Private Equity Investing Trends

Robert L. Waltrip spent virtually his entire life in the funeral business, so it’s no surprise he would come up with ways to make it more efficient. When he took over his father’s Houston funeral parlor, he realized the industry had a lot of room for operational improvements. As Waltrip’s obituary in the Wall Street Journal reports, by buying additional funeral homes and having them share employees and equipment, he reduced idle time and drove profitability. The strategy worked so well he kept at it, and his company, Service Corporation International, went public in 1969. According to its website, today it has some 1,900 locations and 25,000 employees across the U.S., Canada, and Puerto Rico.

When Waltrip started this ball rolling, I’m sure he didn’t call the strategy a private equity roll-up. It was just a smart business model that made money and enabled ongoing growth. Ultimately, that’s what private equity investing is about: taking a business, making it better, and watching it grow. Industry networking, jargon, and financial models are just the means to that end. Waltrip had a long life and a long, successful career. May we all be so lucky.

Red Dog Equity LLC is an Atlanta-based PE firm executing a roll-up play in an industry, car washes, that escaped private equity consolidators’ notice until about a decade ago. Now Red Dog is rolling up car wash businesses across a broad swath of the country through their platform company Mammoth Holdings LLC.

They buy one company in each regional market to function as the brand name for that market, then bolt additional smaller and often less efficient and cheaper acquisitions onto it, integrating them all into Mammoth’s business model, which emphasizes selling subscription memberships with which customers can get unlimited car washes (and the company can create a steady revenue stream).

Another interesting aspect of Red Dog’s roll-up strategy is sale-leasebacks, in which an acquired car wash’s real estate is sold, then immediately leased back from the new owners. The effect is to make the acquisition significantly cheaper upfront. This strategy seems to be working well and is likely to attract imitators, though Mammoth is fast entrenching itself in a strong position.

According to the article, it now operates 107 car washes and is aiming for 500 by 2025, a goal made possible by the fact that it is also building entirely new locations. In the article, Jeff Leko of Hanley Investment Group sums up the financial allure of this industry for investors, “There is no other operation on a 1-acre site that can do $1 million to $2.5 million in sales and pocket half of that.”

Private equity is sitting on a mountain of capital but struggling to deploy it wisely. Per an article in the Financial Times, buyout firms are investing dry powder at the slowest pace since the Great Recession.

Private equity firms have gone from using more than 5 per cent of their capital, quarter on quarter, at the height of the boom years in 2006, to utilising about 1 per cent in the last three months of 2017, an analysis of figures from 1,000 institutional Investors reveals.

I would be interested in seeing how this data skews across funds by scale. I imagine this is more severe in the megafund category where opportunities available are better known by all participants making competition more aggressive (just an opinion).

New players are increasingly emerging to fund loans that do not meet banks’ strict criteria. An article in the WSJ cites nonbank commercial loan growth of 7.5% in the first quarter compared to 3.6% for bank loans. The increase in the number of funds over the prior five year period is impressive:

“Overall, firms completed fundraising on 322 funds dedicated to this type of lending between 2013 and 2017, with 71 raised by firms that had never raised one before, according to data-provider Preqin. That compares with 85 funds, including 19 first-timers, in the previous five-year period.”

The article cites that Ares just raised a record $10 billion dollar fund for middle-market lending, and that KKR is creating the largest business development company. Other titans expanding in this space include Apollo, Blackstone and Carlyle.

Direct loans are generally made as floating rate notes to companies with less than $50 million in EBITDA. For borrowers that have grown accustomed to falling interest rates, a reversal may come as a painful surprise.

With increasingly larger transactions announced in healthcare, an article in The Economist recently highlighted the attractive characteristics driving the titans of private equity increasingly towards this space. Three variables were cited:

1. A defensive play: Those in need of medical attention are unlikely to defer care to wait for an economic recovery.
2. Growth: The health-care market’s growth has outpaced GDP for decades. Annual spending is now approximately ~$3.5 trillion.
3. Bloated cost structures: The innovation and disruption rippling through other industries and making companies more efficient has not yet been mirrored in the healthcare space.

See the article for some great details on specific transactions. Link below.

I was surprised to see the degree to which software buyouts appeared to outperform. There appeared to be an advantage in both the loss rate (3.9% in software vs. 14.7% in non-software from ‘05-’14) and MOIC (1.9x vs 1.6x for the same time period).

One variable contributing to this success, per the paper, is that software firms are often so successful that they fail to successfully optimize their cost structure. The paper introduced the “rule of 40” in this context (which was new to me):

One rule of thumb used by experienced tech investors as a preliminary asset screen is the “rule of 40,” which says that software businesses should have organic revenue growth plus EBITDA margins of 40% or higher. A company much lower than 40 is probably investing too much relative to the profits it takes out. (By contrast, a company that far exceeds 40 may not be investing enough to support growth.) Most software companies and the vast majority of recent software targets for leveraged buyouts fall short of this goal, implying that there are significant opportunities to add value.

Ever a fan of investment check-lists, the paper highlights common tech investment pitfalls on page 29 and 30 of the document – I suggest checking it out.