Private-EquityMedium

3 min read · 608 words

What the seat actually does

A private equity fund raises capital from institutions, buys whole companies with a mixture of that capital and borrowed money, owns them for something like three to seven years, and sells them. The fund makes money in three ways and it is worth separating them, because only one is a skill.

• The business got better — revenue grew, margins improved, something was fixed. This is the part everybody claims.
• The debt was paid down — the company's own cash retired borrowings, so the equity slice grew without anything else changing.
• The multiple moved — it was sold at a higher multiple than it was bought at, which may be skill and may be the market.

The purchase price is an output of the financing. A buyer works backwards: this is the return we need, this is what the debt markets will lend, therefore this is what we can pay. See the leveraged buyout.

A day, and where it goes

• Sourcing — seeing companies, most of which will not be bought. The ratio is brutal and the seat is judged on the few.
• Diligence — commercial, financial, legal, and the part that matters: what has to be true for the model to work.
• The model — an LBO analysis, which is not a valuation but a statement of what can be paid at a given return.
• Portfolio work — board seats, management changes, a bolt-on, and the monthly numbers.
• Exit — a sale, a listing, or a continuation vehicle when neither is available.

What it is measured on

• Internal rate of return, which is sensitive to timing in a way that rewards selling early. See IRR and NPV.
• Multiple of invested capital — the plain number, immune to timing, and the one that says whether money was actually made.
• DPI against TVPI — what has been paid back versus what is claimed to be worth. The first is cash and the second is an opinion.
• Against public markets, increasingly: what the same money would have done in an index, levered the same way. It is an uncomfortable comparison and the honest one.

What it touches on this site

• The transaction — the buyout and the whole leveraged finance desk that funds it.
• What it owns — alternatives and the fund itself as an instrument.
• The arithmetic — IRR and NPV and leverage.
• Where it goes wrong — 2017, and the dividend recapitalisation.

How it goes wrong

• Leverage that assumed the cash flow. The structure works at the forecast and not at the outcome, and debt does not renegotiate itself.
• Buying the cycle and calling it selection. Multiples expanded for everybody; the fund that sold into that expansion looks skilled until it has to buy again.
• Marks that only move up. A portfolio valued by its own manager, quarterly, is smoother than the businesses in it.
• Fees on committed rather than invested capital, for years — the cost that is invisible in a return number and is charged anyway.

Concepts to master

• Entry multiple, leverage, exit multiple. Three numbers explain most of any buyout's outcome, and a return decomposition should say which one did the work.
• IRR rewards speed. Two funds returning the same money in different years show different IRRs and identical multiples.
• The J-curve is arithmetic, not misfortune — fees are paid before value is created, so early years look negative by construction.
• Illiquidity is the product, not a defect. A holder who cannot sell in a panic does not sell in a panic, and that is part of what is being bought.