Private Equity has become a hot trend in the past few years. What makes private equity different and why should one consider investing in the private markets?
To state the obvious Private Equity investments are illiquid. One cannot buy today and sell tomorrow. This will affect what we are willing to pay for any investment. Simply put, if comparable to this business in the public markets are valued at 10 X EBITDA why should I pay the same price for a private company that has no liquidity? There are times there is a very good reason to be willing to pay a public market value, but one has to be able determine the “why”.
While illiquid investments do bear different risks, over time they have shown to provide steady returns with the average PE fund generating 3-5% better returns than the public markets. The equity markets can often move from one extreme to another, meaning the volatility of an individual investment can vary greatly despite nothing material changing in the business. In PE funds we do not have the daily mark to market volatility. This does not mean it is not impacted by what happens in the public markets, but what I call the “noise factor” of public markets is not there. This enables one to really focus on the fundamental story behind an investment.
Normally in the public markets one is a passive investor, meaning I like Amazon for X reasons, but I have no interest or desire to have an influence in how the business is managed. In private equity the investor almost always takes some type of active role in the investment. This is another significant distinction of private equity vs. public equity investments.
When approaching any investment, public or private, the same general principles apply. One must consider the business model, its competitive landscape, what makes it a sustainable growing business, its management and how the current macro-economic and geo-political environment can affect the business. Note, that I have purposely left out valuation in first consideration. This does not mean that valuation is un-important, it just means it is part of the second step in the process when looking for quality investments.
One must always begin by developing a clear understanding of the business and its environment. Without a clear understanding of the business, its competitors, management/owners, its strengths and weaknesses we will never get to the second part of the decision process which is valuation. The valuation part is actually pretty easy, its just data. Of course, one has to insure they have the correct data, that accounting standards are being followed and how the valuation of the company compares to its peers. However, this part of the process is not rocket science. We must begin by having a clear understanding of the business and why this business is potentially an attractive investment. What I have always said is unless an analyst can get my interest in less than 3 minutes in why a particular business is attractive, I will probably give it a pass and go no further in the discovery process. Warren Buffett states it best with: “Never invest in a business you cannot understand.” Also: “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
Quality comes first when considering any investment. Investing in a company just because it is cheap is usually a mistake. One is bound to find out with time why the business was for sale so cheap, and not be happy with the results. “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Warren Buffett
When deciding on an investment one must consider what “margin of safety” is required to make an investment. This margin of safety question is one that applies to all investments. There are times when there is little to no margin of safety in public markets, for example in a high growth technology company. In certain circumstances I am willing to accept this, however in the private markets one must be more discriminating and demand some margin of safety to take on an investment. The most common error when looking at an investment is in being too optimistic in the time needed to achieve the stated objectives. Time = Money which impacts Returns. Therefore, I desire some measure of potential error in the “time factor” built into my underlying valuation from the beginning.
“Warren Buffett uses a baseball analogy to articulate the discipline of value investors. A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are
willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.” Seth Klarman – Margin of Safety.
While we are not value investors in the strictest sense of the word, we do follow certain basic principles of investment commonly used by value investors. For example, as Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” This is something that Tom Bailey, founder of the Janus Funds told me the first week I started working for him, in my early days in fund management. The importance of this basic principle cannot be overstated. This does not mean that a fund manager should never have losses, but that over time those losses are kept to a minimum. It is far easier to recover from a -8% year than a -20% year. It will take 3 years (on average) to recover from a -20% year, vs. 1 year from a -8% year. The effect on compounding returns is huge! However, it does not mean that a manager should never take risks. We are paid to take risk, but it must be a measured risk.
Another core principle for investment is we must have a plan for exit before we invest. The average holding period we estimate to be seven years. Some will be shorter and others longer. We must accept the fact that certain variables are beyond our control, for example the economic cycle. As well as we can prepare for changes in the economic cycle, one can never predict how each turn in the economic cycle will impact each investment. Taking into consideration where we are in the economic cycle and what the investment environment is telling us is an important consideration from the beginning. When we first consider an investment idea, we must consider what I call the “macro”. What the big picture looks like in economic and geo-political terms. For example, today we are in an anti-globalization, tariff threatened environment. This has an impact on the economy and of course companies across the globe. A critical question I ask when considering an investment is what are the headwinds and tailwinds that will impact the operating environment of the company? I will be writing on the current state of the global economy shortly. Bear in mind, good investment ideas come along regardless of where we are in the economic cycle. It may however impact what we are willing to pay for an investment.
The Blue Sky Capital Resources team provides a well-rounded approach to the investment process. Led by Jason who has years of experience in turning around distressed businesses. Troy is what I would call our entrepreneurial mind. He brings a practical approach to managing the risks of any operating business. Troy will quickly find the weaknesses and how to deal with them. Amy is our financial wizard. Honored as one of the 40 under 40 key difference makers of 2017 by the National Association of Certified Valuators and Analysts, Amy has a keen eye for translating financial statements into a picture of the inner workings of an operation. She uses this ability to inform the Blue Sky team of quantitative and qualitative value drivers and opportunities. Ed as our senior advisor brings 40 years of experience in various sectors with both small businesses and large corporates. Lastly, there is me, with +25 years in fund management. I managed portfolios globally mostly in the public markets but in the PE space as well. Having always been a long term investor, I know what makes a good investment. Most of all I understand risk in portfolio construction and how the macro environment can influence (positively and negatively) any portfolio.
Each of us brings unique skill sets to create a great team. I have built investment teams in the past and what brought me the most success is in how the team was built. Jason, with Blue Sky has put together a great team that will provide the maximum capability of success.