NEW: Mr Banker

Too prudent and conservative to invest in private equiy funds? Don’t worry, your super fund has probably done it for you.

Private equity

I’ve made fleeting references to “private equity funds” in previous blogs without explaining what they are or how they work, so an explanation is well overdue.

First things first.

Private equity funds are exactly the same as the leveraged buyout funds of the 1980s. However, whereas leveraged buyout has the word “leveraged” in the name, private equity has the word “equity”, which of course is far more reassuring.

The single most important thing to understand about private equity is that it involves other people’s money. Typically, 80% of the funds invested will be borrowed from banks, and 20% will be yours, leaving a balance of nil, which is invested by the private equity managers.

(Some of my readers will wag a hypothetical finger, smile, and point out that they are too conservative to invest in private equity funds. To them I say: of course, you’re right, you haven’t – it’s your superannuation fund that has done so on your behalf).

I have described the life cycle of a typical private equity deal from the point of view of the fund manager, sequentially, to highlight a certain rhythm, as follows:

1. Find a business to buy. The purchase price is determined by the maximum amount the bank will lend to pay for it.

2. Pay yourself a success fee.

3. Create a “tax consolidation” group, which streamlines the process of offsetting a massive interest bill against the profits made by the business (note: please don’t tell the Australian Treasurer about this, he’ll find out in a year or two’s time).

Take control of the business. Set an achievable performance target, and meet it. Usually this involves eliminating any activities that will take longer than 12 months to be of benefit (corporate planning, research and development, that sort of thing).

4. Pay yourself a performance fee for exceeding the performance target.

5. Find another business in the same industry to buy (or find another business in a similar industry and explain that this is “vertical integration to control the supply chain”).

6. Pay yourself a success fee.

Steps 3 to 6 are repeated between three and five times.

7. Prepare a prospectus that highlights the steady growth in EBITDA (that’s why you were buying those businesses) and sell the business to its new shareholders for five times the price you paid. You can justify this by forecasting a steady growth in net profit (even though it will be the inevitable result of replacing a heavy debt burden with interest free equity, most observers will assume that it reflects good management on your part).

8. Pay yourself a success fee.

Yes, really. Unit holders will be so pleased with a concessionally taxed (and admittedly large) capital profit that they don’t seem to notice just how much you get paid.

9. Wait for the newly floated business to tank due to the lack of long-term initiatives such as corporate planning and research and development.

This will be in about 18 months, by which time you have established another private equity fund that can buy the underperforming business and take it private again.

For more Mr Banker blogs, click here.