The New Era of Private Equity

0:00We saw, and it's the reason that we created Epic and the scalable company and our scale and exit advisory, you know, consultancy that the opportunity and the advantage like where you could actually have an advantage. was no longer on, ooh, look at me, I could raise the most money. Because guess what? Everybody had a ton of money. Or, ooh, look at me. We've got the best analysts and we've got the most access to debt and other types of leverage, liquidity. Everybody had that. Well, when the second thing went away and when the first thing was just table stakes, well, that's no longer your advantage.

0:33What's the only real advantage left as a business? Let's kick it old school. What if we just figure out how to grow this thing, the good old-fashioned way, which is almost only never on a spreadsheet.

0:49Hey, everybody. Welcome to another episode of Business Lunch with your hosts, Ryan Dice and me, Roland Frazier. Wonderful to see you today, Ryan. What's new and exciting in your world? So, thankfully, not a ton of new because you and I have talked about this. I sort of just want to optimize what we have as opposed to creating a ton of new. A few new things here and there. I know we've talked about it on the last episode, but now just kind of getting into a groove. What about you? Yeah. I'm getting ready for our founders board meeting and our Epic board meeting and our Rise Nation meeting, all of which are happening next week, which is quite a lot for one week.

1:28Looking forward to seeing you in person and hanging out. And I may or may not have some some fun bottles of wine for us to enjoy. And then gosh, right around the corner from that is our big event at Get Scalable, right? So it's, it's a busy time of year for us. It is that season. It's the fall. But I, you know, I've said it before, like I'm an introvert, you know that, but I really do like being around my people, our people. That's, that's fun. And, you know, I think we've done a pretty good job at this point of curating a community of people who, when we walk into the room. We're not like, good God, I don't like these people.

2:05And I'll tell you, if you have a business and you would be terrified or not enjoy walking into a room with a bunch of your customers or clients, then something has gone horribly wrong. So all introversion and social anxiety aside, I'm actually really, really excited about the next week. Yeah, me too. I think it'll be really fun. One of the things that we'll be talking about then at those meetings is what's going on in the world of buying and selling businesses. And I recently came across an article that was talking about how private equity has a new set of rising stars and it is evolving into private equity 3.0.

2:52And the thesis behind the article was that originally, back in the day, private equity came in and said, we're going to do financial engineering. We're just going to go in, get your business. You guys don't know that much about finance, so we're going to play with that. They did it. Great returns. And more and more and more people came into private equity, which made it harder to do just that kind of engineering. So they went to private equity 2.0, which was really focused on acquisitions. So how can we acquire companies and just scale up through roll-ups? So where you saw a lot of private equity rolling into brick and mortar businesses like HVAC and plumbing and things like that, electricians, and that was kind of private equity 2.0.

3:48And now they're saying that, and there was an evolution to 2.5. I don't remember what their argument was there, but it wasn't a significant enough upgrade for it to be a full version. So the 3.0 is that the new stars, and this is shocking and revolutionary, are the operators that you bring in to run the businesses efficiently. The people that actually grow it? So the big innovation in private equity is maybe instead of just financially engineering this thing, or maybe instead of just doing leverage buyouts, maybe instead of just juicing it with a bunch of cash so that it can just do a bunch of acquisitions that aren't as synergistic as we would like for them to be, what if, and hear me out, we just try to grow the companies that we buy?

4:40Yeah. That's the breakthrough? That's it. So the focus is on the new rising star is rather than the jet setting hedge fundy investment banker types that are the quants that are doing all the financial engineering, which has fallen to about, I think, between 18 and 21 % of the value that gets added. Hey, Ryan Dice here, co-host of Business Lunch. And before we get to the show, I have an exciting invitation for you. My business partner and Business Lunch co-host, Roland Frazier, and I are hosting a live in-person event. And if you're a bootstrap business owner who wants to build a 10 million and even$100 million business in the next three years, you need to be there.

5:22This event is called Get Scalable Live. And over the last four years, it has transformed from a small gathering of entrepreneurs into the largest bootstrapped entrepreneurship conference in North America. Now, I know what you might be thinking. You're probably thinking, Ryan, really another business event? Is that really what we need, but trust me, this isn't just any other event. You see, unlike most conferences at Get Scalable Live, you'll have dedicated time to take action and actually work on your business instead of just in your business. Over three days, you'll work shoulder to shoulder with like-minded entrepreneurs to implement what you're learning and get valuable feedback that you're just not going to be able to get during the normal day today.

6:01You're going to be immersed in fresh ideas, strategic insights, and you're going to get the support and guidance that you need to actually reach your business goals. So this is your opportunity. This is your chance to step out of the day-to-day to eliminate the noise and finally work again on your business, not just in your business. And if you implement, I'm confident about this, if you implement just one or two key insights from any of our sessions into your business, you're bound to see a return on investment much higher than what we could ever charge for admission. And by the way, speaking of admission, right now, Business Lunch listeners can save an additional 10 % off of our already low early bird ticket pricing.

6:43So just head over to GetScaleableLive.com and use promo code LUNCH at checkout. Again, that's GetScaleableLive.com, promo code LUNCH. It is truly amazing what can happen when you step out of the day-to-day and spend just a little bit of time surrounded by other powerful business owners. And since this opportunity only comes around once a year, you don't want to miss it. Again, the link is GetScaleableLive.com. And don't forget to use promo code LUNCH at checkout to save up to 67 % off the full ticket price. That's all I got. I'll see you in Austin. All right, back to your regularly scheduled programming.

7:23Because these guys, the challenge is you have tens of thousands now of private equity funds with trillions of dollars that are trying to find deals. And the deals that they're finding, particularly with higher interest rates and inflation and uncertain economy around the elections and a drying up of government funds. And increased valuations because of increased competition. like you said they're just being so dang many of these things they're having to overbid for that but even more difficult for them is that if they just like if they go in when they can borrow debt at three percent or five percent then it's very easy for them to make their money with financial engineering and borrowing a lot of money not only to acquire the company but also to acquire other companies.

8:24But when debt becomes significantly more expensive, which it has, then that primary thing that they've been using to fund all of this has gone, has at least doubled in cost. And so what that results in is we can't do nearly as many deals because they just don't have the margins or the metrics for us to be able to do it. We can't just go in and it's good. Now all we have to do is acquire. It is, it's now my goodness, we've got to go in and support this debt. That's twice what it used to be. Plus this debt service. Plus we need to have enough extra money to be able to do this other stuff too. So we need this company to actually grow.

9:06We need the margins to actually improve. And so the new stars are the operators who are now responsible for a, I think it's about two to three times the percentage of growth that gets realized by the firm, or growth in value that gets realized by the firms is coming from these operators. So now they are becoming more of the stars of the show, which means there's going to be a greater need for good operating systems. That's good for us. That's scalable. To be put into these companies that are being acquired and operators who know how to grow, who know how to actually manage a business and identify the KPIs.

9:50And there's always a shortage of those. So look at, I can't remember the names. It's like maybe Coletti or something like that. The guy that was the CEO of Pepsi brands, Taco Bell, and then got promoted, then left and was the CEO for several years for Chipotle and now has just been hired on a$113 million contract to be the CEO of Starbucks. right? $10 million signing bonus, 75 million in, um, in stock as an equity grant and, uh, you know, and all kinds of other stuff. This is kind of insane compensation package that he has in addition to, you know, a million and six or million eight salary plus bonuses that could take that to 3 million.

10:37He's going to do okay, but here's the deal. They need him, right? And these operators are only going to be more and more valuable. So if I was ever looking for a place to focus my attentions, if I was in the working world and not in the investor world these days, it would be, I'm going to go and up my operating skills game so that I can be the person who runs these businesses and, you know, and, and get my increased compensation from all these private equity funds that are trying desperately to find good operators that know how to grow and manage a business. So huge opportunity. And for people who own regular businesses that are looking to exit, this is something that's going to be a huge, huge, huge additional plus for you.

11:27If you've got a solid ops team, then private equity is going to look at that and say, this is a team that we can actually maybe use as our platform team, not a platform company anymore, but our platform team to help grow this and other businesses. So lots and lots to me to take away from what's going on there. Yeah. And I'll tell you, it's incredibly validating because you and I saw this coming because we were living on both sides, both dealing with private equity from the sales side, but also competing with them at times on the acquisition side and seeing it was becoming basically impossible to spreadsheet your way to, you know, a good, a good exit, you know, to, to a good liquidity.

12:11Like it just wasn't there anymore. And so we saw, and it's the reason that we created Epic and the scalable company and our scale and exit advisory, you know, consultancy that the opportunity and the advantage, like where you could actually have an advantage was no longer on, Ooh, look at me. I could raise the most money because guess what? Everybody had a ton of money or, Ooh, look at me, you know, we've got the best analysts and we've got the most, you know, access to debt and other, other types of, um, you know, leverage liquidity. Everybody had that. Well, when the second thing went away and when the first thing was just table stakes, well, that's no longer your advantage.

12:47What's the only real advantage left as a business. Let's kick it old school. What if we just figure out how to, how to grow this thing, the good old fashioned way, which is almost only never on a spreadsheet. So I think it'd be fun to kind of talk about that side of the equation and like what good operators do that's different. But just for context, I think a lot of people may not understand when we talk about financial engineering, can you give an example of in the olden days back, like whether it's like 1.0 or 2.0, some combination, what would private equity companies look to do? Can you kind of give an example, like a prototypical example of a financial engineered business?

13:26The classic one would be if you ever saw the movie Pretty Woman, what Richard Gere's character did there, which was he would go in and buy companies that had assets that were greater than the market was valuing the company at at the time. So the liquidation value of the company, either its assets or its subdivisions, its companies within the company that it held, would be worth more individually than the sum of the parts altogether. So if you went into a company and you buy a company that, let's say it's a scrapyard company and they own 15 scrapyards and they're vertically integrated. So, you know, they have some other, you know, metalworking and other things like that.

14:20And the public, let's say values that company at a hundred million dollars, but just the equipment that's there and the land that it's on and the buildings that it has and the vehicles that it has, if you sold all of those off, the market value of that stuff is 200 million. So the financial engineering is let's go buy that company with debt that matures relatively quickly. But our whole plan is that we're going to liquidate the whole thing anyway. So we go in then we fire everybody that we don't need that was running the management part, which lowers expenses, increases profitability. We then list all of the separate assets for sale and sell them off one by one.

15:05And, um, and in the end make, you know, double our investment relatively quickly. Let's say that it was 10 % money. Even you borrowed a hundred million, you pay 10 million in interest to hold it for a year. You sell everything for 200 million net. You've got yourself 90 million in profit. And they would just do that over and over and over until everybody else was like, wow, that seems really easy. It's not really great by the way, for the people in the company, the individual companies themselves or the economy but it's richard here's character in pretty woman was not like set up and upheld as like this is just a really good dude you know yeah he had a moral change of heart right as a result apparently all you have to do is data data call girl and then you know you will you will have a change of heart and become a better person but he ended up deciding to rescue the uh you know the company that he was going to buy and tear apart instead of destroying it, which meant the end of his relationship with all of his greedy partners, which is the people who are going to do.

16:07So version 1.0 was not, let's build these things. It's we're bankers. We know that the sum of the parts is greater than the whole. So let's go in there. Let's buy the freaking thing with debt. Let's break it all up and let's sell it. We're not going to even attempt to operate this thing. That was kind of version 1.0. 2.0 though - So financial engineering wise is basically just, let's look at the numbers. Let's look at all the numbers of all the different scenarios, do the scenario analysis, whichever one yields the greatest internal rate of return. Let's do that. And who cares about anything else?

16:37All financial engineering, no care to operations at all. In fact, operations is actually probably going to go away because they're just going to sell it all. Well, it's all just a great expense, right? I mean, everything in operations is not seen as a value creator. It's simply looked at on the expense side of the equation. 2.0, though, I feel like it shifted a bit because 2.0, at least from the outside, it was we're going to build this thing. but we're still not going to build it through organic growth of the entity itself. It's still not operations. It's still financial. We're still not operating.

17:08Yeah. So break that down. So 2.0, we're talking roll-ups, break down that scenario. Yeah. So roll-up is basically, we're going to go in, we're going to buy the company with debt that's relatively inexpensive. And now we own the company. How are we going to get it to grow really, really fast? It's our favorite way to grow a business still, right? We're going to acquire other companies that are competitors of the company, direct or indirect, and or we're going to vertically integrate, meaning we're going to buy our suppliers and our distributors or wholesalers. And then by buying those other companies, we will simply glom their revenue and profits onto ours.

17:47We'll use debt or stock from the company that we've got to acquire the other company. And then that company's additional profits will support this. And then when we've got this to a certain level, we'll take it public and we'll make a whole bunch of money there, or we'll sell it to an even bigger company that wants it. So really just growth by acquisition. So we still do that. Like that is still a strategy of ours. I don't want to give the perception that like 2.0 is dead or wrong or evil. I think 1.0, and that still happens to a certain extent. I would argue that's not an inherently entrepreneurial activity.

18:23You could argue 2.0 is an entrepreneurial activity. Why though? Why the pivot? Like, so what changed that made 2.0 not as effective anymore? And like, how would you characterize the traditional 2.0 to more like what we do and what this article was prompting? It's two things, I think, really. It's just straight out competition. The last time I looked, I want to say there were 68 ,000 private equity firms, right? And they had trillions of dollars. And then you've got Warren Buffett, who's sitting on, I think, 275 billion and Apple that's sitting on crazy, crazy cash. And those companies are acquirers too.

19:00So you've got competition from family offices have come in and there are a lot of family offices. And so there's, they're more buy and hold. We're just looking, how can we get a good return on our money safely, capital preservation. Then you've got private equity, which is buying for financial reasons. And then you've got companies that have insane amounts of cash as well, because the value of stocks have gone up so much. And so they're able to issue stock and raise a lot of money. So you have all of this capital that is chasing fewer deals. And so let's look at auto repair centers. So the last time I looked, there was 109, I think, thousand auto repair centers in the United States.

19:47Now, if 50 private equity firms decide they're going after those, that's 50 cash wealthy companies that are going to be bidding against each other for a relatively finite group of companies. Let's say that at any given time, 10 % of those are acquirable. That means that there's 10 ,000 companies that can be bought by 50. And while that sounds like a lot, a lot of those companies are not going to qualify. They're not going to meet the acquisition criteria. So then when you get into the companies they actually want to buy, it's a pretty small number of targets, even in a big market like that. They went to those markets because there were so many more of those than there were like, you know, department stores.

20:30But that competition has driven up the price of the companies that are selling, which means that it's going to cost more to get them and they're going to have to perform better to generate the returns that private equity wants. Now, on top of that, you've got that debt, which was the primary tool for acquisition, has gotten crazy expensive, literally double what it used to cost just a couple of years ago. So higher prices to acquire because of competition, supply and demand and higher acquisition costs because of the increased cost of debt. Plus sluggish sales because these companies are suffering from in the economy what all of the consumer confidence, you know, damage that's taken place because government, free government money handouts are gone from the pandemic.

21:28Inflation is up. Interest rates are up for consumer debt as well. And so consumers are pulling back. Even wealthy customers now are looking for to either pull back on their buying decisions or looking for substitute products that are less expensive that provide the same utility. So when you've got all that going, then let's go buy that company for an inflated price with inflated debt with scary future prospects because of consumer confidence and spending. How then do we find the extra money to use that as a platform to go acquire more companies by borrowing more money, it becomes hard. Who are we going to sell it to up the chain because they don't have the money either?

22:06And we know that. And so you may not even be able, and if you've got debt and that debt has a clock on it and you're worried that normally you're, if you could, I mean, the typical model was three to five and three to five. So if we can three to five X this company in three to five years, we can sell it to someone up the chain with the final leg of the chain being the public markets, right? So if we can 3 to 5 this thing, it keeps moving up the chain. And as long as it's 3 to 5 and 3 to 5, 3 to 5X and 3 to 5 years, there's going to be a buyer somewhere, even if it's the public markets. But when it's 3 to 5X is a lot harder for all the reasons we talked about.

22:46And when the 3 to 5 years now is taking longer and when you don't know there's going to necessarily be a buyer on the other end for all the things we talked about. And now your debt costs a lot more and the maturation rates are still in that three to five range. Boom, business model toodles if you're traditionally just doing those kind of things. So now they say, OK, well, what if instead of just doing all that finance side stuff, because they were really, you know, they wanted the company to operate and make good profits and everything, but it didn't really necessarily need to grow because growth was through acquisition.

23:25And so as long as they had operators that could absorb and integrate the companies they bought, which, by the way, is a huge challenge, because generally the stats are that only about 20 % of the acquisitions that are done realize the projected benefits because, of course, the stats are put together by investment bankers who are compensated based on being able to do deals. Right. So, um, so there's that also, right. The act, the actual, gosh, now we caught the car. What do we do? Can we still bark at it? Right. So, um, so now we need operators and it's, it's, they're like, Holy crap. What if we, where can we look to continue to be in business?

24:08We're going to need to actually get some people that can add margin and revenue in these companies. And so that's the operators. Now, private equity firms for years have had teams of operators that they would bring in to businesses. So it's not new that the operators exist. They would replace people that didn't have as much experience with people that did or people that had better resumes. But now these people are being required to perform and they're going to be compensated much, much more significantly based on how they're going to perform. And private equity's ability to do what they do will be more, more, more dependent now than ever on the ability of these operators to perform.

24:51Therefore, they are the new stars of private equity. So what opportunity do you think this creates for entrepreneurs, business owners? What opportunity do you think this creates in terms, you know, for kind of the entrepreneurial investor class, you know, the people like like us and the folks that we work with? You know, obviously, the the institutional investors, the private equity groups, the family offices, even some of your search funds, they're having to adapt a bit, a lot. But but screw them. Let's talk about like the uss. What is what's the what does this mean for us? I think that the opportunity for all of us who are not private equity, who are the targets of private equity or who are looking to sell, need to be aware that operations in terms of operational efficiency above market performance of your company, above industry performance.

25:47Let's say the industry return on invested assets is 10 % and you're generating 20%. That's going to be significantly more important to increase valuation for you. And the existence of a proven operational team is going to be maybe the difference between you getting a deal done and not getting a deal done. So the opportunity is be an operator and up your skills and create a track record of performance. Hire and put in place in your company proven operators who are achieving and who are being measured and who are achieving results. Have systems so that you can prove the operational performance of the people that you've got running the company.

26:37And as investors, buy companies that already have professional management installed that are professionalized versus owner-operated or use systems like Scalable or other tools to have a plan to build a team or a system or both that can turn owner-operated businesses into professionally managed. because I think owner-operated businesses will be in less demand and you'll see prices decline and professionally managed businesses will be on the rise, will be in more demand and still they're going to have to reach down lower than they were reaching before because there's too many private equity firms competing for the few companies that are out there.

27:19So if you can create a professionalization of owner-operated businesses machine, then I think you're going to have for the foreseeable future a very, very, very valuable thing. And again, not to toot our own horn, but that's why we created Scalable. People are like, oh, why'd you do this? It's like, we did it because we needed it. Because we knew we needed it for our own businesses. We needed a business that we could run our portfolio companies through that would professionalize these owner-operated, these perfectly imperfect businesses. And I just gotta say, we're just... You know what, Roland?

27:55I think this is the point. And I think this should be everybody's takeaway from this episode. we're even smarter than we thought we were yeah yeah yeah so so smart that stupidly we bumble into smart things classic broken clock um you know it's like god dang it there's no way we could compete with these like big money types like what can we do maybe we can actually grow a business yeah let's try that oh hi i can't i joke if i could have any single skill i i would i would like that skill to be the one, you know? And I think in all seriousness, I think, I think what we are shifting is I believe that, that business value, like the value within business is shifting, the pendulum is shifting away from the bankers and the financial engineers and the big money types.