Since the financial meltdown of 2008, everyone's awareness of the financial sector of our economy has been heightened. But many of us have been confused by the avalanche of new (to us) terms and types of financial institutions that we now know play to a great effect in our lives — no matter how far removed from Wall Street we once thought we were.
Modern banking started with Italian merchants lending against the next crop or trading trip. They would set up benches in the town piazza to operate from and that is where we get the term bank from banco, or bench. If the enterprise failed, you had a broken bench, or banco ratta; bankrupt. And you were then "broke."
Today commercial banks have evolved to the global "too big to fail" behemoths that are far removed from the seminal Italian bench. But the niches between these big institutions have allowed a return to the smaller, individually driven financial enterprise, the so-called private equity or merchant bank — although some prefer to call themselves "private firms of investors."
The average doctor reading this might ask "Why do I need to know about these private equity firms? Aren't they all versions of the same thing?"
Yes, there are many different flavors of financial institutions and we have seen what a tremendous, if indirect, influence they can have in our lives, even far removed from Wall Street. What is attractive and interesting about this particular flavor, even in this (very) low interest era, is that they have an industry goal of paying their investors 20% per year!
Ah, now I have your attention.
This kind of financial firm has developed into its current form only in the last 20 years or so; most of the founders are still alive and active. Although still tiny by many standards, they have become big players in the financial markets and much better known since the 2008 crisis. And they have relevance for all of us because of their mushrooming presence and impact.
Most big investment entities such as national pension plans and insurance companies now consider these private equity partnerships to be a major asset class on their own and a necessary part of a diversified portfolio. To give you an idea of scale, one source tallied about 1,900 of these firms, from boutique to world-wide coverage, with some 18,000 senior partners and 4,000 companies in their portfolios.
To better understand this fast-moving and arcane world of private equity investing, I interviewed a principle of a prominent San Francisco firm. It was explained that what these partnerships (usually) do is to buy, improve and sell companies, hopefully making a profit from fees, cash flow and/or capital gains upon eventual sale. They invest their own money, that of investing limited partners, and may or may not acquire additional debt in doing so.
The term "leveraged buy-out" refers to the practice of using the targeted company's assets themselves as collateral for a loan to help in its purchase. The term has acquired a bit of a negative connotation because of too many recent headline-grabbing examples over burdened with debt that have spectacularly collapsed. But even in this post-2008 era, the prudent use of debt still has an important place in business, if not so much in personal affairs.
These private buy-outs of (usually) private companies may seem like a simple concept, but as with most things, the rub is in the details.
It was pointed out to me that each private equity firm has expertise in certain areas, be it high tech, health care or whatever. So how do they establish a target company in one of their areas of interest?
These firms have teams of keen, young MBAs who establish a database of all the companies in a given area, such as telecommunications, retail, health care, etc. And then they monitor the progress of the companies. A company becomes of interest when they begin to go through a period of transition.
Such a trigger putting these companies into play could be a succession issue, such as a Founder needing help with estate and tax issues. Or the founder being unable to take the company managerially to the next level. We sometimes see this in Silicon Valley. Steve Jobs’ story of rising from obscurity to lead a company up the scale ladder is the exception and is a part of his fame.
Or there might be a balance sheet problem (too much debt, too little cash flow, too little growth, etc.) so there develops a perceived need for a strategic partner with expertise and cash. The approach for consideration could be made in either direction, directly or through an intermediary hired by the company to find a partner with a "good fit." As my source puts it, "every acquisition has to have a theme, a reason to do it."
Sometimes one private equity house will approach another to do a "club deal" either because the goal is too big for them alone or because they want to diversify risk. A similar situation is now seen when we go to the movies and see a list of several production companies behind the movie instead of just one.
Working out these complicated deals can take three to 15 months of intensive effort by teams of accountants and lawyers, often involving millions of dollars of invested time. The deals usually get done, but not always, which is an element of risk for any private equity group looking for an acquisition.
Once done, the acquiring partnership puts one or more people on the Board of Directors to oversee the changes that need to be made to make the whole effort profitable. Management may be replaced or simply redirected to reach the goal of 20% per year within the 10-year lifespan goal of the investment.
With visions of that 20% return dancing in front of you, like the seasonal and proverbial sugarplums, I am enticing you to read my follow-on piece next week. I will then tell you how private equity firms go about reaching that return on their investments. And, more to the point, how, or whether, you, dear reader, can join in the financial festivities.