Episode 179: Private Equity is Private

Welcome back to Money with Mak & G. I’m glad you’re here.  Happy New Year. It’s 2023 and it’s an opportunity to change or transform yourself or your life. 2022 ended on a very low note for all of our investments in the stock markets.  With a little luck, the market will transform itself in 2023.  This year is already bringing some changes for me too.  First, it’s a change in my job.  I’ll play a different role in the private equity firm that I work in.  When thinking about the work I do, I often get asked a couple of questions, and thought it might be interesting to talk about investments that are made in a Private Equity Fund.

Most of us easily grasp the idea of stocks.  You buy an ownership position in a company.  You could own some cool stocks for kids like:

1) Funko, which is a pop culture consumer products company that designs, sources and distributes licensed pop culture products like Snoop Dogg, Tha Dogg House from the famous rapper.

2) How about the Hershey company which makes candy like the Hershey bar?

3) Electronic Arts, or EA which is a pretty big name for video games.  They did a deal with Marvel, which means Marvel heroes like Iron Man which should be coming out in the, hopefully near future.

Anyway, each stock should always be reviewed for its investment worth.  Anyway, since stocks are bought on a stock exchange, there are a whole bunch of rules to follow to remain on the stock exchange.  Since anyone can own or buy your stock, that means anyone in the public has access. Everyone can buy it, and so you’re a public company.  It costs a lot of money to be a public company due to all the rules set up by the government.  There are certain reports that have to be filed with the government.  You have to do those reports regularly in order for investors to be well-informed about the company.  But, these rules are called safeguards which are like seat belts in a car, for your investment.  They are meant to protect the investor, which is you and me. 

Since a company is not born as a public company, it has to choose it.  When you initially decide that you want to go public, it’s called an initial public offering or IPO, and it costs around 5% of the sale of all your stock. There were only 181 IPOs in 2022 and 1,035 in 2021.  That means fewer companies thought they could sell their stock at a good price in 2022. OUCH.  So, when selling your company stock for the first time, all of the work that has to be done costs millions of dollars. It’s expensive, and supposedly each year after that costs a couple of million more.

Other investments don’t have all of the same safeguards. If you bought a baseball trading card, the owner doesn’t have to do any legal reporting, they don’t have people come into the company and review all the information about what you’ve sold and all the things you spent money on to verify the earnings for the year.  That’s an audit.

If you bought real estate as an investment, there are a completely different set of rules, but it’s not as demanding or costly as offering your stock on a stock exchange. 

Anyway, I work at a private equity firm.  It sounds pretty serious and complicated to a lot of people.  So, I thought I’d give some insights into what a private equity firm is and how they make its money. 

First, it’s a firm or company, as the name states. I looked it up and it said a firm is a “for-profit business organization”.  So, it’s an organization of people and assets that try to make a profit.  Ok, that sounds like something that someone may want to invest in.  

So, why is it private?  Well, a private equity firms mean they’re owned by their founders, managers, or a limited group of investors — and not the public.  In general, it’s a smaller group of investors, and usually, there is a minimum amount to be an investor.  So instead of buying one share of stock for say $100, you may need $5,000 or $50,000, or $250,000 or more.

By being a private company, it has the opportunity to remove some of the constant public scrutiny of quarterly earnings and reporting requirements.  As a kid, it would be like your mom sleeping in your room, sitting by you when you play your video games, looking at all your text messages, and more.  Ok, that’s a little much but it’s a lot more of being watched. So, that’s all the information the government wants to see.  So you report on it, or submit the information. That’s if you wrote a report to your mom and told her you played 5 hours of video games, sent 20 text messages to a girl you liked, and got 8 hours of sleep.  Get the picture?

When you don’t have to do all the work, it generally saves a company money, but more often it allows the company more flexibility or leeway to make decisions.  Private companies say it allows the company to take a longer-term approach which is better for the company. But, as you can imagine, if your parents aren’t watching you, and I’d never say you’d do this, you may do things you shouldn’t, like get on bad websites, play video games you shouldn’t, and more.  So, there are benefits and possible risks….

It’s weird to think about it, but many public companies seem to worry about making short-term decisions about money as compared to long-term ones.  I have a friend who decided he wanted to get his MBA from a college that cost less and he could do it part-time because he didn’t have the money or want to borrow any money.  Well, another friend went to Harvard and owed over $100k when he was done. In the short-term, if you were at the cheaper school you wouldn’t owe as much money if any, but if you went to Harvard, you’re starting salary is usually $50k more than the cheaper school and Harvard grads look like they get a $30,000 bonus when they decide to work at a company out of school. It’s called a “signing bonus”. So, short-term it’s a better decision with less debt, long-term you earn a lot less money each year.

For public companies, if you have to report how much money you make every three months instead of over a longer period, it changes your decision-making process. So, to make it easy, let’s say a company is expected to earn $1 million over the next 3 months, and they have a million shares of stock out there.  As we’ve discussed before, the stock price is all about expectations. So, in this case, it would mean earnings on a per-share basis are $1 because you earn $1 million and you divide by a million shares.  I know, super easy.  Let’s just say that your company can invest $400,000 to produce a new product that would earn $50,000 every quarter for a long time in the future. Sound familiar? Cheaper school versus more expensive Harvard.  

Well, if you spend the money on producing this new product, there are expenses that will reduce your expected $1/share earnings.  If investors don’t believe in the new product…. management or simply don’t believe the company will make that $50,000 every 3 months it could really hurt the stock price.  The expected earnings of $1 aren’t meant, people lose faith and the stock price falls.  So, management decides not to do it. However, if you have a private company, you can decide to do whatever you want.

So, a private equity firm is a private company that essentially buys ownership or equity in other companies.  You can buy a pizza restaurant, a trampoline park, or say a mall.  But, many private equity firms specialize in the companies that they invest in.  They may only invest in restaurants, entertainment, or real estate, for example.  So, how do they really make money?  First investors put money into the fund.  The leader or general partner will then have a team that will go out and finds companies to buy into.  If they buy the entire company, it makes it easier to explain.

First, it requires a little bit of understanding of how to value a company. I’m going to oversimplify, to make it simple.  The purchase price of a company is generally a multiple of some number.  For instance, when I bought my last company it was 6 times earnings.  So, if a company makes $500,000 then you pay $3 million, which is $500,000 times 6.  I think we know you sell a product or service, you take out expenses, and earnings are what is left over. Remember that price-to-earnings ratio for a stock we used earlier. It was 1 per quarter, so an entire year has 4 quarters, which is 4.  In this case, it’s $3,000,000/$500,000 or 6.

When you buy a stock, you may look at the price multiple. If you look at the stocks that are on the S&P 500 right now, this ratio is around 20, which is a lot more than what I have been using in my examples.  So, what do you think happened over the last year?  Well, dropped down from about 27 a year ago. So, as prices fall, this ratio goes down, which makes complete sense.

But, what happens when you buy a company?  These “multipliers” or “multiples” are based on the type of company you’re buying and are NOT always based on earnings.  Tech companies tend to get higher multiples than non-tech companies.  They have been shown to grow faster and can be more profitable.  If you look at some companies, when they are sold, they are a multiple of SALES.  What?  Not earnings???? Many companies weren’t even making money or had any earnings, but someone is willing to pay them say… 10 times their revenue.  WOW!!!  In my example of the company I bought for $3 million, the price would’ve been $60 million. Said another way, that’s a 20 multiple of earnings. See how that is very different. 

So, the fund has the money to go out and buy investments or equity ownership in companies.  And, let’s just say you take the same company that was making $500,000 a year, and you increased sales because the salespeople weren’t that good when you bought it.  Then you cut expenses because they weren’t using computers as much as they probably should’ve.  Now the company is making $800,000 per year.  Since it’s a better company and is now positioned for more growth, you may get a multiple of 10 x’s.  So, the new earnings of $800,000 times 10 now equals $8 million.  You paid $3 million, it’s worth $8 million, and you sell it.  That’s a $5 million gain.

Pretty cool, huh? But, it requires a lot of skills.  You have a lot of change to implement while bringing in the right people to do the right jobs.  It can be very tough, and it can require money to make changes.  So, generally, people who are in private equity have a really deep level of experience in business.  They’re aware of how to manage people, read the accounting information, help align financing when they need money and can see and implement a great strategy.

If you ever think about professional sports, you need an experienced coach, the right team, and an owner who has money and a vision.  I see it very much as the same thing, but the product isn’t football, even though that is a business, it’s video games, making clothes, selling roofs, pet food, or many other items.

That’s what I do.  I help manage companies to perform better so they grow in value in the private equity fund.  But, even though the reporting is less when an investment is private, there is still a good amount of filing, accounting, and other reporting. I get to that fun stuff too!!!

Hey, it was Martin Luther King day yesterday, and I had to Google his name and the word
“money”.  We know he was crucial in shaping the course of history through his fight for injustice and civil rights.  But, he also spoke of money.  In one article, I read he referred to how money was a worry because as Americans we can be obsessed with it, and he did fear it may lead to our downfall.  He said “Money in its proper place is a worthwhile and necessary instrument for a well-rounded life, but when it is projected to the status of God, it becomes a power that corrupts and an instrument of exploitation”. He lived very modestly.  And, that put a smile on my face.  He had some great common sense tips you should’ve heard before, said in other ways, so I wanted to leave you with 5 of them:

(1) Live modestly

This is rule #1 where you have to make more money than you spend.  You can’t invest in the future or grow wealth if you don’t have money because you’ve spent it all.

(2) Invest in yourself
You increase your income by investing in yourself.  Even if you learn another skill you don’t get paid for today, I believe you will get paid for it in the future. I can name 5 promotions that happened that way.

(3) Give generously
Most financial plans have some portion of charity.  If you’re doing well, most people like to help others. 

(4) Persevere
This has been one of the most common themes for almost every multi-millionaire or billionaire. You can’t quit when you get knocked down.

(5) Build with Intention
That means having a plan because you can’t reach your goal without having a plan.

As always, thanks for being here, and we’ll see you next time for money with Mak and G.  Bye….