The formulas, tricks and trade secrets of Private Equity

Equity Returns Debt Private Equity

Sample Chapter

The mantra of private equity is maximum return for minimum risk. However, I can’t stress enough that the empahsis is on minimum risk.

If we achieve a 10x return on our fund, LPs other PEs will say “they were lucky”. If we achieve a negative return on our fund, everyone will say “they are poor investors”. Both terms are pejorative (hey, life’s unfair), and they’re both typically the result of swinging for the fences.

The art of private equity is achieving relatively good returns without fail. In terms of personal wealth creation, moderate returns are more than enough. And they’re much better than nothing at all, which has time and time again proven the result of people who swing for the fences. This is why we focus on minimizing risk first.

In public markets, you can achieve this by buying put options against a portfolio or through investing in call options. But we all know there’s a cost, and even with that cost, you rarely mitigate risk 100%.

To achieve the same in private equity, we invest via preferred stock, demand preferred coupons, have veto rights over many business decisions, take a board majority, have the right to fire senior executives, demand that managers invest, sometimes even demand redeemable preferred stock, etc. We are simply hedging our bets. But, like option strategies in public markets, the hedge isn’t perfect.

Where this idea of equity returns for debt risk really matters, is within a portfolio of assets. Public equity fund managers invest in equity returns for equity risk and that equity risk means that some investments succeed and some fail (and then transaction costs ensure most fund managers achieve sub-market returns).

In a private equity portfolio, our quasi-debt investments don’t incur as much loss from poor performing investments, so portfolio returns can conceivably be above public equity portfolio returns without investee performance being above average. Of course, this doesn’t hold when private equiteers overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.

This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.

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