The Private Equity Solution

Illiquidity. Illiquidity is an issue with which an investor must be comfortable. There might be an established business plan calling for a five-year ownership term, but the business cycle (or any number of other factors) could render original estimates inaccurate. For investors, there is no surrender period (as offered by many private equity funds) and no thinly traded secondary market for private equity fund shares (as has been initiated by investment bankers such as OffRoad Capital). To maximize the value of the investment, it’s conceivable that the holding period could shorten or elongate by a large factor. However, with the advent of more private equity funds and institutional money managers now making direct investments, there are now more options available than there were 15 years ago to exit these investments. Traditional exit strategies were limited to a merger or sale to a private equity fund or company in the industry, an initial public offering, or a recapitalization.

Adverse Selection. Once expectations of the variability of the holding period have been addressed, the problem of adverse selection must be overcome. Well-managed profitable businesses are rarely available for sale at an attractive valuation. The first option is to sift through the hundreds of businesses for sale that are available to the public in an attempt to identify the few that are valued attractively and that have the best potential to offer an adequate return. The other option is to solicit companies that are not for sale by offering an incentive–usually in the form of an attractive price.

Finding Talented Management. The integral component for creating value in a direct private equity investment is identifying and hiring the correct managers of the company. The correct manager or management team might already work for the company; they might work for a competitor, or they might be in a completely unrelated industry, but the crucial factor is that they are willing to buy into the vision for value creation that you’ve identified.

Only after these three factors have been satisfactorily addressed should a private equity investment take place.

One such direct private equity investment I made was the purchase of assets from DDX, a distressed Denver company that owned a product called Heat Watch. The Heat Watch system involved a radio transmitter device that was attached to the tail of a cow to detect when the cow was in estrus and ready to be bred for artificial insemination or embryo transfer purposes. The data was transmitted to the farmer’s computer so that the farmer could make more accurate breeding decisions that would increase conception rates and, ultimately, the profitability of the farm.

The company fit the model of the prototypical distressed company badly in need of a restructuring. It had accumulated close to a million dollars in debt and the cost of servicing that line of credit was unsustainable, given the company’s current revenue and profit margins. The analysis of the current business and recapitalized income statements and balance sheets were straightforward.

The analysis of the business determined that these important criteria were met:

1. The industry must be understandable to investor(s);
2. The barriers to entry must be high;
3. The business must be solid on its own merit;
4. There must be an opportunity for excess value creation;
5. The worst case scenario must be better than a market rate of return.

(1) I had a very good working knowledge of the business as I had been raised in the cattle industry. (2) The barriers to entry were huge because the main product line had worldwide patent protection. (3) By simply cutting certain costs and removing the debt service through the acquisition, the company was profitable, and it was a solid business on its own merit. (4) I identified the potential for dramatically increasing sales by improving the main product and developing a product that was in the company’s intellectual property portfolio. Either item could potentially greatly increase the company’s earnings. (5) The worst case scenario was that lacking future growth and new product sales, and with additional cost cutting, the company still yielded a profitable investment. The company would make a 5%-10% internal rate of return. If we did our job right and we were good managers and the macro-economic situation met our forecast, we would be hitting a 25%-30% internal rate of return. The five criteria were met; the investment was made, and it has been a very profitable part of my private equity portfolio.

Pooled Asset Funds. The process of identifying and managing a portfolio of private equity companies is time-consuming and requires a specialized skill set, so it is surprising that the use of pooled asset funds has not become more popular. This vehicle allows an advisor or group of advisors to pool client assets and set the compensation structure at a palatable 1%-2% of AUM, dropping the 15%-20% performance fee. A moderately-sized fund could support a quality manager and support staff.

Private equity can provide benefits for your clients and it can add a new dimension to your practice. Before you direct clients into a private equity fund, a pooled asset fund with other advisors or direct investment should be considered.

Andrew Lucas, CFA, CFP, is a principal of Lucas Capital Advisors, a wealth management firm located in Manalapan, New Jersey. A Princeton graduate in economics and mayor of his hometown of Manalapan, Lucas specializes in private equity investments. He can be reached at [email protected].