An interesting tidbit: when Buffett started his Buffett and Associated, Ltd. Partnership in the late ‘50s, he quoted his limited partners a 25% carry (although, I’m sure he didn’t use the term carry). By the time the partnership began investing though, it became a 50% carry above a 4% hurdle and a negative 25% carry on the downside. 

This meant if the partnership made a 20% return, Buffett would keep 50% of the 16% over 4%, which would be 8% of the overall return. However, Buffett didn’t take this payment; he reinvested it back into the partnership to compound upon itself. If the partnership made 4% for the year, there would be no performance fee. The surprising bit is if the fund lost 10%, Buffett would personally cover 25% of the loss below the 4% hurdle. So in this example, he’d pay back 25% of 14%, or approximately 3.5%.

This downside protection for the partners (or as I referred to earlier, a negative carry) was unlimited until all capital was lost. Can you imagine a private equity firm today structuring a fund like that? Buffett’s response to this risk was that he knew he wouldn’t lose money over the long term. Somehow, I suspect he wholeheartedly believed this and didn’t just sprout it for the sake of fundraising.

Another interesting fact about his partnership is that while he convinced his friends and family to part with almost $100k, he only contributed $100 to the fund. A private equity fund would rarely get off the ground with this lack of skin in the game, but after all, he probably had more than enough skin in the game by guaranteeing 25% of the downside.

As an aside, understanding the ventures that Buffett thought up and supported, I would say he’s more of a private equiteer than maybe even he would like to admit.

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.

The earlier English Kings operated their kingdoms mostly unfettered. Pre-13th century, if a king acted against the greater good or in an unethical manner, the response was more of an “oops” than a judicial hearing. But, as King John of England increasingly abused his power, the barons challenged him and the Magna Carta was written. While there may be more regulation around private equity in the 21st century, consensus is that they act in a similar invincible manner. Sometimes when they effect their power, companies collapse, people become unemployed, the banking system suffers, and the final result is chaos and catastrophe. With this in mind, do we need a form of Magna Carta for the private equity industry?

Well… with risk comes reward and without risk, companies and people resign themselves to mediocrity. With risk also comes failure, but it’s a failure that’s a byproduct of reaching for the sky. Particularly with venture capital, we wouldn’t see the innovation and advancement that we do if it wasn’t for people willing to take abnormally high risks. This is just a fact of life, but at times when there is more bad news than good, the scruples of private equity firms come into question. However, many private and public businesses are collapsing without private equity influence. 

This argument could easily go round in circles indefinitely, but I believe private equity is just another form of risk capital that… inherently has risks (sounds like a tautology, but it’s often forgotten). We should expect failures, but we shouldn’t bring the whole asset class into question as a result of a few. If anything, we need to learn from these failures and continue to support private equity by creating lasting value for shareholders, employees, the community and global economies. So in answer to the headline question: No, I don’t believe private equity needs its own Magna Carta.

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.

By saying deal killer, I mean some aspect of a deal that is too severe in risk and nature to allow the deal to continue. There are a few black and white private equity deal killers, but also many shades of grey. The problem with grey is that, especially in private equity, people love to flex their intellect to show why your idea of a deal killer isn’t their idea of a deal killer.

The solution seems to be to have a set list of deal killers and to stick to that list regardless. The problem of course is that you could miss great deals and there’s merit in looking at deals on a case-by-case basis. But I’m sticking by when in doubt, kill it, because you simply don’t need to take undue risk. The following list is not exhaustive, but outlines a few scenarios in which I’d kill a deal (and after all, there’s a rank and file in a private equity firm for a reason):

1. Breach of investment mandate: a breach in mandate (industry, size, ethics, etc) is an instant deal killer. If arguments against this seem to be frequent, either there are issues with the mandate (which aren’t really issues, because it’s the mandate), or your team is just being argumentative.
2. Existing market too small: the usual counter argument is that acquisitions can be made to increase the applicable market size. But, banking your investment on something as significant as an acquisition that may or may not occur is investment suicide in my opinion. There will always be risk in making investments, but why take much bigger risks when you don’t have to.
3. Customer and/or supplier concentration: again, a potential acquisition may mitigate this, but you’re proposing to purchase the business now on its merits. Why pay for a business on the basis of risks being mitigated later, when you’ll have to do a lot of work afterwards to invoke the mitigating actions. If you’re willing to take those risks, then you should be paying less now.
4. Industry concerns: if you’re proposing to enter an industry with fundamental issues or without adequate potential growth, then what are you really doing? Sure, you can reach target returns without market growth, but why take that risk when you don’t need to. Sometimes it’s just best to let a deal go than take undue risk.
5. Management concerns: most importantly, if you don’t think you’re backing an excellent manager from the start, then I’d say that is a deal killer. Again, you can propose the argument that managers can be dumped, by why settle for second best? Private equity is firstly about backing a great manager, because they are the designated driver, so it really is unnecessary to take risks here.

I know I’ve been quite opinionated in this post and I concede that in a day, week or month, I may change my mind on some of these issues. But, I’ve witnessed a lot of self-fulfilling analysis lately and think it’s important to maintain objectivity in this climate. As the cliché says: lemons ripen early, plums ripen late. That is, if the deal looks like a lemon early, it probably is a lemon.

Especially in the current market, it pays to be discerning with potential investees. The current under-performance of many funds has been attributed to over-gearing, high purchase multiples and poor fundamentals, so we don’t want to become caught in the same trap when it’s clearly a better time to be buying. The following list outlines a few characteristics of potential investees that I believe are important to look out for:

1. Potential market size: depending on the size of the fund and the size of the potential investee, the market for that investee needs to be a certain size to mitigate a range of risks. A larger market means you need less of a share to achieve target returns. It also means that competitors have less of an influence when they get aggressive. For a lower-mid-market fund, I look for markets with a current size of at least $0.5-$1b and with growth rates that are at least positive (not as common in our current economic climate).
2. Customer/Supplier Fragmentation: the last thing you want in this market (when it’s already tough to grow) is to invest in a business with high customer concentration. If a major customer is lost, you could lose a significant part of your business. All of those great strategic plans you had to grow the business will now only bring the business back to its former glory. The same goes with the supply side, although there’s often less of an impact (unless you are licensing someone else’s brand). 
3. Counter-cyclical offering: most of the highly defensive industries make for bad investments. They either don’t have the growth prospects or are too risky. I’m thinking agricultural commodities, certain financial services, natural resources, etc. But, you can benefit from counter-cyclicality in other industries too by finding sub-industries that businesses visit in tougher economic conditions due to cost savings. There’s no point going into something like motor yachts with the expectation that next year’s sales will grow upon last year’s sales; common sense in this area will go a long way in saving face (and no, I don’t buy that old money argument).
4. Invested management team: we’re seeing many business owners looking to sell out completely while telling us that their businesses would make great investments even in a downturn. One would think that a mass exodus would indicate something quite different to a great opportunity. So, beware of business owners jumping ship, especially if they’re not on their deathbeds and are sufficiently able to continue their businesses. They know more about their business than you do, so take notice of their behaviour. Also, don’t let earn-outs that seem to lock management in fool you; they’ve often done their numbers and have accounted for the risk of losing the earn-out.
5. Low gearing: a seemingly low risk business with high gearing can become high risk and virtually non-existent if revenue softens or a refinancing event strikes. A lowly geared business also gives you room, should you need it, if things turn sour. We are seeing businesses file for insolvency every second day due to gearing, so it should serve as a powerful warning to private equity investors looking to buy in this market. Again, common sense and looking at deals objectively will save face.

There are many other characteristics to look for in potential investees, but these are the most prescient for the current economic climate. I say, forget about being a contrarian investor when you can just use some common sense; look for fundamentally good businesses, purchase them at reasonable prices, and use private equity value creation principles to exceed target returns. Why make it more complicated than it needs to be?

An investor in a private equity fund invests on the pretence of relatively high returns (usually 25%+ per annum). When a potential investee learns of this target, he/she often adopts a look of, “There is no way I’m guaranteeing that.” This is because when many fledgling entrepreneurs see these growth targets, they don’t fully understand the value creation themes that private equity firms have in mind.

The following three points discuss the major themes for value creation in private equity. I would like to think they’re exhaustive and all encompassing, but please let me know if you believe otherwise.

1. Earnings growth: this is achieved either through organic revenue growth, acquisitive revenue growth, cost cutting (thus, improved margins), reduced taxation, variablising the cost base, etc. Earnings growth links to value creation by creating a higher implied exit price and higher cash flow, which can lead to higher dividends and quicker debt repayment.
2. Increased gearing: this refers to an increase in interest-bearing debt, which can amplify the gains (and losses) to equity holders. A business with no debt can be conservatively geared and subsequently provide much higher returns to equity holders. Additionally, private equity firms pay down debt as quickly as possible with excess cash to decrease risk and increase proceeds to equity holders at exit.
3. Multiple uplift: this is a simple arbitrage between the purchase multiple and sale multiple. Even with the same earnings, if market conditions become favourable and/or risk decreases, a higher sale price results from a higher multiple. While it is difficult to control the market, decreased risk results from reaching a greater size, reducing debt, diversifying the offering, increasing customer/supplier fragmentation, implementing exclusive arrangements and contracts, and/or anything else that may lead to more stable earnings.

Although my analysis of value creation seems simplistic, I can’t think of any value creation initiative that doesn’t apply to these three themes. If there’s anything I’ve missed, please let me know through the comments section for this post.

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.

For businesses considering their options for accelerated growth, they tend to gravitate towards proposals that contain a financial and strategic component. With this in mind, the most compelling expansion deals are usually from trade investors and private equity firms. In this post, I’m going to compare these offerings in a formulaic manner.

So let’s assume:

• $X = The value of financial capital in a deal
• $aX = The value of strategic support in a deal

The value of strategic support is a multiple of financial capital because the whole purpose of the investment is to multiply the initial investment. Note: the “a” only represents the strategic value-add, not the realised cash multiple for the investor because there are other influences that drive the final result.

Therefore, the value of a financial+strategic deal ($Y) is:

• $Y = $X + $aX

When a business faces making a decision between a trade deal (JV, strategic investment, etc) and a private equity deal, they’re often deciding between the following two scenarios:

• Trade Deal:    $Y = $X + $aX
• PE Deal:          $Z = ($X - some) + ($aX + some)

In simpler terms, a trade buyer will usually offer a higher upfront valuation, while a private equity firm will offer greater strategic value. My thinking for this is that a trade buyer has greater immediate synergies and is often the more natural buyer of the business; hence, it may pay more. Whereas, a private equity firm has more experience in value creation AND it has more aligned interests; hence, it offers greater strategic value. I say more aligned interests because there’s the risk that the trade buyer wants to invest in the business as a defensive move and they actually don’t want the business to grow. This is a significant risk compared to a private equity investor who almost undoubtedly just wants to see growth.

With all of that said (and this is hardly an exact science), the question for the business owner is whether the additional upfront value from a trade buyer is worth more than the additional strategic value offered by the private equity firm. This is where the deal becomes self-selecting. If the business owner sincerely believes in the potential growth of the business, then they’d really choose the deal with the higher strategic value: the private equity deal.

With all the chaos surrounding bank deposit guarantees, I had a thought. At school, most of us learnt to use government securities to determine the risk-free rate for use in models that discounted cash flows. Governments are hardly risk-free (I’m thinking Russia, Argentina, Iceland, et al), but the theory is that they’re about as close to risk-free as you can get. That is, if the government’s in trouble, then we’re all in trouble.

Well, now with government guarantees on bank deposits, we effectively have a new risk-free rate. That is, if governments are backing bank deposits, then bank deposits are consequently as safe as government securities. I don’t know what this means for the world outside of academia, but it’s an interesting consideration for anyone discounting cash flows. 

The counter argument is, in most countries at least, bank guarantees are limited to a certain amount (e.g. $100,000). You would think this would apply on a per person basis, but most reports seem to suggest this is on a per account basis. So, by creating multiple accounts can circumvent limits. In some countries though, governments have placed a blanket guarantee across all bank deposits, which negates the need for multiple accounts. Either way, I stand by the idea of a new risk-free rate in any country where these guarantees exist.

The formal definition of private equity is vaguely:

… The ownership of equity securities in a business not publicly traded.

As simple and concise as this definition is, it doesn’t differentiate between passive and active investors. This is an important distinction because the private equity offering contains much more strategic value than the offering of most other private investors. In this sense, a private equity investment more closely resembles an investment made by a management team. The primary difference being that the private equity professionals do not constitute staff and hence, they represent an extension of management that isn’t completely engrossed in the daily operations of the business. This allows them some independence and a refreshingly different view of the business from the outside world. Therefore, my expanded definition of private equity is:

… the ownership by a value-add investor of equity securities in a business not publicly traded.

Best regards,

the Private Equiteer