The big idea and why it matters: If Private Equity were merely a wealth-destruction vehicle, as some media coverage implies, it would not also be a sustainable, growing, and highly profitable asset class. Diving deeper into the areas where PE can drive not only financial but also operational improvements makes it clear that there is an opportunity for real wealth creation in PE transactions.
“The secret of change is to focus all of your energy not on fighting the old, but on building the new.” – Socrates
Today, I am determined to finally end this series, which was intended to add more perspective to various investment strategies and asset classes, for a) keeping an open mind about opportunities for improvement, and b) challenging some preconceived notions that exist in wealth management. In the spirit of Socrates (that’s “sew crates” for you Bill and Ted fans), we’ll continue to focus on the path forward. Here we go!
Bridging the gap
If you enjoy this topic or have any desire to learn more about Private Equity, then Season 2, Episode 11 (“The Evolution of Private Equity – From Wizards to Artisans…”) of the Capital Decanted podcast is a must listen. I’d expect nothing less from the folks at CAIA, but it’s as objective a take on the history and evolution of the subject as I’ve heard. I’ll reference some of what they’ve covered (including the notion of a carveout transaction), as they do a great job of bringing to the forefront what may be the core issue of the negative opinion of PE: it’s hated for what it was, rather than what it is today.
Yes, private equity was once mainly just about financial engineering (i.e., adding leverage and cutting costs, as an overly simplified description) – that allowed PE firms to take significant fees and extract value from balance sheets. And there are real tales of that having been to the detriment of companies, as in the well-known RJR Nabisco saga detailed in Barbarians at the Gate.
However, the beauty of markets is that lucrative businesses attract competition. And competition forces improvement. The “easy money” of the early days is long gone, and private equity has evolved for the better, bringing not only financial improvements but also operational and cultural enhancements, with a focus on real value creation.
Consistency is key
You can’t brush your teeth for 10 hours the day before a dental checkup to make up for months of poor brushing and flossing routines. Your subpar habits will compromise the health of your teeth and gums, and the dentist will easily notice that you aren’t giving your mouth the daily attention it needs.
Private equity results are surprisingly similar. Of course, PE firms are motivated to make money for themselves and their investors rather than fight cavities. But their ability to drive “healthy outcomes” depends on consistent processes that drive a) desirable cashflows, b) desirable sale prices of businesses, or c) both. In other words, they must “do the work” day in and day out, bringing together a variety of skill sets to ultimately create meaningful, measurable value.
Business destruction, on the other hand, is simply not a viable business model, as it results in not making money and a track record/reputation that will significantly impair the ability to fundraise.
New smile
How might this “new” version of PE work (mind you, this has really been taking hold since the ‘90s, aka back in the 1900s, as my kids would say)? Let’s look at a simplified hypothetical example to help make it more tangible.
Imagine you work for a large private company, Smiles ‘R’ Us, that is a market leader in manufacturing dental equipment and oral hygiene products. Their relationships with dentists are the core of what drives the overall revenues of the business. Your role at Smiles ‘R’ Us actually has nothing to do with dentistry, as you work within another division of the company, Accept DeFeet, which focuses on podiatry equipment (stemming from a previous acquisition that hasn’t really gone anywhere). Unfortunately, Accept DeFeet doesn’t get the necessary level of attention or resources it needs from the broader Smiles ‘R’ Us enterprise to operate at full potential.
How might Private Equity step in to improve such a situation?
- Options for PE ownership:
- A PE sponsor could buy a minority (less-than-half) or majority (controlling stake) interest in the overall Smiles ‘R’ Us company. [Note: if Smiles ‘R’ Us were a public company, then varying degrees of ownership could be attained via stock purchases, including a total ownership “take private” transaction.]
- If the PE firm instead sees Accept DeFeet as the real opportunity, they could separate it from Smiles ‘R’ Us to purchase it as a standalone business (a “carveout”).
- Where do they get the money?
- This is historically where PE has caught some heat, with the perception being that they always borrow an irresponsible amount of debt to purchase companies, saddle them with unaffordable interest payments, and drive them into the ground. But that can only happen so many times before lenders or investors stop lending or investing. No one wants to be involved in a failed transaction!
- A typical transaction these days still uses leverage, but it involves putting up relatively more cash (most of which comes from investors, aka limited partners) and less borrowing. The financing may come from a combination of sources, but private credit has played an increasingly important role in these transactions. And since no lenders are there to lose money, they are only going to lend amounts they feel they can protect via Accept DeFeet’s assets (manufacturing facilities, inventory, etc.) or cashflows in more troubled scenarios.
- What happens next (now focusing on Accept DeFeet as a carveout)?
- Since high leverage and financial engineering aren’t going to generate the returns needed for their investors, the PE sponsor has to create real value.
- Cultural Improvement: Bringing new resources (financial and leadership) into Accept DeFeet boosts employee morale. They listen to key employees and implement changes. People feel heard and that there is an opportunity to contribute to growth. Accept DeFeet becomes a place where people love working, rather than one they tolerate for a paycheck and benefits. The workforce naturally becomes more productive.
- Process Improvement: The PE sponsor, and perhaps some lenders, bring experienced teams into the business to refine the many vital components of the overall enterprise (e.g., software solutions, human resources, finance, operations, etc.). Many minor enhancements create a significantly improved operation.
- Organic Growth: Perhaps this PE sponsor has other businesses with a vast network of podiatrists. They can easily introduce Accept DeFeet into those practices to expand its footprint and customer base. Initial sales and recurring revenues rise exponentially. They also have the resources needed to scale up the level of products and services in tandem with that growth.
- Strategic Acquisition (“rollup” model): We didn’t know before that Accept DeFeet is one of many small podiatry equipment providers in a fragmented industry across the US. The broader vision is that the PE sponsor can use their purchase as a platform to acquire and improve many competitors through efficiencies and synergies.
- Rebranding: While “Accept DeFeet” is an incredible name and has some legacy brand recognition (and the person who came up with it is probably pretty amazing), perhaps a new name and entirely new image for the standalone podiatry business can have a positive impact.
From the above example, it should be apparent that there is real potential for business improvement through Private Equity involvement. PE firms are in a unique position to facilitate transactions by identifying potential opportunities and bringing the combination of capital, experience, expertise, and relationships to the table to make it all happen profitably…which most often means creating something appealing to an eventual buyer. If they don’t create value, the business plan will fail!
Cavities
That is not to say that Private Equity is without risk, that some bad actors exist, or that it doesn’t need to continue evolving to create value in the future. Some investments will fail, and people already point to too much “dry powder” (capital raised but yet to be deployed) and to current projects/business plans being extended beyond initial expectations as potential red flags. I can never reiterate enough that the quality of private investment managers and their processes will be paramount to investor success.
Retainers
What did we learn in this series? Here are the Clif’s Notes, along with links so you can revisit anything that may be of interest:
- From Part 1
- Reducing “risk” going into retirement (i.e., more bonds, less stocks) may not make sense in many cases and at least shouldn’t be a general rule of wealth management.
- Investors may do themselves a disservice by keeping multiple advisors.
- From Part 2
- The “4% rule” for withdrawals requires significant equity representation in a portfolio (which flies in the face of the first bullet above).
- Passive indexing introduces oft-overlooked portfolio construction tradeoffs that can outweigh cost savings (e.g., having to hold excessive cash reserves).
- From Part 3
- Credit structures vary widely, and some characteristics are unattainable in public markets. Alts may be needed to target higher portfolio income goals.
- From Part 4
- Credit performance also varies widely in different environments due to rate sensitivity and pricing mechanisms. Floating rates stand out in helping to mitigate periods of rising interest rates. And don’t chase yield!
- From Part 5
- Much negative press regarding private markets relies on generalities, as is the case with many headlines. Manager quality and deal specifics matter.
To rinse or not to rinse?
Now that I’ve exhausted my short list of dental terminology headers, it’s time to officially spit this topic out and move on with our lives. Remember the whole “brushing and not rinsing” idea that kicked off this series? Well, out of the many, many, many, many readers of Alt Blend, I did hear back from one who said that they do brush and rinse, but then apply a new layer of toothpaste to their teeth after that – citing that they didn’t want to leave the remnants of the “dirty toothpaste” from brushing. To each his own (provolone).
As a non-dentist, my guess is that consistently flossing and brushing is responsible for the bulk of positive returns in the oral hygiene department – and rinsing may be an area where we can allow for some personal discretion (I will anxiously await the backlash from our dental professionals). Similarly, in wealth management, it’s most important to get the major long-term decisions (e.g., advisory relationship, investment, tax, income, estate planning) right, and I hope this series provided valuable insights with that in mind.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
