In private equity, we constantly question whether our interests are aligned with the interests of the people running our investees. At one extreme, we have management with no equity (or worthless options), and at the other extreme, we have very wealthy founding managers, whom are equally difficult to motivate. There is no one solution to align interests in PE; motivations can differ enormously.

On the flipside, you have the Y Combinator model, which is roughly founded on the premise of living costs in exchange for a small parcel of equity. So, when YC makes an investment, it invests little more than $10k per founder to fund basic rent, food, travel, etc., for a period of three months. During that three months, everyone works aggressively to make something out of (virtually) nothing.

I realise that private equity and YC business models are chalk and cheese, but it’s an intriguing dichotomy nonetheless. And I can’t help but think the YC model is so darn wholesome.

You have a few founders, fuelled by ramen noodles and a visceral passion, trying to solve the eternal problem of producing something people need. The founders may be motivated by money, they may be motivated by fame, but it seems the YC selection process is focused on finding people driven by something more. Something that transcends salaries and exit multiples and legal agreements and all that stuff we’re faced with in PE. (Or is this another imagined elysium?)

There has been some criticism of the YC model, with people claiming it doesn’t produce results. But we’re already seeing some pretty successful YC offspring, such as Reddit, AirBnB and Disqus. And like most early-stage funds, I suspect the model assumes at least a handful of failures.

Edit: rather than rely on second hand info, check out the interview with YC co-founder, Paul Graham, on Mixergy next week. You know I love Andrew Warner’s interviews, so trust me when I say you cannot miss this one.

Mixergy interview with YC co-founder, Paul Graham, on February 9, at 11am Pacific Time. Visit the live interview link at mixergy.com/live (and check out some of the other interviews in the interim).

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. Niccolò Machiavelli

Private equity is a juggle 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?

I’ve received a few emails asking this question and just realised 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. 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.

I realise this seems somewhat rudimentary, but the popularity of the search term suggests otherwise.

I checked the analytics of The Private Equiteer over the weekend and came across some interesting demographic info. Sure, this isn’t private equity theory, but I thought it somewhat interesting nonetheless.

• The most popular post, Stay Clear of Single-Owner PE Firms, received 1000+ visitors in just a few hours
• The largest source of referral traffic (excluding search engines) is pehub.com
• Of all traffic from search engines, 96% is from Google and 2.6% from Bing
• Surprisingly, 46% of browsers are IE, 34% Firefox, 10% Chrome and 9% Safari
• Operating systems: 86% Windows, 11% Mac and 2% iPhone (Blackberry is 0.2%)
• After English, Dutch and then French are the most popular language settings
• Visitors come from the US, then UK, Australia, India then Canada

As for keywords, the Top 5 traffic generators (not including versions of “the private equiteer”) are,

• “capex formula”
• “private equity blog”
• “does enterprise value include capex”
• “private equity due diligence”
• “how to calculate capex”

It’s interesting to see “capex” twice thrice in that list…

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.

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, but you and I both know they’re doing it to display a UNPRI logo on their website and, in the process, condemning 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.

I haven’t posted anything opinionated for a while (except suggesting you should quit your job every 6 months), so what better way than suggest I have the mid-market private equity ’recipe for success’.

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 realise that a vendor is influenced by all of these ’soft’ offerings, and they may choose a lower price as a result, by 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. This theory is in stark contrast to some of my previous theories, but hey, it’s 2010 (that’s my official reason for everything this month).

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 can connect.

I typically only post thoughts and theories on private equity and entrepreneurship, but this one’s too good to miss. Andrew Warner, of Mixergy fame, is interviewing Seth Godin this Friday (22 Jan 2010) at 2pm Pacific Time (use Google to find your equivalent time). Most of us link Seth Godin to the concept of the Purple Cow, but I suspect this interview will delve much deeper than purple cows. Andrew is an exceptional interviewer, so it should make for great watching/listing/tweeting/whatever.

To watch the interview in real time, visit mixergy.com/live/

To check out who’s coming up on Mixergy check out mixergy.com/coming-soon/

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 pref 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 (see this post on my real-world carry calculations, Part 1, Part 2)
• 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

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.

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 psych-speak, you’ve hit a learning plateau. You’ve learnt 80% of what there is to learn (at that particular firm) and you’ve realised these geniuses are just like everyone else; they only seemed like geniuses because they knew something unique.

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; it’s a collection of many discrete skills. And from my observations, entrepreneurs are rarely specialists; they become masters of many domains, even if originally they specialised 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 won’t 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.

In private equity, despite counterarguments about ‘investing in the future’, we aim to spend less because we see so much waste on a daily basis. This doesn’t mean we’re allergic to investing for growth; rather, our experience shows reducing waste is a more fruitful endeavour (at least at first). We’d love the exposure of running global ad campaigns or buying corporate jets, but in private equity we deconstruct everything with our mind firmly on the exit.

Consider your exit as the day you can do anything you want: create startups, invest in other businesses, join boards of listed companies, or travel the globe. In order to apply private equity principles to achieve a better ‘personal exit’, you must learn to want less (and like it). This sounds like compromising, but it isn’t. As in private equity, keeping your mind on the exit helps you to see the real value (approximately none) of instant gratification. This is the characteristic that creates successful entrepreneurs, investors or even Olympians.

This concept of deconstructing a problem with a firm view on the exit or desired outcome isn’t new. Tim Ferriss talks about it incessantly and shows some very interesting real world examples (see his TED talk). And while you may see this as just self-help nonsense, consider that it’s built an enduring multi-billion dollar industry (the private equity industry, not the self-help book industry).

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… or a consideration, if you will.

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 to be paid while doing other unpaid things (such as studying for school, writing a manuscript or using Facebook). 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 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.

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 (and as much as that may make us cringe, it really can create long-term value in boring industries).

P.S. I really don’t like using the word ‘boring’, but let’s not sugar-coat more than we have to.

I just finished watching an interview on Mixergy (my new favourite 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 travelling 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 (see recipe at the end of Paul Graham’s post) 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 globalisation 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.