Capital Markets & Private Equity
On this episode:
Doug Brody, a Managing Director at KKR, joins the show to discuss his career in capital markets and the basics of private equity. Doug outlines the process of finding and making deals, the structure of leveraged buyouts, and how private equity firms leverage operational efficiencies and financial engineering to create attractive returns. We also discuss common PE exit strategies and how KKR responded to the pandemic to ensure the health of its portfolio companies.
Interview Recap:
5 Quick Bites
Reading list: The Power Broker by Robert Caro, History of Rome by Livy, Steinbeck novels
Skill or topic you’re interested in developing? Fishing & tennis
How do you stay up to date with the latest developments in your industry? One of Doug’s clients summarizes every article related to the industry at 6 am and emails it to him! How cool is that?
Favorite CEO? No one’s perfect, but the CEOs of KKR are pretty cool people!
What industry would you be interested in starting a company in? Health & wellness, especially mental health
What is a capital market?
The capital market sits in between the investment bank and the sales and trading side. Doug’s team interacts closely with investment bankers, buy siders (such as hedge funds) and those in sales and trading. Private equity firms also use capital markets a lot.
There are 2 types of capital: primary and secondary.
Primary capital is new money being contributed to businesses.
Secondary capital is when one owner is purchasing ownership from another owner.
As companies progress from venture capital to private equity, there is less primary capital and more secondary capital. Investors also take on a more hands on approach as capital moves from early stage to later stages.
What metrics do KKR look like before making large investments?
KKR’s goal (and every PE firm’s goal) is to sustain and grow the capital they’re given. Here are some selection criteria they look at:
What portion of the market does the company control?
What are the pricing dynamics of the end market they service?
Customer concentration
ESG alignment - evidence shows firms with positive ESG ratings perform better than those with negative ones
The company’s ability to withstand leverage
EBIT/EBITDA
How are investment deals created?
Proprietary deal: A bilateral deal that is secured through personal networks & relationships that doesn’t include an auction.
The bidding process: KKR competes with other PE firms to secure a deal.
Identifying a target and going after it: Sometimes, KKR will reach out to a firm that they want to invest in. They send a letter to the board and may or may not participate in a bidding process.
PE can be risky because 9 out of 10 deals need to work out in order for the investment to be successful. Doug and his team aim for a 20% gross IRR (over 4 - 5 years) and a 2 - 3x equity multiple in their investments. In other words, all their investments need to be winners!
How long does due diligence take?
Quite a long time! Doug and his team could track companies for YEARS before deciding to start a deal.
Once they decide to invest, there’s a 6 week bidding process that includes multiple presentations and outsourced due diligence teams.
How competitive is the bidding process?
It’s pretty intense.
There are lots of laws to follow, e. g. KKR can’t engage in anti competitive behavior by teaming up with other PE firms to lower the price.
Deals can take a long time, which means that everyone involved is emotionally invested in it. There’s some pros and cons of this - staying objective is important, but so is recognizing the opportunity cost of waiting for the price to go lower. (Time spent negotiating a deal = time that could be spent doing something else!) Staying disciplined and emotionally balanced is very important.
Here’s an interesting fact: KKR sees no meaningful difference between the outcomes of their proprietary and bidding deals. This might not make sense at first, but remember, it’s not where you buy, it’s where you sell!
How did KKR’s approach change in response to COVID?
KKR has always played a defensive role and focused on diversification in their portfolios, which really helped when the crisis hit. Here are some things they did:
Went remote (like everyone else!)
Conducted an intensive portfolio review to see where they could help.
Raised money for the communities of their portfolio companies that were impacted.
Made sure the companies in their portfolio were well financially positioned. If they weren’t, KKR supported them with capital.
What advice would you give college students today who are interested in finance and capital markets?
Develop the ability to recognize patterns.
Pay attention to periods of distress. The impacts of COVID are a great learning opportunity and could be forgotten down the road so soak it up now!
Learn the language of finance. It probably seems intimidating on the surface, but it’s actually really easy to understand once you make the effort.
Have faith in yourself. If you feel like a fraud starting out in finance, don’t worry - everyone feels that way and the feeling never really goes away!
Say what?
Refinancing: Companies will refinance their debts when interest rates get really low. You can get a new loan to pay off your old loan!
EV/EBITDA: a valuation metric that Doug and his team uses to measure the profitability of a company and how they compare to the industry and their competitors.
EV (enterprise value): a measure for the company’s total value that takes into account the opportunistic nature of the company. Factors that affect this include how much debt and cash are on the balance sheet.
EBITDA: Earnings before interest, taxes, depreciation, and amortization. This is used as a proxy for a company’s current profitability.
“It’s not necessarily where you buy, it’s where you sell”: If paying a little more on the initial offering price of an investment generates a great return and exit, take the sacrifice because it’s worth it!
Equity cost of capital: Rate of return that investors are expecting for contributing their capital.
Floating rate debt: Debt that is tied to changing interest rates (contrasted with fixed interest rates that remain the same throughout the life of a security.) This can be risky or beneficial, depending on whether future interest rates rise or fall.
Interest rate swaps: Complex financial strategies that swap fixed & variable rate debts to generate a higher return.
Fun fact: Doug majored in studio art during his undergraduate years at UVA!
Takeaway Quote: “You may think early in your career, ‘I’m such a fraud, I don’t understand this stuff.’ I’m 37. I’m an MD at KKR, and I still think I’m not fully prepared for where I am. But I can tell you that you should trust yourself to dig into things and understand things. It’ll go a long way to have that kind of confidence.” (45:20)
To learn more about Doug and his work, visit https://www.kkr.com/?lng=1.
