The Rundown on Private Equity | AWM Insights #111
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Episode Summary
Investing in private equity (PE) boils down to buying ownership in non-publicly traded companies. Venture capital is just a small subset of private equity and sometimes the lines can be blurred between the two. Within Private Equity, there are multiple niche areas where the PE funds and managers put their focus. Private equity also deals with more mature or later-stage companies than venture capital.
Expected returns in private equity are much different than venture capital, normally with less downside at the cost of the potentially bigger upside. Access to the best PE managers and funds still matters just as it does in VC.
In this week’s episode, Brandon and Justin go deeper on what it looks like to invest in private equity deals, how it’s different than venture capital, and why deals should ultimately be vetted by an experienced investment team to avoid most or all of the returns going to managers rather than you.
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Episode Highlights
(0:58) How is private equity different than venture capital? What are the expected returns in private equity? How do I have success in PE?
(1:16) VC or venture capital is a subset of Private Equity or PE. Private equity is an entire ecosystem of non-publicly traded companies.
(2:30) Private equity can be much more mature companies and sometimes have been around for decades.
(3:01) Later stages of venture can bleed into private equity as startups turn into much larger and mature companies. Hedge funds have also been getting into PE.
(3:33) Private equity is incredibly well-diversified across different types of companies. Venture capital is almost always focused on tech.
(4:22) Private equity firms sometimes come in and buy a company that is public they view as not performing optimally. The PE managers come in and take the company private. An example of this right now is Twitter.
(4:46) The stage of the company doesn’t always mean funding size. Mature companies aren’t always bigger.
(5:25) Middle market private equity is sometimes family-run and geographically focused businesses. Helping owners hire a CEO and exit the company is what they try to solve.
(6:00) Return profiles are vastly different for venture capital and private equity. Early-stage venture capital is the riskiest and therefore has the highest expected returns. It also has the largest range (dispersion) of returns. Something can 10x or go to 0.
(6:40) Private equity returns are not like VC. Most of the companies at least return what you put in. The upside is also limited, at least when compared to VC. It might be a 4x for a best case, base case a 2x, and downside return of .9x.
(7:30) Venture capital funds wouldn’t take a best-case return of 4x like is targeted in PE because it’s not enough return to justify the risk.
(8:40) The drivers of returns for PE are also much different than VC. A lot of the value-add from the PE firms comes in the form of financial engineering and improvement of operations.
(10:40) How do you access the best private equity?
(11:10) The access and specialty of the firms still matter in PE just as they do in VC. The persistence of returns from the best funds is not as persistent as venture capital but is still there.
(12:14) Relationships and what value a limited partner can add will win a lot of deals. Athletes have been able to gain access to exclusive deals because of what they offer besides money.
(13:40) There is pressure when owners take money from private equity. This money comes with expected results.
(15:09) Staying private and growing without PE money allows for independence and the ability to avoid conflicts of interest from outside managers that may not have the same goals as the original owners. This is very important in the wealth advisory industry.
(15:40) Companies that have sold to private equity have pressures to grow and sometimes that comes at the cost of clients.
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+ Read the Transcript
Brandon Averill (00:05): All right, Justin. Well, we're back for another week. We're going to keep on this private market theme. Like we suggested last week, we're going to go from venture capital where we spent a few weeks talking about the nuances, how to do due diligence, et cetera. We're going to move today into private equity. So we're going to spend a little time on this. I think it's a confusing part for a lot of people. How do you differentiate between the two? There are certainly some differences, return profiles, types of companies, all these types of things. But then there's also some big similarities. So we'll hit on those a little bit as well.
Brandon Averill (00:40): But yeah, Justin, let's start there. Let's dig in. Maybe just start super high level. We've talked about venture. What are some of the differences with a private equity backed company, a private equity deal, private equity investors? Really high level, give us the rundown.
Justin Dyer (00:57): Yeah. Well, first I would say that venture, let's call it VC, just to keep things short and sweet, it really is truly a subset of private equity. Let's define private equity. Private equity is, as the name suggests, the ownership of a non-publicly listed company. It's a private company, right? Private markets, we talk about all these terms, time and time again, and venture capital fits within that definition. So that's one similarity you mentioned, but you've also touched on a lot of the differences, and to go there, which is where your question went is let's think through what those are.
Justin Dyer (01:36): So stage of the company is probably the biggest true differentiator between typical private equity or the standard definition of private equity, where we're not talking about venture and true venture capital and what stage is that. Let's go there. It's earlier stage companies that are trying to get off the ground that fall into that venture capital bucket. Whereas private equity, typically speaking, these can be very, very mature companies. In some cases, they've been around for decades, multiple decades in some instances. So that's I would say one of the biggest differentiators.
Justin Dyer (02:16): Now, just getting a little bit into the weeds on the current marketplace, those definitions and people who call themselves traditional private equity shops versus people that call themselves traditional venture capital shops are starting to bleed into one another. You're seeing that at the later stage of venture and more of the growth stage within private equity. A lot of overlap there. Even to get a little bit more inside baseball, some hedge funds as well getting into this space. Tiger Global is a big one. Although, I mean, yes, they've gotten into it, but their returns have suffered quite a bit recently. So I'd say stage being the very, very kind of, I guess, tip of the iceberg key differentiator between the two general broad based buckets.
Justin Dyer (03:00): One other thing I'd say that falls into this pure standard differentiator too is the type of the company. Private equity, you're going to see private equity firms and funds be incredibly well diversified. They'll participate in such a wide range of industries. Whereas venture capital typically is tech oriented. Although now, the common adage, right, tech is eating the world or every company's a tech company now. Whichever one you want to pick, it also kind of speaks to venture capital going much more broad and focusing on a number of different industries, but with that initial layer, initial motivating factor being tech focused. So yeah, I think that's a great place to start.
Brandon Averill (03:48): Yeah. I think the crossover is super interesting right now, too. Because a lot of times, private equity firms come in, for instance, to take a public company back private. So the most recent, right, is Twitter. We certainly have venture capital money in there. We've seen that publicly backing Elon. We've seen private equity money involved right in that process as well. So you have those worlds colliding in a type of deal like that. The other good nuance to make here is stage of company doesn't always mean funding size either, right?
Brandon Averill (04:23): This private equity world is so big, it might be a multi hundred million type company and maybe they are getting ready for IPO or doing some different things and you'll have the private equity folks come in because it's a more mature business, operations are established, but maybe there's some tweaks. You'll hire one of these really strategic private equity firms because you're a consumer play and you want to attract a certain market, but then there's also the other part of private equity, right, that's more "middle market". So you're looking at companies that might be more regional based.
Justin Dyer (05:02): Right.
Brandon Averill (05:02): Maybe they've been ran by a family for 50 years and now it's time to transition. You'll typically see private equity shops come in, really helping those transitions, get a new CEO in place, kind of optimize things, right? So I think the other part, right, to maybe hit on is return expectations or profile. Those are going to be quite a bit different, right?
Justin Dyer (05:26): Yeah. Wildly different. Now, targeted returns are close venture capital depending on the stage, earlier stage let's go there first, has a much higher expected return. You're taking a lot more risk investing in a seed stage company, which is in many cases just an idea, versus a later stage series B, C, D where there's a business model there, there's revenue. So sticking with venture capital, the typical expectation is that the majority of investments actually fail. The same is not true with private equity. There's going to be a little bit more concentration within a typical private equity portfolio. However, the expectation is that most of those companies, if not all of them, at least return what their investment was. There's no expectation that, hey, we're making this significant investment and this thing's going to be a flyer. Maybe it's going to 10 X, but maybe it's going to go to zero. That same concept just doesn't exist within private equity.
Brandon Averill (06:33): I think that's interesting to know. When we're talking to private equity investors and firms, they often provide that analysis, right? We're looking at what's our base case. Okay, our base case is 2X.
Justin Dyer (06:44): Right.
Brandon Averill (06:45): We're looking at our upside case. Our upside case is 4X and our downside case is .9X. So getting their money back to your point. Justin Dyer (06:54): Exactly.
Brandon Averill (06:54): So I think that analysis is a little bit differently, but at the top end too, we've talked to a lot of venture capital funds, right, they would never put money into a deal if they thought the upside case was 4X.
Justin Dyer (07:07): Right.
Brandon Averill (07:08): Right? They look at deals and want that to return their fund. They're looking at 10, 20, 30X type potential. They're willing to take that zero on most of the portfolio to get there. So really good kind of good point there.
Justin Dyer (07:27): Real quick. One thing to add too on that is kind of let's call it the source of returns almost. What I mean by that is not so much the early stage, right? Where it's a company that is you're incubating an idea, it's a new idea that's trying to disrupt an industry. That's super, super important as well. But from a venture capital manager or a private equity manager, the source of their value-add or their returns is often different. Within venture capital, it's very much, hey, maybe I'm a founder myself, I'm an entrepreneur, I'm an operator. We can really help you get this idea off the ground, get the operations of the business really dialed in, build a go-to market strategy, et cetera, cetera.
Justin Dyer (08:12): Whereas private equity, a lot of it is more, what you were hitting on is more financial engineering almost, right? Or just operational improvements. If it's a family business where they haven't had professional management before, hey, let's bring in that professional management. Let's institutionalize what's going on with the business. Let's bring in a CFO that knows what they're doing. Let's potentially put some debt on the business.
Brandon Averill (08:36): Yeah, that's right.
Justin Dyer (08:36): Which we'll touch on probably in this conversation. Maybe there's some nuance or not so much difference as you hear me say that, but there is a lot of true differentiating aspects to those true drivers of return or really kind of maybe the value add aspect is a better way to put it.
Brandon Averill (08:56): You made the point on debt. I think that's interesting. Not often, but you will see venture debt out there. So you'll have a debt partner come in a venture capital type round and the growth of a company, a lot more difficult to underwrite.
Justin Dyer (09:12): Right.
Brandon Averill (09:13): Right? You're not going to have a bank that's going to do too many venture deals. So you have these venture lending shops out there that are really established and typically it's loans plus warrants and all these types of things. But I think we've hit on it before. But oftentimes in these types of deals, right, you're having a big bank and they're going to write a big check, especially later stage private equity. Additional element of risk, sure. But it also, I think, points to the size of the deal, right?
Brandon Averill (09:46): Entrance, the other thing, I was just visiting with a private equity investor in New York this week and they talked about even the price point to play. You're not going to go in as an individual investor and take out a slug too often at a big private equity deal. Whereas with venture, a little more approachable, higher risk from a dollar standpoint and get in trouble a lot quicker.
Justin Dyer (10:10): Sure.
Brandon Averill (10:10): So maybe talk about how do you access the best private equity, should you be investing in private equity? Obviously, this is an investment advice. It's very specialized. But I'm just trying to feel the lay of the land here a little bit.
Justin Dyer (10:26): Yeah. The access conversation or access topic is very similar to venture. There is strong evidence of persistence. It's not as strong admittedly within the private equity space as it is in the venture capital space, but access still matters. The network, the relationships, the specialty or the focus of the firm matters. A beverage company is not going to just go to a random private equity company that's writing them the biggest check. They're going to go to the private equity firm that has experience in that space.
Justin Dyer (11:05): With respect to return expectations and whatnot, the overall differences are relatively minor. But if you think about a compounding effect, venture capital still has most definitely the highest expected return. Again, thinking traditional venture capital in this sense where let's call it the earlier stage, whether it's seed to series A to series B, you're expecting a higher rate of return because you're taking on more risk, and balancing those two things is very, very, very critical.
Brandon Averill (11:43): Yeah. I think you, to your point, the relationships and the value-add, right, still really matters to win a deal. It's still a competitive market. Again, this private equity investor I was just with was talking about winning deals, winning access to deals. It's still a place that you have to come in as a value-add type investor LP. They were able to use some of their relationships. They have some athletes as clients. They were able to basically put together some different elements, go to the CEO and show how they could help, really help them to gain access to one of the more recent deals that they're a part of.
Brandon Averill (12:20): So I think you still have to think about a value-add. But at the end of the day, too, if you're a company, right, and you're taking on this private equity, or certainly venture capital we've hit on, the goal is to re-operationalize some things or go, go, grow, right? We're seeing this actually in our industry right now where your loyalty's change a little bit, let's say that. But if you take on a bunch of private equity, it's something we're passionate about, always staying privately owned, is because we don't want to have pressures to try to make decision making for somebody that's not within our business.
Brandon Averill (12:58): So we want the people that we work with to own our business. It allows us to make, in our opinion, more strategic decisions. I'd love your thoughts on that. But I think just what are some of the pressures that come if you do take private equity?
Justin Dyer (13:12): Well, they're making the investment to turn a profit. Generally speaking, it's a relatively short window. There are very few private equity firms that are making an investment for the true long term. Within our space, we use that term quite a bit, and long term being 10, 20, 30, 40, I mean, you could even argue 50 years in some cases. So it's a very long period of time. When you bring in private equity money as a company, there's going to be a relatively short term window in which results need to be generated. They're investing on behalf of firms like ours. I didn't answer your question specifically about whether you should invest in private equity, and to your point around-
Brandon Averill (13:59): It's a good dodge. You should dodge it.
Justin Dyer (14:00): Not investment advice. It's an attractive space. We do just by way of investing in the private markets and whether it actually falls in the definition of venture capital, et cetera. That's probably a whole another conversation. However, we as investors make that investment and have an anticipated hold time for the fund or the direct investment and the managers that are managing the money or bringing them the capital to the company are communicating that back to us and then they're then putting pressure on the management of that specific company.
Justin Dyer (14:36): So roundabout way of answering a couple questions there, in our industry specifically, it's really important for us to stay truly private and independent, because there's just a huge conflict of interest between having a new overlord, if you will, driving certain metrics that may be completely detrimental to long term client success. We just really don't want to play with that game.
Brandon Averill (15:02): Yeah. No, it's top of mind for me. I was just with a bunch of different advisors back East and talking to one of them. Unfortunately, they're part of one of these firms. You just see the changes and the frustrations, right, that ultimately come out. It's not good, bad and different. It just happens to be the right decision for us to not take that on, but just acknowledging the pressures for these companies. So it is there. You're supposed to grow. You're supposed to go acquire other firms if you have to, or do what you need to do to make it happen.
Brandon Averill (15:34): So both venture, both private equity, it's about growth at the end of the day. It's about profit and reorganizing everything because people like us on the other side want a return for the money that we're putting at play. For you guys that are listening here, we want to make sure that you get the best opportunity for returns and exactly the returns that you deserve based on your financial structure.
Brandon Averill (16:00): So, well, I think that's a good place to kind of wrap up for the day. We're going to shift gears again next week. We're going to stay in the private markets. We're just going to get into private real estate. So probably everybody's favorite topic. We left it for last because we know people love real estate, the tangible nature of it. Hopefully, through our coaching, we try to show that private equity and venture capital and investing in the public markets is tangible as well. But there's a knack for real estate. So we'll get into that next week.
Brandon Averill (16:34): Some of the things you should look for, again, risk return profiles. We'll blow up the notion that real estate always goes up. Spoiler alert, it doesn't. But at least in our lifetimes, it seemed to.
Justin Dyer (16:45): It certainly have.
Brandon Averill (16:45): Seem to have. So we'll close out there. Again, I should have mentioned this at the top and I'm going to start to do that, but I'd love to hear from you guys. Shoot me a text. It's coming right to my phone. Justin and I will get back to you, but we want to know what questions you have. So hot topic next week, real estate. Shoot us your questions. Let us answer them. Phone number is 602-704-5574, 602-704-5574. Until next time, own your wealth, make an impact and always be a pro.