What private equity gets wrong​
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March 2024
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The more I get into institutional capital markets, the more I realize it’s one big career-risk, principal-agent problem from bottom to top across LPs and GPs. The problem for my industry is that traditional private equity terms create terrible incentives for buying and operating a company. A private equity firm is being completely rational when it continues to pay higher prices, does increasingly less due diligence, raises larger-and-larger funds, buys bigger companies, makes short term decisions, and bills the heck out of investors and portfolio companies every time they lift a finger. If that sounds like strange behavior, you don’t understand how traditional private equity works. And it’s not because they’re bad people. Some are, but most are decent people who are trying to make a living and doing the best they can under the circumstances. Those circumstances are co-created with LPs (i.e. the people with the money), and the industry standard is to hog tie the dollars with all kinds of nutty and perverse strings attached.
Here’s a big management fee to pay yourself handsomely. Want more? Raise more. Bill us anytime you work with your companies. Don’t worry about putting much skin in the game. Feel free to use copious amounts of debt, just make sure it’s non-recourse. If the company detonates, walk away. And for goodness sake, never hold an investment longer than 5 years. In fact, make sure you sell your winners early so you can raise your next fund.
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If the standard model is broken, why don’t more people want to change it? The short answer is career risk. No one wants to break wind in the crowded elevator. To quote Austin Powers when asked how dare he, “I didn’t know it was your turn, baby.”
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This results in risk-averse assets and average returns. Down-the-middle opportunities where someone who knows what they’re doing has put in the work to build repeatable systems, generate accurate and actionable data, reduce risks, and provide a clear executional path to scale. The leadership team is experienced and incentivized to stick around. The customer base is diversified and sticky. The industry is fragmented. There’s infrastructure already built for tuck-in acquisitions, and even perhaps that skillset on staff. They tend, on average, to be larger and faster growing, depending on how early you catch them. These types of businesses are highly valuable and can be bought by almost anyone. Most private equity firms buy stuff that’s down-the-middle, and for good reason. Go to the first principles of the analysts and associates who are doing the work.
They’re combing through opportunities to take to their boss. Do you think their first concern is about the absolute value (quality/price) of the investment? Heck no. Their number one objective is to look good to their boss and help their boss, the VP, look good to their boss, the partner. So they’re putting forth deals that at first glance look obviously attractive. And that VP is weeding out even more stuff that might not be quite down-the-middle enough. By the time it gets to the Partner, there’s a beautiful Excel bow tied on it, ready to take to the investment committee. Once it passes the investment committee, it has to be quickly analyzed by the diligence team and approved by the bankers providing debt to the deal, both of whom are even more risk-averse and aren’t necessarily staffed with the same level of talent.
From the associate to the VP to the Partner to the investment committee to the diligence team and the bankers, there’s a decreasing ability to spend time on the investment, decreasing risk tolerance, and escalating career risk, which creates an ever-increasing need to have the investment look good and be easily understandable. The desire for quality, of which the absence of complicating factors is a key component, skyrockets, and so does the necessary price as the firms all duke it out for these easily-understood, down-the-middle investments. To make up for a high price, mountains of debt are added to lipstick the manicured and well-heeled pig. And, oftentimes it works well enough at scale to keep the game going.
The other way to operate is to embrace situations that look complicated, risky, and weird on the surface, but upon closer inspection, are higher quality than you’d expect and can be purchased at a price that dramatically covers any “fur” on the deal. This is where the smart money in PE loves to play, and this segment of the market is ripe for these types of opportunities. Ironically, it's where a lot of the founders of large funds cut their teeth in the beginning of their careers.
All businesses are loosely functioning disasters, especially smaller businesses, and some happen to make money. Small businesses don’t stay small on purpose. So, if you do your homework correctly and the market is big and durable, then the only logical conclusion for why a business remains small is that there are complications. These complications require skill to properly evaluate and risk mitigate, take considerable time to investigate, and provide poor optics and resulting career risk, thereby reducing competition. This is the definition of market inefficiency — skill matters, creating opportunities to make or lose considerable sums, and quickly.
All investing is merely the assumption of risk, and in my experience not all risk is built the same. Good risk is that which can be assumed with probabilistically more commensurate reward by someone who has a relative advantage in mitigating it. But often that risk comes with the downside of being non-conventional and non-consensus, creating heightened personal risk to the taker and often leading to inevitable principal-agent problems.
As a PE firm scales, one of the biggest challenges it faces is to remain open to the weird, the “hairy,” and the complicated, and to create a culture that rewards taking idiosyncratic risks. There’s a danger that as they continue to scale systems and the size of the investing team increases, perceived or real career risk will shoot up and they become far more comfortable playing it safe. Safe doesn’t, hasn’t, and won’t generate outsized returns.