How Private Equity Makes Decisions?
Over the years, Private Equity Primer has come to realize there are some common misconceptions regarding partnering with private equity. As investment bankers and deal attorneys your job is to help protect your client and that means correcting these misconceptions. While not exhaustive the following layouts the most recurring themes.
1. How It Works: Patient (or Inpatient) Capital? Many PE firms like to say they are patient sources of capital. If “patient” is a euphemism for “illiquid” then, perhaps ‘yes’…however “patient” used in the literal sense, then the answer is unequivocally ‘no’. While admittedly anecdotal, I have been in private equity for over a decade, and I am not all that patient nor have I worked with any PE colleagues who I would describe as appreciably patient. In fact, I can think of a few who have the patience and temperament of Ari Gold.
While PE backed companies may not have quarterly public earnings announcements, they most certainly have privately quarterly board meetings where the level of scrutiny and accountability on average arguably exceeds the public company equivalent. Where public companies have their stockholders watch the ticker tape for daily share price fluctuations, PE backed companies have their PE shareholders and operating partners watching daily granular level KPIs ranging from purchase orders to inventory levels. Like the manager or head coach of a pro sports team, non-performing executives are often swiftly replaced. As noted in her study of the PE industry Professor Eileen Applebaum wrote, “One study found that 39% of CEOs were replaced in the first 100 days and 69% in a four year period.” Does this sound like patience?
The typical hold period for a PE investment is three to five years. For most businesses, three to five years is an incredibly short period of time. Think about how long it takes to build new customer relationships, implement major strategic initiatives, research and develop new products, enter new markets, turn around lagging business units—these things often occur over a number of years, not overnight. Most funds have a ten year life before capital must contractually be returned. While fund extensions are not uncommon, the incentive to quickly return capital remains. The rapid return of capital is further incentivized by how PE firms are measured and graded and their ability to raise subsequent funds (more on this in a moment).
The Takeaway—Understand if the PE Time Horizon Aligns with Your Client’s Goals:
The finite life of the institutional PE fund structure incentives quick flips and the rapid return of capital. This is not a judgmental statement but one of fact. If a short hold period averaging three to five years and intense focus on rapid increase in equity value is consistent with your client’s goals, then PE could be a good alternative to purse. If a longer horizon is sought, it might be wise to diligence further and explore other alternatives.
2. How It Works: Fundraising at Times Drives Decisions. The first five to six years of a fund’s ten year life is the investment period. The ability to invest these dollars can be viewed to a degree as “use it or lose it.” Most PE firms aim to invest the capital in the first three to five years of the fund life. This is not only to avoid running up against the investment period window but it allows for the PE firm to have overlapping funds, thus multiple management fee income streams.
While PE firms want to maximize the absolute total dollar return on their investments; after all, there is a powerful incentive for them to do so in the way of 20% carried interest on profits above some minimum return threshold (usually 8%); they really want to maximize the value of all of their funds. This might mean exiting a single investment sooner than they would otherwise if they were merely trying to maximize the value of that one company. If creating liquidity and returning capital sooner to their limited partners (“LPs”) increases the ability to raise their next fund or pushes forward the timing of the fund raising, PE firms may be incentivized to not maximize each investment. It happens.
Furthermore, PE firms are typically measured or graded by LPs across several factors. In addition to absolute dollar return (aka cash-on-cash return) and the ratio of capital returned to capital invested, they are also measured on internal rate of return (“IRR”). In layman’s terms, IRR is the annualized percentage return taking into account the timing of all cash outflows and inflows. The key word there for our purposes is “timing”…IRR is a function of time. The less time, the higher the reported IRR for a fixed dollar return. Simply put, doubling your money in two years is more impressive than doing it in five or six years.
The Takeaway—Fundraising Can Impact Exit Timing:
The PE firm almost always controls the decision to exit. Like the point above, there is often an incentive to exit sooner rather than later, which may or may not align with the business owner’s goals. Sometimes fundraising timing—a factor that should be completely independent of the portfolio company’s operations and optimal time to exit, but isn’t—impacts exit timing and may not maximize the equity value returns of that one company.
3. How It Works: Not A Reserve Piggy Bank. Many business owners and executives view the fact that they are PE-backed as having access to significant reserve capital should they ever need it. After all, many of these PE funds measure equity commitments (fund size) in the hundreds of millions if not billions of dollars. Sometimes the PE firm will even say they have funds reserved for portfolio investment should they be needed. Business owners view this as nearly automatic should they need capital for acquisitions, capital to fund growth, or capital to sustain the business after hitting a bump in the road. News reports of large VC-backed companies raising subsequently more and more capital at higher valuations with existing investors participating in the future rounds only serves to fuel this notion.
However, follow-on investment from PE firms is far from automatic. Recall that PE firms are evaluated in part on the basis of cash-on-cash returns, and they target returns of 3x – 5x their money. Unless they can see a clear path to the return of $3 - $5 for every incremental dollar invested, they will be reticent to invest more capital. Funding add-on acquisitions is more likely to occur than most other needs, but even then PE groups try and finance acquisitions with additional leverage to the extent possible.
Business owners frequently think the PE firm will step up if the business comes upon rough times to retire debt, put in additional equity dollars to cure debt covenant breaches, or provide needed liquidity. Bear in mind part of the beauty of the institutional private equity model is that each portfolio company stands on its own two feet without personal guarantees, fund guarantees, or cross collateralization with other fund portfolio company assets. While PE firms certainly do not want to see any of their portfolio investments go bankrupt, if they view it as throwing good money after bad they are unlikely to invest further.
The Takeaway—Follow-on Investment is Not Automatic:
Do not presume that follow-on investment from the PE backer is automatic just because the business operators deem it necessary or a “no-brainer” investment. Unless supporting a clear cut add-on acquisition where additional debt capital is not available, successful follow-on investments into portfolio companies is not terribly common because of the return threshold required to make the necessary cash-on-cash return work.
4. How It Works: Size Matters. This may sound like the start of a bad joke, but size matters when it comes to PE investments. The amount of time, expense, and diligence effort required to write a $5 million equity check, a $10 million equity check, and a $50 million equity check is not materially different. Ironically enough, smaller deals often require more time and diligence effort due to less sophisticated processes and systems found more commonly amongst smaller businesses. It also becomes unwieldy to have too many portfolio companies, where the PE firm cannot spend enough time with each one or have to hire more people to monitor them. At some point, deals below a certain size do not make economic sense for funds of a certain size to pursue.
There is also less margin for error with smaller sized companies in that an additional expense—be it a key new employee hire or something else—comprises a disproportionate percentage of the earnings of the business. This becomes even more of a sensitive issue in a leveraged environment, where such an incremental expense might easily trip a covenant or put liquidity pressure on the business. Lenders, too, realize this phenomenon and have the same scale issues as PE firms, and thus the leveraged financing options also tends to fewer for deals below a certain size threshold.
The Takeaway—Size Matters:
Sometimes smaller businesses wonder why they cannot attract private equity capital at all or from funds of a certain size. The fund structure, diligence effort and expense, and lower margin for error on smaller businesses makes it such that there will inherently be fewer institutional PE investors for these sized businesses. This can make it difficult to raise capital and/or it can have an impact on the relative valuations for smaller businesses.
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 “How Does Private Equity Really Make Money?” Roosevelt Institute. Eileen Applebaum, June 12, 2012. http://www.nextnewdeal.net/rediscovering-government/how-does-private-equity-really-make-money.
 The rule of thumb used to be for PE firms to target 3x – 5x their money in 3 – 5 years. However, as the industry has become more competitive, targeted returns have arguably come under pressure and been lowered. Some say targeted returns may be closer to 2x – 3x invested capital. Actual returns vs. targeted levels obviously vary.