The Temptation of Private Equity

This content was produced by 21 Hats.

See Full Show Notes By 21 Hats

Podcast Transcript

Loren Feldman:
Welcome, Shawn, Jennifer, and William. It’s great to have you all here. Jennifer, I gather you’ve been getting some phone calls from potential investors of late. That must be kind of fun and encouraging, I would think. Tell us about it.

Jennifer Kerhin:
Sure. I started getting some of them during COVID, as we switched to virtual conventions, and now hybrid conventions, on the technology. Suddenly, I think private equity likes tech. Surprise, surprise, right? So as we started getting into this world, I started getting—for the first time ever—emails from private equity. And they’ve increased in frequency in the past year. So I can’t tell if this is born out of they’re excited about my company or this is desperation of what’s happening in the PE space. [Laughter] So I don’t know. I’ve talked to two of them, and I’m just trying to figure out: Do you just ignore the emails? Do you take the time to talk to them?

Loren Feldman:
Tell us about those conversations. What did you learn, in talking to the ones you did talk to?

Jennifer Kerhin:
So it was two very different conversations on different ends of the spectrum. The first one I took was from a company that’s already in our space. It’s backed by PE, and they were wanting to expand their services. And they reached out to me. I was a newbie. I had no idea what I was asking. So I basically just listened. They talked a lot. And then I asked some questions, very rarely. I think I gave up too much information in the beginning, when I think about it.

Ultimately, my company wasn’t, at the time—it was just about nine months ago—the right fit. And then I took another conversation—well, I started bugging them with questions: Why are you calling me? What’s it about my company? Who’s backing you? What do they want? And they didn’t have any answers. So I was like, “Goodbye.” I’ve listened to all of your up-and-down podcast episodes with Jay about ESOPs. I love the concept of an ESOP. So I take these private equity calls just to learn about what’s out there. I don’t know. Every business owner should always supposedly have an exit plan. I don’t have an exit plan. So I’m thinking, “Huh, maybe I need to think about one.”

Loren Feldman:
Did they know anything of substance about your business? Do they have a sense of how big it is? Or how it’s doing? How many employees you have?

Jennifer Kerhin:
The first one did. They knew a lot about it. They had targeted me specifically. The second one did not.

Loren Feldman:
And did it leave you at all tempted?

Jennifer Kerhin:
Sure. I mean, the grass is always greener. If you offer any small business person who works as many hours as I work what seems like a lifeline: “Here, here’s some potential money.” It’s very tempting, absolutely. I think what I learned in this, though: I need to understand this space better. I completely do not understand.

I’ve learned a lot—I should say, a lot more than I did nine months ago when the calls first started over a year ago. But I learned a lot more about what even private equity is versus startup capital versus angel investors versus family offices or financing. Those words meant nothing to me last summer. You know what, it’s not pretty typical that a company just—or maybe it is—just starts up bootstrapping it. That’s another word I didn’t know: bootstrapping.

Loren Feldman:
You did it before you knew what it was?

Jennifer Kerhin:
I did it before I knew what it was! That’s exactly it. I’m learning the financial lexicon of this world that is so intriguing, terrifying, and tempting all at once. It’s kind of like the Garden of Eden with the apple. God’s telling me not to eat it.

Shawn Busse:
That’s the right metaphor, Jennifer. And of those three words you used, the middle one, “terrifying,” is the one you should focus on. Because private equity—over and over and over I have just seen this—they’re salespeople. And so I’m curious, before I start condemning them and throwing them under the bus—

Loren Feldman:
Oh, I think you’ve started.

Shawn Busse:
I’m curious, what was their sales pitch to you? What did they offer you besides, “Oh, here’s a pile of money”? What is their reasoning for approaching you?

Jennifer Kerhin:
The first one was, “We are looking to get into this space, and instead of building it, we thought to buy it.” The second one was very vague. It was, “Hey, we’re in this space, and we’re looking at companies to acquire.” Nothing of substance.

Loren Feldman:
Jennifer, did it sound like they were interested in just taking over your business, or investing in it and maintaining a role for you?

Jennifer Kerhin:
The first one, I think, the investment and a role for me. The second one, I have no idea.

Loren Feldman:
And when you said before that you were a little bit tempted, maybe, would it be for either of those options, or just one?

Jennifer Kerhin:
I think the temptation comes from, as I’ve said in previous podcast episodes, right now, my company is going through a pretty significant transformation—and a great one. But it means I’m working ridiculously long hours. So if anybody even just offered me a three-day vacation, I think I would jump at it.

But I think when I realize the effort I’m putting in now, I’m going through—and I forget the term when the caterpillar turns into the butterfly—that’s what’s happening right here in this company. Metamorphosis, is that it? But what’s been intriguing to me is knowing that I’m sort of peeling back the veil to understand there’s a whole world out there of the financial building up or taking down of companies that I didn’t really understand. I didn’t understand any of this world. And now, I’m really just getting a feel for it.

Shawn Busse:
Is it that you’re intrigued because if you had more capital, you could hire people to take on some of these jobs that you’re having to do, and you’re working two, three, four 21 Hats roles? Is that what you’re thinking?

Jennifer Kerhin:
I think that’s part of it. I think there’s also an incredible fear that all of my eggs are in this basket, and so to de-leverage some of my risk.

Shawn Busse:
Did they use the term “take some chips off the table?”

Jennifer Kerhin:
They did! Good job, Shawn. [Laughter]

Shawn Busse:
Oh, wow. That’s amazing.

William Vanderbloemen:
Total shocker.

Shawn Busse:
Right, William? I mean, we were talking about the Garden of Eden, William. I mean, you know all about the snakes.

Jennifer Kerhin:
I do! They’re presenting the apple, and saying, “Don’t touch it.” And yet, the snake’s saying, “Take it. It’s delicious.”

Loren Feldman:
I’m guessing William’s gotten some of these phone calls, too. And I want to ask him about that. But first, to Jennifer’s point, maybe we should define these terms. Let me take a crack at it. Private equity is a pool of money, a fund raised by investors who are looking to either outright buy or invest in businesses. It’s different from venture capital, in that venture capital is generally looking for startups they can take from zero to unicorn. Private equity tends to buy existing businesses that have a track record, and may continue to run them for a time.

Shawn Busse:
When I think of private equity, I think of an extractive model where the investors are looking to get a return, and then run the business for three to seven years, and then sell it to another—usually to another private equity firm—who thinks they can do the same thing.

Loren Feldman:
And they often do it using leverage. They buy a company. They borrow against the assets of the company that they’re buying, which often puts a lot of debt on that company and can make it very difficult for it to succeed long-term, but the investors tend to get their money out. That’s one of the horror stories you hear. William, how often do you hear from would-be investors?

William Vanderbloemen:
Oh, two or three times a week. It’s cooled off a little bit. I think, for a while, when debt was basically free, I think private equity was looking for places to park their money besides the market and really went on a buying spree. But having said that, I think, the merger-and-acquisition pendulum swings back and forth in every industry. And right now in the search industry, it’s definitely a hot thing.

So I haven’t taken any of those calls seriously yet, Loren. I took enough of them to start to understand what I think the market currently would value us at. I’m not interested in selling, but it seems to me nearly every small business owner thinks their company’s worth more than what other people will pay for it. [Laughter]

Shawn Busse:
There’s a universal truth.

William Vanderbloemen:
I mean, if you started a business, you ought to be its number one fan, right? You ought to think it’s just the best thing in the world. But I took enough calls to start to understand the options. And I really love our work. I love what we get to do. I’ve also noticed quite a few friends who’ve caught some form of lightning in a bottle with their company and think that they’ll just go do that again, and it’s not quite that easy.

So for me, it’d be more of a question of: How many options am I leaving open for an exit? And let’s stay on radar with PE in case that’s the one we want to do. You know, we might do an ESOP. We might just take passive-owner income and hire a CEO who’s better at this than I am. You talk about the snake in the garden, it is so funny. The old King James version, like the 1611 one that was used forever and ever, when it described the snake, it said, “Now the serpent was the subtlest of beasts.” [Laughter]

Shawn Busse:
Yeah, this is good.

William Vanderbloemen:
So when I think of some of my friends in PE, they’re pretty subtle in the way they state things. I do think I have seen some redeeming value in friends who have used PE and have been like, “You know, we started this thing, but neither one of us has a business degree. We don’t really know what we’re doing, and having a professional management team in place actually is good.” But I tend to agree with you all: If you go down that road, you can forget ever controlling your company again.

Shawn Busse:
Yeah.

Jennifer Kerhin:
The one thing I liked about these calls: One, I’m naturally curious. And so it’s been intriguing to me to see this whole world I don’t know anything about. But also, I’m very naturally attracted to an ESOP. And I’m trying to temper my natural inclination or enthusiasm with more rational thought. And so by looking more into PE, I can hopefully see the pros and cons of ESOP better, right? I’m not sure, but I’m looking at it from a comparison.

Shawn Busse:
William or Jennifer, in your conversations, did you ever get a handle on, “Hey, I can sort of see that this industry is valued at X multiple of EBITDA.” And I know every business broker listening right now is gonna be like, “But Shawn, It’s not just a multiple! It’s a lot more than that.” Whatever. Did you get a sense of that, William?

William Vanderbloemen:
Yep. I did.

Shawn Busse:
What’s kind of the range that you see in there?

William Vanderbloemen:
No one’s gotten inside our books to take a serious look, so a wide variance. In our industry, it depends a lot on how you run: how much of this is personality dependent. If it’s a guy who’s got a great book of business, and he wants to sell, you’re looking at 1X gross revenue. Maybe, maybe five or six times net. Now, on the other hand, if you get a firm that’s fully self-sufficient, that does not depend on personalities, that has a good balance of new business and recurring clients, and it has some digital components with some recurring revenue through software, then you can get up towards 15 on the net.

Shawn Busse:
On EBITDA or net operating income?

William Vanderbloemen:
EBITDA. You know, there’s not a lot of depreciation in such firms. So even a net is much closer.

Shawn Busse:
Like a manufacturer would be very, very different.

William Vanderbloemen:
Very, very different. But yeah, I think the key is, if you’re buying a guy, that’s not worth nearly as much as if you’re buying a process and a system with some software tools added on.

Shawn Busse:
Which has kind of been your journey. Right, William?

William Vanderbloemen:
I hope so.

Shawn Busse:
I mean, you talk about making yourself less relevant every year.

William Vanderbloemen:
Yeah, it’s far, far easier than my ego would like. [Laughter]

Shawn Busse:
I bet you’ve been pretty good on the operating side. I bet the marketing side is the hard side for you.

William Vanderbloemen:
Yeah, it’s what I love doing. So now, my game for marketing, I’m more like a brand ambassador. I’ve got a book coming out in November. And since the firm has the same weird name as me, the author, that’s sort of halo marketing for the firm without my marketing efforts being viewed as essential to a potential buyer. Does that make sense?

Shawn Busse:
Yeah, totally.

William Vanderbloemen:
And it’s a research-based book that tells stories about the common habits we’ve seen in the very best people we’ve interviewed, now that we’ve done 30,000 face-to-face interviews. So it’s pretty cool. And it will position the company as experienced and a trusted advisor. And so that kind of marketing I’m still involved in. But the day-to-day stuff, I’m really getting out of the way.

Loren Feldman:
William, in the approaches you’ve gotten from investors, have they mostly been from investors who are just interested in search in general? Or do you hear from people who have figured out that you have a distinctive firm with a very distinctive focus?

William Vanderbloemen:
Both. And I mean, you end up on a list, I’m sure. Because it’s everything from “We help with exit strategies” to “We’re private equity” to “Hey, we buy search firms, and you look appealing.” I just got invited to a thing next month that I’m not going to be able to go to where I think it’s put on by two dozen PE firms, and they’re inviting boutique search firms.

Shawn Busse:
I mean, the interesting thing, Jennifer, have you gone down the path of… well, the difference between private equity and an investment bank, for example?

Jennifer Kerhin:
No, I went to one of those sessions, though, that William was talking about, where a law firm put on one of these all-day retreats that you could go and listen to. And I remember I left it feeling so strange because they invited CEOs of small businesses to come, right? It was like bragging about how great they were and telling us how important they were. And I don’t know, it just rubbed me the wrong way. And then, when I brought up ESOPs, they were like, “Oh, that’s the stupidest idea ever. It costs too much money.” I didn’t really get a lot out of it or learn about it. But I had a speaker at one of our Vistage groups talk about investment banks. But I don’t know that much—the difference.

Shawn Busse:
I think my shorthand is, essentially, an investment bank is looking to sell a business, and private equity may be a buyer. So that’s another approach you could take, right? You could work with a firm that positions you for sale, and then they play the different capital groups against each other. That’s the ideal situation. If you want to sell, and you want somebody to help you navigate that process, that’s the investment bank route. And they collect a fee and that whole thing, but there are advantages and disadvantages. But they’re all going to tell you ESOP is terrible, because they can’t make a commission on it.

Loren Feldman:
Or not as big a one.

Shawn Busse:
Or not as big a one, yeah.

Jennifer Kerhin:
I met an entrepreneur who sold his third company to a private equity firm. What are they called, the “bolt on?” And I asked him, “They say that saying, ‘Every business owner is like a boat owner. You should figure out how you’re gonna exit. When you’re gonna sell your boat the first day, you buy it, and vice versa when you start your company.’” I was like, “Is that true?” He’s like, “Absolutely. I absolutely think of an exit plan.” And I was like, “Oh.” And he said, “Did you?” I was like, “It’s never occurred to me that I could exit my company.” [Laughter] So I want to learn and understand this world.

Loren Feldman:
But Jennifer, you must know that you are not alone in this. And Shawn, you would probably know best. It’s unusual for a business that’s still kind of in the growing stage to already be thinking about exits.

Shawn Busse:
I mean, what is really interesting to me, because I think last time we were on together, Jennifer, you shared you were just below $5 million, but over 2, somewhere in that—and thanks for sharing that. What’s interesting is that they’re being aggressive with you. And to be aggressive with a company at your size tells me they’re very bullish on the industry or the solution, because usually PE doesn’t want to talk to you until you’ve hit like $5 million or half a million in earnings in EBITDA.

And so I think what’s going on here is, you’re in a hot market, or you’ve created something that’s hot. And I think you want to really keep that in perspective as you go forward, that there’s a reason they’re talking to you. And you have the value. And they’re gonna portray it as like, “Oh, we can help you and blah, blah, blah, blah, blah, blah,” but at the end of the day, I think you’ve got the leverage here.

Jennifer Kerhin:
That is a great insight. Thanks, Shawn. I had not thought about that at all. And to go back to William, they’re being subtle with me, huh? [Laughter]

Shawn Busse:
Well, they are the subtlest of creatures. And the other thing, too, Jennifer is—and William brought this up—the capital markets have radically changed, so money is not cheap-slash-free anymore. So I suspect that the PE folks are starting to look at businesses that have good net operating income. And a well-run professional services business should have really good net operating income. And what they probably see with you, through their lens, is: services. People are moving back into real-life events. This is upward. You know, Zoom is going to go down, events are going to go up.

And they probably see it as the opportunity to squeeze margin out of your business by optimizing it. So let’s say you have 10 percent net operating income, or 15 percent. They’re gonna want to drive that to 20-25 percent. And how they do that is the painful part. So that’s the thing. I suspect they’re moving towards margin and away from speculation, because the capital markets have become so difficult for them. And I’ve read articles that say, basically, the private equity model breaks in a high-interest environment. And that’ll be interesting to see over the coming years.

Loren Feldman:
I should point out, I’ve talked to business owners who sold to private equity, and were very happy with the way it turned out. It does happen.

William Vanderbloemen:
Same here, Loren.

Loren Feldman:
Based on my entirely unscientific, anecdotal survey, those companies seem to be in the minority. And that’s certainly what you tend to read about, but every fund is different and has different characteristics and interests and focus. And I think sometimes the stars do align. It is possible.

I know one company, it’s technically a private equity business, but their name is Permanent Equity. And their strategy is to buy and hold and to keep the owner involved as long as the owner wants to be. And they’ve done that with all their investments. They don’t make that many. They really just focus on bringing in—not professional management to take over, but professional help to supplement what the owner has been doing. So there are other flavors out there.

Shawn Busse:
I’m curious, Loren, when I first heard about the Permanent Equity idea, I was like, “Actually, that could work.” But that was before interest rates went up. And you know, I’m curious if that’s changed.

Loren Feldman:
That’s a great question. I have not spoken to anybody there since interest rates went up. So I don’t know the answer. One thing I do know about them is that, unlike some places, they don’t feel compelled to invest if they don’t have an investment that they find attractive. So they’ll go, you know, more than a year without investing in a business, if that’s what they think is the right thing to do. And maybe, as they say, they’re keeping their powder dry right now.

Shawn Busse:
Well, they are the subtlest of creatures. [Laughter] I mean, that’s a classic sales strategy. I hate to say it, but saying, “Well, we’re really busy, and we might be able to take you on.” Sorry for the cynicism, but I think you could build a model. There are certain industries, for example, where the margins are sufficient to service the debt from an outside investor. The problem is, a lot of owner-run businesses just don’t have the margins to support that type of outside investment. And so when the investment comes in, they’ve got to find the money somewhere. And usually, that means cracking down on costs in the business, and that’s where then the culture suffers. The employees leave. So the owner might be happy.

William Vanderbloemen:
Not to poo-poo, but having learned quite a bit, and still learning, about culture, I think if the private equity does well, and they grow at a triple-in-five-years kind of rate, the culture is going to suffer. Because culture does not withstand fast growth.

Shawn Busse:
Yeah, that’s a good point, William.

Loren Feldman:
That’s kind of damned if you do, damned if you don’t.

William Vanderbloemen:
I think that’s right.

Read Full Podcast Transcript Here