Mindy: Welcome to the BiggerPockets Money podcast where we interview Sachin Kajuria and talk about private equity.
Mindy: Hello, hello, hello. My name is Mindy Jensen and with me as always is my private equity-backed co-host, Scott Trench.
Scott: Thanks Mindy, great to be here and today we’re not BiggerPockets, we’re private pockets.
Mindy: That is the bigger private.
Scott: That’s right. Bigger equity.
Mindy: Should we not even say that?
Scott: That’s great. Mindy and I are here to make financial independence less scary, less just for somebody else to introduce you to every money story because we truly believe that financial freedom is attainable for everyone no matter when or where you’re starting.
Mindy: Whether you want to retire early and travel the world, go on to make big time investments in assets like real estate or start your own business, we’ll help you reach your financial goals and get money out of the way so you can launch yourself toward your dreams.
Scott: Love it. Um, well, before we get into it, we’re going to talk about private equity and I know that private equity has, I’m going use two words depending on your viewpoint, either a stigma or a mystique attached to it for a lot of folks. And we want to demystify it today and and make it more accessible. Just to introduce the subject, the essence of it is this. Folks are going to raise a pool of capital, let’s call it a billion dollars or hundreds of millions of dollars and they’re going to use that capital to invest in businesses, right? They’re going to buy maybe 10, 15, 20 businesses and their goal is to grow those businesses, to cash flow them, and then to sell them in order to produce profit. And done well over a five to seven year period, they could double a billion dollars or $300 million dollars or hundreds of millions of dollars and make a lot of profit for the people who invested with them and then earn a percentage of that profit. So they may earn two and 20, 2% of the um one billion dollars might go to fees that they charge every year to pay their staff, to pay their salaries, those types of things. And then again, the 20, the 20% of the profits on the incremental billion that they earned. So it’s a very lucrative way to make money and a um, a a very powerful way to build wealth. It’s also good for the limited partners or the investors who invest in the fund because they they have the chance to get better returns than they can get in public markets. Very consistent with the concept of investing in an apartment syndication, for example, someone might, uh a big syndicator might raise a fund and buy multiple apartment syndications. That’s the same concept as private equity investing. Raise large large fund, buy multiple businesses, grow them, or attempt to to to drive profits and then return the capital to shareholders after three, five, seven years.
Mindy: Before we bring in Sachin, let’s take a quick break.
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Mindy: And we are back. Sachin Kajuria, welcome to the BiggerPockets Money podcast. I’m super excited to talk to you today.
Guest: Thank you so much. I’m very excited too. I love what you guys do and I’m happy to be on.
Mindy: Sachin Kajuria is a former partner at Apollo, one of the world’s largest alternative asset management firms and is also an investor in funds managed by Blackstone and Carlyle among other investment firms and he has 25 years of experience in investments and finance. So, I am super excited to talk to you about private equity. What is the private equity model and why should I care about it?
Guest: That’s a great question to start with. So private equity essentially is a means of investing. It’s illiquid, it’s private. It’s not the public markets. And what private equity investment professionals do is they lend to a business or they invest in that business, either taking control or a significant stake. They then seek to improve that business over a period of say five to seven years, and then they sell their investment. So they enter, they seek to improve, and then they exit. So, put like that, it sounds very simple, just like buying a house or an apartment, doing it up, and then selling it. But of course, here we’re doing it mainly with operating businesses rather than just assets, fixed assets. So the reason this is important for you, why you should care is that number one, private equity is not an esoteric part of Wall Street. It’s everywhere. It is in chemicals companies, energy companies, could be the owner of your kids’s kindergartens. It could be the owner of the hospitals you go to. Uh, it could be lending to a number of businesses that you use or consume products and services from. Your employer could be owned by private equity.
Scott: BiggerPockets is a private equity backed business.
Guest: There you go. So there you, that that’s that’s probably the number one reason you should care actually is that BiggerPockets is a private equity back business. Um, but jokes aside, I it’s absolutely essential that you realize that it is not Wall Street, it is main Street. And once you realize that private equity firms are invested across the economy in the same way that you think that big public companies are important, you know, all the big tech names, you know, Apple, Amazon, Microsoft, etcetera. You probably know because of COVID all the big pharma names now, Pfizer, um, you know, and AstraZeneca or so on and so forth, you really need to know the big finance names. And the big finance names, particularly since the financial crisis, where a lot of banks stepped back from lending activities and other activities that private equity stepped in. The big finance names are the likes of Blackstone, Carlyle, and so on. And so, you know, if you know about Apple and Amazon in the public world, and you don’t really know about some of these big private equity firms in the private world, that’s something that needs to change. And, you know, where it really hits home is when you look at your own portfolio. If you look at what happened to your own portfolio in 22 could have been tough, like it was for a lot of people. If you look at the alpha for 23, the outlook is not great. If you look at your own portfolio and you ask yourself, no matter what I’m invested in, am I invested in uh, you know, real estate? Do I have public stocks? Am I 60-40 as a lot of people used to be in stocks and bonds, am I being adequately compensated for the risks that I’ve been taking and do I really understand those risks? Or should I consider learning more about private markets, illiquid markets where maybe I can afford to lock up some capital for a little while, but at the same time, I won’t get the volatility that we’re currently seeing in the public markets, and I may earn if I make the right decision, a higher return per unit of risk. Does that make sense? I know that’s a long answer to your question, but does that make sense there two parts, what it is and why you should care.
Scott: Absolutely. I mean it’s pervasive, it’s a major part part of the economy. It’s it any every day we’re interacting with businesses that are private equity backed, whether we know it or not. Can you explain why it’s become so pervasive? How how do these firms make money? How do they raise capital? How do they invest it? Why does private equity have this, uh, I will I I’ll use two words, uh depending on on who the person talking is, it has a stigma or a mystique associated with it um, in in the world of big finance. Why is it so lucrative?
Guest: So let’s break that down. So number one, you know, anything can only really be successful over a sustained period of time if it delivers. You know, this is not a one-year bubble. This is not a latest fad. It’s not driven by crypto that may or may not work out or some other trend that’s emerged in the recent past. This is something that’s been slowly growing, but people have not really been aware of it. And the reason it’s successful is that essentially the people who are doing this activity, these professional investors who run private equity firms and make the deals on behalf of investors, pension funds, sovereign wealth funds, and increasingly individuals, they are generally successful at increasing the amount of capital that’s come in. So the amount that goes out that they’re returning is more than they bring in. And that’s what’s really driven. The success is what’s driven this industry. Now, I’ll throw out a number. The industry is around 12 trillion dollars in size. So it’s not as big as the public markets, but it’s getting there. And I think in the next decade, it’ll probably exceed 20 trillion. So in our kids’s lifetimes, you can look at tens of trillions of dollars of money managed by private markets firms. So it’s an astronomical number. And when you think that a lot of these funds use leverage on top of the cash that’s committed to them when they’re making investments, the actual buying power is a multiple or will be a multiple of that tens of trillions of dollars. So, that’s why it’s so big. The reason is it generally works on average. It generally works because it’s delivering. It’s not paper gain. It’s not a hedge fund where the market goes up, the market goes down. This is cash in, cash out, old school at the end of the day. If you’re not getting cash out, there’s a problem. You should be getting cash out and more cash out than you put in. and then you can work out your multiple of cash you put in and the internal rate of return, the IRR on how much, you know, you are generating on an annualized basis to get there. And so the the reason it’s lucrative as you put it, is going to the second part of your point, is that the incentive for the investment professionals is very different than in passive investing. This is highly active investing on a multi-trillion dollar scale. So in passive investing you invest in a good ETF let’s say, right? They might be charging 10 basis points, 50 basis points or maybe a mutual fund a bit more depends on the, you know, depends on the strategy, depends on the firm. But they generally don’t take a share of the profits. Here, they’re taking a cut of the profits you make. And that’s really why they’re doing it. They’ll have a management fee, that’s usually the 2% or some variation of 2% of assets under management is the management fee. But they’re not really doing it for that, although that can end up being a big number with the kind of numbers we’ve been talking about. They’re really doing it because they’ll take some cut of the profit. And let’s take something like the industry benchmark which is 20% of the profits. If you give them a billion dollars, you’re a big pension fund, and they double it for you, they’ve made you a billion dollars without you doing really that much work or any work through the life of the investment. Of course you’ve monitored it, you’ve maintained relationships, you’ve done all the important fiduciary things, but you haven’t worked on the deals. And they’ve taken your billion, which could be contributed by millions of teachers around the country and they’ve made it two billion. What they’ll do is they’ll take 20%. So in other words, presenting the management fees aside for a second, that billion of profit that’s been generated, they’ll keep 200 million and they’ll give you 800 million. you might say well that’s 200 million. Yes, but they’ve made you 800 million that you wouldn’t have made if you did it yourself. And that 200 million of course, you know, the professionals don’t take that all themselves of course. It’s it’s it’s given to the people who invest in the funds that they’re putting up, right? And so that that that that 20% that that’s coming in, that is then distributed across all the investors and then of course the investment professionals. So going to the stigma, look, these are big numbers, first of all and anything that has very big numbers associated with it, generates attention. Whether it’s the billionaire in Silicon Valley or it’s the billionaire industrialist, or going back I guess to, you know, when we used to have conglomerates, you know, the guys who used to run the big conglomerates in the country before they were broken up. Um, any of these big numbers, this big compensation is going to attract attention. And, and I think that, you know, that can tilt the discussion or the perception in some circles. I think that’s part of the, uh, mystique stroke stigma. The other part is until recently, most of these firms were private partnerships. And the mystique part comes in because there just wasn’t really much talked about, known about, there’s no real websites. You know, these were generally private partnerships even if they were managing large amounts of money. What’s really good is that the biggest ones have gone public. And so now they’re essentially public corporations, there’s an enormous amount of disclosure about who’s working in them, what their background is, you can read the 10ks, the Q’s, you can become an investor in the stock, you can probably buy some of the debt if they’re issuing some debt. And so that’s why I think there, you know, there’s been stigma in the past, given some of the numbers involved, some of the mystique around it. And I think that mystique is going down as we learn more about the deals involved in private equity, as we learn more about the people involved in private equity because ultimately, this is very much a people business, Scott. Right? There’s nothing automated about it. It’s about the judgment of handfuls of individuals managing billions of dollars or in some cases hundreds of billions of dollars. And as a people business, the more that we know about the folks who are doing it, the more we look behind the curtain, the more we’ll understand it and hopefully get comfortable with the guys who do it well, and, and figure out where we should be placing our money to manage our own financial future.
Scott: Awesome. Let’s go into some of the people. Walk us through what a typical deal team looks like and what these private equity professionals do on a day-to-day basis.
Guest: Well, let’s take in my experience of course, the bigger firms tend to be reasonably tight in the way they manage resources. So you won’t have, you know, dozens of people working on a transaction, typically. You’ll have a core team of investment professionals. and those professionals will be called it, you know, three, four, maybe five, but in my experience, it’s typically like three, four guys. Somebody most senior, someone kind of in the middle and someone running the numbers. And maybe if there’s a bit of duplication, if the deal’s particularly complex or it has, you know, certain angles, there’s more geographies involved or, you know, there’s there’s a different products involved, or maybe it needs a couple of people to analyze it. But it’s generally in the single digits, can we say in terms of the deal teams. and they’re really tight at the hip. They’re working together, you know, night and day. and they’re kind of powering through, uh to understand a sector in an industry and then to present investment ideas to investment committees, to get them approved and in most firms, I think it particularly in my experience, my opinion, the best firms, the people who are doing the deals then stay with those deals through the life of the deal. So they don’t just go away. They’re not just consulting on a project and they disagree. They stay with those deals so it actually, if you think about it, Scott, it becomes a major part of their life. If you own this asset for 5-7 years, that’s 5-7 years of your life that you have to work on this deal and make sure it’s a success. You know, you started the deal when you’re 25, you’re 30, 32, maybe even more, you know, older, by the time you’ve exited. So you have a massive interest in this thing going well because it’s not just a big part of your job, it’s a big part of your life. Um, that’s generally how deal terms are constructed. And then on top of that, you’ll often have lots of operating experts, slightly older guys and these women and men are in their 50s or beyond. Maybe they’re, you know, been ex-CEOs of industries uh that are relevant for this business and these operating advisors will be part of the bench to help on particular inputs. And then of course you have all the third party advisors, bankers, lawyers and so on and so forth. but we’re talking in the beginning about who’s in the core team, who’s inside the firm.
Scott: How many deals would a deal team do or be work on?
Guest: Um, it’s a really good question. Um, you know, in full flow, about to commit capital, it’s tough to do more than two, although, I’ve seen some people stretch three. Um, but you know, in reality, when when when you’re just about to commit, it’s tough to do more than two and in many cases, it’s just one. Uh, but of course when you’re prospecting, you know, you can look at lots of projects at the same time. And so you know, you’re kind of all juggling projects at different stages. I mean, the way I’ll describe it is, you know, if you’re kind of, you know, um, if you’re a doctor or a surgeon and you’re analyzing a condition, you know, when you’re doing the analysis and the investigation, you can look at lots of patients, but you’re only ever going to do one operation at the same time, you know, I hope at least, you know. So, um, so it’s it it it it filters down to what you’re really going to do. uh and then it’ll expand again once you’ve done it. Once you’ve done the deal and you’ve invested the money, of course, you know, you don’t just feel like the work’s done. The work’s not, the hard work really starts. You know, you put the money in, you haven’t made any money until it’s come out. And of course, you’re making this for the investors. And so, um, once you’ve committed to a transaction, you’re probably working on a few at the same time, again until you exit when again it’ll get more intense, but that could be years off.
Scott: Okay, so just to recap a couple of points so far. Tell me if I’m correct here. We’ve got we’re having a fictional private equity firm that’s raised a billion dollars from a pension fund. Uh, there’s an investment committee of folks who are the end approver of investment decisions to buy or sell properties, and there are deal teams that work on individual deals or bring deals to this investment committee. Those deal teams may be as little as three or four people and they may work on two to three investments at a time, probably just two, though. uh at the end of the day. Is that a good summary of where we’re at?
Guest: Yeah, I mean probably two if they’re very live or if they’re about to commit, maybe even just one. Um, but if you’re prospecting, you could go up to looking at four, five, six, you know, transactions at the same time. But of course, you want to balance being able to commit depth to a transaction or a project with breadth across, you know, being a fully utilized member of the team. And so, you know, we we’re in the right ballpark depending on what stage of the project is correct.
Scott: Okay, great. And and this private equity firm is going to buy how many businesses and how valuable are those businesses going to be?
Guest: So here’s where, you know, the answer is it completely depends on what kind of firm. I mean, if you’re raising a billion dollars, you’re not going to put one billion dollars the entire fund into one transaction, right? So you’re probably spreading it over at least 10 and maybe 15, maybe even 20 different investments. Although some firms do have a very concentrated strategy and they could say well we want at most 10 in one particular sector or, you know, at least 100 million per deal. So they’re doing less than 10 of equity. Um, but you know, it it depends. I would say the larger the fund, of course, you know, let’s say you have a $20 billion fund, um, you know, you you want to you want to seek to be effective. You don’t want to be writing $50 million checks and using up all those resources because it probably takes nearly as many resources or, you know, hours of work to work on a small deal as it does a big deal. So if you have a very big fund, you want to sort of make sure the check makes sense in the context of the resources that you have. Um, but I I I I think as a very, very rough rule of thumb, you know, uh I’d be surprised if you’re putting more than five to 10% in any one individual deal. You might start off higher than that and then syndicate down in other words sell some of your equity on to investors who want some extra exposure outside the fund, but you you want to manage carefully how you construct your portfolio because no matter how right you think you might be, if you’re wrong and you put 20% of your fund in one sector and you just, you know, it’s a wipe out, then I mean that’s that’s catastrophic for the performance of the fund probably.
Scott: So is it fair to say that that a private equity firm with a billion dollars in assets might purchase 1.5 to 2 billion dollars in total company value using leverage and that will be spread across 10 to 15 deals in a typical world. I it would obviously vary across these businesses.
Guest: I would say you’d probably have a bit more leverage on it. So I’d say if you have 1 billion of equity, you probably have more than 2 billion of purchasing power, maybe even three billion. but I I’d say somewhere between two to 2.5 billion of purchasing power.
Scott: Awesome. And how many people does this do these businesses employ? these these are thousands of employees most likely, right? that are employed by the businesses purchased by this fund.
Guest: It could be tens of employees if it’s a people-light business, but if it’s a people heavy business, of course, it could be hundreds or thousands of employees per company. Now, of course those are employees of the portfolio company, not of the private equity firm. So they’re employed by the investment company that the private equity firm will have its funds invest in.
Scott: Awesome. And so this is the mechanism by which private equity is able to control so much of uh of American wealth, businesses, um and and American business, um with so few people. Probably many people that are listening to this podcast don’t know anyone who works in private equity. Um, yet, most many of the businesses, perhaps half the businesses they’ve interacted with um this year as been two three days into the year as this recording. Um half the businesses they interact with on a daily basis may be owned or backed by private equity in in a lot of cases.
Guest: It’ll be it’ll be a good portion, Scott, but I would say rather than control I would say influence because remember, private equity folks are very careful to they don’t confuse themselves with management. They don’t they don’t making, you know, CEO decisions, they’re assisting and guiding or, you know, interacting with, working with, partnering with the management teams of these companies. So it’s influence across the economy in yeah, in in a great scale, a great scale.
Scott: So, let’s walk through that. What what is the influence? What what are the decisions that these private equity professionals make? Uh I we understand the you know, yes, making the investment in the company in the first place, but what are decisions they would make in the uh operating phase in the five to seven year hold period and then when it’s time to sell. how how do they influence um influence decisions in that those phases?
Guest: Well, the manner of influence is typically through the board. So you’ll have board representatives, you may control the board, if you put the company out right, and you’d have non-executive um presence on the board. You’re not an executive. It’s very important to understand that. You have to have excellent management. And probably the hardest work in these deals is done on the shop floor by the management teams, not by the private equity professionals. It’s the combination, it’s that symbiosis of work between private equity investment professionals and the management teams that gives rise to value being created hopefully over time. Now going into a deal, you’ll have an investment thesis. You’ll say, I think these things are going to happen to this business in this way or this way. and if we can manage these things happening and also make these things happen because you’ve been improvement in the product line, could be cost cutting, could be acquisitions, could be better financing, then I think when we exit, we’ll have this band of outcomes for our return on exit. And so what they’re doing all along is calibrating that investment thesis, helping to execute it, acting as a sounding board for the management, providing network, providing contacts, and it’s pretty detailed stuff. I mean a lot of the work that happens in between the board meetings, you don’t just show up to a board meeting once every two months, you know, um, socialize with them, discuss things in the board and then just disappear. A lot of the work is done in working sessions in between the board meetings. and so you’re kind of like an extra resource, does that make sense? for the management team of that company and you’re a powerful resource because as a firm, you’ll have a lot of data coming in from all over the world. It’s one of the chapters that I put in the book called the library. Well, there’s a huge library of information these firms have on sectors across the economy. and you’ll be providing that information in the right way and the right conditions and the right form, working with the management teams to help them make decisions. That’s how it works. You are helping the management team make decisions. Sometimes of course, you may have to step in, you may have to change management, that would be your decision. If you did that as a private equity investment professional, as a team. but essentially you’re working with them to make decisions and then ultimately then you’ll work with them to figure out who are the right people to sell to is, should you go public? because of course you’ve been private all this time or should you sell to someone either another private equity firm or a strategic firm at the end of the period.
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Scott: Awesome. Can you provide an example or two of of uh successful deals in private equity?
Guest: Sure. It’s it’s important uh, you know, even if they’re successful that I don’t uh, you know, go through case studies of real transactions, but I can provide any number of, you know, examples where I um, you know, fictionalize.
Scott: How about an example from your book that, uh?
Guest: Yeah, sure. Yeah.
Scott: Yeah, how about one of the fictionalized examples from your book that I thought were excellent.
Guest: I think one of the best examples, uh actually is very relevant today. So today, leverage is expensive. Uh, interest rates have gone up. Today, um it’s not easy to raise debt as it was, let’s say a couple of years ago, right? Or even a year ago. And so what private equity firms did the last time this happened, which was in the financial crisis, was they actually changed tack almost entirely. And a number of them looked at sectors that private equity typically did not invest in. So they were really originating new sectors for investment. And one of the best examples of that was in insurance. So you think of insurance, you’re like, insurance, it’s kind of maybe a little boring, maybe does have much make sense for private equity to buy and sell that, It’s pretty technical, pretty specialized, but what happened in the financial crisis was a number of firms and after the financial crisis, 2008, 2009 plus, similar, you know, conditions to today, although even more acute, they started to look at this sector and realize, well, what if I don’t put that much debt in this deal, and I’m able to put more money to work by investing in all equity or mainly in equity, and I buy a business that isn’t as directly correlated to the macro economy. So just from the get-go, you’re not guessing on when there’s a recession or how deep it is, or when you’re coming out, you’re saying, let’s just move away from that. Let’s decouple to some extent from that and look at a business that has a different cycle than the business cycle. And it took I think more than a year, um, of learning, of education, of research into the insurance industry, and then they started buying these businesses and they realized there’s a lot of work to do on the asset side, in other words, the float, the money that we all pay in premiums, and then just sits in these companies and managing how they manage that money because sometimes the money was not managed that well at an insurance companies. and there’s a lot to do on the liability side. Sometimes the underwriters of insurance were writing the business to have the biggest book of business possible because that’s how they were compensated. who’s got the biggest book, who’s writing the most insurance as opposed to surprise surprise, who’s making the most profit from the insurance they’re writing, right? And so you can start to think of a lot of pretty straightforward ways that they looked at these businesses which were, let’s say unloved or unnoticed, and they started to turn things around. say, let’s trim what’s happening on the asset side, let’s trim what’s happening on the liability side, let’s improve the cost, maybe the IT wasn’t so advanced, Let’s offshore some stuff. And then they started making acquisitions. And then before you know it, as we started to emerge from the financial crisis, and the public markets came back, and deal activity generally came back, they were able to exit those insurance companies that they were previously, let’s say, you know, undiscovered gems, unpolished or what I like to call smart bargains, that they’d purchased at or around or even below book value. in other words they didn’t pay any real goodwill premium over the book value of the balance sheet, right? And they were able to sell those as a valuable franchise a few years down the line. And they were doing this in really big scale, like you know, billion dollar plus checks per deal. Um, you know, that that I think is a really interesting example and probably one where, you know, beforehand I wouldn’t know and maybe a lot of your listeners would not have thought of that. say, wow, is my insurer owned by private equity? Oh, that’s interesting. What does that mean? You know, how how does it impact me? Does it mean I’m getting, you know, better service, worse service? What’s going on? That I think is one of the big generational shifts, big shifts we’ve seen. Um, and now of course, so many private equity firms are in the insurance industry that they’ve never been in before.
Scott: What what are the returns like from private equity? that I think that’s like the the the like that’s the fundamental reason why we’re here discussing this is that it produces returns and perhaps in excess of alternatives, um or has historically, what have they been and what’s your outlook for them? for for returns in private equity in the next couple of years? sound you sound fairly bearish.
Guest: Yeah, so, look, I think here’s where you it’s a little bit like saying what’s the outlook for all equities in the public market or what’s the outlook for all stocks or you know, um, how, you know, how good are the movies going to be that are released next year? You just can’t give a generic answer. You have to be a lot more specific. And if we look at the kind of firms we’re talking about in my book, we’re talking about the winners, the ones who are continually doing well, and they may have ups and downs, they may make mistakes of course, but generally speaking, the direction of travel is up up up up. and generally speaking they’re getting bigger and they’re returning more capital than they’re pulling in because per fund they’re doing well again. Private equity deals tend to have a two handle on the return in terms of IRR at least. So, if for example, you have a private equity fund that’s making you 12% a year, you may not be that happy with it, you know, particularly when interest rates, you know, when the Fed rates are where they are, if you know, if you can put money in treasuries and make 5%, you might be worrying why you’re locking up money over five, seven plus years and you know, you’re only making 12. I think you’re really looking in the 20s in terms of IRRs. That’s sort of where I start to think that.
Scott: After fees?
Guest: Net net, net net of everything, right? That’s what starts to look like a private equity investment to me, a good one. And that’s a very powerful filter because just like when you look at all hedge funds or all stocks or all bonds, there’s the winners and the guys in the middle and then there are the folks, you know, who are not doing as well. And so I think successful private equity should have a track record, you know, with this sort of handle. Now, there are very important caveats to that, one of which being the vintage. You could have vintages where everybody was caught out. And so that 12% you got was against 5% for everyone else, you have to look at that and just accept it and you know, not not sort of, you know, uh, bear a grudge on the firm said, why is it only 12? and you have to look at what everybody else is doing as well. And I personally also look at what liquid markets do because remember your money is locked up. So, you know, in a year when the S&P is making 20%, you could look at your private equity firm and say, well, how come my illiquid investment’s only making 22? Okay, but what if the next year the S&P loses 20%, and your private equity investment is still accreated by another 5 10 plus. Suddenly you’re going to be in love with it, right? You’re going to be this is amazing. And so that’s why we’re having this conversation, which is look at your portfolio and ask yourself, can I lock up a portion of my capital? and if I can really lock that up and I know it’s pretty much locked up, where do I do my homework to figure out which of these strategies makes sense for me, for my own case, my personal circumstances and should I have exposure to private markets? And you may end up thinking I should put 10, 20, you know, whatever percent of my portfolio in this as I learn more about it, and change the kind of exposures I have.
Mindy: Okay, so I’m a regular person. How can I invest in private equity and private markets or do I have to be an accredited investor or even a qualified purchaser?
Guest: It’s a great question. So first of all, if you are a uh, public employee, you probably already are invested in private equity or the chances are there’s a high chance you are, but you may just not um follow it so closely or even know about it. So teachers, you know firefighters, uh police women and men, uh a lot of the pension funds that manage, you know, these public retirement systems, right, they often allocate to private equity. That doesn’t mean you’re making the decision of course, but it means that the people who are running the retirement funds that your money is going into and millions like you are in private equity already, a lot of them. And the easiest way to find out is just look it up. You know, you look up the websites, look up if they’ve got an allocation to what’s called private equity or alternatives. In other words, alternatives to stocks and bonds, that’s what it means really. Um, there’s a lot of jargon in the industry. Um, you probably already are an investor. I think what you’re getting at though is how do I make the decision myself whether to go in or not go in to private equity. Now historically, it was only for institutional investors. Then you started to get these feeder funds from the big wealth managers who would aggregate relatively still large checks I think, you know, 500,000 checks, 250,000 checks, and aggregate a lot of these and then present a bundle of these checks to a private equity firm and say, look, we’ve raised 300, 400, 500 million from all of these individual reasonably wealthy folks and then they would get an allocation. What’s happening now is that private equity is, it’s not quite there, but it is going retail as the regulation is slowly changing, as private equity firms are learning about how to provide products to the retail market. So, I wouldn’t say it’s there that just yet. I think the feeder funds and the people who aggregate checks are now lowering the threshold. So it’s not like hundreds of thousands of dollars, it’s now in the tens of thousands of dollars. But they’re still making the decision for you. You’re paying them and then they’re going off and making an investment decision. But before too long, in the next few years, we will have a situation where I’m not sure you can download it on your smartphone, but you will be able to log in and select this or that or that private equity fund to invest in. just like you can today with public funds. And that’s why I think it’s a trend you need to get ahead of and learn more about before the choices is upon you and you don’t know what to do.
Scott: Awesome. So in a practical sense, if I want to invest in the next six months and I have I’m just an an accredited investor and I’ll put 50 grand in. What is the mechanism literally by which I can do that? What are my options?
Guest: If you have that kind of money, you probably are working with someone in some sense to maybe not necessarily manage your money but at least talk to about money or advise on money. If it’s a bank, let’s say you have a, you know, you’re working with a
Scott: All I do is listen to Bigger Pockets money.
Guest: Okay. So in that case, there are a number of firms that do aggregate these checks for you and um they’re reasonably easy to find. I don’t want to plug any of them. Um, but you can easily find these firms that do aggregate checks. Now, depending on where you live and all the regulations and so on, it may or may not be possible for you at that level to put money into them yet. But it’s you should certainly do the research to see if you’re at that level where as an accredited as a professional investor, you’re able to do so. You’ll probably also find that some of the um, large asset managers do start they’ve already got funds that you can invest in that do have some elements of private equity in them. But, you know, I think, you know, if it’s if it’s something as short term as in the next six months, how do I do it? You really need to speak to a professional wealth advisor and see what is on the menu that’s relevant to me in my jurisdiction given my portfolio and you need to really get that proper advice on here’s what the menu is. and then frankly, if it was me, you’d take your time to learn about exactly what it is you’re going into. Don’t just pick a brand name, don’t just, you know, pick what’s on the menu and figure out what the historical returns are, learn more about the product, just like investing in anything new, right? You wouldn’t just suddenly go into an apartment block on the other side of the country without doing your homework, right? Um in the same way, you shouldn’t just say well it’s, you know, I’m eligible for all of it, let me just go for it. So I think, you know, speak to professional uh advisors, wealth managers and so on. there are plenty in what I would call the mass affluent bracket who um have started to talk more about this and you’ll see what’s on the menu for you. Um that that is probably the best next step in that time frame as the industry continues to develop products which are tailored for someone like yourself, uh to do.
Scott: So I I understand that that the right answer is to talk to your wealth advisor um about going into private equity, but, you know, frankly, it feels like there should be at least a place to go type this into Google to learn about this sort of to figure out private equity investing. how what is there out there that I can begin self-educating without having to just go completely through a hired private advisor? Is there anything available on the internet?
Guest: So, look, it’s a really good question and I think one of the things the industry lacks uh is great education for everybody in a no-nonsense way about private markets, not just private equity, but all private markets, including um investing in real estate, infrastructure, private credit, and so on. Now there are, there are, you know, there there are good resources here and there. You will learn something from most things that are out there, whether it’s an academic text or a practitioner’s text, but often it’s not aimed at a broad mass affluent, let’s say audience. Um, if it’s, you know, written by a practitioner about themselves and their personal life story, that’s you know, what you get. If it’s an academic text, it may be more theoretical or maybe a very deep dive into a particular transaction. And so, in the same way, you know, it just doesn’t really exist for everybody. And that was one of the reasons um, you know, behind writing 2 and 20 was to try to get everybody to understand what does good look like, what are the criteria of success that I’ve seen, what you should be looking for when you start to research this industry in depth for you. Um, you know, I think that, you know, we we we gave through some sponsors, you know, folks who bought large quantities of the book, you know, thousands of copies to all the community colleges that we could find across America. I think we’ve given about 1500 copies of the book to um inner city libraries, small community colleges, places that we really want everybody to read this book, borrow it, give it back to the library, borrow it, borrow it and really try to understand this for all the reasons we talked about. Um, but it really should be um, you know, it really should be something that more people can learn about in a very easy, digestible bite-sized way, where people are not trying to sell you something, they’re just trying to educate you about your journey to decide for yourself whether it makes sense for you. So I think the industry does that that. Um, having said that, you know, there there are a lot of courses you could do at uh colleges. Um, you know, there are websites the industry body, the American Investment Council, you know, actually has a a decent website. But I think it goes back a little bit back to what you said on um the mystique and maybe, you know, in some quarters uh a certain skepticism about the industry. And not everybody would believe everything they they read or they listen to because they’re sort of wondering if someone is trying to sell them something. So I think I think there is a space for that and I’m sure it’ll come um because one of the key parts, you know, what will make retail investing in private equity very successful is if everybody knows about it um and they feel comfortable with what they’re being educated about, um, you know, before they’re being asked to buy it.
Scott: I know I said last thing, but I have another idea. I have another something else just popped into my head, which is uh rising interest rates. Um, right, interest rates are are going up, that means that you need to do better on your deal. you need to have even better um, uh outcomes projected for private equity deals for them to make sense, right? Because if the interest rates higher, that’s going to reduce my cash flow during the life of the deal if I’m using debt, it’s going to hurt my ability to sell uh on the next on the next phase. How how do you what in the public markets, that gets priced in immediately, right? Because all the information’s public, the stocks trade on a daily basis. Private equity firms can hold for many years, for example. So what we’ve seen in the last half of 2022 uh and probably heading into 2023 is deal volume collapsing, right? there just haven’t been very many deals done. Does that mean that valuations have come down in the private equity space in your opinion? and they just haven’t been realized by the firms because they’re less liquid and not traded the same way as public stocks. Do you see that as a headwind heading into next year?
Guest: So there are a few things there. So let’s try to unpack each of those points. Um, so there’s no question that a high interest rate environment is going to hurt a lot of deals if those deals, if those deals were predicated on rates staying very low for the duration of the deal. you know, more cash flow required whether you roll it up in some kind of pick interest, you know, paying it in kind or compounding the interest or whether you’re paying it in cash, of course, if your interest expense is higher, then that’s another use for the cash that could be used either to grow the business or to pay back dividends to the investors, or some combination of the two or some other corporate purpose. Um, and so, however, I think going back to what I said in the previous point, the better firms are not buying companies where they assume that multiple stay high forever and interest rates stay low forever. They’re not doing that. They’re saying, let’s assume that multiples contract because we’re in a bubble or we’re in a robust equity environment, let’s assume that rates are only artificially low because of first the financial crisis and then sadly COVID. Um and so, I think it really depends on the transactions, but in general, yes, it should be more difficult um for everybody when rates are high uh if they’ve raised debt on uh on that on those investments. Um, how is it priced in? Well, of course, most valuations are done quarter to quarter, particularly with the big firms, and at least the ones that I’ve seen without giving anything away, you know, are reflecting differences in the environment, you know, pretty accurately. Um, but of course, in a way it it is theoretical because, yes, it has gone down this quarter, it may go up next quarter, but until it’s sold, uh, you know, you don’t really know. And I’ve seen plenty of deals, some of the most exciting deals, um exciting in lots of ways, where the investment was written down because things were just not going very well, but precisely because they were able to hold on to the transaction for seven years, maybe even 10 years, they turned it around and maybe even they made a double at the end of it. That’s very hard to do in the public markets, particularly if you have management teams that may have been replaced in that time frame. Here the deal teams are kind of it’s their deal, it’s a problem, but it’s your problem, it’s our problem. So you stick with it, maybe for up to 10 years. And so I think one of the advantage of the model again for a portion of your capital that makes sense for you, one of the advantages of the model is you do have these very aligned investment uh professionals, aligned in the sense that you’ve been talking about, 2 and 20 is a is a enormous alignment mechanism because you really make money when and only if the investors make money. And so you know, you don’t want to spend 10 years of your life and make nothing, right? You want everything to be successful, of course. And you’re not being changed as a management team, as professional investors every few months or years. And so as a result, it’s not it’s not Wall Street, it’s not investment banking. There’s no real hire and fire mentality as you’ve seen in Wall Street over the decades. Um, you know, typically these these teams are recently stable. And so you will see valuations go up and down, but I think the advantage of holding it for longer, I think that’s in investors’s benefit. Again, for the portion of their capital that they’re comfortable locking up. I think one positive thing about higher interest rates, of course, it comes down to private equity firms are very good at pivoting. If you find that there are sectors which are better to invest in when rates are higher, could be a lending business, credit business, could be a bank, could be something else that is benefiting from a higher interest rate environment, they’ll pivot to it. and they’ll say great, just like we changed our minds and we did insurance or we had a look and we now do pharma, let’s have a look at doing more credit. And one of the most exciting areas for investing today, um, is is actually private credit where unlike a lot of the public credit firms, you see what’s happened to high yield bonds and leverage loans. I mean those markets were pummeled in 22. Private credit has actually been pretty attractive for these private equity firms, for these alternative asset management firms because they’re able to pivot and put more resource and effort in that part of the business that can take advantage of those higher rates. Does that make sense?
Scott: For those listening, you can find a link to uh Sachin’s book, some of the resources he gives in the show notes at biggerpockets.com/moneyshow374.
Guest: that being it’s been a real pleasure. I’m very grateful. Thank you.
Scott: What we’re, you know, one practical application of this is, you know, if you’re considering investing in a syndication or syndicated fund, this they’re going to use a very similar concept to what Sachin just described here. Um, actually the syndicator has an even better model than a lot of the private equity firms because they’ll charge some variation of two and 20, a management fee. Let’s say they raise $100 million to invest in apartment complexes, uh they’ll charge a 2% or $2 million a year to manage the money. They’ll get some variation of two of 20% of the profits, maybe with a preferred threshold. And in that syndication space, the syndicator will get an acquisition fee when they buy the asset, they typically get, you know, around 1% of the the deal in an acquisition fee like a like a real estate broker would, that goes into their pockets uh in many cases. So, uh very similar model, this model is consistent across a lot of things. I think it’s essential to understand it if you want to get into the world of alternative investing. It’s essential to understand the the compensation structure and what these folks are, what the incentives are for the managers of your money. um, and then to dial into what the specific strategies they’re using are to make money.
Mindy: Absolutely. It is essential to understand what you are investing in before you put your money in there.
Scott: I want to say that the inappropriate joke at the beginning of the show was brought to you today by our producer, Calen Bennett. Thank you so much Calen for that inspiration.
Mindy: Bigger private.
Scott: If you enjoyed today’s episode, please give us a five star review on Spotify or Apple. And if you’re looking for even more money content, feel free to visit our YouTube channel at youtube.com/biggerpocketsmoney.
Mindy: BiggerPockets Money was created by Mindy Jensen and Scott Trench, produced by Calen Bennett, editing by Exodus Media, copywriting by Nate Winetraub. Lastly, a big thank you to the BiggerPockets team for making this show possible.
