If you feel a bit shaken right now—whether you are a LP, a GP or just about any other P in private equity—it’s because we are in the midst of a major shakeout.
When the dust settles, the landscape will have changed, perhaps dramatically. Some have suggested that the number of buyout firms will decline by 25 percent to 50 percent. Some will say that this change is necessary and for the better, much like forest fires are important for the long-term health of the ecosystem. But this is scant comfort to the homeowner holding the garden hose ahead of the approaching inferno.
Sitting in the captain’s seat of this 21-year old private equity firm, we may be hopelessly biased, but we believe strongly that private equity isn’t going away, especially not in the small end of the middle market where we play. Inevitabilities like death, estate planning, divorce, and changes in lifestyle, as well as corporate divestitures, drive our deal volume. We offer capital that is truly needed, and the best buyout firms drive consistently superior returns in this imperfect asset class.
The primary determinate of where any buyout shop falls in the new world is whether it will be able to raise funds. Now more than ever, the future of GPs is in the hands of LPs. So, what should LPs consider in making these financial life-and-death decisions? Because Riverside has raised about $1.5 billion over the last 18 months, we’ve crisscrossed the globe and spent countless hours meeting face-to-face with some of the world’s savviest investors, talking through many and varied questions. Here are some of the best.
1. We see that you lost money on these three deals, including Piece-of-Crap Corp. that you bought for 10x peak EBITDA. What drugs were you on when you invested?
Smart LPs know that no GP is perfect. They understand that we’re in the risk capital business, and that the promised returns cannot come without risk. They legitimately want to know where you’ve messed up and, more importantly, what you learned and how you’ve improved. Of course, smart GPs will have already beaten their backs raw with self-flagellation. We learn much more from deals that go wrong than we do from the ones that go right. The tuition is steep, so we squeeze out every lesson. Be wary of GPs who present themselves as infallible. We’ve all had deals go south. The key is how those deals changed us and made us better investors.
2. You made money on 85 percent of your realized transactions. That’s great. What were the sources of your value creation?
This is a trick question. The GP is not supposed to say luck, even though we all know that luck plays a significant role in our industry. Typically, value is ascribed to three factors: (a) growing EBITDA, (b) realizing an increase in the exit multiple relative to the purchase multiple, and (c) paying down debt. LPs correctly put a premium on the first, which is the best proof of the GP’s ability to pick winners and drive performance. But (b) is high art when the reason for the increase comes from selling a company that is both bigger and better than the one that was initially bought. Ideally, a “morph” occurs, and the resulting company literally looks and smells better. The morph can involve some or all of changing strategy and/or management, adding or changing sales channels, product innovation, international expansion and improving facilities. It can be achieved via add-ons or greenfield investments. And (c) shouldn’t be dismissed altogether. Once upon a time this was the idea behind LBOs—leverage up and then pay down debt. But in an increasingly competitive world with higher purchase price multiples, it doesn’t cut it anymore.
3. We’d like to meet with everyone who has ever worked for the firm. We’d like to call every CEO who has ever worked for a portfolio company, especially any you’ve fired. And can we have the contact information for your kindergarten teacher too?
We reference the heck out of the companies we buy, the folks we hire and just about every service we procure. So we applaud those LPs who go the extra mile here. The challenge is to go from the perfunctory to a deeper level that uncovers every strength and weakness. This involves probing deeper and asking for specifics.
4. What were your company and its principals doing 10 years ago? Five years? What will your firm look like in five and 10 years?
Indeed, “past performance may not be indicative of future results.” Nonetheless, the answers to these questions speak directly to experience, stability, and succession planning. Experience is critical in sourcing the best deals, finding the right partners, and creating and executing excellent strategy. Cohesion and a strong track record also bode well for future returns. No one can predict the future, but LPs should be able to get a good sense of where a firm is going based on where it has been. Past performance should correlate to what the firm currently does as well (success with a $200 million fund doesn’t necessarily make the GP a great fit for a $5 billion fund). You also want to see if the firm has improved over the years, and what they’re doing to enhance their processes. Strategies must evolve along with the marketplace. Seek firms that have followed a logical approach to growth, rather than those that are chasing the newest and sexiest things.
5. How much is the GP investing in this fund? Where are you investing instead?
All firms show some goodwill and confidence by investing in their funds, but a GP should invest broadly and deeply to demonstrate confidence in its approach and the returns it generates. For us, that means a minimum of 5 percent in each fund comes from Riverside employees, or a total of $150 million of our collective net worth.
6. For all investments you’ve made in the past 10 years, how did sales and EBITDA growth rates and margins change from before you invested until afterwards?
This is a simple schedule to prepare and one that can provide some real insights into whether the GP has its operational chops. It’s pretty much a follow-up to #2, but it adds heft by backing up the rhetoric with hard numbers.
7. How is carry distributed?
Most firms distribute carry among their top executives and partners, sometimes even vice presidents. Some firms believe in aligning interests not just with investors and portfolio companies, but also among employees. When people at all levels of an organization share in successes, it is a remarkable motivator. By the way, “Sorry, we don’t share that information” is almost never the right answer. Today, LPs value transparency almost as much as they do returns. So private equity has correctly become a bit less private, and it’s open kimono time for GPs.
8. I already have 70 funds and 50 managers in my portfolio. How does adding your fund provide me with the same returns at lower risk or higher returns without taking on more risk?
Everyone knows to diversify, but what does that mean with private equity? Is it regional, by industry, by size? Any of these can provide something your portfolio may lack, but “something different” is what you try at the Chinese restaurant, not an investment strategy. Most firms claim to have a “special sauce,” and we do too. The difference in a select few (and we count ourselves among them) is just that—a real difference. Riverside’s special sauce is a laser focus on the smaller end of the middle market. More than two decades of focus has helped us understand the vicissitudes and challenges of the niche, and it’s allowed us to build the operating-intensive model we rely on to build value. The right firm will be able to tell you that they’re doing the same thing as a comparable fund, but doing it better (and prove it). If they can’t do that, they must be able to give LPs something qualitatively different than what they already have.
9. I just talked to Silver Tongue Partners, the hottest new GP in the land. They never touch auctioned deals; 100 percent of their deal flow is proprietary, typically hand-carved by Buddhist monks in Nepal. What percent of your deal flow is proprietary?
Proprietary deal flow is the siren song of private equity. It is like the elusive alligators in the New York sewer system. LPs should dig deep to understand how the GP has and will find deals. The strategy should be rigorous and consistently applied. It should make sense. And, most importantly, it should be proven to deliver a sufficient number of reasonable opportunities such that the GP can pick the winners.
10. Let’s look at the deals you did in the last downturn (2001-2003) and how they fared. Let’s then compare them, side-by-side, to the deals that you did in the peak of this market (2005 to 2007.) What changed?
It is interesting to see how a GP responds to changing market conditions. Would you want to invest in a fund that is happy to pay peak multiples of peak cyclical earnings for anything that moves in the “good times” and doesn’t buy anything when earnings, multiples, and therefore valuations are depressed?
11. (It’s our experience that LPs always throw in at least one more question than they say they will, so we figured we’d do the same.) Please show us how each deal you did in your last fund fit your articulated investment criteria and strategy.
LPs should be concerned about style drift. Styles can and should evolve. Time and experience should yield new ideas and improvements. But they should be evolutionary. If a firm that did single-cell bacteria deals before jumped to a chimpanzee overnight, alarm bells should sound. We find plenty of challenges coming from just doing one thing over 21 years, and we watch with interest as other firms become overnight experts in buying distressed debt, doing turnarounds, and other such drift.
We could go on, but then it really wouldn’t be a Top 10 list. We’d like to thank some of our sharpest LPs, who have put all these questions to us, along with thousands of others. We adore questions. While at times agonizing, we believe that the fundraising process has made our firm better investors. It forces you to stop, analyze and even reflect a bit—not activities that come naturally to go-go, “make it happen now” GPs. And questions are a great invitation to a conversation. Besides, with the right answers—ones that demonstrate a considered and differentiated strategy proven over multiple transactions and years—you just might raise a little money even in this upside-down and inside-out market. And raising money is the surest way to become a “have” GP and survive this brutal shakeout.
We hope you find this short list useful, and if you want to learn more about us, please ask away.
Stewart Kohl and Bela Szigethy are co-CEOs of The Riverside Company, the New York private equity firm.