Imagine a Private Equity Fund, which has managers responsible for finding, acquiring, advising, and streamlining a portfolio of companies. You may have read about some of these funds in the news:
- KKR was famous for its Nabisco acquisition in the 80s
- Mitt Romney made his fortune founding Bain Capital and acquiring companies like Staples and Dominos through the 80s and 90s
- Silver Lake Partners took Dell private and then helped them acquire EMC, in the 2010s, et cetera.
In short, acquisitions of big businesses by Private Equity firms inevitably make the news.
Within the world of Private Equity there are a few different subsets: Venture Capital, for example, falls under the umbrella. As does Angel Investing, or any form of direct investment in a private business. That said, these differ from the type of PE discussed in this article. PE Funds, especially lower-middle market PE funds which invest in the 7 to 8 digit range (i.e.millions or tens of millions of dollars), often use what is called a leveraged buyout (more on that later) to acquire majority stakes or entire businesses. These acquisitions never make it into the pages of the Wall Street Journal or New York Times because they do not involve billions of dollars.
A simplified, real world example of a Leveraged Buyout (LBO)
Let’s say your friend has built a lemonade stand in front of her house. Your friend has grown it so that it earns $100 in revenue and $20 in profit. A PE firm indicates that they can grow the business to $250 in revenue and increase efficiency so that it makes $60 in profit. They offer your friend $100 for the lemonade stand (5X your friends profit), allow your friend to keep $80 of the $100 offer (i.e.in this case, your friend keeps 20% of the business), and invest the other $20 into the business to help it grow.
Your friend is expected to stay on and continue to run the business for the next five years. In those five years, the firm encourages your friend to hire a manager and open a second location, purchase ingredients wholesale, establish a more standard process for making lemonade, and use more ice in each cup of lemonade. In five years, the two locations are generating $300 in revenue and $80 in profit. The firm sells your friend’s stand to a big chain of lemonade stands for $500 (a 6.25X multiple of profits). The chain will fold these two stands into their operations. Everyone wins: your friend gets to walk away with another $100 and the PE fund gets $400.
The relationship between leverage and Returns
Though at first glance, it seems that the PE fund invested $100 and received $400, a 4X ROI, however, they performed what is called a leveraged buyout and financed the purchase of the lemonade stand with a loan. They found a lender to give them $50 and then contributed $50 themselves. In reality, they received $400 from the sale, returned $60 to their bank ($50 for the loan, $10 for interest), and kept $340, for a ~7X ROI. And of course they kept excess profits during those 5 years for themselves (Starting at 80% of $20 and growing to 80% of $80) as well. It’s typical for this to take 5-10 years to play out.
The above is an oversimplified example of a leveraged buyout (LBO). A Private Equity Firm does this deal multiple times: they buy many different businesses. The expectation is that most of these deals will do well, perhaps providing two or three times the value invested, a small minority of them will not perform well, and a couple of them will do exceedingly well. A typical investment will double, more than offsetting an occasional failure so that all parties still make money. One or two investments may return 7X and ‘make’ the fund. Private Equity firms that have scale often make their money on fees and don’t need those huge returns to get rich. In fact, KKR has averaged ~2.5X on their deals for almost two decades now. Nowhere near the example given above.
Investors can buy shares in the PE firm and pay professionals to build that portfolio for them. Most successful funds do not seek out individual investors. When they do, they aim to obtain tens of millions of dollars as a minimum investment. With rare exceptions, an individual cannot buy into premier funds such as Bain Capital with $250k these days.
So how can you get involved in these deals? Stay tuned for Part II!
In the meantime, check out our existing investment guides:
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