Private equity is very much about growth through acquisition. Acquisitions give the private equiteer the ability to create instant value through multiple arbitrage (see here), synergistic cost savings and synergistic revenue increases. While synergies can take time to realise (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 (more originally) completely-unrelated acquisition.

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. (See The value-based components of a private equity deal for information on the value of preference equity.)

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 $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. 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. See my previous post on coupons (Preference equity and convertible notes) to see a similar argument about how coupons affect value.

If I personally purchased a business as an investment, for wealth creation and as some sort of plan to create passive income, I would want to know it inside-out. I would hope to have access to every scintilla of data available, and even the data unavailable. I would expect to know the people personally, to know the advisors (finance, legal, etc) and be able to recite the key drivers of the business and their latest metrics. This isn’t an obsession, it’s just par for the course considering the obvious consequences of relinquishing control of such an important asset.

I attended a private equity conference recently and spoke with a number of general partners, mostly just idle chatter, but also a tête-à-tête or two on the topic of investees. I was somewhat startled to hear GPs forgetting the name of their investee’s CFO, or not knowing whether revenue last year was $300m or $400m, or not being sure whether an investee has an online e-commerce presence. There could be many reasons for this; I just hope it’s not a sign of what’s to come. By this, I mean private equity continuing the trend along financial engineering and not doing much for the long-term value of companies with a lot of potential.

Marxists, although not so much Marx himself, postulated that there would be a working-class revolt as capitalism disintegrated into the inevitable, classless, political ideology called communism. This transitional revolt, commonly referred to as the Dictatorship of the Proletariat, would overthrow the Dictatorship of the Bourgeoisie and provide a solid foundation for a burgeoning dictatorship. Theoretically, such a turn of events would be the result of a tipping point whereby the proletariat feels pushed to act against the unruly behaviour of the bourgeoisie. If there’s ever been a point in time when the bourgeoisie’s unruliness has stretched the tethers of the proletariat, then I’d say it was now.

Venture capitalists and private equiteers are the epitome of the bourgeois; they’re wealth producers via the work of the proletariat (working-class). Marxists see this as exploitation, capitalists see it as opportunistic, and most others see it as an immutable fact of life. The reason I bring this up is that the current financial unpleasantness has unearthed a range of commentary about the morality of capitalists and the importance of the greater good. Of course, the greater good is a utilitarian theme that borders on socialism and, in some respects, communism. So, this lends itself to an interesting paradox for those extolling the virtues of capitalism (usually in anticipation of benefiting from it) and engaging in this greater good commentary.

Not so much finger pointing, just food for thought.

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.

See this chart of the LPX50 for the past 12 months… wow is all I can muster. The LPX50 is an index of the largest 50 liquid listed private equity funds. The LPX50 is obviously affected by market sentiment and market movements, so to be fair, it’s not the best representation of large unlisted funds. But to be fairer, we’ve seen endowment funds writing down their unlisted private equity investments by similar magnitudes.

The LPX50 has dropped some 60-70% in 12 months. That’s dystopia in anyone’s language. But, I find myself asking why values have dropped so much in such a short period if the world still has a relatively strong pulse. Here are the few off-the-cuff reasons why large funds are having a harder time:

1. High purchase multiples: by paying a high multiple, you’re assuming rapid value creation. When this doesn’t happen, there’s rapid value decimation. A high price also usually means a higher debt/EBITDA multiple.
2. Over-gearing: I’ve seen purchases with a debt/EBITDA multiple of 9x. This implies it would take nine years to pay the debt off… that is, if there were no interest charges. Any minor drop in sales can magnify the issues to the point of instant bankruptcy. This 9x business is now more like 15x as a result of falls in sales.
3. Media exposure: these funds are contemptuously scrutinised on a minute-by-minute basis by the media. Especially with listed funds, this creates negative sentiment and cliff-like price falls. One could argue that smaller funds would experience the same fate with the same level of media exposure.
4. Revenue falls: I explained in a previous post the amplifying effects of revenue falls. I’ve even referenced it in a range of other posts because while it’s so fundamental, it’s so easy to forget. Businesses are risky and sales can be volatile. This hasn’t changed, so there should be mitigation and contingency for these falls.

Mega-buyouts enjoyed a period of higher and higher multiples and easier and easier debt up to 2007. But, that’s finished. The fallout from being overly optimistic is much worse than most of us thought it would be (including me). If there’s anything to learn here, it’s that low purchase multiples and low gearing are key to sustainable private equity investing. Also, businesses are always going to be sensitive to falls in sales when they’re even only moderately geared.

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 realise 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 or a more applicable strategic offering.

Best regards,

the Private Equiteer