Chuck Davis of Stone Point Capital explains what private equity investments are and common strategies.
Transcript
I am Chuck Davis, the CEO of Stone Point Capital. I started the firm about 20 years ago with four partners, all of whom are still with us today. And we invest the Trident funds in financial services. I had a 20-year career at Goldman Sachs before as a partner. So I have a long history of investing in and around financial services, and my partners have as well.
Private equity is private, meaning not public—public means you can buy stock in Walmart or Home Depot, or Google. Private means the stock doesn't trade, the ownership of the company is not available. It's not liquid. You can't call a broker and say, buy me 100 shares of a private entity. Equity means ownership, common stock. And so private equity is investing in companies that are off the market, not publicly traded and owned privately. And it's a sector that started really 30 or 40 years ago and now is very large and has a lot of players and is becoming a very big factor in the investment market.
Alternative assets and private markets are illiquid places to invest, and they require people to put money up and not be able to get out of it a week later and have to hold for a long time. And there's real estate; there's distress, there's all kinds of alternative assets. Private equity has been probably the most attractive place to invest in the last five or ten years. And that sector has been very successful. And there's leveraged buyouts, and there's growth. Leveraged buyout, just to give you one easy example – if you buy a company for $100 million and you pay all cash and this and the company doubles, you double your money from 100 to 200. If you buy that same company for $100 million and you borrow 50 of it, and it doubles in value from 100 to 200, you pay the 50 million of debt back, and you have 150 against your 50; you've tripled your money. If you put 80% of the 100 million in debt on the company and you put up 20, that would be a leveraged buyout. They used to be called bootstraps. Now that company goes to 200, just like it did in the other two scenarios, you pay off the 80 million of debt, you have 120 million against your 20, you make six times your money. So the exact same company doubles in one case triples in another case and goes up sixfold in the third case, that is a leveraged buyout.
The risk of too much leverage is that you get into trouble, and you can't pay it back. The great thing about private equity and leveraged buyouts is smart private equity firms who are thoughtful and careful; if they put leverage on a company and the company can't handle it, they'll put up more money, and they'll keep the company going until it stabilizes and grows. Which is why having the loss ratio we have is so important because when you can make six times your money on the same company that somebody else makes two times their money, that's a nice thing. But leverage is a two-edged sword, and you have to use it very carefully.
Growth capital is just generally not balance sheet oriented where you're borrowing a lot of money. It's where you invest heavily so that a company can grow and succeed. Organic growth means they're just bringing on more customers and making more revenue. Inorganic growth is tuck-under acquisitions where they can acquire more customers and more revenue, and more profitability by making acquisitions.
Good private equity firms can help companies grow organically and inorganically and also help them by optimizing the capital structure. Strategy number one is capital structure– a lot of people like to use debt and leverage. Strategy number two is bringing in operating talent and trying to make the company run better, cutting costs, increasing profit margins. Strategy number three would be helping with hiring and strategic acquisitions. And strategy number four might be figuring out a good exit; you know, before you go into an investment. It's nice to think about how you're going to get out of it. Private equity historically has made net returns to investors in the 10 to 15% range, 10 to 20% range. Solid private equity platforms have very good histories of getting good returns, but it takes them several years to do that.