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Private Equity Demystified - 10 Ways it is Like Investing in a House

Posted on September 1, 2019 at 4:55 PM


Private equity firms seem to have received increased attention over the last several years. Globally, private equity firms made about 3,000 deals worth $582 billion in 2018 ... but are still sitting on a record high of $2 trillion of capital waiting to be invested, according to Bain & Company's Global Private Equity Report 2019. While the names of some of the largest private equity companies are becoming more familiar to the public - e.g., Bain, KKR, Carlyle, Blackstone - an understanding of what these firms actually do can still seem elusive. A helpful analogy comes from the biggest financial purchase that most people make in their lives - their home. Here are ten concepts that you learn as a homebuyer that can help you understand private equity.

 

1 - A House Sale is kinda/sorta like A Private Equity Deal - Both are big and complex transactions. Selling a home is a major financial and lifestyle decision for most people. The equity in a house is often a family's biggest financial asset. Beyond finances, a homeowner has invested a lot of their life turning a house into a home. They also have to figure out a new place for them, and maybe their family, to live after they sell. Private business owners who are selling their company to a private equity firm can feel the same way too. Their business may be their biggest financial asset. They may have invested a lot of their careers building the business and have an emotional attachment to it. They might also have to figure out what they - and family members in their company - will do for a job after they sell their business.

 

2 - Real Estate Investors are kinda/sorta like Private Equity Firms - House-buyers tend to target their searches to certain types of homes in certain neighborhoods instead of looking at every house for sale. Savvy house-buyers (or their real estate agents) may even network to get leads on houses ripe for sale that are not yet on the market - e.g., empty nesters looking to downsize. Private equity firms also know what type of companies they want to buy. They may focus on a specific industry or geography where they have expertise. For example, there are twenty private equity firms today that are focusing on buying ophthalmologist (eye doctor) medical practices in the USA, according to Ophthalmology Times. Savvy private equity firms may also use their networks to look for companies ripe for sale that are not yet on the market - e.g., business owners seeking to retire and cash out.

 

3 - Real Estate Agents are kinda/sorta like Business Brokers and Bankers - Because home sales are such big transactions, many people pay real estate agents to help them sell their house. Private companies looking to sell sometimes use business brokers or their bankers to help them find a buyer and negotiate a deal.

 

4 - Rent is kinda/sorta like EBITDA - One way to determine the value of your home is to view it not as a home, but as an asset that could generate a stream of income each year in the form of rent you could get if you didn't live there. A private company's value can be assessed by the stream of income it produces each year too. Private equity buyers typically focus on that stream of income and define it as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EBITDA measures a company's underlying profitability once you strip out its tax, accounting, and capitalization situation.

 

5 - Using Price per Square Foot is kinda/sorta like Using EBITDA Multiples - A popular way to estimate the value of your house is to look at the price per square foot (or meter) that comparable houses in your area have recently sold for. Once you find a price per square foot, you can multiply that times your house's square footage to get an estimated value. Private equity firms do a similar assessment to figure out the value of companies. Once they get an estimate of what the EBITDA income stream from a business looks like, they know what a range of multiples of EBITDA buyers often pay for similar (comparable) companies. EBITDA multiples are often in the 2-5x range, depending on many factors. So a company with an annual EBITDA of $10 million could theoretically be valued between between $20-50 million.

 

6 - Real Estate Appraisers are kinda/sorta like Business Valuation Firms - Before issuing a mortgage, a bank will often require the homebuyer to get an independent assessment of the value of the house being purchased. There are experts called real estate appraisers who specialize in doing these calculations. Private equity firms typically do the valuation estimates themselves. Business owners looking to sell sometimes hire specialists in business valuations to help them get an independent understanding of their company's market value.

 

7 - House Inspection is kinda/sorta like Due Diligence - After a house sale and price are agreed to, the buyer will often make their offer contingent on a home inspection. The seller will often hire an expert in home inspection to do a thorough search through a house to list all the flaws. Before the sale closes, the house buyer may require the home seller to fix those flaws or lower the price to compensate the buyer for the problems. When private equity firms make an offer to buy a company, they also make their offer contingent on an inspection process they call due diligence. Due diligence can inspect assets, financial records, and all other aspects of a business. Any flaws, holes, or skeletons in the closet that come out can make them lower their offer or back out of the deal altogether.

 

8 - Mortgages are kinda/sorta like Leverage - When people buy their first house, they may put up 20 percent of their own money as a down-payment and borrow the remaining 80 percent in the form of a mortgage with a bank. They might find debt to be scary, but they borrow because they don't want to wait for years or decades to have the money saved up. They want to live in a house now while they need it and bet they can pay back the debt along the way and/or when they sell. Taking on mortgage debt may also enable them to take advantage of tax breaks that can come with paying interest on a mortgage. A private equity firm often does a similar thing when it buys a company. It may only pay 20 percent of the purchase price from its own funds and then borrow the rest from a bank. They do that so they can buy 5-times (1 / 20%) as many similarly priced companies with the money they have available to invest - i.e., leveraging their money. Borrowing may also allow them to take advantage of a tax break if interest can be deducted as a business expense.

 

9 - Rehabbers / Flippers are kinda/sorta like Private Equity Buyers - When house rehabbers (or flippers) are looking to buy a house, they are looking for a house they can buy at a low price that has potential to be worth much more - like a house in need of repair in a nice neighborhood, or a small house on a big lot. They take out a mortgage to cover most of the purchase cost. They invest their own time and expertise to quickly improve the things in the house that will generate the most value - e.g., expanding its livable space, updating key areas like bathrooms and kitchens. Then they sell it. If they are good, the resale price gives them a tidy profit after all their costs, including borrowing costs and the costs of their time and effort, are covered. Everyone wins, because a house that was not at its full potential just got improved and made more valuable. Private equity buyers do a similar thing with companies. They look for companies that have potential to generate more profits and that they can get for a good deal. They borrow most of the money from a bank to buy the company because they want to use their own money to buy as many companies as they can. They use their management expertise to improve the financial performance. Sometimes they even combine small companies they have acquired into a bigger one that is worth more than the sum of its parts. Once improved, they put the company back on the market within a few years and hopefully sell it for a profit.

 

10 - Live-in Rehabbers are kinda/sorta like Management Buy Outs - House rehabbers often do not want to live in the house they are rehabbing. It is messy and noisy and uncomfortable with all the work being done and all the newcomers wandering through the house. Some private equity deals are like being a live-in rehabber. This is when the owner of the acquired company (or maybe their senior leaders) decides to stay and be part of the rehab of their company. They have to manage all the improvement work and take responsibility for it getting done. It can be stressful to rapidly make big changes in the company, but they will have financial incentives to get all the work done in time. But if they do a good job, they will share part of the profits from a sale at a better price in a few years.

 

Every industry has bad actors. Some house rehabbers probably want to cut holes in the walls, strip out all the copper pipes, wallpaper it over, and put the house back on the market right away at a higher price, while pocketing the money from selling the copper pipes. Maybe they could get away with that for a while but people would probably get wise to them eventually. Banks would stop lending to them and real estate agents would quit bringing prospective home buyers to their properties. The same is true with private equity. There are probably horror stories of bad actor private equity companies that have come in and pillaged assets of a company they acquired. Perhaps they made a mistake, and purchased a company without a future and are salvaging what they can. My guess is people would eventually get wise to them as well and quit selling to them, lending to them, investing in them, or buying from them.

 

My first home purchase was from a real estate rehabber/flipper. He bought a house that I would not have lived in and fixed it up enough so I wanted to live in it. In other words, he created some new value that I was happy to pay for. I count that as a win-win.

 

My career as a consultant and coach has also led me to work with and know people on both sides of private equity deals - buyers and sellers. Like any endeavor that seeks to create a lot of financial value, the work can be hard and stressful. But I have found the people in the private equity space to be great to know. I count that as a win-win too.

Categories: Private Equity, Negotiations