How to Invest with a Permanent Approach: Underwriting Based on Exit Arbitrage vs. Free Cash Flow
Most private equity funds are set up to operate for 7 to 10 years. That term means that the firm has to buy, operate, and sell any investments within that timeframe. So when making an investment, traditional private equity funds are underwriting based on how, when, and to whom they will sell a company. This investment underwriting approach, or how the investing firm defends the money being invested in terms of future potential gain, is anchored on exit arbitrage.
Let’s say you own a home services company operating in two mid-sized metros, making $3 million in net profit on roughly $15 million of gross revenue. Underwriting to an exit arbitrage means that the investing firm expects that you can collectively grow your organization by XX% per year, and also acquire 2 or 3 other companies of similar sizes, bringing net earnings to $12M+ within three years. At that point, they know of several larger private equity firms in the home services space that should be willing to pay a higher multiple on the larger earnings set, and their return on investment will be realized in that process. Based on this belief, the firm will invest in your company using a combination of debt and equity (called a “leveraged buyout”), expecting to sell it for significantly more in the next 3 to 5 years.
So what’s your reaction to that scenario?
A. “It sounds compelling.”
B. “That seems like a strong combination of luck and skill will be required.”
C. “Won’t it risk the company’s brand, quality control, and/or team culture?”
D. Some combination of the above.
There’s no objectively wrong answer. And truthfully, in individual cases it’s usually one or more of those things.
Sometimes there are clear paths to growth. Sometimes great things happen when you merge awesome teams together. Sometimes there’s a worthwhile future owner in the wings, and everybody wins. But also, things rarely go according to plan. And with all that change, there will inevitably be sacrifices and unintended consequences (e.g. role cuts, name changes, relocations). As an owner, you have to determine what risks and costs you’re willing to absorb in order to seek the future outcome of that next sale.
That is, if that’s the outcome you’re after.
Private equity and leveraged buyouts have become synonymous, but technically there is more than one way to invest in private companies (a.k.a. private equities). Because leveraged buyouts often need an exit in order to pay off all the initial transaction debt, exit-oriented underwriting became the standard. But what if you don’t want your company to be sold every 3 to 5 years?
At Permanent Equity, we invest with no intention of selling and have not sold an investment in 15 years and counting, making an exit-oriented underwriting approach a poor fit. Rather, we do what generations of families have done: we underwrite free cash flow.
To set a common definition, free cash flow is the liquid earnings generated through operations over which the owner can exercise free will (meaning after necessary maintenance capital expenditures, changes in required net working capital, etc.). They can take distributions, reinvest, let the cash sit on the balance sheet, or some combination of the three without influencing the business.
When underwriting free cash flow, we are considering the company’s consistency and magnitude of earnings over time, and also what a dollar reinvested can yield in growth. When you have a compelling value proposition that consistently generates cash, you enjoy optionality on how to navigate the future.
Successful entrepreneurs recall major pivot and inflection points where flexibility and independence were a friend in responding to a crisis or seizing an opportunity. We stay pretty humble when it comes to predicting the future and maintain that autonomy shouldn’t go away when your company takes on an investment partner. For these reasons, we avoid leverage in transactions. And these experiences inform our operational priorities to do no harm and grow without goals.
30-year funds afford us the luxury of maintaining optionality. Sometimes that may mean growing through acquisition, but not necessarily. Sometimes it means years of stable earnings, but lots of capability-building and structural reinforcement to be able to take leaps in the future. Sometimes it means investments in new roles to expand productivity, and sometimes it means reinvestments in technology or capacity to expand offerings.
In confirming priorities and decisions at any one point in time, we can maintain balance on what makes sense both short- and long-term for the company, given its positioning, internal capabilities, and the broader macroeconomic environment. In short, we never have to be a forced actor.
One day, Permanent Equity will sell a company. But it will be because it’s the right next step for that company’s future, and not because that is the only way to generate a return or satisfy investors. We believe that returns can be generated perpetually – the same way independent owners do – or we do not invest.
In the end, underwriting cash flow has allowed us to align interests between our investors, ourselves, management teams, and the owners who sell equity to us. The shared belief is that through a less traumatic transition and a stable ownership structure, a high-quality, cash-flowing organization can continue to chart its own course, just with more resources in its corner.
What kind of investors sign up for a 30-year fund? What kind of sellers prefer a permanent approach? The short answer is those that care what happens next. They believe that intentional growth and patience pay off, and, by extension, that flipping businesses to the next buyer may not create the optimal long-term outcome for everyone involved.
Read more in How Permanent Funds Work.
Or, reach out to start a conversation.
