John F. Dini, Author at Your ExitMap

Private Equity Leverage

November 11, 2024 by John F. Dini

Private equity leverage can dramatically increase ROI, but it can also be a trap. In our previous article, we discussed the general structure of Private Equity, how it works, and the types of Private Equity Groups (PEGs). They have grown rapidly as an alternative investment that produces far better returns than Treasury Bills or publicly traded equities.

The Power of OPM (Other People’s Money)

How do they provide these enviable 18% to 25% returns on an investment? The simple answer is leverage. An example most business owners can easily comprehend is a real estate mortgage. You put down $100,000 on a $500,000 building. The mortgage, especially in the first few years, is largely interest expense. You lease the building for a rental rate that covers your mortgage payment and expenses. Two years later you sell the building for $700,000. How much did you make?

The obvious answer is $200,000, but what is your Return on Investment (ROI)? If you said 40% you’d technically be correct. You made a $200,000 profit on a $500,000 investment. But what was your cash-on-cash return?

That is 200%. You actually invested $100,000 of your own money and used the building to secure a loan for the rest. Your profit was $200,000 on a $100,000 investment.

Private Equity Leverage(Other People’s Money)

Extend this example to buying a business. The business makes about $2,000,000 a year. (For the sake of simplicity, we won’t discuss here the differences between cash flow and profit.) The agreed-upon acquisition price is $10,000,000, or five times the profits. The PEG contributes $2,000,000 as a downpayment and finances the remaining $8,000,000. The cash flow of the business must cover the loan payments and leave enough working capital for operations.

A 5% loan amortized over 20 years requires a payment of about $53,000 a month or $636,000 a year. The remaining cash flow ($1,364,000) produces a return of 68% annually on the purchase.

Of course, the Limited Partner investors don’t get all 68%. Some must be kept as working capital for expanding operations. The PEG receives substantial fees for creating the deal and overseeing the investment.

In fact, the 25% return to the investors is only part of the story. If the PEG can double the company to a $4,000,000 profit level, even the exact same 5x multiple on exit could produce a $20,000,000 sale, or an $18,000,000 return on the original $2,000,000 cash outlay. That’s a 900% ROI.

Leveraging the Leverage

Buying a middle-market business with the structure outlined above would be lucrative enough, but of course, as professionals, the PEG would like to maximize their return. They frequently cut expenses dramatically upon acquisition (more on this in the next article.)

Often, they will line up a secondary loan, using the company’s cash flow to reduce or eliminate their downpayment exposure.

Private equity leverageDuring the low-interest environment of the last decade, PEGs could negotiate even more favorable terms. If you replace the 5% loan with a 2.5% loan, the annual cost is reduced to $509,000 annually, leaving a 75% return to work with.

Traditionally, most of the loan terms in private equity purchases reset after a few years. Refinancing at 9% raises the loan cost to about $865,000. Still, a 57% ROI is acceptable, if the business is thriving and the other expenses are kept under control. If the cash flow is covering a secondary loan at an even higher rate to replace the downpayment, or it’s been pledged to cover other debt outside the business, the picture might not be as rosy.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Private Equity and Privately Held Businesses

October 28, 2024 by John F. Dini

Depending on who you are talking to, Private Equity is either the Great Satan or the savior of small and mid-market companies in the United States. The stories depend a lot on the personal experience of the speakers.

Once a vehicle for high-risk investment plays in corporate takeovers (see Bryan Burrough’s Barbarians at the Gate,) Private Equity has morphed into tranches where specialists seek opportunities in everything from a Main Street entrepreneurship to multi-billion-dollar entities.

What is Private Equity?

The term itself is relatively generic. According to Pitchbook, there are currently 17,000 Private Equity Groups (or PEGs) operating in the US. The accepted business model for our purposes is a limited partnership that raises money to invest in closely held companies. The purpose is plain. Well-run private businesses typically produce a better return on investment than publicly traded entities.

The current Price to Earnings (or PE – just to be a little more confusing) ratio of the S&P 500 is about 27.5. This is after a long bull market has raised stock prices considerably. The ratio is up 11.5% in the last year. That means the average stock currently returns 3.6% profit on its price. Of course, the profits are not usually distributed to the shareholders in their entirety.

Compare that to the 18% to 25% return many PEGs promise their investors. It’s easy to see why they are a favorite of high net worth individuals, hedge funds and family offices. As the Private Equity industry has matured and diversified, they have even drawn investment from the usually more conservative government and union pension funds.

Private Equity Types

Among those 17,000 PEGs the types range from those who have billions in “dry powder” (investable capital,) to some who claim to know of investors who would probably put money into a good deal if asked. Of course, which type of PEG you are dealing with is important information for an owner considering an offer.

The “typical” PEG as most people know it has a fund for acquisitions. It may be their first, or it may be the latest of many funds they’ve raised. This fund invests in privately held businesses. Traditionally PEGs in the middle market space would only consider companies with a free cash flow of $1,000,000 or greater. That left a plethora of smaller businesses out of the game.

For a dozen years I’ve been writing about the pending flood of exiting Boomers faced with a lack of willing and able buyers. I should have known better. Business abhors a vacuum.

Searchfunders

Faced with an overabundance of sellers and a dearth of capable buyers, Private Equity spawned a new model to take advantage of the market, the Searchfunders. These are typically younger individuals, many of whom graduated from one of the “EBA” (Entrepreneurship By Acquisition) programs now offered by almost two dozen business schools.

These programs teach would-be entrepreneurs how to seek out capital, structure deals, and conduct due diligence. Some Searchfunders are “funded”, meaning they have investors putting up a stipend for their expenses. Others are “self-funded.” They find a deal, and then negotiate with investment funds to back them financially.

Both PEGs and Searchfunders seek “platform” companies, those that have experienced management or sufficiently strong operational systems to absorb “add-on” or “tuck-in” acquisitions. The costs of a transaction have bumped many seasoned PEGs into $2,000,000 and up as a cash flow requirement. Searchfunders have happily moved into the $500,000 to $2,000,000 market.

In the next article we’ll discuss how PEGs can promise returns that are far beyond the profitability of the businesses they buy.

My Interview with Jerry West on Management

August 29, 2024August 29, 2024 by John F. Dini

I once had the thrill of interviewing Jerry West on management. He was “The Logo” for the NBA, although back then they didn’t advertise him as such. Only the Laker followers knew for sure.

In 1989 the “Showtime” Lakers were coming off back-to-back championships. Pat Riley was a year away from his first of three Coach of the Year awards. Jerry was the GM. Many people don’t know this, but starting when Jerry West was drafted in 1960 until he stepped out of the GM role in 2002, the Lakers only missed the playoffs twice. Those seasons (74-75 and 75-76) were the only two seasons out of 42 that West was not on the Laker payroll.

In 1989 I was enrolled in Pepperdine’s Executive MBA program. Our class assignment was to interview a top executive with whom we had no previous relationship or introduction about his management style.

Mr. West Returns the Call

I was an avid Laker fan, and I thought “He can only say no.” So I called the Forum, asked for West’s office, and left him a voicemail. A few hours later our receptionist called me and said “One of your friends is goofing around on the phone. He says he’s Jerry West.” Obviously, I took the call.

We met in his office underneath the stands in the Forum. It may have been 12 x 12 feet, but the magnetic boards lining the wall made it seem much smaller. Each board had an NBA team’s name on top, and magnetic placards for every player currently on that team.

I asked Jerry about how he approached the management of the Lakers. He gestured to the boards. “My job as General Manager is to put the best team on the floor that I can. I look at these boards every day and think who might be better on the Lakers? Then I look at other teams and think who they might have that will convince the team with the player I want to give him up.”

He went on to say that he was sure that business executives weren’t as singularly focused as he was. He thought about the Lakers from the moment he woke until going to sleep at night. I didn’t try to convince him that he matched the profile of many small business owners.

Jerry West on Management

As a manager, Jerry said that he believed that if you hired someone to do a job, then you needed to step back and let them do it. Pat Riley was a broadcaster with no coaching background. Jerry said that the problem with experienced coaches is that they had already been fired once. West took a flyer on Riley, but to appease the media he agreed to sit on the bench to lend advice.

“It was crazy. Riley had no idea what he was doing. He’d call to put guys in the game that we had cut the week before or to sub in guys who were already on the floor. I lasted about three games on the bench. I had to go to my office and let him learn on his own. The alternative was that I’d kill him.”

One poignant moment was when he discussed his family. I can’t imagine the burden being in the public eye brought with it. He talked about his children being bullied on the playground because the team was on a losing streak. Even worse was having his wife accosted in the supermarket aisle by a fan who was incensed over a trade.

One of his greatest tips was when we discussed keeping things in perspective. He showed me two file folders in his desk drawer. “One of these has the most complimentary of the letters I get when the team is doing well. They tell me I’m a genius. The other folder is the worst letters I get when the team is doing poorly. You can guess what they think of me.”

“Whenever we are on a streak, good or bad, I pull one of the letters from the file when we were doing the opposite. It reminds me that it wasn’t always the way it is today, and it will swing back sooner or later.”

Looking to the future

I wasn’t supposed to discuss the Lakers, but the fan in me couldn’t help it. Jerry had just drafted a guy from Yugoslavia that no one had heard of. This was well before European players dominated the top draft picks. I had to ask him about his choice.

“Wait until you see him,” West said. “Seven feet tall and he can pass the ball like Magic.”

He became the starting Laker center for the next seven years. Then Jerry West traded Vlade Divac to the Charlotte Hornets on draft night of 1996 to get the 13th pick, a teenager named Kobe Bryant.

Always looking at those boards.

We’ll miss you, Jerry.

Addressing the Value Gap – Truth in Pricing

July 1, 2024 by John F. Dini

Truth in pricing is a common issue when discussing the sale of a business.

The selling price of their company is a point of pride for any owner. When they are willing to share the price they were paid, they usually include everything that was listed in the purchase agreement. While there is nothing inherently dishonest about that, it’s often not exactly the truth either.

In our last article we saw Bob, the owner of Bob’s Widgets, came to the conclusion that he needed to sell his business for $6,000,000 in order to replace his current salary and the Seller’s Discretionary Earnings (SDE) such as the vehicle and health insurance that his business pays for.

He knows that his friend Edgar sold his widget company for $5,000,000. Both Bob and Edgar have about 40 employees. Bob thinks his newer manufacturing equipment allows him to operate more efficiently than Edgar. Edgar freely discloses that his revenues were $4,000,000 in the year prior to the sale. Bob’s sales were $7,000,000 last year.

We will ignore Bob’s EBITDA ($500,000) for this exercise. Whether his expectations are practical as a multiple of profits is a discussion for another time.

Is it unreasonable to presume that if a $4,000,000 revenue company in the same industry can sell for $5,000,000, then a $7,000,000 company should sell for $6,000,000? Bob figures that he is not only being reasonable, but perhaps he is shooting too low.

Truth in Pricing

To begin, let’s see what Edgar’s price consisted of.

Royalty payments on specialty widgets that Edgar patented were value at around $150,000 a year for the next ten years. That was $1,500,000 of his “selling price.” In addition, although Edgar’s equipment was old, it was paid for. His company was debt-free. He generated almost $1,000,000 in EBITDA annually.

truth in pricingEdgar’s buyer also wanted him to stick around for three years. Edgar calculated his salary of $150,000 a year as part of the “purchase price.” He also had an “earn out” of $500,000 a year for reaching certain sales goals in the next two years. In total, royalties, salary and conditional payments made up $2,950,000 of his $5,000,000 price, leaving only a bit more than $2,000,000 as “cash on the barrelhead.”

Did Edgar lie? Not in his own eyes. Given some time, effort and luck., he will eventually realize $5,000,000 in total pre-tax income related to his business. It’s his version fo truth in pricing.

Bob’s Price

First Bob has to consider what his price would include. He has about $350,000 left on the lease/purchase of his two newest widget manufacturing machines, which would have to be paid off by the buyer. He also owes about $300,000 on his revolving credit line.

Bob has always felt that vacation pay is earned, and never bothered to put a limit on its accrual by employees. He would be shocked to learn that his 40 employees, who average about $50,000 in salary, have about 240 weeks of unused vacation time. That’s another $230,000 plus the employer’s payroll taxes. Let’s call it a quarter million dollars. Edgar had a maximum one-week carryover. His liability was about $40,000. If Bob’s buyer is willing to pay a five (5x) multiple of EBITDA, the unrecognized vacation expense could drop the purchase price by nearly $1,000,000.

Bob is also anticipating a stock sale, with a tax burden of about $1,200,000 on his sale price. If it’s an asset sale (90% of small businesses are asset sales), he can expect that number to be much higher. In short, even if Bob could demand $6,000,000, his actual cash price might be more than a million and a half dollars less, and his tax burden almost a million dollars more. Suddenly Bob has the equivalent (in his eyes) of a $3,500,000 sale.

Closing the Value Gap

Welcome to the second part of the Value Gap. Now Bob realizes that not only will he need substantially more money to fund his post-exit lifestyle, but his company can’t currently provide the level of proceeds he was planning on for retirement.

It may seem surprising, but the answer to this problem for many owners is “I’ll just work longer.” The challenge of closing the Value Gap is too daunting to wrap their thinking around.

Some planning could help Bob. He can modify his benefit structures and pay off some debt, but let’s say that his $6,000,000 price is reasonable, and growing the value to $8,000,000 would meet his goals. Breaking that down on an annual basis renders a growth target of less than 6% annually over the next 5 years.

That may be a better solution than “just keep working.” Bob’s time frame may be longer or shorter. He may modify his target income. He may be able to economize in his business operations to increase cash flow. There are a number of options to consider, but they all require that Bob first understands his Value Gap and truth in pricing.

Addressing the Value Gap – Living Expenses

June 12, 2024 by John F. Dini

The Value Gap is one of the most used phrases in exit planning. Simply stated, it’s the difference between what a business owner would realize if he or she sold the company today, and what they need to embark on a financially secure “next act” after business ownership.

Both amounts can be determined with some accuracy by professionals. A qualified appraiser will analyze a company, its prospects, differentiation, markets, and comparative businesses and develop a value for the business. A good financial planner will look at savings, expected income, anticipated lifestyle expenses, life expectancy, and inflation and develop a scenario for the amount needed to fund those expectations.

Simple, right? Financial plan requirements minus net proceeds from the business transfer equals the value gap.

Testing the Value Gap

If it is so simple, why do so few business owners do it? Instead, they value their businesses by hearsay, misestimate their lifestyle needs by a substantial margin, and think “I’ll probably be fine.” In fact, fewer than one owner in five has even documented any plan for their transition.

Let’s take my favorite business owner, Bob of Bob’s Widgets Inc. Bob pays himself $120,000 a year and lives nicely on that amount. So he estimates that $10,000 a month should cover his lifestyle in retirement. To generate that, he needs $3,000,000 in savings with a 4% return. That means he has to sell his business for about $4,000,000, assuming 24% capital gains tax. His company sold $7,000,000 in widgets last year, with a $500,000 pre-tax bottom line, so he is sure it’s worth at least $4,000,000. (We’ll discuss this valuation in my next column.)

But wait a minute. Is Bob really making $120,000 a year? He drives a Ford Super-Duty company truck that cost $85,000. The payment is about $1,500 a month. Insurance, maintenance and fuel are paid for by the company. Bob’s Widgets Inc. also pays for Bob’s $750 a month health insurance, his $1,200 monthly life insurance, and his $7,200 annual personal tax preparation bill.

“Sellers Discretionary Expenses”

Bob’s company expenses are not only common, but he doesn’t really take all that much in comparison to some owners. Any advisor can tell stories of company-paid second homes, family trips and other expenses far less business-related than Bob’s.

Without going beyond what would be considered “normal” owner perks, we can add about $58,000 a year in post-tax spending to Bob’s lifestyle. At his 4% return assumption, that adds another $1,450,000 in post-tax proceeds from the business to his need for a liquid asset base.

Even if Bob’s assumption of a lower capital gains rate is correct (which is not the case in 90% of small business sales) he actually needs a sale price of at least $6,000,000 just to maintain his current lifestyle.

Even Bob knows that his company can’t sell for $6,000,000. Without getting an appraisal or a formal financial plan, Bob has just had his first lesson in planning for the Value Gap.