Category Archives: Articles

21Aug/17

Why Does a Savvy Public Stock Fund Manager Choose Private Equity?

I have encountered a wide range of investors over my 25 years in the investment management industry. While they often differed in their investment philosophies, time horizons, and risk preferences, they agreed on the importance of diversification, transparency and growth when investing for the long term.

From a public investing standpoint, the goals of diversification and transparency can be relatively easy. The investments are typically in publicly traded equities with daily pricing. I was an investment manager of a fund focused on public growth equities, where the primary objective was capital appreciation. The fund provided transparency and liquidity while generating significant capital appreciation over a long term time horizon.

I utilize the same philosophy in my personal investing. Hence, the traditional “blind pool” private equity funds held little allure to me, as I often didn’t know what I was investing in, the potential return and the specific time horizon.

However, one of the major trends in private equity today is that more individual investors are eschewing the traditional “blind pool” funds, and are engaging in direct investment in Private Equity deals. As a direct investor in several private equity transactions as well as a career money manager in a public equity fund, it is interesting to note that the advantages of the direct investment model in Private Equity can mirror some of the advantages of investing in public stocks as highlighted below:

  1. Better control over each investment

Unlike the committed funds, where individuals are bound to participate in all investments of the fund, irrespective of the risk profile and personal choice, direct investing allows the investors to understand each investment on its own merits. Thus, they are able to invest a higher or lower dollar amount depending on their knowledge of the industry, risk profile of the particular transaction, and their personal capital management.  This allows investors like me to be in control of the decisions such as; a) Where to invest (specific company) and b) What to invest (debt/equity).

  1. Diversification

Committed funds often choose to invest in a particular industry, geography or size. While that may work for some investors, it may not work for others who may be looking to invest a limited amount of capital across a wide range of criteria.

Conversely, a direct investment allows the investors to choose and invest based on the sector, business life cycle (growth, acquisitive, mature, etc.), and capital needs (growth, turnaround, acquisitions and/or financial restructuring), balancing the current risk and return of their portfolio.

I have found this to be particularly helpful as it encourages me to take a deeper look into a variety of industries and sectors, encouraging a more thoughtful approach to my overall investment portfolio.

  1. Current income and future growth

As mentioned earlier, individuals can invest in various levels of the capital structure thus providing for capital appreciation (equity) and/or current income (interest/dividends). The flexibility in investment structures with both debt and equity components provides another method of diversifying one’s investment portfolio.

 

All the above also leads to greater transparency since the individual investor has a lot more say over how and where their money is invested.

Important aspects of direct investing include trust, competency of the financial sponsor, and the ability to communicate regularly and honestly. The sponsor needs to identify appropriate investments and be clear about what would make the investment successful as well as what could go wrong. Regular, periodic communication is key to ensure that the investors are aware of how the investment is performing – during both positive and challenging periods.

As an investor in several transactions of Cave Creek Capital Management (CCCM), I find that well-structured and competent managers like Cave Creek Capital Management, work hard through active involvement on the Board and provide additional support through sales introductions, team augmentations, business planning as well as other skills to grow an investment and mitigate potential losses early. They also provide me with regular updates on all my investments so I stay informed. The team at CCCM is always available to answer questions.

Ideally, a direct investor should be very familiar with the investment manager over an extended time period before investing. I’ve known Kevin Fechtmeyer and CCCM for several years, and the average investor in his group has been investing with CCCM for over 15 years. This is vital to proving a track record of performance and communication, which gives me greater comfort in my investment decisions.

Meighan Harahan has more than 25 years experience in the investment management industry. Ms. Harahan managed the Driehaus Mid Cap Growth Strategy with over $1 billion in assets generating a top 1% rating among peers over a 10 year period. Driehaus Capital Management, LLC, an institutional investment management boutique in Chicago, Illinois focused on small and mid capitalization growth companies utilizing fundamental and technical analysis.

The views expressed are personal. As told to Vibhuti Nayar

 

28Jul/14

Is Private Equity Losing its Taste for Risk?

RiskimgPrivate Equity managers aren’t paid to be patient, they are paid to put money to work and they’ve never had more of it. With over $1 trillion of committed capital coming into 2014, you would think that risk taking would accelerate, but several factors seem to be pushing the industry in a surprising direction; away from risk.

Surplus Capital is driving valuations higher and returns lower

Valuations are approaching record levels for the first time since 2007 and rumor has it that projected equity returns are in the “mid-teens” for large, leveraged buyouts. This means that the average equity investment is projected to return 2 times their principal in 5 years (before any losses or expenses). That’s better than public equity returns but leaves little room for error.

Debt markets are frothy again

Valuations are being levitated by the abundance of debt financing available. Leverage multiples are now exceeding 5X ebitda, on average. This is ok if interest rates stay at historic lows but it can lead to intoxicating overconfidence on a dealmaker’s perceived risk profile. One General Partner at a major fund told us that he was fine going over 5X leverage on a $1 billion buyout. He paid more than 10X ebitda and hence the deal was “under 50% debt to total capitalization”. That seems like cold comfort since a higher level of debt heightens the risk to both the debt and equity holders, regardless of valuation.

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The cost of an investment mistake grows exponentially

Higher valuations and leverage magnify the impact of small changes in a deal, such as higher capital spending, loss of a customer, a rise in interest rates or multiple contraction upon exit. One or a combination of small changes in each of these can quickly crush the equity in a deal.

A single busted deal can put the “next fund” and its fees in jeopardy

If successful deals are projected to return about 15%, you can’t afford a hiccup. A loss on one or two deals in a portfolio can quickly bring the average return down close to or below the fund’s hurdle rate (generally 6-8%) and decimate the value of the GP’s carried interest. At current valuations, the likelihood of a large return from one deal (eg. 5X to 10X) to offset losses in the portfolio is greatly diminished. General Partners in large funds often make more in management fees than they do in carry. Hence, they are forced into “playing defense” in a low return environment; protecting that stream of management fees can become a dominant factor in deal selection, pricing and management.

All of these factors dampen a Company’s risk appetite

Historically, private companies were able to operate outside the spotlight of the public market and act more aggressively to pounce on opportunities. At today’s valuation and structures, the cost of increased R&D, acquisitions or expanding a sales force can become much more risky to fund. Large leveraged buyouts at high valuations can actually make management more risk averse. When banks have a say in funding these unexpected “opportunities”, covenant changes can be costly.

What does this mean for Entrepreneurs? Higher valuations and more choices sound like good news for Entrepreneurs but they need to do more careful homework on potential partners. Here’s what they need to know:

Funds will gravitate toward larger, more stable businesses with less risk but less upside where they can put more money to work. The private equity industry is now dominated by larger funds that prefer to “pay up for quality”. This implies investing at a higher valuation in a larger, more established business with steadier cash flows. This results in a lower, but more reliable investment return with less risk of loss. Higher risk deals for more volatile companies may need bigger discounts in valuation or have a harder time getting done.

Private Equity firms may become more bureaucratic

Success in Private Equity seems to result in bigger and bigger funds. The industry has grown over 1000% in the last 20 years and fund sizes have multiplied. Cultural change is inevitable when companies employ hundreds (instead of tens) of people. While Private Equity continues to attract the “best and brightest” people, they have added more layers and, hence, more uncertainty and complexity in their investment process. Larger organizations tend to be less entrepreneurial and slower moving. They tend to become more inward-focused; towards organizational survival, and less flexible for entrepreneurial CEO’s.

Private Equity could start to look more like the high yield debt market

The “debtification” of the private equity market represents a shift of emphasis towards return of capital rather than multiplication of capital. As Private Equity returns converge with high yield debt, they will favor terms that mitigate and shift risk to the Entrepreneur and founding shareholders who may get less value from a capital partner who is not as aligned with their interests.

Smaller funds will be more effective in the lower middle market

Large Cap funds will be replaced in the lower middle market by smaller funds, spinoffs and independent sponsors, who will be more eager to pursue investments under $10-20 million and allocate time and energy towards their success. Entrepreneurs will be better off avoiding large, “brand name” funds and focus on smaller funds that can give Entrepreneurs what they need most; attention from senior partners.

Cheap capital may not always be a good thing for Entrepreneurs

Lower returns can be indicative of a more efficient capital market which lowers costs and benefits everyone. However, it should also expand companies’ financing options, improve transparency and lower transaction costs which does not seem to be happening. Financing options for Entrepreneurs will become more perilous as funds chase returns lower but structure more onerous downside protection- something akin to offering “teaser rates” to borrowers. You may have to read the fine print to know what you’ve really got in a deal.

Potential Value of Management Options will Decrease

In deals of equal size, management options will be worth 63% less over five years at a 15% IRR versus a 30% IRR. Hence, management may need more equity or become more focused on current cash compensation and less on long term capital gains.

Bottom Line

As Private Equity evolves into a large, institutionalized asset management industry, its success seems to be causing a shift away from its original constituency; smaller, privately-owned businesses that need support and guidance to achieve the next level of success. The economics of larger fund sizes and deals and, hence, fee income to GP’s are just too compelling to ignore. When funds chase bigger deals at reduced IRR’s, they become focused on return of principal, less able and willing to pursue riskier growth strategies and, structurally, more dependent on management fee income vs. carry as a percent of the overall professionals’ compensation. The additional layers of people needed to manage the larger infrastructure can also dilute the talent and attention to the portfolio companies.

Entrepreneurs have a bigger selection of potential partners than ever but a far more complex selection process. Smaller investment firms with a highly engaged senior team who get most of their compensation from capital gains may be harder to find but offer a significantly stronger value proposition as capital partners.

Transparent Capitalism


Why Independent Sponsors Can Be A Better Way To Invest in Private Equity

Transparent CapitalismimgIndependent Sponsors are rapidly penetrating the Private Equity market and are now involved in nearly half of all middle market transactions.  These groups invest in each deal individually,rather than through ten year committed funds (affectionately known as “blind pools”).  As this trend accelerates, it is also helping high net worth investors (“Investors” with >$1MM of investable assets) access and fund deals where they can earn better returns with more control over deal selection, less risk of delayed liquidity, fewer fees and more transparency.  These are not high flying, venture capital “club deals” with lottery style risk and return; these are generally established, profitable middle market companies which are managed through trusted relationships, distribute current income and provide investors with timely access to a company’s detailed information.  This “Transparent Capitalism” is yielding enormous advantages for Investors; they can make their own decision about each deal and pick the ones which coincide with their interests and values and which are better timed and sized to their liquidity. Deal quality is self policing as each investment must stand on its own merits and Independent Sponsors are under no required timetable to invest uncommitted funds.

Independent Sponsors are not tied to a single funding source and can select Investors who offer more than just money.  The best ones often focus their fundraising efforts on Investors who can add value through their expertise, background and relationships. Investors can be more than passive bystanders; they can serve as consultants, board members or just interested parties on the lookout for new customers or key hires.  Their questions, insights and involvement can actually aid in the due diligence process and improve investment outcomes over time.  They are the opposite of “dumb money”.  In Transparent Capitalism, Investors become engaged, informed and focused on a smaller number of deals rather than participants in widely diversified, passive investment portfolios managed or selected by third parties.  Transparent Capitalism also enables a virtuous cycle.  Investors can use these networks to share in deal referrals with other like-minded groups to gain access to a larger number of higher quality transactions than they could otherwise find and invest in individually.

TransparentCapitalismSubtitle

Investors in the public markets face a sobering prospect of lower returns as interest rates have plummeted, earnings growth has slowed and stock performance has declined over the last decade.  They would gladly trade some short term liquidity in return for access to Private Equity opportunities yielding double digit annual returns, but most Investors have little ability to indentify or underwrite these investments on their own.  The majority of large Private Equity funds (often sold to individuals through brokers with a high fee structure) require a 10+ year commitment before you even know the identity, valuation, timing and structure of the investments.  Furthermore, the surplus of capital in the large buyout market has depressed the returns of these large funds which, on average have underperformed the returns of the lower middle market funds.  Hence, the growth of Independent Sponsor networks is creating a much needed realignment of investment opportunities by combining an Investor’s capital with his or her expertise and network of relationships.

Investors historically invested the large majority of their assets in the stock and bond markets and only a small percentage of their assets (“fun money”) went to private deals that were perceived as high risk but high reward for those that worked out well.  However, these deals often created adverse selection risk by focusing on earlier stage investments (or, my favorite, speculative real estate).  Generally, the further away from the Sponsor’s personal network or industry they went to seek funding, the more likely the deal’s risk/return characteristics were mismatched or exorbitantly favored the insiders.  Independent Sponsors in established, profitable middle market companies, putting their personal capital to work alongside Investors, mitigate the risk of adverse selection and provide an important investment discipline.

The advent of Transparent Capitalism is turning traditional investing upside down.  Investors can take matters in their own hands and invest a much larger portion of their assets in fewer companies where they can leverage their industry knowledge and relationships.  Capital has become cheap and oversupplied in most capital markets and Investors have come to accept capital preservation as a more modest and realistic goal for their institutionally managed money.  Investors are realizing that their future wealth will be created by their own business or from private investments coming out of their own network.  Independent Sponsors enable Investors to pick their own deals within a trusted network and favor investment structures that mitigate risk.  Investors sacrifice liquidity but gain access and influence with their Sponsor or Management team.  These investments often yield current income, improving liquidity and providing Investors with some financial cushion in a distressed economic environment.

Individual investing in private companies is not a new concept.  The Independent Sponsor model in Private Equity is just another step in the ongoing financial disintermediation of personal investments from the institutional model; improving transparency and efficiency and leveraging the growth in information technology, a form of social networking with financial objectives.  Transparent Capitalism mimics the benefits of the merchant banking model of the 1800’s by ensuring that investors’ interests are closely aligned (ie. Everyone is writing a check and has money at risk).  The model takes advantage of trusted networks that need to maintain each party’s reputational status.  By pooling talent and capital, Investors’ ongoing business relationships and investment results are strengthened, generating transcendent franchise/network value.  Importantly, Transparent Capitalism can function as an evergreen source of investment opportunities and funding for the Investor network, with proper incentives for all parties’ active involvement towards a successful investment result.

09Dec/12

An Executive’s Perspective on Private Equity


Mark Harshbarger, former CFO and COO of Philosophy, talks to us about his experience helping build one of the most successful cosmetic companies in the USA
K: Mark, thanks for coming in.

M: You’re welcome!

K: For the benefit of our CEOs, we want to showcase the success that you’ve had with Philosophy and talk about the lessons you learned. So why don’t you start by telling us about your role with the company.

M: I worked at Philosophy for a little over ten years. I held several positions, but for most of the time I was both the CFO and the COO. The founder was basically the visionary and the leader of the firm but in terms of executing the day to day operations, that was me.

K: What was the biggest hurdle you faced in growing Philosophy?

M:  Philosophy was an exciting company to work for. It had a very small revenue base when I joined and it grew to be a very nice sized organization when we sold. And it was growing rapidly so it did have many challenges. The biggest  was how to maintain the sales growth but not grow beyond our capacity to serve the customer and the consumer. You only have one chance to make a good first impression and since we were growing so fast we had a lot of first impressions and I wanted them to be solid, good, and lasting.

K: At what level of sales did that hurdle start to become apparent?  20 million, 50 million, 100 million?

M: We started to have serious growth pains right around the $30 million range.  When we were at the $10 to $20 million level, we were fine. But when we went from $30 to $60, $90, and $120 million we started to face many challenges, particularly because  we were making those jumps on an annual basis and also the fact that we were manufacturing 90% of our product.

I would recommend to anyone growing a business that you have to understand what your strengths are, what your weaknesses are and let your ego stay at the door…if there’s a weakness, go get help and don’t hold back.
K: How did you choose people to hire and promote?

M: That’s an interesting question because at the time when we started or when I came on we were a small enough company we did not have the ability to go hire the “big talent” out of a major city. So what I looked for, especially given the culture that we tried to nurture at Philosophy, were individuals who fit that  culture. There was the question of, “Did they have good teamwork and good chemistry”?  It was almost like a sports team because if you have a bunch of stars that don’t play the same play, you are going to lose.  I wasn’t worried about having a lineup of stars, I was more worried about having a team of winners.

K: So how did you determine if a candidate was  a good fit?

M: I listened for a variety of key phrases and words were indicative of where they were coming from: integrity, loyalty, family, respect. There were about eight or nine of them in total.  In an interview I would explore those types of characteristics because I wanted to make sure that you, as an employee, weren’t worried about your career number one or your department number one. Then you weren’t going to be a member of the team. Glory couldn’t be to you. The question was, “Could you focus on the growth of Philosophy and work as part of the team”?

K:  How big was Philosophy in sales and employees when you sold?

M:  When we sold we were approaching the $150 million range and 300-400 employees. Since we manufactured our product, the actual number could range from season to season depending on the number of temp employees that we had at the time.

K: When did you know it was time to sell?

M: It was easier for me to ascertain when it was not time to sell. Philosophy was growing and was a niche brand and for years there were a lot of people that wanted to get in and buy it from us. I knew from a valuation standpoint that we were growing at such a fast pace that our profits were going to grow faster in the years to come. Even though I had faith in that, I had doubts that we could effectively communicate that to outside buyers and to get the true multiple of future earnings that we wanted. So I knew when we shouldn’t sell.  When we were in the $60-$90 million range, it was too soon. We were just starting to leverage our overhead and our ability to grow profits. Our revenues were growing at a very fast rate and on the margin; your EBIT is going to grow a lot faster. Now in terms of deciding when to sell, I intuitively knew when to sell based on my abilities, the company’s abilities, and the staff’s. You get to a point where you’ve almost outgrown your organization with the staff you have and it‘s time to go out and get outside help. We had reached a point where it was time to say that we’ve taken this about as far as we can go, let’s get some outside help that can help us take this to the next level.

K: With the parade of private equity firms coming in how did they differentiate themselves and why did some of them do better than others in that process?

M: Well it’s interesting when I look back at the private equity firms. Ones that struck a chord with me were similar to the types of employees that we hired. Since we were going to sell the entire organization, we viewed them almost as a future employee and really sought out team players. I wanted a team that could fit into our culture, fit into our work style, and there definitely was a difference between many of the firms.  Ones that had the attitude, “Okay, we’ve arrived and we’re taking over,” I wasn’t interested in. But the ones that said, “We like what you have going on here and we want to partner with the strengths that you have and offer the strengths that we have and make the company a better company moving forward,” that was very interesting to me.

K: Any big mistakes that turned you off from some of them?

M: The ones that would turn us off were the ones that would come in and appeared too overly confident or even arrogant. I’m not an arrogant person. I know that I have my own strengths and weaknesses, but I know anyone else coming in the door has their strengths and weaknesses too. So, I just felt it was a mistake when they came in and assumed they were “the gift to the world.” And it doesn’t mean that is always bad thing. It’s just my personal opinion that I find it to be very difficult to partner, move forward,  and grow the company with those types of personalities.

K: Looking back now, would you do anything differently over those 10 years?

M: I tend not to be a person that worries about mistakes or things that you did wrong because I find that to be counterproductive. When things don’t happen properly, I tend to focus more on what can you learn from that opportunity and don’t beat yourself up for the past. One of the things that I would have done differently is I would have focused on international growth.  I’m not going to beat myself up for it, but I think we missed the ball on developing the brand internationally.

K: Are there any other lessons that you took away from the experience?

M: I would recommend to anyone growing a business that you have to understand what your strengths are, what your weaknesses are and let your ego stay at the door. You have to understand what you’re good at and what you’re not good at and go get outside help. The goal shouldn’t be your own ego, the goal should be growing your organization as fast as you can from a revenue standpoint, cultural standpoint, social standpoint,  and a  profit standpoint, and if there’s a weakness, go get help and don’t hold back.

K: Thank you very much.

M: Great, thank you for the opportunity.

10Sep/12

7 Questions Every CEO Should Ask

You may have been wondering about private equity. But is it right for your company?

 

When should I look for private equity?

If your company is at a turning point, chances are you should be looking into private equity. Often it’s because you are growing faster than the bank can fund, a new acquisition opportunity becomes available, or you or your partners need some meaningful liquidity for retirement or estate planning purposes. It is best if you are always looking ahead at least a year or two and don’t wait for an issue to erupt to start looking for financing alternatives. Companies that aren’t doing this can easily grow beyond their management infrastructure, get stretched operationally and then “plateau” or even decline. Owners are then faced with the decision to either sell outright or seek capital in a rushed timetable. The right investment partner can help you meet personal financial goals as well as finance an improved competitive position, attract management talent, and build a stronger balance sheet.

What do I need to get ready?

The quality of your financial records is a major investment criteria so it’s important that you have audited or reviewed statements for the last few years. In addition, you are going to need a business plan detailing your company’s products, customers, management, and also showing a good understanding of your market and competitors. Most business plans also outline the financial projections and the underlying assumptions over a three to five year horizon. Since most middle market companies have limited resources to produce these items, outside resources are often brought in to assist and this process can take more time than owners expect.

Should I use an investment banker?

The right one can be helpful and the wrong one can be worse than useless. Most business owners utilize a wide range of advisors, including lawyers, accountants, consultants, as well as investment bankers to assist in a potential transaction. Investment bankers can be instrumental in leveraging your time by managing an offering process. They can give you an objective assessment of value and structure. To maximize price, investments bankers sometimes run an auction with a large universe of potential buyers. While this process may result in maximizing the price, it can also take more time to accomplish and carry some risk. Many companies have also had success in initiating a limited dialogue directly with one or more likely investors, allowing them to maintain strict confidentiality while “testing the market” on pricing and terms. Sometimes this can quickly lead to an agreement or, at least, provide owners with fresh ideas.

A word of caution should you choose to utilize an investment banker: prior to engagement, verify that your advisor has a referenceable track record in the industry and type of transaction contemplated. Advisors can often pitch deals without relevant credentials, which may end up damaging your company’s prospects and put any transaction at risk.

 

Do I have to give up control?

No, contrary to the fears of many owners, change of control is not required. Most investors will expect to participate on a Board of Directors with qualified processionals  including management. Investors will expect some degree of influence on the Board depending on their level of ownership but major decisions are typically by consensus. The level of investor influence depends upon the investment structure, ownership, amount of capital, and the needs of your business. Each private equity firm has differing requirements, which makes finding a cultural fit vital when selecting a private capital partner.

How do I make sure I pick the right partner?

Communication is critical when you are selecting your partner. Before signing a term sheet, make sure you have had several conversations with your prospective partner to align expectations. The investment timeframe, financial projections, Board composition, and Management compensation including bonus and option plans are all topics that should be well understood and agreed upon by both parties. Thoroughly vetting these topics early on will not only minimize future issues, but it will also give you insight about your potential investors. As the discussions unfold, your instincts will generally guide you to the right choice. Consult with the investor’s references to get a sense of their style and culture. Also, don’t be afraid to ask for references on companies that have failed or struggled to perform in order to give you insight on how the investors will behave in difficult situations.

What strings are attached to a private equity investment?

Generally, investors will have one or more seats on the Board and must be consulted on major decisions, such as a sale or merger.  As a practical matter, management runs the company’s operations and the Board provides strategic oversight. Most decisions thereafter are discussed in a small group at the Board level and are almost always by consensus. The Board of Directors usually convenes quarterly to review the status of the company and any major decisions.  Financial reporting is required monthly, quarterly, and annually to keep all parties informed of status of the company and its progress towards its budget and strategic goals.

What benefits/value should I expect after closing?

A good private equity partner should bring real value to the Board. With experience and insight in your industry, they are a good sounding board for new ideas and offer a fresh perspective on key decisions. Since they share in the investment returns in your company, they are committed to bringing their capital, talent, and network to augment growth. A good partner can provide a wide network of contacts to source M&A prospects, key executive hires, or new customer introductions. A high quality private equity firm will also have a track record with lenders which can substantially improve the pricing and terms of bank debt to finance a company’s working capital growth.