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The following excerpt comes from chapter 6 of the book The Dealmaker by Guy Hands. This is a simple and plain explanation of how Private Equity makes money.
The following excerpt comes from chapter 6 of the book The Dealmaker by Guy Hands. This is a simple and plain explanation of how Private Equity makes money:
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… I'm not saying that it doesn't take a degree of skill and a lot of hard work to pull off a successful deal, but then that's true of a lot of other jobs as well. I remember once giving a speech to several hundred private equity practitioners, investors and advisers in which I explained the simple maths behind private equity. At the end of it a senior private equity partner took me aside and asked me never to give that speech again.
*'If people actually understood what we do,' he said, 'they wouldn't pay us as much. We're probably in the best paid profession in the world. Let's not spoil it?’*
If claiming that private equity isn't that complicated sounds like false modesty, it's perhaps worth saying a little more about the simplicity of the basic principles behind it. Essentially, doing a leveraged buyout is much like buying a house - except that you're using a company rather than a house as collateral for the loan and you have to ensure that you are borrowing from banks at a cost lower than the return on the deal you expect (a good relationship with trusted bankers is therefore absolutely essential).
Imagine you were to buy a company for £10 million at a price-to-earnings ratio of 10 - that is to say that if the shares are trading at £10 then the earning per share for an investor over a year is £1 - this would provide you with a 10 per cent yield each year. You then reinvest all the money the business gives you each year at a similar rate and you also gain, say, 2 per cent each year in earnings growth through inflation. After five years, you sell the business at the same price-to-earnings ratio. In the process you've made one and a half times your money.
Obviously, for this to happen you have to buy well, but there are also other weapons you can deploy to increase value. First, you can borrow, which will enable you to increase the return on your equity, as the debt is other people's money. In a typical leveraged buyout you use one third equity and two thirds debt. Let's say you borrow the debt at around 5 per cent interest for five years. Because the cost of your debt is much lower than the 10 per cent yield on the business, the return on your equity is supercharged. In this example, as you've paid 10 per cent (ie. a price earnings ratio of 10) on your equity, which forms one third of your purchase price, and 5 per cent on your debt, which forms two thirds of your purchase price (and is someone else's money), at a stroke, your returns have gone from a multiple of 1.5 to 2.3: it is just maths.
Next, you can make operational improvements by increasing sales (which affects the top line) and increasing margin or cutting costs (which influences the bottom line).
In the deals I look at, my objective in the first five years of owning a business is to achieve operational improvements of 4 per cent a year (we've usually done better than that, but 4 per cent over a longer period of ten to twenty years is ambitious). Now your returns - including leverage - have increased three times over.
Then there are mergers and acquisitions. Let's assume that you decide to merge your business with another business that trades on exactly the same multiple and that this merger occurs simultaneously with selling the combined business.
It could be expected that the larger business will trade at a higher multiple (i.e. a lower yield). Say, for example, you increased the multiple from ten to twelve, and brought the yield down from 10 per cent to 8.33 per cent. The reason for a higher multiple is that you have created a larger business, which most would deem as being safer. By making the business safer, along with the other improvements, you have now increased the value of the business by four times its original value.
Finally, you can reposition the business, something I learnt during my securitisation days at Goldman that PFG and then Terra Firma specialised in. You might opt, for example, to change the business's profile, perhaps getting rid of its riskier parts to make the remainder safer.
Or you might find ways to explain cash flows more transparently to give potential buyers more confidence in the numbers the company is producing. The word 'transparently needs to be stressed here: there have been notorious cases where management teams have changed the way they report their results to achieve the opposite of transparency. Get it right and, in my experience, you achieve a higher multiple. Let's assume you increase the multiple again by two turns, taking the exit multiple from twelve to fourteen. Now you have made 4.9 times your original investment.
Back in my Nomura days I had one other trick in my magic box that other private equity firms at the time didn't understand at all: technology. One of Nomura's greatest assets was that they focused more on technical and analytical skills than sales and marketing skills.
This meant they were much less likely to be impressed by an arts student from Cambridge than someone with a Ph.D. in data science. With the bank's financial support I set up what became known as the Cyber Room - a room full of extremely analytical, ludicrously intelligent, quantitative mathematicians, or 'quants, most of whom had a Ph.D. in maths or particle physics. One had that rare neurological condition known as synaesthesia, in which senses that aren't normally connected merge.
In his case numbers evoked colours. He'd talk about moving a bid up or down to avoid a 'dirty brown cowpat' or to achieve a 'kingfisher vibrant aquamarine blue. He was one of the smartest people I'd ever met, and I relied on him heavily.
With the help of the information the quants provided, I could make the most of the five ways private equity can increase value, while also leveraging the essential human element wherever I could. So, with Phoenix, for example, part of our success was down to the relationship I managed to develop with Grand Metropolitan's chairman and chief executive, Lord Sheppard. But the quant element was also crucial.
Grand Metropolitan measured the company's asset value in terms of a multiple on the value of beer being sold in their pubs. Since beer consumption had been going down for some time, so had the pub chain's value. We, however, factored in what could be done with the properties, which might not have been doing well over the previous five years but had been great performers over the longer term.
When it came to Angel Trains we found that our competitors were looking at the deal as though it were a management buyout. This meant that they focused on the amount of debt a bank would give against the equity put up (normally around two times the equity check).
We approached things very differ-ently, calculating how we could reduce the cost of capital by borrowing against the cash flows of the business. People may have thought our bid was crazy, but it was based on forensic number-crunching.
Not that it was always the quant factor that gave us an edge. With William Hill, for example, which we bought in 1997, our success came down to making the betting shops less spit-and-sawdust and much more female-friendly and technologically savvy. The view of John Brown, William Hill's CEO, was that no woman would ever want to go into a betting shop.
My view was that in that case we should change the betting shop. We therefore got rid of the blacked-out windows, cleaned up the inside, put in water and coffee, banned smoking and allowed people to bet on more than just horses. John Brown was also against computers and internet betting, which he worried would bring down margins by letting the punter shop around for the best odds at a time when most of his customers lived within two miles of his shops.
Eventually we persuaded him to introduce internet betting, making William Hill among the first companies to do so.
John had been a runner back in the I96os when there had been very tight legal restrictions on gambling and he had worked his way up the industry to the point where he was overseeing 1,500 licensed betting shops. During the sales process he made it quite clear that he didn't want someone from the City like me - who, he was convinced, had been born with a silver spoon in his mouth and had been privately educated - buying William Hill. Not surprisingly, therefore, rumours started to fly that the first thing I was going to do if I won the auction was to dispense with his services.
And, indeed, when we met the day after the deal had been signed, his opening remark was, 'I guess you're going to fire me. However, once I realised that it was his passion for the business that had made him so difficult during the negotiations, and he realised I was a grammar school boy just like him, we got on famously. He stayed on and even got himself a laptop that he would take to race meetings. He was one of the nicest CEOs I've ever met, and I still regret that we sold the business as soon as we did. But Nomura needed the profits that year.
Two other deals we did illustrate the two other facets of private equity. With the Unique Pub Company, we opted for expansion via a process of mergers and acquisitions.
By the time we sold it we controlled 3,200 pubs and its substantial market share became a crucial factor in the premium it commanded.
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