Most investors focus on run-of-the-mill stock and bond investments when choosing how to allocate their personal portfolios, and completely overlook alternative investments such as private equity. These strategies, however, can be extremely rewarding long-term investments because managers can exploit opportunities that might not be available in the public markets. Given fears that stocks could be at peak levels and bonds offer paltry yields, private equity deserves more attention from investors.
In order to maximize your return potential, choosing the right private equity manager is of utmost importance. The key to this is understanding what separates a particular manager from his or her peers. Does the investment team have special relationships with operating partners so that they can enhance the value of the investment once they close on the transaction? Does the manager have a special skill set in a particular industry and know how to implement a winning long-term strategy? Does the manager employ a conservative or aggressive capital structure when putting deals together?
How a private equity manager sources his or her investment opportunities is also a key dimension to choosing the right firm. Today, most deals are subject to a competitive process where multiple private equity firms submit bids, driving up the value of the deal and hence lowering the return potential of the investment. Private equity firms need to articulate how they approach this dynamic, and what sets them apart.
We’ve asked three smart private equity managers their thoughts on strategies firms can employ to get a leg-up on competitive bidding processes and generate attractive returns on their investments. They share their insights below:
Jonathan Slonim and Andrew Hennessy, Ilion Capital Partners
In 280 BC, King Pyrrhus of Epirus defeated the Romans in battle at great cost to his armies. His experiences gave rise to the saying “pyrrhic victory” – a regrettable triumph. Today’s private equity environment, characterized by high multiples and an oversupply of capital, has increased the risk of regrettable triumphs for investors. For decades, the top private equity firms have had access to “proprietary deals,” or those that don’t go to market. Unfortunately for LPs, those deals are becoming increasingly uncommon as more capital floods the space. It may be possible to find firms with truly differentiated deal flow, but, in the lower middle market especially, it is critical to identify firms who can bring a unique edge to competitive processes. There are two primary ways to create this edge and avoid pyrrhic victories: 1) find markets that are simply less competitive, and 2) offer better terms. We suggest asking a few simple questions to GPs as you evaluate investing alongside them.
What is your niche and how competitive is it?
Revenues between $50 and $500M, a market leading product or service, a stable history of growth, a stellar management team, and recurring cash flows… all investment criteria quite familiar to sponsors in the middle market. Companies meeting these criteria have a long list of suitors and will typically sell at hefty valuations. Sponsors should be assessing how their in-house expertise positions them to target less conventional opportunities. Firms with strong legal, financial or turnaround capabilities may look a bit closer at bankruptcies. The authors’ passion for small businesses leads our firm to pursue smaller deals than most firms would consider. Others might look into orphaned carve-outs, highly regulated industries or cross-border transactions. The point: the best sponsors have a niche and own it.
What do you bring to a buyer that others don’t?
Many deals are still competitive regardless of the strategy, but there is almost always more on the table than money. In many cases, sellers have spent decades building their businesses, creating institutions of which they are rightfully proud. These sellers are focused on their legacies, employees, customers, and communities. Beyond the purchase price, sellers are looking for a buyer they can trust to meet their non-monetary objectives. Speed to close may be critical for a corporation looking to finish a carve-out by the end of the year or for a family business undergoing health or relationship issues. Founders usually look for a buyer who they are sure will steward their business through further decades of success. Sponsors must understand each seller’s unique motivations to make a deal and ensure communications, process, and terms address their needs.
Much has changed since Pyrrhus fought the Romans, but, unfortunately, the trap of regrettable triumphs remains. In this competitive market, true victories will accrue to investors who marry discipline and creativity and, as in any market, engage all counterparties with honesty and respect. “Buy low and sell high” is always hard in competitive markets, but a select number of managers are still able to do it. Asking these questions will help investors to identify those sponsors ahead of time.
This article was authored by Jonathan Slonim and Andrew Hennessy, Co-founders and Managing Partners at Ilion Capital Partners.
Chris Salerno, QC Capital
Real Estate is a very relationship-driven business. While a real estate manager’s relationship with their investors is extremely important, and enable them to be in the business in the first place, equally as important is their relationship with the commercial brokerage community. Strong connections here take time, energy and reputation to establish, but is critical in order to source deals that are on-market in a timely fashion, and off-market that may be less competitive. Successful relationships can serve as a competitive advantage and be a meaningful driver of alpha.
When it comes to a deal, we are all about the numbers. If the numbers don’t make sense, we are not going to pursue it. This is especially true now because this market is extremely competitive and the margin for error is low. In markets like today, in order to make the numbers work, you have to think outside the box. And for us, this means we typically are looking for ways to add value post-close.
We evaluate each deal individually because real estate is a very location-dependent asset, and it’s hard to make generalizations even within similar real estate types (i.e. multi-family, industrial, office, etc). Characteristics such as market demographics, traffic, competition, and availability all differ strongly by market and warrant a different strategy and approach. For example, when we are determining what type of value we are going to add, we ask ourselves: what can we input into these units to increase the rents? People want everything right now, and they want it luxurious, how can we provide that? Will upgrades help us with getting the rate premiums that ultimately enhance the return profile of the investment?
Typically, we end up focusing on the amenities and very simple upgrades, with the goal of improving the lifestyle of the tenant. For example, we look at closet upgrades, changes in flooring, addition of accent walls, or the inclusion of an Alexa or some other tech package. The idea is, can we spend $200 on a backsplash in exchange for a $50 increase in rent? If we find that makes sense, we try to partner with companies that specialize in upgrades for best execution.
With a solid understanding of what the consumer wants and where that property sits in that market, our strategy has been to typically look for newer types of assets where upgrades are not a heavy lift, and end up spending roughly $12,000 to $16,000 per unit on improvements. We have found that these newer assets can be very poorly managed and rents are under market, especially if they are still owned by the developer. Developers are great at developing the assets; but if they are honest, they will tell you that they hate to operate. Their goal is often times to lease up the building as quickly as possible with less regard to achieving market rates, with the objective of selling a ‘stabilized’ asset and recycling their capital to the next project. Exploiting this dynamic is one of our key sweet spots, and when combined with adding value through modest enhancements, provide extra room in our return profile that can allow us to be more aggressive and have an advantage in acquiring properties.
Darrell Morris, The Morris Capital Group
One of the main barriers we face in the bid process as Independent Sponsors is inherent to the model itself, surmounting the stigma that we are raising capital on a deal by deal basis. Brokers and sellers both are usually hesitant because of past transgressions of similar groups. We have to be mindful about this issue because this one pain point could be the difference between winning or losing the bid.
Here are a few strategies we deploy to get an edge in the process.
As an emerging manager or someone new to the ETA we’ve found success in getting to know the brokers, talking through deals on the phone, and introducing our group. Now brokers understand the deals that match with us and could prioritize us for that coveted “first look”.
Don’t Get in a Bidding War in the First Place
This goes hand in hand with building relationships. If you can build relationships with brokers, investment bankers and intermediaries, you could find yourself in a position to skip the bidding process altogether. Sometimes managers need to take a bold approach and just ask to skip the bidding process if both seller and buyer needs align at the beginning.
Top-grade Deals and Move Fast
At GS Equity Partners, we use a CRM to capture contacts, add deals to a structured pipeline to visualize where we are in the process, and make sure the deals have a deficiency that we’re capable of solving rapidly, which is usually technology enablement or high customer concentration.
“The FIFO” Trap
We try to get the “first look” at deals as often as possible. However, just because you reach the deal first doesn’t mean you will win the bid. Managers should avoid the First-In, First-Out trap. The bid process is fluid and new Q&A could bring fresh perspectives from buyers late to the table making your initial bid appear less competitive. The right approach to this issue is to understand the objectives of the seller, tease out preferences to expand the scope of negotiating topics, and create opportunities for creative deal structuring. This process creates an advantage that is difficult for other bidders to replicate and deepens rapport even further.
Red Herrings in the Q&A
Remember, Q&A is often publicly disclosed to all bidders without knowing the other groups. This creates a huge opportunity for experienced teams and can be problematic for teams that are unaware that Q&A is a blend of real questions and landmines to weaken other bids. Be careful about changing your bid based on the Q&A as this may weaken your bid. We take the approach of making sure our bid aligns with the objectives of the seller.
Jonathan spent over 6 years in McKinsey & Company’s corporate finance and industrials practices before launching Ilion Capital Partners. He has a passion for helping small companies develop the capabilities to compete effectively with Fortune 100 firms, and has seen huge value left on the table in this low end of the market.
Ilion Capital Partners exists to allocate both capital and talent to opportunities that others overlook. They are flexible to look at smaller or more complex deals than most other PE funds or search funds would consider, and count on their diligence and patience to pay off in the long run as they help grow the companies that they partner with.
Chris Salerno attended Wharton Business School and Winthrop University. Chris successfully transacted more than $40mm in real estate volume and helped lead the #1 real estate team in the Carolinas to produce more than $140mm in annual sales prior to creating QC Capital. Named to Charlotte’s 30 under 30, Elite 50, Elite 50 entrepreneurs, 30 under 30 entrepreneurs, and nominated for Forbes 30 under 30, 2018 and 2020. Chris has quickly gained recognition, and notoriety for his hard work, and dedication.
QC Capital, LLC is a national multifamily investment company acquiring complexes of 100 units or greater in the major southeast markets. QC Capital, LLC focuses are markets that demonstrate consistent rent growth, population growth, and job growth.
Darrell Morris is a focused business developer with exceptional analytical, planning, and implementation capabilities. He is able to meticulously assess data and integrate processes for effective change and increased profits. Darrell completed his MBA in 2018 from Rice University’s Jones Graduate School of Business with a concentration in Finance and Entrepreneurship.
Darrell Morris has recently formed GS Equity partners with another Rice MBA Alum, Adam Vital.