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As a younger man- bright eyed, bushy tailed and naive, I spoke of Private Equity (PE) as a farmer speaks of the ocean. Viewed from a distance, viewed from the surface and not aware of what lies beneath the surface: “It looks so beautiful.”
The purpose of a PE firm is simple enough. When they invest in a Portfolio Company (PC), they are doing so to sell it later at the highest price possible. 3-5 years is an ideal time frame. If you haven’t sold by 5 years, the investment is probably under water and things haven’t been very fun for quite some time. For the fans of Good to Great where companies are measured over 50 years, 5 years may feel like a particularly short time. However, like the Canadian / American dollar exchange rate, PC’s are measured in “PE years”, so you have to multiply everything by 11 to get an age equivalent.
On the other hand, 12 months to exit is most excellent. This means that the money that was deployed is probably worth 3x what was paid and there is lots of profit sharing to be had. Keeping this simple timeline in mind makes PE easy understand and why PE folks are happiest when in deal mode.
But what of the PE folks themselves? Sharply dressed, rich and powerful, these folks were mavericks, bastions in a sea of despair in downturns and beacons of hope for substantial wealth creation in the up. Smart, hungry, young people with unending energy. Tireless workers, literally pulling endless all-nighters for deadlines, sleeping under their desks and being ready to go for the 8 am meeting with a crisp suit and understated tie.
However, the years play their toll on these people and for this reason, you can always recognize a banker because they look twice as old even when they are half your age, as most of them probably are. The first one I met had a very old sounding New York name, sounded very old on the phone and sent emails like an old person – which is to say like your mother and had lots of questions but when I met him, he was 29 and looked like he hadn’t slept since 2008 (which is probably true- 2008 was a very, very difficult time for New Yorkers in Private Equity and he had to compete which meant not sleeping)
However (WARNING… the following contains graphic scenes that may cause bright eyed, bushy tailed and naïve people to throw up a little in their mouths and curl up in a ball and cry), simply because you can’t see the danger lurking beneath the surface, make no mistake, you are the farmer and are at risk of being eaten at any moment. It is for you, fair ocean going farmer, that I write this so that you can understand “The Money.”
“The Money” and the people who control it, are the by far the most important factor when you are starting a business, growing a business, or running a business. They–your investors–control you. It is the true Golden Rule: He who has the gold, makes the rules.
Not understanding “The Money” was what led to my first start up’s epic failure. I thought we were in excellent shape, we had a deal in-hand that fit beautifully with our original strategy; we were in relatively exclusive negotiations with the vendor and in the “last stages” of fund raising with a pension fund. Lesson 1: the term “last stages” in fund raising is very relative – until their money is in your bank, you are in the “last stages.” It is also at this stage that you may hear the phrase “We absolutely love this deal but we don’t invest in oil and gas assets directly unless we invest along side a PE firm that we trust. Could you go talk to XYZ PE firm. We like those guys…” (another variant of this expression is “Yeah, we love this deal and we are committed to doing it with you but could you go bid it at 25% less than this price because we REALLY want to love it”)
Having no other choice, we set up and had a meeting with XYZ PE firm. I’ve had some meetings end abruptly before in my career, but none quite this fast. We pitched the asset, the plan and the return profile- when the man across the table asked what the full cycle rate of return was, I said 12%. I was very pleased with 12%- I would do that in my account all day long. He looked at me and said “I don’t take a shit for 12%.” End of meeting. Blank stares, awkward handshakes and ushered out of the office to the waiting elevator.
The part about the cost of capital, I learned about in business school. The part about needing a rate of return higher than 12% to go to the bathroom, I did not.
We didn’t know what “the money” wanted. We built a lower risk, lower return model for gentlemanly bankers who work from 9-5 and love to make 10% returns while they coach their kids’ soccer team, make it home for dinner every night and make love twice a month with the lights off.
What we did not know at the time was that these gentlemanly bankers have a desire for returns that far exceed the risk they are willing to take to achieve said returns. So you can imagine, these bankers who lack the industry-specific expertise to invest in the opportunities that exceed their desired rate of return, need a friend. A hard charging, lights on f@&king kind of friend. Enter stage left… Private Equity.
May I have the pleasure of introducing you to the people behind the sharp dressed, rich and powerful people I described before. The image I conjure to describe them is a Liger- a cross between a lion and a tiger, with a big mane, they are very fast and want to eat you.
The heads of PE firms–the Alpha Liger–have all survived for an eon, which in real years is 15 but in banking years is 630. The Alpha is are scarred, proud, and they will eat younger Ligers just for fun for having a bad tie. So when a young Liger pitches an idea to the Alpha Male, it had better be F@&KING FLAWLESS.
What makes a flawless idea? Three things:
- It has to have been done before.
- Be headed by someone who has done it before
- And, most importantly, it has to be an absolute and complete shock if it doesn’t work out at which point, the responsible Liger may still be eaten and being eaten by an Alpha is not anyone’s idea of a good time.
This is why portfolio companies, or PC’s as they are called, all kind of look the same. And historically, they have been filled with “technical basin experts” who have “cracked the code” (at least that’s what they say in their pitch book). To quote a PE friend of mine, “I like to know that the team has been licking the rocks for the last thirty years.” In truth, his boss said that to him and his to him and so on and so forth. But that’s what he’s been told so by God, that is what he is going to do.
Let’s witness this in practice.
The Alpha-Male Liger picks up the phone (presses the speaker button actually, because Ligers don’t pick up phones), and calls the institutions when they have a need:
“Hey. Give us your money. We know what the f@&k we are doing.”
The institutions say: “Okay.” (They may be gentlemanly, but they are not stupid. When a Liger calls you and has a track record of making a lot of money and your bonus depends on how much money they can make for you, you comply.)
With money in-hand after quickly being wired into a gigantic slush fund of “investment capacity” the Alpha Male Liger calls a meeting with the pride (or harem.) All the adolescent Ligers take their position around the rock (which in most of these firms is a 130-foot marble conference table that was specially built in Italy and needed to be crane lifted through a window to make it into the building only to find that the table legs couldn’t support the weight of the table so it remains unused until they can reinforce the legs and buy 120 chairs to surround the table for meetings that usually involve 4-6 people.)
“Go find me some people who know what the f@&k they are doing…. And they better be F@&KING FLAWLESS.”
The younger Ligers, terrified that all their hard work could go to waste, race out of the conference room and search high and low to find management teams who look very similar to all the people their Alpha had invested in before (hopefully were the people they invested in before.)
To their new disciples who, like me, know nothing of the capital markets, the young Ligers say:
“We will give you money, but you better know what the f@&k you are doing with it and your plan better be f@&king flawless.” (In case you are wondering, young ligers don’t speak in capitals.)
The key for the Liger is to have ten portfolio companies and makes big bets with big risks in hopes that in a portfolio of ten companies, one fails (and the Liger responsible is eaten), one or two is a HUGE homerun, and the other seven or eight “flawless ideas” make a 10% return (despite the fact that they were supposed to be homeruns.) Just as they taught in business school, a portfolio-approach is most efficient when looking for returns. The game is that the PE firm has already diversified its portfolio through concentration of each of its portfolio companies. They want everyone to succeed. But they know they won’t be because the oil and gas industry is cyclical and it rotates in and out of basins. The Bakken gave way to the Eagleford;. The Eagleford to the Midland; The Midland to the Delaware; (And please God don’t be in a gas basin!)
This is a known fact. This is the core of the PE business model. This is why if you are a XYZ basin team and you see an opportunity in 123 basin, it may dawn on you to ask your PE Sponsor “Hey, I see this amazing opportunity over in 123 basin- I want to go buy it!” The answer will be “Why are you looking in 123 basin?!? What the F@&K is wrong with you?! Go back to looking in XYZ basin… we have 123 basin covered. I swear to God, next time I am going to eat you.”
For the portfolio companies, some are extremely successful: They find the right play at the right time and they make an insane amount of money, risk adjusted. For others, their concept doesn’t work, the company gets sold, the team goes in the penalty box, and the liger responsible gets eaten.
As scary as failure is, by far the worst scenario is what I call Private Equity Purgatory. This is a scenario in which you hope those that have crossed you end up. It is a horrible place and is truly the worst imaginable punishment. You, said lamb, have funding, have hired thirty of your closest business associates, have the perfect team, and have bought a deal that you need to invest capital into to prove it’s the most incredibly flawless idea of your generation. Then something happens–perhaps the first few wells don’t turn out as you planned or the commodity price turns against you. The Ligers, in fear for the damage to their portfolio, cut you off. They no longer approve of any more investing, they know if they sell you now that they will have to mark down their investment and ,in return, will be eaten, so they keep you. With no funding. While your interest rate clock ticks…. You can hear it, like the alligator in Captain Hook. Every day that goes on is a day in which your demand return gets higher making it less and less likely that you will get any money. But you can’t leave. Oh, no. You are stuck having to go to work everyday while smiling at your business associates and telling them that money is right around the corner. Then you go to your big office with nothing to do, nowhere to go, and no way out. THAT is Private Equity Purgatory.
There is nothing wrong with Ligers, you just have to know how to tame them, or risk being eaten. Don’t say I didn’t warn you.