Private Equity's Calculus: Aligning Incentives Across the Value Chain

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of Best But Never Final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Mooney. Together, we'll navigate the corridors of private equity, revealing the uncommon knowledge, challenges, successes, And lessons that drive the world of private equity and business forward. 

 

Let's go. 

 

[00:00:34] Sean Mooney: Today, we're going to talk about the math of private equity and how overarching incentives and measurements drive behaviors. Throughout the entire private equity value chain. So this is the entirety of limited partners through the private equity firms that are investing all the way down into the portfolio company themselves. 

 

So, Lloyd and Doug, I think this is going to be a really interesting conversation that's going to help. All our listeners, including those in the private equity industry, and those who are curious about the private equity industry. understand the why behind how private equity moves with such tenacity and pace to transform the companies that they're investing in. 

 

And so maybe to kick things off, let's talk about the beginning of the value chain, the limited partners that really are kind of setting off the whole motion of the private equity industry as the first investment entity that invests into the private equity firms that invest in the. Portfolio company. 

 

So maybe Doug, can you share a little bit about what are LPs investing in, in general, across the spectrum of the things they do? How are these maybe similar or different? And then how are the LPs measured in the course of their own jobs?  

 

[00:01:59] Doug McCormick: So, let's try to put some meat on the bone around what a limited partner generally is. 

 

So, first of all, sophisticated investors generally pass this test or always pass this test of an accredited investor. And for the most case, and at least in our business, they're institutional investors. So what does that mean? It means they're an insurance company, a pension fund, a foundation, an endowment, could be some high net worth individuals. 

 

And so they're generally deploying large pools of capital, they're relatively sophisticated, and they're in many cases doing it on a global basis. And so the same way an individual thinks about a diversified portfolio to generate attractive risk adjusted returns, these institutions think about it the same way. 

 

And so they have a portfolio and it spans multiple asset classes, so fixed income, commodities, emerging markets, equities, and when I say equities, I'm referring to publicly traded things. And then alternatives broadly, and alternatives could be private debt, could be private equity, which is traditionally more leveraged buyout, and then it could also be venture capital. 

 

And they think about all of these assets competing against one another on a risk adjusted return perspective. And so, as we think about our asset class being competitive in that framework, we have a lot of things that make private equity risky, duration, illiquidity in my business, which is a leveraged buyout business, leverage. 

 

And so, because of those things, our investors need to be compensated, and they're compensated with return, measured as IRR, and also the implication of IRR is multiple capital, which is simply, Something's been compounded in IRR over many years, you grow that capital base.  

 

[00:03:38] Sean Mooney: I think that's really helpful in terms of framing what limited partners are, the types of areas that they're allocating their investments around. 

 

How are limited partners themselves measured as they think about their constituents that are upstream from them, their stakeholders?  

 

[00:03:56] Doug McCormick: I think capital flows to the best opportunities, and so I generally think the way All investors are measured is on a relative basis, right? Like how much did the tide go up and everybody should have participated in the rising tide. 

 

And then how much did you differentiate above and beyond that? So I think the most standard benchmark is probably the S and P and everybody thinks about discounts to the S and P or premiums to the S and P based on some of the measures of risk I talked about, volatility, leverage, duration, et cetera. 

 

[00:04:27] Sean Mooney: That makes a ton of sense. And maybe to dig a little deeper on that. Lloyd, one of the things that Doug mentioned about is they're looking at whether it's the S& P 500 or private equity, the venture capital industry, they're looking at things called IRR and MOIC, otherwise known as multiple invested capital, sometimes called multiple money. 

 

What are those? What do those mean?  

 

[00:04:50] Lloyd Metz: That's a good question. I just want to address one of the things that Doug said, when we talk about sophisticated investors at these insurance companies, endowments, foundations, and pension funds. The folks who work there work for future retirees, current retirees at an endowment, you're trying to invest so that the university or the charity or what have you is viable a hundred years from now, right? 

 

So these folks are pretty sophisticated and thinking about risk and thinking about opportunity, but ultimately like an insurance company, you have claims that you're going to pay those ultimate pensioners. The university 100 years from now or the future claimant in an insurance company, they must have their money come hell or high water. 

 

Basically they understand that things happen in the world, but those investors need more certainty and confidence that you will be able to deliver. A dollar amount of return and a percentage sort of return. So that's how the MOIC and the IRR come together. That MOIC ultimately though is how they meet their obligations at the insurance company or the endowment or the pension, because those are the actual dollars that you're giving back. 

 

So private equity needs to deliver just for argument's sake, two times the invested dollars or three times the invested dollars that those pension or endowment. or insurance companies give us. That's what we're trying to deliver. So to your question about IRR, that is how you compare whether I should give private equity a dollar or should I give European large cap equities a dollar or emerging market small caps a dollar or infrastructure funds a dollar. 

 

The LPs have a wide range of choices of where they can put their dollars. That's a big part of the calculus.  

 

[00:06:47] Sean Mooney: And I think that's really helpful. And the IRR is. Maybe the rate of return that they're earning over a period of time, whereas the multiple of invested capital is how much the multiple of turn. 

 

And you really, from my perspective, you always have to look at those hand in hand. And so when I would always compare investments, even just on my own balance sheet, sometimes you get this great IRR. If I put a dollar in something and a year later, I get a dollar 40 back. It's great. I made a 40 percent IRR, but I got 40 cents back. 

 

Or if I do a dollar in three years from now, I get 2 back or five years from now, 2 back. That might be a 20 percent IRR, but now I at least got a whole nother dollar. And so I think that's one of the big nuances that I would always look at is like they got to go hand in hand.  

 

[00:07:35] Lloyd Metz: That's right. And I think a lot of the LPs use IRR because you can compare across different strategies There are two sides to the argument as to whether that is right or not right, but that's what it is. 

 

And the biggest driver of IRR when you look at the actual formula to calculate it is time. So delivering two times your money in a shorter period of time gets you a higher IRR. Delivering two times your money in a longer period of time gets you a lower IRR. So time is a big factor that Drives private equity and starts to trickle down into some of the strategies, approaches, investments we select, and then even how we interact with the portfolio company leadership teams that we invest behind. 

 

[00:08:23] Sean Mooney: That's a really good distinction on the time. And so limited partners want their money back with relative velocity, and they also want more of it back over time. And Doug, to your point, they're looking at things like the S& P 500 to say, okay, what's kind of a thing that we should measure things across all of us. 

 

And as a caveat, every limited partner is going to do things differently. This is kind of a general perspective on how limited partners are looking at the world. And so there's a whole lot more that goes into all of this, but it's just as framework. I think that sets the stage really nicely with this understanding that limited partners invest capital across a range of different types of investments to generate a combined return over time. 

 

Some have different risk profiles than others, some return more than others based on those risk profiles, and the expectations are similarly aligned. And then the way that the limited partners are measuring those that they invest in, by and large includes something called IRR and MOIC. That includes speed and money back. 

 

[00:09:33] Doug McCormick: Sean, let me just build a moment on something you and Lloyd are both touching on. Lloyd commented that just the way the math works, IRR is heavily dependent on time required to realize the return. And you were commenting that this asset class is generally has a higher return expectation. And so essentially what that means is this is expensive capital. 

 

Let's just go down the path of why that is. For starters, we mentioned investors. command a premium for investing in this asset class because there are a number of things that make it riskier for them to manage things like liquidity, things like duration. It's a long term commitment is 10 to 12 years and things within the businesses such as leverage, for example, that introduce risk from their perspective. 

 

So they demand a premium. We're using that capital to buy businesses, usually a change of control. You often pay a premium for change control. You've got to compel. An entrepreneur with a compelling offer, and so we often pay for what we think we can do with the business, not just what the business is worth today. 

 

And then the last thing to acknowledge is this is an expensive investment model. So the private equity model is 2 percent of assets under management generally, plus a share of the profits after a preferred return. That share is often 20%. So expensive compared to buying an index fund for the S& P at 10 basis points. 

 

So you combine all of those things together and it creates this tension where there's a real need to create value quickly and that's why really we're having this conversation about the way private equity engages with their assets they purchase to really drive that value.  

 

[00:11:04] Sean Mooney: I think that's a really important distinction to set the stage for all the conversations that are happening here. 

 

There are higher expectations of return both in terms of the rate of return and the speed of return because Transcribed There's certain elements of PE that are different from getting in and out of the S& P 500 by clicking a button. This episode is brought to you today by HCI Equity Partners, a lower middle market private equity firm focused on partnering with family and founder owned manufacturing service and distribution companies. 

 

ICV Partners, an innovative private equity firm. Supporting management teams of leading companies at the lower end of the middle market and BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical variable on point and on time due diligence and value creation needs. 

 

Now back to the episode. As we set the stage here, we have this concept of the limited partners are thinking about the IRR and the multiple money they're going to get across all of their investments. They have different expectations for those returns, depending on things like liquidity and duration and other elements of the business. 

 

Private equity is one that if you look at studies from pitch book and Hamilton lane, you see the private equity industry differentiating themselves over both shorter and longer periods of time. Look at those studies. Don't take my word for it. But part of that is because of this alignment of incentives and how they act. 

 

And so maybe Lloyd, let's talk about this. The private equity firms are measured on IRR and MOIC. How do these measurements that are then kind of thrust upon the private equity firms as their expectations from the limited partners? How does that impact how private equity firms then take action to manage those outcomes? 

 

[00:13:04] Lloyd Metz: Again, this is in the context of working with really sophisticated investors, right? So there's another layer. If you listen to some of the other podcasts and blog posts that people who are allocating capital at these institutional investors talk about how they think about things, they have a point of view on certain asset classes. 

 

You do do the index fund. There's very little advantage of an active manager in that asset class. So that's what they do in private assets, whether it's infrastructure, credit, or equity, many LPs are of the view managers actually can generate alpha. So return over and above the overall market movement, right? 

 

The amount of return generated by that manager. Private equity is one of those asset areas where manager selection is important. So the skill of the private equity investor matters, right? So with this whole dynamic of MOIC and IRR, it starts to factor into things like, what is your strategy? What sort of companies do you select and choose to invest in all things being equal, investing in a slow growth market and a slow growth company. 

 

Has perhaps a different IRR and risk profile over time than a fast growing market and a fast growing company in that fast growing market. And the question then becomes, how much do you have to pay for one versus the other? How much time will it take for those companies to achieve their growth? Is there going to be much volatility in the path that they take to get their growth in revenue and cash flow and value? 

 

So you factor all of that in when you make your decision, right? So there are some slow growing, stable growing businesses and markets that the market will ascribe in the private equity world, a pretty high multiple because there's very little volatility and you're going to make your two times your money. 

 

It'll just take four years or five years or six years. You might make two and a half, three times your money and people will invest behind that. There are other companies that may be growing faster, 10, 15, 20%. And you'll invest in those two, right? And you may get to two times your money in three years, right? 

 

24, 25 ish percent annual returns. But that's for the private equity manager to figure out what approach are they going to try to take? How do they construct their portfolio? So how many of the first type of company, if any, do I want to invest in? Or do I want to invest in only the fast growing markets, fast growing companies, fast growing industry segments? 

 

I think that is up to the decision of the private equity firm, right? So in terms of how they set their strategy,  

 

[00:15:55] Sean Mooney: I think it's a really good point. And even within private equity, there are a whole host of different approaches. What is kind of the commonality in terms of this concept that we've talked about that private equity firms are measured on returning capital quickly and returning multiples of it over time? 

 

What does that mean in terms of what they're going to do once they own this business? Generally within the, even this broad spectrum of B firms that have different strategies.  

 

[00:16:20] Lloyd Metz: Generally speaking, and again, if I were talking to the leadership team of a company or a founder, who's considering taking on private equity, faster is always better. 

 

Acting faster, figuring things out faster, getting results faster, growing sales and cashflow and profits faster is always better. So that's the going in approach philosophy, whether it's in the front of your brain and top of mind with your private equity partner, it's definitely running in the background. 

 

And so things that slow down execution, things that slow down or obstacles to entering a new market or launching a new product or building a new plant. Private equity professionals tend to want to remove those obstacles and help the leadership teams of the companies that they invest behind, get over them, get around them, get under them, but get that stuff out of the way so you can get at the opportunity faster. 

 

And that, Doug, you used the word tension earlier. That's a source of tension, but we like to think it's creative, constructive tension.  

 

[00:17:28] Doug McCormick: So, one of the ways I like to very simplistically kind of characterize this is, I would argue the private equity market is a bit more inefficient than other markets like public markets, but it's still relatively efficient, right? 

 

So there's lots of capital out there. And so we should assume that in any process we're participating in, there's going to be an efficient outcome. So that's point 1, it's competitive. The 2nd is 1 of the things That we view that we are paying for when we're doing a majority deal is we're buying governance rights. 

 

And that is one of the key elements of how we think about creating value. And if you think about it, just super simplistically, I would argue with those governance rights, investors can generally do four things. One is you can change their trajectory of growth. It'd be organic growth could be M and a. The second is I think you can change, we would say, optimize the business model. 

 

Right? So improve the value proposition that changes things like margin profile or maybe customer retention. I think the third area is increasing the size of the addressable market or getting access to new markets that have faster growth rates. And so kind of repositioning the business in terms of where those skills can be applied elsewhere. 

 

And then the fourth is team. And I would tell you, if you don't have the fourth, you probably can't do the first three. And so we think about all four of those is really fundamental value levers that allow us to compete.  

 

[00:18:46] Sean Mooney: That's another really important point, what the private equity firms can do and think about doing when there are investing as fiduciaries in these assets and these companies and these dreams. 

 

And one of the things is I kind of reflect back in the late 90s when I started in PE and Doug, you mentioned this work efficiency of the market and. The market was pretty nascent back then, but it was like one of these things where like companies would line up to us, we would pick the best one and we would probably be able to invest at a pretty reasonable price in our value. 

 

Creation plan was we were going to update the accounting system or at a salesperson. And then everyone would do well, because just the whole industry was just less competitively tense. And then as I rolled the clock forward in time, it was, whoa, now I'm competing against many different entities, whether it's an investment firm, like a private equity firm or another strategic acquirer that we're also looking at making these investments. 

 

And so suddenly I was having to pay more to get these companies and then from an economics 101 perspective, my choice was I could either pay more and accept a lower return basic supply and demand type pressures, or I could create value. And I could create it more quickly and that's a big evolution that I think we've all seen in private equity is people in P. E. are incredibly creative and tenacious and kind of like best but never final. They're going to always do whatever they need to not only reach the finish line, but then keep on going after that. And so we've seen this acceleration in value creation and both the speed and the amount of it that's conducted in private equity and a lot of this all goes right back to where we started our conversation. 

 

It's in part because they're measured on the returns that they make. And then multiple of dollars and so as an industry for anyone who's involved in it, there's this idea that they're like, wow, why is everyone telling me I got to go so fast and why are the private equity folks telling me that we've got to like, transform this company? 

 

Why can't we just keep on growing at the same rates that we used to? And this is a family business. And so maybe Lloyd and Doug, can you talk a little bit about. As a transition or a conversation here, how this stuff translates into how that you interact with the leaders of your portfolio company saying, we are expected to move fast and do a lot of change because that's what our stakeholders, our key stakeholders, our limited partners want from us. 

 

And thus we have to do this in partnership with you as well.  

 

[00:21:17] Lloyd Metz: Sean, you raise an interesting point that may take us off. Topic for a second, but one of the things that we didn't really get at that, I don't know if everybody appreciates, but I think some of these evolutions that you alluded to with private equity are good because what it makes us all do is make the companies we invest in better. 

 

Like once upon a time, like you said, you could just change accounting, add a few salespeople and voila. The market multiples were going up, so you look like a genius over time. You actually had to build out bigger or more effective sales department. And you had to figure out how to add an innovation engine, or even if you were growing inorganically through acquisition, you don't just slap a bunch of acquisitions together, wrap it up and say, it's just bigger and better and pay me more. 

 

No, you actually not only have to integrate acquisitions that you make, but if you intend to be a serial acquirer. That's actually a feature function and capability you need to build. So ultimately you just have to build a better business to get the returns. And for a lot of us in private equity, it's that part that gets us fired up. 

 

And so to your question, again, different private equity firms have different approaches. We. And I think Doug probably agrees with this, but he'll chime in, but we try to find the business leaders that have aspirations to grow to double or triple the size of their company or what have you. And what we're signing up for is helping them get there either faster or with less risk or with capital support, intellectual capital support, all that stuff, right? 

 

That's what we look for. That's our strategy in our approach, but other firms have different approaches, but ultimately you have to build a better business for this to all work.  

 

[00:23:07] Doug McCormick: First of all, totally agree with the way you guys are thinking about the evolution of the asset class. One of the things I would say it's been really a good thing is as the markets evolve, so have PE firms in terms of their capabilities to deliver on the value add that we were talking about. 

 

So it's not been like something that happened over a year or two. This has been arguably a. 30, 40 year evolution of the asset class in terms of the development of those capabilities. The 2nd thing is just from a history perspective, because I think it is really interesting as you think about the hurdle that we're all trying to keep up with. 

 

The PE community has done a great job of innovating and today we're innovating through adding value and operational improvements, strategic improvements, but the early innovation was more around financial engineering. And so while prices of assets have gone up, our competition has gone up, actual financial leverage has come down substantially. 

 

And I think that has a couple of implications. One, it means you got to really deliver on the value add. And two, I think it's better from a societal perspective, right? Because we're delivering return and value generally associated to a growth. I think that's an important aspect. And then just to comment on how you think about partnering with entrepreneurs who are looking for that opportunity to transform their business. 

 

I would say, We're probably a little more willing to think creatively there. And what I mean by that is we want to partner with an entrepreneur who shares our vision. They may or may not want to be part of that journey. And so in many cases, we have folks that we have alignment on where we're trying to go. 

 

And there's an open acknowledgement that because of their retirement or whatever, that they're going to be an investor and a partner, but not the leader of that transformation.  

 

[00:24:44] Sean Mooney: Those are also really good points. And as we think about the business of private equity, one, I think it has transformed into a huge value creator. 

 

It's driven by a lot of the fundamentals that we've talked about here in terms of here are the expectations and the outcomes. And we did a study and Doug, we enlisted some of your team's help as well, kind of cutting through the data of the Inc. 5000. And what was really interesting is a relatively smaller subset of the Inc. 

 

5000 companies were private equity backed. I think it was 11 percent of the companies in the Inc. 5000. But they accounted for 60 percent of the job creation in the 5, 000 companies in that subset, of which I know Doug, you guys had a bunch of companies in there. And so it's become this economic engine to create and add jobs. 

 

That's a really important thing. And once again, it's like, you want to understand the outcomes, follow the measures. Like, what's measured? And it's, we got to do things well, consistently, and we got to do it substantially.  

 

[00:25:41] Doug McCormick: And Sean, I would just comment, as you think about the Inc. 5, 000, it also highlights. 

 

The part of the market that the private equity community is generally playing in, like we talk about transformation and value creation and we're trying to double or triple a business, but let's also acknowledge these are relatively small businesses, right? We're truly playing in what we kind of characterize lower middle market or middle market to buy kind of an S& P 100 business. 

 

And do the things that we would do would be really, really hard. They're so big, they're often very capable. And so we are playing in a part of the market where the size of the company allows us to be very nimble and really create value pretty quick.  

 

[00:26:17] Lloyd Metz: I would add to what Doug's saying, Sean, a lot of the companies of the size you're talking about that private equity invests in benefit from focus. 

 

I mean, that's part of when I said intellectual capital, that's part of what philosophically most private equity firms bring to their investment companies. Is focus what markets, what customers, what products, what geographies, whatever is relevant. Should you focus on, if you're focused on six things, that's too many. 

 

What about these two? And oftentimes that's where the disproportionate growth comes from. You double down on those two, you add salespeople, you add product people, you add production capacity or whatever the heck it is. You drive growth, your organization grows, your profits grow, sometimes just bringing focus to the situation is the big part philosophically of where private equity brings. 

 

I don't know what you think about that.  

 

[00:27:09] Doug McCormick: Yeah, I think it's the classic saying. If everything's a priority, nothing's a property, right? Instead of have the conviction of. Off and back by data of what are the two or three value levers that can really transform this business. And then going after those maniacally, I think it's a huge value creator. 

 

[00:27:23] Sean Mooney: I think a hundred percent in the focus thing is a really important aspect. And certainly I feel it as an operator business, how you still want to do a hundred things. And then you realize to your point, Doug, I tried to do a hundred things. We're going to get two of them done. And so how do you do the fewer things that matter? 

 

In terms of the discussion here, we've talked about how there's a couple key measures that are inspiring how the private equity industry takes action, how that in turn leads to focus to tremendous, really de novo value creation. The engineering game is kind of like a 1980s movie now, and so the idea that you have to create value. 

 

What does that mean if you're an entrepreneur, or you have a family business, or you're a first time PE backed executive? What does that mean in terms of the expectations that that business owner that executive needs to be prepared to embrace in order to be successful as part of this ecosystem and that story of value creation that's occurring in the industry. 

 

[00:28:29] Lloyd Metz: The first thing that I would say is you got to be mentally ready to PR every month, every quarter, every year, set a personal record. Pick up the pace, do achieve results that are better than you were yesterday, better than you were last year, and be prepared to do that again, right? There's no point at which you kind of cross a finish line and you can rest, right? 

 

And so mentally you have to be prepared for that kind of journey, because that's sort of how private equity works. Again, that dynamic of time and faster being better than slower. Once you show me how fast you can run, I'm like, well, hell, can you run a little faster? Can you run a little faster? Still like all of that makes the outcome better from where we sit. 

 

And for some people, for some leaders of companies, that's energizing that challenge, that push that nudge, but it's not necessarily for everybody. So you just have to do a self check, look yourself in the mirror, got checked and see if that's how you want to go. Listen,  

 

[00:29:35] Doug McCormick: I think this is intended to be an eyes wide open conversation, right? 

 

As you think about private equity as an alternative for your business, you want to understand the positive attributes of the experience or the partnership and the negative. And I think to Lloyd's point, status quo in the businesses, the private equity, that's called a bond, right? A business that generates the same income every year is an annuity, and that's valued a certain way. 

 

Most of the businesses that are purchased in a private equity context are oriented around growth. So status quo is kind of a failure. The 2nd thing I would say, though, is we are a long term asset class, and at the end of the day, we really all care about terminal value, not year 1 performance. But if you look at all a lot of studies, they'll say year 1 performance and terminal value are very highly correlated. 

 

So getting out of the box fast and delivering on the plan is important. It's important step forward as you think about the success. And then the last thing I'd leave everybody with is we've talked about like this tension and it's a demanding environment and that's all true, but I would say it's my own personal experience. 

 

It's 1 of the few places where the alignment with all constituents is so tight that everybody wins and everybody fails together. And when I say constituents, I mean, the investors, limited partner, the GP or the private equity firm and the portfolio company or entrepreneur who took capital. And so personally, I take a lot of comfort in that alignment because it's kind of like you're on a team and you're all working together and you know, who wants an easy game? 

 

You want a hard game that was well played and the success is all the sweeter that way. And so I think that is one of the uniquely positive aspects of this experience.  

 

[00:31:09] Sean Mooney: A conversation comes to mind that I had with, we had a relatively newer CEO to the kind of what we'll call the private equity way of doing things. 

 

So they're just the ecosystem of private equity. After a long board meeting, we went and had dinner and it was just one of those open conversations. And he's like, well, I'm just trying to get my hands around. It's like, I don't feel like I can ever cross the finish line. And to your point, if I'm running fast enough, now I got to go faster. 

 

Why? We just had this really open conversation. It's almost, I wish I had this conversation with them earlier where it was, here's what you CEO need to understand. Is that my bosses who are LPs, they require us to have really high IRRs and high multiples of capital. And if we don't do that, we're all out of jobs. 

 

And so we're all feeling the pressure ourselves. And it's not that we're trying to be someone that's not letting you kind of cross the finish line. It's just these incentives and these motivators and these measures, like your point, they're aligned all the way through the entire ecosystem. And I go, when we're doing this, it's because we're trying to create value for University endowments that are trying to provide resources to their students. 

 

We're trying to create a value for pensioners and we're held accountable for that. And so it's not that we just are people who say you can never go fast enough. It's the measures that we're also held accountable to and that's why we're managing this way as well with our portfolio companies. And then he got that. 

 

He's like, Oh, now I get it. It's like, it didn't feel personal then anymore. And we mentioned there was some of that tension that sometimes occur at the beginning of new relationships because they don't quite understand. And then once he got it, you know, it's like, Oh, this is just the way the world is. 

 

Let's just play the hand as it's dealt because it's meant to be dealt that way. And it's consistently dealt that way. Does that kind of resonate?  

 

[00:33:00] Lloyd Metz: It does. But I'll even add an element to it. I think a lot of us in private equity have a view where there's no ceiling to your performance. So intrinsically, when you look in the mirror, ask yourself the question, how good could I be? 

 

How big could we be at this company? Right? And so it was private equity. Sometimes I threatened by leadership teams with put on a cheerleader outfits because we are oftentimes cheerleaders. And so, yeah, I'm pushing you, but it's not because I don't think it's enough. It's because I'm coming from a place of how good can you be? 

 

Right. Your product is good. Your leadership team is good. This market is good. How big can you be? I don't know. Let's go find out. Right. That mindset is important.  

 

[00:33:48] Doug McCormick: I think many entrepreneurs have grown up in a world where the number one constraint has been capital availability, right? I could do X, where am I going to get that capital? 

 

And you're coming at it and going, well, just. Theoretically, let's take that off the table for a second. I always tell people good projects and good deals fund themselves. And so I think your job as the private equity executive is to ensure that good business plans and good teams that have great opportunities can finance them. 

 

And when you take that constraint away, a lot of these things can be pretty extraordinary in terms of what the growth potential is. Sean, to your point on this accountability and the pressure, I often joke, everybody's got a boss or a customer. Right and at the end of the day, we all take orders from somebody or we have customers that get to choose by giving you their business or not. 

 

And so we all feel that pressure in one way or the other.  

 

[00:34:35] Sean Mooney: I think those are both really good points. And Lloyd, also, to your perspective there, it's just like, how could you be? History is replete with all these stories of people not knowing how good they can be until they get there and they break through a moment. 

 

And so like, there's the stories about the four minute mile, right? No one for years and years and years could beat the four minute mile and then someone did and then it was immediately beat by 10 other people. And I'm paraphrasing, but it's that idea, like we don't even know how good we can be. And Doug, your point, like we're all working with and for people with expectations. 

 

And I think it does nicely with this, the name of the podcast, right? It's just best, but never final. You're going to give your best, but you're never going to, it's never going to be a final piece of work.  

 

[00:35:17] Lloyd Metz: I agree with that. A hundred percent. Well said.  

 

[00:35:20] Sean Mooney: Lloyd and Doug, I think we've had a great conversation that pulls back the curtain on. 

 

What you all and we all are thinking about in terms of how the incentives and the expectations inform measures that are tracked, which informs activity and outcomes. And that happens in every aspect of life, including private equity. And so I think for our listeners, hopefully, this gives you a really good understanding of. 

 

Not only the how private equity manages because of these measures and expectations, but also why in, I think, as we've talked about throughout this discussion here, it's because of this alignment that happens throughout the entire value chain of the industry, and that in turn is one of the major reasons why the private equity has not only created so many returns for stakeholders that need and want them, uh, But also created just tremendous value for the economy at large. 

 

Does that kind of make sense in a line with what you all kind of perceive from this conversation, Lloyd and Doug?  

 

[00:36:26] Lloyd Metz: It does, Sean. I think you guys did a good job sort of framing that up and I think we have a few other future episodes to talk about, right? Just even your question with the LPs and how they think about things, we should probably have somebody on in a future episode. 

 

[00:36:40] Doug McCormick: I think the one thing I would encourage folks to leave with is. None of this works without actually delivering value. We talk about speed and speed impacts IRR, but we're still talking about a short duration is three years, four years. So this is truly about how do we align together with partners of all kinds, limited partners and management partners to go do something special. 

 

[00:37:01] Sean Mooney: Thousand percent. I think, and that's one of the true creators of value for this entire industry is the thing that we've talked about throughout is alignment. All right, gentlemen, this was a great conversation. Thanks so much. We'll talk soon.  

 

[00:37:14] Lloyd Metz: Thanks, Sean. Thanks, Doug. Talk to you guys later. Thanks, guys. 

 

[00:37:23] Doug McCormick: Special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies. by partnering with family and founder owned manufacturing services and distribution companies. Learn more at hciequity. com. ICV Partners, an innovative private equity firm supporting management teams of leading companies at the lower end of the market. 

 

Learn more at icvpartners. com. And finally, BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, on point, and on time due diligence and value creation needs. Learn more about BluWave at BluWave. 

 

net. For further information on HCI, ICV, and BluWave, and relevant topics discussed here in the episode, please see the episode notes for links.  

 

[00:38:21] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced herein. 

 

BBNF Ep 006 - Scott Milberg 

 

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of Best But Never Final. I'm Lloyd Metz, joined by Doug McCormick and Sean Mooney. Together, we'll navigate the corridors of private equity, revealing the uncommon knowledge, challenges, successes, and risks. And lessons that drive the world of private equity and business forward. 

 

Let's go. 

 

[00:00:35] Sean Mooney: We have another great episode today where we're going to talk about value creation from both the lens of the private equity firm, but also the portfolio company CEO. So today we're really fortunate, not only to have our co host, Extraordinary Doug McCormick, who leads HCI as their managing partner and chief investment officer. 

 

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of Best But Never Final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Mooney. Together, we'll navigate the corridors of private equity, revealing the uncommon knowledge, challenges, successes, And lessons that drive the world of private equity and business forward. 

Let's go. 

[00:00:34] Sean Mooney: Today, we're going to talk about the math of private equity and how overarching incentives and measurements drive behaviors. Throughout the entire private equity value chain. So this is the entirety of limited partners through the private equity firms that are investing all the way down into the portfolio company themselves. 

So, Lloyd and Doug, I think this is going to be a really interesting conversation that's going to help. All our listeners, including those in the private equity industry, and those who are curious about the private equity industry. understand the why behind how private equity moves with such tenacity and pace to transform the companies that they're investing in. 

And so maybe to kick things off, let's talk about the beginning of the value chain, the limited partners that really are kind of setting off the whole motion of the private equity industry as the first investment entity that invests into the private equity firms that invest in the. Portfolio company. 

So maybe Doug, can you share a little bit about what are LPs investing in, in general, across the spectrum of the things they do? How are these maybe similar or different? And then how are the LPs measured in the course of their own jobs?  

[00:01:59] Doug McCormick: So, let's try to put some meat on the bone around what a limited partner generally is. 

So, first of all, sophisticated investors generally pass this test or always pass this test of an accredited investor. And for the most case, and at least in our business, they're institutional investors. So what does that mean? It means they're an insurance company, a pension fund, a foundation, an endowment, could be some high net worth individuals. 

And so they're generally deploying large pools of capital, they're relatively sophisticated, and they're in many cases doing it on a global basis. And so the same way an individual thinks about a diversified portfolio to generate attractive risk adjusted returns, these institutions think about it the same way. 

And so they have a portfolio and it spans multiple asset classes, so fixed income, commodities, emerging markets, equities, and when I say equities, I'm referring to publicly traded things. And then alternatives broadly, and alternatives could be private debt, could be private equity, which is traditionally more leveraged buyout, and then it could also be venture capital. 

And they think about all of these assets competing against one another on a risk adjusted return perspective. And so, as we think about our asset class being competitive in that framework, we have a lot of things that make private equity risky, duration, illiquidity in my business, which is a leveraged buyout business, leverage. 

And so, because of those things, our investors need to be compensated, and they're compensated with return, measured as IRR, and also the implication of IRR is multiple capital, which is simply, Something's been compounded in IRR over many years, you grow that capital base.  

[00:03:38] Sean Mooney: I think that's really helpful in terms of framing what limited partners are, the types of areas that they're allocating their investments around. 

How are limited partners themselves measured as they think about their constituents that are upstream from them, their stakeholders?  

[00:03:56] Doug McCormick: I think capital flows to the best opportunities, and so I generally think the way All investors are measured is on a relative basis, right? Like how much did the tide go up and everybody should have participated in the rising tide. 

And then how much did you differentiate above and beyond that? So I think the most standard benchmark is probably the S and P and everybody thinks about discounts to the S and P or premiums to the S and P based on some of the measures of risk I talked about, volatility, leverage, duration, et cetera. 

[00:04:27] Sean Mooney: That makes a ton of sense. And maybe to dig a little deeper on that. Lloyd, one of the things that Doug mentioned about is they're looking at whether it's the S& P 500 or private equity, the venture capital industry, they're looking at things called IRR and MOIC, otherwise known as multiple invested capital, sometimes called multiple money. 

What are those? What do those mean?  

[00:04:50] Lloyd Metz: That's a good question. I just want to address one of the things that Doug said, when we talk about sophisticated investors at these insurance companies, endowments, foundations, and pension funds. The folks who work there work for future retirees, current retirees at an endowment, you're trying to invest so that the university or the charity or what have you is viable a hundred years from now, right? 

So these folks are pretty sophisticated and thinking about risk and thinking about opportunity, but ultimately like an insurance company, you have claims that you're going to pay those ultimate pensioners. The university 100 years from now or the future claimant in an insurance company, they must have their money come hell or high water. 

Basically they understand that things happen in the world, but those investors need more certainty and confidence that you will be able to deliver. A dollar amount of return and a percentage sort of return. So that's how the MOIC and the IRR come together. That MOIC ultimately though is how they meet their obligations at the insurance company or the endowment or the pension, because those are the actual dollars that you're giving back. 

So private equity needs to deliver just for argument's sake, two times the invested dollars or three times the invested dollars that those pension or endowment. or insurance companies give us. That's what we're trying to deliver. So to your question about IRR, that is how you compare whether I should give private equity a dollar or should I give European large cap equities a dollar or emerging market small caps a dollar or infrastructure funds a dollar. 

The LPs have a wide range of choices of where they can put their dollars. That's a big part of the calculus.  

[00:06:47] Sean Mooney: And I think that's really helpful. And the IRR is. Maybe the rate of return that they're earning over a period of time, whereas the multiple of invested capital is how much the multiple of turn. 

And you really, from my perspective, you always have to look at those hand in hand. And so when I would always compare investments, even just on my own balance sheet, sometimes you get this great IRR. If I put a dollar in something and a year later, I get a dollar 40 back. It's great. I made a 40 percent IRR, but I got 40 cents back. 

Or if I do a dollar in three years from now, I get 2 back or five years from now, 2 back. That might be a 20 percent IRR, but now I at least got a whole nother dollar. And so I think that's one of the big nuances that I would always look at is like they got to go hand in hand.  

[00:07:35] Lloyd Metz: That's right. And I think a lot of the LPs use IRR because you can compare across different strategies There are two sides to the argument as to whether that is right or not right, but that's what it is. 

And the biggest driver of IRR when you look at the actual formula to calculate it is time. So delivering two times your money in a shorter period of time gets you a higher IRR. Delivering two times your money in a longer period of time gets you a lower IRR. So time is a big factor that Drives private equity and starts to trickle down into some of the strategies, approaches, investments we select, and then even how we interact with the portfolio company leadership teams that we invest behind. 

[00:08:23] Sean Mooney: That's a really good distinction on the time. And so limited partners want their money back with relative velocity, and they also want more of it back over time. And Doug, to your point, they're looking at things like the S& P 500 to say, okay, what's kind of a thing that we should measure things across all of us. 

And as a caveat, every limited partner is going to do things differently. This is kind of a general perspective on how limited partners are looking at the world. And so there's a whole lot more that goes into all of this, but it's just as framework. I think that sets the stage really nicely with this understanding that limited partners invest capital across a range of different types of investments to generate a combined return over time. 

Some have different risk profiles than others, some return more than others based on those risk profiles, and the expectations are similarly aligned. And then the way that the limited partners are measuring those that they invest in, by and large includes something called IRR and MOIC. That includes speed and money back. 

[00:09:33] Doug McCormick: Sean, let me just build a moment on something you and Lloyd are both touching on. Lloyd commented that just the way the math works, IRR is heavily dependent on time required to realize the return. And you were commenting that this asset class is generally has a higher return expectation. And so essentially what that means is this is expensive capital. 

Let's just go down the path of why that is. For starters, we mentioned investors. command a premium for investing in this asset class because there are a number of things that make it riskier for them to manage things like liquidity, things like duration. It's a long term commitment is 10 to 12 years and things within the businesses such as leverage, for example, that introduce risk from their perspective. 

So they demand a premium. We're using that capital to buy businesses, usually a change of control. You often pay a premium for change control. You've got to compel. An entrepreneur with a compelling offer, and so we often pay for what we think we can do with the business, not just what the business is worth today. 

And then the last thing to acknowledge is this is an expensive investment model. So the private equity model is 2 percent of assets under management generally, plus a share of the profits after a preferred return. That share is often 20%. So expensive compared to buying an index fund for the S& P at 10 basis points. 

So you combine all of those things together and it creates this tension where there's a real need to create value quickly and that's why really we're having this conversation about the way private equity engages with their assets they purchase to really drive that value.  

[00:11:04] Sean Mooney: I think that's a really important distinction to set the stage for all the conversations that are happening here. 

There are higher expectations of return both in terms of the rate of return and the speed of return because Transcribed There's certain elements of PE that are different from getting in and out of the S& P 500 by clicking a button. This episode is brought to you today by HCI Equity Partners, a lower middle market private equity firm focused on partnering with family and founder owned manufacturing service and distribution companies. 

ICV Partners, an innovative private equity firm. Supporting management teams of leading companies at the lower end of the middle market and BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical variable on point and on time due diligence and value creation needs. 

Now back to the episode. As we set the stage here, we have this concept of the limited partners are thinking about the IRR and the multiple money they're going to get across all of their investments. They have different expectations for those returns, depending on things like liquidity and duration and other elements of the business. 

Private equity is one that if you look at studies from pitch book and Hamilton lane, you see the private equity industry differentiating themselves over both shorter and longer periods of time. Look at those studies. Don't take my word for it. But part of that is because of this alignment of incentives and how they act. 

And so maybe Lloyd, let's talk about this. The private equity firms are measured on IRR and MOIC. How do these measurements that are then kind of thrust upon the private equity firms as their expectations from the limited partners? How does that impact how private equity firms then take action to manage those outcomes? 

[00:13:04] Lloyd Metz: Again, this is in the context of working with really sophisticated investors, right? So there's another layer. If you listen to some of the other podcasts and blog posts that people who are allocating capital at these institutional investors talk about how they think about things, they have a point of view on certain asset classes. 

You do do the index fund. There's very little advantage of an active manager in that asset class. So that's what they do in private assets, whether it's infrastructure, credit, or equity, many LPs are of the view managers actually can generate alpha. So return over and above the overall market movement, right? 

The amount of return generated by that manager. Private equity is one of those asset areas where manager selection is important. So the skill of the private equity investor matters, right? So with this whole dynamic of MOIC and IRR, it starts to factor into things like, what is your strategy? What sort of companies do you select and choose to invest in all things being equal, investing in a slow growth market and a slow growth company. 

Has perhaps a different IRR and risk profile over time than a fast growing market and a fast growing company in that fast growing market. And the question then becomes, how much do you have to pay for one versus the other? How much time will it take for those companies to achieve their growth? Is there going to be much volatility in the path that they take to get their growth in revenue and cash flow and value? 

So you factor all of that in when you make your decision, right? So there are some slow growing, stable growing businesses and markets that the market will ascribe in the private equity world, a pretty high multiple because there's very little volatility and you're going to make your two times your money. 

It'll just take four years or five years or six years. You might make two and a half, three times your money and people will invest behind that. There are other companies that may be growing faster, 10, 15, 20%. And you'll invest in those two, right? And you may get to two times your money in three years, right? 

24, 25 ish percent annual returns. But that's for the private equity manager to figure out what approach are they going to try to take? How do they construct their portfolio? So how many of the first type of company, if any, do I want to invest in? Or do I want to invest in only the fast growing markets, fast growing companies, fast growing industry segments? 

I think that is up to the decision of the private equity firm, right? So in terms of how they set their strategy,  

[00:15:55] Sean Mooney: I think it's a really good point. And even within private equity, there are a whole host of different approaches. What is kind of the commonality in terms of this concept that we've talked about that private equity firms are measured on returning capital quickly and returning multiples of it over time? 

What does that mean in terms of what they're going to do once they own this business? Generally within the, even this broad spectrum of B firms that have different strategies.  

[00:16:20] Lloyd Metz: Generally speaking, and again, if I were talking to the leadership team of a company or a founder, who's considering taking on private equity, faster is always better. 

Acting faster, figuring things out faster, getting results faster, growing sales and cashflow and profits faster is always better. So that's the going in approach philosophy, whether it's in the front of your brain and top of mind with your private equity partner, it's definitely running in the background. 

And so things that slow down execution, things that slow down or obstacles to entering a new market or launching a new product or building a new plant. Private equity professionals tend to want to remove those obstacles and help the leadership teams of the companies that they invest behind, get over them, get around them, get under them, but get that stuff out of the way so you can get at the opportunity faster. 

And that, Doug, you used the word tension earlier. That's a source of tension, but we like to think it's creative, constructive tension.  

[00:17:28] Doug McCormick: So, one of the ways I like to very simplistically kind of characterize this is, I would argue the private equity market is a bit more inefficient than other markets like public markets, but it's still relatively efficient, right? 

So there's lots of capital out there. And so we should assume that in any process we're participating in, there's going to be an efficient outcome. So that's point 1, it's competitive. The 2nd is 1 of the things That we view that we are paying for when we're doing a majority deal is we're buying governance rights. 

And that is one of the key elements of how we think about creating value. And if you think about it, just super simplistically, I would argue with those governance rights, investors can generally do four things. One is you can change their trajectory of growth. It'd be organic growth could be M and a. The second is I think you can change, we would say, optimize the business model. 

Right? So improve the value proposition that changes things like margin profile or maybe customer retention. I think the third area is increasing the size of the addressable market or getting access to new markets that have faster growth rates. And so kind of repositioning the business in terms of where those skills can be applied elsewhere. 

And then the fourth is team. And I would tell you, if you don't have the fourth, you probably can't do the first three. And so we think about all four of those is really fundamental value levers that allow us to compete.  

[00:18:46] Sean Mooney: That's another really important point, what the private equity firms can do and think about doing when there are investing as fiduciaries in these assets and these companies and these dreams. 

And one of the things is I kind of reflect back in the late 90s when I started in PE and Doug, you mentioned this work efficiency of the market and. The market was pretty nascent back then, but it was like one of these things where like companies would line up to us, we would pick the best one and we would probably be able to invest at a pretty reasonable price in our value. 

Creation plan was we were going to update the accounting system or at a salesperson. And then everyone would do well, because just the whole industry was just less competitively tense. And then as I rolled the clock forward in time, it was, whoa, now I'm competing against many different entities, whether it's an investment firm, like a private equity firm or another strategic acquirer that we're also looking at making these investments. 

And so suddenly I was having to pay more to get these companies and then from an economics 101 perspective, my choice was I could either pay more and accept a lower return basic supply and demand type pressures, or I could create value. And I could create it more quickly and that's a big evolution that I think we've all seen in private equity is people in P. E. are incredibly creative and tenacious and kind of like best but never final. They're going to always do whatever they need to not only reach the finish line, but then keep on going after that. And so we've seen this acceleration in value creation and both the speed and the amount of it that's conducted in private equity and a lot of this all goes right back to where we started our conversation. 

It's in part because they're measured on the returns that they make. And then multiple of dollars and so as an industry for anyone who's involved in it, there's this idea that they're like, wow, why is everyone telling me I got to go so fast and why are the private equity folks telling me that we've got to like, transform this company? 

Why can't we just keep on growing at the same rates that we used to? And this is a family business. And so maybe Lloyd and Doug, can you talk a little bit about. As a transition or a conversation here, how this stuff translates into how that you interact with the leaders of your portfolio company saying, we are expected to move fast and do a lot of change because that's what our stakeholders, our key stakeholders, our limited partners want from us. 

And thus we have to do this in partnership with you as well.  

[00:21:17] Lloyd Metz: Sean, you raise an interesting point that may take us off. Topic for a second, but one of the things that we didn't really get at that, I don't know if everybody appreciates, but I think some of these evolutions that you alluded to with private equity are good because what it makes us all do is make the companies we invest in better. 

Like once upon a time, like you said, you could just change accounting, add a few salespeople and voila. The market multiples were going up, so you look like a genius over time. You actually had to build out bigger or more effective sales department. And you had to figure out how to add an innovation engine, or even if you were growing inorganically through acquisition, you don't just slap a bunch of acquisitions together, wrap it up and say, it's just bigger and better and pay me more. 

No, you actually not only have to integrate acquisitions that you make, but if you intend to be a serial acquirer. That's actually a feature function and capability you need to build. So ultimately you just have to build a better business to get the returns. And for a lot of us in private equity, it's that part that gets us fired up. 

And so to your question, again, different private equity firms have different approaches. We. And I think Doug probably agrees with this, but he'll chime in, but we try to find the business leaders that have aspirations to grow to double or triple the size of their company or what have you. And what we're signing up for is helping them get there either faster or with less risk or with capital support, intellectual capital support, all that stuff, right? 

That's what we look for. That's our strategy in our approach, but other firms have different approaches, but ultimately you have to build a better business for this to all work.  

[00:23:07] Doug McCormick: First of all, totally agree with the way you guys are thinking about the evolution of the asset class. One of the things I would say it's been really a good thing is as the markets evolve, so have PE firms in terms of their capabilities to deliver on the value add that we were talking about. 

So it's not been like something that happened over a year or two. This has been arguably a. 30, 40 year evolution of the asset class in terms of the development of those capabilities. The 2nd thing is just from a history perspective, because I think it is really interesting as you think about the hurdle that we're all trying to keep up with. 

The PE community has done a great job of innovating and today we're innovating through adding value and operational improvements, strategic improvements, but the early innovation was more around financial engineering. And so while prices of assets have gone up, our competition has gone up, actual financial leverage has come down substantially. 

And I think that has a couple of implications. One, it means you got to really deliver on the value add. And two, I think it's better from a societal perspective, right? Because we're delivering return and value generally associated to a growth. I think that's an important aspect. And then just to comment on how you think about partnering with entrepreneurs who are looking for that opportunity to transform their business. 

I would say, We're probably a little more willing to think creatively there. And what I mean by that is we want to partner with an entrepreneur who shares our vision. They may or may not want to be part of that journey. And so in many cases, we have folks that we have alignment on where we're trying to go. 

And there's an open acknowledgement that because of their retirement or whatever, that they're going to be an investor and a partner, but not the leader of that transformation.  

[00:24:44] Sean Mooney: Those are also really good points. And as we think about the business of private equity, one, I think it has transformed into a huge value creator. 

It's driven by a lot of the fundamentals that we've talked about here in terms of here are the expectations and the outcomes. And we did a study and Doug, we enlisted some of your team's help as well, kind of cutting through the data of the Inc. 5000. And what was really interesting is a relatively smaller subset of the Inc. 

5000 companies were private equity backed. I think it was 11 percent of the companies in the Inc. 5000. But they accounted for 60 percent of the job creation in the 5, 000 companies in that subset, of which I know Doug, you guys had a bunch of companies in there. And so it's become this economic engine to create and add jobs. 

That's a really important thing. And once again, it's like, you want to understand the outcomes, follow the measures. Like, what's measured? And it's, we got to do things well, consistently, and we got to do it substantially.  

[00:25:41] Doug McCormick: And Sean, I would just comment, as you think about the Inc. 5, 000, it also highlights. 

The part of the market that the private equity community is generally playing in, like we talk about transformation and value creation and we're trying to double or triple a business, but let's also acknowledge these are relatively small businesses, right? We're truly playing in what we kind of characterize lower middle market or middle market to buy kind of an S& P 100 business. 

And do the things that we would do would be really, really hard. They're so big, they're often very capable. And so we are playing in a part of the market where the size of the company allows us to be very nimble and really create value pretty quick.  

[00:26:17] Lloyd Metz: I would add to what Doug's saying, Sean, a lot of the companies of the size you're talking about that private equity invests in benefit from focus. 

I mean, that's part of when I said intellectual capital, that's part of what philosophically most private equity firms bring to their investment companies. Is focus what markets, what customers, what products, what geographies, whatever is relevant. Should you focus on, if you're focused on six things, that's too many. 

What about these two? And oftentimes that's where the disproportionate growth comes from. You double down on those two, you add salespeople, you add product people, you add production capacity or whatever the heck it is. You drive growth, your organization grows, your profits grow, sometimes just bringing focus to the situation is the big part philosophically of where private equity brings. 

I don't know what you think about that.  

[00:27:09] Doug McCormick: Yeah, I think it's the classic saying. If everything's a priority, nothing's a property, right? Instead of have the conviction of. Off and back by data of what are the two or three value levers that can really transform this business. And then going after those maniacally, I think it's a huge value creator. 

[00:27:23] Sean Mooney: I think a hundred percent in the focus thing is a really important aspect. And certainly I feel it as an operator business, how you still want to do a hundred things. And then you realize to your point, Doug, I tried to do a hundred things. We're going to get two of them done. And so how do you do the fewer things that matter? 

In terms of the discussion here, we've talked about how there's a couple key measures that are inspiring how the private equity industry takes action, how that in turn leads to focus to tremendous, really de novo value creation. The engineering game is kind of like a 1980s movie now, and so the idea that you have to create value. 

What does that mean if you're an entrepreneur, or you have a family business, or you're a first time PE backed executive? What does that mean in terms of the expectations that that business owner that executive needs to be prepared to embrace in order to be successful as part of this ecosystem and that story of value creation that's occurring in the industry. 

[00:28:29] Lloyd Metz: The first thing that I would say is you got to be mentally ready to PR every month, every quarter, every year, set a personal record. Pick up the pace, do achieve results that are better than you were yesterday, better than you were last year, and be prepared to do that again, right? There's no point at which you kind of cross a finish line and you can rest, right? 

And so mentally you have to be prepared for that kind of journey, because that's sort of how private equity works. Again, that dynamic of time and faster being better than slower. Once you show me how fast you can run, I'm like, well, hell, can you run a little faster? Can you run a little faster? Still like all of that makes the outcome better from where we sit. 

And for some people, for some leaders of companies, that's energizing that challenge, that push that nudge, but it's not necessarily for everybody. So you just have to do a self check, look yourself in the mirror, got checked and see if that's how you want to go. Listen,  

[00:29:35] Doug McCormick: I think this is intended to be an eyes wide open conversation, right? 

As you think about private equity as an alternative for your business, you want to understand the positive attributes of the experience or the partnership and the negative. And I think to Lloyd's point, status quo in the businesses, the private equity, that's called a bond, right? A business that generates the same income every year is an annuity, and that's valued a certain way. 

Most of the businesses that are purchased in a private equity context are oriented around growth. So status quo is kind of a failure. The 2nd thing I would say, though, is we are a long term asset class, and at the end of the day, we really all care about terminal value, not year 1 performance. But if you look at all a lot of studies, they'll say year 1 performance and terminal value are very highly correlated. 

So getting out of the box fast and delivering on the plan is important. It's important step forward as you think about the success. And then the last thing I'd leave everybody with is we've talked about like this tension and it's a demanding environment and that's all true, but I would say it's my own personal experience. 

It's 1 of the few places where the alignment with all constituents is so tight that everybody wins and everybody fails together. And when I say constituents, I mean, the investors, limited partner, the GP or the private equity firm and the portfolio company or entrepreneur who took capital. And so personally, I take a lot of comfort in that alignment because it's kind of like you're on a team and you're all working together and you know, who wants an easy game? 

You want a hard game that was well played and the success is all the sweeter that way. And so I think that is one of the uniquely positive aspects of this experience.  

[00:31:09] Sean Mooney: A conversation comes to mind that I had with, we had a relatively newer CEO to the kind of what we'll call the private equity way of doing things. 

So they're just the ecosystem of private equity. After a long board meeting, we went and had dinner and it was just one of those open conversations. And he's like, well, I'm just trying to get my hands around. It's like, I don't feel like I can ever cross the finish line. And to your point, if I'm running fast enough, now I got to go faster. 

Why? We just had this really open conversation. It's almost, I wish I had this conversation with them earlier where it was, here's what you CEO need to understand. Is that my bosses who are LPs, they require us to have really high IRRs and high multiples of capital. And if we don't do that, we're all out of jobs. 

And so we're all feeling the pressure ourselves. And it's not that we're trying to be someone that's not letting you kind of cross the finish line. It's just these incentives and these motivators and these measures, like your point, they're aligned all the way through the entire ecosystem. And I go, when we're doing this, it's because we're trying to create value for University endowments that are trying to provide resources to their students. 

We're trying to create a value for pensioners and we're held accountable for that. And so it's not that we just are people who say you can never go fast enough. It's the measures that we're also held accountable to and that's why we're managing this way as well with our portfolio companies. And then he got that. 

He's like, Oh, now I get it. It's like, it didn't feel personal then anymore. And we mentioned there was some of that tension that sometimes occur at the beginning of new relationships because they don't quite understand. And then once he got it, you know, it's like, Oh, this is just the way the world is. 

Let's just play the hand as it's dealt because it's meant to be dealt that way. And it's consistently dealt that way. Does that kind of resonate?  

[00:33:00] Lloyd Metz: It does. But I'll even add an element to it. I think a lot of us in private equity have a view where there's no ceiling to your performance. So intrinsically, when you look in the mirror, ask yourself the question, how good could I be? 

How big could we be at this company? Right? And so it was private equity. Sometimes I threatened by leadership teams with put on a cheerleader outfits because we are oftentimes cheerleaders. And so, yeah, I'm pushing you, but it's not because I don't think it's enough. It's because I'm coming from a place of how good can you be? 

Right. Your product is good. Your leadership team is good. This market is good. How big can you be? I don't know. Let's go find out. Right. That mindset is important.  

[00:33:48] Doug McCormick: I think many entrepreneurs have grown up in a world where the number one constraint has been capital availability, right? I could do X, where am I going to get that capital? 

And you're coming at it and going, well, just. Theoretically, let's take that off the table for a second. I always tell people good projects and good deals fund themselves. And so I think your job as the private equity executive is to ensure that good business plans and good teams that have great opportunities can finance them. 

And when you take that constraint away, a lot of these things can be pretty extraordinary in terms of what the growth potential is. Sean, to your point on this accountability and the pressure, I often joke, everybody's got a boss or a customer. Right and at the end of the day, we all take orders from somebody or we have customers that get to choose by giving you their business or not. 

And so we all feel that pressure in one way or the other.  

[00:34:35] Sean Mooney: I think those are both really good points. And Lloyd, also, to your perspective there, it's just like, how could you be? History is replete with all these stories of people not knowing how good they can be until they get there and they break through a moment. 

And so like, there's the stories about the four minute mile, right? No one for years and years and years could beat the four minute mile and then someone did and then it was immediately beat by 10 other people. And I'm paraphrasing, but it's that idea, like we don't even know how good we can be. And Doug, your point, like we're all working with and for people with expectations. 

And I think it does nicely with this, the name of the podcast, right? It's just best, but never final. You're going to give your best, but you're never going to, it's never going to be a final piece of work.  

[00:35:17] Lloyd Metz: I agree with that. A hundred percent. Well said.  

[00:35:20] Sean Mooney: Lloyd and Doug, I think we've had a great conversation that pulls back the curtain on. 

What you all and we all are thinking about in terms of how the incentives and the expectations inform measures that are tracked, which informs activity and outcomes. And that happens in every aspect of life, including private equity. And so I think for our listeners, hopefully, this gives you a really good understanding of. 

Not only the how private equity manages because of these measures and expectations, but also why in, I think, as we've talked about throughout this discussion here, it's because of this alignment that happens throughout the entire value chain of the industry, and that in turn is one of the major reasons why the private equity has not only created so many returns for stakeholders that need and want them, uh, But also created just tremendous value for the economy at large. 

Does that kind of make sense in a line with what you all kind of perceive from this conversation, Lloyd and Doug?  

[00:36:26] Lloyd Metz: It does, Sean. I think you guys did a good job sort of framing that up and I think we have a few other future episodes to talk about, right? Just even your question with the LPs and how they think about things, we should probably have somebody on in a future episode. 

[00:36:40] Doug McCormick: I think the one thing I would encourage folks to leave with is. None of this works without actually delivering value. We talk about speed and speed impacts IRR, but we're still talking about a short duration is three years, four years. So this is truly about how do we align together with partners of all kinds, limited partners and management partners to go do something special. 

[00:37:01] Sean Mooney: Thousand percent. I think, and that's one of the true creators of value for this entire industry is the thing that we've talked about throughout is alignment. All right, gentlemen, this was a great conversation. Thanks so much. We'll talk soon.  

[00:37:14] Lloyd Metz: Thanks, Sean. Thanks, Doug. Talk to you guys later. Thanks, guys. 

[00:37:23] Doug McCormick: Special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies. by partnering with family and founder owned manufacturing services and distribution companies. Learn more at hciequity. com. ICV Partners, an innovative private equity firm supporting management teams of leading companies at the lower end of the market. 

Learn more at icvpartners. com. And finally, BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, on point, and on time due diligence and value creation needs. Learn more about BluWave at BluWave. 

net. For further information on HCI, ICV, and BluWave, and relevant topics discussed here in the episode, please see the episode notes for links.  

[00:38:21] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced herein. 

Best But Never Final: Private Equity’s Pursuit of Excellence is a biweekly conversation between three private equity veterans — Sean Mooney, founder and CEO of BluWave, Lloyd Metz of ICV Partners, and Doug McCormick of Oridian Capital Partners. They work through the timely questions facing deal teams, operating partners and portfolio company executives, with an emphasis on what actually gets done rather than what sounds good in a headline.