt in the EV calculation and the original valuation will

hold true. If the vendor must take value from the business for some reason, a

similar adjustment can be made.

As for the problem of receiving profits while not holding business risk, well, the

solution is to introduce an interest charge over the business whereby the vendor

receives compensation for holding the risk. Most likely this interest charge will

offset the purchase price. This isn't a perfect solution by any means, because the

interest charge introduces subjectivity. But, it does seem to be the lesser of many

evils.

Working Capital Series: Measuring and monitoring

To recap, we care about working capital because it is a direct driver of free cash

flow and everyone loves free cash, ergo, everyone cares about working capital.

But, before we talk about improving working capital, it's important we understand

how to measure and monitor it. If we measure it in a consistent way, we'll learn the

effectiveness of our improvement initiatives and may even find ways to create more

cash from the same accounting earnings.

So, what are we actually measuring? We're measuring something called working

capital absorption. That means, we're measuring how much cash is absorbed by

our working capital profile. The best case is negative absorption (production of

surplus cash) and the worst case is total absorption (no one pays their bills;

imminent insolvency). The most common way to measure this absorption is via a

ratio of working capital and sales (WC/Sales), which conceptually tells us what

percentage of sales is tied up in paper earnings and not yet realized as cash.


The genius of WC/Sales is in its simplicity and scalability. Even as a business

grows, we can monitor how our working capital profile is changing with that

growth. Ideally, it will get better as our power over customers and suppliers

increases through shear size, but it can also get worse if our growth is the result of

lower credit standards and less reliable debtors. Either way, WC/Sales is best

measured weekly or even daily and viewed as a trend over weeks or months.

For a more granular measurements, we can look at the day measurements. That is,

debtor days, creditor days and inventory days. Don't be fooled, these are just

standard ratios converted to “turnover” measures. For example, debtor days is

simply Debtors/Sales multiplied by the number of days in the year (note: some

people use year-end debtors and some use average debtors). The creditor and

inventory day measures are the same, except they're a ratio denominated by

COGS rather than sales, for obvious reasons. In a conceptual sense, these day

measurements tell you on average how long those items are turned in a year. For

example, debtor days of 45 means on average debtors are settling their accounts

within 45 days.

In practice, I like to use WC/Sales and debtor/creditor/inventory days in unison. If

I see an investee's WC/Sales increasing, I immediately look to my day

measurements to find the offending driver. Often there is a single offending driver,

which I can place most of my focus on to help management rein it in. However,

there are often cases where that driver has become unruly due to some

uncontrollable factor, like a structural shift in the market. In those instances, I can

focus my attention on an opposing driver to help management rein in the broader

WC/Sales metric.

Since working capital can be influenced greatly by a single payment or shipment, it

is important to measure it often and monitor trends continuously. In fast growing

businesses, you won't believe how quickly poor working capital management can

yield devastating results.


Working Capital Series: Improvements and one-off cash wins

I’ve previously harped on about how working capital drives value. It receives this

attention because it can affect value more than we often want to believe.

Additionally, it's not something that's easily controlled; many external forces are at

play (forex, shipping, terms, supply, demand, etc.)

But, with risks, we get areas for potential improvement. And, just as working

capital can collapse a business, it can make a business thrive too.

The primary drivers of working capital are the trade accounts: debtors, creditors

and inventory. These accounts financially represent the trade cycle, which starts

from the moment a customer commissions a product or service, to the moment all

cash settles (inflows and outflows). Optimizing working capital is really about

optimizing this trade cycle. This means ensuring your bottleneck is customer

demand rather than your production cycle or payment terms.

One-off cash win #1: Payment Terms

When financial analysts think about improving working capital management, they

immediately think of improving payment terms. This means getting your customers

to pay sooner and your suppliers to accept payment later. Sometimes these are

non-negotiable, but most of the time there's potential movement. A particular area

for improvement is on the supplier side, especially if they're overseas. Most

overseas suppliers will ask for a prepayment before they even ship the goods. But,

if you can build trust and have them waive payment until the goods arrive at your

local dock, this can lead to a monumental improvement.


One-off cash win #2: Inventory Management

It goes without saying that if you can sell the same amount and spend less on

inventory, you'll be better off. You can achieve this through streamlining any

number of parts of your production and sales processes. You can also achieve this

by rationalizing your offering and reducing your number of SKUs (stock-keeping

units). Overall, you need to find a balance between the inventory kept on hand and

satisfying customer demand. Often it's better to disappoint customers than to keep

hundreds of slow-moving SKUs. Also, a great one-off cash win is to put your

obsolete and slow-moving stock on sale, but make sure to keep your stock

rationalized after you get rid of the dross.

One-off cash win #3: Operational Efficiency

When you optimize your payment terms (see #1), you're bringing your inflows

closer and pushing your outflows further. But, what does this really mean? Well,

you may pay a supplier 60 days after you receive your raw materials and you may

demand customers pay within 14 days of receipt of the finished product. But, there

is still one major variable left: the time between receiving the raw material and

shipping the finished product. This is where operational efficiency matters. You

want to minimize this time to further optimize your cash cycle.

Operational efficiency deserves a few textbooks of its own, but for the purpose of

this post, just consider what drives timing in your organization. Often it's people

and process. Keep your people motivated and continually improve your processes

and there's no reason you shouldn't excel in the area of operational efficiency.

Working Capital Series: Preparing for sale

Preparation for sale or exit should start the day you make an investment: potential

buyers of your business in three or four years will look at long-term trends in

determining their price. A sudden spike in earnings just before sale will likely be

discounted and an abnormally good working capital profile will likely be ignored.

You would do the same if you were the buyer, so put yourself in the potential

buyer's shoes from day one.


As part of your initial 90-day tactical plan, you should aim to make all of the

working capital improvements discussed in Working Capital Series: Improvements

and one-off cash wins. Implementing these early will establish a good working

capital profile and show long-term structural improvements to potential buyers.

As a potential sale looms (before you even prepare a prospectus or deal book),

draft a plan to deal with the negotiation tactics of potential buyers. The following

list provides a few hints to maximise the final sale value:

• Pay out excess cash as dividends before anyone gets there hands on your

financials. Buyers will no doubt try to justify why it's not, in fact, excess cash and

is actually required working capital. So pull out the cash long enough before the

sale to show it's not required.

• Make a particular effort to collect bad debts and late debtors. Potential buyers

will exclude these from any net asset calculations, so it's important you don't give

this cash away for free.

• Sell obsolete and slow-moving inventory. Buyers won't place a value on excess

inventory, so it's better for you to profit from selling it. It will otherwise be

absorbed by the buyer's earnings multiple valuation.

• Sell all other excess and non-operational assets. Again, buyers will typically value

your business on earnings, so excess assets don't enter the equation. It's best for

you to profit from an asset sale, but make sure it doesn't appear that you're

preparing the business for sale; buyers don't like such premeditated actions.

• Fully prepare yourself for the "net asset" conversation. At some stage you will

need to decide what the buyer will receive at the date of settlement. This means

putting a stake in the ground and declaring final debtors, creditors, inventory,

cash, etc. Understand all of the options, test all of the calculations and consider

all of the scenarios. This will help you to maximise value when the topic arises,

which it inevitably will (see Working Capital Series: the locked-box approach for

the theory behind net assets at settlement).


As you can see, the best way to prepare for a sale is to imagine you're on the other

end of the transaction. Think of all of your own negotiation arguments when

you're making an investment and then turn them around to help you prepare for

those same arguments, but from the other side.

Confidentiality during market due diligence

Founders of potential investees take substantial risks going to the market, sharing

information and looking for investors. Oftentimes, they're required to send

intricate details of their proprietary processes, historic financials and industry

forecasts to advisers, bankers, private equiteers and even competitors.

It's no wonder then, that some founders can be extremely precious about

confidentiality. Not only due to competitive threat, but also due to the potential

damage of critical relations.

Concerns around confidentiality arise when private equiteers ask founders for

customer, supplier and employee contact details. Most of the DD until this stage

relates to pieces of paper and historic financials. But, once you have unbridled

access to stakeholders, it becomes the real deal. Sure we all sign confidentiality

agreements beforehand, but these agreements are little consolation to founders

with ruined businesses and without the cash flow to fight a case in court.

As with most conundrums, there's a relatively simple solution that entails staging

the analysis:

• In the early stages, contact industry associations, research providers, colleges and

then competitors. Be a little careful with competitors; don't mention the potential

investee's name, try not to mention you're a private equiteer, and be quite vague

regarding the purpose of your call. Also, now's a good time to advise the potential

investee that you will need customer and supplier details soon, so they prepare

themselves early to entrust you with that info.


• The next stage involves retaining anonymity, but reducing the search grid to

competitors, customers/suppliers of competitors and maybe even customers/

suppliers of the potential investee (if the founders have given approval). The idea

of these anonymous calls is to make contact, advise you're researching the

industry and ask broad-based questions about all players in the industry. If they

volunteer information on your potential investee, you may feel adventurous and

decide to follow their lead with a few brief (and seemingly off-the-cuff) questions.

• Once the founders agree to you directly contacting customers/suppliers/etc,

ensure the questioning guidelines are clear and ensure you make the most of your

time with these stakeholders. Keep the founders updated along the way to give

them comfort that you're not ruining their business while they wait in suspense

for the outcome. You may also like to make clear the entire plan with them first,

even the anonymous calls to associations and competitors.

Market analysis can be tricky because you need to access the people that matter to

get the best and most unique information. But, your relationship with the potential

investee is also important to the process, so it pays to balance their paranoia with

your thirst for information carefully. There's always a way to work around ultra-

paranoid founders, so be willing to give a little.

8. Valuation: Making Sense of What to Pay

The silence of snow and investee valuation methods

I had a surreal experience at the end of 2008 trying to make sense of investee

valuations. While I sat, staring at the snow in anticipation of some profound

thought, I realized that all of the noise and clamor of the "financial crisis" had

disappeared. It was as if some deity had used a constant and unrelenting snowfall

to hypnotize the globe into a cryogenic slumber to give it time to reconsider itself

and its actions.


Anyway, after rejoining reality, I wondered what

the softening economy and 30-40% falls in public

equity markets meant for my firm's investees.

Since times had significantly changed, I had to

revisit the EVCA valuation guidelines to

understand how I would be valuing these

businesses. In doing this, I thought it would make

a worthwhile post to give a very brief overview of

the recommendations.

The EVCA uses the same guidelines that many

other national private equity associations use, and

as such, they recommend the following valuation

methods:

• Price of a recent investment method - used within 12 months of an investment if

there haven't been any material changes (I think we'd all agree that expectations

have materially changed).

• Earnings multiple method - using the latest earnings forecast and an appropriate

and reasonable multiple for the applicable industry and size of business, with a

marketability discount applied.

• Net Assets method - only used in cases where the underlying asset is traditionally

valued according to specialized methods; such as property or a portfolio of listed

investments.

• Discounted cash flows method - used in many other circles, but apparently based

on too many subjective assumptions to be useful to the time horizon of private

equity.


Upon reading the guidelines, you quickly notice support for the concept that

something is worth only what someone is willing to pay. I say this because there is

a heavy bias towards the earnings multiple method. This is okay with me, but I feel

I should make a post in the next few days on the implications of using this

valuation method. So stay tuned, and don't spend too much time staring out into

the snow.

The earnings multiple valuation method

Following on from my previous post regarding investee valuations, I want to give a

brief explanation of (and make a few comments on) the earnings multiple valuation

method. As discussed, in the other post, this is the preferred valuation method for

most situations. It represents what someone would pay if you tried to sell under

normal conditions, which is arguably the most appropriate valuation method for

private equity investments.

In the broad strokes, this method entails applying an industry-based multiple to the

earnings of a business to arrive at an implied enterprise value. From this enterprise

value, subtracting net debt gives the equity value. In simple scenarios (involving

only ordinary equity), a private equity firm's relevant investment value is equal to

their proportional stake in the investee's equity.

The subjectivity of this method comes in the following forms:

• Do you use last year's actual earnings number? Do you use a forecast? If so,

whose forecast do you use? And what earnings are we talking about: NPBT,

NPAT, EBIT, EBITDA? What about the effect of non-recurring costs,

contributions from discontinued business units, forecast acquisition synergies,

etc?


• What is an appropriate multiple? Are transactions from six months ago

reasonable comparisons? Should I only use transactions from the same industry

as comparables? What about company size: should I only compare those of

similar size? What if there haven't been any transactions for 12 months (this is

especially applicable now)? Should I use the mean, mode or median of

comparable transactions?

There are lots of questions and not many answers; it really depends on how honest

you want to be with yourself and the limited partners. Here are my suggestions:

• Earnings - You should use the earnings number that you expect at the time of

reporting. For example, this may be the current year's EBIT forecast adjusted for

the latest actual earnings figures (that is, if you were below budget, adjust the

forecast months accordingly). If the trend is towards using the previous year's

earnings, then you should follow suit.

• Multiple - In the current climate, you may need to look outside your industry for

trends, but also make sure to look for similar sized transactions. There's no

perfect multiple to use, but there's certainly a range that will seem reasonable. I'd

say in the current environment that anything over 8-10x would be unreasonable.

For mid-market deals, I wouldn't expect to see multiples over 6-7x, unless there

is a strong case for exceptional growth. It may surprise you, but I'm seeing

interesting deals go for 3x now.

You'll know in your own mind whether you're being fair with your analysis. Try

not to cheat yourself because there's a real danger that it could come back to haunt

you. There's always the argument that if things really do get better, investors will

be glad to see a significant uptick in your next report. If you're too optimistic now,

disappointing them twice will hardly be fun. Also, investors won't be surprised

with value losses now; they're probably expecting them. So take this opportunity

to take an honest look at your portfolio and move on to planning for the upturn.


Quick and dirty, yet conservative, valuation in these crazy times

Of course, a multiples valuation consists of just earnings and a multiple, but due to

recent volatility, there are a couple of important considerations.

These considerations are based on using a fair and likely maintainable earnings

figure and using a fair and reasonable market multiple. My method for coming to

the earnings figure is to extrapolate the most recent performance using historic

seasonality.

1. Understand the monthly seasonality of the earnings - by knowing seasonality of

the earnings, we'll be able to extrapolate a maintainable earnings figure from

the most recent actual data. Normally we'd just apply a growth rate to last

year's earnings, but due to high volatility, I only want to use the most recent

data to determine maintainable earnings.

2. Find the last three months of performance data - let's focus on EBIT as a proxy

for maintainable earnings since it's probably most representative of

maintainable cash flow (FCF). I say this because recent actual FCF may be

higher than maintainable FCF because most businesses have put the brakes on

capex and other things that affect FCF. If expectations are that maintainable

earnings will fall even further, don't ignore it, make the required and fair

adjustments.

3. Extrapolate the three month data using seasonality estimates - for example, if

our three months worth of earnings data (say March, April and May) has

historically accounted for 30% of total earnings, let's extrapolate that out to a

full year. So if the three months of EBIT is $7m and we suspect it will represent

30% of the full year, divide $7m by 0.3 to get about $23m for the forecast of

maintainable earnings. Again, make any fair adjustments.


4. Glance over similar listed businesses to choose a multiple - forget recent

transactions (unless they're very recent and in the same industry and of similar

size). Don't get cute with overly geared listed companies with $0.01 share

prices trading at multiples of 200x. Also, don't over-do the conservatism with

companies teetering on the edge of bankruptcy and trading at multiples of 1.5x.

Ask yourself, what multiple would I pay for this business right NOW. If it's

over 5x or 6x EBIT, then chances are you need to get a grip.

5. Calculate the enterprise value - multiply the earnings from 3) by the multiple

from 4). This should give a relatively fair EV if the earnings and multiples were

themselves fair and conservative. So say we had $23m in maintainable earnings

and a multiple of 5x, then our EV is $115m.

6. Adjust to get your equity value - in simple cases, take EV, subtract debt and add

back cash. If we say our net debt in our example is $30, then $115m - $30m =

$85m. From that total equity value, multiply your percentage share to get the

value of your specific equity. So say we own 60% of the company, our equity

value is $51m.

There you have it, a quick and dirty, yet conservative, multiples valuation for crazy

crazy times.

Comparing a trade deal with a private equity deal

For businesses considering their options for accelerated growth, they tend to

gravitate towards proposals that contain a financial and strategic component. With

this in mind, the most compelling expansion deals are usually from trade investors

and private equity firms. In this post, I'm going to compare these offerings in a

formulaic manner.

So let's assume:

• $X = The value of financial capital in a deal

• $aX = The value of strategic support in a deal


The value of strategic support is a multiple of financial capital because the whole

purpose of the investment is to multiply the initial investment. Note: the "a" only

represents the strategic value-add, not the realized cash multiple for the investor

because there are other influences that drive the final result.

Therefore, the value of a financial+strategic deal ($Y) is:

• $Y = $X + $aX

When a business faces making a decision between a trade deal (JV, strategic

investment, etc) and a private equity deal, they're often deciding between the

following two scenarios:

• Trade Deal: $Y = $X + $aX

• PE Deal: $Z = ($X - some) + ($aX + some)

In simpler terms, a trade buyer will usually offer a higher upfront valuation, while

a private equity firm will offer greater strategic value. My thinking for this is that a

trade buyer has greater immediate synergies and is often the more natural buyer of

the business; hence, it may pay more. Whereas, a private equity firm has more

experience in value creation AND it has more aligned interests; hence, it offers

greater strategic value. I say more aligned interests because there's the risk that the

trade buyer wants to invest in the business as a defensive move and they actually

don't want the business to grow. This is a significant risk compared to a private

equity investor who almost undoubtedly just wants to see growth.

With all of that said (and this is hardly an exact science), the question for the

business owner is whether the additional upfront value from a trade buyer is worth

more than the additional strategic value offered by the private equity firm.This is

where the deal becomes self-selecting. If the business owner sincerely believes in

the potential growth of the business, then they'd really choose the deal with the

higher strategic value: the private equity deal.


I'll take your privates and give you my publics

There's much in the deal-making world, especially at the mid-market level, that is

based on the concept of buying at a private market valuation and selling at a public

market valuation (hence the title of this post).

A private market valuation simply refers to the value placed on private businesses,

while a public market valuation refers to the value placed on public businesses. In

the private business world, multiples are often in the range of 2x to 5x EBIT. In

the public (listed) business world, multiples are more like 5x to 20x EBITDA.

Note the reference to EBIT and then EBITDA, which stretches the gap even

wider.

For listed businesses, the theory is they can purchase a private business at say 5x

EBIT and immediately their own public market multiple is applied. There could be

an instant doubling or tripling of value (just on paper of course). This is why so

many listed companies are opportunistic with regard to acquisitive growth; there's

this concept of instant upside without the need to integrate or realize synergies.

Of course, such strategies are the antithesis of long-term value proponents, but in

good times, they can work to create significant shareholder value. The same carries

across to private equity. At the mid-market level, funds have access to businesses

on private market valuations. Assuming they grow these businesses (usually

through acquisition) to a size conducive to an IPO, they can effectively sell them

on a public market valuation. If you apply this multiple uplift to the results of

organic growth initiatives, the introduction of debt, increased efficiency, etc., you

can see it can easily create the bulk of additional value.

With the current unpleasantness, you may actually find that public multiples have

dropped much more than private multiples, which somewhat hampers the

effectiveness of this strategy. But, cashed up funds can still take advantage of the

private market now, implement their improvements and be ready to exit when the

public market is back to its old irrational self.


Pre-money versus post-money valuations

Private equity valuations sound simple enough, so what's all this talk of pre-money

and post-money? How can a business have a different valuation at the same point

in time?

It generally comes down to the purpose and use of your investment. There are two

broad options:

• Existing Capital - e.g. buy-out an existing stockholder, retire debt, etc.

• New Capital - e.g. invest for growth, invest to make an acquisition, etc.

If you swap your new capital for existing capital (buying out another shareholder

or paying down debt), then there's generally no change to the valuation. However,

if you are investing cash as new equity (for growth and/or acquisitions), then

you're increasing the equity value of the business and hence, increasing the EV and

overall valuation.

A quick example: we value a company with EBIT of $20m using a multiple of 5x.

It has debt of $50m, no material amount of cash and therefore, equity value of

$50m and EV of $100m.

In scenario 1, I'm paying down $50m debt. This means I'm swapping my $50m of

equity for the $50m of debt. This transfer of capital means we now have $100m of

equity , but $0 of net debt, so still an EV of $100m. As you can see, the EV and

overall value didn't change.

In scenario 2, I'm investing $50m to make a new acquisition. My investment enters

the business as new equity to fund the acquisition. Total equity is now $100m, net

debt is still $50m and hence EV is $150m.

In scenario 1, the pre- and post-money valuations were the same, both $100m. In

scenario 2, pre-money was $100m, whereas post-money was $150m. This is all due

to the new equity injection.


Like most things, there's a caveat to this. In scenario 1, we swapped different types

of capital, which mean they have different risk and return profiles. Most financial

analysts would argue the value of the business changed due to the change in capital

structure. However, we tend not to go into this detail in private equity for a few

reasons (e.g. we're not operating in efficient markets, our preference equity more

closely resembles debt, we do the deals we can irrespective of theoretical nuances,

etc.)

So, at least for simplicity, pre- and post-money valuations only differ if new equity

is invested in a business.

An apples vs apples comparison of earnings

In all of my posts about FCF, I haven't yet mentioned why investment bankers and

private equiteers don't use FCF in practice. Well, FCF is still too "bottom line" for

business valuation. It includes taxes and, depending on what version you use

(there's FCF, FCFE & FCFF), it can still be swayed by capital structure. This is

why good ol' EBITDA still forms the basis of most valuations.

However, EBITDA isn't the perfect measure either; it is still an accounting

construct. The advantage of EBITDA over FCF/FCFE/FCFF is that it is

independent of depreciation, cost of capital (such as interest on debt) and taxes.

The disadvantage of EBITDA is that it doesn't account for capex, which is a vital

driver to ongoing earnings. The other difference compared to FCF, is that

EBITDA still includes accrued debtors and creditors. However, for the purpose of

business valuation, this is a better representation of the future (as long as there's no

fraudulent manipulation) because accrual accounting is forward looking.


The implication of the capex omission (from EBITDA) is that the EBITDA of one

business doesn't compare well to the EBITDA of another business; the reason

being that each may have different capex profiles. In a previous post, I explained

that we can't just use historical capex to adjust FCF (or in this case EBITDA),

because it usually contains one-off items. So, what many people do is use EBIT as

their earnings proxy because it accounts for capex via depreciation (the argument

being that depreciation is a good proxy for capex). Of course, this is fraught with

danger because the past isn't the future and the future isn't the past. If anything,

most businesses will spend more on capex than they depreciate as they grow and

enter different industries.

Unfortunately, the solution isn't so simple. In my opinion, the best earnings

measure to use for business valuation is a maintainable and forward-looking

EBITDA figure adjusted for the capex required to operate the business under

normal conditions. Most of the work will probably go into understanding the real

capex position of the business, but at least you can sleep well knowing you've

invested in robust, rigorous and realistic analysis. So just to recap, the potential

measure for earnings when calculating value includes:

• NPAT - almost never used, too "bottom line" and a pure accounting construct.

• FCF - still too "bottom line", capex is often backward looking, rarely used in

valuation.

• EBITDA - ignores capex, which is an absolute sin, but this measure is commonly

used.

• EBIT - ignores the evolving nature of capex, sometimes used, 2nd best of many

bad options.

• EBIT-DAC - can still be manipulated by accruals, but the best of a bad lot.

For the record, EBITDA minus capex is denoted as EBIT-DAC or EBITDAC.


Should I consider EBITDA or EBIT?

The problem with any measure from the P&L statement (such as EBITDA, EBIT

and NPAT) is that they rarely represent cash flow. Cash flow is important because

we like to understand returns from a cash, rather than paper, perspective.

However, measuring maintainable cash flow from the financial statements can be

inaccurate and difficult, especially with public companies. Therefore, we're often

relegated to using P&L measures.

With this in mind, the major problem with EBITDA is that it has no provision for

capital expenditure. Capex is a major cash item that doesn't make it onto the P&L

statement because capital assets are capitalized to the balance sheet. Some capital-

intensive companies have huge capex, so knowing that EBITDA is $10m may be

inconsequential. That company's capital-spend alone could be $9m, leaving cash of

only around $1m (all else being equal).

The advantage of EBIT (over EBITDA) is that it somewhat accounts for capex

through depreciation. This depreciation figure often represents a smoothed

measure of capex since it accounts for items purchased over many years. So, in

short, EBIT is a much better measure of real earnings, even if still a little

inaccurate. (These other inaccuracies come from various deviations between cash

and accrual accounting.)

For most companies, the disconnection between EBITDA and cash flow is too

wide to be of any real use. The only exception I can imagine is using EBITDA in

the analysis of businesses within the same industry where capex to revenue ratios

are similar. In those cases, it is more feasible to use EBITDA, but still not ideal.

Does enterprise value include working capital?

I've received a few emails asking this question and just realized it's one of the most

popular search terms (that generates traffic to The Private Equiteer). The

question, as per the search term, sounds a little ambiguous, so let's reword it...

The question: should working capital affect an enterprise value calculation.


The answer: absolutely.

Your calculation of a firm's enterprise value must account for working capital

because it affects cash flow. And, anything that affects cash flow, affects returns,

and anything that affects returns, affects the value of an investment.

For a full run-down of the nuances of WC vs. EV, check out the Working Capital

Series in this book. For a quick and dirty understanding, think about changes in

working capital. If you must pay creditors before debtors pay you, there is a drain

on cash. All else equal (including revenue), this requires a one time injection of

cash to support the perpetual lag in payments. But, if revenue grows (and your

working capital profile stays the same), you must inject more cash into the business

to support the changes in absolute working capital. This continues as long as

growth continues and hence affects the long-term investment value.

What happens to EV when you issue more equity?

I received the following question from a reader and wanted to share my answer

because it seems like a very simple question, but it's actually a little complex.

The Question: “There is a company with 100 outstanding shares and the market

price of each share is $10. Now, what happens if the company issues 10 shares

through a private placement at price of say $12. Everything else (i.e. debt, cash

etc.) remains same. What will happen to Enterprise Value? Will it increase or

decrease? Why? How will EV be affected if the private placement is done at

discount to current share price (i.e at $8)?

The Answer: EV is generally used as a proxy for market value. So it really depends

if the issue of shares is adding to the market value of the business. At one extreme,

if you issue the shares and set fire to the cash you just raised, then EV will stay the

same and your individual shares will just be worth less. At the other extreme, if

you buy a distressed competitor for $1, and synergies mean you double the value of

your business, then EV will roughly double, meaning your shares will increase in

price.


So the important distinction is that we tend to work backwards with the EV

equation. That is, we work out EV (often using a multiple of cash flow or

earnings), then we subtract net debt to find the equity value. This makes it a

"market" valuation. We generally don't add up the book value or par value of

shares and add the book value of debt, because that would be a "book" value and

not necessarily represent what people will pay in the market.

So, let's work through some numbers.

• If the equity is issued for no reason, just to increase cash for a rainy day, then

there is no affect on enterprise value (EV). Theoretically, equity increases, but so

does cash, which offsets debt to give net debt. Intuitively, if you sell the business

the day after raising the money, the cash is just used to pay back the people that

just funded the new issue. Practically, it could be a little different. If you raised

money at a premium, the new shareholders will get less back as the new cash is

shared between everyone (either by paying down debt or via a capital return).

The opposite happens if you issue at a discount.

• If the equity is issued to invest in the business, then the affect on EV depends on

the profitability of the investment. Remember, we're working with market value.

If the "market" values the investment at cost, then it cancels out. If they value the

investment at zero, the EV stays the same, the equity value stays the same, but

you have more share, so the per share price drops. If they value it above cost,

then the opposite happens.

Drivers of valuation multiples

It's not exactly news that multiples are heading south. Data from Preqin and many

other sources showed 2007/2008 purchase multiples being north of 8x, often with

debt representing 5x. Now however, purchase multiples are more likely to be

around 5x, with debt representing about 3x. This is a major issue for funds that

made purchases at 8x, because they need to use regular value creation tools

(heaven forbid), such as sales growth and cost cutting, to keep value from

plummeting.


But, that's another story for another day; I would rather talk about what drives

valuation multiples. This can refer to multiples used in fund valuations, deal

negotiations, or for whatever purpose. So, the following list describes the

individual drivers for proposed purchase multiples of businesses:

• Business size: a larger business has a larger market share (usually), more stability

(mostly) and is more attractive to buyers (generally). Therefore, a larger business

demands a premium.

• Stability: revenue and earnings stability drives confidence in forecasts, which

demand a premium. Unstable businesses are riskier and require a higher required

return, hence a lower multiple.

• Diversification: a business with a diversified product range, customer base and

supplier list is less risky. These all affect earnings stability (see above) and hence,

influence the multiple.

• Capex: this is often forgotten when just looking at EBITDA, which is why some

people use multiples of EBIT (using depreciation as a proxy for capex) or good

ol' FCF (free cash flow, which accounts directly for capex). Capex represents a

large portion of costs that don't hit the P&L (until depreciated), so it's important

to consider capex in your valuation. Reduce EBITDA multiples for high capex

businesses.

• Intellectual property: in private equity, we tend not to pay extra for IP because it

is often needed to produce the cash flow. However, we may pay a higher multiple

because proprietary IP represents greater differentiation, more stability, higher

barriers to imitation and less risk.

• Growth: revenue growth is important to private equity because it's one of the

main tools to achieve non-geared value creation. So, a business with higher (and

realistic) growth forecasts demands a higher multiple. However, it's important to

be pessimistic about management forecasts because most of the time they don't

eventuate.


• Synergies: a buyer that has the potential to realize synergistic benefits from an

acquisition can generally pay a higher multiple because the acquisition represents

a greater value to them. This is one of those drivers that mean the ideal multiple

for me can be different to the one for you.

• Debt capacity: more debt adds more risk (insolvency, default, etc) to the

business, but it also amplifies returns and reduces the overall cost of capital. The

ability to add more debt commands a premium.

• Deal terms: a purchase multiple can be manipulated by the terms of the deal. If

the deal is 100% cash up-front, the multiple will be lower than if some of the

purchase price is contingent on future earnings. Be very cognizant of the time

value of money and that contingent payments have less value if paid later. So, if

$100m is paid today plus $100m is paid in 5 years, the purchase price isn't

$200m. It could be more like $130m, depending on your discount rate. A much

higher multiple can be shown on paper through deal manipulation.

• Comps: although comparable transactions are the most common drivers of

multiples, they are often the least appropriate. Even if exactly the same business

sold at exactly the same time, synergies and other buyer-related drivers (deal

terms, debt capacity, etc.) can affect the real value of the business. But in saying

that, you'll almost never see the same business for sale at the same time, so many

other variables are introduced. So, it's best to be more objective and concentrate

on the more fundamental drivers that I've listed above.

Negative equity, but positive cash flow

The question: does an investment with negative equity, but positive cash flows,

mean positive or negative value for the investor? Using the earnings multiple

valuation method, if net debt is greater than EV, then equity value is negative for

the investor. However, it also seems intuitive that if FCF is positive (after interest

payments are deducted), then the investment should have a positive value.

So, which one is correct?


This is a similar issue that VCs have with investees that don't have positive

earnings (or only slightly positive earnings). If they use an earnings multiple to

arrive at EV (and hence equity value), then often they will see negative equity

value. But, there's usually value in patents or technology or products or people or

distribution channels or other IP. VCs deal with this concept on a daily basis, but

private equiteers don't (well, they do now), so it all seems quite foreign to them.

The simple solution is to use another valuation method, such as a DCF,

comparables, or revenue multiples. But, this seems like finding a solution to give a

desired outcome. Maybe, these investees are really worth nothing. Maybe, the

inherent risk in them has a greater cost than the PV of the cash flows. Maybe,

these cash flows represent a return less than the required return to the investor. In

all honesty, I'm not feeling the need to change valuation methods; if the numbers

are poor enough to show negative equity but positive cash flows, then I think I'd

leave it for another investor or another day.

Negative equity: just add a pinch of debt and stir gently

In a previous post, I talked about the amplifying effect of diminishing sales. I gave

a short example in which a company had sales of $100m. This company had

variable costs of $40m and fixed costs of $40m; hence, EBITDA of $20m. A 20%

loss equals sales now of $80m, variable costs of $32m (using the same gross

margin), fixed costs of $40m (because they're fixed), and EBITDA of $8m. In

short, a 20% drop in sales led to a 60% drop in EBITDA.

I want to take this example a little further to show the amplifying effects of debt.

So let's use our two scenarios from above; Scenario 1 is the business with $100m

sales and $20m EBITDA, while Scenario 2 represents some period later when

sales drop to $80m and EBITDA is $8m. (Quick note: see how EBITDA margin

dropped from 20% to 10%? That's due to the fixed costs staying fixed. And this

isn't an extreme case; it's actually based on conservative numbers.)


Let's assume the market is paying 5x EBITDA for this type of business. In

Scenario 1, that means enterprise value (EV) is $100m, while in Scenario 2,

enterprise value has fallen to $40m. When we made our investment into this

business, we were quite conservative by employing debt of 3x EBITDA; so let's

assume net debt for the business is $60m. In Scenario 1, we invested $40m of

equity with the $60m of debt to buy the business. But, now that sales have

dropped, we're worried about the value of our equity investment.

Well, you can probably see where this is going. With a drop in sales of 20%, which

hypothetically led to a drop in EBITDA of 60%, we now have a business with an

EV of $40m, with net debt of $60m, and hence, a negative equity value of $20m.

That's right, our investment is worth less than zero; it's worth negative $20m. All

of this, just from a 20% drop in sales. Quite a sobering thought.

The "plus stock at value" phenomenon

In the private business world, vendors often list businesses for sale as price plus

stock. For example, you may see a business advertisement with the price listed as

$Xm + SAV (stock at value). The vendor is assuming a separate value for the

business (assets, goodwill, etc.) and a separate value for the stock (or inventory).

If this business is an insurance company and the stock refers to items with no

relation to the insurance business, then I can understand the separation. But, if the

business is a computer retailer and the stock relates to computers for sale, then I

disagree with the separation. (The business requires the stock to operate.) The

price for any business should relate to the cash flows of the business. Without the

stock, there is no business and there aren't any cash flows. Ergo, the stock and the

business are one, and the total price paid should reflect the value of the cash flows

from the combination.


Let's try an example. Say a vendor asks for 4x earnings plus stock. Earnings are

$10m and stock is worth $30m. So that equals $40m + $30m, which equals $70m.

To me, that's 7x earnings, not 4x. The usual argument from the vendor is that if I

ignore the value of stock and only pay $40m, then I could run the business for a

year ($10m in earnings), sell all of the stock ($30m+) and I'd have all of my money

back, hence, I am only paying 1x earnings. At first, that seems reasonable.

But, my assumption is that the business needs $30m in stock to operate properly

(as a result of lead times, bad stock, warranty claims and forward orders). So, if I

sold the $30m in stock, then I couldn't operate the business properly and hence

wouldn't have a business with ongoing earnings of $10m anymore. What this

inventory requirement really represents is a necessary investment in the business

to maintain normal operations. It is an investment to produce the $10m earnings; it

will not lead to extraneous earnings. Moreover, if there are plans to grow the

business, the inventory requirement will increase and the business will require

additional investment.

When I say I'll pay 4x earnings for the ongoing cash flows of $10m, that $40m

includes my total investment to produce those cash flows; it includes the initial

purchase price, the adoption of any debt, working capital requirements (including

inventory) and anything else that is deemed a liability (such as pension provisions).

If, for example, pension provisions plus required inventory totals 4x earnings and I

only want to pay 4x earnings, then it becomes investment gratis (purchase price

zero). (Sometimes a business is worth more liquidated than as a going concern.)

Let's be honest, we're over-geared and in hot water

I'm talking about our investees; we were gearing them to 2-4x EBITDA (in mid-

market deals) but today's EBITDA isn't yesterday's EBITDA and hence the

multiple may not be 2-4x anymore. On top of that, we geared to the point where

covenants were tight and now, well, let's just say they're not tight anymore because

they've been smacked out of the park. Okay, maybe that's an exaggeration, my

firm's covenants are borderline, as long as borderline means safely into breaching

territory.


So going through a similar example from a previous post, consider a business that

is doing sales of $100m, has a gross margin of 60%, EBITDA of $20m, debt of 4x

EBITDA ($80m) and interest payments of 7% ($5.6m). Let's say sales drop 20%,

so there's an instant loss of gross profit of $12m. So EBITDA is now $8m and you

still have interest payments of $5.6m. On the positive side, you still have the paper

earnings to potentially pay your interest. On the downside, your debt is now 10x

EBITDA (Breach!), your EBITDA is less than 2x interest payments (Breach!),

and you can almost be certain your FCF won't cover principal and interest

payments (Breach!).

I don't mean to sound like a killjoy, but this is the landscape of private equity now.

This even goes for the mid-market managers that lamented high gearing ratios and

are self-professed conservatives. A drop in sales from an economic downturn can

have serious consequences and that's before thinking about debt covenants. Here's

hoping for more sales and fewer breaches.

9. Entrepreneur: Donning an Important Hat

Fundamental themes of private equity value creation

An investor in a private equity fund invests on the pretense of relatively high

returns (usually 25%+ per annum). When a potential investee learns of this target,

he/she often adopts a look of, "There is no way I'm guaranteeing that." This is

because when many fledgling entrepreneurs see these growth targets, they don't

fully understand the value creation themes that private equity firms have in mind.

The following three points discuss the major themes for value creation in private

equity. I would like to think they're exhaustive and all encompassing, but please let

me know if you believe otherwise.


• Earnings growth: this is achieved either through organic revenue growth,

acquisitive revenue growth, cost cutting (thus, improved margins), reduced

taxation, “variablising” the cost base, etc. Earnings growth links to value creation

by creating a higher implied exit price and higher cash flow, which can lead to

higher dividends and quicker debt repayment.

• Increased gearing: this refers to an increase in interest-bearing debt, which can

amplify the gains (and losses) to equity holders. A business with no debt can be

conservatively geared and subsequently provide much higher returns to equity

holders. Additionally, private equity firms pay down debt as quickly as possible

with excess cash to decrease risk and increase proceeds to equity holders at exit.

• Multiple uplift: this is a simple arbitrage between the purchase multiple and sale

multiple. Even with the same earnings, if market conditions become favorable

and/or risk decreases, a higher sale price results from a higher multiple. While it

is difficult to control the market, decreased risk results from reaching a greater

size, reducing debt, diversifying the offering, increasing customer/supplier

fragmentation, implementing exclusive arrangements and contracts, and/or

anything else that may lead to more stable earnings.

Obvious value-add for private equiteers

There's never-ending conjecture around the value that private equiteers really

bring to investees. Ask a private equiteer and the list is long; ask certain jaded

investees and the list is non-existent. The truth is probably somewhere in the

middle.

Unlike venture capital, most private equity firms don't have domain expertise in all

of their investees' industries. But, what private equiteers undoubtedly bring, is a

fresh and external perspective. And, just as a second set of eyes improves most

writing (this post is a good example), a second set of minds improves most

investees.


So, if we're not industry gurus, how do we expect to add value through applying a

second set of minds? Well, it's best to start with what we know best... business.

Rather than trying to teach aeronautical engineers how to design planes, we should

show them how to make money from planes as a business. We should provide the

complementary skills to take an ordinary business with great products & services

to a great business with amazing products & services.

The is all much easier if you start with complementary areas first. Back to the

aeronautical engineering company, chances are, they aren't as good at selling

planes as they are at making them. And, they probably aren't as good at

negotiating strategic acquisitions as they are at appraising the technologies used in

those companies. So, know your strengths and start by adding value in the most

obvious places first; consider:

• Sales Generation

• Financial Management

• Business Transactions

Now, I'm not saying these are the only areas in which private equiteers can add

value. I'm simply saying that my experience is that private businesses are weakest

in these areas.

It's an interesting exercise to consider in your investees right now. Are you doing

everything possible for them in the areas in which you have the most

complementary skills? Everything possible? Do they have an amazing sales team?

Are they aware of the most important financial drivers and do they monitor them

very regularly and act on the data? Are they fully aware of acquisition

opportunities and are you doing everything to land them? Conceivably, if you can't

say yes to all of these, then you'd have to ask yourself what you're really doing.


I just made an investment, what do I do now?

It takes tenacity and stolid determination to push a deal to completion. From

originating the deal to negotiating terms, it's thankless work. But (and this is a big

but), you sold yourself as a master of value creation, not a master of closing deals.

So, you haven't even begun to prove yourself. That rigmarole of closing the deal

was part and parcel, it was expected, it's nothing but another sunk cost. It may feel

like the end of the journey, but it's only just the beginning.

People will make up their minds about you in these first few weeks. They'll be

watching and analyzing your every thought, every word and every action. They'll

use this to decide whether they'll work for you or against you. It may sound unjust

of them, but you probably closed the deal by promising the world. So now it's

showtime.

Here are a few other thoughts to consider once you make a new investment:

• There may be lingering bad blood from the negotiation phase, so make sure you

reconnect with everyone who's still involved in the business; change the focus

from the transaction to the future.

• Make sure you act on the findings from due diligence; it wasn't just for show, it

was commissioned to better understand the business and better understand the

next steps to strengthen the business.

• Communicate with management and visit them often to show your support;

again, you need to transcend the adversarial relationship that developed during

deal negotiations.

• Minimize the annoyance of implementing new systems by making changes fast;

this applies especially to new financial reporting processes, which often require a

lot of effort upfront.

• Offer your services and your firm's services over and over and over again, and

act quickly on any promises; you will gain respect and credibility by showing you

don't mind rolling up your sleeves.


• Focus on tasks that businesses often neglect, for example, contacting acquisition

targets, renegotiating bank terms, gathering intelligence from competitors,

collecting customer feedback, etc.

• Most of all, keep acutely aware of the culture, people and politics and adjust

quickly and ask for explicit feedback; you need the support of the people, without

it you're doomed from the outset.

As you can imagine, your performance early on sets the stage. It feeds back to

others and especially onto other entrepreneurs who may be looking for investors

now or far into the future. Think of that extra effort now as what it takes to future

proof your firm.

An ounce of entrepreneurial blood

Private equiteers need at least an ounce of entrepreneurial blood to handle the

travails of the private equity industry and to make, manage and exit great

investments. This ounce of said blood has its downfalls though; it constantly pulls

at the strings of a private equiteer's ambition. He/she spends so much time looking

for great businesses, helping them improve performance and guiding business

owners to riches that he/she often dreams of being in the opposite position.

The fixed management fees of a private equity fund (until raising subsequent

funds), don't allow for too much in the way of salary increases and bonuses (we're

talking mid-market funds here). And carry for fledgling private equiteers can

amount to little more than gym membership once present value is calculated (note:

we private equiteers calculate the present value of everything).

So, why aren't we all off to run our own successful businesses? Firstly, the patient

private equiteer arguably has a good chance to build greater wealth if he/she can

just keep a lid on that entrepreneurial pull. Secondly, going for broke as an

entrepreneur has a binary outcome, either success or failure, and not everyone is

willing to gamble with their livelihood.


Lastly, who says private equiteers aren't actually running off to start businesses

right now? It's a very real career path and can be a very rewarding one.

Sometimes, being on the sidelines as a private equiteer just isn’t enough.

A lean mean entrepreneurial machine

What does it take to become a lean, mean entrepreneurial machine? One that

doesn’t just pass comment to the real entrepreneurs, but one that lives the life and

walks the walk?

• Live simply: it's a monumental advantage to not need what others need. To not

need expensive clothes, gourmet food, a luxurious condo, a regular cup of coffee,

an LCD television, etc. Living simply saves money, time and, most importantly,

brain power.

• Think big, think laterally: swing for the fences, like really swing for the fences,

but do so independently. Make your goals unachievable, but find innovative ways

to achieve them. Thinking laterally isn't about inventing another Google or

Facebook; it's about working with a clean slate. No limits, no preconceptions, no

egos, no vices, no money, no skills, no rules, no bureaucracy, just a few thoughts,

a pencil and a bag-full of determination. Traditional wisdom is your enemy.

• Debt is king: this is daring to say right now, but let's be honest, if you have great

ideas, great skills, great conviction and great execution, what's the problem with

debt? You're putting everything on the line anyway, so why dilute your equity if

you have the cash flows and ability to raise debt? Buffet would disagree, Trump

would agree; but we've ditched traditional wisdom remember, so who cares who

agrees? Do it properly, do it sensibly, only do it with conviction, and hopefully

you and debt will remain best friends.

• Scalability is paramount: your potential market needs to have serious scale to

provide the necessary opportunity and to allow for miscalculations and mistakes.

Rock stars and movie stars are wealthy because their work is scalable. If there's

anything you need to learn from a movie star, it's the value of scalability (one

performance can lead to millions of viewings).


• Education drives success: identify what matters to business success and learn to

be successful in those areas. Learn what matters; prioritize what matters; become

an absolute master at what matters. This doesn't mean enrolling in degrees to

learn low level skills, quite the opposite. It means talking to competitors, learning

the market, understanding the customer, knowing how to run tight cost centers,

etc. You should never need to take an exam for this education; exams are for

company-men/women who need to justify their existence. (I realize we all need to

do exams at some point, whether it's in prep school or college, but work with me

here.)

• People provide the power: it's not easy leading people, but people give you more

leverage than debt. People allow you to build a phalanx of business mercenaries

with which you can take down the most difficult markets. You can invest

$100,000 a year in one person whom can easily make you $5,000,000 a year; now

that's an investment. Many highly intelligent and motivated people would rather

work for the certainty of a salary, and this is one of your greatest assets in

business.

• Patience is not a virtue: waiting for yourself is procrastination, waiting for others

is subservience. An entrepreneur doesn't wait; he/she moves constantly in mind,

body and spirit. Time is money, time is scarce, allowing time to lapse

unnecessarily is certainly not an entrepreneurial virtue.

• Be honest with yourself: even if not with others. What is your actual situation,

what do you actually need, how is your business actually placed in the market,

etc? This can be as simple as realizing you don't need a new suit. Or it can be as

critical as realizing you need to improve your communication skills. Be honest

about what really matters and be honest with what really needs to be done.


Entrepreneur-in-residence

You may see the term entrepreneur-in-residence (EIR) bandied around from time

to time. In the broad strokes, it simply refers to a person with extensive

entrepreneurial experience interning with a private equity or venture capital fund

to learn the game. The word interning is used loosely because EIRs often have

deep business experience and are really only interning to learn the distinct skills of

a private equiteer or venture capitalist (deal making, running a fund, etc.)

The EIR term triggers a question in my mind: how disparate are the skill sets of

entrepreneurs and private equiteers? Also, irrespective of how disparate they are,

how disparate should they be?

In times of unpleasantness (now), I really think private equiteers need to get their

hands dirty. And, to be a part of the solution, rather than the problem, the private

equiteer needs some serious entrepreneurial nous. Standing on a pedestal

proclaiming to add value only via deal making is a sure way to differentiate your

firm on the downside. Of course, dealmaking matters, but your firm needs much

more than that to differentiate in this market.

EQ: Entrepreneurial Quotient

I realize the term sounds somewhat silly, as if it came straight from the annals of a

stuffy Yale or Harvard lecture room, but let's ignore that for a moment.

The following list contains the competencies I believe make up your EQ. This may

be helpful to private equiteers as they appraise potential investees and associated

founders and managers.

• Financial management - you really need to understand how money flows through

a business, from its income statement, through its balance sheet and out via the

cash flow statement; plus there are all of those concepts aside from the standard

statements, such as cash flow management, working capital management,

inventory management, capex, capital structure, etc.


• Sales - you need to be able to sell to gain customers and you need customers to

have a real business; grass roots experience with sales gives you the perspective

needed to understand why people may or may not buy your product or service,

which is paramount to being successful as an entrepreneur.

• Organization - as your business grows, the business needs someone with the

organizational nous to direct efforts into the most efficient, effective and

profitable activities; being organized is key to keeping focused.

• Deals and transactions - deal experience gives you clout with external investors;

it also helps you appraise opportunities and prepare for capital raisings, exits,

acquisitions, etc.

• Strategy - I personally believe we're of an age in which people are overly

besotted with the idea of corporate strategy. With that said, a business still needs

a strategy to pave a path to its objectives and goals; strategic experience is

necessary if you plan to work on your business and not just in it.

• Business modeling - this sounds simple, but when it comes time to build one, it

can be quite difficult to compete with others who’ve already spent thousands of

hours looking for new ways to make money. It really is an art.

• Marketing - most of us are tempted to lump marketing with sales, but it really is

in a different kettle; marketing is less direct and requires an in-depth

understanding of your customer; you should gain experience in learning from

your customers as practice will lead to more targeted products and services.

The customer value proposition

The customer value proposition (CVP) refers to what a customer receives when

he/she pays for a product or service. It is a crucial topic for discussion when

understanding how and why a business makes sense. If the CVP isn't compelling,

then one would think that a private equity deal involving the business wouldn't be

compelling either. There are both tangible and intangible aspects to the CVP, but

two dimensions often divide it:


• Comparative value: this is the perceived value of the offering compared to

competitors' offerings. It could be as simple as one product is twice as good as

another product and hence worth twice as much. In practice though, there are

many variables and a lot more subjective analysis is required.

• Monetary value: this is very similar to comparative value, but using money as the

medium for comparison. So while it may not be reasonable to compare chalk and

cheese, you can compare the price of each and the perceived value from one

dollar's worth of each offering.

Not only should the business owner be able to communicate the CVP clearly, but it

should be reasonable and believable. Some of the components that the CVP should

include are:

• The issue or problem to be addressed

• The need and urgency

• The target result and its benefits and risks

• The merits against competitors (comparative value)

• The cost and time incurred (monetary value)

If these aren't clear and believable, then it's difficult to understand how the

business will survive and grow. With markets being competitive, survival and

growth isn't as easy as it may sound.

Making something of this downturn: cyclical businesses

We all know multiples have fallen, and, we know that for most businesses, earnings

have fallen too (see correlation vs causation). But, the problem is that vendors

don't always have to sell and so it isn't so easy to make cheap investments in a

downturn. Sure, distressed businesses may not have a choice, but solid quality

businesses often do have a choice and they can wait and trade back to previous

levels before selling.


For vendors still eager to sell now (for whatever personal reasons), they seem

prepared to take a haircut, but not always in the order of the buyers expectations.

This raises an issue with the typical private equiteer. Do I pay the higher price

because the business has traded very well for the past 5 years, or do I pass on the

deal since the performance hit could be indicative of other problems? Maybe

earnings will be back to $50m next year, but just maybe they'll drop further to

$10m and stay down there.

I don’t have any hard and fast answers, but I will say that great businesses can

experience arrhythmias too. If due diligence (DD) on the business is favorable, it’s

a great opportunity to get in at an unprecedented price. I’m the first to

acknowledge private equity is all about risk mitigation, but there's something said

for buying a great business at an average price compared to an average business at

a great price, especially when the average price would represent a great price in

normal economic conditions.

We’re looking at three separate deals like this now, and were currently pondering

this very issue. The vendors want more than we’d normally pay for the latest

earnings (and sure there’s some room for negotiation), but conceivably the most

recent earnings don’t represent maintainable earnings. There’s great potential here,

enough to make a material difference to fund performance, but there’s also a lot of

risk, which is hard to stomach for an ultra-risk-averse firm.

Apparently everything is counter-cyclical now

Let's be honest with ourselves, and I'm a big proponent of being honest with

myself (albeit a self-professed hypocrite too), everything can't be counter-cyclical.

It defies logic; it's just not possible. So, it's curious that every company I talk to

now says that their product or service is counter-cyclical.

Truly counter-cyclical industries typically make poor investments for private

equity firms. They are often low growth, driven by commodity prices, or simply

too risky. Sure, this isn't a coverall, but I've found it's a safe bet in most cases. So

where are we left?


We simply have to stick to fundamentals. Times are a changing, but there's no need

for traditional investment philosophies to change. Businesses that have relatively

stable and resilient earnings are always revered and this shouldn't be anything

new. We can't be sucked into making arguments to fit the available opportunities;

we need to be vigilant, discerning and objective.

Anyway, the point of this post is it's up to you to work out which businesses are

resilient and which aren't, because business owners will happily tell you why their

offering is counter-cyclical regardless of reality. And the problem is that their

arguments will often make a lot of sense, but the key is to be objective and

remember you have a world of opportunities to choose from.

Drucker's third deadly business sin: cost-driven pricing

Correct pricing is of paramount importance in any business. Pricing directly

relates to demand, which directly relates to sales, which directly relates to profit,

which directly relates to value, which directly relates to carry. Yes, the C word. If a

business charges too much, it wont be competitive. If it charges too little, it wont

be profitable. At worst, a business that doesn’t price correctly will be competed out

of the market or driven to a loss-making state. With the right pricing, a business

will lead its field, build brand loyalty, have the cash to expand, and be highly

profitable.

There are generally three different pricing strategies as follows:

• Cost-driven pricing: this involves adding up all costs and adding a profit margin

to arrive at price.

• Competitive pricing: this involves using the prices of competitive products to

arrive at your price.

• Price-driven costing: this involves understanding the ideal market price and

incurring costs accordingly.

As per Peter Drucker’s Five Deadly Business Sins:


The third deadly sin is cost-driven pricing. Drucker suggests that the only thing

that works is price-driven costing, even if starting out with price and whittling

down costs is more work initially.

Drucker’s argument is certainly robust and prescient. It talks about delivering on

required specifications and required price; the two go hand-in-hand. Whereas, the

typical method of pricing is to design a product based on initial market testing

about specifications, and price it according to the costs incurred for the desired

(and assumed) specification. This ignores the relationship between specification

and price; customers only want a particular specification if the price is right.

As my introduction suggests, pricing can create effect all the way down the food

chain (all the way to a firm's carry). With that said, I thought it would be an

interesting topic for today, especially for investees that are proactive in developing

new markets.

More than an arbitrary academic theory: Porter's 5 Forces

Maybe I'm not speaking for everyone when I say this, but I found many of the

models and theories presented at university to be largely theoretical and not very

practicable. CAPM comes to mind immediately, as do many of the monetary policy

theories. However, on reflection, a few make honest sense.

For example, I recently posted on the principal-agent problem and it's salience in

regard to public vs. private markets. I concede that it is hardly a solution to a

common problem, but I think it goes quite far in supporting the concept of private

equity.


Similarly, Porter's 5 Forces model won't give you the meaning of life, but it is an

honest, simple, applicable and highly useful model for the private equity industry.

Again, it won't give any profound answers, but it will go a long way to

understanding whether an industry is attractive. I say this because as private

equiteers, we know there are many sources of value creation, but an attractive

industry is always a salubrious start. Something to keep in mind though, is that the

model is designed to analyze industries, not businesses, sectors or markets. Be

diligent with your definition of an industry or see web resources for further

guidance.

I'll give a very brief description of each of the 5 forces (see the image above for a

pictorial representation):

• Substitutes: understand the threat of substitutes within the industry. A moderate

to high threat will result in high price elasticity of demand because it will be easy

for consumers to swap when prices move (if networking costs are low).

• Competitors: if barriers to entry are low and competitors can enter the market

easily, then a business won't enjoy economic profits for very long. Equally, it will

be difficult to maintain a competitive advantage and the associated high margins.

• Competitive Rivalry: high levels of competition can turn industries into price

wars, which doesn't help anyone, including the consumer, if quality is affected.

Rivalry is less intense when the fundamentals of the industry hinder it: think

scale economies, differentiation and diversity.

• Customers: if customers have high bargaining power, industry players will have a

low likelihood of securing an economic profit. The customers will use this power

to shift value to themselves. This power will also lead to higher price elasticity of

demand.

• Suppliers: similar to customer power, high supplier power can lead to a loss of

economic profit and lower margins. Power on either side of an industry player

typically leads to a shift of value along the value chain. The ideal position to be in

is at the most profitable point in the value chain.


Based on each of these forces, an industry receives an arbitrary rating. For

example, a 5 star industry is one that is attractive and one that receives a positive

rating for each force. A 0 star industry is unattractive for similar reasons. However,

this doesn't necessarily mean that a particular underlying business is given the

same rating; great managers use differentiation to stand out in any industry; their

job is just easier (and success is more likely) in attractive industries.

Porter's 5 Forces: what about a 6th, 7th or even 8th force?

Some suggestions for a 6th, 7th and/or 8th force are as follows:

• Government: the thinking being that government regulation and intervention can

drastically change the dynamics of an industry. And some industries are more

exposed than others.

• Complements: since substitutes are included, many argue that complements

should also be included. The thinking being that complements can drive an

industry in unique ways too.

• The Public: similar to government, the public (in the form of pressure groups,

lobbyists, trends, etc) can play an important role in the dynamics of an industry.

When Michael Porter himself revisited the model recently, he considered the

inclusion of new forces but ultimately decided against it.

Playing the role of a cynic, maybe he just wanted to save face or keep the model

simple. Then again, maybe he's right in keeping the model simple and maybe the

government/complements/public belong at the business, opposed to industry, level

of analysis.


Risk management is temporal for private equity

It is very easy to use a risk management strategy as a tool to justify a not-so-great

investment. Risk management is temporal; a valuation should be based on the risks

of an investment at the time of the investment, not just what they're planned to be

at a later point in time. For example, if a business only offers one product, your

valuation should be congruent with this concentration risk. Don't pay a price that

is contingent upon the acquisition of an unknown business that you expect to

diversify the product base. If you're doing the work to improve the business, why

pay the vendor for your hard work?

The theory of risk management requires (and deserves) a large tome. However, as

an aside, I'd like to share the very basics of the risk management process. The steps

in the process according to the International Standards Organization, although

slightly abridged, are as follows:

• Establish context: understand the situation and the need for adequate risk

management. In a private equity context, realize it is linked to price and

performance and is a major subject of analysis.

• Identification: think about objectives, scenarios, best practice, etc. to identify the

risks that are present. Look at other businesses and their risks to ensure you've

been exhaustive.

• Assessment (analyze and evaluate): analyze the risks and understand their

likelihood, impact, sources, consequences, etc. Evaluate this data to prioritize the

mitigation of the risks.

• Treatment (plan, implement, review): create a plan to treat the risks, but

remember treatment means treating them now, not in the future. Implement the

treatments and review success. Ensure that a variety of objective people agree

with the treatment and the perceived results.


I hope this has helped, but more critically, the purpose of my post was to propose

that risk management is temporal. Planning to ameliorate a risk in the future

doesn't mean you have managed it now. Also, invoke an iterative risk management

process and be diligent about the entire concept. After all, it can literally mean the

difference between a horrific failure and an outstanding success.

The competitor without a face: internal investment

Private equity is a seller's market because our potential investees are already very

successful and consequently attract many alternative offers. As with most

negotiations though, the key to providing the best offer is to understand what the

other parties are actually offering.

The problem is that the other guy is often no guy at all. That is, a business may

decide to fund its growth using its own cash flow. Such businesses understand

private equity is an expensive proposition (i.e. a high cost of capital), so they don't

see the logic in employing external funds if they already have the funds. This may

sound somewhat limiting, but with millions of dollars of free cash flow and

significant borrowing capacity, most successful businesses can do quite well

without external investment.

However, there's always the what if scenario: what if we had virtually unlimited

funding and what if we could achieve world domination? This is where private

equity enters the fray. With virtually unlimited capital and an extended team of

highly experienced businessmen, there are fewer limits; the sky is the new limit.

Additionally, it's human nature (and the nature of most entrepreneurs) to become

more excited about potential upside than potential downside.

So, the decision often comes down to the volume of that niggling voice. The voice

that brings dreams into the scope of reality. The voice that feeds an entrepreneurs

voracious appetite for risk and adventure. The voice that ignores the size of your

offer and currency of your attire. It often comes down to an irrational voice.


Salary versus performance

This isn't a post about bonuses and other monetary incentives. (That's already

been done to death and we're none the wiser.) This is a post about the psychology

of salary.

Let's start with an analogy.

Imagine you're a rock star. You arrive at a nearby hotel with the rest of your band

after headlining a concert. The hotel manager tells you there's only one room left,

and due to high demand from the concert, the last room is renting at a premium.

You feel the manager is taking advantage of your fame and extorting you. But, you

pay the price anyway because you have no other viable option.

So, how will you and your rock star friends treat the room, given that you feel

ripped off?

Simple-minded business people think a transaction ends when the money changes

hands. But, it doesn't. If you're paying money for a product or service, your

perceived value of the transaction will shape and influence your subsequent

actions. You may not trash a hotel like a rock star, but you may use the liquid soap

in larger quantities, or drink from the mini-bar without paying, or take a little less

care when checking out.

The same goes for employees. As an employer, it's your choice whether you

underpay, fairly pay or overpay your staff, but be aware of the consequences. Sure,

they can leave if they're not satisfied, but in private equity and many other

industries, work is scarce. There are people out there that will work for a pittance

for the chance to enter certain industries. And, they do. But, employers must be

careful with this power.


Just as a ripped off rock star can cause calamity, a ripped off employee simply

won't provide value. For example, would you rather pay a CTO $90k to work at

20% of their capacity or $140k to work at 80% of their capacity? For some CTOs,

the difference in output (from 20% versus 80% capacity) might be negligible. But

for most great CTOs, the difference would reach orders of magnitude. This is the

choice you're making every time you decide a salary.

They may not even know they're underperforming, you may not even know they're

underperforming, but it's the risk you take. So, don't be a manager that

underestimates the influence of fair pay. Great people make great companies and

great people don't work at high capacity (or for long) on poor pay grades. This

sounds obvious, but one-dimensional managers continue not to understand the

concept.

Workplace performance

This is Take 2 of my last post, Salary versus performance. I've had a rethink about

the topic, or more specifically, about workplace performance. Let's start with a few

thoughts:

What does it mean to work at capacity?

Capability and capacity relate to more than just potential physical energy. For

example, I could apply 100% of my physical energy to lifting tiles onto a roof, and

by day's end, move 500 of them. Or, I could use 10% of my mental energy and 10%

of my physical energy to move 5000 tiles by hiring a conveyor belt for the job. The

combination of mental and physical energy can move mountains.

How productive do you think you are?

I find that people are rarely honest with themselves about this question. Ask

yourself how productive you are (in percentage terms of mental and physical

capacity on an average day) and then ask yourself again. Remember, at 100%

capacity you'll be moving figurative mountains.


So, imagine the mountain you're capable of moving and compare that to how

productive you think you are. Then, once you know you're being honest with

yourself, compare that to the productivity of your team and your expectations of

your team.

How does salary affect workplace productivity and output?

In my last post, I lamented that managers don't realize how unproductive

underpaid people can be. However, this is only an issue when employees aren't

fully engaged (and inspired and challenged and appreciated). The problem is, I

think most employees feel somewhat disengaged most of the time. So, when they

cross a certain level of disengagement (even if only for a day), salary becomes an

issue very quickly. Then once it does come up, it generally remains an issue until

rectified.

My suggestion isn't to grant six-figure bonuses; I think you can get much more

value from being genuinely fair. Keep an eye on market rates and adjust your

employees' salaries without them having to ask. The average employee doesn't

expect you to be proactive with pay rises, so this token gesture can actually make a

tangible difference to productivity, loyalty and even engagement.

But, what does that really have to do with productivity?

You're hedging your bets. In the rare (likely) case you don't provide a fully

engaging environment for your employees, at least they'll know they're being paid

fairly. And maybe, just maybe, they'll look to themselves to find the reasons for

their disengagement. It means one less issue, a little more trust and a lot of

potential upside.

Okay, protection is in place, but what about increasing workplace

productivity?

This question is like asking "how do I lead a team?" While there is so much

subjectivity involved (from human emotion and irrationality), the underlying

solution is still the same: communication. Don't just sit their like a typical

scheming, self-interested, self-conscious manager, ask your people what they want.


"What do you need to be fully engaged, to think of the business like your own, to

get the most out of yourself, to gush about your position to your friends, to think of

new ideas when walking your dog, to figuratively move mountains; what do you

need?"

If they look at you with contempt and put up a stone wall, give it a day to settle

and try again. And, if you still get those looks tomorrow, fire them. You'll be doing

both of you a world of good.

The essence of a business

If you ask a CEO, "what is your company about?", he/she will probably describe

the company's products or industry or strategy. That's all fine, and to be expected,

but the more I look at businesses, the more I realize they have an underlying

"essence" that transcends their products, industry and strategy (and even people).

Think about the big tech companies such as Google, Microsoft, Cisco and Apple. If

you ask what these businesses are about, you'll get closer to the root of essence.

I'm stepping a little out of my circle of competence here, but I'd say Google's

essence is providing a nurturing environment that supports unfettered research

and development. I'm sure they'll gush some company line about being customer

focused or shareholder focused or focused on whomever is asking. But I think the

essence of Google is more about its employees and R&D than anyone else.

I think Apple's essence is about design innovation and product differentiation.

Again, they may argue they're customer focused, but the truth is plain as day. We

don't really hear about Apple's employees the way we hear about their rock star

counterparts at Google. We don't even hear about Apple's newest, most

revolutionary technology. But we do hear about design, about simplicity, and about

differentiation.


Okay, this is all a little wishy-washy, but it became apparent when we recently

tried to hire people for a new investee. There was talk of "culture" and how the

new person had to be easy going, easily approachable, and not too aggressive. But

that wasn't the essence of this particular company. We could hire innumerable easy

going people, but would they relay "the message"?

It's worth asking what you'd like the essence of your new/existing company to be.

Compare that to what it really is and ask why. As we can see with Google, Apple,

et al., essence drives businesses beyond facts and figures.

The most important ingredient to success in business

The #1 ingredient to success in business has nothing to do with ideas, execution,

education, connections, or locale. It's something much cheaper, much easier, and

requiring much less skill.

So here it is, the #1 ingredient to success in business is “Hustle”, which generally

means being resourceful and uninhibited in going after what your business needs

most. Not what you're willing to do most, but what the business needs most (big

difference). I know what you're thinking, "I already do that." Well, I bet you don't.

But don't worry, neither do I. And since admission is the first step to recovery,

we're making good progress. Consider the following to demonstrate this concept:

• Make a list of the things your business would most benefit from.

• Forget convention, forget inhibitions, even forget morals, laws and ethics (for a

moment).

• Items may include, contact Steve Jobs, get PR via popular TV show, paint your

company name onto the side of Air Force One, call the CEOs of all your

competitors, call your top 100 customers, run naked through the streets handing

out PR material, etc.


• Items shouldn't include, update CRM, lodge my tax return, post on blog every

day, make a couple of sales calls, etc., they must be things that will add massive

value to your business (e.g. Gary Vaynerchuk getting featured on Conan

O'Brien).

• Don't ponder the items, just write them down before you find reasons not to add

them; forget reasons, just think "value".

• Now, look at the list, consider each item and watch yourself rationalize not

following through.

If you "had your hustle on", you'd do most of the items. If you don't have your

hustle on, you'll make excuses. "Oh, Steve Jobs won't answer my email; that TV

show won't have me on; I'll do that task tomorrow; I'll be arrested and charged

with treason. Etc." If you had your hustle on, you'd think, "there is no tomorrow,

there's only right now!"

I guarantee if every day you made that list and did everything on it (that didn't

lead to a Colombian jail), you'd be many times more successful. Just like keeping

fit and healthy, success in business doesn't depend on skill, it depends on excuses

(or lack thereof).

The business model: a humble hero

Successful businesses are often celebrated for their innovative ideas. When we

think of Google, we think of fast and relevant search results. When we think of

Kiva, we think of catalyzing entrepreneurship in developing countries. And, when

we think of TripAdvisor, we think of an endless range of travel reviews.

But, in many cases, it's the underlying business model, rather than the customer-

facing concept, that creates real economic value. For example, a distributed ad

network made Google profitable; co-operative field lenders made Kiva's social

concept viable; and affiliate advertising funded TripAdvisor's rise to the top of the

web.


While it may be easy to create traffic from a quirky idea (think Twitter), it takes

business model innovation to make that quirkiness last. As the title suggests, the

business model is often the humble hero of successful businesses.

So what is a business model exactly? It's simply the system or framework used to

create economic value. A successful company's competitive advantage must have a

distinctive link to its business model. The focus may be on generating revenue,

saving on costs, optimizing working capital, maximizing cash flow or anything that

creates economic value-add in a unique manner.

Keeping a safe distance when advising investees

There's a fine line between advising investees and doing their work for them. And,

this fine line is easily crossed as private equiteers try to add their own unique value

to portfolio companies.

The typical scenario starts with witnessing something that could be done better. It

may be related to sales, costs, relationships, inventory or whatever. You first

discuss the issue with one of your C-level execs, you make a few suggestions, you

query how your suggestions fared, you make the same suggestions again, etc.

Depending on your level of patience, there comes a time when you finally think to

yourself, "if I want it done properly, I'll have to do it myself".

But, this is dangerous for many reasons:

• You have an entire portfolio of companies, and playing CFO or CTO or COO in

all of them is untenable; you'll sacrifice your performance as a private equiteer to

become, at best, a mediocre manager spread thinly across investees.

• You're setting a precedent; the next time you call for something drastic, they'll

expect you to oblige.

• You're creating a dependency; if you're out to build great companies, you'll be

doing them a disservice by not allowing them to make mistakes, learn from those

mistakes and refine their skills.


• You may be wrong; yes, it's possible; while a fresh eye often provides new insight,

a weathered eye often has the benefit of previous experience and a more informed

visceral intuition.

With all of that said, it can be helpful to get your hands dirty in an investee to

really understand how it ticks. You are the owner (or part owner) of the business,

so it's clearly in your best interest to help where you can. But there's helping and

then there's helping; one involves keeping a safe distance.

10.Dealmaking: The Art of Getting In

Private equity deal strategies

This wouldn't be a technical private equity book without a rundown of private

equity deal strategies.

• Management Buyout (MBO): this is the renowned buyout model from the boom

in the '80s, although they called them Leveraged Buyouts (LBOs) then. It simply

means that the management team in a business buys the business from the

existing owners with support of private equity.

• Management Buyin (MBI): this is very similar to the MBO, except a manager or

management team from outside the company purchases and manages the

business. In some respects, this entails more risk than an MBO because the new

managers are foreign to the intricate details of the business.

• Buyin Management Buyout (BIMBO): this term allows the word "bimbo"

around the office without the threat of a harassment lawsuit. Seriously though, it

is just a combination of an MBO and MBI, where managers from inside and

outside the company unite as investors.

• Public-to-Private (P2P): this is the purchase of all publicly listed shares in a

business to have it delisted from the exchange and classified as "privately owned".

Often there are perceived benefits in escaping regular public scrutiny and the

requisite reporting, hence the motivation to do a P2P.


• Secondary Buyout: this is the purchase of an investee business from another

private equity fund, either because it has outgrown the fund or because the

selling fund doesn't see value in keeping it. In rare cases, it can also involve

buying a business from a fund managed by the same firm.

• Expansion Capital: this is the investment of new capital as new shares into a

business to facilitate growth. In a pure expansion deal, the existing shareholders

stay on the register and 100% of the invested funds (less fees and costs) enter the

business as cash.

In practice, most deals are a combination of these strategies. Often some money

leaves the table and some money enters the company, represented by new shares.

One could argue that the value propossition of private equity isn't crystallized

without some capital entering the business as cash to support growth. The one

exception is if the business has cash and is just looking for someone to support a

sell down by another investor.

Channels for private equity deal origination

Private equity deal origination involves finding, negotiating and securing potential

investees. Since a firm seeks to invest in only 7-10 businesses for a particular fund,

it is crucially important to select the right businesses. However, contrary to

popular opinion, there's more to private equity deal origination than just short-

listing the hoards of entrepreneurs with new ideas knocking at the door.

One other important distinction is that the deal origination process differs for

different sized private equity funds. For a $10b fund, there aren't many

opportunities outside the public markets (and even then, the options are limited).

For a $10m fund, there are innumerable opportunities, so deal origination methods

are much different.

The channels for deal origination are as follows:


• Proactive: this involves a private equity firm proactively researching, short-listing

and contacting businesses that fit certain criteria. A common approach is to select

an industry with compelling fundamentals, spend a day on industry research, and

then iteratively contact businesses in search of opportunities. The major benefit

of proactive origination is that there is less competition with other private equity

firms. The disadvantage is that it takes much longer to qualify leads.

• Intermediated: this refers to cases whereby an intermediary facilitates a potential

deal. For example, a business broker or investment banker may introduce a

potential investee to a private equity firm. Unfortunately, multiple buyers see the

offer, which creates an auction and inflates the price. The advantage is that

businesses are qualified as real leads before presented to the private equity firm.

• Passive: this is where a potential investee contacts the private equity firm directly.

This can be through a link on a website, the phone book, or a related contact. As

with an intermediated lead, the potential investee is already qualified. The

perceived disadvantage is (and this has no technical basis) that businesses

looking to sell equity probably aren't the best businesses to be buying.

For larger funds, it is very difficult to originate proactive deals, as there's so much

competition with investment bankers looking to clip the ticket. At the mid-market

end, proactive origination is more the norm. Firms like to think they're

differentiating themselves by originating deals away from the brokers and bankers,

but in reality, most low-value deals originate from proactive industry research. The

advantages of not partaking in a process and not having to manage conflicts with

intermediaries generally outweigh the extra cost of qualifying these cold leads.

The pros and cons of intermediation

Intermediation in private equity refers to a middleman that facilitates a deal

(business brokers, investment bankers, corporate advisers, strategic consultants,

etc). I talked briefly about intermediation in my post about deal origination, but

here I'm going to expand on what I believe are the pros and cons.


Personally, I much prefer to work on proactive deals because you have the chance

to build a rapport with the owners and work on a more personal level. The

processes created by intermediators typically (not always) take the subjectivity out

of the deal, which is the foundation of most private equity deals. With that said, the

higher prices typically achieved with intermediated deals suits private equity firms

when they want to exit investments. So, it's really a case of "can't live with them,

can't live without them".

Intermediation Pros

• The potential investee is usually qualified: that is, the private equity firm knows

that the business is interested in a sale or investment. This negates much of the

extensive legwork required to sell the idea of private equity and to get a

commitment. There is still the risk that the owner can pull the pin at any time,

but it is less of a risk in an intermediated deal.

• The intermediator can smooth negotiations: when a private equity firm tries to

convince a business owner that equity clawbacks are typical and that their

business is only worth 3 times earnings, it doesn't hold the same credibility as it

does from an independent party. That's not to say that intermediators are

independent, but they're arguably more independent than the private equity firm

is. So, the intermediator may help by prepping the owner beforehand.

• Many deals are only available through intermediation: this is especially true with

larger buyout deals where business owners (or directors in the case of public

companies) are obligated to run a process and shop the deal around. Similarly, if

a business owner enlists the services of an intermediator, they tie themselves to

that agreement for a lengthy period, which essentially thwarts the efforts of

private equity firms looking for proactive deals.


Intermediation Cons

• Interests are often unaligned: deal-related fees often incentivize an intermediator.

If this is on the top-line payment price, then the incentive is for the intermediator

to secure a higher price. If it is on the cash payment/injection, this will shift

incentives away from expansion deals towards full sale deals (it will also create

disincentives towards earn-outs and the like).

• Shopping the deal takes place: in intermediated deals, the private equity firm is

only one of many parties in contact with the deal. The first problem with this is, a

trade buyer can create a better deal with a higher top-line valuation (remember,

often they are the more natural buyer due to synergies). The second problem is, it

creates an auction for the business and private equity firms rarely care to be the

highest bidder in auctions.

• It becomes difficult to learn about the business: this is a by-product of misaligned

interests, but it warrants special note because it can be terribly frustrating.

Intermediators often prefer to create bargaining chips and burning platforms in

order to inflate their advisory fee. This usually works against a private equity

firm attempting to understand the motivations and thoughts of the business

owners.

As difficult as it may be, it pays to be nice to bankers

Contrary to common belief, merchant bankers have feelings too. In fact, bankers

think of us (private equiteers) the same way we think of them; as cold, callous,

calculating financiers. Sure, we act like close comrades in tete-a-tete, but deep

down we boil each others' blood. You see, bankers hamper our dealmaking efforts.

They may think we wouldn't have access to deals without them, but we actually

think we'd have a more direct path to deals if they disappeared. We'd understand

vendor needs to a greater extent, be able to negotiate more effectively and not have

the usual problems dealing with middlemen. So, it's very love/hate as you can see.


But, this is a dangerous view. Bankers undoubtedly have influence over markets

and their clients (who just happen to be our potential investees). And even leaving

the banker value-add debate to one side, it's impossible to make a case that states

bankers have no influence over our deals. They are hired as stewards, have pride

in this implied stewardship and don't exactly have a lack of access to private equity

firms (or other potential buyers).

So what's my point? Well, we only hurt ourselves by disrespecting merchant

bankers. I'm not talking about the kind of disrespect that gets in a banker's face;

I'm talking about the disrespect we try to obfuscate but secretly hope isn't too

obfuscated. The disrespect that says you are middleman pond scum and we're the

kings that control the money.

I've found it pays high dividends to empathize with a banker's endeavors and to

treat them as equals. They provide additional deal flow, intel on the market, hints

to handling vendors, notes on competing offers, honesty around expectations and

suggestions on deal structuring. But remember that they're generally quite

perceptive, so any egregious attempt to appear best pals will just make the

situation worse. You need to find some genuine empathy, which may just be the

difference between a great deal and no deal at all. Plus, you never know, your new-

found banker friends may even provide good company over a cold ale on a hot

summer's day.

The many drivers of a private equity investment

In a recent post about pre-money and post-money valuations, I talked about two

primary uses of private equity in a business: 1) to replace existing capital, and 2) to

invest new capital. So, this begs the question, what drives investments that swap

capital and inject capital?


Swapping Capital

• Transition - many private equity transactions occur because, for whatever reason,

there's a transition of ownership and/or management. We know these

transactions as MBOs, MBIs and, of course, BIMBOs. The drivers for transition

can be anything from an outrageous offer to the current owner simply calling it a

day.

• Succession - this is a form of transition, but more specifically involves an owner

reaching pension age and passing the business on to family members or new

owners. In either case, a private equity firm can sponsor the buyer to purchase

the business from the seller. This often works well because the prospective buyer

has an entrenched understanding of the business, but doesn't have the funds to

help pay the seller a hefty one-off pension payment.

• Privatization - we hear about many private equiteers that exit investments via the

public markets (i.e. IPOs). But sometimes, if a listed business is undervalued, we

also see them enter via public markets. We know these transactions as public-to-

private deals. However, they're not as common as other transaction types because

the process can be painful. Apart from needing to convince thousands of

stockholders to sell, you often need to pay a premium to convince them.

• Consolidation - sometimes it can be a pain in the backside to have a fragmented

stockholder base, even if there are only 5 or 10 investors. In this case, a private

equiteer will sponsor a more enthusiastic stockholder to buy-out the less

enthusiastic stockholders, giving him/her more control to drive growth. This may

also be the result of a succession or expansion transaction.

• Equitization - this involves changing the balance of debt and equity in a business.

Often a private equiteer will invest to de-leverage a business by paying down

some of the debt. This may be a turnaround situation or as a way for a business

to bring in a private equiteer (for their skill, contacts, etc.) without burdening the

company with new equity it doesn't yet need.


Injecting Capital

• Expansion - this is the typical venture capital scenario, but also a private equity

scenario, when a business needs more money to expand. The money may fund

plant & equipment, working capital, staff, professional services, marketing, or

any number of other needs. In this case, the investment requires the issuance of

new stock, often with preferred status. This isn't as common as one may think (in

private equity) because typical private equity candidates already produce

significant cash flows to fund growth or at least the interest payments on debt

(which we know is much cheaper than private equity). It's more common in

businesses with unstable cash flows, already high gearing, a lack of financial

sophistication, or a specific need for a private equity investor.

• Acquisition - this is simply a specific example of expansion funding, but it differs

because it often requires capital that can't be funded by maintainable cash flow.

Acquisition funding is a very common driver for private equity funding, and

unlike my comments above for expansion funding, it is often needed by

businesses with stable cash flows and only moderate gearing.

As you can imagine, most transactions fit into more than one of the above

categories. Expansion deals may consolidate the stock register, acquisition deals

may involve ownership transition, and privatization deals can often trigger some

form of equitization.

As a private equiteer, there are many tools in the toolbox, and by using these tools,

we can structure deals that appeal to the most stakeholders while also delivering

value to our funds.

Opportunities abound, but what about the existing portfolio?

First off, a lot of private equiteers are resenting deals done at the peak of the

market. The peak was characterized by abnormally high earnings and abnormally

high multiples. Since both of these characteristics are inputs into price, the prices

paid recently were doubly inflated. So, now many of us are trying to fix deals that

represent retrospective multiples of over 10x earnings.


Put that negativity to one side for a moment and we have a market ripe for great

deal-making. Earnings in many industries are at cyclical lows, multiples are also at

cyclical lows, plus there are a few distressed sellers trying to sell good assets to

support bad assets. All of this makes for great deals; it's just a matter of managing

this process while managing the rest of the portfolio.

With both of those points made, it's a great time for newly formed funds that don't

have the baggage of underperforming investees. For the rest of us, I think it is

crucially important to understand how valuable this landscape is for our funds.

We're all so worried about our current investees (and rightly so), but the

opportunities available now could conceivably have much more impact on our

overall performance. Just to make the point again, I'm not suggesting that we

leave our existing investees to twist in the wind, just that we should not let rare

opportunities pass us by.

Minimum stake a private equiteer will take in a business

Private equiteers often boast that irrespective of their percentage ownership in a

business, their shareholder terms are so tight that they are a proxy to majority

control anyway. This may be true for certain terms, but it's important to note that

the type of control a private equity firm wants is the control that limits their losses

when disaster strikes (or that may lead to disaster).

Many private equity firms join syndicates to invest in larger businesses, but that

has its own issues. I find that syndicates are difficult to manage, especially when all

firms are looking to add real strategic value to the business. Some argue that two

heads (firms) are better than one, but others argue that syndicates create

unavoidable conflicts.

Either way, firms like to own enough shares to make their investment influential,

even if their shareholder terms are restrictive. I can only speak for the firms I've

dealt with, but this is typically at least 15-20% of the firm. Wanting majority

control (i.e. 50%+) is more a myth than anything, except for firms dealing with

special situations (e.g. turnarounds).


A preference for partial sales

One of the many paradoxes in private equity is as follows:

“A private equity offer is the most valuable to vendors, yet the lowest priced. “

This refers to private equiteers priding themselves on being the lowest bidders in a

business sale (hence, entering at a low price), but at the same time believing their

offer is the most valuable to the vendors.

How is this possible? Through the creation of future value; value in addition to the

prima facie purchase price.

The implication is that private equiteers look for deals in which vendors don't want

to sell all of their stock. Because, if they do sell down completely, they'll mostly

focus on the purchase price rather than future value creation. Private equiteers

generally can't compete with strategic buyers on purchase price because they don't

have as much access to synergistic value creation. So, it helps if a private equiteer

can make a case for future value creation.

To recap this post with previous posts, here are the main reasons you'll witness

private equiteers urging vendors not to sell all of their stock:

• Because it's more risky if the people with the greatest knowledge of the business

leave the business.

• Because the more left invested in the business, the more motivated the vendors

will be to ensure the success of the transaction.

• Because it provides a way for a private equiteer to demonstrate greater deal

value.

Unless the deal is a spectacular standout, a private equiteer will generally move to

lower hanging deal fruit if the vendors aren't willing to remain in the business. This

makes sense because if the vendors are fixated on the initial purchase price and

there is a likely strategic buyer offering a higher price, there's little point in wasting

time on negotiating the deal.


Of course, this also works well with the fact that we like to invest in businesses in

which the managers invest cold hard cash (see my recent post on this topic). This

isn't to say a vendor can't sell out while new managers invest, but typically it's less

risky if the current vendor/manager stays around with money at risk. With all of

this in mind, you can see why private equiteers often prefer partial sales.

Low-hanging deal fruit ain’t what it used to be

When faced with the task of deal origination, one quickly realizes there's low-

hanging deal fruit and five-storey high deal fruit. What I mean is that some deals

are much easier to find, negotiate and close than others. However, most of the low-

hanging deal fruit is hotly contested, ergo, it's highly priced.

At the other extreme, more difficult deals (such as those that require complex

collaboration) often just waste time; this becomes obvious after one or two drawn-

out failures. (They get your hopes up when you're a greenhorn, but you quickly

learn to save time in future.) So this begs the question, what is the sweet spot for

mid-market private equity?

Well, I believe the cumquat of deal origination (read: sweet, succulent and bite-

sized), is the deal that isn't hotly contested because it isn't shopped around, but it

should be hotly contested because it represents great value and great potential.

This deal originates via a cold call or a warm lead from an industry event. Often, in

this deal Elysium, the vendor is a business owner that is great at their trade, but

isn't financially sophisticated enough to have approached an investment bank. The

business may not be in the most obvious industry for value creation, but the

product or service offering will have a quirky competitive advantage that is

brilliant in its simplicity. This deal is probably right under your nose.

In short, it's not the low-hanging fruit you should be after; it's the fruit sitting on

the ground under a big leaf that if approached correctly, doesn't even require the

raising of an arm to grasp. The beauty is that even though it's so close, the majority

won't take time to look under the leaf.


A word on private equity and franchises

When focusing on retail segments, we often discover franchised businesses. The

primary argument supporting the franchise model is that having entrepreneurial

individuals operating stores leads to better performance because as part-owners,

their interests are more closely aligned. If you compare this to salaried employees

working just another job (as managers of stores), you can see how franchising

makes a lot of sense.

In most franchise businesses, there's constant conjecture around the ideal balance

of franchised versus company-owned stores. Prima facie, you may think company-

owned stores breach the idea of the franchise model, but we also interminably hear

how repurchased stores operate more profitably when company-owned.

Maybe franchises only work in certain industries, maybe it's just not easy to find

great entrepreneurs to run stores, or maybe the fault lies with franchisors.

As a private equiteer, it's important to analyze the dynamics and differences

between franchised and company-owned stores. But, more importantly, be wary of

bold plans to repurchase stores just because the franchisor thinks they'll become

more profitable. I see countless deals solely based on this premise, but I just don't

buy it. They're especially questionable if the businesses success was founded on the

original franchise model.

With all of that said, company-owned stores are great for franchisee training,

market and product testing, and benchmarking; they're not all bad like it may

sound. There are also situations in which the franchise model was only originally

needed as a workaround for limited capital. And in these situations, it's hard to

make a case against a franchisor looking to buy back great money earners with the

support of a friendly private equiteer.

Private equity deal killers

By saying deal killer, I mean some aspect of a deal that is too severe in risk and

nature to allow the deal to continue. There are a few black and white private

equity deal killers, but also many shades of grey. Author: The Private Equiteer © 2011

The solution seems to be to have a set list of deal killers and to stick to that list

regardless. The problem of course is that you could miss great deals and there's

merit in looking at deals on a case-by-case basis. The following list is not

exhaustive, but outlines a few scenarios in which I'd kill a deal:

• Breach of investment mandate: a breach in mandate (industry, size, ethics, etc) is

an instant deal killer. If arguments against this seem to be frequent, either there

are issues with the mandate (which aren't really issues, because it's the mandate),

or your team is just being argumentative.

• Existing market too small: the usual counter argument is that acquisitions can be

made to increase the applicable market size. But, banking your investment on

something as significant as an acquisition that may or may not occur is

investment suicide in my opinion. There will always be risk in making

investments, but why take much bigger risks when you don't have to.

• Customer and/or supplier concentration: again, a potential acquisition may

mitigate this, but you're proposing to purchase the business now on its merits.

Why pay for a business on the basis of risks being mitigated later, when you'll

have to do a lot of work afterwards to invoke the mitigating actions. If you're

willing to take those risks, then you should be paying less now.

• Industry concerns: if you're proposing to enter an industry with fundamental

issues or without adequate potential growth, then what are you really doing?

Sure, you can reach target returns without market growth, but why take that risk

when you don't need to. Most of the time it's best to let a deal go than take

industry risk.

• Management concerns: most importantly, if you don't think you're backing an

excellent manager from the start, then I'd say that is a deal killer. Again, you can

propose the argument that managers can be dumped, but why settle for second

best? Private equity is firstly about backing a great manager, because they are the

designated driver, so it really is unnecessary to take risks here.


I've witnessed a lot of self-fulfilling analysis lately and think it's important to

maintain objectivity in this climate. As the cliche says: lemons ripen early, plums

ripen late. That is, if the deal looks like a lemon early, it probably is a lemon.

The aftershock of hard negotiations

They say the best salespeople can sell just about anything to anyone: ice to the

Eskimos, sun to the Saudis and fire to the Devil. They do this by understanding

behavior, analyzing motives and focusing on what matters at the time (which may

not be what matters in the long term).

In private equity, we make investments in businesses worth many millions of

dollars. The need for negotiation is therefore implicit. But, we don't just negotiate

price, we negotiate terms, contracts, and many other things, which in aggregate,

constitute the deal.

I suspect a salesman who can sell ice to Eskimo can also sell a 3x multiple and

aggressive anti-compete terms to a founder. But unlike the Eskimo, whom you'll

likely never see again, you may have to work with the founder for many years to

come.

If you create resentment now, your great multiple of 3x EBITDA may look like 9x

EBITDA in six months when earnings tank due to managerial revolt. You may get

comfort from the fact the founder is still invested and wouldn't want to sacrifice

his/her own wealth, but then you'd be ignoring human irrationality and the feeling

that comes from revenge.

So what's my point? I think it's important to play it fair with founders and

managers for the sake of the future. While significant value can be created by a

great entry price, significant value can be lost thereafter. I'm not suggesting that

you capitulate to founders' demands, but I suggest we all practice a little foresight.

Nothing can beat the power of a fully-aligned, determined and resourceful team (of

investors and investees), even a low entry price.


The economics of bolt-on acquisitions

In private equity, we make primary investments and bolt-on investments. A

primary investment is a direct investment of cash into a new business (often in a

new industry). A bolt-on investment is an investment via an existing portfolio

company into a business that presents strategic value (usually in the same

industry).

Primary investments get most of the press. But, many private equity funds spend

just as much cash on bolt-on investments. And, bolt-ons have the potential to

create much more value (I'll explain why later). So, it pays for a private equiteer to

give up some of the glitz and glamour of primary investments to become a quiet

achiever through bolt-ons. Here are a few of my thoughts:

• Bolt-ons are usually smaller businesses, which attract lower multiples with better

terms.

• Bolt-ons provide the chance to create instant value (by acquiring lower multiple

businesses using a higher multiple vehicle).

• Bolt-ons often require less work because they are smaller and attract less

competition.

• Bolt-ons offer strategic value (revenue and cost synergies), meaning you can pay

a little more and be more successful in an auction process.

• Bolt-ons provide for easier due diligence since you have access to industry

experts in your primary investment vehicle (access to this experience is

invaluable).

• Bolt-on owners are more likely to do a deal with a larger industry player, since

there is prestige in being part of a leading firm (compared to being gobbled up by

financial vultures).

• Bolt-ons give you access to a whole new market of potential investees as certain

mandated restrictions (regarding size) don't apply.


With that said, there are countless studies lamenting the destruction of value that

occurs daily via mergers and acquisitions. So, it's imperative to maintain focus on

likely integration issues and ensure there's a cultural fit.

Methods for private equity firms to exit investments

A private equity firm receives the lion's share of its returns upon exit of an

investment. (The remainder is realized along the way as dividends, distributions,

management fees and capital returns.) The exit of an investment is typically in the

form of one of the following:

• Trade sale: this is the most common exit for private equity. The reason being that

trade buyers in the same industry are often more likely to have synergies with the

business. Therefore, they are the most natural buyers of the business and, ipso

facto, trade buyers can pay the highest price.

• Public listing: in the right market conditions, an IPO can lead to very fruitful

outcomes for business owners. The major benefit of an IPO is that the business

owners don't need to subscribe to a raft of warranties and earn-out conditions,

which are usually present in a trade sale. The downside is that the process is

relatively costly and the results are acutely sensitive to market movements.

• Recapitalization: in some cases, the management team and other shareholders

may decide they want to continue running the business after the private equity

firm exits. Recapitalizing the business (usually with debt) and using the new

capital to buyout the private equity owner can achieve this.

• Secondary sale: this involves selling the business to another financial investor

(usually another private equity fund). Although this seems perverse, (you'd

imagine if one private equity firm didn't want the investment, others wouldn't

either), a deviation from a firm's investment mandate can drive it (e.g. the

business is getting too large for the fund to support).


Exiting founders, unaligned interests

There's a simple yet particularly salient post over at the Carried Interest blog about

exiting founders and the lack of implied alignment. The age-old question is,

• why are you selling your entire business if you're young, healthy and ambitious,

and if the business and industry have huge potential?

It doesn't make sense when you hear it, read it or think it. Yet, we have to ask this

question at least once a week. Sometimes I almost convince myself to ignore it, but

it's safest to go with common sense and avoid these situations because chances are

that the business/industry isn't so great and the founder is being opportunistic.

Is a recapitalization a compelling exit strategy?

A recapitalization (recap) is one of many potential ways that a private equity firm

can exit an investment. It involves a business borrowing money to fund a

repurchase of equity from an investor that wants to exit. A recap is usually

marketed as a way for an owner/manager to continue running the business if they

do not want to sell when the private equity firm does.

There are a few points I'd like to make about recaps:

• A recap is unlikely if the firm owns all/most of the business. If the investor owns

most of the business, then it is unlikely the bank will lend enough to buy the

entire equity stake. The only way this would work would be if the expected sale

multiple was the same or lower than the lending multiple. That is, if the bank

would lend 3x earnings and the investor only wanted 3x earnings for their stake.

But, this would be highly unlikely.

• A recap will rarely involve the natural buyer. The buyer in a recap is the business

itself and one would imagine that the most natural buyer of a business wouldn't

be the business itself. The natural buyer is the buyer that can rationally pay the

most for the business due to synergies, opportunities and other areas of value

uplift. This is why sellers most commonly seek to sell to the most natural buyer,

because in theory they can pay more.


• A recap represents increased risks and costs. Even though we've learnt that

capital structure shouldn't influence our valuations, in reality, the remaining

owners of a recapitalized business will incur increased risks and costs due to

increased debt. This can only negatively affect the price a rational buyer is able to

pay. The counter argument to this is that gearing also represents the potential for

increased value creation, so in some ways it offsets risk, but in reality the risk is

still there.

Overall, I'd say that a recap would represent a less than ideal outcome. It may be

necessary when a private equity firm must exit, but it would rarely be the ideal

plan prior to the initial investment. This is simply for the fact that a recap doesn't

represent the most natural buyer and hence it wouldn't represent the highest

possible price. For this reason, I would say that a recap isn't a compelling exit

strategy and is only a saving grace in unfavorable circumstances.

How to get the best price when selling a business

Most private equity firms are meritocracies. And merit is largely founded on

investment success. We can improve the chances of investment success by paying

lower multiples, commanding preference coupons, investing in favorable structures

and making smart strategic decisions. But by far, investment success depends on

the price at exit.

So, here are a few tips to getting the best exit price for your business:

The Buyer Pool

Financial buyers (e.g. private equity buyers)look mostly at cash flows and likely

investment returns. Strategic buyers (e.g. competitors, customers and suppliers)

look at synergies, strategic value and brand power. But, don't only focus on

strategic buyers; keep financial buyers in the pool to increase competition and keep

options open (financial buyers regularly forgo rationality and become competitive

too).

Competition


Competition is good for bidding up prices. But, competition can also deter financial

buyers who don't want to compete with strategic buyers on price. You should

maintain ambiguity in the early stages of a sale process and allow buyers to become

emotionally attached to the business before stirring competitive tension. Don't be

the real estate agent who announces there are hundred of interested parties. Some

buyers will flatly pullout if you announce competition. (Be especially careful with

other private equity buyers; they don't like competition.) Irrespective of the buyer

though, focus on the value above maintainable cash flows (synergies, etc.) to elicit

the best price.

Expectations

High price expectations can drive potential buyers away. But, low price

expectations can set a psychological cap on the price. Again, be ambiguous at first,

but aim to set a floor on the price early without actually naming a price. Talk about

similar transactions and other subjective measures that help plant the seed for a

higher price. This is difficult, but if you're too ambiguous, buyers will justify a

lower price in their own mind and find it hard to move upwards later.

Communicate methodically and try not let anyone hasten you.

Metrics

In the early stages, try to negotiate in multiples, as it leaves more room for

flexibility. If you set a price at $xm, you give the buyer power to manipulate the

deal (e.g. around cash, inventory and debt levels), all while maintaining the price at

$xm. Sure, you can increase a price, but you want to avoid setting unnecessary

psychological caps. However, if you find the buyer is fixated on paying a certain

multiple or price, adapt and put your efforts into negotiating on inclusions.

Inclusions

With both metrics, multiple and price, there is a lot of room for manipulation. So,

be prepared for various discussions about inclusions, which include fixed assets,

cash at bank, earnings normalizations, etc. Understand these subjective factors

before talking to buyers and make sure your arguments are rational. Also, make

sure you keep a few bargaining chips up your sleeves.


Integrity

Above all, maintain your integrity, be friendly, be honest, but remember, this is a

once in a life time opportunity, so don't be overly generous. However, if you're too

tough and manage to get an unfair price, you may benefit now, but you may also

witness repercussions later. As a private equiteer, you already have more than

most, so don't take unsophisticated buyers (in a transactional sense) for a ride.

Keep your spine, be decent, be one of the good guys.

There's much more to negotiations, but these are the points I thought especially

salient for private equity.

Tips for an entrepreneur to investigate private equity options

I've probably written quite a bit already on why an entrepreneur or business

owner should consider a private equity partner, but I thought it would be helpful

to discuss how I think they should go about investigating their options.

• I'd recommend avoiding the intermediaries (brokers, advisers, investment

bankers, etc). My reason is that middle-men inherently introduce new layers of

costs and complexity and in most instances, a business owner is sophisticated

enough to deal directly with potential partners. However, with that said, I fully

acknowledge that there are cases where an intermediary can add significant

value. Such examples may be where a family estate wants to sell a business, or

where the business owner is very technical and hasn't had to be commercial in

their role.

• Talk to the principals of different investment firms to get a feeling for their

mandate, intellect, philosophies, but most importantly, make sure they have direct

skill and experience in your industry. If the firm says they have secondary

associations with people in your industry who can help, don't buy it. Make sure

someone on their direct investment team will be able to help extract the most

from your business. Even if you just want to sell and get out, most private equity

firms will tie you into earn-outs and such, so this is still very important.


• When progressing discussions, make sure you understand the firm's intentions

with your business before you commit to anything. That is, ask to see their first

draft strategy and gauge the value of it. Use you intuition here and don't let

yourself be bullied. A lot of value can be created with a private equity firm

partner, but you want to find the one that can add the most value. Similarly, if the

firm's intentions seem overly risky, then don't go for it. Your chances of losing

value are also much higher with a new business partner.

• Talk to the relevant private equity association, ask their opinions about different

firms and ask to see a list of registered firms and their mandates. This will help to

narrow down your initial contact list. In Europe, the applicable body is the

European Private Equity & Venture Capital Association, whereas in the States

the applicable body is the National Venture Capital Association.

I'm sure there's much more to think about when approaching private equity firms,

but these are a few tips that I hope would provide comfort around the process.

11.Anti-PE: Is It Really Magic or Just a Con?

Stay clear of single-owner private equity firms

At the smaller end of town (say under $200m of capital), there are a plethora of

private equity firms that are individually owned. Often these owners come from

larger firms where they didn't get along with others or preferred the idea of

running their own show (for a larger portion of carry). This isn't such an

unconscionable act in isolation, it's actually quite industrious, but there are

fundamental flaws to single-owner private equity firms.

Private equity firms must have a deep and thorough understanding of deal-making,

financial instruments, legal structure, business strategy, and of course, debt

management. It's hard for a single private equiteer to have a deep understanding in

all of these areas, which is why it pays to have a range of senior partners/owners.

Conversely, most single-owner firms are bottom-heavy and don't have this

diversity and therefore contain much more risk for every stakeholder in the firm.


In addition, here are a number of other important considerations regarding single-

owner firms:

• They're a textbook example of a dictatorship - one person, with all of their

emotions, persuasions and biases, has carte blanche over every major decision;

decisions such as selecting investees, hiring new staff and leading due diligence.

In private equity, two, three and four heads are definitely better than one.

• Key-man risk is a repellent - investors (limited partners), investees, staff, media,

bankers and advisers tend to steer clear of single-owner firms for various reasons.

LPs will give a wide berth because there's increased risk borne by having only

one decision maker. Investees will do the same because there is often less value-

add from a less experienced team. And staff, if they know better, will steer clear

because a dictatorship is not the best place to learn.

• There is fundamental risk to the fund - as previously noted, most of these single-

owner firms are bottom-heavy. If something unpleasant affects the owner, the

fund is left with a phalanx of fledglings whom may be versed in the daily

ruminations of the firm, but lack the critical relationships to run the fund.

• They circumvent necessary checks and balances - even the most competent

business-people need checks and balances in cases where they aren't thinking

straight, aren't completely objective, aren't available or are simply too stubborn

or clueless. Companies have boards of directors, Presidents have senior advisers,

but single-owner private equity firms only have LPs, whom most of the time are

oblivious to what's really going on (sorry LPs, but it's true due to a lack of

transparency).

• The arrangement is often a sign of the owner's character - in most cases private

equity firms benefit from multiple owners with complementary qualities. My

experience is that single-owner firms are single-owner for a reason: the owner

finds it hard to compromise and deal (closely) with other people. Additionally, it

gives LPs and others comfort to know three or four top equiteers can work

productively (even if at times with tension) using their complementary skills for

the greater good.


• Management fees are squandered to profit the owner - with a single owner, there

is a real conflict regarding management fees. "Do I spend $x on business tools or

tell staff to make do and save the money for dividend time?" Of course this could

happen in multi-owner firms, but chances are they'll keep each other honest.

And, having multiple people with a financial interest in the management company

will increase the chances that fees are put to good use.

To reiterate, I think it's industrious and quite brave for a private equiteer to open

up their own PE shop. But especially in private equity, it's best to have a number

of owners/partners with complementary contacts, skills, and experience. Multiple-

owner firms are generally better investors, have better contacts, are better places to

learn, are more enjoyable to work within and have more overall success.

Equity returns for debt risk

The mantra of the private equiteer is maximum return for minimum risk. However,

I can't stress enough that the emphasis is on minimum risk. Private equiteers

essentially want all of the upside in a deal and none of the downside.

In public markets, you can achieve this by buying put options against a portfolio or

through investing in call options. But we all know there's a cost, and even with that

cost, you rarely mitigate risk 100%.

To achieve the same in private equity, we invest via preferred stock, demand

preferred coupons, have veto rights over many business decisions, take a board

majority, have the right to fire senior executives, demand that managers invest,

sometimes even demand redeemable preferred stock, etc. We are simply hedging

our bets. But, like option strategies in public markets, the hedge isn't perfect.

Where this idea of equity returns for debt risk really matters, is within a portfolio

of assets. Public equity fund managers invest in equity returns for equity risk and

that equity risk means that some investments succeed and some fail (and then

transaction costs ensure most fund managers achieve sub-market returns).


In a private equity portfolio, our quasi-debt investments don't incur as much loss

from poor performing investments, so portfolio returns can conceivably be above

public equity portfolio returns without investee performance being above average.

Of course, this doesn't hold when private equiteers over-gear their investments,

but think about this without above-average debt. Especially in current markets, I

see private equity characterized more by strict legal terms than mountains of debt.

For the record, we have made two investments this year that are completely debt-

free.

Natural selection or naturally speculation?

Most private equity firms look to invest in only 7 to 10 portfolio companies over

the 10-year life of each fund; fewer portfolio companies means more value-add per

investee (a resource allocation argument). Keeping this in mind, it is quite

important that each investment represent a great opportunity. One failed

investment won't necessarily bring the whole fund down, but it may materially

impact overall returns. So, how speculative is investment selectivity?

When a private equity firm evaluates a potential investee, firstly they prognosticate

potential returns and the likelihood of meeting their target return (often 25%+ pa).

If presented with five potential investees simultaneously, the question becomes,

which investees will meet our target return and do we have the resources to engage

them all. If resource constraints limit the number of simultaneous deals, focus is

constrained to deals that present the most opportunity on a risk-adjusted basis.

However, even with very detailed analysis, many assumptions underpin all of this

prognostication and in the end, it is all highly speculative. Moreover, even if there

is a real science to assessing current deals against each other, how do you compare

these deals to future deals. What would a firm do if presented with 10 great

opportunities all at once? Would it invest in all of them if analysis showed they'd

all meet the target return? There must be some thought given to the deals of

tomorrow. Maybe the 10 great deals today will pale in comparison to the 10 great

deals tomorrow. So, how does one decide that a deal today is one of the best

opportunities that the firm will see over the life of the fund?


Of course, there is no real answer to this. I just wanted to bring this topic to light

to show how subjective and speculative the investment decision really is. But, this

is what private equity firms value themselves on; their ability to remove as much

speculation as possible and to make essentially profitable decisions. On the other

hand, maybe this discussion sheds light on why we're seeing so many write-downs

of late. Maybe funds were too busy trying to get their money out the door and

weren't focusing enough on the comparative value of future opportunities. Of

course, everything is clear in hindsight.

Private equity returns are misleading

Let's start with a few standard private equity terms:

• Committed capital: this is money "committed" to the fund, but not necessarily

paid. So when you hear about a firm raising a $1b fund, it doesn't mean they're in

receipt of $1b in cash, it means that investors have contractually promised to

invest $1b as (and if) needed. Be aware that management fees take a big bite out

of the $1b. At a 2% p.a. fee, you're looking at a minimum of $100m (equalling

10% of committed capital over the life of the fund) and a maximum of $200m (it

would be less than $200m in practice as investors don’t pay fees on distributed

capital).

• Called capital: this is money "called" from investors to fund investments in

companies. A fund only calls money from investors when it's ready to invest that

money. It typically takes a fund five years to "call" most of its capital (not

including the cash required to pay management fees). This is a primary difference

between a mutual fund and a private equity fund. (You commit and invest all

capital simultaneously in most mutual funds.)


And, how does this result in misleading returns? Well, private equity funds use the

internal rate of return (IRR) on cash inflows and outflows as their return metric.

The implication is that the return doesn't account for you having to hold cash. A

fund may not even call a dime until year nine, then return double your money in

year 10, and then quote a 100% return for the fund. The fact is, you held that cash

for nine years at a negligible rate (or had it invested at risk in another investment),

and achieved an overall return of only a few percent on the commitment (certainly

not 100%).

This issue isn't so black and white because,

• no one is forcing you to hold that money at low rates of return, and

• no one is forcing you to hold the money at all since the fund only needs it when it

needs it.

However, you really do need to hold the cash if you want to limit your risk to the

risk of the investment itself. And you really do need to hold it in a risk free

investment, again, if you want to limit your risk to that of the private equity

investment. Ipso facto, the return from the risk free investment should be included

in the overall return. And if you do invest that cash elsewhere OR if you don’t

actually have that cash yet, then the risk of that investment must be considered for

the private equity investment.

So what effect does this have in economic terms? Well, most private equity firms

look to return 2x the original cash investment. But remember, 2x cash is a 100%

return, not a 200% return. Now, if my math from many years ago serves me well,

that's a ~7% return for a 10 year investment. Of course, that's too conservative as

you receive distributions well before the 10 years is up. So let's take an average of

five and 10 years. That equates to about 10-11% p.a. Certainly not what most

private equiteers espouse.

Sure, my methodology and math isn't going to win any prizes, but I'm sure you get

my point.


Private equity returns are misleading - Part II

It seems I've ruffled a few feathers with my previous post, ”Private equity returns

are misleading”. The main point of contention is that limited partners (LPs) don't

hold committed capital as cash from day one. Someone even suggested it was

ludicrous to make this assumption and that the premise of my argument collapses

as a result.

However, that's not the point I was making. Of course LPs time their cash flows

across their portfolios, which is probably the reason why so many have defaulted

on capital calls recently. If anything, this supports my argument rather than refutes

it. So let me make my points a little clearer.

If you hold all of the committed capital in cash from day 1, then you are exposed to

the normal risk of a private equity investment. However, the return of the

investment must take into account the risk-free rate on the cash for the entire

period it is held in cash (before it is called).

If you do NOT hold all of the committed capital in cash from day 1, then you

increase the risk of the investment. If you default on a call, you destroy massive

amounts of value (except in rare cases). Therefore, the risk you are exposed to is

not just the risk of the private equity investment and hence the return should be

considered in light of the higher overall risk. Even then, any loses or gains from

activities designed to meet capital calls should be accounted for in the overall

return.

I'm certainly not suggesting private equiteers are misleading LPs, but more that we

all mislead ourselves through blinkered analysis. Investment returns must be risk-

weighted and compared like-for-like. It's convenient for most of us to forget the

risk of default, even in the wake of the GFC when such ludicrous assumptions led

to cataclysmic outcomes.


It's all about investing in the best management team... isn't it?

Would a private equiteer prefer to hire the best manager in the industry?

Absolutely. Do private equiteers only do deals in which they believe they have the

absolute best manager in the industry? Ha!

As I've mentioned before, private equiteers don't enjoy the same luxuries as

venture capitalists; we can't be so selective because we're dealing with very

successful businesses and people whom have myriad options. We do deals that we

can do; we don't go chasing managers hoping to get lucky. Similarly, we don't limit

our options to a single company in any industry (the one with the best manager,

whoever that may be); we keep our options open.

So, why do private equiteers insist on spreading this “best management team“

voodoo? Well, it sounds great and is difficult to measure, ergo, who's to say you're

not investing in the best management team? Also, they have to say that because

they don't have the time, capacity or (often) capability to run these businesses

themselves. And, it's scary to think of a highly geared business with mediocre

managers and a trigger-happy PE investor.

What's more, it doesn't sound as holistic to sell your firm on its ability to invest on

a low multiple, gear a business to the nines, and then sell it at a much higher

multiple. The idea of long-term value creation, great managers, entrepreneurial

flair and of course total humility is much more post-financial-crisis-friendly. But,

with all of that hate projected on deal-focused private equity firms, I must say there

are truly great managers out there with real business experience and the nous/

drive/passion to make a long-lasting difference. It's just a wheat/chaff sorting

exercise for LPs.


Clip-on acquisitions in private equity

Private equity is very much about growth through acquisition. Acquisitions give

the private equiteer the ability to create instant value through multiple arbitrage,

synergistic cost savings and synergistic revenue increases. While synergies can

take time to realize (some may be instant), it's the multiple arbitrage that can really

boost value quickly.

Because of this phenomenon, private equiteers are highly motivated to make high-

value acquisitions for their primary investments. However, it is important that

these acquisitions are highly strategic in nature, otherwise long-term value may be

negatively affected. Acquisitions should create real synergistic value, they should

align with the core objectives of the group, and generally, they shouldn't just be

based on multiple arbitrage.

The reason for this is manifold. Prospective buyers of the overall group will only

apply market multiples to businesses that make sense. If I'm trying to sell a

furniture retailer at a market multiple of 10x, most strategic buyers won't also pay

10x for a small green grocer that I've bolted on.

Additionally, even if I bought the green grocer for only 3x, there is an

administrative overhead with running another business. With another furniture

retailer as a bolt-on acquisition, this overhead may be relatively minor since the

skills already exist to run the business and most of the back office integrates

anyway. However, with a green grocer, we don't have the skills, there's virtually no

integration and we now essentially have an investment in a completely new market.

Out of all this, I don't think the term bolt-on acquisition is pejorative enough to

describe many of the acquisitions that are occurring. Maybe more fitting is the

term clip-on acquisition, stick-on acquisition or staple-on acquisition.

The puzzle of private equity

PeHub reported a somewhat scathing piece in The Economist about the value-add

of private equity. One of the lines that caught my eye was:


"You are far more likely to achieve billionaire status by running an asset

management business than by setting up an operating business"

This may be true by looking at raw statistics; obviously there are many more

operating businesses out there with many lesser qualified owners (than those

running PE firms). I think the question that's more relevant (though likely

untestable) is whether a suitably qualified person is more likely to achieve

billionaire status from an operating or asset management business. Anyway, it's

mostly trivial, though in the same vein, I think the media trivializes how easy it is

to do well in private equity. Sure, some people do very well, but in a previous post

I showed how financially unrewarding life can be in private equity.

One of the other lines to catch my eye was:

"Aha, I thought, evidence that finance, not good management is at work."

Private equiteers typically (emphasis on typically) aren't entrepreneurs. They often

aren't even senior managers from operating businesses. So, would that suggest

their greatest value-add is in private business managerial improvement? What

would it suggest if we knew most private equiteers were lawyers, accountants,

consultants, B-school grads, etc?

When we talk about experiential value-add for private equiteers, I tend to think of

the following:

• Financial and legal engineering - it's true; most private equiteers have a financial,

law or consulting background, and unsurprisingly, they use this background to

create value the way they know how.

• An external eye - you don't necessarily need a private equiteer for this; anyone

with business experience can often find simple and obvious improvements in even

the best-run businesses.

• Value creation experience - by fact of investment in various businesses and

involvement in various value creation strategies, private equiteers have

experience creating value, and that can be handy.


Private equity: having your cake and eating it too?

Let me pose a question: when you invest in a business, as an external investor, how

much business risk should you take on in comparison to the founders? Should you

take on less risk, since you know less about the business? Should you take on more

risk, since the founders have put in more work that you to date (and likely more

work in the future)? Or should you take on equal risk as equal partners?

The caveat is that it depends on the price paid. I may pay more to take on less risk,

or vice versa. But, for simplicity, let's assume I pay a fair market rate for a

business. So, at this perfect market rate (whatever that means), what risk should I

be exposed to in comparison to the founders? And why?

Here are my thoughts on each scenario:

• The private equiteer takes on more risk than the founders - I don't agree with this

because all the hard work that the founders have contributed is paid for as a

multiple of the earnings they've created. If they've put in 10 years of effort and

have $0 EBIT, I feel bad for the founders, but private equiteers can't be expected

to pay for hard work without receiving maintainable earnings. Similarly, the

founders' future work is paid by a salary and the upside of their retained equity.

• The private equiteer takes on less risk than the founders - I don't agree with this

because the private equiteer has ample opportunity to conduct thorough due

diligence (and they sell themselves on this due diligence, so it's hardly fair that

they use it as a basis to take less risk). When you buy something, you have the

chance to examine it first, but then it's buyer beware. If the economy turns, a new

competitor takes market share or technology changes, that's your problem. You

were looking for equity returns and you've taken some equity risk, so you should

be ready for the consequences. With that said, I agree there are exceptions in the

cases of fraud, impropriety and lack of care (e.g. investors should be shielded

from losses due to founders acting against the interests of the business and new

investors).


• The private equiteer takes on equal risk to the founders - In principle, and in

some magical and mythical wonderland, I believe investors and founders should

share the same risks. Again, the caveat being that a fair market price is paid and

there is no price adjustment for taking more/less risk. This is a marriage, you

each have different skills, but the mutual plan (at least for an active investor) is to

work towards creating barrels full of value.

I'll leave that thought for now in hope something more profound comes from it

soon. My initial thinking is that most private equity deals do not divide risk

proportionally between founders and the fund. Maybe this is positive in a greater

good sense, or maybe it's negative; either way, I sometimes wonder about the

triteness of private equiteers claiming aligned interests with founders.

The superficiality of most due diligence

I read a memorable quote in the Harvard Business Review recently: “all too often

[due diligence] becomes an exercise in verifying the target's financial statements

rather than conducting a fair analysis of the deal's strategic logic and the acquirer's

ability to realize value from it.”

Unfortunately, this is supremely true; due diligence is often just a triviality. If you

don't believe me, ask a private equiteer how many times they've binned a deal due

to new discoveries regarding the fundamentals of the business. And you can't

really blame them; they're incentivized by carry, and carry is just as easily created

from financial engineering as it is from long-term value creation. Therefore, it often

becomes more about closing deals than closing quality deals.

But, it doesn't have to be this way, and it shouldn't. The same Harvard Business

Review article suggests asking yourself four questions:

• What are we really buying?

• What is the target's stand-alone value?

• Where are the synergies and the skeletons?

• What's our walk-away price [and what findings would see us walk away]?


I believe you need to define the hypotheses for investing early in the process. Then,

decide what findings would lead to pulling out of the deal. Finally, conduct the

analysis to test the hypotheses and determine whether the deal should continue.

The DD process should be methodical and purposeful if long-term value creation

is the goal. If it's not, then ignore this post and keep closing those deals.

Then again, who am I to edify the private equity community on long-term value

creation. I suppose I'm directing this sermon more at those looking to become

uniquely differentiated private equiteers. And trust me when I say, you will be

unique if you conduct purposeful due diligence. Like a straight cop in a corrupt

precinct, try not to let the financial engineers in this industry deprave you.

A sure-fire way to get private equiteers talking nonsense

Normally, private equiteers are calm, controlled and objective when dealing with

just about any business issue. They pride themselves on considering the full facts

and making carefully measured decisions. But, there's one certain way to get a

private equiteer to leave it all behind and spout a tidal wave of utter nonsense: just

ask them to size a market.

A market refers to the total sum of potential buyers for a group of products or

services. The market we refer to in private equity is the target market, which

consists of buyers actively looking to purchase and whom can afford our type of

product or service.

Private equiteers get carried away when sizing markets because they want other

partners in the firm to like their new deal and to think the market is large enough

to support exponential growth. In many cases, markets really aren't as large as we

hope and there's no way to measure them accurately, so we embellish a little. But it

doesn't do anyone any good in the long run.


In a previous post (the amplifying effect of diminishing sales), I wrote that even

small changes in a market can have a devastating affect on investee equity value.

So while exaggerating the size of a market may get a deal done, it will also likely

explain why your investee is having a lot of trouble in challenging times or not able

to grow in prosperous times.

The step of the market sizing process that allows private equiteers to embellish is

the one in which you define the market. For example, does the market for an

arborist (tree surgeon) include landscaping? Does it include soil and sand supply?

Or to really push the friendship, does it include operating a florist? Although these

sound outrageous, I've heard it all before and I've seen partners regularly lap up

the reasoning behind these claims.

The way to get around this embellishment is to understand the different levels in a

market and be honest with yourself about how each relates to the firm in question;

the levels include the following:

• Penetrated market - this includes the buyers that the firm is currently servicing.

• Target market - this is the market segment that the business has targeted for

strategic reasons; it is bigger than the penetrated market because it includes those

customers that haven't bought from the firm.

• Available market - this market includes all buyers whom want and can afford

your product/service; it is larger than the target market because it includes

segments that the firm has labelled as a lower priority.

• Potential market - this includes all of the buyers who need or want your service,

but that can't necessarily afford it or don't have access to buy it; sometimes

regulations or other restrictions also keep buyers out of reach.

Personally, I think that sizing a potential investee's market should focus between

the available and target markets. However, most analysis I see goes way out of

even the potential market and includes groups of products or services that would

require new acquisitions, new people, new skills and new experience to even

contemplate servicing the market. If you want to conduct honest analysis, stay

within your potential market and limit your sizing to the available market. Author: The Private Equiteer © 2011

The perversity of secondary buyouts

Maybe it's just me, but the idea of secondary buyouts seems completely perverse.

The only exceptions I can imagine are mandate issues (e.g. the investee is

becoming too large for the fund to support) or if there is a logical secondary buyer

with a specialist skill set that may be able to realize further value. In all other cases,

if one private equity firm can't extract value, then why would another firm believe

they can (egos aside for a minute)?

We've had a few approaches at my firm from other private equity firms for

secondary deals, but if I'm looking for the best deals available, I'm certainly not

thinking of buying businesses that other private equity firms reject. These are

smart people and you have to give them some credit. Sure, there are other

arguments, such as the business may make sense as a bolt-on to another investee,

but for a private equity firm to sell an investee at a deep discount, there must be

serious concerns.

With all of that said though, I'm sure there have been successful secondary

buyouts and I'm certain that the bigger private equity firms often don't have a

choice but to consider them. There's also the case of selling non-core business

units, but I don't really consider these as secondary deals. The types of deals that I

question are those where a private equity fund buys a primary investment from

another fund and the acquirer doesn't have a materially different mandate.

Venture capitalists stymie innovation

... or so says Vivek Wadhwa in a recent TechCrunch article on the uselessness of

venture capital.

Vivek, if you're reading, let me tell you, you're officially a marked man by the

industry. Not so much for insulting everything VCs believe they bring to

innovation, but for doing it with more than just a modicum of truth. (However, I

also think you went a bit far with "VCs at best have little to no impact on these

companies and at worst have a negative impact.")


First up, I agree with Vivek that it's important to make the distinction between

Vinod Khosla et al., who can draw upon their own operational experience, and the

rest, who can only draw on their experience investing in and servicing operational

companies.

The fact is, experience matters. We all know this, but many of us rationalize it

away. Would you go with the guy who founded Sun Microsystems or the guy who

negotiates tough liquidation preference terms? Enough said, at least in my book.

So, to focus the discussion a little more, I suspect Vivek has issue with the latter

group, the group that signs checks, loves to draft legal agreements, and doesn't

understand the difference between a bit and a byte. On this, Vivek says:

“My VC friends complain over drinks about a new breed of VCs who are crowding

out the really smart and experienced. These gold digger VCs bear MBAs and have

no real operational experience but plenty of taste for IPOs. (Interestingly, if they

don’t have an MBA, they have a law degree. Go figure.)”

My point in bringing up Vivek's article is that I see a similar trend in private

equity: lawyers, consultants, bankers, MBAs, etc., taking over the industry with

financial engineering and very little operational or strategic value-add. They will

quote years of experience servicing businesses, but to me, that's like a bookmaker

advising a horse trainer on strategy. Sure, they may have a few tidbits of good info,

but I'd hardly call a bookmaker an experienced horse trainer.

So, back to my previous argument: experience matters. If you haven't ever

founded a startup, are you absolutely the best person to be advising a startup?

Likewise with private equity, if you've never run a n operating business, are you

absolutely the best person to be advising a mature business?


Stop deceiving your limited partners!

As a result of the global economic unpleasantness, many investees are having a

difficult time and private equity investors are covering this up through lies,

damned lies and statistics. An article from Denise Palmieri at peHub talks about

improving relations with limited partners (LPs), one of which is a suggestion that

private equiteers have some humility and don't cover up the blatant truth.

I'm receiving many reports from roadshows that say LPs are becoming quite

annoyed and distressed at the obvious sugar-coating that's taking place.

Apparently general partners (GPs) are talking about future earnings that are

multiples of current earnings and then applying outrageous pre-2008 multiples to

those with the explanation that by the time they exit they'll receive those multiples

and hence they should use those multiples now. Please...

When the chickens come home to roost, LPs will only give thought to what was

done to combat the downturn and what the result is via the exit. Only negative

thought will be given to fictitious earnings and multiples, so why bother? Please

show some humility, talk about what actions are being taken, and leave the excuses

at home. Like many other firms, my firm has spent an inordinate amount of time on

investor relations (weekly updates, roadshows, etc.), but none of that matters if

you're not honest and genuine; they're not brainless, they can see right through it.


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