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.

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 (I concede my last post was a little rushed):

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 to mean anything and to be 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.

• 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.)

So, what does this have to do with anything? Well, most sane investors put aside the entire committed amount from day 1, because it would be very risky to commit more capital than you currently have. Why? Because if you default on a “call notice”, you could lose your entire investment without reimbursement, or at best, have it sold at a heavy discount to a secondary buyer.

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, 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,

1. no one is forcing you to hold that money at low rates of return
2. 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.

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.

If I achieve a 10x return on my fund, LPs, other PEs and most others will say “they were lucky”. If I achieve a 0.5x return for the fund, everyone will say “they suck”. Both terms are pejorative (hey, life’s unfair), but in one scenario you get to boast 10x returns and in the other you don’t get to boast at all.

So, back to the title of this post, equity returns for debt 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 overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.

This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.

“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 trivialises 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, but someone 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

Just my thoughts.

Here are the reasons:

1. 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.
2. Tax gives private equiteers a bargainning 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.
3. 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 don’t have to pay it and still get the benefit, it creates a bargaining chip, and it helps to show alignment with vendors. I’d be a billionaire if I was paid a million dollars 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; they tend to value that.

Private equiteers (especially in the mid-market) look for opportunities with a high chance of closure, try to secure great terms on those opportunities and hope they get great managers they can work with. If the mangers don’t work out (too rebellious or clueless), they transition new managers into the investee business. As with any employment process, the best applicant, which agrees to the proposed terms, is hired.

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/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, whomever 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.

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:

1. 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.
2. 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 caveat emptor – 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 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).
3. 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.

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 embelish 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.

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 parnters/owners whom do in aggregate. 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:

1. 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.
2. 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.
3. 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.
4. They circumvent necessary checks and balances - even otherworldly businesspeople 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 at mid-market level due to a lack of transparency).
5. 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.
6. 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, personas 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.

You may be thinking that people like Buffett and Branson didn’t need others when they started their ventures, but we’re talking about PE firms run by relatively average earthlings (plus think of Gates and Jobs… and how Buffett fared with Munger). So, whether we talk about investment performance, esprit de corps (team morale), or access to capital, I really believe that multi-owner funds reign supreme.

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.

Private equiteers often insist on investing via preferred equity, which includes a preferred coupon (see this post for info on preferred equity). 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 any 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 a 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.

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.