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Private equity playbook - tips from an insider · The Money Puzzle

0:10
Speaker 1: Hello and welcome to today's episode of The Money Puzzle.
0:13
Speaker 1: I'm your host, James Gerrard, standing in for James Kirby
0:16
Speaker 1: this week as he enjoys a well-deserved break. Today, we've
0:19
Speaker 1: got a special episode planned, which is all about private
0:22
Speaker 1: equity investments and venture capital investments. It may sound very mysterious.
0:27
Speaker 1: At the end of the day, private equity is just
0:29
Speaker 1: basically investing in a company that's not listed on the
0:32
Speaker 1: share market. So imagine investing in your local bakery. That
0:36
Speaker 1: could be considered private equity. And for those who have
0:39
Speaker 1: watched the TV show Billions, if you don't have billions
0:41
Speaker 1: of dollars like Bobby Axelrod does to invest, there are
0:44
Speaker 1: still some pathways for the everyday mom and dad investor
0:47
Speaker 1: to invest into private equity. But this particular asset class,
0:52
Speaker 1: it requires a lot of research into it because it's
0:56
Speaker 1: a big case of buyer beware with private equity. There's
0:59
Speaker 1: a lot less information there. There's a lot more risks.
1:02
Speaker 1: So it's generally a lot more less transparent than the
1:07
Speaker 1: share on the share market. So investors need to be
1:09
Speaker 1: a lot more careful before they invest into private equity.
1:11
Speaker 1: So today we'll break down the basics. We'll share some
1:14
Speaker 1: tips and tricks. We'll discuss the ins and outs of
1:16
Speaker 1: private equity. And to help us do this, we've got
1:18
Speaker 1: a very special guest. Rudy Engelbrecht is a close friend
1:21
Speaker 1: of mine and also a private investor. And he's kindly
1:24
Speaker 1: agreed to open the books and share his experience on
1:27
Speaker 1: private equity investing in Australia. Having migrated from South Africa
1:31
Speaker 1: around 10 years ago, But to be very clear, Rudy's
1:33
Speaker 1: not providing advice. All his views are his own personal views.
1:36
Speaker 1: He's not acting in any other capacity. So always, as
1:39
Speaker 1: is the case on the money puzzle, everything we discuss
1:42
Speaker 1: is general advice. It's not personal advice. And you should
1:45
Speaker 1: seek your own advice from a professional before making any decisions.
1:49
Speaker 1: So without any further ado, Rudy, welcome to the money puzzle.
1:52
Speaker 2: Thank you, James. Thank you for inviting me today to
1:55
Speaker 2: the show.
1:56
Speaker 1: My pleasure. Let's get right into it. So firstly, I'd
2:00
Speaker 1: like for you to tell our listeners a little bit
2:02
Speaker 1: about yourself. So your background and what's your history of
2:05
Speaker 1: private equity? What attracted you to this type of asset class? Sure.
2:10
Speaker 2: I'll give you a quick overview. My journey started in
2:14
Speaker 2: 2000 when I was still in South Africa and had
2:16
Speaker 2: an opportunity to join a young fintech startup and they
2:19
Speaker 2: were going to build a new wealth management platform. I
2:22
Speaker 2: had experience in that industry. And then as a key person,
2:25
Speaker 2: And the venture, I wanted to leverage my knowledge, use
2:28
Speaker 2: my experience of wealth platforms and technology. And to do that,
2:32
Speaker 2: I asked them to invest in the holding company who
2:35
Speaker 2: actually owns a fintech startup at that time. That was
2:38
Speaker 2: quite nice. And two years later, when I left the
2:41
Speaker 2: fintech to pursue my next venture, I then realized, hang on,
2:44
Speaker 2: these shares are now locked up somewhere and I need
2:48
Speaker 2: to find a buyer for my shares or leave it
2:50
Speaker 2: behind and wait for future exits. So that was my
2:53
Speaker 2: first introduction into liquidity and also the premium on buyer
2:59
Speaker 2: and selling the shares and the differences in the prices.
3:02
Speaker 2: So it was a good introduction into this unlisted private
3:05
Speaker 2: equity market. It was a good lesson. And I managed
3:08
Speaker 2: to sell my shares for a slight loss, but I
3:11
Speaker 2: went on and I learned from that.
3:13
Speaker 1: Great. So to start, you fell into it by default.
3:15
Speaker 1: You joined a company that was a private company that
3:18
Speaker 1: was growing. So it wasn't so much you were actively
3:20
Speaker 1: seeking a private equity investment. You were a staff member
3:22
Speaker 1: that had equity in this company.
3:24
Speaker 2: That's right. Yes. I wanted to, just being a normal
3:27
Speaker 2: staff member and also being part of the key team,
3:30
Speaker 2: I wanted to leverage that knowledge. And so, look, I
3:33
Speaker 2: want to take my investment and grow it in a
3:36
Speaker 2: higher capacity.
3:38
Speaker 1: Perfect. You started there and then what happened from that point?
3:41
Speaker 1: What more did you do in private equity?
3:42
Speaker 2: Then was the normal business world. I started a business
3:46
Speaker 2: as well. And when I moved to Australia, I started
3:49
Speaker 2: another business here. And through starting that business, I got
3:53
Speaker 2: involved in another fintech startup, also in the wealth platform industry.
3:58
Speaker 2: This was a wealth platform that offered their products and
4:02
Speaker 2: services to Australian financial advisors. So it sounds a bit
4:06
Speaker 2: like a case of deja vu, and it is. So
4:09
Speaker 2: I ended up investing in the startup. And I educated
4:12
Speaker 2: myself on shareholder agreements, company constitutions, got introduced more to
4:18
Speaker 2: subscription notices, company valuations, annual financial statements. And in this case,
4:23
Speaker 2: I also engaged with legal advice and legal counsel to
4:27
Speaker 2: review shareholder agreements and the terms and conditions and term sheets.
4:31
Speaker 2: It was a bit expensive because I had to pay
4:33
Speaker 2: the market rates for legal advice, but it was a
4:36
Speaker 2: good lesson again, because I learned a lot from reading
4:40
Speaker 2: pages and pages of documentation.
4:42
Speaker 1: Got it. So it sounds like this is another case
4:44
Speaker 1: of using your professional experience, be in a company, but
4:48
Speaker 1: also invest in that company as well. Apart from that,
4:51
Speaker 1: have you invested in other companies that you haven't worked
4:54
Speaker 1: in or you don't work in?
4:56
Speaker 2: Definitely. As you can see, at first I started with
4:59
Speaker 2: companies where I had a deep understanding of the industry
5:02
Speaker 2: and I had a passion in that world. And over time,
5:06
Speaker 2: I started to look for other opportunities out there I
5:09
Speaker 2: branched out into other industries, not connected to wealth platforms,
5:12
Speaker 2: but still with a heavy focus on technology because of
5:15
Speaker 2: my background in technology. So one was a valuation platform
5:19
Speaker 2: for property. Another one was a financial advisor platform providing
5:27
Speaker 2: financial advice technology. Another platform was purely building fund management
5:33
Speaker 2: type solutions. And then over time, I even ventured into
5:38
Speaker 2: more nuts and bolts type of businesses. These are businesses
5:41
Speaker 2: that would, say, invest in a fund management company that
5:46
Speaker 2: they would then acquire a company that builds patios and roofs,
5:53
Speaker 2: for instance. And they have then a different profile. It's
5:56
Speaker 2: a lower risk profile and there's a dividend income coming
5:59
Speaker 2: out of that investment. Yeah, so it actually brought an
6:02
Speaker 2: added to anything else.
6:05
Speaker 1: Excellent. But it still sounds like that the type of
6:07
Speaker 1: companies you invest in, you understand them because they're either
6:10
Speaker 1: in the finance sector or the IT sector or maybe
6:13
Speaker 1: a crossover of both. So is it fair to say
6:16
Speaker 1: that you have a preference to invest into private companies
6:20
Speaker 1: that you have a finger on the pulse using that
6:23
Speaker 1: saying rather than something that might be totally foreign to you?
6:26
Speaker 1: So investing into a home tools company, for example?
6:30
Speaker 2: At first, I obviously wanted to be engaged and wanted
6:33
Speaker 2: to understand a lot about the businesses. And then over time,
6:37
Speaker 2: the last few investments I've made were more about show
6:39
Speaker 2: me your track record, show me your history with the company,
6:44
Speaker 2: show me the returns, look at the balance statement, financial statements,
6:50
Speaker 2: and look at the risk profile. I've actually now ventured
6:53
Speaker 2: into other more, I would say, as I said before,
6:56
Speaker 2: the nuts and bolts. The other one is also a
6:59
Speaker 2: building trust company. So They actually provide construction services. I
7:03
Speaker 2: don't know anything really about that industry, but I like
7:07
Speaker 2: the fact that there's a sound financial model and it's
7:10
Speaker 2: literally about products and services they sell and then they
7:14
Speaker 2: have estimated earnings and then they either deliver on that
7:17
Speaker 2: or not.
7:18
Speaker 1: I'd like to know more about how these opportunities come
7:21
Speaker 1: across your plate, but also how you do the due diligence.
7:24
Speaker 1: We might do that in a little bit more detail later.
7:26
Speaker 1: But for now, I'd like to move on to getting
7:28
Speaker 1: started in private equity. So what type of investor is
7:32
Speaker 1: suited to private equity, in your opinion?
7:36
Speaker 2: Yeah, this really depends on each individual. The private equity
7:39
Speaker 2: is quite different from listed shares. And some of the
7:42
Speaker 2: factors you need to consider for yourself as an individual
7:45
Speaker 2: is your financial capacity, how much savings you have. that
7:48
Speaker 2: you want to allocate to this asset class, what kind
7:51
Speaker 2: of risk are you prepared to take? Because many of
7:55
Speaker 2: these investments are quite risky and then some you could
7:59
Speaker 2: actually lose your whole investment. And then also the other
8:03
Speaker 2: one is how long are you prepared to keep your
8:07
Speaker 2: capital locked up in this investment? Because they typically are
8:10
Speaker 2: quite lengthy type of investments that could be five plus years,
8:14
Speaker 2: 10 years, sometimes even longer.
8:17
Speaker 1: I think it'd be good to explain a little bit
8:19
Speaker 1: more about what is the whole life cycle of a
8:23
Speaker 1: private equity or a venture capital investment. And maybe we'll
8:26
Speaker 1: start with just clarifying the difference between venture capital and
8:29
Speaker 1: private equity, and then we'll talk through what the life
8:31
Speaker 1: cycle is. And we're going to have a brief chat
8:33
Speaker 1: about the different rounds of funding as well that companies
8:36
Speaker 1: would typically seek. So my understanding is that a venture
8:38
Speaker 1: capital company is more at the incubator early stage where
8:43
Speaker 1: they're at their infancy, they're either just an idea or
8:46
Speaker 1: they're a company that's relatively recently formed that's running at
8:49
Speaker 1: a loss because they have wages but they're not selling
8:52
Speaker 1: any products or services yet whereas private equity is a
8:54
Speaker 1: little bit further down the track they're not there as
8:57
Speaker 1: a share market listed company but they're probably more developed
9:00
Speaker 1: with regards to their offering and they still may be
9:02
Speaker 1: running at a loss and they may need some capital
9:05
Speaker 1: to kick off marketing further or to develop further but
9:09
Speaker 1: it's later on so is that your understanding as well
9:11
Speaker 1: rudy of how private equity and venture capital are different.
9:15
Speaker 2: Yeah, that's right. So usually most people will start off,
9:21
Speaker 2: the first phase will be I've got an idea and
9:24
Speaker 2: I think I've got a great business that I'm going
9:27
Speaker 2: to now build. And typically you could access, there are
9:33
Speaker 2: different ways you could access capital. You could go to
9:35
Speaker 2: friends and family, you could use your own funds, et cetera,
9:37
Speaker 2: and you kick that off. Over time, what you could
9:41
Speaker 2: do is then go to an early stage, And again,
9:45
Speaker 2: you would talk to angel investors. You'll have your pitch
9:48
Speaker 2: deck ready, which will explain later exactly what goes into that.
9:52
Speaker 2: You'll have areas that you highlight in that, which is
9:55
Speaker 2: your valuation, how much capital do you require and how
9:58
Speaker 2: you're going to sell that to the investor. the angel investors.
10:01
Speaker 2: And then over time, you get into a growth phase
10:03
Speaker 2: where you will then do subsequent rounds. And this is
10:07
Speaker 2: how you can get more private equity companies and also
10:10
Speaker 2: venture capital companies to then invest bigger chunks of capital
10:13
Speaker 2: into your business. And now you're in the final stages.
10:17
Speaker 2: And if you're lucky, then you could actually have a
10:20
Speaker 2: positive return where you actually have dividends coming out or not.
10:24
Speaker 2: Or if it's a growth-based company, you could focus on
10:26
Speaker 2: growing the business through revenue. And even if you're making
10:30
Speaker 2: a loss, as long as there's enough growth to back it,
10:33
Speaker 2: you could then get VCs to come in as well
10:36
Speaker 2: or other institutions and an exit can be prepared where
10:41
Speaker 2: you could sell the company as well and work through
10:44
Speaker 2: the phases or you could IPO it even. So, yeah,
10:47
Speaker 2: that was a quick summary of that. And we can
10:49
Speaker 2: dive into more detail into each of the phases again.
10:51
Speaker 1: Now, I think that is good as a high level summary.
10:54
Speaker 1: So basically, company starts up. The first one is the
10:58
Speaker 1: angel round. So that's right at the beginning to help
11:02
Speaker 1: kick things off. And then you have the seed round,
11:04
Speaker 1: which is at the early stage of development. And then
11:06
Speaker 1: you might have a bridge round and series ABC and
11:09
Speaker 1: so forth. And then you might have a pre IPO
11:11
Speaker 1: raise afterwards. or there might be other raises beyond that.
11:15
Speaker 1: But that's the general cycle there with raises. And what
11:19
Speaker 1: generally happens is that new investors are brought in, new
11:22
Speaker 1: shares are issued, existing shareholders can be diluted because there's
11:25
Speaker 1: more shares now. But generally, the company valuations go up
11:28
Speaker 1: every time a company raises capital. That is the hope.
11:32
Speaker 1: It doesn't always happen. Now, one thing which I find interesting,
11:35
Speaker 1: because I look at private equity investments as well and
11:39
Speaker 1: have invested in some, is how they... to me and
11:42
Speaker 1: how they come to you? How do they get in
11:44
Speaker 1: front of us? And the first thing that I always
11:46
Speaker 1: think is, why is this company coming to me? Because
11:50
Speaker 1: in my head, I have this thing called the sucker money.
11:53
Speaker 1: And so I think, is this company trying to find
11:55
Speaker 1: the easiest source of money? They're showing a fancy pitch deck,
11:58
Speaker 1: a nice PowerPoint presentation with all these charts around the opportunity,
12:03
Speaker 1: the billions of dollars of market there and how they're
12:05
Speaker 1: going to penetrate that market and do great. And they're
12:08
Speaker 1: hoping to dazzle the mom and dad investor and get
12:10
Speaker 1: them to invest into it. But a more seasoned private
12:14
Speaker 1: equity investor or private equity firm would probably be able
12:18
Speaker 1: to see through that. What are your thoughts around the
12:21
Speaker 1: funding side of things? And also, how do they come
12:23
Speaker 1: across your desk, these opportunities?
12:25
Speaker 2: Yeah, so that is totally true, James. There's, as you said,
12:29
Speaker 2: the term, the sucker money, or sometimes the triple F,
12:32
Speaker 2: which is the friends, family and fools. So yeah, you
12:35
Speaker 2: got to watch out. And if you have any, they're
12:37
Speaker 2: going after the easy money, then you're probably going 90%
12:41
Speaker 2: of the time, right? There is a lot of that.
12:44
Speaker 2: What I do is I try to see who else
12:47
Speaker 2: is also part of this investing round. I look at
12:50
Speaker 2: their track record in terms of who are they, if
12:53
Speaker 2: they're like a Macquarie bank who's also investing then or
12:57
Speaker 2: another listed company or even a company who's specializing in
13:01
Speaker 2: this industry with big funds or they've done this before,
13:05
Speaker 2: then you know that their due diligence are going to
13:08
Speaker 2: be quite thorough because they're not going to invest their
13:10
Speaker 2: millions of dollars alongside your few hundred thousand or 10,000
13:14
Speaker 2: or whatever it is, they're going to make sure that
13:17
Speaker 2: they look after themselves first. So you can be rest
13:20
Speaker 2: assured that most of the times they've got armies of
13:24
Speaker 2: consultants and auditors, et cetera, for the due diligence. So
13:28
Speaker 2: that's a good one. If you're in a scenario where
13:32
Speaker 2: you don't have other investors who are co-investing that you
13:36
Speaker 2: can lean on, then you've got to do a lot
13:39
Speaker 2: of your own due diligence. And This literally means working
13:43
Speaker 2: through the sessions with the founders, the current executive team,
13:48
Speaker 2: the team management, working into the next level down in
13:52
Speaker 2: the company, the senior leadership team in the company. And
13:58
Speaker 2: in my case, because I had some of the knowledge
14:03
Speaker 2: in the industry I worked in, also did quite a
14:05
Speaker 2: lot of deep tasks into technology, as well as the
14:10
Speaker 2: financial models, and I had some experience. In an area
14:14
Speaker 2: where you don't have that experience, you can also then
14:17
Speaker 2: engage with other people who's got similar experience and bring
14:20
Speaker 2: them in. And this is how this market works is
14:24
Speaker 2: people talk to other people. There's a network of people.
14:26
Speaker 2: You start to build up a, like a trusted network.
14:31
Speaker 2: If I trust this person and they trust that person,
14:33
Speaker 2: then I can probably lean on the trust relationship between
14:37
Speaker 2: these parties. And then I can also start to do
14:40
Speaker 2: some more due diligence there. Unfortunately, it's 90% of the
14:44
Speaker 2: cases you do tend to do a lot of the
14:48
Speaker 2: due diligence for yourself because this is your money that
14:52
Speaker 2: you're going to invest. And yeah, if you don't do that,
14:55
Speaker 2: it's a buyer beware type situation. Yeah.
14:57
Speaker 1: And you've told me before with some of the due
14:59
Speaker 1: diligence that you do, you mentioned doing due diligence on
15:03
Speaker 1: the management team. And that can include things like looking
15:06
Speaker 1: at their LinkedIn history, Where were they at before? Were
15:09
Speaker 1: those companies successful? What was the exit for that company?
15:13
Speaker 1: And you can get a sense as to whether they've
15:16
Speaker 1: been successful or whether they're serial entrepreneurs where they're jumping
15:20
Speaker 1: from one startup to another startup. They're raising capital, so i.e.
15:23
Speaker 1: using other people's money to try and get a business
15:26
Speaker 1: off the ground. If it does, great. If it doesn't,
15:29
Speaker 1: they sink it and they start something again. So they're
15:32
Speaker 1: the type of entrepreneurs we probably don't want to invest into,
15:36
Speaker 1: whereas we have others that have been management in companies
15:40
Speaker 1: they've grown it it's either IPO'd or they've trade sold
15:43
Speaker 1: it and then they go for a holiday for a
15:45
Speaker 1: while they come back they do something else so they've
15:47
Speaker 1: got pedigree they've got runs on the board well what
15:51
Speaker 1: we'll do is Rudy we'll take a quick break and
15:53
Speaker 1: then we'll come back and have a chat more and
15:55
Speaker 1: we'll jump into private equity jargon listeners we'll be back
15:59
Speaker 1: in a moment Hello and welcome back to The Money Puzzle.
16:12
Speaker 1: I'm James Gerrard, writer, contributor to the Wealth section of
16:15
Speaker 1: The Australian and also financial advisor with financialadvisor.com.au. And on
16:20
Speaker 1: this week's show, I have Rudy Engelbrecht. So we're going
16:23
Speaker 1: to dig deeper into private equity. But before I do that,
16:26
Speaker 1: I just want to remind everybody again that this is
16:28
Speaker 1: general advice, not personal advice. So please seek out a
16:30
Speaker 1: qualified advisor before making any decisions. Now, Rudy, let's have
16:34
Speaker 1: a chat about some jargon in private equity there's all
16:37
Speaker 1: these words that sort of flow around burn rates and
16:40
Speaker 1: runways and pitch decks so why don't we go through
16:43
Speaker 1: some of those top ones and you can just break
16:45
Speaker 1: it down in simple english what are these things so
16:47
Speaker 1: let's start with a pitch deck p-i-t-c-h deck what is.
16:51
Speaker 2: That so a pitch deck is a very detailed usually
16:57
Speaker 2: it's a presentation that could range from literally five pages
17:02
Speaker 2: to 50 pages And the whole key is to get
17:06
Speaker 2: the message across in 30 minutes or less to investors.
17:10
Speaker 2: You can imagine that a founder and their team have
17:14
Speaker 2: to pitch this deck to probably 10 to 100 people
17:20
Speaker 2: to raise money. And they want to make it as
17:23
Speaker 2: streamlined as possible. The details that will usually be in
17:27
Speaker 2: that pitch deck will be a quick overview of the company,
17:30
Speaker 2: the market opportunity, and the company's unique selling proposition, the
17:35
Speaker 2: competitive advantage they have, a bit about the management team.
17:38
Speaker 2: If they've got a good management team with a good
17:42
Speaker 2: track record and runs on the board, then they're obviously
17:45
Speaker 2: going to put that in there. The business model with
17:48
Speaker 2: their revenue streams and cost structures, and I usually look
17:52
Speaker 2: at those numbers and I multiply all costs by three
17:55
Speaker 2: and our revisal revenues and divide by three. And then
17:59
Speaker 2: I also look at up and down cases and that.
18:02
Speaker 2: So I always look at those numbers, never trust the numbers,
18:05
Speaker 2: ask deep questions on those numbers when you see them.
18:08
Speaker 2: The product offering or the service offering that they will
18:10
Speaker 2: have and the pipeline. And then they even have, should
18:13
Speaker 2: have financial performance, sorry, performance as well as future projections
18:19
Speaker 2: and forecasts. And then also a little bit more about
18:22
Speaker 2: the capital structure. in terms of how much money they've
18:25
Speaker 2: got in the bank, how much money they need to raise,
18:27
Speaker 2: how much money they have raised and what valuations they've
18:31
Speaker 2: used in the past. And then basically some of the
18:34
Speaker 2: risk factors that they see or companies carry risk and
18:37
Speaker 2: issues that they can try and look at and prevent.
18:41
Speaker 2: And then some reasonable exit strategy or sometimes they don't
18:45
Speaker 2: have one, but if they have one, then usually some
18:48
Speaker 2: clear numbers or like in three years, they want to
18:51
Speaker 2: do this or sell to someone or, list, etc.
18:54
Speaker 1: Excellent. Thanks, Rudy. What I find is a red flag
18:58
Speaker 1: when I review pitch decks is if there is no
19:01
Speaker 1: financial forecast, if there are no financial numbers in there
19:04
Speaker 1: around income and expense or even projected, because in a
19:08
Speaker 1: pitch deck, the company is trying to show you things
19:10
Speaker 1: that they want you to see. If they don't want
19:12
Speaker 1: you to see something, then they don't put it in
19:14
Speaker 1: the pitch deck. So I get a bit concerned when
19:16
Speaker 1: they're light on the financial and the forecast, and they're
19:19
Speaker 1: more about the big picture, this is the market opportunity,
19:22
Speaker 1: because They then have this valuation, which could be anywhere
19:26
Speaker 1: from a few hundred thousand to tens of millions of dollars.
19:29
Speaker 1: And there may not be as much science behind it
19:32
Speaker 1: as the investor would want, particularly if they're not showing
19:35
Speaker 1: the financials in the pitch deck. So it's always prudent
19:38
Speaker 1: that if you're interested in the company and you see
19:40
Speaker 1: the pitch deck, but even if it has financials, it's
19:44
Speaker 1: generally a good idea to ask for what's called the
19:46
Speaker 1: data room, which is generally a cloud-based location where the
19:50
Speaker 1: company will store more information. So they might have an
19:52
Speaker 1: Excel spreadsheet with financial forecasts, and it's interesting to drill
19:56
Speaker 1: down into that because although they may be projecting certain
20:00
Speaker 1: things around the growth of the company, you need to
20:04
Speaker 1: check that and be critical, as you were saying, Rudy,
20:06
Speaker 1: of those assumptions. So Is the growth rate they're using of, say, 40%,
20:11
Speaker 1: is that in line with the market growth rate for
20:13
Speaker 1: that particular company? Is it achievable to increase customers from
20:17
Speaker 1: X to Y over a 12-month period? Is it reasonable
20:20
Speaker 1: that they're going to only spend this amount on marketing
20:23
Speaker 1: to acquire customers? So all these sort of things need
20:25
Speaker 1: to be sense-checked to get a good understanding of, is
20:30
Speaker 1: this a realistic picture of where the company might be
20:33
Speaker 1: into the future? What do you reckon, Rudy?
20:34
Speaker 2: 100% agree. A good check is exactly the historic numbers.
20:39
Speaker 2: Look at the historic numbers. And if there was a 40%
20:42
Speaker 2: growth rate over the last two years, and they're projecting
20:45
Speaker 2: a 200% growth rate over the next two years, you
20:48
Speaker 2: want to know what events are actually going to trigger those.
20:52
Speaker 2: And you can ask questions around that. And you can
20:54
Speaker 2: see on a graph visually, why is this thing spiking up,
20:58
Speaker 2: the revenue? What about your costs? And was the cost
21:01
Speaker 2: not going to go up, et cetera? So there can
21:04
Speaker 2: be a lot of promises made. without the real backing.
21:08
Speaker 2: And you want to see historic numbers because that gives
21:11
Speaker 2: you good indication.
21:12
Speaker 1: Yeah, no, it does. And what would be a rule
21:16
Speaker 1: of thumb? Is there one for valuations? How do you
21:19
Speaker 1: value a private equity company? Is it a multiple of revenue?
21:23
Speaker 1: Is it a multiple of profit? What about in the
21:25
Speaker 1: early stage where there is no revenue or profit? There's
21:28
Speaker 1: just an idea or maybe just losses that makes it
21:32
Speaker 1: more difficult to value that type of company as well?
21:35
Speaker 2: Yeah, so first of all, before we jump into the value,
21:39
Speaker 2: the rule of thumb could be if you don't have
21:42
Speaker 2: any earnings or profits, then you could use revenue or sales,
21:47
Speaker 2: and you could use multiples there. You literally look at
21:50
Speaker 2: other companies in the market who are either listed, so
21:55
Speaker 2: you can then get good ratios in terms of their
21:57
Speaker 2: revenue is X and their valuation is a multiple of X.
22:01
Speaker 2: What is that multiple? You can start to apply that.
22:04
Speaker 2: But remember, a listed company is different from an unlisted
22:07
Speaker 2: company because they are liquid and they have nice financials
22:11
Speaker 2: that you can look at. In this case, you're going
22:13
Speaker 2: to then have to reduce the multiple by a factor.
22:17
Speaker 2: So it's unlisted. It's not proven yet. It's still in
22:20
Speaker 2: the growth stage as well. That's one way. If there
22:22
Speaker 2: are earnings, you can use that. And again, you can
22:25
Speaker 2: relate it to other companies in the market. If they
22:28
Speaker 2: are listed or if they are unlisted, you might get information.
22:31
Speaker 2: You might have had a company that you raised that
22:34
Speaker 2: you were involved in and they raised money and you
22:36
Speaker 2: can use similar multiples. And you can also then look
22:39
Speaker 2: at the unique areas that they claim that's going to
22:42
Speaker 2: be better and then you could adjust the multiples. But
22:45
Speaker 2: those are typically the rules of thumb is look at
22:47
Speaker 2: other companies and multiples and try to find something that works.
22:50
Speaker 1: Got it. In the companies that you've invested into, what
22:53
Speaker 1: would be a broad range of multiples of revenue that
22:55
Speaker 1: have been attached to valuations of those companies? Are we
22:58
Speaker 1: talking five times revenue, 10, 20 times?
23:01
Speaker 2: Yeah, if it's non-tech, you could have three times to
23:07
Speaker 2: five times sales, so the revenue. So three times, it
23:13
Speaker 2: depends on the industry. Again, look at industry. Tech companies
23:16
Speaker 2: could sometimes go five times or more. And obviously, if
23:19
Speaker 2: they have a unique product that no one else has,
23:21
Speaker 2: then the scar's the limit. Someone could literally see the
23:26
Speaker 2: idea and value that differently, and you could get 10
23:28
Speaker 2: times or 20 times. And if you look at in
23:31
Speaker 2: the past, you could have seen typically crazy types of
23:34
Speaker 2: multiple supply to certain industries and certain companies. But look
23:39
Speaker 2: at the average and work with that. But yeah, 5
23:41
Speaker 2: to 10 times is high, but it can happen.
23:45
Speaker 1: Well, let's do one more jargon and then we'll move on. Rudy,
23:47
Speaker 1: tell me what is the burn rate? What does that mean?
23:50
Speaker 2: Okay. A company, obviously, every day that it operates, it
23:55
Speaker 2: has expenses and it also has revenue coming in. And
23:59
Speaker 2: if you measure that on a monthly basis, then this
24:01
Speaker 2: is how much money is either being burned because they're
24:05
Speaker 2: running at a loss or if they're lucky, they actually
24:08
Speaker 2: show profit. But usually because you're investing in a growth-oriented company,
24:13
Speaker 2: they'll be burning at a loss and you measure this
24:17
Speaker 2: on a monthly basis. And then the other piece of
24:20
Speaker 2: jargon that we can add on is the runway. So
24:23
Speaker 2: after you've calculated the burn rate, you can then figure out,
24:26
Speaker 2: based on these numbers and your future cash flows, you're
24:29
Speaker 2: going to have, let's say, 24 months of runway left.
24:32
Speaker 2: And it's typically used in the context of an airplane.
24:35
Speaker 2: When they want to take off, there's a piece of
24:37
Speaker 2: runway left, and the airplane needs to be up in
24:40
Speaker 2: the air before it runs out of runway. And obviously,
24:43
Speaker 2: if the runway is going to be too short, then
24:47
Speaker 2: we need to raise more money again. And that's when
24:49
Speaker 2: the next round happens, hopefully at a higher valuation.
24:51
Speaker 1: I like it. I like the financial engineering there with
24:54
Speaker 1: the wording of it rather than saying, I'm losing heaps
24:56
Speaker 1: of money every month and I'm going to run out
24:58
Speaker 1: of money in X number of months. I've got a
25:00
Speaker 1: burn rate of this and a run rate of that.
25:02
Speaker 1: Sounds a lot better.
25:03
Speaker 2: Yeah.
25:05
Speaker 1: All right. Let's have a chat about risks. So what
25:07
Speaker 1: would you say are the top couple of risks that
25:10
Speaker 1: you would say to investors to think about before they
25:14
Speaker 1: jump into a private equity or a venture capital type investment?
25:17
Speaker 2: We've touched briefly on this before and when we discuss
25:20
Speaker 2: what type of investor would like to invest and what
25:23
Speaker 2: factors you need to consider. So the risk or the
25:25
Speaker 2: one is liquidity risk. So PE or private equity investments
25:29
Speaker 2: are not traded on public markets and your capital could
25:32
Speaker 2: be locked up for five to 10 years. Sometimes you
25:35
Speaker 2: like in less than five, but it's a long time.
25:37
Speaker 2: So are you prepared to have it locked up and
25:41
Speaker 2: you can't sell it? If you sell it, usually sell
25:43
Speaker 2: it at a discount to other investors and you don't
25:46
Speaker 2: want to do that. Market risk. If there's a market downturn,
25:50
Speaker 2: then the cost of capital and debt becomes quite expensive.
25:55
Speaker 2: So if you're raising capital and investing for your downturn,
25:59
Speaker 2: obviously you could invest at a time when the company
26:03
Speaker 2: is valued at X. And then two years later, they're
26:07
Speaker 2: valued at a lower valuation. And then like anything, any
26:11
Speaker 2: investment that could be lower, they now need to raise
26:13
Speaker 2: new money. They ran out of runway. They need to
26:16
Speaker 2: raise new money and the shares that the issue will
26:18
Speaker 2: be at a lower valuation. This is known as a
26:20
Speaker 2: down round and typically it's not favorable and that will
26:24
Speaker 2: dilute the current shareholders even further. And then there's the
26:27
Speaker 2: other one, which is the operational and execution risk. So
26:30
Speaker 2: the company and management team simply could, they just could
26:34
Speaker 2: simply struggle to execute operationally or there's no sales or
26:37
Speaker 2: something changed in the market. Some regulation came through and
26:41
Speaker 2: closed down the market opportunities for them. So, That's a
26:44
Speaker 2: few of the risks.
26:45
Speaker 1: Got it. All right, so we've got liquidity. Your money
26:48
Speaker 1: is trapped until there's an exit event in most cases.
26:50
Speaker 1: There's this market risk, so conditions can change and the
26:53
Speaker 1: valuation of the company can be affected. And then we've
26:55
Speaker 1: got operational risk, so things may not go to plan
26:57
Speaker 1: and that might be due to the company itself or
27:00
Speaker 1: broader market conditions. That's really good, Rudy. I want to
27:03
Speaker 1: get your tips and tricks for success in private equity.
27:06
Speaker 1: But before we do that, let's just take another short break.
27:25
Speaker 1: Hello and welcome back to The Money Puzzle. I'm James Gerrard, writer,
27:28
Speaker 1: contributor to the wealth section of The Australian and also
27:31
Speaker 1: financial advisor with financialadvisor.com.au. And on this week's show, I
27:35
Speaker 1: have Rudy Engelbrecht. So Rudy, let's have a chat about
27:38
Speaker 1: tips and tricks for private equity investors. So what are
27:43
Speaker 1: some of the things that you've learned over the years
27:45
Speaker 1: that you think would be useful for a new investor
27:48
Speaker 1: in this area to know about?
27:49
Speaker 2: I would start off with looking at the people, the
27:53
Speaker 2: management team, the key executives, their track record, make sure
27:57
Speaker 2: that I'm comfortable with them, then I can actually relate
27:59
Speaker 2: to them. This is my own personal way of doing
28:02
Speaker 2: a bit of due diligence on the people first. Ultimately,
28:05
Speaker 2: companies are built by people, selling products, built by people
28:09
Speaker 2: again and selling it to other people. So it is
28:12
Speaker 2: ultimately driven by that. The second thing I would do
28:16
Speaker 2: is work through the numbers, due diligence, questions, try to
28:20
Speaker 2: break the assumptions and models down and ideas, and sometimes
28:26
Speaker 2: it could be that you just don't know enough, and
28:28
Speaker 2: they do know quite a lot more than you do.
28:31
Speaker 2: But keep on asking the questions that would seem obvious,
28:35
Speaker 2: even in that way. Also, don't be too scared by
28:39
Speaker 2: too much technology talk or other questions. If they cannot
28:42
Speaker 2: explain it clearly, then they're going to have to sell
28:45
Speaker 2: these products and explain it to other people. So it
28:48
Speaker 2: must be simple to understand for you. If you don't
28:50
Speaker 2: understand it, then maybe it's also not for you. and
28:53
Speaker 2: you can pass. Another area that I look at is
28:56
Speaker 2: the industry. I look at similar companies and or competitors.
29:00
Speaker 2: I compare the valuations. Like we mentioned before, look at
29:03
Speaker 2: similar multiples. I'll look at how they raised capital, how
29:07
Speaker 2: much capital that they raised, just to get another data
29:10
Speaker 2: point and guideline on that. And in general, I avoid
29:14
Speaker 2: companies with debt. I don't understand why you would want
29:18
Speaker 2: to raise capital and then use that to service your
29:20
Speaker 2: current debt, even if they promise not to Payback debt,
29:24
Speaker 2: and they use it for working capital. I just don't
29:26
Speaker 2: understand why they can't just issue more shares. Again, there
29:30
Speaker 2: could be other reasons for that. That's me. I just
29:32
Speaker 2: don't want more debt. And then be patient. Ensure that
29:36
Speaker 2: you're comfortable, that the money that you invested can be laundered.
29:40
Speaker 2: locked up for many years. Don't expect it to have
29:43
Speaker 2: a return next year. And then also accept that not
29:46
Speaker 2: all investments will yield the 5x or 10x or 20x
29:51
Speaker 2: type of returns and multiples that everyone else talks about. Remember,
29:55
Speaker 2: people talk about the winner, not the 10 losers. out
29:59
Speaker 2: there or the average returns. Bear that in mind.
30:04
Speaker 1: Excellent. And in terms of the way that people can
30:06
Speaker 1: get access to private equity investments, we've been talking mainly
30:09
Speaker 1: about the direct pathway where we're investing, we become shareholders
30:14
Speaker 1: on the share register of a private company, but there's
30:16
Speaker 1: also other pathways available to the everyday investor. There's ETFs,
30:21
Speaker 1: there's a Pingana, or maybe that's not an ETF, but
30:23
Speaker 1: it's a Maybe it's a listed investment company or it's
30:26
Speaker 1: a listed trust. Pengana have one and they invest into
30:28
Speaker 1: private equity investments. So that's bought through the ASX. There's
30:32
Speaker 1: a managed fund by Schroeder as well. They've got a
30:34
Speaker 1: private equity fund. So you can take a hands-off approach
30:38
Speaker 1: and let a professional fund manager invest into a portfolio
30:42
Speaker 1: of private equity investments. for you if you don't want
30:44
Speaker 1: to go through the trenches and the hard work of
30:47
Speaker 1: doing the due diligence yourself. And also if you want
30:50
Speaker 1: to diversify more and have a whole portfolio of investments
30:53
Speaker 1: rather than a smaller amount, because generally private equity investments,
30:56
Speaker 1: if you go direct, they will usually want you to
30:59
Speaker 1: be what's called a wholesale investor, which means that they
31:02
Speaker 1: will want you to have an accountant's letter clearance signed
31:07
Speaker 1: off on, which means that The accountant needs to certify
31:09
Speaker 1: that you earn either more than $ 250, 000 per year for
31:12
Speaker 1: the past two financial years, or your net worth is
31:15
Speaker 1: more than $ 2. 5 million. And then the minimum investment, it's
31:19
Speaker 1: generally $ 100, 000, sometimes $ 200, 000. Some companies will drop it to $ 50, 000,
31:24
Speaker 1: but they're larger amounts. They're not like $ 500, which is
31:27
Speaker 1: the case when you buy shares on the share market.
31:29
Speaker 1: Even for quite wealthy investors, it's quite difficult to invest
31:32
Speaker 1: in a whole heap of private equity investments just due
31:35
Speaker 1: to the minimum investment restrictions. Funds are another way to
31:38
Speaker 1: do it. And really, there's a few websites around out
31:40
Speaker 1: there that crowdfund into private equity investments. So they put
31:45
Speaker 1: up a campaign about a chili sauce or something like that,
31:49
Speaker 1: or a new gin distillery, and they try and get
31:51
Speaker 1: people into that. That's another way that people can get
31:54
Speaker 1: into private equity investments. But I would caution that pathway
31:58
Speaker 1: because my perception is that pathway appeals to more the,
32:02
Speaker 1: I hate to use that term, but the sucker money,
32:04
Speaker 1: because they're throwing more around the images and the market
32:08
Speaker 1: opportunity more than the numbers in those type of things.
32:10
Speaker 1: And it's more of a psychological thing that, oh, yes,
32:13
Speaker 1: I use this product. I can actually go buy some
32:15
Speaker 1: shares and be a shareholder. But when you have a
32:17
Speaker 1: look at what you own of the company, it might
32:20
Speaker 1: be like 0.01%, whereas you thought it might have been
32:23
Speaker 1: a bit more than that. But it's a little bit
32:25
Speaker 1: opaque with regards to the financials and evaluations. It's more
32:28
Speaker 1: on the idea.
32:28
Speaker 2: That's right. Yeah. Yeah. To add on to your comments
32:34
Speaker 2: about investing in the illicit trusts or on the ASX,
32:39
Speaker 2: there are companies and funds that will offer you a
32:44
Speaker 2: product where you invest, say, $ 50, 000 or $ 10, 000 into the fund.
32:50
Speaker 2: And then the fund manager will perform all the due
32:52
Speaker 2: diligence for you because that's their job. And they will
32:57
Speaker 2: then obviously charge an annual fee to manage the fund.
33:00
Speaker 2: There will be performance fees that they'll charge based on
33:03
Speaker 2: the performance of the assets in the fund and the
33:05
Speaker 2: companies they invest in. And you're just one of the
33:08
Speaker 2: investors in this PE fund. However, it can be worth it,
33:13
Speaker 2: especially when the fund invests in multiple companies over the
33:17
Speaker 2: timeline of the fund. They diversify the risk for you
33:21
Speaker 2: and they will also offer you some liquidity where you
33:24
Speaker 2: might not have to wait five to seven years. You
33:26
Speaker 2: could once a year or twice a year be able
33:29
Speaker 2: to withdraw a percentage of your funds in them. So
33:32
Speaker 2: that is one way, instead of going crowdfunding where, James,
33:35
Speaker 2: you're totally right, the crowdfunding feels like a hail gun
33:39
Speaker 2: approach where you just spray money and hope to get
33:42
Speaker 2: something back, where at least with a fund manager with
33:45
Speaker 2: a good track record, they will do a lot of
33:47
Speaker 2: the work for you.
33:48
Speaker 1: That's right. Rudy, we're almost out of time. If you
33:51
Speaker 1: could give me one final thought with regards to private
33:54
Speaker 1: equity and venture capital to take our listeners away with,
33:58
Speaker 1: what would you say?
33:59
Speaker 2: I would definitely take the advice of a financial advisor
34:03
Speaker 2: to walk with me through the detail and assess my
34:09
Speaker 2: risks and my profile and goals before I just go
34:12
Speaker 2: and invest. Because the last thing you need is to
34:15
Speaker 2: invest a big chunk of your life savings into something
34:19
Speaker 2: and then wait for that or might not get a return.
34:22
Speaker 2: So make sure your asset allocation and your goals are aligned.
34:27
Speaker 1: Fantastic. Thank you for that, Rudy. And thank you so
34:30
Speaker 1: much for joining us today. It's been really insightful and
34:32
Speaker 1: I've enjoyed our chat and I'm sure our listeners will
34:35
Speaker 1: as well. So thank you again, Rudy Engelbrecht, for joining
34:38
Speaker 1: us on The Money Puzzle.
34:40
Speaker 2: Thank you, James. Really enjoyed it. Thanks for the time.
34:42
Speaker 1: Excellent. And to our listeners, thank you for tuning in
34:45
Speaker 1: to today's episode of The Money Puzzle. Send in a
34:47
Speaker 1: question and James Kirby will answer it in a couple
34:50
Speaker 1: of weeks' time. I'll be with you for the next
34:51
Speaker 1: two weeks. And coming up on next week's episode... we're
34:54
Speaker 1: going to have a return of an accountant named Timothy Ricardo.
34:58
Speaker 1: He was on a few months ago when I last
35:01
Speaker 1: guest hosted and he copped a bit of flack from
35:04
Speaker 1: his clients and friends because we were talking about what
35:08
Speaker 1: are some of the things that you can claim as
35:10
Speaker 1: a tax deductions. And we had a lot of weird scenarios,
35:12
Speaker 1: but Tim seemed to say no to everything. So Tim's
35:15
Speaker 1: been given the task of saying yes to something. So
35:18
Speaker 1: he's going to come prepared next week with some tax
35:20
Speaker 1: deductions that you didn't think that you could get, that
35:22
Speaker 1: you could actually get, as well as talking about other
35:26
Speaker 1: contemporary tax issues. So we look forward to that. You
35:29
Speaker 1: can tweet us your thoughts. Just use the hashtag TheMoneyPuzzle,
35:32
Speaker 1: all one word, or email us on themoneypuzzle at theaustralian.com.au.
35:37
Speaker 1: Until next time, I'm James Gerrard. Talk to you soon.