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 favoured by venture capitalists.
Image: Private equity, just sit back and relax [source: Shutterstock]
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.
This isn’t to suggest PE and VC are in any way substitutable. But, like all investments, we can analyse and consider the implications of each strategy.
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 organise 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.
I’m now curious. You say “any increase in revenue”. I assume that to be able to sell the business, you’ve either had to demostrably achieve higher (real and relatively sustanable) profits, or find a greater fool (to borrow a term from the capital markets).
I can see a number of ways how to achieve the above, but the only one that doesn’t seem relatively dodgy to me is streamlining the organization – which may or may not be sustainable (loading the company with debt without increasing the revenue is not what I’d consider sustainable).
If I was a buyer (private or public) of a company from a PE, I’d actually quite like to see what the company looked like before they got it and how they got it where it is. That is, unless I plan to flip it to a yet greater fool.
Again, I am more than happy to be proved wrong – that’s how we learn after all.
vlade
22 Oct 09 at 08:37
Hi vlade. I reworded the post a little because it sounded like I was suggesting our plan is to invest in businesses that don’t grow. Quite the contrary; we love growth, but we also see opportunity in lower-growth businesses.
In terms of making a good return from a business whose revenues don’t grow… consider the following:
1) if you invest in a business with good FCF at a 3x multiple; your investment could be paid back by dividends in 3 years and you could sell the business for the same price you paid and overall, receive 2x your cash. Not ideal of course, but still 2x cash.
2) take that same business, rationalise management, make it a little more efficient, increase earnings by say 15% (on the same revenue) and get a 4x sale multiple since it’s more diversified and represents less risk; now you could be talking a 3x cash return without any revenue growth.
3) again, take the above scenario, add debt that’s 2x earnings, use the great FCF to pay interest and principle (obviously this reduces your dividends), make a couple of cheap strategic acquisitions (all while like-for-like revenue doesn’t grow), sell at a 5x multiple due to the extra scale from acquisitions, and maybe you’ll see a 4-10x cash return in a few years.
Of course these scenarios are all simplified, but they don’t necessarily involve a greater fool. In scenario 1, you don’t need a fool to buy a high FCF business at a 3x multiple or even a 4x multiple (as per scenario 2). And, in scenario 3, you’ve used leverage to increase scale, which in turn would attract a higher sale multiple. All while like-for-like revenue doesn’t have to move.
Of course people will ask questions about the fundamentals of the industry if revenue is flat. And, this will likely affect exit options, but people also recognise the value in high FCF businesses at low multiples. There are still many more caveats, but boring businesses (at low multiples) often represent great opportunity (and even better opportunities if you can extract revenue growth).
The Private Equiteer
22 Oct 09 at 10:04
Thanks PE
I didn’t consider your scenario 1 – if there’s a businerss that chucks out cash at this rate, I’d have thought you’d have to pay higher multiple (high FCF with no possibility to growth and low multiple would imply high risk to the business in the first place) if it was relatively “safe” (high dividends not created by extra debt => high ROI => high multiple)
2 is what I termed “sustainable real profits by streamlining the operations”.
3 I didn’t consider as if your acquisition doesn’t grow your revenues, what’s the poin?
Maybe my bemusement comes from the fact that I agree that boring good investments are the best – but I think that by the nature there’s only relatively few of them for purchase at any given time – since they are good opportunities, I’d think the law of supply and demand would drive the price up until it wasn’t so good one anymore. Of course, you can always find the occasional nugget…
Again, I’m very happy to be told that I’ve got it all wrong (I think I will stop repeating this – please consider it as given for any of my future comments).
vlade
22 Oct 09 at 12:32
vlade, your comments are very welcome; you’re making me think for a change.
Re scenario 1… trust me, there are businesses out there with great cash flows selling for low multiples. In fact, we just recently did a ~4x deal and believe it will pay itself off via dividends in 2 years (we not only got it at a great multiple, but it’s growing quite quickly too).
Re scenario 3… sure, overall revenues grow when you make an acquisition, but the point was that these can be low-growth businesses. So, the value creation here isn’t through high growth, but through diversifying and de-risking via gaining scale and realising synergies. You can even have no growth, but as you say, streamline operations (synergies, efficiencies, etc.), and realise a higher exit multiple. Add sensible debt to the mix and you can see surprisingly high returns.
On reflection, I think my main point was that boring businesses can be pots of gold because they receive less attention. The same way Buffett looks for pots of gold that attract less attention (i.e. lower price to value ratio).
The Private Equiteer
22 Oct 09 at 22:12
Ah, I see, so basically main main assumption there (these businesses are valuable => hunted => not likely to be undervalued) was wrong. I wonder why – I know I’d want to invest a large part to into a good stable business with good dividends and then make a few relatively small bets that would be essentially lottery tickets.
vlade
23 Oct 09 at 06:54
Hi – love the blog, which I’ve recently started reading. Lots of good stuff for wannabe’s like myself. However, I’m confused by one minor thing in the post above. I’ve always heard “Private Equity” as a general term that encompasses both VC and Buyout/Mezzanine funding, yet you make a distinction between VC and PE? Aren’t VC’s considered to be part of the PE world?
Matt
26 Oct 09 at 17:37
Thanks for the kind words Matt; they’re very much appreciated.
You bring up a good point, which is worthy of a brief post. So, stay tuned.
The Private Equiteer
26 Oct 09 at 23:56
I find this post a little bit blasé about multiple arbitrage. I mean it’s just thrown in like a detail – when really it’s the key to the whole return in a low growth scenario…
The point about leverage is fair enough, but leverage needs an ungeared return to get underneath and lever – and the ungeared return has to come from profit growth, multiple growth, or cash generated. Typically the last factor is small (high debt service costs and no multiplier) and I don’t think it’s sensible to model multiple growth into investments, leaving you with profit growth…
Alex
14 Nov 09 at 09:38
Agreed it’s not sensible to model multiple growth. However, I think a combination of cash generation, gearing, mild multiple growth, and low (but still positive) revenue growth has led to many fortunes being made. These businesses receive less attention, which helps the cause further.
The Private Equiteer
16 Nov 09 at 00:11
[...] 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 [...]
A problem with the ‘we love boring businesses’ argument | A Private Equity Blog
12 Jan 10 at 02:07