The New Era of Private Equity

We saw, and it's the reason that we created Epic and the scalable company and our scale and exit advisory consultancy, that the opportunity and the advantage, where you could actually have an advantage, was no longer on, "Oh, look at me, I could raise the most money," because guess what? Everybody had a ton of money. Or, "Oh, look at me, we've got the best analysts, and we've got the most access to debt and other types of leverage liquidity. Everybody had that." People, when the second thing went away, and when the first thing was just table stakes, "Well, that's no longer your advantage. What's the only real advantage left as a business? Let's kick it old-school. What if we just figure out how to grow this thing, the good old-fashioned way, which is almost only never on a spreadsheet?" Hey, everybody. Welcome to another episode of Business Lunch with your hosts, Ryan Dice, and me, Roland Frazier. And recently came across an article that was talking about how private equity has a new set of rising stars, and it is evolving into private equity 3.0. And the thesis behind the article was that originally, back in the day, private equity came in and said, "We're going to do financial engineering. We're just going to go in, get your business. You guys don't know that much about finance. So we're going to play with that. They did it. Great returns, and more and more and more people came into private equity, which made it harder to do just that kind of engineering. So they went to private equity 2.0, which was really focused about on acquisitions. So how can we acquire companies and just scale up through roll ups, so where you saw a lot of private equity rolling into brick and mortar businesses like HVAC and plumbing and things like that, like tritions. And that was kind of private equity 2.0. And now they're saying that there was an evolution to 2.5, I don't remember what their argument was there, but it wasn't a significant enough upgrade for it to be a full version. So the 3.0 is that the new stars, and this is shocking and revolutionary, are the operators that you bring in to run the businesses efficiently. The people that actually grow it? So the big innovation in private equity is maybe instead of just financially engineering this thing, or maybe instead of just doing leverage buyouts, maybe instead of just juicing it with a bunch of cash so that it can just do a bunch of acquisitions and aren't synergistic because we would like for them to be, what if and hear me out, we just try to grow the companies that we buy? Yeah, that's the breaker. That's it. Brilliant. So the focus is on new rising star is rather than the jet setting, hedge fund, the investment banker types that are the quants, that are doing all the financial engineering, which is fallen to about, I think, between 18 and 21% of the value that gets added because these guys, the challenges, you have tens of thousands now of private equity funds with trillions of dollars that are trying to find deals, and the deals that they're finding, particularly with higher interest rates and inflation and uncertain economy around the elections and a drying up of government funds and increased valuations because of increased competition. Like you said, they're just being so dang many of these things, they're having to overbid it. For that, but even more difficult for them is that if they just, like if they go in when they can borrow debt at 3%, or 5%, then it's very easy for them to make their money with financial engineering and borrowing a lot of money not only to acquire the company, but also to acquire other companies. But when debt becomes significantly more expensive, which it has, then that primary thing that they've been using to fund all of this has at least doubled in cost, and so what that results in is we can't do nearly as many deals because they just don't have the margins or the metrics for us to be able to do it. We can't just go in and it's good, now all we have to do is acquire. It is, it's now my goodness, we've got to go in and support this debt that's twice what it used to be, plus the debt service, plus we need to have enough extra money to be able to do this other stuff too. So we need this company to actually grow. We need the margins to actually improve, and so the new stars are the operators who are now responsible for a, I think it's about two to three times the percentage of growth that gets realized by the firm or growth in value that gets realized by the firms is coming from these operators. So now they are becoming more of the stars of the show, which means there's going to be a greater need for good operating systems, that's good for us, that's scalable, to be put into these companies that are being acquired, and operators who know how to grow, who know how to actually manage a business and identify the KPIs, and there's always a shortage of those. So look at, I can't remember the names, it's like it's like maybe Coletti or something like that, the guy that was the CEO of Pepsi brands Taco Bell, and then got promote, then left, and this was the CEO for several years for Chipotle, and now has just been hired on a hundred and thirteen million dollar contract to be the CEO of Starbucks, right? Ten million dollar signing bonus, 75 million in stock as an equity grant and all kinds of other stuff, this kind of insane compensation package that he has, in addition to a million and six or a million eight salary plus bonuses that could take that to three million, he's going to do okay, but here's the deal, they need him, right? And these operators are only going to be more and more valuable, so if I was ever looking for a place to focus my attentions if I was in the working world and not in the investor world these days, it would be, I'm going to go and up my operating skills game so that I can be the person who runs these businesses and get my increased compensation from all these private equity funds that are trying desperately to find good operators that know how to grow and manage a business. So huge opportunity, and for people who own regular businesses that are looking to exit, this is something that's going to be a huge, huge, huge additional plus for you. If you've got a solid ops team, then private equity is going to look at that and say this is a team that we can actually maybe use as our platform team, not a platform company anymore, but our platform team to help grow this and other businesses. So lots and lots to me to take away from what's going on there. Yeah, and it's incredibly validating because you and I saw this coming because we were living on both sides, both dealing with private equity from the sales side, but also competing with them at times on the acquisition side, and seeing it was becoming basically impossible to spreadsheet your way to a good exit, to a good liquidity, like it just wasn't there anymore. And so we saw, and it's the reason that we created Epic and the scalable company and our scale and exit advisory consultancy, that the opportunity and the advantage, like where you could actually have an advantage, was no longer on, ooh, look at me, I could raise the most money. Because guess what? Or, ooh, look at me. You know, we've got the best analysts and we've got the most access to debt and other types of, you know, leverage liquidity. Everybody had that. Well, when the second thing went away, and when the first thing was just table stakes, well, that's no longer your advantage, so what's the only real advantage left as a business? Let's kick it old school. What if we just figure out how to grow this thing, the good old fashioned way, which is almost only never on a spreadsheet? So I think it'd be fun to kind of talk about that side of the equation and like what good operators do that's different. But just for context, I think a lot of people may not understand when we talk about financial engineering. Can you give an example of, in the olden days, back like whether it's like 1.0 or 2.0, some combination, what would private equity companies look to do? Can you kind of give an example, like a prototypical example of a financial engineered business? The classic one would be if you ever saw the movie Pretty Woman, what Richard Gears character did there, which was he would go in and buy companies that had assets that were greater than the market was valuing the company at the time. So the liquidation value of the company, either its assets or its sub-divisions, its companies within the company that it held would be worth more individually. than the sum of the parts all together. So if you went into a company and you buy a company that, let's say it's a scrapyard company and they own 15 scrapyards and they're vertically integrated so they have some other metal working and other things like that. And the public, let's say, values that company at $100 million. But just the equipment that's there and the land that it's on and the buildings that it has and the vehicles that it has, if you sold all of those off, the market value of that stuff is $200 million. So the financial engineering is let's go buy that company with debt that matures relatively quickly but our whole plan is that we're going to liquidate the whole thing anyway. So we go in then, we fire everybody that we don't need that was running the management part, which lowers expenses, increases profitability. We then list all of the separate assets for sale and sell them off one by one. And in the end, make, you know, double our investment relatively quickly. Let's say that it was 10% money even. You borrowed $100 million, you pay $10 million in interest to hold it for a year, you sell everything for $200 million net, you've got yourself $90 million in profit and they would just do that over and over and over until everybody else was like, wow, that seems really easy. It's not really great, by the way, for the people in the company, the individual companies themselves or the economy. But the original years character in pretty woman was not like set up and upheld is like, this is just a really good dude. Yeah. And again, it had a moral change of heart. Right. As a result, apparently all you have to do is data, data, call girl and then, you will, you will have a change of heart and become a better person. But he ended up deciding to rescue the, you know, the company that he was going to buy and tear apart instead of destroying it, which, which meant the end of his relationship with all of his greedy, you know, partners, which is the quality. So version 1.0 was not, let's build these things. We're bankers, you know, we know that the some of the parts is greater than the whole. So let's go in there. Let's buy the freaking thing with debt. Let's break it all up and let's sell it. We're not going to even attempt to operate this thing. That was kind of version 1.0. 2.0. So financial engineering wise is basically just, let's look at the numbers. Let's look at all the numbers of all the different scenarios, do the scenario analysis, which everyone yields the greatest internal rate of return. Let's do that. And who cares about anything else? All financial engineering, no care to operations at all. In fact, operations is actually probably going to go away because they're just going to sell it all. Well, it's all just a great expense, right? I mean, everything in operations is not seen as a value creator. It's simply looked at on the expense side of the equation. So 2.0 though, I feel like it shifted a bit because 2.0, at least from the outside, it was, we're going to build this thing, but we're still not going to build it through organic growth of the entity itself. Right. It's still not operations. Right. We're still not operating. Yeah. So break that down. How does it? So 2.0, we're talking roll-ups break down that scenario. Yeah. So roll-up is basically, we're going to go in, we're going to buy the company with debt that's relatively inexpensive. And now we own the company. How are we going to get it to grow really, really fast? It's our favorite way to grow business still, right? We're going to acquire other companies that are competitors of the company, Director Indirect, or we're going to vertically integrate, meaning we're going to buy our suppliers and our distributors or wholesalers. And then by buying those other companies, we will simply glom their revenue and profits onto ours. We'll use debt or stock from the company that we've got to acquire the other company. And then that company's additional profits will support this. And then when we've got this to a certain level, we'll take it public and we'll make a whole bunch of money there or we'll sell it to an even bigger company that wants it. So really, just growth by acquisition. So we still do that. Like that is still a strategy of ours. I don't want someone to give the perception that like 2.0 is dead or wrong or evil. I think 1.0, and that still happens to a certain extent, I would argue that's not an inherently entrepreneurial activity. You could argue 2.0 is an entrepreneurial activity, why the pivot? So what changed that made 2.0 not as effective anymore? And how would you characterize the traditional 2.0 to more like what we do and what this article was prompting? It's two things, I think, really. It's just straight out competition. The last time I looked, I want to say there were 68,000 private equity firms, right? And they had trillions of dollars. And then you've got Warren Buffett who's sitting on, I think, 275 billion in Apple that's sitting on, you know, crazy, crazy cash. And those companies are requires too. So you've got competition from family offices have come in and there are a lot of family offices. And so there's, they're more buy and hold, you were just looking, how can we get a good return on our money safely, capital preservation? Then you've got private equity, which is buying for financial reasons. And then you've got companies that have insane amounts of cash as well because the value of stocks have gone up so much and so they're able to issue stock and raise a lot of money. So you have all of this capital that is chasing fewer deals. And so let's look at auto repair centers. So the last time I looked, there was 109, I think, 1000 auto repair centers in the United States. Now if 50 private equity firms decide they're going after those, that's 50 cash wealthy companies that are going to be bidding against each other for a relatively finite group of companies. Let's say that any given time, 10% of those are acquirable. That means that there's 10,000 companies that can be bought by 50. And while that sounds like a lot, a lot of those companies are not going to qualify. They're not going to meet the acquisition criteria. So then you get into the companies they actually want to buy. It's a pretty small number of targets, even in a big market like that. They went to those markets because there were so many more of those than there were department stores. But that competition has driven up the price of the companies that are selling. Which means that it's going to cost more to get them and they're going to have to perform better to generate the returns that private equity wants. Now on top of that, you've got that debt, which was the primary tool for acquisition, has gotten crazy expensive, literally double what it used to cost just a couple of years ago. So higher prices to acquire because of competition supply and demand and higher acquisition costs because of the increased cost of debt, plus sluggish sales because these companies are suffering from in the economy, what all of the consumer confidence, you know, damage that's taken place because government free government money handouts are gone from the pandemic. Interest rates are up for consumer debt as well. And so consumers are pulling back even wealthy customers now are looking for to either pull back on their buying decisions or looking for substitute products that are less expensive that provide the same utility. So when you've got all that going, then let's go buy that company for an inflated price with inflated debt with scary future prospects because of consumer confidence and spending, how then do we find the extra money to use that as a platform to go acquire more companies by borrowing more money? It becomes hard to change because they don't have the money either and we know that. And so you may not even be able to if you've got debt and that debt has a clock on it and you're worried that normally you're if you could, I mean, the typical model was three to five and three to five. So if we can three to five X this company in three to five years, we can sell it to someone up the chain with the final leg of the chain being the public markets, right? So if we can three to five this thing, it keeps moving up the chain and as long as it three to five and three to five, three to five X and three to five years, there's going to be a buyer somewhere, even if it's the public markets. Well, when it's three to five X is a lot harder for all the reason we talked about. And when the three to five years now is taking longer and when you don't know, there's going to necessarily be a buyer on the other end for all the things we talked about. And now your debt costs a lot more and the maturation rates are still in that three to five range, boom, business model, totals, if you're traditionally just doing those kind of things. So now they say, okay, well, what if instead of just doing all that finance side stuff? Because they were really, you know, they wanted the company to operate and make good profits in everything, but it didn't really necessarily need to grow because growth was through acquisition. And so as long as they had operators that could absorb and integrate the companies they bought, which by the way is a huge challenge because generally the stats are that only about 20% of the acquisitions that are done realize the projected benefits because of course the stats are put together by investment bankers who are compensated based on being able to do deals, right? So there's that also, right, the actual gosh, now we caught the car, what do we do, can we still bark at it, right? Right. So now we need operators, and they're like, holy crap, where can we look to continue to be in business? We're going to need to actually get some people that can add margin and revenue in these companies. And so that's the operators. Now private equity firms for years have had teams of operators that they would bring in to businesses. So it's not new that the operators exist. They would replace people that didn't have as much experience with people that did or people that had better resumes, but now these people are being required to perform. And they're going to be compensated much, much more significantly based on how they're going to perform in private equity's ability to do what they do will be more, more, more dependent now than ever on the ability of these operators to perform. Therefore, they are the new stars of private equity. So what opportunity do you think this creates for entrepreneurs, business owners? What opportunity do you think this creates in terms, you know, for kind of the entrepreneurial investor class, you know, the people like us and the folks that we work with? You know, obviously, the institutional investors, the private equity groups, the family offices, even some of your search funds, they're having to adapt a bit a lot, but screw them. Let's talk about like the essence. What is, what's the, what does this mean for us? I think that the opportunity for all of us who are not private equity, who are the targets of private equity or who are looking to sell need to be aware that the operations in terms of operational efficiency above market performance of your company, above industry performance, you know, let's say the industry return on invested assets is 10% and you're generating 20. That's going to be significantly more important to increase valuation for you. And the existence of a proven operational team is going to be maybe the difference between you getting a deal done and not getting a deal done. So the opportunity is be an operator and up your skills and create a track record of performance. Higher and put in place in your company, proven operators who are achieving, who are being measured and who are achieving results have systems so that you can prove the operational performance of the people that you've got running the company. And as investors by companies that already have professional management installed that are professionalized versus owner operated or use systems like scalable or other tools to have a plan to build a team or a system or both that can turn owner operated businesses into professionally managed because I think owner operated businesses will be in less demand and you'll see prices decline and professionally managed businesses will be on the rise, will be in more demand and still they're going to have to reach down lower than they were reaching before because there's too many private equity firms competing for the few companies that are out there. So if you can create a professionalization of owner operated businesses machine, then I think you're going to have for the foreseeable future a very, very, very valuable thing. And again, not to tune around horn, but that's why we created scalable. People are like, oh, what'd you do? This is like we did it because we needed it because we knew we needed it for our own businesses. We needed a business that we could run our portfolio companies through that would professionalize these owner operated, these perfectly imperfect businesses. And you know, I just got to say we're just, you know what, Roland, I think this is the point and I think this should be everybody's take away from this episode. We're even smarter than we thought we were. Yeah. Yeah. So smart that simply we bumble into smart things. So it's classic broken clock. You know, it's like, God, there's no way we can compete with these like big money types, like what can't we do? Maybe we can actually grow a business. Yeah. Let's try that. Oh, hi. I can. If I could have any single skill, I would like that skill to be the one, you know. And I think in all seriousness, I think I think what we are shifting is, I believe that business value, like the value within business is shifting, the pendulum shifting away from the bankers and the financial engineers and the big money types. And I do believe it's shifting back to entrepreneurs. And I think that's a really, really, really beautiful thing. If entrepreneurs and people not just entrepreneurs, actually get paid, that would be nice. Yes. Yeah, because I want to clarify, I don't just mean the entrepreneurs that are starting the company. I mean, the entrepreneurs within the company, the people who, whether you're a marketer, or a salesperson, or, you know, just a rock solid manager operator, the people who actually know, and there's a clear through line from their efforts to money and profitability. Those are the people that are going to be valued. And the nice thing is it's just not that complicated. I know when we go into a business, we're always saying, how can we grow it? How can we increase leverage sales? How can we improve profitability in margins? How can we increase bankable profit? And how can we improve and increase the transferable value of that business through systems, through improved structures, through all the exitability factors? But those three things, leverage sales, bankable profit, transferable value. Those are the three things that we've always focused on. And I think those are the three things that are going to get hip and cool again. Yep. 100%. Well, anything else to add there before we sign off for today? Just a kind of quick tactical thing. If you are an owner-operated business, I would be slow to just say, I'm going to go in higher. A CEO or an operator to run my business is like your very first thing. It can work. I'm not saying that it can't. But there's about to be a lot of out-of-work VPs and executives who are going to be looking for jobs. And they're out of work because they just weren't that good at it. But they will have come from very large companies. In many cases, they will have very impressive resumes working for businesses where they didn't do a damn thing while they were there. They were just there for the right. They were in the back seat. Right. Right. So I would just encourage all the business owners out there. And this sounds self-serving because it is, but it's also true. I firmly believe that good people don't fix broken systems, broken systems, break good people. Focus on your systems first. Let's put some of these systems in place first, people second. And you and I had a conversation, good friend of ours, Jonathan Cronstad, who took a business from about $8 million to north of almost $200 million in revenue. And his whole message right now is people come last. And what he's basically saying is, let's get good solid systems, build things around it. And I get it. I want the best people in the world, too. But for our organizations, my goal is not to only hire a players and rock stars. Our goal is to build a business with solid systems that does not require them. And the nice thing is, is if you have good solid systems in place, and if the business is winning, you wind up attracting the a players and the rock stars anyway. You get both. So just if you're out there as the default setting of like, it's need to bring, you know, I need adult supervision. I need somebody else to come in and run this. It can work. If you've got the right advisors around you to really vet those people, just we would caution it. We would pause it. There's other steps that would come that would come before that. So I just want to make sure we talked about, want to make sure we discuss that. Because some people can hear professionalization and like, oh, so just hire a CEO. Yeah. I'll tell you. I'll, I'll, I'll chime in. My advice to most of the CEOs I talked to is hire a COO that there is no CEO that you're going to hire that you will get along with or who has the interest of the company at heart like you do because nobody's going to care like you do. And so if you're still wanting to be involved in the operations of the company, but you want to have a professional who's seen the next place that you haven't seen and who knows how to put systems in and that sort of stuff, then get a COO. It'll cost you less. It'll probably cost you no equity to very little equity, certainly in comparison to a CEO. And you'll still be the boss. You won't have a major disagreement with somebody who has a completely different vision of how the company is to go. You'll have an operator who's a lieutenant, whose mission is to help the company realize your vision with their experience. And that, I think, is something that you should, like that would be the place I would focus. I just read a big article, I think it was from McKinsey talking about, this is the time of the CFO. And if you look at the people who are ascending to CEO positions, more and more and more in big companies, it's CFOs, CFOs have become significantly more important in their overall role. I could, if I could hire anybody, I could probably hire a really strong COO and a really strong CFO for the same price that I could hire a CEO. And maybe I'd even get a marketing person in there too, right? So that's something to think about as you go into. I just don't think anybody cares about the business like you do when you're the founder or the creator of the company. Hey, man, don't give up the CEO role until you've taken the big ol' bag of cash because you salt the thing, at least a majority stake in it. the men, the men you probably won't hold on. to it. So, go man. Awesome. Well, thank you guys for joining us today. Hope you found it helpful. 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