Why taking PE money is better

A few weeks ago, I shared an overview on how private equity roll-ups work.  I started with a statement that PE (private equity) is more aligned your interests than other investors are.

This led to many of you asking, “Why? I thought VCs help entrepreneurs build companies!"

Today's newsletter will shed light on why PE is a better choice for founders building profitable, ambitious companies.

And it all starts with… THEIR business model.

There are lots of ways to win a baseball game.  Some teams have a few HUGE hitters who will crush the ball.  They have big wins and some losses, but overall they do great.

A different team may have consistent hitters across the lineup.  They win and lose games, usually by a close margin but, again, overall they do great.

This is very similar for the business models of venture capital vs private equity.  Let's look at the similarities and differences between how their businesses work.

Both VCs and PE raise "funds."

Let’s use a hypothetical example:

PVP and PPE both raise $500M funds.

Their “customers,” the people they raise money from, are called “LPs” (Limited Partners).  These are pension funds (e.g., CalSTRS, which is the California State Teachers Retirement System, has over $1T to allocate), endowments (e.g., Harvard University), and rich people (e.g., Jeff Bezos).  All those investors have tons of money looking for better returns than the stock market (S&P 500), and a way to diversify beyond traditional stock investments.

Both $500M funds promise the same result: a 3X return on the capital invested over a 10-year period, or $1.5B on the principal of $500M.  That's around 12% annual return on the money.

If any fund manager generates a 2X return or below, they are likely to be out of business soon.  If they are 3X or above, they can raise more funds and grow!

There are a lot of ways to "skin the cat" when taking $500M to $1.5BN over 10 years.  Hedge funds (a different group than VC or PE), for example, can invest in public stocks and get a return every year and compound it.  Some funds invest in real estate or even patent litigation!  There are tons of ways to get returns.

Here's why it matters for you: VCs play for occasional grand slams, while PE is all about consistent singles/doubles.

For a $500M VC fund, it may write 25 checks of around $20M (likely series A or B).  (There are a bunch of complexities around deal size, follow-ons, dilution, etc., which I won't go into).  VCs typically target 20% ownership.  So for this example, 25 checks are written at a $100M valuation per company.

A "good" result for this VC's fund to hit $1.5B is:

15 companies go to ZERO - loss of $300M (exit at zero)

5 companies return the capital - $100M back to the fund (exit between $20-100M)

2 companies 5x - $200M back to the fund (exit at $500M)

2 companies 8x - $360M back to the fund (exit at $1B)

1 company 50x - $1 BILLION back to the fund (exit at $5B)

That is $1.36B returned on $500M.

But look at what happened: 15 founders failed.  5 more or less failed.  And 5 had big/meaningful outcomes.

The business model of VC is to go big or go home.  If you, as a founder, want that, then by all means… raise VC!  I’m not saying that sarcastically. Just realize they’re incentivized to get a few companies to become huge and to write off the rest.

In a PE’s $500M fund there are usually FAR fewer investments.  10 or fewer. (Vs 25, the previous example.) They are also buying controlling stakes in businesses.

To understand PE’s business model, we’ll do the math based on JPE buying 100% of each company. But often PE buys 60 - 70% of a business because they want the founder to have a vested interest helping them grow the company.

So PE invests in 10 companies at $50M each.  These companies likely are doing $4-6M in EBITDA and being bought for an 8-12x multiple. 

A successful PE fund looks like this:

1 company is a dud - they give no return but don't fail: $50M returned to the fund

4 companies double - (sell for $100M each) - returns $200M to the fund

3 companies are a 3X (sell for $150M each) - returns $450M to the fund

1 company is a 5X (sells for $250M) - returns $250M

1 company is a 10X (sells for $500M) - returns $500M

$1.45B returned.

But how did it go for the entrepreneurs?  In every case, they had a good outcome.  Even the dud still got their initial exit and, if they retained 30%, got a second exit.  It may not have been that great, but it wasn't zero.

There are a few things going on here:

1) The PE firm OWNS more of the company than a VC does.

If I own 100% of a company for $50M, then a $500M company exit is MASSIVE.

Meanwhile, if I only own 20% of the company (as a VC might), the company has to exit for $2.5B for me to get $500M. Increased ownership makes a more modest outcome meaningful.

2) PE is buying "real businesses.”

They are buying companies with cash flows that are established.  That means they don't have massive failure events.  VCs are often buying a wish and a prayer. (Remember when VCs put $1.5 million into Yo, the app that lets you send a “yo” to your friend?) Or they back money-losing businesses. (WeWork lost $4.63 billion in 2021.)  That creates a lot more outcome volatility.

Keep in mind that this is over a 10-year horizon, so it's likely that my PE outcomes are quite modest.  For PE to 10X a business over 10 years it needs to grow it by 20%-30% per year.  Meanwhile, turning a founder’s unproven vision into a $5B unicorn requires a substantially higher growth rate.

PE is simply playing a different game.

That game is often much more aligned with profitable, growing founders!

-jesse