Why Most Private Equity Pitch Decks Miss the Point

0:00Hello, everyone, and welcome to another episode of Acquisitions Anonymous. I am one of your hosts, Bill D 'Alessandro, and this will be a fun episode because it's a little different for us. So Mills and I did a candid conversation on how we think about investing in private deals. So if someone approaches us and says, hey, I'm doing a search fund, or hey, I've got this deal under LOI, or hey, I'm buying this piece of real estate or this building, how do we evaluate that from an LP's perspective? We talk a lot in the podcast about how to evaluate deals from the GP perspective, from the sponsor perspective.

0:32of, hey, there's a business I want to buy and run. But we get approached a lot. I'm sure there are people that listen to the pod that get approached a lot or are thinking about raising equity from limited partners. So we talked a little bit on this episode about how we would think about evaluating deals from the limited partners perspective. So a little bit different today on Acquisitions Anonymous, but it's a different side of our small business acquisitions industry that we hope is interesting to people. So without further ado, please enjoy this episode of Acquisitions Anonymous.

1:02of Acquisitions Anonymous. We don't have 100 % beers anymore. Thumbs down on just the plus inventory. Hi, Heather here. When I'm not breaking down deals with these guys, I'm helping people get the right SBA loans for their business acquisitions. Because when you're buying a business, the best financing isn't one size fits all. There's the best rate, fastest to close, the specific loan structure that you need, or a little of all of those things. That's why my company, Viso Business Capital, works with over 30 different lenders to find you the best funding in less time and with less friction so you can focus on the deal.

1:35Sign up for a free live Q &A session on SBA loans at visocap.net. Then click Zoom Sign Up in the top right corner. That's V-I-S-O-C-A-P.net and click Zoom Sign Up. Hey, Mills. How are you, man? What's up, man? I'm excited. It's just us today and we are going off book. We are trying out a different format for Acquisitions Anonymous today. And this is a conversation between Mills and I about how we look at deals as investors. We talk a lot on this pod, almost 500 episodes of how we would look at a deal as though we were buying it ourselves. But Mills and I also have invested in other people's deals and our approach frequently to be an LP, an investor.

2:23And that's a little bit of a different diligence angle. So what we want to talk about today is sort of how we approach those opportunities. And this is coming from the place that we've had a couple of people recently that we're not going to help who've said, I saw this deal. I first heard about this deal on the podcast. I'm letting you guys know I've signed the NDA, I'm getting the SIM, and I think I want some investors. And we're already familiar with the deal. And we're like, man, that's kind of like the natural progression of this, whether it happens or not, whether the deal is good, but we're so used to talking about buying the business as the owner operator.

2:58Now thinking about it as an investor has a slightly different layer and lens to it. Yeah. And we love that by the way. I mean, this has happened non-zero number of times where we'll do a deal on the podcast. The episode comes out and we either get somebody who emails and goes, I'm already looking at this. Damn it. Why did you want to do your favorite or hey, I heard about it on the pod. And it's my first time. I would love some experience capital. Would you guys ever invest? And I mean, how cool. That's one of the awesome parts about the internet. And this has happened to us a couple of times recently.

3:28So we thought we would do an educational pod, just for everybody who is thinking about taking on investors in their deal or thinking about investing in deals as an LP, how to think about it. So Bill, I get this question all the time whenever deal talk comes up and people are like, how do you, like, how do I get invited? How did you hear about that? Like, how, how do I hear about those opportunities? Cause it's usually all said and done, you know, once like you have anything to talk about. So how do, how do these opportunities come up for somebody other than just, you know, having 500 episodes on a podcast?

4:02So people assume that, oh, you guys must have the podcast. You must get a ton of flow for the podcast. And I, you know, we do get some, but it's not as much as you would think. Uh, we would like more, so send it our way. Um, but a couple ways, places where I get deal flow. There are the aggregator sites. If you're a regular listener to the pod, you may know Travis Jameson from Capital Pad, where they feature search deals fairly regularly. So you can go on Capital Pad or other places like that. One place, groups of high net worth people. So like Long Angle is a great community you can join. YPO you can join, EO.

4:40So if you are around other people who are investing in deals, very often those groups will actually aggregate deals and bring them to their membership. And you'll have the opportunity to invest. And sometimes it comes with kind of prepackaged diligence, which is nice. So that's one place that I've seen some flow. How about you, Mills? Yeah. The other thing I would add is like there's kind of regional or local angel investing networks that I've dabbled in for a while, but they're usually so early stage that it's like we're building some like pre-revenue thing and we need to raise capital that is different than what we typically look at on the podcast and is different than what I am used to underwriting.

5:17And so I'm like, I have no idea if this is going to be the next like viral app. Like I don't, I don't have any basis for that. So I found those to be not very effective for me. I think there's a big part of this is just like the more active you are and the more the flywheel churns, like Like if you're an investor in a partnership that is buying something, you know at least who your other partners are. And you start to see patterns of names, right, in your operating agreement or in your partnership agreement. You're like, oh, I didn't know that that guy did stuff like this. And then you see him at like, you know, a kid's soccer game or something.

5:52And it's like, hey, man, like we're in this deal together. This happened to me the other day at an event. And it was like all of a sudden we're talking about other stuff I'm invested in, other stuff they're invested in. And it just creates this flywheel when opportunities come up that people know that you're effectively raising your hand versus just the deal's done. People are like, shoot, how did I, how did I find out? How do I find out about that next time? Yeah. And it's worth saying, like, as you talk to people, if somebody is talking about a deal that they did, it is not, maybe you got to eat a little bit of your pride, but to go up to somebody and say, hey, like I would love to invest in some deals like that.

6:26I'm actively looking. And that's a phrase that I've kind of used. hey, I'm actively looking to do more deals like this. Would you ever include me if you see other opportunities? And very often, there's room in the deal. People are passing the hat. It's really a matter of staying top of mind. So if somebody's investing, oh, Mills would probably like that too. I think you also got to be prepared to not embarrass yourself, so to speak. Most times, these investments, when somebody is soliciting, you need to be an accredited investor. And also you need to be prepared to at least just ask the question of what is the minimum investment?

7:04In my experience, it's usually between$100 ,000 and$250 ,000 minimum investment on these deal by deal. Now, if you're going to like CapitalPad and an aggregator, they're lowering the bar because they have a lot better kind of coverage, right? And those might be$10 ,000 to$25 ,000 minimum investments. But for most of the stuff I've done, it's in the kind of$100 ,000 to$200 ,000,$250 ,000 range because they just don't want like a investor relations with you know 100 people yeah i've seen kind of 50 to 100 you know on the low end and honestly like if they're taking 10 000 checks it probably you know the deal they don't have enough interest it's kind of a negative signal and also i mean investing 10 000 like you're gonna get a k1 like there's you're gonna deal with this for five to ten years like even if you triple it it's just not really worth it in my opinion.

7:57So I'm always trying to balance, can I invest enough here that it's going to make a difference? But also I'm trying to stay diversified as well. I'm not trying to put huge chunks of my net worth into single deals. Yeah. But one last thing I'll say about where do opportunities come up is capital follows a path of where it's taken well care of. So I'm going to reinvest with folks who did well in previous investments? The outcome maybe aside, but were they thoughtful? Did they give me a K1 in time? Are they quick to give me regular updates? Did they at least acknowledge when things went the way we thought or differently?

8:39And similarly, the sponsor is going to do the same thing. If you're a pain in the ass LP, like you're not going to get phone calls as regularly. You know, if you want to nickel and dime them over every little thing or just be a thorn in their side, you know, it kind of works both ways. I've found though, that asking really thoughtful questions as an LP really helps the sponsor and helps the GP, not like death by a thousand cuts questions, but just asking thoughtful questions. Um, some of my friends who are GPs like roast me about like always having like the longest list of questions, you know, or the most strenuous questions in a deal.

9:16And I may be the smaller of all the LPs, but I, I at least am just going to keep doing that. Cause that's the way my brain works. So how do you balance that though, Mills? Because like, you know, if somebody is raising 5 million bucks and I'm going to put in a hundred grand, you know, like you're not investing enough of the round to like be the pain in the ass guy and drive the diligence. Like you're, you're investing a single digit percentage of the round. Like to some degree, you just kind of send the check-in, right? Yeah. I think you definitely have to balance it. I think usually the questions, what I've found is that if I'm asking the right questions, it's helping the GP round out their understanding of the deal too.

9:56You're not doing spreadsheet checks for them and like, you missed this thing, but just trying to understand the cash flows in and out, the sources and uses, making sure that the assumptions are correct and asking thoughtful questions. the investor, the sponsor knows more about the deal than anyone. And they're excited. Like I had this deal recently where they had interest only debt for three years on a development. I was like, dude, interest only for three years. That's amazing. Like nice work. And they're like, hell yeah, we were really proud of that. But you know, nobody else is giving us a thumbs up for it.

10:27They're like, whatever you did your job. But the difference between three years interest only in 18 months is material to the cashflow, you know, in the pro forma. So I think, I think there's like a little bit of an art to it. So let's actually move into diligence. So a deal's in front of you, you think you want to invest. How do you think about it as an LP versus a GP? So a GP, a sponsor, to not use fancy terms, this is somebody who has a deal and wants your money. They want to buy the business, the piece of real estate, whatever it is, and they're trying to raise money. And they're putting an offering in front of you and saying, hey, invest 100 grand, invest 200 grand whatever um this is the business we're buying or this is the real estate we're buying you know the way we kind of sketch it out pre-show is sort of three categories of diligence first business then structure of the deal uh and then sponsor the person bringing the deal so we're kind of kind of work through three categories of diligence the first one being business so how do you decide whether this is a business you want to invest in i mean mills how do you narrow it down i think that like we talk about it and we've talked about it for all these episodes of like is the business attractive?

11:36Is the price attractive? Are the terms right? All those things. As an LP, it's a little bit different because I don't necessarily need to be the one who can get in there and wrestle the business into submission. It's more like, do I add anything to this operating entity as a very in the background type of partner? I still want it to be in the path of progress. I still want it to be compelling from a risk return profile, all those kinds of things, but it's more like as a, as somebody who's in the backseat or the very, very backseat, you know, do, do I add value here? Does it, does it help me in any way?

12:12So you're focused first on, can you provide value beyond capital? Do you do deal where it deals where you're just the capital? Yeah, I have, we have. Um, and I, I think that like geography matters for me. I would much rather invest in stuff that's in my backyard that maybe doesn't have, doesn't check every single box, like 10 out of 10, but it's here and I know it and I can see it and touch it. And like, I can go visit the business or, you know, go visit the piece of real estate or like drive by and see how it's doing. So geography is important to me, but there's plenty of people that doesn't stand on their radar at all.

12:48They'll invest in something in Arkansas, you know, if it's the right deal and they'll never see it. I mean, I think we all like to touch and feel anything, you know, in our backyard. I mean, for me, one of the first questions I ask, obviously everybody has their own preferences about what industries they feel like have tailwinds, et cetera. But one of the first questions I ask is why did this sponsor see this deal? Did they just pluck it off a biz buy sell? That's a negative signal to me, unless, and we'll get to kind of buy our business fit later, unless they're like a particularly great fit to run it.

13:22But I really like to see a deal that was off market, that they had a special look at for some reason that didn't get shopped, that's a proprietary opportunity. That's generally a positive signal to me. So kind of the first thing I'm going is, is there a biz buy sell logo on the top corner of this offering memo? I don't love that. Yeah. I would get behind, I've never done one, but I would totally get behind a management buyout for the same reason. If you have a management team that's maybe undercapitalized, has been in the business a long time, wants to help the owner exit, I would love investing in something like that because you de-risk several factors already.

13:59That's right. So how about, obviously I want stuff that's structurally stable. I'm not a venture investor, Mills, you mentioned at the top. I'm not either. I'm not trying to, and if you're going to do venture investing, that's not what this podcast is about. That's not why you're listening. If you're going to spray and pay venture investments, there are other podcasts probably that will teach you to do this. The lens that Mills and I are coming at it from is kind of more of your classic search or real estate. I want mid-teens to 20s IRRs, and we'll talk about hurl rates later. We're not looking to shoot the moon here.

14:35So I'm not trying to predict the future. I'm more looking for a business that is not going to zero. We'll get to structure in a minute. I don't want a structure that increases the chances of going to zero either. But one of the first questions I'm asking is, is this business likely to be around in five years? I see a lot of e-commerce deals because of my background. Is this a fad? Is this heavily dependent on an e-commerce platform like Amazon where the winds can shift? Is it heavily dependent on an advertising platform where the algorithm can change? My first screen is I want anti-fragility in this business because it's constructually, this is a private deal.

15:15This is illiquid capital. Your capital is going to go in. And if the winds of change kind of come blowing through, if it's a public equity, you just sell, you go out. But there's no selling. So you're going to ride kind of the next five years of macro, whatever it is. And so I want to make sure that it's not like massively exposed to huge macro uncertainty. Yeah, no, I think that's a good point. And that's why we've tended to invest more in real estate, one, because it's roofing related and because it's so asset backed. Like our podcast has a cashflow backed component. Real estate is an asset backed component.

15:54The venture stuff is, you know, just like excitement. Vibes backed. Yeah, exactly. Vibes. So then like, let's say you, you know, you, you've heard about the opportunity. You're excited about it. It checks your boxes in terms of like what the business is, then the next set of questions is like structure, right? Who is, who is doing what, what are the shared economics? What are the unique economics between the two parties? Like the devil's in the details on this. And your first time around, you will not know any of the questions to ask. It's a totally different set of questions and vocabulary than just buying a business for yourself.

16:34And structure is the type, let's say it's a great business structure can make it even if it's a great business a bad deal to invest in yeah um so let's kind of talk through the components of structure um first let's talk about the deal structure which is what structure is the sponsor getting in acquiring the business and then the second level structure is what structure are you the lp experiencing your capital in as equity in the deal so the first question i want to know is kind of capital structure on the acquisition. What is the price? Are they paying a reasonable price? And how much leverage are they planning to use and how much equity?

17:11And that gets back to my earlier point about fragility. If this thing is very under-equitized, a whole lot of leverage, and they're paying a super high price, that's just more risk versus something that is a big margin of safety on the price and it's over-equitized. That might bring the returns down a little bit, but that's not the end of the world because what i don't want is a zero and i think that's a lot of times it's a it's you got to thread the needle as a sponsor too if you're going out to lps there's this compulsion to show the biggest irr number like this is gonna like we're gonna return this is gonna be a great deal and you can definitely juice the irr by ramping up the debt right but balancing that margin of safety if you show two conservative people aren't going to get excited yeah but threading the needle of the right structure that delivers good enough returns to get people excited without getting greedy.

18:02So that's kind of the first thing I'm looking for. I just basically, we were talking about hurdle rates earlier. I throw IRR completely out the window because I know IRR isn't actually real. When you look at a pro forma and you've run enough businesses and you've seen enough pro formas, but when you look at somebody's pro forma, IRR is based on functionally like NOI or net income, if it's an operating business. You and I both know we don't actually distribute NOI. You don't distribute net income, right? There's all the money that has to stay in the business and timing of cash flows in and out and reinvestment, all those kinds of things.

18:39So IRR ends up being based on the highest possible number of cash generated in the business, assuming 100 % of it gets distributed, which is never the case. So when I'm looking at the pro forma on a deal, I'm going, okay, IRR aside, how much free cash flow do we anticipate this business to make over the next five to seven years? And then discount from there, how much is actually going to have to stay in because we're not distributing 100 % of it. Also important too is taxes. And the models never account for taxes because you really can't because everybody got a different tax situation. But taxes are really real.

19:17A got you that happens a lot is people will structure as an LLC and then they've got to make cash distributions because they're going to allocate out income to everybody and that's going to create taxes, a tax burden for you. And you better hope you're getting a distribution in order to pay those taxes. I have definitely seen sponsors go in and not realize that they need to distribute 40 % of net income every year. Otherwise their investors are coming out of pocket for taxes. And that, so expect to get that tax distribution. Like that's a question I always ask. Like, are you guys doing tax distributions at what rate?

19:52you typically have to assume the highest marginal rate for everybody which can be ironic because if you're not paying taxes at the highest marginal rate you can actually keep some of the money the tax distribution but the taxes and that's a drag you're going to run that nice IRR on cash distributions but a lot of that is lost to taxes so be aware that is a pre-tax model when you see it one of the biggest risks in entrepreneurship through acquisition is buying a business with fragile systems, unclear demand, or a single owner who holds all the knowledge. Franchising approaches that problem differently.

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20:55If you're exploring ETA and want to understand whether franchising fits your acquisition strategy, visit franzi.com. That's F-R-A-N-Z-Y.com. And thanks to them for sponsoring today's episode. The structure on these deals can get so insanely complicated so fast. So there's kind of a sliding scale in my mind from like simplicity to complexity. The simplest is everybody has a common share class and everybody is just getting paid periposuit, which I hate that term, but everybody's just getting paid pro rata. If there's$100 of equity required and Bill, you put in$50 and I put in$50, okay, great. It's pro rata.

21:34You put in$60, I put in$50. sense. Yeah, exactly. So that's the simplest structure. Everybody has a common share class. What most of the time though happens in these deals is there is a preferred equity component where there's a pref being paid, a preferred kind of coupon being clipped, not just everybody's at common. So that pref rate ends up being like one of the headline things that you'll see in a pitch deck for something like this of, okay, you're getting guaranteed, whether it's paid or accrued, you're getting guaranteed to get a 8, 9, 10, 11 % PREF right off the rip. That becomes the floor of if this business doesn't go to zero and it is creating some cash flow, even if we don't pay it out at month 12 or 24 or whatever, before the sponsor, before the GP is getting any money, I'm guaranteed to get at least this hurdle rate.

22:31There has to be a balance between PREF, fees to the GP and other things, but that is going to be one of the headline numbers you're going to see is what's the prep. So I think that, so yes, it's funny because you as more of a real estate investor probably put a little bit more stock in the prep than I do because a real estate, a building has cash flows. A business cannot have cash flows. So when you're buying a business, uh there if there is a pref it's frequently accrued um and even if it's paid out the sponsor typically has the right to pause the payouts and begin accruing the payouts to keep the business alive obviously you're not going to bankrupt the business on distributing cash you know out to your lps uh so at the first sign of hiccup your pref is not really the pref so whether or not there is a pref.

23:23This is something I put more stock in earlier in my investing career, and now I put less stock in as I've been in some deals where the pref became not very relevant. And it kind of pretty quickly comes back to, is there a terminal value or not here? So real estate may be more weight on that. I am much more focused on the total return profile. Yep. So then that comes down to, first thing is maybe prep. And then the second kind of correlated thing is what is the co-invest? What's the split between GPs and LPs of the cash that is distributed? It's like a waterfall, right? Is what most people would talk about it as.

24:02So the typical kind of like traditional private equity model is 2 % management fee that the GP is going to charge and a 20%, two and 20 is like the model, a 20 % co-invest that goes to the GP. So I put the deal together. A 20 % carry. Yes. Carry. Yeah. So I put the deal together, I get a 2 % management fee, and then I'm going to get 20 % carry, you know, on, on this investment. And then 80 % goes to the LPs. Um, there's all kinds of layers and like hurdles and things flip. If certain IRRs are met, like it gets way, way complicated quickly. I tend to err on the side of simplicity and I like deals that are more simple over one that is maybe more complicated and slightly better rate of return.

24:51But you'll see, right, as you move up and down the risk spectrum, these splits start to change from 80-20 maybe to 70-30, right? What's your experience been with that, Bill? I mean, this is much more common in real estate, where you have these cash flows. In search deals, you'll typically have a little bit more of a sweat equity component. where the, cause they're going to operate it. You know, somebody putting another real estate deal. Yeah. They're operating a piece of real estate, but it's not the same. Um, where, you know, you will typically get, uh, you're going to, you can be giving the searcher some sort of free equity, sweat equity that's really vests in over time.

25:31The, and I almost within reason don't have a lot of sensitivity around that because typically if it works, you want the searcher to get rich and it almost gets a little bit more binary. It's not going to make or break like in a middling outcome, you know, you're, Oh, I made 12%. I made 15%. You know, the search took home a little more, you know, that doesn't matter as much to me. The, what I don't want is the searcher getting really rich on management fees or closing fees or refinancing fees, or, Or I've seen these deals with all these fees kind of loaded in just for kind of not creating EBITDA value.