Arthur Petropoulos’ Post

Transcript

Do you ever wonder how private equity works, particularly in the middle market or lower middle market? Well, this video is going to walk through 7 concepts explaining how the typical private equity roll U aggregation or consolidation strategy works. What are the different components? What are the different considerations? So you can understand how a very large part of the acquirer market for the middle market actually functions, what their goals are. And so in private equity, a fund raises a certain amount of money and looks to deploy that money in the acquisition, operation and ultimate exit or sale. Of a series of businesses. So the first part of this is a thesis, what is their strategy? What are they looking to do? And so some private equity firms are entirely industry focused, some are more industry agnostic, but they all have a view, a thesis towards something we're going to aggregate services, products, we gutter cleaning software, urgent cares, whatever it may be. But the same concept applies. What is the thesis? What is the thing that's fragmented that they're looking to consolidate? So the next concept is that it usually starts with a platform acquisition. So when private equity, you'll hear the phrase. Platform acquisitions and Boltons tuck in or add-on acquisitions, but largely speaking the private equity thesis is first started through the acquisition of a platform company. That's a sizable business from which subsequent acquisitions can be added on to. And so an example is a lot of private equity firms will say for a platform company we want a $5,000,000 or $3,000,000 EBIT dot business. Yet for all add-on acquisitions we'll look anything north of 500,000 is the operational infrastructure for the businesses established and developed smaller acquisitions. The integrated more readily. We'll touch on integration a little later in this video. O as we mentioned the third idea are bolt on acquisitions. O company has a thesis, it buys a platform company to begin the effectuation of this thesis and then it goes out to the market and looks to bolt down or tuck in other similar if not identical companies that oftentimes are small or sometimes can be bigger, oftentimes address or have access to different markets, oftentimes have adjacent or complementary capabilities, but things that are related that all come into the same overall portfolio. Company Concept #4 is integration. And so as they're buying all of these things, you can't really just mush them together and pray that it works. And so there is a lot of strategy involved in private equity in terms of buying things that make sense and actually bringing them together. Now that's people, processes, standard operating procedures, things of that nature, but bring all of the companies together so that they're operating efficiently, so costs can be optimized along the way and so that revenue synergies can be acted upon. So if two companies are put together, they can sell their complementary. Products to each of their audiences would maybe demographically or geographically different. That's where you see a lot of these synergies being explored within the integration process. O concepts number 56 and seven are really the driving factors of the Y, right. So we've talked about, OK, there's a thesis, you get a platform, you start bolting things on to it, you integrate it all into a company and that must create some good growth for the business from a profitability perspective, from a cost control perspective. And yes, those are true. These next three items are the real driving forces of the private equity business model. So the first of these is the concept of multiples expansion O as a business grows the multiple if you will, which as we've discussed in other videos is the driving valuation tool for middle market businesses expands. And So what we mean by this is typical value you'll see for a million to $2,000,000 EBITDA business or pretax profit business is 6 times. So business makes a million and a half dollars of pretax earnings will oftentimes sell for six times that or $9 million for the enterprise value oftentimes we're able to. Exceed that based on other videos we've discussed have access capabilities, things of that nature. But as a general rule of thumb and for purposes of simplicity for this video, think of it in terms of a 6X multiple. So a business that does, let's say for again for round numbers, $1,000,000 in EBITDA will sell for $6 million. And so if that being said, as Evita grows, the multiple increases as well. And so a $5,000,000 EBITDA business may trade for eight times a $10 million EBITDA business may trade. Yourself or 11:50 times. So the thesis in much of the private equity world is the idea of aggregating enough so that the business gets large enough that the EBITDA multiple expands. And so the simple example of that is if you bought ten $1 million EBIT dot companies for $6 million each, you would have spent $60 million to aggregate $10 million of EBITDA. However, when that $10 million of EBITDA us together it would sell for 11:50. Times. So if we said 12 times, it would be $120 million. Again, there are a lot of costs along the way. There's also cash flow generated along the way. There's also synergies to be effectuated both from a cost and revenue side of things. But that's the general concept of multiples expansion by ten $1 million things for $60 million in total and you have $110,000,000 thing that you could sell potentially for $120 million. Now what private equity does to further enhance that is the idea of leverage and so historically. This goes back to the barbarian at the Gates times where I think in the embryonic stages of private equity there were 90% leverage plus deals, 95% leverage deals and it was way too much debt and that's private equity to this day still has a bit of a reputation for that. But largely speaking in most middle market private equity, the leverage that you will see applied is effectively 50%. So what do we mean by that if they were going out to buy again those first ten companies for $1,000,000 of Evita, so $60 million, about 50% of that. $60 million would be borrowed, so $30 million would be bought in equity. The other $30 million would be financed with debt. And So what does this mean from a return perspective or how does it affect things? Well, think of it this way, If you paid purely equity or 100% of the purchase price for the $60 million of companies and you sold it for $120 million, then at the end of that whole period, typically about seven years, you would have doubled your money and the return over 7 years, the rule of 72, right? Over 7.2 years, something will double if the return. Is 10% a year. So the implied return in doubling your money over a typical private equity hold period with no leverage would be 10% in that situation. Now that in leverage and let's walk through that again, $30 million of equity was put in $30 million of debt. The whole thing is sold for $120 million at the end of the day. Thirty of those proceeds are used to pay back the debt leaving $90 million of proceeds at the end of the day on a $30 million. Initial equity investment. So instead of doubling the money, they've tripled the money within that same hold period. And that is oftentimes the utilization of leverage within the private equity model. Now leverage has its issues. It can constrain operations. It can be a problem when cash flow decreases unexpectedly. However, the moderate utilization of leverage is still a hallmark of most private equity, particularly as the strategy starts to prove itself out and the financing of future acquisitions becomes more. Cost efficient via the use of debt versus purely equity, the concept that has a lot of nuance and it can get somewhat intricate, but that's the general thought. So the last concept of this video is returns. Those are the whole idea of private equity and why they are selling their services to pension funds, endowments, high net worth individuals, family offices is that they ultimately generate a return that is better than what people could get in a risk free environment. So as we've talked in the past, the risk free rate of return is about 5%. So that you figure that's a 5 to 10 year. Treasury bond from the US government, which is contemplated as the risk free rate. So if you were to say you could get 5% doing nothing, would 10% or 5% premium to the risk free rate be adequate to entice investors to come into the private equity model? Perhaps, but it starts to feel a little thin and therefore it's the leverage that increases that rate of return. And So what we mean by that is go back to that example we just discussed, $30 million of equity investment to yield $890,000,000 return after the debt. Was repaid is a tripling of the money over a 7:00-ish year hold period is effectively a 15 to 17% annualized return. There's cash flows that come along the way, there's synergies that come along the way and obviously there's certain expenses that must be paid along the way to relative to the transactions and integration. But that being said, oftentimes you will see private equity penciling out their returns to 15 to 20% and this is effectively the way it works. And so while there's many people you can sell a business to between large strategics. Family offices, private equity is going to be particularly in the middle market of companies generating 1 to $10 million of Evita. They are going to be a major player in any engagement that we are undertaking and they all have different styles, approaches, temperaments, personalities and they cannot be considered all in the same bucket. But it is important to understand how their model predominantly works, whether you're contemplating selling as a platform company or as a tuck in or bolt on acquisition for an existing platform company. These are the seven primary concept to be aware of. To better understand how the private equity model works. So that's a thought for today. Hope the weeks getting off to a good start for everyone. Keep pushing forward. God bless. We'll see everyone next time.