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Hey Mike, welcome back.
Back in action.
Back in action, back at it.
I thought today that we could take a little trip down memory lane from about five years
ago when I joined TriVista.
I remember you were pretty instrumental in helping me in what we're going to talk about
today.
To kind of set the tone for our listeners, I had come out of a publicly traded company
and been in publicly traded companies for a while.
And through a series of events, found TriVista found me and was able to join.
And what we're going to talk about today...
You respond to an ad in a paper?
That's correct.
Correct.
Classifieds?
Yeah, I think it was Craigslist.
But what we're going to talk about is an introduction to private equity.
And I was familiar with M&A activities.
I've been familiar with carve-outs, take privates, all that type of stuff, but hadn't really
had the opportunity to really understand private equity to the depth five years later that
I have now.
But it was thanks to you kind of pushing my boat off the shore that I was able to learn
some of those things.
I thought it'd be good for you, Mike, to be able to share some of that with your listeners.
But to maybe start it off, could you share a bit about how you got in private equity
and how you kind of started on this journey?
Yeah, absolutely.
So not dissimilar from you, my private equity origin story was I used to work at a large
Fortune 300 business, diversified industrials, couldn't be further from the private equity
sector.
Candidly, I don't even think I had ever heard the words private equity.
Maybe I had read about it in the Wall Street Journal or something like that.
I wouldn't suggest that I understood what those two words meant at all at the time.
This is going on 20 years ago now.
And after a fairly short career in industry, I had the opportunity to start our firm with
some of our other partners.
And it just so happened that we decided to start a consulting business that would consult
to the private equity industry.
Now, fortunately, my partners knew a little bit more about private equity than I did.
A little bit is probably an exaggeration.
They could spell the words private equity.
I'm still to this day wonder kind of how they found themselves understanding what it meant
even to at a surface level.
But that's a story for another time.
That would be a good interview to do.
But that was the beginning of my journey.
So it was via consulting was my first exposure to PE, short for private equity.
Our business at the time, the kind of thesis for starting the company was that private
equity investors who were out there acquiring businesses, for us, businesses in the industrial
space and industries that we were very well versed in from our industry backgrounds, these
private equity firms were out investing in these companies.
And we were going to provide them with expertise, sector, industry expertise, functional operational
expertise and guidance as they did due diligence on some of those acquisitions.
And then our thought was we could help some of those companies after they were acquired
to grow and prosper and optimize operations, et cetera.
So that was my first foray into the private equity ecosystem.
So spent a good decade or so working in a lot of private equity backed businesses as
an advisor or as a consultant, sold a lot of work to private equity firms, built a lot
of relationships with private equity firms.
I've probably personally visited four or 500, maybe more different private equity firms
around the world, do a lot of work in Asia and Europe over the years, as well as a lot
of work, obviously, in the United States and throughout North America.
And to be honest, through that, throughout those first 10 years or so really started
to take an interest beyond the companies that they were buying in industries that were interesting
to us and relevant to our industry backgrounds, but really started to get interested in and
more involved in understanding how the private equity business model really worked.
And I think at first it started from a place of pure curiosity, but also I was trying to
better understand my customers.
And I felt like if I could better understand the investor's business model as a, you know,
I wasn't a professional investor by training or by trade at that point.
I was an operator of businesses and a consultant to businesses, operating companies.
My thought was that if I much better understood the private equity business model and the
investment theses and how the underwriting process for new deals took place and really,
quite frankly, ramped up my financial acumen, my M&A acumen, that I could serve those private
equity clients better.
So I decided at one point, and I'm not sure if it was a conscious decision or what, but
I started researching a lot more than I ever had on how the private equity ecosystem worked.
We had done a little bit of co-investing into some of the deals that our private equity
clients were acquiring.
And that, I think that actually with hindsight was probably what piqued a lot of my curiosity
too, because we had some successful investments and I wanted to do more of them.
And I was just really curious as to how they worked.
So I spent probably five or six years going deep down some dark rabbit holes online and
listening to podcasts and reading books and attending some courses that I could find that
were about the topic of how private equity works, how funds get raised, how deals get
done, how terms of M&A transactions get negotiated, how deals get financed, a lot of things that,
quite frankly, were impacting all of the businesses that we were involved in.
Our firm, as we started out, our consulting business exclusively advised private equity
firms, not the case today.
We advise a broad spectrum of clients.
But in spite of the fact that I had worked in that sector for 10 years, I really didn't
understand how the PE business model really had come together.
So I spent a long time researching it and that's how I kind of stumbled into it.
Now, I think the great thing for our listeners today is kind of culminating all that into
kind of a 101 as we discussed and kind of taking our listeners through all that experience.
You save them all that Googling, I guess the new way of saying it's all that GPT and they
can kind of use that knowledge, a lifetime of knowledge for a 30 minute conversation.
And maybe we can just jump in and kind of the 101 crash course.
Let's do it.
So as we were preparing for this episode, I was trying to put myself in the shoes of
the listener.
So kind of beyond just recognizing there's a lot of folks out there who like me 20 years
ago, like you five years ago, really don't understand private equity, at least not to
a level that they would like to.
So just recognizing there's a lot of people out there that are in those shoes.
So it's important to provide some relevant content to those folks.
But also, I think we hear a lot about private equity in the media.
You can't read a single national newspaper without reading about some private equity
deal that's getting done in some industry or another, whether it's private equity firms
trying to get involved in sports teams, private equity firms doing take privates of large
publicly traded businesses, backing the next great consumer brand, fast growing consumer
business.
It's in the media.
It's prolific.
It's kind of omnipresent these days.
The reason that that is, it's not just because private equity firms have great PR departments.
In fact, I think very few private equity firms even have PR departments.
But the reason that that is, is that private equity is a bigger part of the US economy
than I think most people realize.
And I pulled some stats, and to put that into perspective, the stat that I have is from
2021.
You could presume it's a little bit more than that today after a couple more years of economic
growth.
But in 2021 alone, private equity invested over a trillion dollars in the American economy,
one trillion dollars.
Currently, private equity firms manage about $3 trillion of capital that is committed to
their funds, but has not yet been invested in businesses.
Three trillion dollars.
So it is a huge part of the US economy.
2021, 5,200 businesses representing 74% of all of the investments that were made in businesses
in the US were private equity backed deals.
And 97% of those deals were businesses in the middle market under revenue size of, let's
just call it roughly about $500 million.
So the number of 10, 20, 50, 100, 200, $500 million revenue businesses, these are sizable
businesses could employ hundreds or thousands of people across the country that have private
equity as an investor is quite significant.
Maybe something like a couple hundred thousand, maybe three or four or 500,000 businesses
in the US that are backed by private equity firm in some way, shape or form.
So a big part of the US economy.
And I think it's important that executives who are less familiar with their private equity
ownership model, who are maybe working in a large family owned business or maybe a publicly
traded business or division of a publicly traded business, if you've never been owned
or backed by private equity investors before and you're halfway through your career, it's
highly likely that at some point you're going to be working with a private equity firm directly.
It's tough for us to think at that scale, right?
That's that Apple, Amazon scale of value.
And I think those kind of make headlines when you think about the total, that's a larger
number than I expected.
I think one of the things that you mentioned, putting on my 101 hat is committed to their
fund.
Could we maybe, and maybe you're going to cover it a bit in the future, but just to
kind of talk about what that commitment means and kind of parsing that out from deployed
to committed.
So let's come back to commitment.
And here's why.
I want to start by talking about what private equity is and what private equity isn't.
So I'm going to kind of go 100,000 foot level, and then we're going to get more into the
nuances of the actual business model and some of the specifics.
So first and foremost, private equity invests in typically mature operating businesses.
So this is not venture capital.
This is not early stage businesses.
This is not angel investing.
This is not $0 in revenue.
We've got the next Facebook or Airbnb.
As a result, while there certainly are private equity firms that exclusively invest in mature
tech businesses, tech is a much more common place for venture capital firms or VC firms
to play than it is for private equity firms.
It involves investing in these mature operating businesses.
Being an investor in those companies for X number of years could be three, four, five,
seven, 10.
Some firms have longer strategies up to 20 plus years.
Trying to grow those businesses to the next level of maturity and then exit or realize
or sell those investments onto somebody else.
It could be another private equity fund.
It could be another corporation, maybe selling it to a publicly traded business, could be
doing an IPO.
So big difference between private equity and venture capital.
Venture capital tends to be very early stage businesses, sometimes pre-revenue, like I
said, sometimes pre-product concepts, sometimes slightly more mature than that, but oftentimes
very early stage businesses.
Also what private equity isn't is private equity is not a hedge fund.
A lot of people think hedge funds, private equity, kind of same thing.
Hedge funds typically are buying large stakes of publicly traded businesses using private
capital that they've raised.
So that element, the capital sources tend to be similar of the private equity fund to
a venture capital fund as well as to a hedge fund, but the types of investments that they're
making couldn't be more different.
So private equity think investing in private businesses that are mature to some degree
or another.
Venture capital, same thing.
You're investing private capital, but in the early stage businesses.
Hedge funds, investing private capital, but investing into typically publicly traded businesses.
So those are some of the key differences, but there are a number of similarities.
It's not surprising that they're confusing to folks who aren't living in this world each
and every day.
Yeah.
My first business was actually VC backed.
I think as I learned more, I had that assumption that there was a lot of similarities in the
two and quickly learned that there are some vast differences on, I think some of the things
we're into, but around structure and communication, what they're looking for.
And I think that's a good distinction because I think to me previously, I would view them
as more synonyms and kind of the way that the firm or brand kind of presented itself,
but it's more than that.
So what it is, is a group of professionals will go out and they'll raise capital, right?
So they're going to go out to any number of different type of investors.
They could go out to some large wealthy families.
They could go out to some university endowments, some pension funds, the same places that they
are venture capital firm is going to raise money from, the same place that a hedge fund,
the same place that anybody in the world who's raising significant capital, who isn't going
to the public markets to do so via some type of initial public offering or something similar.
So this group of professionals will start this private equity firm and they will go
out and raise a private equity fund.
So big difference between those two things.
The private equity firm is the brand, it's XYZ investors would be the brand of the private
equity fund.
I'm sorry, the private equity firm.
And they would go out and start raising their first private equity fund.
They're going to go out to some of those investors that I mentioned and they're going to go and
try and raise X number of dollars.
Let's just, for the purposes of this discussion, they're going to go out and raise $500 million,
right?
It sounds like a lot of money.
It is a lot of money.
There's more money in this world, certainly than I ever realized.
There's a lot of these private equity funds out there raising capital all the time, but
they go out, they raise this capital and they put it into what's referred to as a private
equity fund.
So you have many different investors all pooling their capital into one singular fund.
And then that singular fund managed by XYZ investor, private equity firm is going to
go out and start to make investments in these mature operating businesses.
Different investment firms have different strategies.
One might be focused on industrials, one might be industry agnostic, one might be focused
on services businesses.
There's a bunch of different strategies out there, geographic strategies, et cetera, as
you might imagine.
So they're going to take this private equity fund, this $500 million that they've raised
and they're going to go and try and make investments.
Most of the time in your kind of typical fund, they're going to make, let's say somewhere
between eight to 10 investments.
For example, purposes we're going to continue to use 10 to allow us to do some easy math
on the fly here.
So they raised the $500 million, they go out and they make 10 investments.
The size of their fund oftentimes will dictate the size of businesses that they're going
to buy.
Earlier when I described them buying mature businesses, mature businesses in what we would
refer to as the middle market.
A synonym for that would be medium sized businesses.
These are companies that typically have between 20 and 500, maybe 20 million and a billion
dollars in revenue, maybe up to about two to three billion is kind of the upper end.
Somebody who's raised 500 million in a fund, they're probably going to go look to buy or
invest in 10 companies doing somewhere between 100 to 150 million dollars a year in revenue.
So they're buying fairly medium sized, on the smaller end of medium sized businesses.
And they're going to invest in those companies through a combination of the equity, which
is the fund that they've raised at $500 million.
They're also going to go and probably raise some debt and put some debt on the balance
sheet of those businesses as they acquire them or as they invest in them.
They're going to try and grow those businesses over time and they're going to try and sell
them at some point in the future at a profit.
There's a lot of commonalities that the simplest way I've ever come up with describing this
is flipping a house, right?
Private equity firms, they gather a bunch of money up, they go out and they look for
quote unquote houses to buy.
They're looking for ones that they think that they could reasonably improve over a reasonable
period of time.
And to the extent that they can be successful doing that, sell it to somebody else and make
a profit.
There's no more complex than that in its simplest form.
Obviously, doing it is a lot harder though than the simple description would suggest.
But that's the basic business model.
And we can talk more about how they do some of those things in a little bit more detail.
But that's kind of the next level of granularity.
For our listeners, who primarily is, as hopefully most of our listeners have come to appreciate,
we primarily are speaking to kind of operating executives who are leading medium-sized organizations
who are executing M&A strategies, who are growing businesses, trying to grow EBITDA,
a little pun intended there.
I think it's really important for the reasons we described earlier that they understand
these mechanics of the private equity industry because like we talked about, oftentimes they're
going to be coming across these private equity firms, whether they're working with them in
some type of collaborative way or you're selling a business to a private equity fund.
It's important that you understand some of these dynamics.
So now I've got my pot of money for all intents and purposes.
I worked really hard on getting that.
I know kind of generally what my mantra is and what I want to do.
Now I want to go invest in a business.
What do I do?
What is that process?
What does that look like?
What are those kind of next steps I'm doing now that I have my fund?
Yeah.
So the private equity firm has raised their fund, and they're going to go out and buy
these 10 businesses.
So how they start, let's just go with company number one.
There are a number of sources that you can go to to look for businesses for sale.
This is not a podcast about all of those sources, right?
But there's investment bankers, there's five different flavors of investment bankers, there's
approaching companies directly.
And these private equity investors get quite good at finding those sources for what they
would call their deal flow.
They're trying to look at a lot of deals because they're trying to be selective.
Even though they're trying to invest in 10 businesses, it's certainly not going to be
the first 10 businesses that they stumble across.
You may not, some of our listeners may not realize just how many they look at.
To invest in 10 businesses, they're probably looking at somewhere between 500 to 1,000
businesses, if not over their fund's life cycle.
Maybe even more than that.
It could be 500 to 1,000 a year to try and invest in those 10 businesses.
And by the way, I'd point out those 10 investments, they're typically making those over about
a five-year horizon.
So this is not raise $500 million, invest $500 million.
This is raise $500 million and that might take them one, two, three years to raise the
money.
And after they've done that, they're going to go and start investing it, right?
So a typical private equity fund life is about 10 years.
So from the time that you commit to the fund, if you're an investor, you're involved in
that for 10 years, there's really no out that's easy.
So these are really kind of long-term investors for the investors in these groups.
So the private equity funds raise the money, they're going out, they're looking for their
deal flow, they're trying to do their first investment.
Let's just say they find a business that they like.
Let's use that example from before, $100 million revenue, industrial manufacturing business.
So they found this business, they like it, it's in the right geography, it's serving
some growing end markets.
They think it's got a decent leadership team.
It seems like it's got a sound strategy, it produces nice margins.
And they negotiate a purchase price and a purchase structure for the business.
They're going to go and do their due diligence, right?
So they go there, do their due diligence.
It could be legal diligence, accounting diligence, human capital, management diligence, obviously
near and dear to our hearts, right, James, especially yours, technology, cybersecurity
diligence, operational supply chain diligence, they're going to pick apart that company with
a fine tooth comb, really because they want to make sure they're making a sound investment
decision.
They want to know are there skeletons in the closet, so on and so forth.
So let's say that all checks out and they like it, they think they like the team and
they close on the transaction, right?
So they acquire the business.
Now, interestingly, sometimes they're acquiring 100% of the business, but a lot of people
don't realize that in many, many situations, they might not be acquiring 100% of the business.
There may be the founder of the business who is rolling some of his equity into the, we
call it rolling equity into the deal, right?
So maybe the founder, the entrepreneur owned 100% of it until the private equity firm comes
along.
Maybe the private equity firm buys 40%, 60%, 80%, it could be minority, majority control,
but they're buying a meaningful percentage of the ownership of the business and deals
come in many different shapes and sizes.
We're not going to get into structuring here today.
We don't have time for it, but I bring this up because it's not always them doing complete
buyouts.
Oftentimes there's other parties involved, but they'll go in and acquire the business.
And then obviously they're going to hope that the company does well over the next five years,
seven years, whatever their ownership cycle is going to look like and grows the revenue
and profit grows and EBITDA grows and it creates a nice investment outcome when they go and
sell it for more money.
Obviously they're trying to do than they paid for it, right?
Now I used the word hope here a moment ago.
Some private equity firms are, their style is a little bit more make a good decision
and hope it works out.
But what's kind of played out over the last 25 or 30 years as this industry has evolved
and it's evolved quite, quite profoundly is that most private equity firms add what they
call operational value.
So it's not just going to be that they invested in the business like it is in the public markets
where you kind of buy X percent of the company and hope the management team does a nice job.
And if you happen to have a bunch of money and you've bought 10 or 20% of the business,
maybe you could get a board seat.
In most cases in these private equity back deals, they're buying a material stake in
the business, 40, 80, 60, somewhere like that percent.
And they have governance control.
So they often have all or most of the board seats.
So they're rather involved in the decision making at the highest levels.
They also have the responsibility of in almost every situation, choosing who the CEO is.
And that could be whoever the current CEO is, it could continue to be the entrepreneur
or founder who started the business.
But in many cases, they may be bringing in a new CEO or a new CFO or a new CEO and a
new CFO.
Every deal is a little bit different, but they're typically very involved in those decisions.
And oftentimes, especially in larger businesses, they're going to be quite hands on in helping
to work with those management team members to try to develop strategies to grow the business
and make sure the company has the resources it needs to be successful and then implementing
some of those strategies.
And it's not to say most private equity firms, the professionals that run those firms, they're
really not operators.
They can be quite wise when it comes to structuring deals, finding good businesses to buy, raising
capital to do that, both the debt and the equity, getting those deals done, coming up
with strategies, challenging strategies of the management team.
And they're particularly good, many of them at helping thinking through M&A strategies
and executing M&A and trying to grow through acquisition.
That's really a big, strong value add that they can bring to the table.
But they typically don't have a tremendous amount of operational expertise.
So there is this, if all goes to plan, there needs to be a really symbiotic relationship
between the management team who's responsible for operating the business every day and the
private equity investors who are responsible for making sure that their investment goes
to plan, that they've got the right leadership team in place, the company has the right resources.
And sometimes they'll bring some of those resources, those resources may be in house.
Those are called operating partners. In many instances, you're going to have a lot of consultants
who come in, not that bringing consultants in is necessarily a bad thing or represents
that there's a deficiency in the business, James, but really it's maybe a company is
trying to do something it's never done before, open up on a new continent, a new manufacturing
facility.
Maybe they're trying to penetrate a new market that they've never done that before, or they've
never been good at or really terribly structured about optimizing their pricing or optimizing
their inventory management. Oftentimes you find businesses at different stages of their
growth need different resources, right? And private equity firms are often very quick
to bring in experts, consultants, new additions to the management team that are going to help
that company grow and prosper. So I can talk about this all day. So you got to stop me
if I'm wrong.
Yeah. Yeah. I think we've done a nice job by we, I mean you on the, we've established
what is a private equity firm. We went into how does it fundraise? We then talked about
how does it find businesses? Really nice conversation right now on how does it deploy? You talked
about it for a second, but maybe we could just kind of close out. Let's finish the loop.
You said three to five to seven year hold for those firms. How does it exit? Now I know
we said where it exits, but how does it exit? Let's close it out on that. And what are some
of the implications? Because now they have these investments. Do I just cut a check back
for you to invest it or how does that kind of exit process work? And guess one of the
base questions, why do you folks invest in private equity and why do businesses exit
private equity firms?
That's a great question. These 10 investments in the private equity world, we call them
portfolio companies. It's a company that's in a portfolio of the fund, right? Portfolio
company. You've bought it, you've improved it. Now you're time to, now it's time to exit
it. How that happens, we on our channel here, we always use the selling house or flipping
house analogy. Another really good opportunity to do that here. We probably should have called
this the house flippers podcast. It's just a very convenient, it's a very convenient
analogy. Not dissimilar from house. There are agents in the M&A world, private equity
community, we call them investment bankers. They kind of act like real estate agents.
The process that they use is the investment bankers will come in. They may already be
familiar with the business. Maybe they helped sell it to the current owners, the current
private equity firm, but they're going to come in, they're going to look at all the
financials. They typically are very sector focused, especially the kind of more well
renowned ones. They tend to specialize in industrials or tech or B2B services. They
tend to have that type of expertise. So they're very familiar with the industry typically
that you're whatever industry that particular portfolio company may be involved with. So
they'll come in, they know what's going on in the industry. They tend to know a lot of
the buyers in that industry. So they kind of know what people are paying for businesses
of certain sizes in certain sectors with certain characteristics. Characteristics could include
gross margins that look like X versus Y, or if your CAGR is 3% versus 8%, they'll have
a pretty fundamental understanding as to what type of premium you might command for the
7% CAGR business versus the 3%. So they do bring quite a bit to the table even in those
preliminary discussions, but you'll typically approach two, three, four, five would probably
be a large number of bankers that have the relevant sector expertise. You'll say, hey,
we're thinking about selling this business. Obviously, this is all done very confidentially.
We're thinking about selling this business. Come and take a look, give us some thoughts
on where the market is. Do you think this is a good time to sell? And if the parties
agree, yes, it's a good time to sell. The owners of the business, in this case, the
private equity firm, they'll work with the CEO to help choose which banker they think
would be best to represent them in a sale process. They may do some sell-side due diligence.
We've talked about that briefly on other episodes, but sell-side due diligence is really a company
that's selling themselves. They're going to hire some experts to come in and write some
fancy reports. I'm not trying to belittle them, but this isn't a sell-side due diligence
podcast episode, so we're going to cover it briefly. They're going to create some fancy
reports that kind of help prop up the business and why it's a good company to buy. They may
do things like look at the technology stack in the business. Does the company have the
appropriate cybersecurity protocols that a company this size should? You might go, well,
why would somebody selling that want to talk about their cybersecurity protocols and advertise
that to the next buyer? Well, the reality is if you can de-risk the deal for the next
buyer, in this case, if you can convince the buyer that, hey, listen, we know cybersecurity
is important to most investors out there, we do a really great job. As attested to by
this world-renowned third-party consulting firm or advisor, it gives those buyers a lot
of comfort that, hey, we're probably going to check this out when we do our own diligence,
but it gives them comfort that what they're looking at is as exciting as they hope it
is. Keeps them a little bit more engaged in the process. You may do some stealth side
due diligence, but then that investment banker is going to help, again, on a very confidential
and limited basis, go out to the buyer universe that they typically have strong relationships
with. That's what those guys do for a living. They're going to go out to that buyer universe
and articulate the great things about this business and try and convince people that
buy businesses for a living. That oftentimes means other private equity firms, but it also
could mean large corporations or maybe some large families who acquire large businesses.
Try and get them excited about looking at the business and hopefully convince one or
two of them to put in bids and hopefully sell the business for a nice profit.
Yeah. Interesting. Then the beauty of that is that that goes back to the folks that invested
and it's a nice symbiotic circle there. I thought, Mike, we kind of had a really good
chat where we crammed in a lot on the 101 to try to talk about these topics. I thought
we'd end on maybe a little bit of a lighter note if you're okay with some quick hits.
Go for it.
I'm going to read you some sentiments around private equity based on organizations going
bankrupt and the sensational headlines that were created from those organizations going
bankrupt.
Go for it.
The idea is misconceptions.
Got it.
Quick hit.
You're assuming I've read those headlines. We'll see.
You're a studied man.
First quick hit. Private equity only focuses on cutting costs.
Yes. The media loves to talk about how bad private equity is because all they do is slash
and burn to line their pockets. I'm sure there are a handful of firms out there whose culture
it is and their business strategy is and their investment thesis is let's cut every cost
we possibly can to line our pockets as quickly as we possibly can.
I've worked with 500 or more different private equity firms. There's about, it depends on
who you ask, but there's probably about 5,000 or so private equity firms out there. I've
worked with a reasonable chunk of those over the last couple of decades. I haven't really
found any of those yet, at least not at the firm level. There may be some individuals
at some of those firms who would be maybe bad actors as the media would like to describe
them, but couldn't be further from the truth in my experience at least. I think most of
the folks in the industry would attest to this.
The reality is that you can't really get where you're trying to go in private equity if all
you do is cut costs. If you come into a business, let's use this $100 million industrial manufacturing
business as an example, if you've bought it not in a turnaround situation, there are certainly
going to be some situations where businesses are either in bankruptcy or close to being
in bankruptcy or just coming out of bankruptcy and there's a lot of tough decisions that
need to get made because you got to take costs out to save the enterprise. That is not most
private equity deals. Most private equity firms, their strategy involves buying, generally
speaking, fairly healthy companies and helping them to become even more healthy companies.
Really their incentive is to grow them, to grow their earnings. This isn't the turnaround
industry. This is the private equity industry. A subset of that is involved in fixing broken
companies, but the vast majority of these dollars are going into the guy who down the
street from you, he started a company when he was 31 because he had an idea about how
to make some kind of product better or how to deliver a service better or somebody who
started one franchise and went on to grow it to 20 different franchise units in a particular
geography. It now does five or 10 or 20 million, 30, 40 million of EBITDA, very profitable
business. Those people need liquidity. Liquidity doesn't exist anymore in the IPO market like
it used to 30, 40 years ago. In fact, there's been a material decline in the number of
companies that are able to go public. To be a publicly traded company these days below
about a billion or $2 billion in revenue, it just doesn't make sense with all the compliance
regulations. Really, there aren't that many other people out there who you can sell a
business when that owner goes to sell outside of private equity. Private equity firms, if
they come and buy a business that's doing, let's just say 10 million of EBITDA and 100
million in sales, the only way that they're going to make a great investment return is
if they grow sales and grow earnings. It's not a sales stay flat and earnings double.
If it was that easy, it'd be easy to make it. Every executive on earth, if it was that
easy, wouldn't be making their bonuses this year because they'd be all getting costs in
order to get to that place. Even if they were successful doing it this year, good luck trying
to repeat the same performance next year. You can shoot yourself in the foot from a
long-term strategy perspective. It really could be further from the truth. My experience
is this, James. I've seen family-run businesses, a lot of them. I've seen a lot of private
equity-owned businesses, and I've seen a lot of publicly traded businesses. My assessment
is this. Family-owned businesses tend to manage those businesses to, and many of them want
to grow, but many of them also want to maximize cash flow in the year. The reason being that
that cash flow that those businesses generate for those families funds the lifestyles of
those families. When you start earning three or four or five or 10 or $20 million a year
as a family-owned business, you get used to having that type of significant discretionary
income. When you have to go and grow that business, if that means going and setting
up a new factory, and that's going to cost $20 million in new equipment, you have to
make the tough decision of instead of making $20 million that year, I'm going to make
$0 that year, because hopefully five years from now when that factory is at full production,
I'll be making $30 million instead of the $20 I used to take. That's a very large risk
for a family to take on, right? A very large risk. That's just one example. There could
be many others.
Now, on the other end of the spectrum, you have publicly traded businesses. It's widely
known, pick up any newspaper and media is going to give those guys a hard time about
this too, it's widely known that most publicly traded businesses have to manage to the quarter,
because if they don't manage to the quarter, the street gets upset, the stock price goes
down, all the executives don't hit their bonuses, their stock options aren't worth anything.
The executives in those businesses who are running those companies every day are highly
incentivized to keep the stock price as high as possible. How do you do that? You always
deliver on your numbers, quarter in and quarter out. You're managing to the quarter. So family
businesses, they're kind of managing to the year. Publicly traded businesses managing
to the quarter, that's even shorter term thinking. In every private equity investment that I've
ever made, I think I've made now 40 or so private equity investments in every one of
those and in almost every private equity business, back business that I've ever consulted to,
every single one of those businesses has a five year plus investment horizon. They have
a five year strategic plan. They're making those $20 million investments in that new
factory because they're like, listen, the only way that I can achieve my investment
objectives five or seven years from now, which is typically their target hold period is if
I build this factory. Therefore, I would argue that private equity owned businesses or private
equity backed businesses tend to receive a significantly higher level of reinvestment
back in the business to fund growth. And it couldn't be anything more opposite than cutting
costs than reinvesting tons of money back in the business so it can grow. Again, I'm
sure somebody will have examples that they'd love to use to prove me wrong, but that's
just been my experience.
Yeah. That's the point of this. So my inspiration for PE only focused cutting costs is Toys
R Us. A trivia for today, and I make it easy on you, only in the last 10 years is this
answer. In what year or in which year, we'll have someone who's better at English to myself
tell me, did Toys R Us go bankrupt in the last 10?
I feel like Toys R Us might've gone bankrupt twice. I might be wrong. I don't know. It's
got to be post financial crisis. I'm going to guess 2012.
Pretty close. 2017. You know, the interesting thing about 2017 is neither of our children
will have ever experienced the opportunity of walking through Toys R Us, the free Disneyland
and experiencing all that was Toys R Us.
Well, to be honest, with as many Amazon packages as my house receives every day, I'm not sure
that even if they had managed their balance sheet a little better during those tough times,
I'm not sure my kids ever would have seen the inside of a Toys R Us anyway.
Fair point. Okay. You got, you ready for the next one?
I'm ready. Shoot.
Private equity only focuses on short term profit and their short term profit seekers.
Yeah. I mean, like I was talking about, you know, it couldn't be further from the truth
in my experience. I haven't talked that much about debt yet either, but the thing about
most private equity investments, not all, certainly not all, but I think it's fair to
say most are going to involve a reasonable amount of debt. Some might argue unreasonable
amount of debt. And certainly some deals get done with probably too much debt. Usually
that is realized in hindsight. These private equity investors are pretty smart guys and
gals. They're not intentionally putting too much debt on businesses balance sheet, despite
what the media I think would love to have the population believe. But they really can't
be short term profit seekers. When you invest in a private equity fund and the investors
know this, you know, like I mentioned earlier, it's a 10 year fund life cycle. So you're
investing in a fund today, hoping that by 10 years from now, you're going to get an
acceptable level of return on your investment. 10 years is a really long time. I mean, it's
obviously not 20 or 30 years, that'd be even longer, but 10 years is a pretty long time.
So the investors in the underlying fund have a long term mindset. The manager of that fund
who set up the fund in the first place as a 10 year fund has a long term mindset. Their
target hold period is, you know, five to seven years. That is a, I would say at a minimum
a medium term mindset. But when they go to sell that business, if they're going to sell
it for a really nice number, it has to be a growing business that looks attractive to
the next buyer who is going to want to grow that business. Right? So I think private equity
gets a little bit of a bad rap because, you know, some people might want to argue or maybe
it's easier for the media to argue like, well, if you're only going to own a business for
three or four or five years, like you can't be thinking long term. And I would argue,
you know, hey, let's give them a little bit of credit for the fact that, you know, they
can't do what they're setting out and intending to do unless they're preparing the business
for future long term ownership, even if they don't happen to be the owners of that particular
asset, you know, beyond their hold period. So, you know, this right here is something
I'm sure the pundits could talk about for, you know, days on end. And, you know, you're
going to have a lot of differences of opinion, but, you know, I've been in this industry
for a couple of years now, at least, you know, those are my opinions.
I like them, stand by them. So, my inspiration for short term profit seekers was Sears. So,
you know, going back to it, it's kind of interesting. Young James went to Sears a lot. My grandfather
said if it didn't come from Sears, it wasn't worth it. Craftsman tool guy loved it.
Don't you still shop at Sears? Isn't that where you got that outfit you're wearing?
Yeah, that was actually JCPenney, Mike.
Okay.
And the Sears side of it was a popular thing in the bandy household. And so, I was a little
sad, maybe let me rephrase that. In which year was I sad that Sears went bankrupt?
I didn't realize I needed to take a retail history lesson here before today's cast.
Can I step your game up?
In what year did Sears go bankrupt? I don't know. I'm going to probably have the same
answer. I feel like I went into a Sears at one point post global financial crisis and
there wasn't much on the shelves. 2013.
Okay. Unfortunately, it was the domino after Toys R Us in 2018. It's an interesting childhood
domino effect. I would also like to ask you, not accuse it, Tori, but just a question.
Did you look at my show prep sheet before the cast today?
I did not.
Your crystal ball is really coming into play because my next one is private equity always
saddles their target with debt and the deals are always highly leveraged.
Yeah. I mean, like I said, not every deal has debt, but oftentimes it's a tool that
private equity firms use to improve their returns. Going into that in detail is an episode
in and of itself. Listen, there's always going to be examples of businesses that had too
much debt put on their balance sheet, whether it was from their original acquisition or
some other add on acquisition that they did, or they funded new equipment purchases, whatever
the case may be. There's always going to be businesses that get over leveraged with debt,
get too far out over their skis and have issues.
The reality of the situation though, and what I always like to encourage people to do is
look at their personal investment portfolios. Go pull the reports, the 10Ks from some of
the businesses that you have in your 401k or your brokerage portfolio. Go look at those
companies' balance sheets. There are very few publicly traded businesses that don't
have a lot of debt on their balance sheets. In fact, one of the primary reasons to go
public in the first place for most companies is to access the debt capital markets more
efficiently and at better pricing than you can in the private capital markets. I venture
to guess that if you compared the average amount of debt of publicly traded businesses
on their balance sheet to the amount of debt on private equity backed businesses' balance
sheets, that private equity would actually have less debt on a relative basis.
Again, media loves to talk these things up. Actual reality, what we're living and seeing
is we're inside these businesses every day. A little bit different from what you're reading
on the front pages of the journal at the time sometimes.
Interesting. It's an interesting point. I always have these moments where I learn things
by accident, let's call it. I was working at a company, $19 billion company. We go in
and we acquire a $40 billion organization. I'm not the best at math, but it was double
the annual revenue. The way that my life works is it usually I have to make more than the
number I want to spend to be able to get there. That's the first time I ever learned that
these groups leverage debt. The second time I learned that these groups leverage debt
is about 30 days after close when I got my new P&L and I got my new pressure. Because
the new kid in town, everything got cut from my budget. It was a good lesson. I think that's
an important one for folks that maybe haven't had that experience or done the research that
you do. It does happen. Let me tell you the one I have for this one. I think this will
shock people. I don't think a lot of people know that these guys went through a bankruptcy.
Caesar's Entertainment. Do you gamble at all?
No, thankfully.
Great. Well, good thing you didn't gamble on Caesar's because in which year did Caesar's
go bankrupt?
Geez, you're pulling out all these retail businesses.
Caesar's isn't retail. Caesar's is an entertainment brand.
I don't work much in entertainment.
If you ask Zach Galifianakis, it's where the real Caesar lives. It's his house.
By the way, if you start asking me names of celebrities and expect, I know he's a celebrity,
but if you expect that I know who that is, you just couldn't be further from wrong. I
don't do celebrities. I don't know who anybody is.
Do you do movies?
Movies. I watch movies.
Okay. Let's try to get there. He wore a baby on the front of him.
Oh, okay. Hangover.
Hangover. Correct. He, I believe, was quoted to say, does the real Caesar live here? It's
that joke.
I know who that guy is now.
Okay. In which year would Zach be sad that the real Caesar got kicked out of his house
because that organization went bankrupt?
Caesar's went down.
Yeah.
Learned something new every day. Won't catch me in Vegas unless I have to go there for
a conference.
Yeah. Agreed.
I have no idea.
2015.
News to me.
Yep. We're going to round it out with another retail brand just to give you the heads up
and warning before we get there.
Make this stop.
Well, hold on. One of us comes from retail and didn't have the private equity background.
The other has the private equity background.
Yeah. Fair. Fair.
It's a chance for the retail guy to get a swing at it. The last one. I think this one's
interesting because I honestly had this opinion before coming in and learning from you and
others about private equity. They only buy struggling companies.
Yep. We hear that a lot. Common misconception. Even if you have a broad definition of struggling,
again, it wouldn't really be true. Like I was talking about earlier about turnarounds.
Certainly companies that are having a bad day sometimes come up for sale and there are
certain types of private equity investors who like doing those kinds of investments,
who are good at stepping into a situation where maybe some tough decisions need to get
made or maybe they just lost their largest customer and they're trying to figure out
what to do about that situation or businesses that have some type of supply chain constraint
that was unexpected and catastrophic or whatever the case may be.
But again, it depends on what you mean by struggling. I would say there's a couple of
different types of firms. There are firms that like to get their hands really dirty,
really deep turnarounds. Those obviously would be struggling companies. And there are a number
of firms, private equity firms that specialize in that. Not as many as you might think though.
It's a fairly small subsector of the industry. The next group of companies, and there's a
lot of these companies and as a result, there's a lot of these kinds of private equity firms,
are companies that aren't necessarily having a bad day, but also aren't having their greatest
day. And probably a better way of explaining that would be, you know, sometimes businesses
go through seasons is how I like to think about it. You know, maybe you are a founder,
entrepreneur-owned business and the entrepreneur started the business in his or her 40s. And
that was 45 years ago. And now that owner is 85. And maybe they have no family members
that were involved in the business, or maybe no family members want to be involved in the
business. And they've got 10 grandkids that they want to spend a lot of time with. And
for the last 15 years, that's been their priority as they've gotten on in life. But they still
own and maybe still operate the business themselves. Maybe they have a leadership team. But maybe
as a result of some of the things that we talked about earlier as well, where, you know,
they've used the cash flow that the business generates to fund their lifestyle. This is
not every example. It's just one example. They've defund that lifestyle of spending
more time with their grandkids. Maybe you have a situation where they haven't been investing
back in the business as vigorously as they might have when they were in startup mode
some 40 plus years prior. Maybe they're not introducing as many new products. Maybe they're
not exploring new customers because they're happy with the ones that they have. Maybe
they're not great at implementing the latest and greatest ERP system or solution. Or, you
know, they're not able to leverage automation or don't want to fund automation that would
unlock growth opportunities for the business. So, you know, is that business having a bad
day? Listen, we see businesses all the time doing 10, 20, 30% EBITDA margins on a couple
hundred million dollars in sales that fit that exact scenario that I just described.
Are they doing anything wrong? No. Are they struggling? Absolutely not. In fact, highly
profitable enterprises creating really nice lifestyles. But is there room for opportunity
for improvement? Absolutely. We always go back to the great Jim Collins book of good
to great, right? And what we tell a lot of our clients, our consulting clients over the
years was we like to take good companies and help them become great companies. And I think
that's a really good example of just that, right? You can have a great, a good little
company that maybe isn't a great company yet. And I think that really is, you know, private
equity. This isn't my thinking. This is the private equity industry at large. Many, many,
many, definitely most private equity firms are out there hungry looking for those types
of opportunities where they can step in and buy a pretty good business with a pretty good
team and help make it a great business. And maybe that team becomes the great team. They
just needed more resources or maybe in other instances you need to, you know, upgrade the
team. Every situation is a little bit different. But, you know, the notion that private equity
only buys struggling companies couldn't be further from the truth. You know, private
equity investors love to buy good companies, make them great. They also like buying great
companies and keeping them great. It's actually a, you know, I eventually guess there'd be
a lot of consensus if you pulled a bunch of private equity firms. Would you rather buy
a good company, make it great or a great company and have it continue to be great? And they
would probably be happy with both.
Interesting. I know you're a little fatigued on the guessing and I know this one's near
and dear to your heart because you used to be a model for these guys. J.Crew.
Oh yeah.
In 2020.
Yeah. Yeah. I probably modeled for them for a long time. I just can't remember the years.
J.Crew went under in 2020.
Yeah.
Yeah. I mean, if I was a retail focused guy, I spend most of my time in industrials. You
know, I might know some of these dates, but are they still around? J.Crew is still around?
No.
I don't know. I know you know Joritz, but you may not know J.Crew. Well, I want to thank
you for your time. Sorry, we're in a little retaily at the end there, but I think it's
a good education for our listeners to understand private equity, a bit of a one-on-one course.
I think there's a couple of interviews maybe that we can do after this and a couple more
deep dives.
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