As Stephanie and I have explored potential pivots into the space of private equity, I wanted to share the mental model that has helped me understand the space: comparing private equity and home flipping.
Private equity is the business of buying and selling companies. Private equity firms conducting “traditional” leveraged buyouts (LBOs)1 fund their purchases of companies with a mixture of equity (cash which they raise from investors, called “limited partners (LPs),” similar to the way venture capital firms work) and debt (which they raise from lenders - debt is usually 7-8x the amount of equity). This financing of a purchase with a combination of equity and debt is similar to the financing of a home purchase with a down payment and a mortgage. Another similarity to the home buying process is that private equity firms use brokers. These brokers are called “investment bankers.”
The role of the investment banker is to maintain relationships with companies that will eventually require infusions of capital, and then to line up financiers (including private equity firms) to provide that capital. Investment bankers spend much of their time producing “pitch books” (40-100 page slide decks) that explain to a company’s leadership why an infusion of capital is a good idea. While this pitching process (called “advisory”) is unpaid, investment banks make money when a deal closes (they get a percentage of the transaction). Investment bankers’ doing free work is similar to real estate agents’ providing free estimates on home values or free signs for garage sales. These brokers are building a relationship so that when a big transaction takes place, the asset owner will use that brokers’ services over those of a competitor.
A hypothetical example
Let’s see how all these players interact in a hypothetical deal. Though this deal has many players, we’ll give names to only 3 of them: investment bank Soldman Gachs, private equity firm RKK, and target company Curbside Liquidators. From the top:
Soldman Gachs convinces Curbside Liquidator’s management to sell the entire company or part of the company
Curbside Liquidators and RKK firm agree to a non-disclosure agreement (NDA) - similar to someone signing a COVID disclosure before showing up to your open house
Soldman Gachs sends RKK’s sourcing team a Confidential Information Memorandum (CIM, pronounced “sim”) about Curbside Liquidators - similar to a brochure or posting on Zillow
If RKK’s sourcing team sees a good sectoral fit they send the CIM to an associate
RKK’s Associate spends 20-30 minutes reviewing the CIM and doing basic Google searches about the company
If the Associate thinks Curbside Liquidators is a good fit for RKK’s portfolio, the associate does a deeper dive (1-2 hours) which may involve expert network calls, financial modeling, and Google searches to prepare a pitch.
The RKK associate pitches the deal to a Vice President (VP).
If the RKK VP agrees it’s a good fit, the VP and associate spend time building pitch more and then pitch to RKK’s investment committee
If RKK’S investment committee agrees they want to move forward, RKK sends a bid to Soldman Gachs
Soldman Gachs sends the bid to Curbside Liquidators. If Curbside Liquidators accepts the bid, RKK begins “diligence.”
Soldman Gachs shares a data room with RKK where Curbside Liquidators can share financial models and historical data. RKK will often hire a consultancy like McKinsey to assist in the due diligence process. Due diligence serves a similar function to a home inspection during the home buying process: it confirms that the asset you’re paying for actually has all the features you are expecting
During diligence, RKK starts looking for lenders. RKK aims for lenders they know well but that they haven’t used recently. Especially in “bulge bracket,” lenders can be the “buy side” of an investment bank (as opposed to the “sell side,” which produces CIMs), so bulge bracket PE firms have an incentive to rotate through lenders so that they can keep investment banks happy and continue receiving CIMs from all of them. In the middle market (MM) and lower middle market (LMM), lenders are often publicly traded “business development companies” (BDCs) like Ares
PE firms usually talk to 3-4 lenders max. Larger PE firms have a dedicated “capital markets” partner or team. The capital markets team will decide which lenders to work with. Some middle market firms use “debt placement” firms instead, like CenterPoint. Both capital markets and debt placement professionals serve the same role as a “mortage loan officer” in a home loan - finding a lender who matches the profile of the borrower and asset.
Looking for lenders also means negotiating “covenants” (contractual terms in the financing deal that incur penalties like increased interest rates if the borrower does not meet certain thresholds)
A lead lender sets the terms of the loan including the covenants, and then other lenders pile in to fill out the round.
Once the deal closes, RKK can undertake operational improvements in Curbside Liquidators like replacing management or merging the company with other, similar companies in the portfolio; usually this process takes 5-7 years.
During the operational improvements phase, Curbside Liquidators sends monthly updates to RKK, which RKK uses to update its forecasts about revenue and decide whether to notify lenders that it is likely to break covenants (note, getting flexibility on covenants is one reason PE firms will sometimes accept worse loan terms in order to work with lenders they’re familiar with)
RKK will sell Curbside Liquidators or its successor, either to another PE firm or through an initial public offering (IPO). This resale is similar to flipping a house. Proceeds are either reinvested to the fund or returned to RKK’s LPs as partnership income2
X for Y?
Metaphors are all well and good, but we’re in the startups business. Is there anything we can learn from recent disruptions to the business of buying and selling homes that could apply to the world of private equity tech?
iBuying
Instant home buying (“iBuying”) propelled Opendoor to an IPO in June 2020. But Zillow exited the business in 2021 so there’s a pall over the space. The parallel in private equity (buying a company and then finding a buyer for that asset) would likely not port well because:
it would be extremely capital-intensive (think $100M for a “small” company)
there’s less public data available to properly value assets
we’d be saddled with expensive assets which we’d struggle to unload if the market were to go down
Broker comparison
Upnest lets you compare real estate agents to find a ones with better rates. Technically companies could do the same thing for comparing investment bankers. This would work if companies generally know when they’re ready to sell, but might not work so well if companies need a lot of “nudging” to sell.
These purchases are called “leveraged” buyouts because the debt is the “lever” that the private equity firm uses to move the transaction. Private equity firms traditionally look for profitable companies with steady cashflows, because the profits of the business are enough to pay back the interest on the debt, yielding returns for the private equity firms.
n.b. PE firms can also raise additional money after buying a company, which is similar to refinancing a mortgage after buying a house. This re-financing process is called “dividend recapitalization.” PE firms will often do recapitalizations when they want to pay back their LPs and managers, so they raise additional debt in order to issue a dividend to them. Because a recapitalization adds more debt to the balance sheet without doing much for the company, it’s frowned upon by existing creditors.