What does it take to become a lean, mean entrepreneurial machine? I’m not so sure, but I’ve listed a few points to keep in mind (this is just as much a note to self as it is a post for you). All of these points involve differentiating yourself from the herd; they involve working hard mentally, which really means leaving your comfort zone and realising the scarcity value of certain skills.

• 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 brain power, and it promotes lateral thinking.
• 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 rock star, it’s the value of scalability.
• Education begets success: identify what matters to business success and learn to be successful in those areas. Learn what matters; prioritise what matters; become an absolute master at what matters. This doesn’t mean enrolling in degrees to learn low level skills. It means talking to competitors, learning the market, understanding the customer, knowing how to run tight cost centres, 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 realise 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 $500,000 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. Learn to lead and work as a team with other people and realise they don’t all need equity to be motivated.
• Patience is not a virtue: waiting for you 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 realising you don’t need a new suit. Or it can be as critical as realising you need to improve your communication skills. Be honest about what really matters and be honest with what really needs to be done.

I’m very interested in your thoughts and other comments about what makes a lean mean entrepreneurial machine. So please post a comment if you have something interesting.

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.

Especially in the formative years of a private equiteer’s career, the returns (in terms of both satisfaction and cash) look much more compelling. The sobering fact is that it often proves true. 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 greater 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. (Note: in my opinion, the opposite of success is failure and the opposite of mediocrity is mediocrity; so, failure is a very likely outcome if you put everything into achieving success.)

Lastly, who says private equiteers aren’t running off to start businesses? It’s a very real career path and can be a very rewarding one. The fact is that we can’t all start our own private equity firms and achieve great success, so the entrepreneurial route isn’t such a bad one.

I’ll start by saying: I know how painful these exams are. People who have relinquished all things enjoyable just to study for these exams are all around me. I have witnessed the toll of failure, the elation of success, and the frustration of the 4-6 weeks between sitting the exam and discovering the results. It’s downright masochistic, but really, isn’t that the fun of it?

People in the industry argue that the CFA charter is a fund manager certification; it concentrates too much on portfolio theory and not enough on strategy, law, and deal-making. Maybe this is true if the CFA designation is your only weapon. But, like everything, you have a tool belt, and the experience amassed from the CFA programme is just one of the tools. Private equiteers must be well rounded; they must know public markets, financial modelling, corporate finance and statistics. They need to understand the world around them to understand the world within (wow, that was very Zen). 

Look, it’s impossible to know what the opportunity cost of sitting the exams is. But, I think they’re worth it. They keep your technical knowledge current, they prove your discipline and commitment, they show tenacity, they give you more than enough to hold your own with colleagues, they introduce you to a diverse community, and as the CFA Institute website suggests:

The CFA charter it is the designation of excellence in the investment community.

Tereza Tykvová 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 (in Germany). A captive fund, according to Alt Assets, is:

A private equity firm that is tied to a larger organisation, 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 the purpose (and circumvents the value-add) of traditional private equity. 

Anyway, Tykvová 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. Rather than harp on about my biases either way, here’s a list of captive characteristics (as usual though, the list isn’t exhaustive):

1. 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.
2. 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… ummm… arm for access to potential investees like that. 
3. 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. 
4. 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.
5. Deal competition: this is a pro or 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.
6. Interference: private equity teams love autonomy and flexibility; nothing’s going to kill the vibe more than a corporate dictator trying to flex his 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.
7. People: private equity is as much an art as a science (cliché police?) 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 bullshit) 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.

In a previous post I talked 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 realisation 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:

1. The private equity team, which includes the founders, directors, associates and analysts (sometimes).
2. Previous founders, who aren’t active in the firm anymore, but who struck profit sharing agreements.
3. Previous team members, who keep the stake of carry that they accrued while employed (sometimes).
4. Overarching parents (banks, etc), which may have a stake in the carry if the fund is captive.
5. Early investors, which may have a stake for helping to establish the fund from a funding perspective.
6. Legacy partners, 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.

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:

1. 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.
2. Deal origination: this involves finding potential investees and conducting the initial analysis needed to know whether the deal is worth progressing. 
3. Due diligence: when a deal progresses beyond the early origination stages, much more in-depth analysis in conducted to confirm the investment hypotheses.
4. 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.
5. 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.
6. 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.
7. 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. 
8. 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.
9. 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.
10. 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 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.

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 realise a favourable 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.

From what I’ve seen, there are two ways that private equity teams can discuss, debate, contemplate and decide on deals:

1. All-in discussion
2. 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-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.

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:

1. Founding Director
2. Managing Director
3. Director
4. Associate Director
5. Associate 
6. Investment Manager
7. 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.

Best regards,

the Private Equiteer