For this post, I interviewed dozens of private equity operatives and surveyed hundreds more to collect their views on private equity. The result is a collection of thoughtful and intelligent takes on the world of leveraged buyouts. Because my research was anonymous, many of the takes are funny and witty, and they are definitely brutally honest.
It's like having a connected friend in private equity telling you all the secrets of how private equity really works. I hope you find the post illuminating and useful for navigating your interactions with private equity, or your career in private equity. Please feel free to contribute if you have anything to add to the discussion.
Top 5 Takeaways
If you only have a few minutes to spare, here are the top 5 takeaways:
- Private equity is predominantly an exercise in financial engineering. If you want to excel in private equity then you need to become a world-class financial engineer.
- Private equity does very little actual business improvement. Sure, we bolt on acquisitions to create the impression we have increased revenue and profit, but we rarely take the core business and fundamentally make it better. We do all our work on raising expectations to drive multiple expansion and using debt to turbocharge returns.
- A top earner in the industry makes well over $100 million a year. Oftentimes they put no capital at risk, use the same proven framework over and over again, and spend most of their time attending meetings. Imagine that.
- If you’re thinking about getting into the private equity industry, I have a question for you: is rolling up niche coffee roasters really how you want to spend your precious time? It works because it’s boring, but a lot of private equity is following a standard playbook of buying and bolting on boring and simple businesses.
- Private equity keeps management teams on their toes, and performing well. Not just at their portfolio companies, but at all companies that might become targets of private equity. In a small but not insignificant way, this benefits the whole market and shareholders in all companies.
These are just 5 interesting snippets from the interviews and surveys with private equity practitioners, and the full responses are below. Please read on for more insights on private equity (point #4, #8 and #16 are my favorites). If you’re leaving now, do you want to know how to 10x your impact in your chosen field? You should sign up for free and I’ll show you how.
How Private Equity Really Works
1. Private equity is predominantly an exercise in financial engineering. If you want to excel in private equity then you need to become a world-class financial engineer. That’s not all you need, but it’s a ticket to play.
2. There are three ways private equity creates value:
- Multiple expansion - buying for $1 billion at a 10x EBITDA multiple and selling for $1.5 billion at a 15x EBITDA multiple, creating $500 million in value from the multiple expansion. Essentially, this boils down to buying well, identifying mispriced companies.
- Business or profit improvement - making improvements to the acquired company to increase EBITDA from $100 million to $150 million, creating more earnings to distribute while the PE owns the company and $500 million in value when the asset is sold (assuming a 10x EBITDA multiple on entry and exit).
- Refinancing - taking a company that is largely funded by equity and then adding debt to the balance sheet to free up capital and lower the cost of capital. You can take a company with $500 million in equity and no debt, borrow $400 million so there is $900 million in capital total, then you pay $300 million to private equity investors and keep $100 million to “grow” the business. Instant returns for PE stakeholders, debt-tax shield deployed and potentially a lower cost of capital too (assuming low interest rates). This is where the financial engineering skill set comes into play. Not rocket science at all, but creates explosive returns.
Private equity does very little actual business improvement. Sure, we bolt on acquisitions to create the impression we have increased revenue and profit, but we rarely take the core business and fundamentally make it better. We do all our work on raising expectations to drive multiple expansion and using debt to turbocharge returns.
3. PE only holds an asset for the life of the fund, which is generally 7 to 10 years. Think about it, if the asset was any good we would hold onto it forever and never sell it. Just like Warren Buffett does, he knows good businesses are few and far between and that when you find one, you don’t sell it. So by this logic, we don’t buy and sell good businesses. We deal in average businesses at best. You need to know this. Don’t buy from us easily, and be very careful if you do.
4. Recapitalizations, or recaps, are a favorite tool of the private equity industry. To newbies, it sounds like daylight robbery. Basically, you borrow money against a company's earnings and assets, then use that money to pay yourself a special dividend. It works like this, buy a business for $500 million using $200 million in cash and $300 million in debt. Ride the growth of the business and work on getting a more favorable deal on your debt as the characteristics of the asset become more clear to your borrowers. Refinance your $300 million loan, by borrowing $500 million on fresh terms, as the business is now “worth” $700 million. Pay the $200 million from the increase in the loan value back to the private equity investors. You have your original $200 million back, and own the company for free. See, daylight robbery! :)
5. Cool PE trick 1: if an investment isn’t working out, and the fund is close to the end of its life, simply sell the company to another PE investor. This happens more than you think. Selling companies to another PE allows you to release capital, often to show a return, and then it’s their problem. Great way to turn a loss into a win.
6. Cool PE trick 2: if an investment isn’t working out, do a backdoor listing or SPAC to easily sell the company to the public. These pathways often have way lower disclosure requirements so are a really great way to get an underperforming company off your books.
7. A few years back, a private equity player in my country bought a “turnaround” play and hammered short term profit initiatives, added debt and started working a good story through the media. For memory, they paid something like $20 million for this asset. After pumping it for a while, they floated it for $800 million and cashed out. Turns out the business improvement initiatives were unsustainable and the stories were “tall” to put it nicely. They made off like bandits, turning $20 million into more than $800 million, and retail investors we left holding the bag.
8. The bad actors in private equity do a lot of damage to the industry. This brand damage hurts all of us and makes it harder to have our social license to operate, and societal buy-in to our proposed deals. I wish these bad actors would stop, or at least not try to squeeze every single cent out of the asset. What’s the difference between a 30% IRR and a 30.5% IRR? Or $50 million and $55 million? Are you ever going to spend it anyway?
9. It’s surprising to most new starters in the private equity industry just how much time we spend on raising debt, restructuring and refinancing. A lot of new associates think it’s all investment activities and actually running companies. Hardly. This is not where our value is created and it’s not where we spend most of our time.
10. The standard fee structure is 2% of funds under management (FUM) and 20% of performance. So if we manage $1 billion we’ll charge $20 million a year, and if we make our investors $2 billion, we’ll take $400 million of that as a performance fee. Do you think it takes $20 million a year to run 10-person investing and operating teams? Sure, align our interests by sharing 20% of the upside, but I see management fees declining over time as firms compete with each other and the new standard becomes something like 0.5% of FUM and 20% of performance.
11. A top earner in the industry makes well over $100 million a year. Oftentimes they put no capital at risk, use the same proven framework over and over again, and spend most of their time attending meetings. Imagine that. Use none of your money and spend no time running a business and you can make hundreds of millions per year.
12. The challenge of private equity is fun and rewarding, but I had to get out of the industry. Some of the people you have to work with are just too intense, too wound-up and quite frankly, too horrible. PE attracts the worst of the A-type personalities you find in the finance world. I want other people to be prepared for this if they are going to enter the industry.
13. If you’re thinking about getting into the private equity industry, I have a question for you: is rolling up niche coffee roasters really how you want to spend your precious time? It works because it’s boring, but a lot of private equity is following a standard playbook of buying and bolting on boring and simple businesses. If coffee roasters, marinas, outdoor advertising and other similar companies don’t inspire you, there are plenty of other options.
14. One of the plays in the PE playbook is the cost reduction play. Buy a business with bloated costs, or one that’s in decline, and rip out every single cent of cost possible. This is a common accusation against private equity. But arguably, this would have happened anyway (the business or industry is in decline) and the PE firm has saved the jobs of the people who remain.
15. Beware predatory private equity operatives. You invite them into your business and into your ownership with the promise of fresh capital and a helping hand. Next thing you know, they’re voting against raising more fresh capital from other investors in favor of their own money (on very favorable terms to them), they’re “help” is surface level and you’re slowly losing control of your company. Pro tip: if you accept growth capital, keep the terms clean and don’t give them too much control.
16. The regulatory environment and legal system really favor private equity, especially in the United States. How many times have you seen a prominent private equity player in trouble with the authorities? Sure, some for tax reasons but that’s a different system. In a cut throat industry like this with our model and tactics, you’d expect to see a lot more cases against PE players who step over the line. They take pride in stepping over the line! Structurally, the system really favors private equity investment and it has been a massive tailwind for the industry.
17. The beauty of the PE industry is that you don’t really have to build a public facing brand for your firm. Sure, there’s a brand within the industry, but the industry is small enough to make this a relatively easy matter of just being a good operator. People will find out. I’ve worked in other areas of asset management where the public brand is vital (see some of the feedback in venture capital secrets, for example), and it’s just such a hassle.
18. A bottleneck that has emerged in the last few years is access to investable companies. My firm literally can’t find enough opportunities. We have engaged all sorts of advisors and third parties to help, and resorted to many new and innovative ways of sourcing. There is just so much dry powder in the PE industry chasing too few good deals, it’s starting to become a real problem for us.
19. Private equity keeps management teams on their toes, and performing well. Not just at their portfolio companies, but at all companies that might become targets of private equity. In a small but not insignificant way, this benefits the whole market and shareholders in all companies.
20. Overall, private equity increases productivity in any economy where they are active. We take underperforming and undercapitalized companies and improve the performance and recycle the capital into more productive uses. Resources are allocated better in markets where private equity is a big player. On an individual level, it might not look like each investment contributes much to society, but as a collective we have a massive impact.
I hope these insights from current and former private equity operatives informed you about the true nature of private equity and provided useful information on how to navigate the industry.
Private equity is a cut throat business. To make it in private equity you need to be on top of your game. You need all your actions to be as impactful as possible. If you want to find ways to 10x your impact, you should sign up for free and I’ll show you how.
I have interviewed 500+ professionals, surveyed thousands more, and I am always probing for their best tips, tricks and hacks to get ahead. There are five that stand out above the rest and you can get them right now by joining my free email list. You won’t find these ideas anywhere else.