Saturday, April 30, 2016

Private Equity 101

Please understand: I am a software engineer, not a financier.

My understanding of Private Equity is wholly experiential.

But, after 4 months of such experience, I think I now understand enough to have some initial observations to share.

In general, in the world of business, there is buying, and selling.

Businesses buy raw materials (of which labor is a sort of raw material; thus my time is the raw material of software), fashion salable goods, and sell those goods, at a higher price than they paid for the raw materials, thus resulting in a profit.

That's not the only business model, of course, but it certainly is the most prevalent model.

Some companies are, themselves, publicly-traded. You, or I, or anyone, can buy a share of Amazon, or ExxonMobil, or Coca Cola, or General Electric. And, subsequently, you can sell your share. During the time that you held your share, if the company was successful, the value of the share increased, and so you made a profit (the company may also have paid you a dividend during that time, which complicates things slightly, but still).

The jargon for buying and selling these shares in publicly-traded companies is "equity trading," or often just "trading."

But not all companies are publicly-traded. Many are not.

If a company is privately-held, then you cannot simply buy shares of that company on the public stock exchange(s).

However, there is still buying and selling of companies in this situation.

Very large, deep-pocketed organizations, with substantial resources available to them, can arrange to buy and sell ENTIRE COMPANIES.

In principle, the idea is the same: an offer is made for the company; if it is deemed acceptable, it is accepted; the transaction occurs, and the company now has a new owner.

Since the companies being bought and sold in this manner are private, the jargon for buying and selling these companies is "private equity."

Thus: a Private Equity Firm is an investment company which makes money by buying companies, and then subsequently selling them at a higher price than it paid, realizing a profit.

Central to this approach is the idea that the Private Equity Firm has ways to increase the value of the company that it bought.

Although there are a lot of such ways, the most common approach that a Private Equity Firm uses to increase the value of a company it owns is four-fold:

  1. Mergers and acquisitions
  2. Price increases
  3. Cost cutting
  4. Leverage

Let's look at each of these in turn.

The underlying concept of mergers and acquisitions involves the notion of "synergy:" two entities may be worth more if operated as a single unit, than if operated separately.

For example, in the realm of software, if you owned a company that made a spreadsheet, and then you bought a separate company that made a word processor, and then you bought a separate company that made a project management application, and then you bought a separate company that made presentation software, you could then assemble all four of these products into a single package, which you'd call an "office suite," and you could perhaps sell that entire suite to customers for more money than you could make by selling each product individually.

Furthermore, you could sell each company's products to the customers of the other companies, so you'd end up with four times as many customers and four times as much software to sell. Yay!

Price increases are simpler. Perhaps the previous owners simply weren't charging enough for their products? In that case, raise the price, and the company will make more money. This approach is particularly popular right now in the pharmaceutical industry, but it applies to any industry, including software.

Cost cutting is also a pretty simple strategy. Perhaps the previous owners had too many staff, or were paying them overly high salaries, or were generating too many expenses. Reduce staff; cut wages; eliminate or reduce expenses.

Cost cutting can work particularly effectively with mergers and acquisitions. If you merge two companies together, you arrive at what the English so delicately term "redundancies."

You may not need two entire Human Resources departments. You may not need two entire Accounts Receivable departments. You may not need two Vice Presidents of Engineering.

Considerable cost cutting can be possible (if quite painful).

The jargon term for these sorts of things is "realizing operational efficiencies."

The fourth linchpin in the approach, leverage, is the most powerful, although simultaneously the most dangerous.

It is perhaps easiest to explain with a simple example.

Suppose that you buy the company for 100, then later sell it for 120. Well:

120 - 100 = 20

and

20 / 100 = 20%

You started with 100, and you now have 120, so you've realized a profit of 20, which is 20% of your original 100. 20% profit! That's pretty good!

But suppose that you don't actually work things this way.

Suppose that, instead, when you buy the company for 100, you actually do this by putting 15 down, and borrowing 85 from a bank, just as you might with a house or a car.

Now, when you subsequently sell the company for 120, you have to pay back your loan, and there will be some interest charged by the bank, so let's say that you have to pay the bank 90 to pay back your 85 loan. After that's done, you have 30 left, since

120 - 90 = 30

But since you only started with 15, and you now have 30, you've realized a profit of 15, which is 100% of your original 15. 100% profit! That's wonderful!

Unfortunately, leverage works just as well to amplify a loss as it does to amplify a gain.

Suppose that you buy the company for 100, then later things are tough and you can only sell it for 90. Well:

90 - 100 = -10

and

10 / 100 = 10%

You started with 100, and now you have 90, so you've realized a LOSS of 10, which is 10% of your original 100. A 10% loss. That's bad, but you still have 90 left, so you can try again somewhere else.

But if you employ leverage, well, it turns out that when you sell the company for 90, all of that 90 has to go back to the bank to pay back the original loan and its interest. You started with 15, borrowed 85, and after you repaid the loan you have 0, so you have LOST ALL OF YOUR MONEY.

And imagine that you could only sell for 89. Instead of being just a 1% change in your loss, it means that you can't pay your loan back. You're bankrupt, kaput. That's the end of your business, and of your Private Equity Firm, too.

This ability of leverage to magnify your gains is very powerful, but its unavoidable ability to magnify your losses makes it incredibly dangerous.

Leverage can turn a small improvement into a big profit, but it can turn a small mis-step into a big loss, even to bankruptcy.

This tends to make people at Private Equity Firms rather edgy, and high-strung, as they are playing for Extremely High Stakes.

Now, you'll notice that, in this portfolio of ways to increase the value of the company, nowhere did I mention

  1. Make a better product

This simply isn't part of the Private Equity process, as the people who are doing these things aren't engineers: they are financiers.

In this way, Private Equity is completely and totally different from Venture Capitalism. Where Private Equity staff are almost totally uninterested in building better products, Venture Capital staff are almost totally devoted to building better products.

However, clearly Private Equity employs a methodology, a process, an approach, an algorithm, so there is definitely some aspect of science and engineering in all of this.

To recognize that reality, the jargon for this entire strategy, nowadays, is to call it "financial engineering."

Look that up in your web search sometime, and you'll see that it's in fact quite advanced, and includes lots of subtleties such as tax codes, interest rates, etc.

Like I said at the beginning, I'm a software engineer, not a financial engineer.

However, like any engineer, I find pretty much all engineering interesting, and so I have a certain morbid fascination with the ways of the financial engineers in the world of Private Equity.

But, I'm a software engineer, so I really would prefer to Build a Better Product, and create value that way.

Sadly, the world isn't always run To Please Bryan.

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