Note: click on the video below to play or, alternatively, if you prefer you can read the course transcript underneath.
Training course provider: We’ve got this first session here – key principles and roles of private equity; introduction to private equity. So where do we start? What’s on the menu for this little section? We’ve got a high-level review of the market for private equity; we’re going to talk about how private equity works, basically. And also how buy-outs work; and this is a chance to unpack any jargon that you guys haven’t seen – please interrupt and pitch in.
How private equity firms make money: buy businesses at a low price, sell at a high price
Training course provider: The first… first thing there’s a space in your packs here for thinking about, talking about, writing some notes on how private equity firms make money. Matt, have you got any thoughts? How do private equity firms make money?
Delegate: Buy low, sell high.
Training course provider: Buy low, sell high. Buy low, sell high. David buy low, sell high?
Delegate: Strip out as much cash as possible along the business.
Training course provider: Strip out as much cash as possible along the business – let’s talk about that. I think buy… buy low, sell high is probably… buy low, sell high is probably about as accurate a description as we can get. What are they going to do? Here’s the… here’s the space in your packs here; you’ve got some space to write this – buy low – let’s imagine that…
Buying a business with private equity has some similarities to investing in property
Training course provider: I tell you what; let’s use… use an analogy to start with. Buy low. We’re thinking about an analogy between what private equity firms do and real life. Ollie, in the olden days you could buy a house and expect to sell it in a little while and maybe make some money on that house, yeah?
Training course provider: What’s the property market doing at the moment do you think?
Delegate: It’s flagging.
Training course provider: Flagging, isn’t it? So I’m not sure that this is a good analogy. What’s the market for buying and selling businesses doing at the moment?
Delegate: …It’s doing the same.
Training course provider: Well it’s a… there’s been a lot of… there’s been a lot of uncertainty, hasn’t there? So maybe it is a good analogy to use. But in the olden days what you could have done is bought a flat in London – I don’t know how much you’d pay nowadays, but perhaps a long time ago when I first came to London you could buy a flat probably for a hundred thousand pounds; wouldn’t probably even get you the front door now, would it? But here we go; let’s imagine we’re buying a flat for a hundred thousand pounds, or we’re buying a business for a hundred million or whatever our… our valuation is. And we’re going to… we’re going to hope to do what Matt suggested we would do – buy low, sell high – so Ollie, let’s imagine that we’d sold that business, or that flat – that’s what we’re trying to do with private equity; trying to buy low, sell high – that’s probably the best description that we could have of it.
Private equity traditionally looks to invest over a 3-5 year time horizon
Training course provider: But let’s learn about some things that which are specific to private equity – again, a little test for my guys this morning – how… what… over what kind of timeframe – you might have heard this before – David, I’ll ask you; what sort of timeframe would private equity be expecting to sell over?
Delegate: A three to five year…
Training course provider: You’ve heard that phrase? They often talk about a three to five year time horizon. OK, so that’s one of the things they’re looking to do is turn these businesses around quite quickly. As well as making sure we know about timeframes, what’s affecting that… or what’s happening to that timeframe? This is the olden days, Ollie, that we’re talking about here – the olden days – buy low, sell high; it all works according to plan, you sell over that three to five year horizon.
Time horizons for private equity investment have increased
Training course provider: David what’s… what’s happening at the moment do you think? To that time horizon?
Delegate: Well the… the three to five years is becoming five plus.
Training course provider: The three to five years is becoming five plus. That’s absolutely right; the timeframe… the timeframe for exit is extending, isn’t it? Is extending. And before we started this session we were talking about some of the private equity firms that we know: the ones that might, if we’re lucky, take us to the races, or those track days, which is a great thing; but thinking about those private equity firms, what is the impact of that timeframe slipping for them and their business do you think? What’s the impact of that?
Delegate: It makes it harder for them to get a return on their finance.
Training course provider: It… it makes it much harder for them to get their return, isn’t it?
Training course provider: OK, and one of the things we’ll talk about in this session is… is private equity fees and how they earn their money; but it’s harder for them to get a return. Matt knows this – it’s all about buying low, selling high – it’s all about that; but of course if those timeframes are being pushed out it’s much harder for private equity to get their returns.
Lack of acquisition debt has shrunk the pool of buyers for private equity owned businesses
Training course provider: Ollie, what do you think has been stretching those returns? What’s been the main force that’s made it difficult for private equity firms to sell in that three…?
Delegate: They… they… they probably can’t get the valuations that they initially hoped for.
Training course provider: They can’t get the valuations. Absolutely right. Essentially what’s happened is the market for buyers has… of private equity businesses has dried up, hasn’t it? The market for buyers has dried up. And we know that part of what’s caused that is the credit crunch, hasn’t it? The credit crunch and the lack of debt available for acquisition. OK, so lack of debt for acquisition.
All right, so we’re talking about what private equity firms are doing; we know that one of the trends that’s affecting the market is the timeframes over which they can sell, that’s all stretching out because of the credit crunch, because of the lack of availability of debt.
Traditionally, debt has been used to amplify private equity returns
Training course provider: Let’s think about some other things that are affecting private equity. I tell you what we could do is we could look quickly at the impact of leverage. And I know I’ve got a reasonably advanced group this morning. In the good old days, Ollie, on your London flat, what kind of mortgage could you get? If you had a… if you’re buying a flat for a hundred thousand, how much… what percentage of that price could you….?
Delegate: Ninety percent.
Training course provider: Ninety percent mortgage on the basis that you… you’d be a good safe bet for the bank.
Training course provider: And you’d be a good risk and they’d lend you ninety percent of that hundred thousand. That’s a bit harder today, isn’t it? And I’ve got to be honest, in the good old days for companies, I don’t think you could ever have got a ninety percent mortgage on a company.
Pre-credit crunch, high levels of debt were available to buyers of businesses
Training course provider: Pre-credit crunch, Matt, what… what kind of levels of debt might you get into… into a buy-out?
Delegate: Well you’re getting, sort of, five or six times EBITDA in the extreme.
Training course provider: You’re getting five or six times EBIDTA. In terms of percentage I… I’d…
Delegate: I suppose it’s seventy.
Training course provider: Seven…
Delegate: Sixty, seventy.
Training course provider: …sixty or seventy percent. Sixty to seventy percent and that’s quite difficult. Well I tell you what, let’s… I agree with you; I think pre credit crunch you could probably get sixty or seventy percent of the purchase price as… as debt; but just to make the numbers simple, lets imagine that we had a very friendly bank in the old days; they’re not going to lend us ninety percent, Ollie, but they’re going to lend us, let’s say, eighty percent. And we know that’s unrealistic – especially in today’s market – but let’s imagine we could get eighty percent of that price by… by way of… of debt. This is not a trick question. Ollie, when we sell; when we come to sell – again in the good old days in our three to five years – what we’re going to have to do is pay off that debt. Maybe we’ve paid off a little bit along the way, but let’s assume that the business was growing and it needed more debt along the way – perhaps to fund working capital – let’s imagine, just to keep the numbers simple, not a quick trick question – once we sell we repay the debt, Ollie, what’s our profit? If you like… what are our net proceeds on that little deal?
Training course provider: Yeah, so, OK, so let’s… let’s have a look at it, so we’ve put… what we’ve done is we’ve had to… we’ve taken our twenty…
Training course provider: …that we’ve put in, so if you like your twenty was your deposit on your flat in London; OK, so we’ve raised eighty in debt – actually we could make this one-forty just to make sure we don’t get too confused with the numbers – we sell at one-forty, pay off the eighty, so we’ve turned our twenty into sixty, ok?
Continue with the introduction to private equity course