Private Equity in an Hour

Do you know what house-flipping is? It was all the rage before the financial crisis of 2008. Still goes on. Let me explain.

At a very high level, you buy old homes, fix them up quickly, and sell them for more than the original price and the effort of fixing them.

That might be too high-level though. Example. You buy an old house with good bones for $100K. You borrow the money from the bank after they make you put down some of your own cash– say 20%. So their $80K… your $20K…. You got yourself a small house in need of some love. You pour a lot of hard labor– your own physical labor– into improving that house. You re-do the kitchen. You rip out the old flooring and the old roof. And you put in hardwood floors and some fancy solar panels on a new roof. You modernize the bathrooms. Maybe add some curb appeal. Like every show on HGTV. Remember, you bought it for $100K, and let’s say all that labor and material cost you $15K. Add another $10K for the interest you’re paying on that loan. So your tab so far is $125K. Well, you then sell that much-improved house for $200K, and bam you just made $75K. The bank’s happy because they made $10K of interest income and got the rest of their money back. You flipped that house. You deserve a television show. Go buy another house. Rinse. Repeat. Film the whole thing. Emmy award.

Usually, you get so good at that process I just described that you hire a crew– you have a person that redoes kitchens, one that does floors, one that does bathrooms. You get the picture. It’s no longer your elbow grease that you sink into the next property– you have to pay that team… say $50K. But you’re a house-flipping machine now. You do them fast and efficiently. You make less on each– because you’re paying a team– but you do a lot more of them. Everyone’s happy. You, your crew, the bank. Your viewers. The critics.

Well…

If you understand house-flipping, you understand private equity.

Instead of buying old homes with good bones, you buy old businesses with good bones. You don’t go to your mortgage bank to take out the loan, but it’s still a bank that you go to. You don’t borrow small amounts of money, so there’s a higher bar… but financing is financing. Instead of having a kitchen guy and a bathroom guy and a good plumber, you have a debt-restructuring person, a productivity expert, and a good plumber. You always need a good plumber.

Your team dives into your new business. Does their magic (which we’ll talk about later on this walk). Increases the value of the business. And you flip it– sell it for more than you put in.

Everyone’s happy. You, your crew, your bank. And it begs the question: why isn’t there a private equity TV channel? I asked my son that question– what he thinks about PETV… and he said that no one’s interested in Phys Ed. Even with dodgeball.

PE… Gym class. You’d think that’s cute but… my son is 43.

Ok, you got it at a high level. Let’s get into it.

The Investment Lifecycle– what actually happens if you work in a private equity firm is a 10-step process.

Step 1: Sourcing– industry jargon for finding potential acquisitions, seeing if those businesses have the kinds of problems that you and your team have solutions for– seeing if that business is a match for your investment strategy– because even if you do have the right tools for the job, the potential returns on that specific business transformation might not be worth your time. That’s step one– source: in the language of house-flipping… go find some houses we can buy. How do we find them? 1) Internal research. 2) Networking. 3) External research– like consultancies. And 4) Investment Banking Relationships. By research I mean, inhouse fact-finding… using publicly-available information… to go deep into whatever narrow space your Firm’s investment strategy is focused on. In housing terms, it would be “We’re only interested in mid-century modern homes built between 1950 and 1960 in Los Angeles.” The PE or business equivalent would be we’re all about acquiring healthcare providers in the NY tri-state region or AI platform companies in the Asia-Pacific region. Some sector or some geography or some intersection of the two. The narrower, the more niche, the better. That will be (hopefully) outlined in the PE Firm’s investment strategy. There’s a ton of publicly available information that will help you source that kind of opportunity. That’s research. What else? Networking also helps you source. That means using your Rolodex, your relationships, and good old-fashioned marketing to get the word out about the kind of companies you’re looking for. Lots of introductions. Lots of events. That hopefully gets your broader network to help you source. Networking. The third way to source: external research… essentially getting some niche consultancies who already have subject-matter expertise in your niche of choice to help you. And fourth– investment banks… who have lots of clients already… businesses that ask their bank to find private equity partners. Sourcing PE prospects isn’t as easy as finding homes to flip… because there’s no Zillow app or Trulia app or Realtor app. But because it’s a relationship business, prospects have a way of finding you.

What kind of companies do you source? I’ll talk about cash flows in a sec– when we talk about due diligence– but it’s worth spending a little time on what– other than good numbers– you look for. Well… market positioning. Is that business the Kleenex of its market? Kleenex is the best example I can think of because even if you buy tissues from other companies– like we buy a brand called Puffs– you still call them Kleenex when you get home. Best case scenario, you source a company that’s Kleenex in a growing market… that’s somewhat future-proof… maybe with tech barriers to entry– a high cost of entry– like 3D printing– those commercial machines are expensive– it’s a market called rapid prototyping.

You’ll also want a business that you can actually improve– to grow– while you own it. Why? Because private equity funds create value– they create investment returns– in two ways: they 1) use a lot of debt and pay it down rapidly– and they 2) grow the business while they’re in charge. They look for businesses that have multiple ways to create value– some of those ways perhaps the previous owners didn’t pursue. Diverse income streams always mean less risk. And less risk (thumbs up).

What else? You try to source companies that have material assets. Your bank or lender– the people allowing you to use debt to buy that business– would greatly appreciate that. Having stuff that can be used as collateral… sold if something goes wrong… or sold as a funding source. Would you rather buy a company with 10,000 smart people– any of whom could quit… or the same company that also owns the 10 high-rise office buildings… where those smart people work. In a future where more and more companies can operate with people working from home. You can quickly sell a couple of those high-rises for working capital. And the other 8– well, they’ll let your lenders sleep easier at night, knowing that if you fail, they’ll be in the real estate business.

Material assets. Important.

Ok, let’s say you’ve sourced a potential business… or more likely, have a living pipeline of endless potential businesses… what’s next?

Step 2: Initial due diligence. Fancy words for getting into more details. Because you can’t tell if a house has good bones by just looking at it from the curb. But that’s all you can do at this stage… use publicly-available information to do initial “outside-in” research. On the company. On the industry. More of it than you did in the initial sourcing. Publicly-available info is nowhere near the level of candor and detail you’ll need, so you’ll want to get an invite into the house (so at this step, everyone– the homeowner, the target business– will sign NDAs… non-disclosure agreements) and once you’re in the house, you get on your knees to look into every dark and damp crawl space. What does a good house look like from the inside? Well, you’re going to look for some of the things I mentioned earlier– market dominance, multiple paths to growth… also called value drivers… you’re going to look for tangible, material assets… but mostly at this stage, you look at the numbers: whether they have stable cash flows.

Let’s walk thru that slowly. The target company needs to have predictable, mature, noncyclical cash flows. Why? You’re going to need to pay down a lot of debt that you incurred when buying the business. You’ll want to pay down that debt using money that the business is making. Or you’re not going to get a good return on your equity.

There’s no good house-flipping analogy here. So let me use a poor one. You buy an old farmhouse to flip for $100K. You take a loan for 80K of that, putting down 20K of your own money. Every month that you haven’t sold that house, you’re paying down that 80K from the bank, with interest. Now imagine that the farmhouse came with 10 acres of mature avocado trees. Well, you would want to keep selling those avocados while you’re fixing the house. That cash flow– if it were predictable, mature, noncyclical– would help you pay down that loan– that $80K from the bank– every month until you sold the property. When you sell that farm– your return on your equity would be so much better *than* if you didn’t have the avocado farm.

I know that sounds obvious. But remember, we’re not talking about $100K farms with PE. Just for some perspective, the total private markets for PE assets under management as of June of last year was– drumroll– $11.7 trillion. In that same period, there was north of another $3 trillion looking for good businesses to buy. The PE war chest. So… very large avocado farms. The size of Nebraska.

Ok… you need to look for cash flow. What else? Companies with high margins– which is jargon for… when they sell something for a dollar, they keep more of that dollar than a lower margin business. Good example of a high-margin product: Candles. The ones that smell like springtime or falling rain or some nonsense. Cheap to produce but priced for people who clearly have too much money.

What else? 1) Stable cash flows… 2) high margin business… Oh, 3) low capital expenditure– they have to spend relatively little to maintain equipment. So, for example, that farm with the avocado trees, if we can pick them by hand, yay…. low capital expenditure. If we need to buy an avocado-picking machine or two or three… or god-forbid, have to replace the machines every month– high capital expenditure.

In that example, it doesn’t mean avocado farming with high capital expenditure is a bad business. It’s just not ideal for flipping. Because with private equity, you don’t want to keep going back into your pocket for more cash. In other words, you want to source a company that has low working capital requirements. Every time you reach back into your pocket– to take out more cash– that’s working capital and it’s lowering your fund’s returns. The less you go into your pocket– the lower your capital injections– the more flexibility you have to spend elsewhere, to run your operations. So capital-intensive projects attract lower valuations.

And you want to discover all of that during this stage– initial due diligence. This is also the step when you start conversations with your debt partner– whoever is going to help finance the deal– your bank or bank-like entity. Because whoever they are, they like to be brought in early on potential deals. They’re going to have views on the business… views on your debt financing options… they’re going to want to talk about the cost of different debt instruments (what they have to offer) and how to balance the level of debt with the returns you expect.… you know… the how of financing. You’ll need to loop them in because they’re your silent partners… except not-so-silent.

With all that out of the way, you’re ready for…

Step 3: Your first Investment Committee Review. What is an investment committee? Usually the senior-most people in your org– hopefully with different skill sets, perspectives, experiences. And if that Committee review goes well– this step generates an Initial Offer to the homeowner– the prospective business. Now this first offer is non-binding– which means that neither party is legally obligated to carry out its terms– but it’s enough to signal that you’re interested as a buyer and serious enough to want to dive deep into more details. Not ready to pay yet… because you need a full home inspection… but that’s how you get an invite into the house.

Probably worth mentioning: a PE deal can be public or private. Your sourcing might have you targeting a privately-owned company– owned entirely by private shareholders (think family business)– or you can target public companies, listed on a stock exchange. It doesn’t have to be out of nowhere. Lots of PE deals start with the target company– its owners or management team– reaching out to the PE firm to be bought out. Just as many deals are unsolicited– you know the stereotypical barbarians at the gate… popularized by the book about KKR’s leveraged buyout of RJR Nabisco back in the 80’s… where they tried to forcefully take over. PE has matured since then. For the most part. There’s always some Twitter-like mess somewhere but they’re mostly the exceptions now.

Oh, and I can’t believe this… but I just used a really common– and as-yet-undefined term: leveraged buyout… LBO for short. Definition: the purchase of a controlling share in a company using outside capital. That little oversight is going to cost me. It’s like doing a lecture on great American presidents and somehow forgetting Lincoln until… 27 minutes in. Let’s all just quietly agree that I suck.

And now that I know the time… we’ll want to speed this up.

Step 4: Detailed Due Diligence. This is where you’re finally crawling around under the house– usually with a small army of accountants– looking closely into every dark and damp crawl space. That’s how you find *not whether* there are bodies buried under the house but how many. There will always be bodies. Detailed Due Diligence. You don’t fear dead bodies. You just need to know the effort it’ll take to exhume and bury the dead… preferably in the middle of the night.

Who on the team does this crawling around? Usually, an accountant and/or a tax specialist and/or a lawyer who is good with contracts and/or other functional specialists– a senior technologist if they’re a tech company, a poet if they sell poems…. highly lucrative, especially when put to music.

The point is: PE– the process– appreciates specialists. Fine tuners. Because the previous management team was tuning… maybe just not fine-tuning.

While the functional specialists do that, the internal team beefs up their Excel spreadsheets, their modeling– their PowerPoint presentation– their investment case– their preliminary investment committee paper— digging further and further into the market opportunity, the company’s returns, and whether the deal continues to meet the return expectations for the fund.

That model– which the deal team will present at the next step– will need to speak to the key operating assumptions that everyone on the investment committee should agree on: things like the price of whatever the business is selling, how much they're selling, how fast their customer base is growing, renewal rates, fixed costs, variable costs, how their margins are changing over time, how their earnings will grow over time… and all the assumptions that go into answering those questions. That’s how to get to an accurate IRR– an internal rate of return… IRR– that’s the annualized rate of return expressed as a percentage. That’s how you get the MoM– multiple on money… MoM… the ratio between 1) the total cash inflows received and 2) the total cash outflows. These are all data points that will make or break the company during the PE team’s ownership period.

The point here– as you get more and more information… you hopefully make fewer and fewer assumptions… all the while asking: Is this business the right next house to flip?

Step 5: You’re back in front of your investment committee with an update on what you’ve dug up upon closer inspection and how what you’ve seen has changed your thinking about the deal– the opportunity– its terms and potential returns if you were to invest. If there are any open questions, you resolve them at the next step.

Before we jump there though– let’s walk through the typical deck that will be presented to the investment committee. Think of this as the PowerPoint template of everything we’ve talked about on this walk. First couple of slides would be the deal summary– the investment thesis, transaction details, high-level summaries of risks. If any member of the committee has been sleepwalking, these will wake them up… give them the background on the deal, where it started, its journey to date… you put these slides in so everyone in the meeting can stop thinking about the meeting right before this one and context-switch. If anyone asks *anything* on these first few slides, the speaker either answers “Great question… we’ll get to that on slide 7” or “Great question… that’s in the appendix.” Just once, I wish someone would answer with “I dunno. We’re predicting the future here. How accurate could that be?” But that never happens. It would shake some very well-dressed people down to their core.

Next set of slides– the middle of the deck– will be the details about the company– the management team, business model, their differentiators, their competitive advantage, their market position, their addressable market size; and all this is a historical, numbers-heavy, graph-heavy view of all those operating assumptions I just said everyone should agree on– fixed costs, variable costs, margins— and think about it all over time… and projected into the future– customer growth, renewal rates, earnings– past and future. Anything and everything that could indicate future performance.

If you’ve ever read the financials of a business– or done the accounting on it– that’s mostly what this middle part is– revenue, earnings, cash flow, and an explanation of how the deal team constructed their financial forecasts– the investment case they’re making. They’re just flexing their Excel skills.

The last two parts of the deck are the valuation and the exit details. The valuation– which is just a fancy word for “how much should we pay for this opportunity”-- the word itself– valuation– means the process of figuring out the present value of an asset… in this case a business. And how do you figure that out? Remember all the numbers and forecasts in the middle of the deck? There are common methodologies– think Excel formulas– that are applied to all the business’s numbers. Generally, it’s belt and suspenders on the valuation formula. You don’t pick one methodology. You apply several and triangulate to a consensus number. That sentence wasn’t helpful. Imagine there were three business professors, each with a unique way to price a business, each with a slightly different Excel macro. You run all three formulas against your numbers– and each one gives you a slightly different number: let’s pay $10M for the business, no $12M, no $15M. You smoosh them together (triangulate) to get *your* number– one that shows you played out all the scenarios, that you did the math… that you were thoughtful and multidisciplinary.

And finally, the punchline to the whole joke: the expected return on the investment. The conditions for the exits– will it be a sale or an IPO? When? How many months, or years of work will it take? And this part comes as a set of ranges– return ranges– each with its own set of assumptions… and they’re ranges because remember: we’re predicting the future.

Ok… where’d we stop before the deck? Step 5: the second Investment Committee review. Let me do 6 thru 10 fast so we can talk about debt structuring (an important term I’ll explain shortly). So….

Step 6: This is also where your partners in the potential deal do their due diligence. For instance, the bank that’s financing the deal. They’ll want to look at the house, at your plans for it, and they’ll have their own set of questions. Term of art for this step: Confirmatory Due Diligence… which is jargon for that part of the wedding where the priest asks “If anyone knows any reason why this couple should not be joined in holy matrimony, speak now or forever hold your peace.” Confirmatory Due Diligence.

Step 7: Bring all that back to the Investment Committee– because we don’t want to waste their time– hence the Confirmatory Due Diligence in that last step– and we ask the committee for approval for a final offer. Why do we ask for their approval? Depends on your philosophy of life. I– for one – would think it’s because we are collaborative, consensus-building animals that understand that you get better outcomes through diversity and inclusion. Someone else might think we get Committee signoffs because if the deal goes pear-shaped later, all asses are covered. Potato, potahto.

Step 8: That final, binding offer– the one we just got approval on– is signed… well hopefully signed… by everyone. Lots to consider at this step. Like when you’re closing on a home purchase. For instance, if the deal is keeping the company’s current management team, something called a management equity ratchet will need to be part of the closing. The equity ratchet is the terms by which that management team will stay on– what targets they need to hit and how they’ll be rewarded. This is also the step when money exchanges hands… exactly like when you’re closing on a home purchase… except for a lot more money. And once that closing ceremony is done, the fun begins.

Step 9: Bring in your crew. Have them do what they do.

Step 10: Flip that house.

–

Now that’s the process. I’ll explain what happens in steps 9 and 10 in a sec. But before we jump to that, let’s quickly talk debt structuring. And we should probably have *started* the walk here.. given how important debt is to an LBO – a leveraged buyout.

What is debt structure? If you’re going to borrow money (to acquire debt) you’re going to want to know– and to negotiate– the terms of the loan– the interest rate you’re paying, the repayment terms on the principal, and prepayment provisions on it (like… what if you win the lottery and want to pay it off early… will there be prepayment penalties?). These are all questions about your liability– that’s the term or art: your company’s liability… all the responsibilities that fall on you as the company taking the loan.

And those terms… that debt structure… is/are the most important factor in how much money you’re going to make when you flip a business. The loans you’ll be taking aren’t like mortgages where there’s some standard interest rate– some 30-year fixed rate– that everyone uses.

Your deal’s terms come from your relationship with your lender or financing bank. You’re going to negotiate terms with them and they’ll make their decisions based on the strength of the business case (that deck), their own due diligence, your track record with past deals, your collateral (what you’re putting up) but most importantly, it’s your reputation, your relationship.

Money is a relationship business. It’s all about trust. But you knew that. So let’s get into the stuff you don’t know.

Ok.

Three different types of capital typically sit within an LBO structure: 1) bank debt, 2) high yield also called subordinated debt, and 3) equity. Don’t worry. I’m gonna define ‘em.

One’s easy– bank debt is money you got from the bank. 2) High yield or subordinated debt: that’s debt that ranks after other debts if a company falls into liquidation or bankruptcy. They use the word 'subordinate' because that class of investors isn’t first in line, they’re second to bank debt. If everything goes boom, you pay the bank first, then the subordinates, and if there’s anything left over, you toss it to the people with equity. I did a video about Mortgage-Backed Securities (MBS) in which I talked about something called a CMO – collateralized mortgage obligation– and how if the plane goes down (that’s the analogy I used) and there’s only one exit door and it’s in the first-class cabin, that determines who gets off the plane first safely… well, in most LBO structure, the banks who are financing the deal have all the first class seats, they get out first… then business class– the high-yield subordinate debt… then economy– the PE equity folks – the losers in the back of the plane.

You can see how that would be a neat ordering of default risk. Which I didn’t define. Default risk is the probability that the other party in an investment doesn’t fulfill its part of the deal. They default. Like when you default on a load. In the case of a default risk… in the case of a plane crash… in the case where the company you bought were to go bankrupt or needed to be liquidated, the “structure” is the order in which people would get paid back. So bank debt gets paid back first, then high yield (subordinated debt), then equity.

It’s an active, thoughtful tradeoff: the less risk you take, the less you make in these deals. The more risk you take, the more you make in these deals.

Let’s make it super tanbile. If you’re a bank sitting in first class– the seats with the least default risk– you make somewhere in the range of x%. If you’re in business class– high yield– you’re middle-of-the-plane-risk, you’re making a 2x percentage. The bank’s 5% win would be your 10% win. And if you’re in the cheap seats… those folks holding equity… the PE Firm… the last to exit the plane… you’re making north of 4X as a percentage… and that last number could be a whole lot more if you and the team do your job well.

In a typical LBO structure, bank debt– those first-class seats from a risk perspective– will make up the majority of the plane (like 50% or more of the debt you’re using)… because it’s cheap money– it comes with the lowest interest rates. High yield or subordinated debt– will be a thin percentage slice in the middle of the risk plane… and it’s used sparingly (think 10-15% of the seats). Why use any of it if you’re a PE firm– the economy class seats– because those business class seats minimize the amount of equity that you’d need to sink into the deal initially. To kill this plane analogy, you use high yield so you can have more economy seats on the plane. Because the *more* economy seats you have when you successfully land the plane, the *greater* your returns.

Let’s do an example with small numbers. (Which I’ll put up here when I get home) You’ve sourced a company that has earnings of $10. You’ll need $100 to buy the business. Your impressive banking relationships step up and promise you 50% of all the money you’ll need: $50. You tap high yield for another 10% of what you’ll need: $10. And you’ll sink in your own money for the last 40% or $40 from your PE fund.

Given that it's a $100 deal, this setup would give us a 60% debt to 40% equity split when we first buy the business. People in PE use the language of leverage when talking about LBO structures. The word leverage means “a multiple of debt over earnings.” It’s shorthand… for some very basic, very easy math. Two main kinds of leverage: “senior leverage” and “total leverage.” Senior leverage is all the money from the first-class seats… over… earnings. In our example… it would be $50 (senior debt) over $10 (earnings). Or 5x senior leverage. 50 divided by 10 is 5.

Total leverage is first-class + business class over economy. $50 (senior debt) + $10 (high yield) over $10 (earnings). Or 6x total leverage. Easy math.

The higher your leverage multiple– what’s better than 5x? 6x! The higher your leverage multiple… the more debt you’re using for the acquisition… the greater your returns if you successfully land the plane.

More debt = outsized returns. Plus, always remember that PE firms aren’t doing just one deal a year. They’re hopefully doing many. And many simultaneously. And each one is going to lock up some of their equity… their ability to put their money down on the next house that they want to flip. So… lots of good reasons to bulk up on OPM– other people’s money– not a banking term. Lots of good reasons to bulk up on debt. Lots of good reasons to shoot for higher leverage multiples. Higher senior leverage. Higher total leverage.

And it’s worth noting: the level of leverage in an LBO depends on the target business's cash flow… because that’s the best indicator of how quickly the team will be able to pay down the debt. If you’re their lender, the larger the target business's cash flow, the more you’re willing to lend, the less you’re willing to charge in terms of interest. All because you’re betting on more and more of a sure thing… taking less and less risk… but still making a percentage return that makes you– your institution– happy.

Ok.

Jumping back to the larger explanation. I spent like one sentence each on steps 9 and 10… and I sounded all rhyme-y like Dr. Seuss. “Bring in your crew. Have them do what they do.” And that might have been the highlight of this walk. But it wasn’t enough.

Let’s talk about what happens once the house is yours. How do you get it ready to flip?

Or to use fancy words:

How do you manage your portfolio company?

So how do PE funds create value?

Let’s start with the soft stuff. Relationships. If the PE firm kept the old management team in place, they’ll need to build a strong working relationship with them. We’re not talking micro-management… because remember– a PE firm doesn’t do just one deal at a time. They have their fingers in a lot of pies. So their job– their approach– is to set that management team up for success.

The easiest way to do that is soft: introductions. You should meet this person because they’d make a great hire. You should meet this person because they’d make a great customer. A great supplier. A great advisor.

If the PE firm has been around for a while, they’ll have a long list of existing companies they’re plugged into… and an even longer list of former companies that they have deep relationships with.

So these introductions aren’t cold calls. They’re introductions to “my good friend so-and-so” and “my old friend so-and-so”-- people with whom they’ve spent cold nights in foxholes… enduring relationships with people who many times feel indebted to the person doing the intro. That’s the best kind of intro.

Some of those intros will be to other portfolio companies– creating what’s called “portfolio synergy”-- where the intro will sound… to both companies.. a lot like a mandate from the owners.

Seriously. If you’ve never been a business owner, you dream about these kinds of intros.

Before we jump off the soft value adds– the relationship-based ones– the other way that PE funds set up management teams for success is by helping build up their boards. Need someone with even more connections than the PE team brings… a senior board member.

Ok… what other ways can the team create value? Operational expertise. We’re not talking soft skills anymore. Need fewer defects on your assembly line? There’s an app for that– a specialist. Having a hard time navigating regulatory or compliance issues? There’s an app for that. Problems with customer satisfaction? Too much waste in your value stream? Are you losing customers left and right? There are apps for that…. Specialists sitting in the PE firm or a phone call away.

The best example of skills that already sit in the PE firm that the company can use: help with structuring and restructuring debt… because you wouldn’t be in the PE business unless you were a world-class operator on the use of debt…. on optimizing capital structures… finding the profit-maximizing equilibrium between debt and equity in any business.

And these debt experts are already swarming the business for their own reasons– to accelerate what’s called “de-leveraging”– fancy word for quickly reducing the amount of debt in that business by paying it down, by growing and redirecting cash flow.

What else? Helping set strategic priorities. That one’s obvious. You don’t buy a house to flip without a vision for what you want it to look like before you sell it off. Strategic priorities.

And I left my favorite for last. Bolt-on acquisitions! You just bought a pizza-oven company in Akron. Now it’s time to buy a dough-making factory in Cincinnati, a cheese-making concern in Columbus, tomato-sauce-R-us in Cleveland… and I’ll stop there because I don’t know any more cities in Ohio. Plus, I’m cool with plain pizza.

Bolt-on acquisitions can take a million shapes. They can be as simple as “buy all the competitors in your acquisition’s sector” to “buy adjacent business functions to broaden that core offering.” Your imagination is the limit.

In tech, we call that platform thinking. There’s a network effect. The creation of a less constrained, more borderless business ecosystem that produces a multiplier effect … where 1 + 1 = more than 2. That’s the advantage of a platform.

And that– broadly– is the kind of value that’s added day after day, week after week… sometimes for months and years until you can see the light at the end of the tunnel.

The Exit

When exactly do you flip that business? In practice, it’s hard. It depends on how and how much you’ve improved it during the ownership period. It depends on the state of markets, macro-economic conditions like interest rates. It depends on whether there are buyers out there and how serious they are.

In theory, though, it’s a lot easier. So let’s talk theory. Long before you bought the business– while you were still making the case for buying it– you’d have a sense of how you plan to improve it. You might be ready to exit– when its earnings get to a predetermined size… that you set. You might be ready to exit– when it was generating cash flow at a certain level… that you set. You might be ready to exit– when it grew large enough and strong enough to attract a higher valuation multiple… that you set.

My point here is that in theory… PE funds have a plan– an investment thesis. “We’ll first focus on scale and fixing margins.” That’s a plan. “We’ll next focus on sales and fixing gross margins.” That’s a different, equally-valid plan. “We’ll then focus on Capex– capital expenditures– and fixing margins.” Everyone loves fixing margins. Another equally valid plan. They all simplify into some combination of “make more money” and “spend less.” There: an MBA in 6 words– Make more money… spend less. 5 words.

But… what do we know about every plan? Philosopher extraordinaire Mike Tyson. “Everyone has a plan until they get punched in the mouth.”

That’s why I said– ten feet back– that in practice, it’s hard. It takes agility, experience, and what no one will ever admit– luck.

Three different exit options: 1) an IPO– an initial public offering, 2) a trade sale, and 3) a secondary sale.

IPO is where the portfolio company gets listed on a public stock exchange– with the help of an investment bank, they go public. Whether you can actually land that outcome will depend on market conditions. If you’re lucky, the market will be up– frothy– companies will be attracting higher valuation multiples– which is a way of saying people will be willing to pay more for them– which will obviously be a boon for the PE fund’s returns. By the way, as exciting and profitable as an IPO, that’s never the end of the journey for the PE fund. Because they’re not allowed to sell their full stake on day one of the listing. The markets block them from doing that… because no one wants to buy something that the owners look desperate to sell. It’s a market protection mechanism– implemented by the exchanges– to protect everyone involved. If you’re lucky enough to go public, you’re stuck in that position for at least a year or two. Not that you’d care… because your personal stock just went up. Remember how I said “Money is a relationship business… and it’s all about your reputation and your relationships. You go IPO, it’s a whole lot easier when you go ask for more debt/financing for your next deal.

The build-up to the IPO takes about a year. Working with their investment bankers, the PE team will work out the details of two different offerings– primary and secondary. “Primary” offers new shares in the company– bringing in new investors… new money. While “secondary” doesn’t create any new shares. It just sells the PE firm’s existing shares… those equity seats on the plane. Economy class. Now, more expensive. So when you hear about primary offerings and secondary offerings when you read about IPOs– that’s the difference.

Next potential exit: a trade sale… that’s where you flip the company– sell it– to a strategic player… again with the help of your investment bank. Unlike that 1- to 2-year wait on cashing out when you IPO, a trade sale give you a full exit– you get all your money– liquidity as an event is a beautiful thing. All the seniors at a fund– the LPs– will be dancing. This outcome isn’t as market-dependent as the IPO. Whoever you’re selling to has to be “very well capitalized”-- have a thick wallet– and a good reason to spend… which means you’re going to need to sell to winners because middlers and lower-performing companies won’t have the kind of cash you’ll be charging. You could– in theory– sell it at a lower valuation but again remember– it’s a relationship business– so your reputation is tied to your company’s valuation.

With a trade sale, the PE firm’s investment bank will manage a two-stage sales process: with an initial bid and then a final bid. Usually takes about 12 months. They usually use an auction format to amp up the drama– trying to build some tension into the auction to maximize bid prices. Another good source of drama– and it’s pretty common– is running both the IPO prep and the trade sale auction… at the same time. They both take about a year… and if you’re a potential buyer in a trade sale, they’re playing with your emotions by looking like they’ll do it without you– by going IPO. There’s also a bit of FOMO– fear of missing out. So your investment banker will run both preps simultaneously… and keep playing with buyer’s emotions up until the last possible moment to pull out from one or the other. It’s quite clever actually.

Third exit option– what’s called a secondary sale… you pawn off your business on another private equity shop. Usually a bigger one than you. Because you’ve grown the company during your ownership period– which means the buyer will need to pay more than you did. And who can pay more? Shops that are bigger and better capitalized than you. If you exit this way, it’s another full exit– like the trade sale– seniors dancing because liquidity events are like music. You get all your capital out. Your investors are happy. +1 on your rep score.

There’s no drama on this one because the buyers– the other PE firm– use the same tricks as you do. There’s a little bit of market dependency on this one. Because the buyer also uses what we’ve been talking about on the walk– bank financing, debt– the structuring we talked about… they’ll have a plane too… with their first class seats (their bankers)… and their business class seats. It’s market dependent because markets determine financing costs– the cost of the tickets on their plane. The cheaper the cost of debt, the more likely you can exit through a secondary sale.

Ok… only thing left to cover is– what do you do with all that cash after the sale. This is where I wish you’d watched my video on MBS - mortgage-backed securities.

Short answer: everyone exits the plane and as they’re exiting, they get their cash. There’s only one exit. It’s in first class. So first class cabin exits first… the bankers. They’ve been making money all along… because their money came with interest payments…. But if you weren’t able to pay down all of that debt during the ownership period, well, they get their remaining balance.

It’s an orderly exit from the plane. So who’s next? The business class seats… your high yield subordinated debt. Again… if you weren’t able to pay down all of that debt during the ownership period, they get their remaining balance as they exit the plane.

And then the cheap seats. Economy class. The PE firm. But unlike every plane deboarding you’ve ever seen, the people exiting last off the plane aren’t pissed off and tired and angry. They’re jubilant because they keep everything else. They just made a shit ton of money.

They go have a nice celebratory dinner. And then get to bed early because they still have… and will always have… a lot of other planes in the air.

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That’s it. I hope you got something out of this.