Most concisely, private equity is the business of acquiring assets with a combination of debt and equity. It is sufficiently simple in theory to be frequently compared to the process of taking out a mortgage to buy a home, but intentionally obfuscated in practice to communicate a mastery of complex financial science. When encountered, the latter should be thought of largely as a marketing effort. Vocabulary aside, the process is simple. Incredibly detailed and at times chaotic, but not the product of financial wizardry.
The Private Equity Training course will focus on the acquisition of operating businesses with a history of positive cash flow using the aforementioned combination of debt and equity. In an effort to get readers up to speed expeditiously, in this lesson we will cover a few basic concepts, including:
- The Benefits of Leverage
- Example of Leverage Creating Value
- Example of Leverage Destroying Value
- Deciphering Between Item Number 2 and 3 Above
- Introduction to Independent Sponsors
- Comparison of Independent Sponsors and Private Equity Funds
The Benefits of Leverage: Debt + Equity
The benefits of leverage are easily captured by comparing identical investments that differ only in the amount of leverage employed. If the value of the asset grows over time, the amount of leverage used to acquire the asset will enhance the amount by which shareholder value grows. Think about the two terms as follows:
- Debt is borrowed money that earns interest until it is repaid. For so long as the investment performs, and principal and interest payments remain current, the principal balance for interest bearing debt will remain fixed.
- Equity, on the other hand represents ownership. It is the value available to shareholder’s after all debts have been paid. It follows that as an asset increases in value, so does shareholder’s equity.
Per the table below, in both the Equity Investment and the Levered Investment, the shareholders own 100% of the same asset even though $100 and $25 were used respectively to purchase it. In year one both investments grow in value by 5%, but a 5% increase on a $100 investment acquired with $75 dollars of debt causes the equity value to grow by 20%, which compares nicely to 5% growth in the unlevered example.
Note that the Value Change and the Cumulative Value Change are identical in both scenarios. The only variable contributing to the different return profiles is the amount of debt used to acquire the asset, which brings me to my next point. In this course we are exploring the acquisition of businesses with a history of positive cash flow. This cash flow can be used to further reduce the debt burden by paying it down over the course of the investment, which reduces interest expense and lowers the risk profile of the business. The terrific artistic rendering below, where E.V. stands for enterprise value , further demonstrates how this also benefits equity value.
As these simple explanations might suggest, the limiting factor for the private equity industry was not ingenuity. It was the availability of capital. Private equity gained popularity quickly as debt became increasingly available to finance what had previously been considered too risky. The amount of debt available to finance an acquisition has fluctuated over time. In the 80s, easy money, which refers to lax lending standards, made outsized returns easier to achieve for the small number of private equity firms looking to benefit from this growing alternative investment trend. To highlight the benefits and dangers of excessive leverage two examples are included below. The first was a wild win for investors in the early 80s, and the second a modern-day private equity horror story.
Leverage Creates Value: 200x Return on Capital
The acquisition of Gibson Greeting Cards Inc. (Gibson) is one of the best examples of using leverage to make money in private equity. In 1982 a private equity firm purchased Gibson, which, and this may not be a surprise, published greeting cards. The firm paid $80 million, but borrowed $79 million to make the acquisition. The transaction closed with only $1 million of equity invested, $660,000 of which was split between two of the partners of the firm.
The private equity firm took the company public in a stock offering that valued it at $290 million sixteen months later. The two partners realized a return of 200 times their invested capital, turning an initial investment of $330,000 into $65 million each. This transaction instantly became legend and is credited as one of the variables that convinced Steve Schwarzman to pursue a career in private equity.
It should be noted that this amount of leverage would be difficult to secure today, but it is a tremendous example of how returns can be enhanced when an investment performs. The counter is what happens when leverage is aggressively applied in the wrong scenario.
Leverage Destroys Value: 0x Return on Capital
Private equity funds typically apply leverage to each portfolio company individually to diversify away from the risk that any single loss will affect the rest of the portfolio. Unfortunately, EnerVest Ltd., a $2 billion private-equity fund, learned first-hand the risks of applying leverage to a levered portfolio of investments. The fund used $1.3 billion of debt across the fund to increase the amount of capital it could deploy in energy investments.
Unfortunately, the fund had two variables with the capacity to affect all of its investments simultaneously: (1) the aforementioned debt, and (2) the price of oil. When the price of oil started to plummet in 2014 the firm began to realize losses that ultimately could not be sustained. Per an article in the WSJ, it may be the largest private equity fund loss to date:
"Though private-equity investments regularly flop, industry consultants and fund investors say this situation could mark the first time that a fund larger than $1 billion has lost essentially all of its value."1
The Right Amount of Leverage
Given these two scenarios, the immediate follow up question should be, “How much leverage should be used for any particular investment?” This question is at the heart of private equity. It is perhaps the second most important objective behind price discovery (i.e. valuation). The decision to assume debt should follow a careful evaluation of the company’s cash generation and potential to maintain appropriate levels of liquidity moving forward.
To elaborate, often debt is secured by a lien on assets. Which means that a company’s decision to secure a loan comes with the legal obligation to pay interest and repay the principal (the amount of the loan) on a schedule provided by the lender. As such, all eyes are on cash flow, frequently referred to as the “life blood” of a business, because ample cash flow permits the company stay current on its obligations. If the company fails to make these payments, the bank can take legal action to recover the balance owed.
The challenge for creditors comes when the collateral used to secure the loan is not sufficient to recover the balance owed. Seizing and liquidating assets is not attractive if it is done at a loss. This will compel some creditors to act swiftly when possible, which typically puts them at odds with the private equity firm. Without any knowledge of the future, private equity firms can protect their equity with conservative underwriting standards.
It follows that the answer lies in the comparison of a company’s ability to generate cash measured against the company’s obligations. A company’s obligations, in this context, are generally referred to as “fixed charges.” To provide a more specific example, the fixed charge coverage ratio (FCCR) is used to measure a company's ability to cover its "fixed charges" (largely debt-related payments but this can include additional obligations as you will see below) due in any given period.
Formula from the image above: (EBITDA – Capital Expenditures – Cash Taxes) / (Cash Interest Expense + Scheduled Debt Amortization)
The logic behind subtracting capital expenditures instead of depreciation and amortization (the “DA” in EBITDA) is that capital expenditures are a cash outflow whereas D&A are noncash items. After that cash taxes are subtracted to arrive at a better approximation of cash flow. Interest expense is not subtracted, but it can be found in the denominator (interest expense is one of the "fixed charges").
To elaborate on the denominator, this calculation looks at the actual cash required to remain in compliance in each period. Since you are more closely comparing the cash available for debt payments to the debt payments required in each period, a lender typically requires that this ratio remain above a minimum threshold of 1.2x.
This minimum threshold, along with other so-called “covenants,” will be included in the credit agreement, which outlines the remedies available to the lender. As a transaction moves towards a close, the investment team will be carefully evaluating all of these covenants against recent performance and each projected period. Multiple capital structures will be compared against each other until the appropriate relationship between risk and reward is revealed.
Private Equity Approach
In the lessons that follow, we are going to learn more about the individuals and teams engaged in this rigorous exercise of sourcing, pricing and structuring transactions. To make the content easier to absorb, we will approach private equity by first introducing the independent sponsor and then following up with an introduction to the private equity fund. By starting with an independent sponsor, the focus is narrowed to how an individual buys one company, which will make it easier to grasp the concepts involved. With this framework in mind we can then add detail to explain how a team backed by a fund builds a portfolio of companies.
Before the next lesson, however, I thought a little background on the independent sponsor would be helpful. Superficially, an independent sponsor is an individual that acquires companies and raises funds on a deal-by-deal basis without raising a committed pool of capital. A book titled “Investing in Private Companies: A Financing Manual for the Entrepreneurial Investor” that was published in 1984 opens with the following:
The unsung heroes of our American from of capitalism are the private individuals who provide financing for the more than 11,000 companies formed every week in the United States. These informal investors, aptly known in the business world as angels, venture where bankers fear to tread.
Per the book, in the early 80s it was unlikely that an entrepreneur would secure outside funds, and if they did, the funds were most likely sourced from an inexperienced investor. In contrast, today a healthy founder-entrepreneur run business is the diamond-in-the-rough investment sought by many venture capital and private equity firms. Perhaps more surprising is how the formerly “inexperienced investor” has become a well-established and accepted player in the private equity industry. So much so that funds have been raised solely to support independent sponsors looking to secure funding.
In the mid-2000s, the term independent sponsor (or “fundless sponsor”) nearly carried a derogatory connotation, but growing competition across the private equity landscape made capital a commodity and deal sourcing a priority. This dynamic increasingly gave individuals talented at finding opportunities for investment the confidence to go out on their own. In the current market, independent sponsors with the right reputation can operate at nearly any scale. In this capacity Bradley Jacobs is incredibly impressive. From his one-page website for Jacobs Private Equity (JPE.com):
Bradley S. Jacobs is managing director of Jacobs Private Equity, LLC, and chairman and chief executive officer of XPO Logistics, Inc. (NYSE: XPO).
Jacobs' track record in the business world is unique. He has founded five companies to date and built them all into billion-dollar or multibillion-dollar operations. XPO is the 7th best-performing stock of the last decade on the Fortune 500 based on Bloomberg market data, and XPO Logistics, United Rentals and United Waste were all ten-baggers, with the share prices rising more than 1,000% from the time Jacobs took control.
Over the course of his career, Jacobs has led teams that integrated approximately 500 acquisitions and opened over 250 greenfield locations, raised over $25 billion of debt and equity capital, including two IPOs, and created icons of business excellence across several industries. He maintains strong relationships with leading investment banks, sovereign wealth funds and other buy-side institutions.
This is clearly an extreme example, but I think it is important to be aware of what an individual with the right skill set and network can do in this space without a pool of committed capital.
Coming full circle, the reason an introduction to the independent sponsor is helpful to understanding private equity is the focus on a single initial transaction. In the lesson that follows we will explore how this structure comes together (see image).
The process required to arrive at this structure is similar to the process required to close each transaction at a private equity fund. In the image below, each of the small “Portfolio Co.” boxes at the bottom of the image are the equivalent of the one red-lettered gray box titled “Acquisition” above. A strong understanding of both frameworks will make the content that follows easier to digest.
In the videos that follow both of these structures will be dismantled and explained one component at a time, and by the conclusion of this course you should have a greater understanding of how these two private equity participants operate. The additional advantage of this approach is that it should help those interested in pursuing a career as an independent sponsor or private equity professional focus on the contents of the curriculum most relevant to them.
1 Ryan Dezember | “From $2 Billion to Zero: A Private-Equity Fund Goes Bust in the Oil Patch” | The Wall Street Journal | 7/16/2017