Nuances of a Private Equity Strategy
Private equity and various forms of investment management have become the en vogue form of financing. Twenty years ago, it was investment banking, but now private equity has become the de facto, most elite form of financing—at least from a reputational and PR perspective.
Private equity has gone through different phases of growth. A big part of their focus was saying, “You’re a conglomerate, and you’re not able to extract the maximum value from this because you have multiple conflicting demands on your capital and management time. So, why don’t we buy this from you? We’ll pay you a bigger premium than you would get if you managed this business by yourself. We believe that with the right kind of focus, we can create a lot of value, and we’ll make a return so everyone’s happy.”
As private equity firms grew and started piling in funding from institutional shareholders, instead of just going after divisions of big companies, they started going after entire companies. But there are only so many big companies and divisions you can acquire in established Western markets. Then private equity firms started moving outside the US. In the latest shift, they have moved into Japan, where they’re expecting that COVID and the digitization of the Japanese economy will force Japanese conglomerates to pick and choose where to compete. That may happen, and it may not happen. It’s not the first time private equity firms may have chosen to make a bet in a market and have mistimed the bet, but those are standard investment risks that many investors would take.
The holy grail of private equity that nobody wants to touch because it’s such a contentious topic is taking over state-owned enterprises and taking them public. Few private equity executives even want to think about it because it’s difficult to buy a crown jewel of a country with so much emotional attachment. There are also strict labor laws, so any of the tough cost cutting and decision making that a private equity firm can traditionally make is constrained. It’s a pity because there’s a lot of value to be created in terms of the universe of potential juicy assets—whether you’re buying the entire enterprise or a portion of the enterprise. But of course, there needs to be a compact between the government and the private equity firm so the necessary changes can take shape.
There are many trends in private equity. The Financial Times had an article about how the towers that distribute signals for cell phone companies are being spun off to private equity players who believe there’s a market for consolidating them. Through consolidation, they’ll get efficiencies, better bargaining power, and they can raise the value and exit them either through an IPO or by selling them to someone else.
Over the years, FIRMSconsulting has changed to become a private equity firm. We have a lot of clients who come to us and ask for help. We have a lot of clients who are very successful in business and have access to funding from the Middle East, China, and so on. The insight is that you need to have a distinguished private equity strategy. Just saying you’re going to be a private equity firm and raise a lot of cash doesn’t mean you’ll be successful.
For example, let’s talk about buying towers from telco companies. A few private equity firms have gone this route, so other private equity firms have decided to do it too. When you’re pursuing a valid trend in the market, the fact that it’s validated means many other people agree with you. If many other private equity firms agree with you, you have a bidding war. Being involved in a bidding war means you’re going to overpay. The more topical a trend is in private equity, the more you’re going to overpay. You need to think about how to extract the value from the asset because you’re overpaying by default, which means you have a smaller margin for error.
The insight is that if you can see value in something that no one else sees, you bid for it, and you’re able to extract that value, you will underpay, and there probably won’t be any competitors for that asset. So, when you put it on the market later, you can get the highest value. You need to think like a strategist here. Ask yourself: “How do I create value from an asset that nobody else sees any value in?” That’s not corporate finance work. That’s pure strategy: finding value where no-one sees value and pulling it out.
For FIRMSconsulting SLIDES members, we have an update coming out this year that will show you how to analyze a dying sector. We’re going to show you that it doesn’t matter what the market says or what the press spins. If there’s a market, it won’t disappear overnight. Even if the market disappears, the strongest players may survive. Even if the market disappears in 20-60 years, a lot of money can be made in that time horizon. But how do you find value in a sector where there is apparently no value? It’s easy to build a private equity strategy when you’re looking for value and when everyone thinks there’s value. While you may find the value, the cost of finding it is so high that the value that you return to yourself is incrementally lower. If you can find value in a sector where there’s supposedly no value, there’s no competition for the asset, and you don’t have to overbid, you will be in a strong position.
SLIDES members can see how we analyze all of this. How do we choose which assets to keep? How do we analyze those assets? What do we prioritize once we acquire this asset?
A lot of people think private equity is all about the cash flow modeling. But a model isn’t that smart—it depends on what you tell the model to do, and that’s based on how you understand values created in the sector.
We spoke about how if you pursue a trend in private equity, such as the consolidation of telco towers, you’re going to face competition from other private equity firms, which will bid up the price and reduce the return you can create once you eventually go public. But there is another problem you will face. If you’re in a sector that’s automatically growing and people see it as a strong vehicle for value creation in the future, you don’t just have to worry about other private equity firms, you’re also in a race with very educated executives in the target company. You have to acquire the assets before they make changes because after they make the changes, they’re going to price in the improvement they made into the sales price, which again means you have to overpay.
A while ago, we had a program where we took 10 clients and placed them in private equity firms. We placed 9 out of 10 and decided not to work with the 10th client for ethics reasons and released them from the program. For those 9 clients, we didn’t focus on their modeling capabilities. One of the biggest challenges I had with these clients was that they all told me they needed to learn how to leverage buyout models and cash flow models. I told them it was a basic skill, and I didn’t want to teach them that because they could have learned it from an Excel model or YouTube. I wanted to teach them how to decide what to model and how to decide where the value lies.
What makes you a principal in a fund where you share in the profits is whether you can find value so that when the private equity firm invests in your idea, they earn a return. So, how do you think about that? It’s about a deep understanding of strategy and how value is created.
While you’re thinking about private equity, whether you run a private equity firm, or you’re a strategy person trying to set up a private equity shop, or you have a lot of funding, remember that it means very little unless you know how to create value. But to create value, you first have to understand where value lies, and that’s purely a strategy skill.
This is an excerpt from Monday Morning 8 a.m. newsletter, issue #12.