The formulas, tricks and trade secrets of Private Equity

Private Equity Risk

Sample Chapter

Let me pose a question: when you invest in a business, as an external investor, how much business risk should you take on in comparison to the founders? Should you take on less risk, since you know less about the business? Should you take on more risk, since the founders have put in more work that you to date (and likely more work in the future)? Or should you take on equal private equity risk as equal partners?

The caveat is that it depends on the price paid. I may pay more to take on less risk, or vice versa. But, for simplicity, let’s assume I pay a fair market rate for a business. So, at this perfect market rate (whatever that means), what risk should I be exposed to in comparison to the founders? And why?

Private Equity Risk

Here are my thoughts on each scenario:

  1. The private equiteer takes on more risk than the founders – I don’t agree with this because all the hard work that the founders have contributed is paid for as a multiple of the earnings they’ve created. If they’ve put in 10 years of effort and have $0 EBIT, I feel bad for the founders, but private equiteers can’t be expected to pay for hard work without receiving maintainable earnings. Similarly, the founders’ future work is paid by a salary and the upside of their retained equity.
  2. The private equiteer takes on less risk than the founders – I don’t agree with this because the private equiteer has ample opportunity to conduct thorough due diligence (and they sell themselves on this due diligence, so it’s hardly fair that they use it as a basis to take less risk). When you buy something, you have the chance to examine it first, but then it’s caveat emptor – buyer beware. If the economy turns, a new competitor takes market share or technology changes, that’s your problem. You were looking for equity returns and you’ve taken equity risk, so you should be ready for the consequences. With that said, I agree there are exceptions in the cases of fraud, impropriety and lack of care (e.g. investors should be shielded from losses due to founders acting against the interests of the business and new investors).
  3. The private equiteer takes on equal private equity risk to the founders – In principle, and in some magical and mythical wonderland, I believe investors and founders should share the same risks. Again, the caveat being that a fair market price is paid and there is no price adjustment for taking more/less risk. This is a marriage, you each have different skills, but the mutual plan (at least for an active investor) is to work towards creating barrels full of value.

I’ll leave that thought for now in hope something more profound comes from it soon. My initial thinking is that most private equity deals do not divide private equity risk proportionally between founders and the fund. Maybe this is positive in a greater good sense, or maybe it’s negative; either way, I sometimes wonder about the triteness of private equiteers claiming aligned interests with founders.

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