My latest book, Private Equity Deals: Lessons in investing, dealmaking, and operations from private equity professionals, arrives next week. I was fairly sure I would never write a second book after my first one, and just about pledged my firstborn (actually both, they’re twins) after the second one, so I wanted to share how this third book came to be and offer a glimpse at what’s inside.
Over the last twenty years, private equity has transformed from a cottage industry to a powerful juggernaut that controls approximately $6.5 trillion in assets.[1] There is no more important sector to understand for investment portfolios. Private equity-owned businesses are everywhere around us and touch every aspect of our daily lives.
David Swensen dubbed private equity “a superior form of capitalism.”[2] Private equity managers have long-term capital, control, and drive returns through management, operations, and financing. They bring deep industry knowledge, deal-making and operations experience, vast resources, and creativity to add value at each stage of their investment. Bottom line: private equity has delivered outstanding returns that have significantly contributed to institutions meeting and exceeding their spending needs.[3]
Yet the public perception of the industry is terrible. Those outside the investment world think of private equity managers as the same predators and corporate raiders Connie Bruck wrote about 35 years ago in The Predator’s Ball. Even though a lot has changed since then, last year two journalists used the word “Plunder” in book titles about the industry.[4]
Private equity is far from perfect, but criticisms of the industry often miss the big picture. Those throwing darts typically highlight poor investments that comprise a tiny, non-representative subset of the industry or short-term cyclical challenges that will work their way out over time. I’ve included rebuttals to common critiques in the appendix.
I wrote Private Equity Deals to help change the industry’s negative perception, even a little bit. The book shares a dozen deal stories, as told by some of the best practitioners in the business. These deals range from large to small, from growth equity to distressed turnaround, from financial engineering to operational restructuring, and from a leveraged buyout of a manufacturing business to an unleveraged minority stake in a sports team. Together, they offer insight into what really happens when a private equity manager buys a business.
There’s a reason David called private equity a “superior form of capitalism.” Private Equity Deals helps explain why. To give you a sense, what follows is the introduction to the first deal in the book – KKR’s purchase of garage door manufacturer CHI Overhead Doors.
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The Perfect Buyout
CHI Overhead Doors by KKR
An ideal private equity acquisition target is a high-quality business with great management that can operate efficiently with debt on its balance sheet. Some of these business characteristics include the following:
- free cash flow generation;[5]
- consistent, steadily growing revenue;
- insensitivity to economic cycles;
- pricing power;
- diverse customer base;
- efficient cost structure or low-hanging fruit to reduce cost; and,
- outstanding management or readily available new management team.
Great businesses are coveted by private equity firms. In theory, they might want to own these businesses forever. In practice, the average private equity holding period is three to five years.[6] Private equity fund vehicles typically have ten-year lives, which prevents managers from investing with a longer duration. [7]
As a result, great businesses may change hands from one private equity firm to another. 806 companies have changed hands at least three times between GPs over the last 23 years, including 173 four times, 29 five times, and one each six and seven times.[8]
KKR has been at the center of the private equity industry since the firm’s founding in 1976. It gained prominence from the purchase of RJR Nabisco in 1989 for $24 billion, in a year when the entire industry raised only $12 billion.[9] Today, KKR is a public company that oversees over $500 billion in assets and is one of the leading private equity firms in the world.
KKR’s purchase of CHI Overhead Doors in 2015 is a deal right out of the private equity textbook. CHI manufactures custom garage doors—a business that has grown steadily for decades. Homeowners buy from CHI when they move into a new house or when a garage door needs to be replaced. Volumes from new ownership are sensitive to economic conditions, but replacements generally aren’t. When a garage door breaks, a homeowner tends to buy a replacement quickly. CHI runs operations efficiently, holding little excess inventory and generating lots of cash.
KKR was the fourth private equity owner of CHI, following three successful investments by prior owners. Warren Buffett says, “I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” Pairing a business as good as CHI with great management teams (that aren’t idiots) has been a repeated recipe for profits.
You might think that these private equity firms are passive winners, handing off CHI from one lucky owner to the next. But that wouldn’t explain why CHI became one of the most successful deals in KKR’s history.
KKR seeks to buy businesses it can transform through faster growth, higher profitability, and innovation. At CHI, KKR saw an opportunity to improve the engagement of the workforce and increase operational efficiency.
Pete Stavros, KKR’s global head of private equity, described in our conversation on July 21, 2022 that KKR introduced broad employee ownership to CHI. This structure provided alignment and incentives for everyone down to the line worker to benefit from the success of the business.
And benefit they did.
When KKR sold CHI to a strategic investor in 2022, it paid out more than $340 million to CHI’s employees. That payout was more than the $250 million KKR paid in equity for the entire business seven years prior.
KKR’s CHI deal is an example of a company private equity firms love to buy: a strong foundation with upside optionality that came from KKR’s operational improvements and ownership works model.
Appendix – Rebuttal to Common Critiques of Private Equity
Let’s examine the criticisms of plundering companies for cash, return smoothing and stale prices, and performance requiring low interest rates one by one.
- Plundering businesses for cash. Have private equity firms taken dividends out of companies that later struggled? Is that subset of anecdotes even close to representative of the 10,000 companies owned by the industry? Not at all. Enough said.
- Return smoothing and stale prices. Cliff Asness and I spoke about private equity return smoothing on a recent Capital Allocators podcast. Cliff makes a great observation that the pricing conventions in public and private equity are inconsistent. Public market investors price assets where someone else is willing to pay every second, whereas private market investors price assets quarterly at their perception of fair value. When he says it out loud, it really makes you scratch your head.That said, history shows that private marks sit at discounts to public comps. When public markets sell off, the discount narrows but has not been held at premiums in the past.[5] We’ll have to see if private marks are overpriced this time around.More importantly, private marks at any given time are not a significant driver of returns. I believe return smoothing is a symptom of one of private equity’s great features: avoiding behavioral bias. Fund lives of 10-15 years prevent LPs and their boards from reversing investment decisions in times of fear. Additionally, illiquid assets, by definition, can’t be sold quickly, which may prevent private equity managers from acting sub-optimally on emotion as well.
Cliff wisely points out a contraction that investors see illiquidity as both a feature, as I described, and a bug. If illiquidity is a feature, investors should have to pay a premium to benefit from it. If it’s a bug, they should be offered a discount. His premise is true in theory, but in practice, private equity managers often buy companies at discounts; they get to have their cake and eat it too.
- Macroeconomic shifts. Investors are increasingly cautious about the prospects of private equity returns going forward. A higher rate environment leads to either higher interest costs on the same debt load or similar interest costs with less debt, both of which lower returns. That headwind is not isolated to private equity – public equity investors and owners of other privately held businesses face the same conditions.That said, private equity managers have taken advantage of a longstanding favorable environment using the many levers at their disposal. They are some of the savviest investors in the world, and they can adapt to the changing environment. If sales growth, multiple expansion, and leverage are less favorable return drivers than in the past, look for private equity firms to lean into operational improvements. The stories in Private Equity Deals demonstrate that this is already happening.
