Private Equity Explained with Michael Faciana

Venture Capital

The earlier startup stage-type private equity companies are called venture capital. They specialize in these idea stage companies that might be working out of a garage. They’ll provide some funding and guidance to these early-stage companies.

Let’s say three or four or five years go by and business is building up. He’s selling more books and wants to expand the inventory and upgrade the website. Maybe he’ll borrow some more money from venture capital. I should rephrase that. They invest and buy a portion of Amazon, in this instance.

[00:05:30] Michael Faciana: Maybe they’ll fund a company like Amazon three or four different times. Venture capital companies specialize in these idea stage early startups. They don’t want to get too concentrated in any one singular company.

So Jeff Bezos says, “I need to expand some more.” They might say, “We love what you’re doing and you’re doing great, but we’re out. Our thing is the early-stage stuff.” But Jeff Bezos needs to expand. That’s where the private equity companies come in. They’ll continue funding, buying more pieces of Amazon, in this instance, and help them grow.

The Lifecycle of a Private Company

[00:06:11] Michael Faciana: If you go back about 20 years, the lifecycle of a private company that’s doing well, like Amazon, is expanding and gaining traction. It might not be profitable yet, but it’s really doing well. Usually, the lifecycle from first funding and venture capital, they’d usually IPO around seven years. That was about the average time from a startup to an IPO in the instance where the company is doing very well.

[00:06:37] Dean Barber: And for people that don’t know what IPO is, it’s the initial public offering.

[00:06:41] Michael Faciana: So, you’d list your shares of Amazon on a public exchange. You’d raise a lot of capital and that would free you up to expand and grow the business greatly.

[00:06:51] Dean Barber: It’s an influx of cash from the public because anybody can now buy into Amazon stock.

Companies Are Staying Private Longer

[00:06:56] Michael Faciana: Correct. The landscape has changed greatly over the past 10 or 15 years in this regard. Like I said, it usually was around the seven-year mark that these companies would’ve IPO. Today, on average, companies IPO in roughly 14 years. There’s a big difference now.

[00:07:16] Dean Barber: They’re staying private longer.

[00:07:17] Michael Faciana: They are.

[00:07:18] Dean Barber: And you’re seeing companies go from public back to private.

[00:07:24] Michael Faciana: We’re seeing a lot of that. If you go back 20 years, roughly 8,000 companies in the U.S. traded on major exchanges. Today, there are roughly 4,000. A big portion of the reason for why that’s the case is because private equity is continuing to fund these private corporations longer.

If you are the founder of a company, why would you do that? Why wouldn’t you want to go public? There are a lot of reasons. One of the biggest reasons is the expense of doing so. It’s very expensive to hire an investment bank. An IPO usually costs you 6% or 7% of your company value. It’s very expensive.

On top of that, if you go public, there are a lot of regulatory SEC filings you need to do. There’s a lot of administrative work that you need to do. There’s a lot of expense with that. You need to hire additional staff to manage and service all that.

The Patrick Mahomes Effect

[00:08:18] Michael Faciana: Private equity is continuing to fund these private corporations longer. I think that’s a good thing. I call this the Patrick Mahomes effect. He didn’t start his first year and sat behind Alex Smith.

[00:08:42] Michael Faciana: That allowed him to grow, mature, and learn. Then, he started the next year, and he was Patrick Mahomes. Everything was wonderful. That’s sort of the concept with keeping these companies private instead of pushing them out

Be Careful About Stepping into the Limelight Too Soon

I started in this business around 2000. If you go back to the late 1990s, there were a lot of IPOs for companies that probably weren’t ready to do that. They weren’t profitable. They weren’t terribly well managed, but they got shoved out into the limelight and a lot of them failed. Private equity funds them longer and I think that’s a wonderful thing. It helps them mature and grow. And then as they reach that stage that they’re ready, then they can IPO.

[00:09:32] Dean Barber: When you say that we’ve gone from 8,000 publicly traded companies to 4,000, that doesn’t necessarily mean that 4,000 publicly traded companies are now private companies. Because you have the Lucent Technologies and Enron‘s that just aren’t there anymore.

[00:09:51] Dean Barber: Some companies were purchased by another company, so that stock was swallowed up. But that’s not to say that we haven’t seen a shift of companies staying private longer or being public and being purchased by a private equity company and taking it back to the private side.

One of the Best Things About a Private Equity Company

[00:10:09] Michael Faciana: That’s a lot of what we see. About half of the time, a private equity company will acquire a private company. And the other half of the time, they’ll acquire a publicly traded company and take it private.

One of the benefits about private equity firms with the expertise that they have is they don’t just acquire a company. They have teams of accountants and legal and sales professionals on their staff. So, they acquire a company, but then work with the management of those companies to help them run it better.

[00:10:45] Michael Faciana: So, they’re incentivized to do that. Private equity companies will usually invest in a company, get it running better, increase profitability, which increases the valuation of the company. And usually at about the 10-year mark, they’ll sell it off. They’re really adding a lot of value to these companies. That’s part of the reason why the private equity returns overall are so much more significant or higher than what we’re seeing in the public markets.

A Big Difference Between Private and Public Companies

[00:11:13] Dean Barber: Think about that just for a minute. There’s less regulation, less scrutiny. If you’re a publicly traded company, you need to forecast your earnings. You need to hit your earnings and you’re accountable to the stockholder.

How many times have you seen a publicly traded company simply managing to hit a number as opposed to managing and running that company to significantly increase the value of the company over time?

When you’re a private company, you’re not running the company to meet next quarter’s earnings. You’re running the company to turn it into something much better over a longer period. If a private company misses a quarter of earnings, it’s not the end of the world because there is no public market for it.

[00:12:06] Dean Barber: It isn’t public, so nobody knows. All they know is that this is the five-year plan, seven-year plan—whatever it is. It gives the people that are running those companies and the investors more autonomy to do what they know needs to be done without having to worry about meeting quarterly earnings estimates.

More Private Companies with Higher Revenue

[00:12:28] Michael Faciana: Absolutely. Here’s an interesting note. There are about 2,600 publicly available IE traded on exchange companies in the United States that have over $100 million in revenue. There are 17,500 private companies that have a $100 million in revenue or higher.

A lot of investors and advisors are maybe a little uncomfortable with valuations. There are a lot of uncertainties if the old 60/40 stock and bonds that we’ve used for so many years is going to continue to work as well as it has. Is it going to work for the next 10, 20, 30 years?

[00:13:18] Michael Faciana: They’re looking for alternative investments, which means anything other than stock and bonds. Private equity fits under that umbrella of alternative investments. If we’re only investing in publicly traded entities, that’s 15% of companies that are earning more than a $100 million in revenues. So, we’re only really investing in a small portion.

A Couple of the Nation’s Largest Private Equity Companies Are in the Midwest

The second largest private company in the country is right here in Kansas with Koch Industries. On the Missouri side in St. Louis, Enterprise is like the 10th largest private company. I’d love to invest in companies like that, but I can’t.

[00:14:11] Dean Barber: Well, until now.

[00:14:14] Michael Faciana: Until now. Yeah.

Private Equity People Aren’t Dumb

[00:14:16] Dean Barber: Let’s get down to this because the financial industry has recognized that there is a need and benefit to allow the average investor access to these private companies that don’t trade on an exchange. When you start investing in these private companies, your liquidity rules are different. There are things you need to understand before you do this.

This isn’t a ticker symbol that you’re going to buy one day and sell two weeks later. You’re not looking at the price every day. You need to dig in and do some research to understand who this is.

[00:15:02] Dean Barber: We need people to know that it’s possible to invest alongside of the private equity people who really specialize in finding the right company, buying it, and getting it to grow. Private equity people aren’t dumb. They know what they’re doing. They have a mission to turn around or drastically improve a company to increase the valuation over time.

The Many Different Types of Private Equity

[00:15:34] Michael Faciana: Dean is right. With private equity, a lot of people hear about it and don’t know what it is. The reality is that private equity can mean a lot of things.

Sometimes private equity means I’m buying apartment buildings that are private or public, and I’m taking them private. Or maybe I’m buying entire companies. Or maybe I’m issuing debt. There are a lot of different things that fit under that umbrella. And then there’s private equity companies that specialize like the venture capital, which is like the shark tank.

[00:16:05] Michael Faciana: Those are the guys that are funding Jeff Bezos early on. And then the private equity guys will come in at that midpoint. There is early, mid, and late stage private equity on top of that. A lot of the private equity firms specialize in certain segments of the life stages of those private company shares.

Access to Private Equity Investments Can Be Very Exclusionary

The one thing that I hear, and it’s true, is that access to private equity investments is very exclusionary. And there are two main reasons for that. One of the reasons is regulation. The SEC, which is a regulatory agency, says that you need to have a certain amount. Because to Dean’s point, these are liquid. They have a longer time horizon. Unless you have X-amount in assets or make a certain amount of income, the SEC says…

[00:16:56] Dean Barber: You can’t buy them.

[00:16:56] Michael Faciana: You can’t buy them these things.

[00:16:58] Dean Barber: It’s for the protection of the investor. It needs to be there.

[00:17:02] Michael Faciana: Yeah, no question. Here’s the second reason. Investing in some of these large private equity funds is very difficult. It’s challenging to get access to them unless you can write a $10 million check or you are a pension, foundation, or some large institutional investor.

There’s an exclusionary nature of private equity firms. It’s not that they’re mean or don’t like us. It’s just math. If I’m a private equity firm and I’m trying to raise $1 billion, would you rather have 10 entities investing $100 million with you? Or would you rather have 100,000 people investing $10,000 with you? Well, obviously they’d prefer the former than the latter.

How the Private Equity Landscape Has Changed Since 2015

[00:17:53] Michael Faciana: It’s very difficult to get into some of the most successful private equity funds themselves. That landscape has changed a lot too. This is very new with private equity keeping private companies private longer. If you go back to 2015, there were right around 50 private companies that were valued at $1 billion or more. We call that valuation level. We call those unicorns. Today, there are about 1,100 of them.

[00:18:34] Michael Faciana: This is all very new where private equity is keeping private longer. These valuations are growing, which I think is a good thing again.

How Are Private Equity Companies Valued?

[00:18:41] Dean Barber: So that raises the question, how are they valued? When you look at a publicly traded company, the value of that company’s stock is pretty much whatever somebody’s willing to pay for it.

[00:18:56] Dean Barber: It’s like your house. The appraisal value doesn’t matter. It’s what somebody willing to pay for it. So, how do these private companies get valuations to say what they’ve done for the company and this is what they think the value is now?

Funding Rounds

[00:19:14] Michael Faciana: There are very definitive valuation stages for these private companies and they’re called funding rounds. It’s not that different from valuing a public company. It’s based on your revenues and profits, if you have any. What are your sales growing at? Profit margins? All that fun stuff.

They’ll go on and they’ll have these funding rounds. Venture capital is usually the first two or three funding rounds. Each time they do a funding round, the venture capital companies will, again, look at the math, look at the numbers. That’s one of the benefits they have because private companies don’t have to post their financial information.

So, how would we decide to invest in a private company? We don’t have access to that information. But if we’re coming in as investors, then they’ll open the books and let us see so we can make those decisions.

The Risk vs. the Rewards

[00:20:07] Michael Faciana: Interestingly enough, within the first three funding rounds, 90% of those startup companies fail and go away. You can make a fabulous amount of profit in that early stage, but it’s also very risky.

We’ll take a pass on some of that stuff. And then the private equity comes in. Before a company goes private, A, B, C, D E, usually around the H time is when companies are ripe enough. And each time they’re valued. On average, that usually happens about every year and a half, maybe two years. You go through a funding round again, assuming business is doing well, and you’re growing.

[00:20:48] Dean Barber: Couldn’t you also say that multiple companies are sold in this industry, and this is the multiple that they sold at and here’s our earnings? We could take a multiple of that and apply it.

[00:21:01] Michael Faciana: Absolutely.

[00:21:01] Dean Barber: And here’s the estimated value of that at that point.

How Can an Average Person Trust Private Equity Companies?

[00:21:05] Dean Barber: But this isn’t something where the individual investor is going to look at their statement and say, “Look how much money we made yesterday” or “What did we do?” There’s less transparency there. I think that a lot of people think, “How do I know? How do I trust that?”

[00:21:20] Michael Faciana: Right.

[00:21:23] Dean Barber: How can the average person buy this in this new environment? Is there any more transparency for that person? Because they don’t have the private equity guys behind the scenes crunching the numbers and putting the valuations together and doing it on a regular basis. How do they know what’s going on?

Transparency Is Building Slowly But Surely

[00:21:42] Michael Faciana: Yeah, that’s a good question. Private equity is becoming more transparent, but it’s still a long way from the public markets where they need to file their financial information, holdings, and the like every quarter.

[00:21:55] Dean Barber: And they don’t want to do that.

[00:21:56] Michael Faciana: They don’t want to do that. And frankly, with the regulation, there is expense to doing that. There is this wall where we as investors don’t completely know. That’s why so many of the people who invest in private equity are top-tier managers. That’s why they’re so exclusionary. We can’t get in because they’ve got so much money coming in.

The reality is we don’t know, but something’s cropping up. As potential investors, we can sit down with management and get access to their private financial information to help us make those decisions.

What About the Late-Stage Private Equity Companies?

[00:22:32] Michael Faciana: A lot of companies focus on the very late-stage private equity companies. These are the companies that are big and strong and have over $1 billion in valuation. Their revenues are growing and they’re likely to IPO in the next one to three years. There is an SEC form that a private company needs to file with their intent to go public.

[00:22:54] Michael Faciana: If you know the lay of the land and what to look for, there is some information to make those decisions. But Dean is right. For individual investors, there isn’t transparency. And that’s a problem for some people.

COVID’s Impact

[00:23:07] Dean Barber: Would you consider the late-stage purchase a more conservative purchase or would you consider that to be a speculative purchase? Because you never really know what’s going to be going on in the economy or the markets when they decide to IPO. Even though the company itself may look super healthy, what if they IPOed at the wrong time—like during the Financial Crisis or the middle of COVID?

[00:23:33] Dean Barber: Suddenly, the market opens up and the valuation is discounted by 20% because of what’s happening in the economy.

[00:23:41] Michael Faciana: That’s very accurate and very true. In fact, last year, the S&P 500 was up 27%, 30%. The NASDAQ was about the same. There were around 1,000 IPOs in 2021 and the average return of those was -20%.

[00:24:01] Michael Faciana: Maybe that was because of what was going on with the economy because of COVID and all that fun stuff, but there’s legitimacy to that. Because you see a lot of things that are doing well because of what’s going on in the economy or the world today. A lot of companies were hurt by COVID, and a lot of companies benefited from it. As we come out of COVID, are those still big viable, strong companies?

Researching the Late-Stage Companies

[00:24:20] Michael Faciana: One of the things that a lot of private equity companies will do is vet maybe 100 of these late-stage companies that fit our parameters. Out of 1,000 that exist, we’ll look at about 100. We’ll meet with management on about 80 of them. Maybe we’ll put an offer letter to about 40 of them. And finally, we’ll buy maybe 15 or 20 of those companies. We spend a lot of time researching them.

[00:24:51] Dean Barber: Hold on second. When you’re buying, are you buying the whole company or are you just taking a share of that company? Is it a majority share, minority share? How are you doing that?

[00:25:01] Michael Faciana: It’s just a minority share.

[00:25:03] Dean Barber: So, you just want to participate in what you think is an opportunity that’s going to present itself over the next one to three years?

The Secondary Markets

[00:25:09] Michael Faciana: Right. It’s a significant change in the landscape. This, in part, will answer your question on valuations and pricing also. Between those funding rounds that I just described, there’s something that’s cropped up over the past five years or less called the secondary markets.

There are secondary markets that have existed for dark pools on trade stocks and all that fun stuff. This leads into companies staying private so much longer. If you started at a startup company, for the most part, they don’t have a lot of money to pay you. You’ll accept a smaller salary and maybe not as good benefits for the opportunity to get some shares. So when this company goes public, you make a ton of money.

The Time It Takes for a Company to Go Public Can Make a Big Difference for People

[00:25:59] Michael Faciana: When the companies went public in five to seven years on average, I can do that. But now that it is 14 years, that’s a long time. Because guess what? Life happens and people need money for whatever reason.

[00:26:13] Michael Faciana: If I started a company 10 years ago, my kids were 15 then. Now, they’re 25. No matter what big life event—marriage, birth, death, divorce, etc.—people need liquidity. They need access in this time that IPO has been stretched out so much.

So, the secondary market has cropped up. Roughly 50% of private company CEOs now allow their employees to sell their shares. When a private equity firm comes in and buys a company, it’s a little bit of a misnomer. They usually buy about two thirds or 50% of the company because the employees and senior management still hold the rest and private equity will buy the other chunk. Individual employees still have those shares.

The Need to Provide Liquidity

Historically, they couldn’t sell those shares. But now since they’re staying private so much longer, the CEOs have identified the need to provide some liquidity. Roughly half of the companies today allow their employees to sell these shares on the secondary market. A secondary sale would be anything in between those funding rounds that happen.

[00:27:15] Dean Barber: Liquidity events. Let’s call them recapitalization or whatever you’re doing.

[00:27:19] Michael Faciana: Exactly. A lot of companies meet with the CEOs and more often not they’ll say, “Talk to these employees. We’ll say we love your company. We love what you’re doing. They’ll refer us to some employees.” In fact, a lot of the senior executives will sell their shares too, because a lot or all their net worth is tied up and locked up in those shares.

[00:27:44] Dean Barber: Right. They want an opportunity to take some chips off the table.

What Are You Acquiring the Shares at?

[00:27:45] Michael Faciana: Absolutely. The secondary market has cropped up. That’s frankly how we acquire these shares is directly from the companies, from the employees. By doing that and providing liquidity to these employees, we generally get a discount to the last valuation. That could be the last funding round.

This is where a private equity firm needs to have that expertise and know where to value. If a funding round happens every year and a half, but the company’s grown at 80% over the past six months, is it worth more than that? Probably.

[00:28:19] Michael Faciana: Has it grown at all? Is it worth less? You need to make those decisions on what to acquire the shares at. That’s called the secondary market.

Online Exchanges

[00:28:27] Michael Faciana: Now we’re seeing online exchanges that have cropped up. We have our own online exchange and there are many others that do the same thing. Within the next five years, it’s going to be more commonplace to exact trades in private company shares through these online exchanges. We’ve got one built where we have over 50 institutions that execute buys and sell orders electronically.

[00:28:50] Dean Barber: Do you think that leads to more regulation from the SEC then?

[00:28:53] Michael Faciana: More than likely. Yes.

[00:28:55] Dean Barber: The one thing that the private companies want to try to avoid.

[00:28:57] Michael Faciana: Right. It’s a little bit of a catch 22 because it’s a benefit to the private companies and to the private equity companies to not have to deal with all that regulation.

Transparency Begins to Set in

[00:29:05] Michael Faciana: You’re starting to see a little bit of a crossover where private equity is allowing a little more liquidity, sharing a little bit more of that private information, and being a little bit more transparent. The converse to that is that you can now access private equity shares inside your 401(k). I think there’s a bill going through Congress right now where they’re trying to lessen those standards that we talked about earlier.

[00:29:35] Michael Faciana: There are a lot of people in the government that are saying that’s not fair. We need to democratize access and let other people invest in these vehicles. We’re starting to see both ends, but unfortunately, Dean is right. The result might be more regulation.

People Need to Understand What They’re Investing in

[00:29:51] Dean Barber: I think we ought to keep government out of this deal. They can mess up anything they touch. We’ve seen that happen many times. We know now from our conversation that private markets are very good, solid companies that, until just recently, the public has not had the opportunity to own any shares in.

[00:30:31] Dean Barber: That landscape is changing, people now have access to it, but they need to do some homework. They need to understand what they’re investing in. This is not your old limited partnerships in real estate. You’re not doing something for some tax credits or something like that.

There have been a lot of things that have sprung up over the years. I’ve been doing this now for 35 years and I’ve seen about all of it. You just need to caution people. Don’t just jump out and say, “I heard Dean and Mike talking about the private market, I need some of the private market stuff in my portfolio.” They need to understand where it fits and how it works.

[00:31:12] Michael Faciana: Absolutely. That’s why I tried to lay out the different stages. You can go on some website and see hundreds, if not thousands, of private equity funds. What are they and how do you know? It’s very confusing to figure out what they do, what they invest in, what stage companies are in, and the rest. It’s a big decision.

Again, It’s About Assessing Risk vs. Rewards

There’s a huge difference in risk between those venture capital funds and maybe a late-stage private equity company right before it goes public. We believe the best risk-adjusted return lies in those big companies. They stay private longer and now they’re ready, they’re mature.

[00:31:50] Dean Barber: You’re probably not going to get the home runs, but you’re going to get a lot of singles and doubles.

[00:31:54] Michael Faciana: Right. A lot of people’s contentions are that the money today is to be made on the private side. There are so many private companies to invest in. They’re staying private so much longer that a lot of that profit that you would’ve seen if they had IPOed at year seven, instead of year 14, that seven-year period is eliminated and is now on the private side with private investors that are making that profit.

This Is Complicated Stuff that a Professional Can Help With

When they go public, you got that seven-year window that’s gone of those potential profits. But to Dean’s point, even with stock and bonds, what are there, 10,000 mutual funds and ETFs? How do you know? How do you decide? It’s crazy. And that’s why you need to work with a seasoned professional to sort that out. And what’s suitable for you? Because everybody’s so different, right?

[00:32:49] Michael Faciana: And it’s the same thing, if not more so, with private equity because there isn’t as much information available. The most common reason for individual investors that don’t invest in private equity is that they don’t completely understand what’s going on.

[00:33:04] Michael Faciana: And to follow up on that, the most common reason I get from financial advisors that aren’t using private equity for their clients is that same thing. They don’t completely understand what’s going on.

So, education is paramount in working with financial advisor, an investment advisor, more specifically a fiduciary that has responsibility to doing the right thing for the client and seeing where that fits or doesn’t fit.

Private Equity Isn’t for Everyone

[00:33:32] Michael Faciana: For a lot of clients, private equity isn’t going to be suitable. Don’t just hear something that sounds neat and say, “I want that.” This is definitely not for everybody, but for some people, it could be a real nice addition to their portfolio.

[00:33:44] Dean Barber: I agree. Most people don’t know what they don’t know. Get the education, sit with a financial professional, and see if it works. Make an informed and intelligent decision.

[00:33:59] Michael Faciana: Those are the best decisions. The decisions that people are most comfortable with is when they sit down with a financial professional that can give them an explanation of exactly why this might or might not be suitable for each client. Not that they’re going to know everything about private equity, but get them to the point where they can know enough to make an informed decision. That’s where it really gets powerful. But how do we know?

Knowing the Rules of Private Equity and the Private Markets

[00:34:21] Dean Barber: And the other thing too that I think people need to be aware of are the companies that are doing what your company is doing. There are going to be a whole bunch of them out there right now that are saying, “Hey, we got the corner on how to invest in private equity or the private markets.” But they’re all built different. They all have different rules. And so, again, make sure that you understand what’s going on behind the scenes as much as possible.

[00:34:50] Michael Faciana: Do your homework. Be educated. And most certainly get the advice because otherwise, how would you know? Like Dean said, you don’t know what you don’t know.

If you go back about four or five years in private equity, there was roughly about $3.5 trillion in assets under management by all these private equity companies. Today, it’s closer to $11 trillion. To Dean’s point, I think a lot of people if the 60/40 stock and bonds is going to get them where they need to be over the next 10 or 20 years. There are a lot of people trying to capitalize on that that don’t have level of expertise and knowledge to provide those investments to your clients. There are 10,000 mutual funds, but there are a lot of private equity funds too. You need to do your homework.

Find a Financial Professional Who Can Explain Private Equity to You

[00:35:39] Michael Faciana: You need to work with somebody that can vet, because there are a lot of them. Sit down and meet with them and get that initial clearing that these guys are good and know what they’re doing. You need to work with financial professionals who are legitimate and have a great track record and history so you can trust them.

[00:35:54] Dean Barber: Totally agree. Well Mike, thanks so much for joining me on The Guided Retirement Show. I’m sure that everybody has learned something, so thanks again for your time.

[00:36:07] Michael Faciana: I enjoyed it. Thank you very much, Dean.

It All Starts with a Plan

[00:36:08] Dean Barber: Don’t forget that we’re offering you access to the same financial planning tool we use for our own clients. Just click the “Start Planning” button to begin building your retirement plan from the comfort of your own home.

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If you’d like to visit with one of our CERTIFIED FINANCIAL PLANNER™ Professionals about investing in private equity, you can schedule a 20-minute “ask anything” session or complimentary consultation by clicking here. As always, thanks so much for joining us on The Guided Retirement Show.

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