So how does an LP conduct due diligence on a GP to make their investment decision?

1. Past performance: in public markets you often hear the disclaimer, “past performance is no indication of future performance.” If you watched the men’s snowboarding at the Winter Olympics, you’d probably disagree. Actually, if you look at most things in life, you’d have to disagree. If a PE firm consistently outperforms, through thick and thin, that’s a very good bet. But, people and times change, so it’s important to look at other factors too.
2. Team dynamics: I can’t overstate how important team dynamics are in a fund. You need the team committed, engaged and motivated to do its best work. But more importantly, you want them to care about the success of the fund. LPs wrongly think that giving GPs equity will make them care. We’re not that rational. People care about whatever the heck they want to care about. Visit the team, talk to a sample of people, and ask questions that will gauge their emotional commitment. If GPs aren’t excited and engaged, there’s probably an underlying problem that you won’t be able to uncover in the time allotted.
3. Leadership: any group of people can do amazing work if they’re inspired by a great leader. The group doesn’t need to be intelligent by IQ standards, or have contacts within the industry, or even have a history of performance, as long as they’re inspired. An LPs questioning should test whether the employees think they work for the best people in the industry. Any indication otherwise is a bad sign. Apart from the fact people will jump ship, it shows something fundamentally wrong with leadership at the firm.

You may be wondering why I’ve concentrated on the “soft” aspects of a firm. Why haven’t I talked about education, qualifications, seats on boards of public companies, industry lobbying, etc? It’s for one simple reason. An uninspired and unmotivated team is dead wood, no matter how qualified they are.

I’ve seen it time and time again, qualified people who are absolutely useless because they aren’t engaged. But I’ve also seen engaged novices originate leads, close deals and make a difference, without an ounce of finance experience. That’s why I think it’s important for LPs to focus on team dynamics, leadership and care factor.

Of course, I’m not an LP, so I wouldn’t know what works best, but that’s my take nonetheless.

Back in the ol’ days, it took a lot of effort to get enough food to maintain health. You had to chase animals, kill them, skin them, cook them, etc. Now, you just dial Dominos and can over-eat to your heart’s discontent. So ironically, rather than chase animals to keep healthy (which is very hard work), we just have to stop putting nasty food into our mouths (relatively easy). Sounds crazy in the context of Sub-Saharan Africans dying from starvation. But I digress. Success in business is very similar; it’s more psychological than physical or skillful.

So here it is, the #1 ingredient to success in business is … Hustle, which generally means being resourceful and uninhibited in going after what your business needs most. Not what you’re willing to do most, but what the business needs most (big difference). I know what you’re thinking, “I already do that.” Well, I bet you don’t. But don’t worry, neither do I. And since admission is the first step to recovery, we’re making good progress. Consider the following to demonstrate this concept:

• Make a list of the things your business would most benefit from
• Forget convention, forget inhibitions, even forget morals, laws and ethics (for a moment)
• Items may include, contact Steve Jobs, get PR via popular TV show, paint your company name onto the side of Air Force One, call the CEOs of all your competitors, call your top 100 customers, run naked through the streets handing out PR material, etc.
• Items shouldn’t include, update CRM, do SEO, lodge my tax return, post on blog every day, make a couple of sales calls, etc., they MUST be things that will add MASSIVE value to your business (e.g. Gary Vaynerchuk getting onto Conan O’Brien)
• Don’t ponder the items, just write them down before you find reasons not to add them; forget reasons, just think “value”
• Now, look at the list, consider each item and watch yourself rationalise not following through

If you “had your hustle on”, you’d do most of the items. If you don’t have your hustle on, you’ll make excuses. ”Oh, Steve Jobs won’t answer my email. That TV show won’t have me on. I’ll do that task tomorrow. I’ll be arrested and charged with treason. Etc.” If you had your hustle on, you’d think, “there is no tomorrow, there’s only right now!”

Of course you shouldn’t do anything too illegal, but err on the side of taking chances (certain jails are way too horrific to teach you any worthwhile lessons). And before you get all holy-than-thou on me, remember it can be illegal (in some places) to put up posters, market to the public, run around naked, and even search the web using Google. But I very much doubt people will go too crazy; the real risk is in being too mediocre.

I guarantee if every day you made that list and did everything on it (that didn’t lead to a Colombian jail), you’d be many times more successful. Just like keeping fit and healthy, success in business doesn’t depend on skill, it depends on excuses (or lack thereof). What do you think? Am I talking nonsense?

You’re probably thinking, “what does that even mean… be true to yourself?” Well, I’ve come to realise a career in private equity is tangential to my overarching goals. I know, I know… that sounds very self-help-esque, but you’ll be glad to hear the result involves a very exciting startup venture (stay tuned).

So, what’s the future for The Private Equiteer? Well, as the title of the post suggests, I’m just leaving the building, not the blog. Conceivably, my new material will be refreshed by a different perspective of private equity; an “ex-insider’s now-outsider’s” view, if you will. I’ll also continue to post responses to your comments/emails and share all new thoughts on PE and VC.

The Question: There is a company with 100 outstanding shares and the market price of each share is $10. Now, if the company issues 10 shares through a private placement at price of say $12. Everything else (i.e. debt, cash etc.) remains same. What will happen to Enterprise Value? Will it increase or decrease? Why? How will EV be affected if the private placement is done at discount to current share price (i.e at $8)?

An Answer:

EV is generally used as a proxy for market value. So it really depends if the issue of shares is adding to the market value of the business. At one extreme, if you issue the shares and set fire to the cash you just raised, then EV will stay the same and your individual shares will just be worth less. At the other extreme, if you buy a distressed competitor for $1, and synergies mean you double the value of your business, then EV will roughly double, meaning your shares will increase in price.

So the important distinction is that we tend to work backwards with the EV equation. That is, we work out EV (often using a multiple of cash flow or earnings), then we subtract net debt to find the equity value. This makes it a “market” valuation. We generally don’t add up the book value or par value of shares and add the book value of debt, because that would be a “book” value and not necessarily represent what people will pay in the market.

So, let’s work through some numbers.

1. If the equity is issued for no reason, just to increase cash for a rainy day, then there is no affect on enterprise value (EV). Theoretically, equity increases, but so does cash, which offsets debt to give net debt. Intuitively, if you sell the business the day after raising the money, the cash is just used to pay back the people that just funded the new issue. Practically, it could be a little different. If you raised money at a premium, the new shareholders will get less back as the new cash is shared between everyone (either by paying down debt or via a capital return). The opposite happens if you issue at a discount.
2. If the equity is issued to invest in the business, then the affect on EV depends on the profitability of the investment. Remember, we’re working with market value. If the “market” values the investment at cost, then it cancels out. If they value the investment at zero, the EV stays the same, the equity value stays the same, but you have more share, so the per share price drops. If they value it above cost, then the opposite happens.

Does this sound right to everyone? Any comments?

All courses of action are risky, so prudence is not in avoiding danger (it’s impossible), but calculating risk and acting decisively. Make mistakes of ambition and not mistakes of sloth. Develop the strength to do bold things, not the strength to suffer. Niccolò Machiavelli

Private equity is a juggle of many roles, most of which rely on explicit risk calculation. And as with any juggling act, mistakes are inevitable. But that’s okay because we learn from mistakes and we probably learn more from mistakes than successes. However, there’s a catch.

If I touch a hot plate and burn my hand, I learn that it’s hot and that I shouldn’t touch it again. If I touch it again, then the mistake is reinforced. But if I continue to touch the hot plate, I’m not learning a whole lot more, I’m just getting burned.

We make mistakes of sloth (laziness) every day. We know laziness, contemplation and apathy are all toxic to progress. So, just like touching a hot plate over and over again, being slothful loses it’s punch pretty quickly. We may get some other benefit from being slothful (such as relaxation), but an education isn’t one of them.

On the other hand, mistakes of ambition are generally different day-to-day. We tend to learn something profound from each and every ambitious pursuit, even if it’s not immediately obvious.

In the context of private equity, you’ll learn nothing from NOT contacting a potential investee. But at a minimum, you’ll fine-tune your ‘get around the gatekeeper’ skills if you do call. And more than likely, you’ll have a valuable chat with an industry professional, which may even lead to a successful investment. The same goes for investee improvement; you’ll learn much more from conducting analysis and making suggestions, compared to doing nothing.

If things aren’t going as you planned, is it due to mistakes of ambition or sloth?

The question: should working capital affect an enterprise value calculation.
The answer: absolutely.

Your calculation of a firm’s enterprise value must account for working capital because it affects cash flow. And, anything that affects cash flow, affects returns, and anything that affects returns, affects the value of an investment.

For a full run-down of the nuances of WC vs. EV, check out the Working Capital Series. For a quick and dirty understanding, think about changes in working capital. If you must pay creditors before debtors pay you, there is a drain on cash. All else equal (including revenue), this requires a one time injection of cash to support the perpetual lag in payments. But, if revenue grows (and your working capital profile stays the same), you must inject more cash into the business to support the changes in absolute working capital. This continues as long as growth continues and hence affects the long-term investment value.

I realise this seems somewhat rudimentary, but the popularity of the search term suggests otherwise.

• The most popular post, Stay Clear of Single-Owner PE Firms, received 1000+ visitors in just a few hours
• The largest source of referral traffic (excluding search engines) is pehub.com
• Of all traffic from search engines, 96% is from Google and 2.6% from Bing
• Surprisingly, 46% of browsers are IE, 34% Firefox, 10% Chrome and 9% Safari
• Operating systems: 86% Windows, 11% Mac and 2% iPhone (Blackberry is 0.2%)
• After English, Dutch and then French are the most popular language settings
• Visitors come from the US, then UK, Australia, India then Canada

As for keywords, the Top 5 traffic generators (not including versions of “the private equiteer”) are,

• “capex formula”
• “private equity blog”
• “does enterprise value include capex”
• “private equity due diligence”
• “how to calculate capex”

It’s interesting to see “capex” twice thrice in that list…

Similarly in business, you can apply for funding using your assets or cash flow. Clearly, an asset-lend is less risky for the bank. However, many businesses don’t have the assets to secure the size of loan they need. Moreover, few businesses have the assets to back a loan anywhere near the size of what’s available if the bank approves a cash-flow-lend. Regarding what a bank will approve…

• For an asset-lend, banks typically offer a percentage of the total fixed asset value (an independent market valuation)
• For a cash-flow-lend, banks typically offer a multiple (x) of maintainable cash flow (FCF) or earnings (EBIT); the multiple depends on volatility and similar factors

Imagine your EBIT is $10m and, if approved, the bank will lend 4x EBIT. That’s $40m. If the same bank would lend 70% on assets, you would need almost $60m in assets to raise a similar amount. Sure, certain businesses have those assets (at market value, not book or cost), but I’d say most don’t, and most don’t want their assets encumbered anyway.

One caution, made more apparent by the GFC, is that you shouldn’t rely on the amount a bank approves as a gauge for responsible gearing levels. If you borrow 4x earnings on an earnings figure that you know isn’t sustainable, you could easily end up with negative ownership. That is, the business is worth less than the debt it owes. Credit teams can be tough, but there’s always information asymmetry; you know much more about the business than they do.

Of course I support good people doing good things, but I just can’t compute the UNPRI. There are no concrete rules, there’s no stewardship, there’s no recourse, nothing. If we boil it down, it’s a vague guide that suggests I shouldn’t use child labour, or slave labour, or ruin the environment, etc.

Here’s a thought, WHY DO I NEED SOMEONE TO TELL ME NOT TO USE SLAVES? Should I pinch myself; am I really in 2010? Do I need someone to tell me not to be a monster? Obviously the signatories think so.

I’m not questioning the efforts of the UNPRI team; I’ll assume they have good intentions. What is suspicious, are firms that need to tell the world they aren’t morally corrupt. (And you know what they say about people that harp on about their own integrity.) If you ask any one of them, they’ll say they’re supporting the cause and doing it for the children, but you and I both know they’re doing it to display a UNPRI logo on their website and, in the process, condemning others as irresponsible.

It’s truly disgusting in the context of these issues. If they really want to make a difference, they’ll donate a % of their carry to these causes (Ha, best joke of the year). My suggestion: do a little more due diligence on PE firms that are signatories to the UNPRI.

This won’t be a popular view, but it’s my view. And it goes for similar treaties or protocols; stop signing pieces of paper and start acting responsibly on a global scale.

The role of a mid-market private equiteer is divided into, 1) Origination, 2) Analysis, 3) Dealmaking, and  4) Consulting. In simpler terms, 1) you find investees, 2) analyse them, 3) close deals with them, and 4) improve them. (Of course, you then need to exit your investments, but I classify that as dealmaking.) All of this is done to achieve target returns for investors, but more importantly, so you can take lots of carry home.

To find the recipe for success, we just need to deconstruct each of these roles and understand what is most important to achieve good outcomes.

Origination

This refers to finding leads that may turn into investments. You can sit back and wait for bankers to bring you deals, or you can use your resourcefulness to go in search of good deals. Both work, and both have their ups and downs, so it’s best to keep your nets spread wide and options open.

The main problem we face in proactive deal origination is just getting a few minutes of a business owner’s undivided attention. The recipe for success is to be amiable and tenacious. That is, be genuinely friendly to everyone (including receptionists) and try to contact business owners over and over again (not necessarily the same ones; just keep active). I guarantee, if you are nicer and more genuine than your colleagues, and you make MANY more calls than them, you’ll trounce your colleagues in terms of lead volume and quality.

Analysis

This refers to appraising a business before making an investment, plus the analysis required to help improve the investment later. The main problem is boiling the ocean. What I mean is, spending too much time building pretty (useless) financial models. The recipe for success is to ask yourself what matters most and just focus on testing a handful of related hypotheses. Are earnings maintainable and real? Do earnings translate well to cash flow? Are there any anomalies regarding Capex or working capital? Are exit opportunities plentiful? Etc. It shouldn’t take more than an hour with the information already at hand.

Keep in mind, great financial models don’t make great investments; great businesses make great investments. And great businesses aren’t found using financial models; they are found by getting away from the computer and developing your entrepreneurial intuition.

Dealmaking

This refers to turning a lead into an investment. The main problem is losing a deal due to a gap between your offer and the vendor’s expectations. The recipe for success … well, it really depends on the situation. Your offer doesn’t just include a monetary value. It may include prestige, future returns, profitable ideas, strategic synergies, and even friendships. If you deconstruct this, you’ll realise that a vendor is influenced by all of these ’soft’ offerings, and they may choose a lower price as a result, by monetary value is always a trump card. Depending which way the wind is blowing, a vendor can suddenly forget the connection you made and go for the highest price; that’s human irrationality.

But I don’t want to sit on the fence with this one. If I had to say there was one thing that constitutes a ‘recipe for success’ in dealmaking, I’d say it’s transparency. People are blown away when you’re amiable and transparent, especially when they’ve been dealing with ‘bankers’ all day. This theory is in stark contrast to some of my previous theories, but hey, it’s 2010 (that’s my official reason for everything this month).

Consulting

This refers to giving advice to help improve it your investee. I call this consulting because that’s what it is. You’re not employed by the business, you’re only on the board (or not even that in some cases). And the board is there in an advisory capacity. The main problem is actually making a difference. Too often, private equiteers mess with the mojo of their investees by trying to implement textbook McKinsey concepts in a world they’ve never operated in. The recipe for success is to acknowledge your relative inexperience in the investee’s industry and listen to what people say (and talk to them). Then, deconstruct the investee’s issues by focusing on what matters most to desired outcomes. It’s that easy.

Above all, work with your investees, roll your sleeves up and get your hands dirty. Become one of them, earn their respect and be diplomatic with ideas; form ideas together and implement them together. Don’t be the private equiteer that drives up in his/her Porsche and walks around with some superiority chip. You don’t effect change unless you can connect.

Learning Curve

• We’re not dealing with rocket science here, so the learning curve isn’t particularly steep for private equity; once you’re through the door (i.e. you get hired), it becomes more about your resourcefulness
• For larger funds, the focus is firmly on becoming a confident and polished dealmaker; this means developing great communication skills and fitting in with the culture at the big end of town (sounds easier than it is)
• For smaller funds, the focus is on becoming an amiable dealmaker and an articulate consultant; this means personally connecting with business owners (often ‘moms and dads’) and learning how to deliver pragmatic advice with confidence (which can be a challenge for some people)
• The other difference relates to structuring; larger deals are more likely to use complicated instruments, whereas smaller deals often stick to pref equity and senior debt; but, none of this is too difficult if you apply yourself

Compensation

• Make no mistake, in a large firm you will earn multiples of what your smaller firm counterparts make, and the gap only increases from the day you start
• Smaller firms will attempt to bridge the gap by offering carry (albeit, a small %), but don’t become blinkered by this; it takes a long time for your carry to fully vest (10 years+) and there’s a lot of fine print that will mean you get much less than your initial calculations (see this post on my real-world carry calculations, Part 1, Part 2)
• With that said, carry is the holy grail for private equiteers, but you need a relatively large fund to make it meaningful (or great performance, but don’t count on that); of course there are many other variables, but you know what they say about a bird in the hand (base salary)…

Quality of Life

• Private equity isn’t investment banking, we work pretty reasonable hours
• If anything, smaller firms will work you a little harder as they often have fewer people working on more deals
• Irrespective of firm size, before accepting a position at a PE firm, make sure it doesn’t have a PowerPoint culture; this can indicate they work 80+ hours a week pumping out decks, which as we know, is what most investment bankers do
• You can do the sums to work out the management fee income to work out if they’re running on fumes or flush with cash; there’s a lot to be said for frugality, but it can be downright dispiriting having to pay for your own gas to drive out to investees (trust me, it happens, especially in single-owner firms)
• Above all, you need to be inspired by the people you work with and you need to feel that you’re a part of something big; great teams will make 90-hour weeks enjoyable, and uninspiring teams will make 35-hour weeks painful

Hierarchy

• You operate much more autonomously at smaller firms and get experience across a wide range of domains; this is implicit in having fewer people and working on smaller deals
• At larger firms, you’re more likely to have a set of duties that complement the overall team
• If you pick the right mid-market firm, you can grow very quickly, simply by having complete autonomy to close deals, manage investees and effect exits; you’ll never enter a mega-sized fund as a junior with this level of autonomy
• With that said, you’ll quickly feel under-compensated if you’re closing all the deals as a junior and being paid a janitor’s salary; you need a different mindset regarding compensation and duties going into larger vs. smaller firms

Clearly my experience with mega vs. mid-market firms is limited to a sample that’s nowhere near the entire population of private equity firms. So I’d be interested to hear thoughts, disagreements, questions, etc.

Then four, five or six months later, it all slows down. Now, you’re essentially one of ‘them’… and they don’t seem like geniuses anymore. In psych-speak, you’ve hit a learning plateau. You’ve learnt 80% of what there is to learn (at that particular firm) and you’ve realised these geniuses are just like everyone else; they only seemed like geniuses because they knew something unique.

With sports, music, and other discrete skills, smashing through the learning plateau separates the hobbyists from the champions. But entrepreneurship isn’t a discrete skill; it’s a collection of many discrete skills. And from my observations, entrepreneurs are rarely specialists; they become masters of many domains, even if originally they specialised in one. So, what does this mean?

The significance is as follows: The effort to move from 80% to 85% competence for a particular skill, could reasonably get you from 0% to 80% in a new skill. So, especially for an entrepreneur, it can be much more fruitful to string learning curves together (compared to smashing through a plateau). This would suggest you’d learn much more by joining new companies every 6 to 12 months, unless your environment (at the same firm) is constantly changing.

This won’t be a particularly popular view, but technically I think it has merit. Sure the process of becoming an expert is educational in itself, but that last 20% of competency is so easily lost once you change focus (and it requires so much more effort), that for future entrepreneurship, it rarely paves the road to success.

Consider your exit as the day you can do anything you want: create startups, invest in other businesses, join boards of listed companies, or travel the globe. In order to apply private equity principles to achieve a better ‘personal exit’, you must learn to want less (and like it). This sounds like compromising, but it isn’t. As in private equity, keeping your mind on the exit helps you to see the real value (approximately none) of instant gratification. This is the characteristic that creates successful entrepreneurs, investors or even Olympians.

This concept of deconstructing a problem with a firm view on the exit or desired outcome isn’t new. Tim Ferriss talks about it incessantly and shows some very interesting real world examples (see his TED talk). And while you may see this as just self-help nonsense, consider that it’s built an enduring multi-billion dollar industry (the private equity industry, not the self-help book industry).