- NEWS & ANALYSIS
Alex Lykken March 25, 2014
Casual observers often lump private equity (PE) in with the rest of Wall Street, particularly hedge funds and investment banks. Like hedge funds and i-banks, exactly what PE does to make eye-watering amounts of money is often misunderstood, if contemplated at all. For many, the old South Park joke about underwear gnomes rings true:
1. Make firm
In reality, the PE industry differs significantly from the rest of Wall Street, and from the rest of the economy in general. No one really does what PE does.
Which is what, exactly? Well, a lot of things, but for brevity’s sake, PE excels in three approaches to its investments: healing sick companies, adopting orphan businesses, and helping companies grow. A much rosier image than the “barbarians at the gate” depiction. But, as any PE investor will tell you, those approaches are where the big profits are today.
Heals the Sick
Successful, well-run companies are not typically targeted by private equity. In that sense, PE differs significantly from, say, mutual funds, which bet on securities of well-run companies appreciating over the long-term. Companies facing significant headwinds are not likely to attract those kinds of investors. Their stocks go down and shareholders lose money.
Private equity, taking a long second look, sees opportunity in sick companies. Instead of buying stock or bonds in the company and betting on an eventual turnaround, PE firms, armed with coffers of capital and managerial know-how, buy control of the company and get their hands dirty making improvements. New management is brought in. Outside consultants are hired and put to work. Cost-cutting measures are introduced to stanch capital bleeding. A “shot of adrenaline” is injected to boost passion and energy for the business.
In the case of public companies taken private, changes are made to existing business models that will help the company compete more effectively. As public companies, the kinds of changes that need to be made can’t really be made at all, given the expectations of short-term-focused shareholders concerned about quarterly earnings. Once taken private, those changes can be made out of the glaring, relentless spotlight of the market.
Most notoriously, firms can, and often do, create more efficiency in their portfolio companies by cutting jobs. No employer or investor enjoys cutting jobs, and most aren’t indifferent about it, either. But, particularly for unhealthy companies with heavy payrolls, cutting jobs may be necessary to turn the company around. As Paul Levy of JLL Partners put it, “if there are more people there to make shoes than needed, you can’t keep the people. It’s not about wanting to get rid of people.” It’s about wanting to make the company healthy again. In many cases, the alternative is to allow the company to fail altogether, in which case all jobs are lost.
For companies facing dire straits and considering a lifeline, the private equity option is expensive. Not unlike the big bill that shows up after an emergency surgery, the cost of handing over the keys to a PE firm is pricey. Alternative financing options often aren’t available, say from a commercial bank. And the odds of finding strategic acquirers, even competitors, that will pay reasonable prices for the company go down when it’s struggling. In those cases, private equity is often the last, best alternative for companies facing oblivion.
Neglected, ill-fitting corporate orphans, of which there are dozens and dozens in the global economy. They aren’t always poorly run companies—in fact, they’re often very successful in their own right. But, for any number of reasons, they don’t fit in with their parent company’s core strategy. That can mean less resources available from the parent company, resulting in underperformance and a detrimental cycle. Given the right circumstances, however, the business can improve its performance by operating independently.
Enter private equity, which is willing to make the investments needed in the neglected business to bring it to full strength.
The Carlyle Group, one of the bigger investors in the industry, adopts orphans pretty frequently. Helpfully, the firm put together a case study on one of its adoptions, Wall Street Institute. Carved out of Laureate Education in 2005, Wall Street Institute, which provides English language learning services, was under-resourced and under-managed before Carlyle stepped in. Over five years, Carlyle capitalized the company, brought in new management, enhanced its curriculum offerings and expanded its geographic presence. By the time Carlyle exited its investment in 2010, the company was ranked #1 or #2 in most of the markets it was competing in.
The key to profiting off of neglected businesses is to focus on their specializations, not ignore them. To that end, PE firms often acquire several orphans in an industry and fuse them together. Investors have a knack for finding complementary, synergistic businesses and collecting them all under one roof, often for relatively cheap. The combined entity, now firing on all cylinders, flourishes. As does its investor.
PE firms approach growth investments in two ways—organically and acquisitively. More often than not, both approaches are used concurrently to spur growth.
Organic growth comes in many forms. Not unlike the venture capital approach, organic growth initiatives include efforts in product improvement, sales enhancement and geographic expansion. In other words, anything that grows the company without having to outright buy another company. That approach is known as acquisitive growth, which is utilized to quickly augment a portfolio company’s market share through “add-on” deals. Growth through acquisitions, unsurprisingly, is achieved much more quickly than organic initiatives, which can take months or years to bear fruit. Importantly, add-ons have become much more popular among PE firms over the past few years. According to PitchBook data, and for the first time ever, add-on deals accounted for a majority of all PE deals in 2013. The trend toward more add-ons goes back several years, indicating a possible long-term shift in the PE model toward a “buy and build” strategy, and away from the “lever and engineer” approach.
Private equity loves consolidating. Several industries are fragmented, like insurance, waste management and certain niches in the healthcare market, to name just a few. Once a consolidation opportunity reveals itself, PE firms gobble up several players in the market, often cheaply, and weld them together to form a united, more dominant market player. A great example is Confie Seguros, backed by ABRY Partners. An insurance company, Confie Seguros was acquired in late 2012, with ABRY eyeing an opportunity in the Hispanic-focused insurance market. Highly fragmented, the market is littered with small, non-dominant mom n’ pops spread scattershot across the country. Over the past year and a half, ABRY’s acquisition spree has gone into overdrive—dozens and dozens of companies have been added to the Confie Seguros platform. The company, founded in 2007 as humble Westline in southern California, today brings in almost $300 million of revenue out of 540+ locations.
As mentioned, private equity utilizes several strategies for its investments, not just these few. The list seems to keep growing every year, too. Wherever value can be identified, unlocked and exited, and hands need to get dirty to extract it, private equity is likely to be there.
Featured image courtesy Wikimedia user Hu Totya.