Private Equity Investing: Part Two

Last week I began a description of what a private equity firm of investors is and does. They have been so successful that, as a group, they have become a major asset class in just the last 20 years. However, they remain comparatively tiny in comparison to the more well-known international commercial banks.

To better understand their role and methods, I interviewed a principle of a San Francisco-based private equity firm, who identified the industry standard on return on equity invested in acquired companies as an eye-popping 20% goal per year.

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s you might expect, some companies yield returns of multiples of that and others do not turn out well at all. It was pointed out that the 80-20 rule applies in some aspects of her business as it does in many others. The trick is to put 80% of your money and time into the 20% that will produce the biggest gains.

We know, as Robert Burns once wrote, that "...the best-laid schemes o’ mice an’ men / Gange aft agley." The tech-bust of 2000 and the everything-bust of 2008 most recently come to mind. But these "Black Swans," or unforeseen circumstances, while rare, did not harm all financial institutions equally. And one person's crisis is another's opportunity if you are holding cash and have an eagle eye.

Remember Warren Buffett stepping in to be the white knight for Goldman Sachs with his $5 billion? He was lauded at the time, but he was also able to wangle special rights in the deal that netted him more billions. Ah, them that has, gets....

So how does the business model actually operate? The private equity bank raises X amount millions or billions of dollars to fund a limited partnership. A limited partnership means that the investor is passive and has no say in management. The investor typically surrenders 1% of its value for fees to operate the Fund, as it is called, over the projected life of the Fund, which is typically 10 years. Bear in mind that for a $10 billion Fund however, the fees alone will amount to $100 million, a burden upon potential returns to be overcome.

But that 1% is small change compared to the 20% off the top that the private equity bank harvests at cash-out time, before the limited partner sees a dime. This hefty skim is known in the trade as the "ups," to be shared by the equity bank's partners. It is the biggest burden upon hoped-for returns by the limited partner. But in exchange what the limited partner gets in part is limited liability. They can only lose what they invest. The general partners are at open-ended risk, but they buy limited liability insurance out of their 1% fee for operating income.

What the limited partners primarily get is access to the 20% per year goal returns that the general partner/private equity group is shooting for. And this is the kicker; what the limited partner investor is really putting its money on is the expertise, track history and reputation of the privately held equity partnership firm.

My principle emphasized the value of attracting investors to be put in "the top quartile" of all such equity groups by the various rating entities. Big institutional investors rely on such judgments for guiding their megabuck investments. They like a big return, of course, but they realize full well the huge fiduciary responsibility that they bear for their constituents and look for all reassurances possible.

As you might imagine, with so much at stake, these equity banking houses have people as their primary asset, which "...goes up and down the elevator each day" as the General Partners are fully aware. So these people are well rewarded and appreciated.

Another valuable asset for these firms is the proprietary computer models, which allow identification and evaluation of these critical deals. So loyalty and secrecy are essential to success in this closely watched business. And ethics are emphasized by the top "white shoe" firms. Some of these top firms, in an effort to avoid even a whiff of potential conflict of interest, forbid their people from owning any specific stock or even bond. Their outside personal investments in the market are therefore limited to things like diversified mutual funds. Not a bad idea for most of us, come to think of it, albeit for different reasons.

Somewhere along about now, dear reader, you are probably thinking "How can I get in on this kind of return?" For one thing, the Feds have regulations about such things to protect us from ourselves and from the occasionally unscrupulous. An "accredited investor" by regulation is someone who has a net worth over $1 million and/or and annual income of over $200,000.

For a typical mid-career doctor, so far so good. But even this qualification will not automatically open the door to many of what are essentially private deals. And when you are talking about a Fund in the billions of dollars, many such firms will have minimums of $1 to 10 million-plus, in cash, for any possible investor. I was told that if you show up with a check for $10 million you will get a good look, of course, but they also want to know who you are, where did you get the money and other due diligence type stuff.

So this is a relationship business: who you know is at least as important as what you know. Of course, in the end, for the investors' due diligence, the most important goal of all for these investment partnerships is "To be right."

The Chairman

If you'd like an easier and fun introduction to this area I would suggest a novel by Stephen Frey called . It has all the basics plus sex, murder and what my principal calls "New York sharp elbows" for reader interest. Not just dull financial stuff. And it was written in 2005 before the meltdown and the heightened degree of public awareness that has followed and made the whole area more real. This stuff can be tough going to get your arms around, but it has reverberations throughout our economy and our lives so it helps to know a bit about it.

Twenty percent, huh? Call my accountant!