Don’t Count Your Dollars Yet! The Truth About PE Valuations

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Welcome to the Private Equity Experience Podcast.
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Your backstage pass to the strategies, stories, and secrets that drive value in the PE universe.
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No filters, no fluff, just straight talk and expert insights to help you navigate the private equity world with confidence.
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And now your hosts, ed Barton, Rory Leaphart, and Emily Sander.
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Yeah.
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like your necklace by the way, dude.
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Is that like a, is
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Thanks.
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Etsy buy or...?
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Actually, it is, as a matter of fact.
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Yes.
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Yep.
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It is an Etsy buy.
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Spot on, actually.
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Yeah.
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Yeah.
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Yeah.
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Yeah.
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No, I love
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Thanks.
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Yeah.
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Yeah.
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Very cool.
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Okay.
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Big Riggs, manly Etsy necklace man, um, you came up with the Wall Street Journal article that, uh, I could not read'cause I'm not fancy like you and subscribed to that, but it, the title was Crazy Math.
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it was,
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And so what, what,
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Yeah.
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what is this article about?
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What's it talking about?
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it i- the, the article was a Wall Street Journal article published a couple weeks ago.
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It was called"The Crazy Math Confronting Everyday Investors in Private Markets." And these articles are clickbait in a lot of ways, which clicked me in, and I was baited and hooked to read it.
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And, uh, this one was actually about really bringing into context today how there's this perception that private credit, which is an asset class of its own, but different than private equity credit being, you know, debt financing versus equity being, you know, um, ownership, if you will, rather than lending to the, to the folks listening out there.
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Um, you know, there's been this, there's been a couple public- publicized stories where, you know, big investors in private credit funds have, um, you know, redeemed from the funds that they are in, and so the funds themselves are, you know, i- in some ways struggling with liquidity.
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Although, I think, I think the story's been overblown.
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But the point is that this article is saying,"Hey, um, private, private credit funds are having problems with investors leaving based on performance of their loan portfolios." So you have a couple bad loans go, or a couple loans go bad, investors say,"Oh, I don't want any one of-- I don't want any more of this asset class.
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I gotta get out of it." That's the perception.
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Um, they're comparing it to private equity, which is a different asset class for a variety of reasons.
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Um, and the, the, the thought that maybe that if there's performance issues within private, private equity funds, that maybe investors would get scared and, and run away too, which, you know, I don't think that's ever gonna happen en masse.
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But, um, one of the things that was brought up in this, and this is where, you know, we can kinda talk about some more esoteric elements, is that- Um, private credit funds, how they account for their portfolio is very different than private equity funds because, uh, a private credit fund is, uh, is making loans to middle market companies or other, other funds and things like that.
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And so their upside is capped, so they're basically accounting for losses, but they're not re- they can't really reap more gains than what their, their, their coupon is really, and, and some other small elements to that.
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Whereas private equity funds book gains on the acquisition of their portfolio companies.
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So there's some, there's some esoteric gain on purchase and sale, uh, math that goes into it, and how that plays out is, um, you know, some managers are incentivized based on fund performance, and fund performance is dictated by the way some of the accounting rules work.
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It's not just always just based on cash flow.
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So it just brought up a whole host of questions around, well, what is, how do, how, how is private, private equity account for performance of its portfolio?
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How does it mark that to market as it should be on a quarterly basis, yada, yada, yada.
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So it was kind of like a clickbaity story, but it made, uh, me think about, hey, maybe our listeners wanna know all about the ways in which the accounting for, um, acquisitions of companies and, and participations in companies, uh, is booked on the balance sheet and tested.
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Probably not, but maybe they are.
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Who knows?
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I, I'm sure all two of the listeners left are intrigued by this, this topic.
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Um,
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Yeah.
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just to like for, for my refresher, uh, private credit is like the, the debt side.
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So
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Yeah.
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rattle off some common examples just so people...
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Uh, as far as names go, like, uh, Blue Owl Capital, Castle Lake, and then you, you know, as we've, as Ed and I have mentioned before, like you have big firms that have both private equity and a private credit, uh, you know, call it, you know, business.
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So Blackstone would be an example of that, something like that.
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So big, big funds, billions and billions and billions of dollars.
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What-- But what's like a...
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Okay.
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Now your, your challenge here, as Rory kind of noted, is liquidity when it comes to private debt is a different animal than it is for private equity even.
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Because
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Yeah.
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you think about kind of the nature of debt, it's a fixed...
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normally a fixed term instrument that you're lending.
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And you're lending knowing the risk profile of that borrower is not bankable or
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bankable.
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So, so no normal bank is gonna extend credit to that borrower.
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They're probably pre-profit.
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They're, they're...
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They may be pre-revenue.
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They have-- And so normally with these private credit, there's, there's structuring in the private credit instrument you know, potentially allows for warrants
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Yeah.
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or something which is an opportunity to buy equity when the company becomes successful.
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Or there's, you know, different escalators on repayment, or it's gonna be cashflow-driven repayment as opposed to a steady, you know, you pay back$10,000 a month plus interest.
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It's gonna be, you know, if your revenue is this, if you pay back this
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Yeah.
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revenue is less, you pay less, and if your revenue is more, you pay more.
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There's a structuring in those that allows what would otherwise be a non-creditworthy borrower to borrow the money, and the folks lending into that space are essentially, you know, again, they're looking for private equity type returns.
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Private credit is, is looking for similar returns to private equity because got a, a similar risk premium.
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So for private credit, you're the
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Yes.
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and then just give me an example of like what type of loan I would-- like what type of loans are we talking about?
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Uh, construction loan perhaps, or an infrastructure building loan.
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So just, just what Ed said is, like, it's not that sophist-- I mean, it's not that complicated in the sense that it's no different than taking out a personal loan, you know, for ten grand that you pay o- back over three, three years.
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In this case, it's like you're taking out, you know, tens of millions, hundreds of millions of dollars that you are agreeing to pay back principal and interest in, you know, five years, ten years.
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So, and let me get, let me, let me give a real-life example Rory and I
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Yeah.
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We dealt with the old RBS Greenwich Capital back 20 years
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Yeah.
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Yeah.
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and the deal that we had with RBS Greenwich was essentially they let us borrow to buy big portfolios of bankrupt consumer debt.
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They would lend us, on the first deal we did with them, 95% of the purchase
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Yep.
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Yeah.
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Mm-hmm.
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And they said,"Okay, now you..." And then you'd get this little, what they call a servicing strip.
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So they would go,"You could get$10 per account to manage it." as cash flow comes in, we get all the cash flow except for a small amount to repay principal plus interest.
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And then once the loan's paid back, we get 80% of the cash flow after that.
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So that, that's
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yeah.
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a classic private, kind of private credit experience where the, the structure of that note is done in such a way that no bank would ever do that.
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But RBS Greenwich Capital was kinda like their non-traditional-- Was RBS, Royal Bank of Scotland's non-traditional, non-traditional arm, and they made loans like that all the time
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Okay, wait.
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I gotta back up'cause my,
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Hmm?
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um, So private credit, I'm a lender.
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This is a loan.
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And so the whole mechanism is kind of flipped from private equity.
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So y-y...
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Yeah.
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category.
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And then, so the way I earn money in private credit, you said, Rory, it was capped.
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Like, what are like the basic mechanics of like you, you give a loan and then you get the loan repaid
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That's it.
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Yeah.
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supp-supposed to be predictable and
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Yeah.
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I mean, uh, y- that, that's the way to think about it.
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Now, of course, again, what Ed said is also true, is there's usually some sort of equity incentive or kicker, if you will, to that the lender is granted by-- for doing that loan.
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But by and large, that's
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And this...
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that's a whole'nother...
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Just think about it this, the difference between that and private equity is like private equity wins when they buy a company low, do a bunch of stuff operationally and financially, and sell it high.
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The difference is their profit.
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Well, for a private credit fund, they just make money on that interest that they're charging.
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Okay.
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Okay.
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So
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Yeah.
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a
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Completely different category.
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Yeah.
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this would be like kind of
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Yeah.
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Y- yes.
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Yeah.
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reluctantly,
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yeah, I
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Okay.
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yes.
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Yeah.
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There's obviously, you know, lots of caveats to that.
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Of course, there's different gradations and grades of loans and, uh, ratings and things like that, um, that, you know, the highest quality private equity play could be, um, less risky than the lowest quality credit play.
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But yeah, I mean, that's the way to think about it.
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So, so is it, um, these types of loans a normal bank wouldn't take'cause they're too risky or just because they're structured in a kind of a way?
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Yeah.
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Both, both are largely true.
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Yeah.
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Exactly.
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Now, the, the issue, as Rory was noting, is you've got-- these have two elements, and one of which is what's this loan carrying value?
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So how is it valued for an investment perspective?
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So is it
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Yep.
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So is, e-essentially, are we gonna get our money back?
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yeah.
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That's one way to think about it.
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Is it stumbling along?
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Yeah.
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in a
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Yeah.
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Yeah.
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Is
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Yes.
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A-and then the second piece is
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Oh
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Yeah.
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my
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in the sense that in order to get the money out, you've got to
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Yeah.
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the company or you've got to sell your shares on a secondary.
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It's the same thing with private debt, where you essentially-- or private credit, where you, i-in order for you to be able to get your money out.
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So when somebody goes,"I want out of this fund," they-- you've got to be able to get that loan paid back by somebody, or you got to sell the loan to somebody.
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Yep.
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Well, that's a different--
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if you're selling a loan, it's not being sold at par either on something like that.
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It-- yeah, so
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Now
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par value is like the actual face value of a loan.
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hell?
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All right.
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Yeah, this is-- and, and what's funny is like Rory
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drunk.
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Rory and I, we're both on the private l- uh,
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know,
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We did,
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credit, we've
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yeah.
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private credit, and
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That's, that's fantastic.
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But so, okay,
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so we, we might get geeking out and talk like words that no one
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It's gonna
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got it.
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be a five-hour podcast.
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No, I was kidding.
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got it.
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What are you carrying?
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What's the carry?
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What is just, like, simple definition?
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Carry
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It--
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is...
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the value of the asset.
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It's that, it's that simple.
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And then impaired, impaired is
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Yes.
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Yes.
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So
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It's a really good segue, by the way.
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company a million dollars,
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Yep.
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normally you would have that loan on your books, and you'd value that loan at a million dollars.
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But if you think that it's not gonna get paid back or it's delinquent or it's something, you, you impair that.
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You reduce the value to maybe$700,000.
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by doing that, Emily and listeners, that difference between the prior carrying value and the new value that's impaired is basically take-- it's taken as a loss.
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So if you think about that, it goes from the balance sheet to the income statement.
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Now we're getting...
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And that
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Yes.
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Oh,
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as the, as the manager, it impacts my
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Yep.
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on the assets under management because now those
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Boom.
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That was a perfect segue there, Emily.
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Exactly.
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That's it.
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And so, so therein lies the, the interesting part, and that's-- we're just talking about private credit right there.
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It's, that's just, it's actually pretty simple.
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One thing that does need to be noted is that you're required to test these loans and these assets for impairment quarterly,
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Oh.
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right?
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So Ed and I, a-again, we worked at a company together where we built an entire system where we would literally test thousands of portfolios in an automated fashion every single...
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We did it monthly, actually, but we reported quarterly.
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Yep.
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Uh, we did it monthly, and we would basically book a shitload of journal entries that were at the portfolio level, basically gains and loss On the portfolio and, and without getting too crazy into the GAAP accounting, because that's even-- it's, it's, it is very complex, but you can reverse losses.
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You can, you can take gains as well.
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It just hap...
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Yeah.
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So it's t- it's point in time, but the point is you're supposed to do it every quarter.
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And guess what?
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It's e- you know, with, with loans, it's pretty easy to determine what the, what the impairment is.
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Are you getting paid back on time?
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Yes, no.
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What's the magnitude of, of, of the miss?
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Then you basically impair it.
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Well, think about pr- well, transitioning that to private equity, which is the crux of this, this article, is to say,"Well, hey, that's all happening for private credit, and people are freaking out." Well, what about private equity?
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It's even more wild because private equity, what can happen is when a fund acquires an interest in a business, it puts it on its balance sheet as, um, puts it on its balance sheet.
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But in the process of that, there's all sorts of things that go into how much is put on the balance sheet.
00:15:07.085 --> 00:15:10.384
In other words, you can book the purchase price.
00:15:10.384 --> 00:15:16.514
You could, you could book the value of the asset at different value than what you actually paid for it.
00:15:16.514 --> 00:15:19.485
You basically can make the case that I got such a screaming deal.
00:15:19.695 --> 00:15:22.004
In a lot of cases, that's true for a private equity fund.
00:15:22.004 --> 00:15:29.884
It's, they're buying something that's got way more intrinsic value than what they paid for it, because maybe they bought it in distress.
00:15:29.884 --> 00:15:35.335
Maybe it's a perfectly good company that just ran out of cash and had no prospects for getting more cash.
00:15:35.335 --> 00:15:36.924
They're like,"Wait, this is a good business.
00:15:37.125 --> 00:15:37.634
We'll pick it up.
00:15:37.634 --> 00:15:45.725
We got the cash." But anyway, so the point is, you can do all of these, these, um, calculations about market value and things like that.
00:15:45.725 --> 00:15:49.054
It's kind of subjective, and you can put on your balance sheet a certain value.
00:15:49.485 --> 00:15:50.095
But guess what?
00:15:50.095 --> 00:15:56.544
You still have to do, uh, they call it mark-to-market, uh, impairment testing, if you will, and you do that quarterly as well.
00:15:56.544 --> 00:16:00.294
I think y- you can go for, like, a period of time before you actually do that, I want to say.
00:16:00.934 --> 00:16:03.164
But over, at a certain point in time, you're doing it regularly.
00:16:03.784 --> 00:16:16.475
So think about the fact that there's all sorts of subjective, uh, ways to look at a market of va- market value of a company, and so you can make a case for any number of things at even an inflated value.
00:16:16.475 --> 00:16:47.465
So you might be able to kind of surmise that there might be some moral hazard in that, where, you know, somebody that runs a fund might be incentivized to keep a value inflated for just a little while, uh, while we work this other portfolio company out so that they don't, as Ed said, lose that denominator from which their 2% asset management fees calculate off of and their profits interest that is, you know, uh, partially due to the actual book profitability of that fund.
00:16:47.684 --> 00:17:01.990
So it's way more complex, I, I would say, or I guess more subjective than Private credit, but s- so, you know, you c- people aren't running to the-- people aren't rushing to mark things down, let me just tell you that.
00:17:01.990 --> 00:17:05.450
Like, unless they've already sold the asset and they're getting some tax benefit from it.
00:17:05.549 --> 00:17:06.099
I don't know, but...
00:17:07.089 --> 00:17:18.269
so it's kind of like they are figure skating of the Olympics, where like figure skaters are athletic, but they have these weird scores that are
00:17:18.420 --> 00:17:19.049
I'm tracking.
00:17:19.359 --> 00:17:19.779
Yeah.
00:17:19.890 --> 00:17:23.630
performance and like verve and what-- like what?
00:17:23.789 --> 00:17:25.589
Like, okay, the guy did a triple axel
00:17:25.849 --> 00:17:26.140
Dude,
00:17:26.339 --> 00:17:27.400
the costume, like I
00:17:27.470 --> 00:17:27.829
yeah.
00:17:28.059 --> 00:17:28.309
So
00:17:29.269 --> 00:17:30.119
Imagine, um,
00:17:30.339 --> 00:17:30.549
things
00:17:30.660 --> 00:17:31.029
look at the,
00:17:31.150 --> 00:17:31.480
on?
00:17:31.480 --> 00:17:32.920
public equities markets, right?
00:17:32.920 --> 00:17:41.920
Where it's all transparent and you're actually-- you look at some of the p- price to earnings ratios, which figures into the price of the stock, right?
00:17:42.549 --> 00:17:48.059
And this is, this is published information public, and, like, these valuation ratios are, are nuts.
00:17:48.690 --> 00:17:52.500
Think about certain sectors that are crazy hot, AI, that kind of stuff.
00:17:52.500 --> 00:17:52.960
Like, there's no...
00:17:53.660 --> 00:17:53.890
Aren't they
00:17:53.960 --> 00:17:54.660
That's what I'm saying.
00:17:54.809 --> 00:17:56.450
Like, it's, it's all relative.
00:17:56.490 --> 00:17:57.390
It can be relative.
00:17:57.390 --> 00:18:00.359
One can make a case of relativity on just about anything.
00:18:00.970 --> 00:18:08.470
We can say that this is a cyclical issue, that there's inherent, um, value in this business that's unrealized today.
00:18:08.940 --> 00:18:16.619
Uh, you can talk about it from a competitive standpoint, which is kind of like a competitive, like, mark on private companies, what transacted previously.
00:18:16.619 --> 00:18:19.170
You can put yourselves-- I've, I've been in companies that have done this.
00:18:19.170 --> 00:18:23.809
I've been, I've done these calculations where it's like, where's your company amongst its peers?
00:18:23.809 --> 00:18:28.839
Well, these are all private companies, so how do you put a value on your business and, you know, what have you?
00:18:28.869 --> 00:18:41.539
And so the point is there's, there's a lot of ways to, um, uh, how do I delicately put it without saying game things?
00:18:41.539 --> 00:18:48.779
But like, you, you can, you can engineer yourself out of taking big losses or you can engineer gains.
00:18:49.400 --> 00:18:54.819
But at some point, as we do all know, uh, you do-- private equity doesn't make for life.
00:18:54.819 --> 00:19:03.349
So like when you do sell the asset, let's say you kept it at a way inflated value and you sell it way down here, you do have to pay the piper at some point.
00:19:03.849 --> 00:19:18.259
But along the way, who's really incentivized to, you know, um, keep, keep things, um, marked to market in all cases objectively if you're talking about fee income being driven from that?
00:19:18.259 --> 00:19:18.410
That's
00:19:19.634 --> 00:19:19.835
Yeah.
00:19:19.839 --> 00:19:19.910
a,
00:19:20.085 --> 00:19:29.724
I, what I would, what I would say is I have seen on-- in my private equity experience, when you have a home run hit, at that point, they might
00:19:29.970 --> 00:19:30.720
reasonable question.
00:19:30.750 --> 00:19:31.069
Yeah.
00:19:31.164 --> 00:19:31.244
to
00:19:31.349 --> 00:19:31.410
Yeah.
00:19:31.694 --> 00:19:32.055
down to
00:19:32.069 --> 00:19:32.130
Yeah.
00:19:32.355 --> 00:19:32.394
of
00:19:32.480 --> 00:19:32.740
Yeah.
00:19:32.750 --> 00:19:33.539
Oh.
00:19:33.694 --> 00:19:34.365
kinda..." So
00:19:34.410 --> 00:19:34.599
That's a
00:19:34.734 --> 00:19:35.154
maintain
00:19:35.289 --> 00:19:35.720
call.
00:19:35.950 --> 00:19:36.289
Yeah.
00:19:36.775 --> 00:19:37.335
but we're
00:19:37.529 --> 00:19:37.849
Yeah.
00:19:37.904 --> 00:19:43.644
bringing that other valuation down as we realize a big value on something else so that it kinda
00:19:43.880 --> 00:19:44.259
Yeah.
00:19:44.325 --> 00:19:46.184
it a little bit and keeps the reported
00:19:46.220 --> 00:19:46.460
like at
00:19:46.464 --> 00:19:47.025
return higher
00:19:47.289 --> 00:19:48.730
when you kind of dump some
00:19:48.769 --> 00:19:49.619
Loss harvesting.
00:19:49.619 --> 00:19:50.509
Yeah, exactly right.
00:19:50.509 --> 00:19:51.329
That's a great call.
00:19:51.384 --> 00:19:51.704
Yeah.
00:19:52.890 --> 00:19:53.099
Yeah.
00:19:53.619 --> 00:19:53.720
Okay.
00:19:53.880 --> 00:19:58.329
So is this article saying there should be more of the impairment checks
00:19:58.579 --> 00:20:10.990
more of an expository article in, in such form that like, it's just saying,"Hey, for all of you don't, that don't know about this, this, this happens." This-- You're, you're worried about private credit and people fleeing from the,
00:20:11.019 --> 00:20:11.099
okay.
00:20:11.339 --> 00:20:12.759
from the, the funds.
00:20:12.759 --> 00:20:18.119
Well, private equity is bigger and is even more, uh, squishy.
00:20:18.144 --> 00:20:19.005
Subjective.
00:20:19.319 --> 00:20:19.559
Yeah.
00:20:19.559 --> 00:20:24.809
So if you're into certainty and things like that, then, you know, um, that's so- that's something to think about.
00:20:24.809 --> 00:20:27.650
It's more just an intellectual article.
00:20:27.700 --> 00:20:28.890
Like I said, clickbaity.
00:20:28.920 --> 00:20:31.759
I found it interesting, but, you know, I don't...
00:20:32.059 --> 00:20:35.619
This is, this is how it's always been, probably how it always will be, you know?
00:20:36.109 --> 00:20:49.069
So because if you-- I, I mean, how do you make the case the other way that like, there's a objective way to mark a private company to market based on m-myriad factors and that impact valuation in any day.
00:20:49.069 --> 00:20:54.240
These are not publicly traded, fully liquid securities, so how much of your value is liquidity based?
00:20:54.240 --> 00:20:57.140
How much of it is based on the fundamentals of the business?
00:20:57.140 --> 00:20:57.809
Things like that.
00:20:57.839 --> 00:21:04.920
How do you value a company that's just been part of a bunch of acquisitions that, like synergies?
00:21:04.960 --> 00:21:15.569
I think that's actually like one of the main, main, um, main, uh, like, uh, supports for certain valuation is like you create synergy, right?
00:21:15.569 --> 00:21:17.589
Like you bolt something onto another company.
00:21:17.970 --> 00:21:21.519
Well, those synergies will be realized over the next five years, and we're gonna factor that in here.
00:21:21.670 --> 00:21:23.240
You know, that kind of stuff, so.
00:21:24.400 --> 00:21:29.599
You know, it'll be interesting to see how these financial folks are evaluated.
00:21:29.599 --> 00:21:36.009
Like, are you getting, getting good marks for like,"I can creatively craft this subjective thing," and then it's
00:21:36.039 --> 00:21:37.190
That's an interesting question.
00:21:37.220 --> 00:21:37.690
where it's good?
00:21:37.839 --> 00:21:41.109
Or like,"No, no, no, like you had the biggest gap in the world where you're doing and you're, you're
00:21:41.369 --> 00:21:44.619
my guess would be CFOs can keep their jobs if they do it well enough.
00:21:44.680 --> 00:21:51.130
Um, uh, and don't, I don't wanna miscon- I don't wanna misconstrue the message here.
00:21:51.170 --> 00:21:53.049
All of this stuff is totally audited.
00:21:53.079 --> 00:21:57.970
So like, again, y-you're, you-- these are things that are modeled out.
00:21:57.970 --> 00:22:01.849
It's just that the variables are what's kind of somewhat subjective.
00:22:01.970 --> 00:22:05.369
Like you're not just making up, you're just not making up numbers generally.
00:22:05.369 --> 00:22:13.339
You're, you are creating a case for it because you will be audited, but the auditors will look at this stuff and say,"Okay, I can see the logic in it.
00:22:13.339 --> 00:22:19.049
Can I actually like prove it out?" Not necessarily, but that's not necessarily what the barometer is.
00:22:19.049 --> 00:22:22.759
It's like, is there supportive, uh, thinking behind this?
00:22:22.759 --> 00:22:25.150
And yeah, I mean, generally it is, yeah.
00:22:28.680 --> 00:22:29.140
Does...
00:22:30.039 --> 00:22:32.470
Is this one of those things where it's like,"Everyone's doing
00:22:32.799 --> 00:22:33.259
Kinda.
00:22:33.359 --> 00:22:33.440
I
00:22:33.470 --> 00:22:33.779
doing
00:22:34.150 --> 00:22:34.400
yeah.
00:22:34.710 --> 00:22:35.039
Yeah.
00:22:35.079 --> 00:22:35.150
I
00:22:35.440 --> 00:22:35.809
Okay.
00:22:36.200 --> 00:22:52.545
I would say that like, you know, um, I don't know that there's like a pervasive like direct,"Hey, what's the performance of this fund?" To our investors, are we hitting our 10% preferred return to our investors?
00:22:52.994 --> 00:22:57.115
If so, then, you know, we can be a little more conservative on the mark.
00:22:57.154 --> 00:22:58.644
If not, then we could be more aggressive.
00:22:58.674 --> 00:22:59.805
I don't think that's happening.
00:22:59.865 --> 00:23:09.674
I just think that there's just, you know, people put thought into how to, how to put it on the balance sheet originally based on the, uh, acquisition, and then they basically test it from there.
00:23:09.674 --> 00:23:24.575
And unless there's some major sea change reason to market-to-market, um, or like Ed said, you know, kind of since situations come up where there's like a home run where it's like, okay, you know, uh, we probably ought to, you know, sort of slow things down.
00:23:24.575 --> 00:23:37.765
Like, you know, it's just why are you gonna spend the time every quarter to do a comprehensive market valuation to justify whether your, you know,$100 million investment is appreciated or depreciated by 3% either way, you know?
00:23:38.734 --> 00:23:39.384
It's just not gonna happen.
00:23:42.193 --> 00:23:49.624
Yeah, I'm kind of wondering, like, I remember it's different than accounting and balancing the books where you wanna be like penny perfect if you
00:23:49.875 --> 00:23:54.345
it is, uh, this is an accounting, this is an accounting exercise 100%.
00:23:55.025 --> 00:24:03.724
Um, but, but finance fuels accounting in this case, or I should say, you know, financial planning and analysis fuels accounting.
00:24:04.444 --> 00:24:07.375
Um, the accountant is just booking the journal entry on it.
00:24:07.375 --> 00:24:09.234
The balance sheet still does balance, I promise you.
00:24:09.684 --> 00:24:15.835
Um, but the, the, you know, the, the, the analytical teams are the ones doing the work.
00:24:16.125 --> 00:24:37.565
Um, and like I said, I think quarter to quarter, not a lot changes unless you do have like, you know, maybe the, the, the operating company itself underlying that investment either buys and sells another, um, com- part of, you know, either divests parts of itself or acquires a, you know, ancillary business or something like that, which you would then record, so.
00:24:38.494 --> 00:24:47.204
Um, but I think, um, you know, this, like I said, I think this article is interesting just'cause I think it might be an eye-opener for people that are intellectually curious about it.
00:24:47.234 --> 00:24:53.384
But I think, you know, anyone that invests in private equity understands private equity for what it is.
00:24:53.414 --> 00:24:58.394
It is a risk-based investment, more so than a credit investment for the most part.
00:24:58.914 --> 00:25:10.174
And so, you know, I don't think you're gonna see a lot of people fleeing for the, um, exits because of like some revelatory article in Wall Street Journal about how the accounting works.
00:25:10.174 --> 00:25:13.265
So at the end of the day, it's still really about cash.
00:25:13.295 --> 00:25:15.224
So, um, you know.
00:25:15.555 --> 00:25:26.575
But, but you know, maybe private equity fund managers kind of keep tabs on things so that the, you know, incentive fees and, and asset management fees are not out of whack quarter to quarter.
00:25:28.805 --> 00:25:38.414
Reputationally, like just, just like on the street, it's like,"Oh, like private credit is way more risky," or like,"Oh, private equity is like you're kind of rolling the dice
00:25:38.684 --> 00:25:43.704
My, my impression talking to folks is people still don't really get private credit.
00:25:43.845 --> 00:25:47.825
They don't-- It's just, i- which is a funny thing because it's been so much more
00:25:48.744 --> 00:25:49.085
They were like
00:25:49.180 --> 00:25:49.460
Yeah.
00:25:49.460 --> 00:25:56.480
No, but now you're-- you, you took, you took, uh, you know, 22 minutes to, like, figure it out, and you're like,"Oh, yeah, I get it now." Like, um,
00:25:56.755 --> 00:25:56.845
Yeah.
00:25:57.730 --> 00:26:04.549
I think pe- but private credit, as Ed said, we've been doing deals in private credit for 20-plus years, and it's been a long far beyond be-before that.
00:26:04.579 --> 00:26:19.690
But, but people generally just look at these, this whole private equity or credit as just like this really scary alternative asset class that's like, you know, um, only the institutional investors plan.
00:26:19.690 --> 00:26:24.859
Which is funny because now this has never been more democratized for the masses than it is now.
00:26:24.859 --> 00:26:29.670
You, you know, as an individual, I can go participate in any private equity fund.
00:26:29.670 --> 00:26:33.160
Maybe not every fund, but, like, there's a lot of funds that are available to reta-retail.
00:26:33.160 --> 00:26:36.460
We're, we're retail investors, uh, let's, let's say.
00:26:36.660 --> 00:26:51.700
Um, it's available to everybody, and there's a lot of publicly traded private equity group companies that are large that you can, by buying the stock on the, you know, uh, Nasdaq or wherever it's traded, you're, you're, you have the same risk profile at that point.
00:26:51.809 --> 00:26:56.480
Maybe more liquidity with your own shares, but the underlying business is the same.
00:26:58.265 --> 00:27:03.194
its own category or is that within one of...
00:27:03.579 --> 00:27:03.930
it's...
00:27:03.930 --> 00:27:05.349
I don't know, Ed, what do you think on that?
00:27:05.559 --> 00:27:07.589
I, I'd be interested in your perspective there.
00:27:07.910 --> 00:27:08.019
Yeah.
00:27:08.644 --> 00:27:09.424
Yeah, it's in both.
00:27:09.424 --> 00:27:17.944
So real estate, it-- again, if it's private credit, there's generally gonna be a structuring difference between what you would get from a traditional commercial
00:27:18.160 --> 00:27:18.450
Yeah.
00:27:18.994 --> 00:27:20.625
you know, if you're doing a real estate development.
00:27:21.204 --> 00:27:30.875
Um, and that's generally gonna have either some level of escalator or graduated repayment or equity participation, along with it.
00:27:31.545 --> 00:27:32.555
Explain those three
00:27:32.644 --> 00:27:39.964
So an escalator is gonna be you borrow money for the, uh, development, and for the first two years,
00:27:40.130 --> 00:27:40.480
Yeah.
00:27:40.734 --> 00:27:45.565
development or you're building an apartment complex, for the first two years it's interest only at a twelve percent rate.
00:27:46.005 --> 00:27:52.464
And then once the apartment building goes live, you start paying principal, and then your interest rate drops to eight percent or seven percent.
00:27:52.984 --> 00:27:59.164
And then at ten years, and it might be on a thirty-year amortization, and at ten years you have to refinance the whole thing.
00:27:59.785 --> 00:28:03.684
So it may be that's gonna have an escalator or a graduated payment structure.
00:28:04.075 --> 00:28:13.734
Or it may be that you go,"Okay, we've got..." You know, the, the real estate developer borrows ten million dollars to build this, to build this building, and they put up certain amount of money.
00:28:14.065 --> 00:28:23.964
And if the building sells within the first, you know, five years or ten years, that the-- not only does the, uh, loan get paid back, but there's
00:28:24.160 --> 00:28:24.440
Yeah.
00:28:24.815 --> 00:28:25.525
penalty or
00:28:25.579 --> 00:28:25.849
Yeah.
00:28:26.585 --> 00:28:27.714
which is effectively an
00:28:27.740 --> 00:28:28.049
Yep.
00:28:28.049 --> 00:28:28.140
Yep.
00:28:28.765 --> 00:28:38.924
amount that says, okay-- or, or it's a profit participation amount that says,"Okay, if you really make a bunch of money and sell this thing, get-" You know, an additional, an additional
00:28:39.069 --> 00:28:39.420
Yeah.
00:28:39.474 --> 00:28:44.775
on it because you didn't hold-- you didn't keep our loan out long enough, which also slows down the
00:28:45.160 --> 00:28:45.480
Yeah.
00:28:46.750 --> 00:28:47.660
That's very common
00:28:47.805 --> 00:28:55.505
it's gonna have some of those types of structures in there on real estate that you're not necessarily gonna see in a deal where they're...
00:28:55.694 --> 00:29:05.525
You know, like the one that Rory and I were involved in, where it was really a different type of collateralized asset, which was loan pools, or into an operating company.
00:29:05.525 --> 00:29:21.275
But they all-- anything in private credit is going to have some variation on a traditional loan theme you know, makes it not what a typical bank on Main Street is gonna, is gonna offer to anybody, or even a JPMorgan Chase.
00:29:21.275 --> 00:29:24.295
Although, like a JPMorgan Chase does have a, a
00:29:24.400 --> 00:29:24.460
Yeah.
00:29:24.555 --> 00:29:30.845
of specialty lending group that will do those types of, those types of loans, which is how we ended up with RBS, Greenwich Capital.
00:29:30.994 --> 00:29:33.644
Greenwich Capital is Royal Bank of Scotland's version of that.
00:29:34.599 --> 00:29:54.940
But in theory, you could say,"I know where my money is going to be for the next 30 years and how the repayment schedule is gonna look like." And there's gonna ha- be some where they don't go to plan, but in some-- in a lot of ways, it's more predictable than like private equity, and we think this company is gonna grow to be the next Facebook and da, da, da,
00:29:54.974 --> 00:29:57.375
Yeah, but it's not a collateralized mortgage pool.
00:29:57.375 --> 00:29:57.914
It's not...
00:29:57.994 --> 00:30:07.214
I mean, it is a different risk profile with a different return profile because of the risk premium that's got to be built into that for illiquidity and for v-volatility.
00:30:07.845 --> 00:30:11.194
But it, it's sits somewhere between...
00:30:12.025 --> 00:30:14.605
And Rory described it earlier extremely well.
00:30:14.605 --> 00:30:19.934
Like, the best private equity is less risky than the worst private credit, and vice versa.
00:30:20.615 --> 00:30:20.855
You know?
00:30:20.855 --> 00:30:24.244
So it really should, all things being equal, if you look
00:30:24.269 --> 00:30:24.579
Yep.
00:30:24.765 --> 00:30:30.484
stack, the private credit's gonna be ahead of the private equity on a capital stack in any given company.
00:30:31.095 --> 00:30:37.305
But it's really how is that pool assembled, because it's normally a fund of, and so there's multiple investments.
00:30:37.305 --> 00:30:38.535
How's that pool assembled?
00:30:38.934 --> 00:30:39.734
And that
00:30:39.849 --> 00:30:43.849
Yeah.
00:30:43.924 --> 00:30:47.454
credit a little bit less risky than private equity, but not always.
00:30:47.805 --> 00:30:54.105
And within that pool, you're gonna have, you know, riskier and less risky loans and riskier and less risky equity investments.
00:30:54.914 --> 00:30:58.585
And you were mentioning, like, the, the grades earlier and there's different classes of things.
00:30:58.934 --> 00:31:03.335
Um, and then just to cover off on it, so what's the distinction for real estate?
00:31:03.704 --> 00:31:05.894
What would make it credit versus equity?
00:31:05.894 --> 00:31:06.865
You said they could be both.
00:31:07.744 --> 00:31:13.234
it's gonna have-- normally have some component in it that is not a traditional credit component.
00:31:13.865 --> 00:31:18.634
So a traditional credit component for a traditional mortgage on real estate is you borrow.
00:31:19.105 --> 00:31:32.855
The following month, you start repaying on an, on a amortization schedule that has essentially, for simpli-simplified, again, commercial is sometimes a little bit different, but basically has a level repayment a term of,
00:31:33.150 --> 00:31:34.609
Mm-hmm.
00:31:35.220 --> 00:31:35.480
Yeah.
00:31:36.160 --> 00:31:44.869
A private credit instrument and real-- that's secured by real estate may be in a second or third position, so it may not have the first mortgage.
00:31:44.869 --> 00:31:46.839
It may be in a second or third mortgage position.
00:31:47.289 --> 00:31:58.940
It may have something that varies that re-- that amount based upon collected, based upon completion, based upon some other methodology.
00:31:59.410 --> 00:32:18.740
And it may also have a, if the, if the project is sold or refinanced within a certain amount of time, and the amount is in excess of X or Y, that we have a participation in that profit the sale of the, on the sale of the business or on the sale of the development as part of our
00:32:18.855 --> 00:32:19.144
Yeah.
00:32:19.339 --> 00:32:19.900
package.
00:32:20.174 --> 00:32:44.295
I mean, I think on a practical basis, and this is just Rory speaking from Rory's perspective, I do look at real estate as a separate asset class in itself in the sense that the characteristics of what makes a real estate play successful or unsuccessful are, is different than investing in a private credit fund or like a, a, a, a credit strategy or an equity strategy.
00:32:44.964 --> 00:32:46.994
We were dealing with businesses and operating companies.
00:32:47.164 --> 00:33:02.474
That being said, like Ed, where I attach it all is to say, if I'm investing in real estate, I do wanna understand how leveraged that real estate fund is because that itself creates a different risk profile than something that's not leveraged.
00:33:02.525 --> 00:33:07.595
So more leverage, more risky, less leverage, less risky, basically, all things being equal.
00:33:07.994 --> 00:33:27.144
So I think the, the interesting thing about, um, real estate is that it is its own unique thing, but it, it's-- the level of performance and profitability dic- is dictated by, you know, kind of the level of debt and equity supporting that strategy, I guess.
00:33:27.184 --> 00:33:35.224
I mean, I, I guess you could say the same thing about any, you know, any business, but like, I don't know, it, it is its own unique thing.
00:33:35.224 --> 00:33:46.265
And the, the other thing I would say about real estate, since we're turning this into a real estate pod, which is great, uh, is that, you know, it's also, there's some s- very interesting tax strategies associated with that.
00:33:46.265 --> 00:33:53.884
So you can continue to flip properties and flip properties and flip properties on a 1031 exchange, which gives you significant tax benefits as well.
00:33:54.555 --> 00:34:19.005
Um, so it's, it's why it's generally offered as its own asset class and why we think about, like when we, we most, most individuals think about,"Hey, you know, I have my real estate, I have my home, like that's my own asset class," versus,"I also inves- I invest in the stock market too." People generally separate their investment holdings in like what properties they own and what like stocks and bonds they own.
00:34:19.034 --> 00:34:22.364
They don't really like think about it as one, one and the same, to make it simple.
00:34:24.699 --> 00:34:29.559
So if people are-- have read this article or have listened to this episode and now know
00:34:29.585 --> 00:34:31.155
Hit me up if you have any questions.
00:34:31.155 --> 00:34:32.775
Hit Ed up if you have any questions.
00:34:34.690 --> 00:34:37.909
what, what, if anything, should they do with this information?
00:34:37.909 --> 00:34:38.130
Or is it
00:34:38.315 --> 00:34:39.355
I don't know, just, just to
00:34:39.360 --> 00:34:40.059
and have a fuller picture"?
00:34:40.235 --> 00:34:40.614
add to that brain, you
00:34:40.695 --> 00:34:40.775
the
00:34:40.795 --> 00:34:44.315
It's just one more kind of interesting piece of information to have.
00:34:44.675 --> 00:34:59.815
I don't know that there's anything really applicable unless you're like, uh, you know, running a, you know, endowment or, you know, um, you know, like a sovereign wealth fund and, like, want to think about whether to run for the streets be-because of, like, accounting rules.
00:34:59.815 --> 00:35:00.704
But, you know, I don't...
00:35:01.525 --> 00:35:29.655
I think it, I think it is a-- I think the practical answer is, and, and Rory kind of talked about the institutional investor who's gonna have significant money is, there is a lot of squish in the valuation that your private equity fund is reporting to you on your private equity position and the underlying valuation of each of those companies within the pool, which are then aggregated to come up with a pool, you know, a,
00:35:29.954 --> 00:35:30.175
Yep.
00:35:30.195 --> 00:35:32.275
value or a fund value.
00:35:32.275 --> 00:35:53.164
So proceed with caution and don't, you know, basically don't count those, don't count those dollars before they hit the bank because they may be particularly, you know, in a period of rising interest rates or a period of uncertainty, they may be significantly, overvalued at present relative to what you'd be able to realize on a transaction.
00:35:53.164 --> 00:36:11.795
And that's the kind of the underlying piece of this is you're gonna get a statement or a report out from your, from your private equity general partner that says, you know,"Your, your portion of fund seven is worth eleven and a half million dollars." eleven and a half million dollars probably plus or minus
00:36:11.855 --> 00:36:12.315
Yeah.
00:36:13.144 --> 00:36:29.295
because that val- underlying valuations of the companies within there are s- are so subjective both in terms of value, uh, which Rory noted, you know, it's tough when you've got all these components in there that you could go,"Well, you know, what's the liquidity?
00:36:29.295 --> 00:36:42.784
What's the non-liquidity premium?" in terms of timing you know, that subjectivity really does provide a lot of, you know, like, like I said, plus or minus twenty percent would not...
00:36:42.784 --> 00:36:47.844
To me is actually probably a conservative estimate of how much that value can be in swing
00:36:48.005 --> 00:36:48.364
Yeah.
00:36:49.469 --> 00:36:51.800
So that's kinda like what I heard about nutrition labels,
00:36:51.954 --> 00:36:52.514
Oh, really?
00:36:52.719 --> 00:36:54.650
by, they said like 40 to 50%.
00:36:54.760 --> 00:36:56.710
I was like,"40-- like, but then
00:36:56.835 --> 00:36:57.155
No way.
00:36:57.155 --> 00:36:57.864
I didn't know that.
00:36:58.025 --> 00:36:58.215
Huh.
00:36:58.385 --> 00:36:59.284
Not, not surprised, though.
00:37:00.369 --> 00:37:00.750
Yeah.
00:37:00.789 --> 00:37:02.289
It, it-- Yeah.
00:37:02.329 --> 00:37:15.429
I mean, that might be for dramatic effect, but I think there is like a argument for like, hey, it's probably like plus or minus 10%,'cause like, I don't know, like a potato or something, like a different sized potato or like a package of something might not have the exact
00:37:15.625 --> 00:37:15.934
Yeah.
00:37:16.335 --> 00:37:16.755
You know what?
00:37:16.840 --> 00:37:17.269
whatever.
00:37:17.375 --> 00:37:34.039
Here's a, here's one takeaway that if, if, uh, one of our listeners is out there and they're in a meeting and somebody hands them a deck with all these performance metrics and they wanna sound smart, they can say,"Hey Are these values based on fundamental analysis or is this a GAAP basis?
00:37:34.960 --> 00:37:35.900
And you can sound smart.
00:37:36.650 --> 00:37:41.940
And I don't know what you can do with that information based on the answer you get, but you can sound smart asking the question.
00:37:43.579 --> 00:37:45.079
You can check the smart box.
00:37:45.079 --> 00:37:45.550
Check, check.
00:37:46.389 --> 00:37:50.489
Um, what, what is this part of the calculation called again?
00:37:50.489 --> 00:37:52.210
So there was like impairment on the credit side.
00:37:52.210 --> 00:37:52.619
What is like
00:37:52.909 --> 00:37:54.068
Mark to market.
00:37:55.579 --> 00:37:56.940
mark to market?
00:37:57.150 --> 00:37:58.590
So people can be creative in
00:37:58.688 --> 00:37:59.068
Yep.
00:37:59.250 --> 00:37:59.900
to market
00:38:00.708 --> 00:38:00.929
Yep.
00:38:01.030 --> 00:38:01.760
or analysis.
00:38:01.784 --> 00:38:02.065
sound
00:38:02.199 --> 00:38:02.449
Yeah.
00:38:03.429 --> 00:38:04.949
Truly.
00:38:05.409 --> 00:38:09.730
I, in my head, I'm gonna be like, that is like in the Olympics for figure
00:38:10.099 --> 00:38:11.059
I like your analogy.
00:38:11.108 --> 00:38:11.509
I do.
00:38:11.769 --> 00:38:12.849
score that people
00:38:12.949 --> 00:38:13.199
Yeah.
00:38:13.309 --> 00:38:13.480
it's
00:38:13.599 --> 00:38:13.978
Yeah.
00:38:14.000 --> 00:38:14.030
a
00:38:14.248 --> 00:38:16.208
His smile was good while he did the triple lutz,
00:38:16.239 --> 00:38:16.809
All right.
00:38:16.938 --> 00:38:17.418
More score.
00:38:17.628 --> 00:38:17.809
Yeah.
00:38:18.688 --> 00:38:18.898
Yeah.
00:38:19.000 --> 00:38:19.369
Yeah.
00:38:20.300 --> 00:38:20.630
Yeah.
00:38:21.030 --> 00:38:22.559
The performance was, was,
00:38:22.568 --> 00:38:22.958
Yes.
00:38:23.378 --> 00:38:23.728
Yes.
00:38:23.878 --> 00:38:26.608
I was moved by this mark to market valuation.
00:38:28.208 --> 00:38:31.989
I am moved to commit two billion more to your fund.
00:38:31.989 --> 00:38:32.829
I'm so moved.
00:38:33.369 --> 00:38:33.818
Yes.
00:38:35.858 --> 00:38:36.338
Awesome.
00:38:36.378 --> 00:38:36.889
Well, I feel
00:38:37.239 --> 00:38:37.789
Oh, good.
00:38:37.789 --> 00:38:38.000
Good.
00:38:38.070 --> 00:38:38.349
Yeah.
00:38:38.478 --> 00:38:38.809
Ed.
00:38:39.110 --> 00:38:39.619
Yep.
00:38:40.099 --> 00:38:40.630
Thanks, man.
00:38:41.125 --> 00:38:42.494
Go from triple luts to triple
00:38:42.619 --> 00:38:44.059
Yeah, back to triple putts.
00:38:47.168 --> 00:38:47.289
That's,
00:38:47.340 --> 00:38:47.550
there
00:38:47.639 --> 00:38:48.871
that was pretty funny
00:38:54.346 --> 00:38:59.001
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