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

The Core Concept

Understanding this topic is essential for any private equity professional. Let’s break down the fundamentals.

Common Mistakes to Avoid

Learning from errors can save you millions in actual deal situations.

If we achieve a 10x return on our fund, LPs and other private equiteers 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 downside 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 have a toolkit that can be applied to a variety of situations. We invest via preferred stock, demand preferred coupons, implement ratchet mechanisms, have veto rights over many business decisions, take a board majority, have the right to fire senior executives, demand that management 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 to get 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 actual portfolio company performance being above average. Of course, this doesn’t hold when private equiteers over-lever their investments, but think about this one without above-average debt.

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