Private Equity: Part 2
Covering the basics of private equity and its role in the car wash industry.
Private equity in action in the car wash industry
In the previous article I gave an overview of private equity and their investing interest in the car washing industry. Now we’ll cover how they seek to make money and how that impacts their approach. I will use a fictitious PE investment team to illustrate how it all works.
Quick recap from the first article: What is a PE fund?
A PE fund is a pooled investment vehicle that invests the money into assets with the hope that they can make those investments worth more when it’s time to return the capital to the investor – as well as generate management fees for the PE firm in the interim. Rarely is a fund evergreen – meaning that they just provide returns and don’t state a return time frame for the initial capital.
Now let’s review an example of how a private equity fund with an investment focus on car wash stores might get started, how it is set up and how it gets the investment process going.
Suppose Rina is a partner at Hub Boston Equity Partners, a private equity firm in Boston. She has become familiar with the car wash market from a local express exterior wash. She becomes friendly with the owner and notices the new license plate recognition (LPR) system being used to automate club membership verification as well as keep track of usage of non-club members. She also observes how the technology reduces labor by signing up new club members with zero employee involvement as well as displaying different screen flows at the kiosk based on the customer’s transaction history resulting in more revenue per vehicle.
They discuss how the club model and the software provided by the car wash POS provider has converted many car wash stores into subscription businesses. They also discuss how the new license plate recognition technology (with a 98%+ read rate) is a real game changer for automating customer loyalty programs and managing recurring revenue. These conversations are not new to Rina as she has been involved in private equity funds that invest in companies in the automotive aftermarket industry where efficiencies and automated processes opened the door for the businesses to scale (dent repair, retail, parts etc.).
Beyond the LPR functionality managing the club and loyalty programs, Rina is blown away by LPR’s ability to feed a marketing machine.
So after much research and discussion, Rina develops a business plan to go out on her own and start a small private equity fund with a focus on building and acquiring car wash stores across upstate New York and Vermont. She reasons these areas will gain population with the migration of people leaving urban centers as part of the fallout from COVID-19. She also observes the land prices for commercial real estate is still relatively low and competition is scarce.
In general a PE firm generally has more than one fund at different stages but, when she starts out she will just have one fund. In any case, each fund has General Partners and Limited Partners. The GPs direct the investments and the LP provide the money with little say on how it’s allocated.
Her decision to start her own PE firm is daunting; she decides that she’d like a partner. She approaches a former colleague, Greg, with the idea and they decide to form the business calling it ‘R & G Capital.’ The business will be their formal entity to pool money for their car wash investment strategy, with funding from others. This fund strategy is to buy or build a chain of car washes under a unified brand. And at the end of the fund’s life, say 5 years, they will sell the new entity at a profit returning the initial capital and a majority (80% typically) of the gains to their investors.
The key is they want to use other people’s money to make the capital pool big enough to execute on the strategy. Generally, a PE fund needs to be of some size to generate fees that pay the GPs and their teams as well as gather enough assets to execute on their strategy. $100 million fund wouldn’t work for a nationwide roll up but could be enough to create a smaller, regionally- focused fund. With that said, they often minimize their upfront investment and borrow as much as the car wash can afford to pay interest on given the site’s cash flow. This ‘leverage’ can tremendously multiply their return of capital invested.
So let’s suppose Rina and Greg, the GPs, think a $100M fund is a good size to buy or build enough sites to develop their regional chain. As is typical with these funds, they will typically charge a 2% fee of the investment fund per year to the investors and they will share in the upside to the tune of a 20% carry. So let’s step back here: the fund owners, the ‘GPs’ as they are known, need money to pay their administrative teams, themselves, their office lease, their travel to evaluate investments, and so on. $2 million is 2% of a $100 million fund and that fee is taken each year of the fund’s existence regardless of performance. This is the fund fee to essentially keep the lights on.
Side note: how is a PE fund different from a venture capital fund?
In comparison to venture capital funds, PE is more hands-on with their portfolio companies, acquire a larger (if not controlling) ownership stake, and typically invest in lower risk businesses. PE funds can’t afford to be wrong, so they are more risk averse than VC funds that invest in riskier startups. By contrast, VC investors spread smaller investments around to earlier stage companies, have less of a say on their investment’s day-to-day operations, and fully accept that some of their investments may flop, but see the overperformance of other investments as the hedge. To put it another way, while they both pool and invest money from their investors, PE firms place very careful bets, require more control, and are more conservative; while VCs are looking for a moon shot, they are more understanding that some of their investments may not pan out – and so they are seeking higher risk for higher return.
Rina and Greg don’t just look to make money from the 2% management fee. They also take a 20% portion of the profits. This portion of the profits is called the ‘carry.’ Carry is an old term that referred to the amount of cargo carried on a boat that the captain was able to keep if the voyage was successful. In the car wash fund example, this carry may come from revenues of the stores that are sold at the end of the fund’s term. Suppose you bought a $3 million car wash and sold it 4 years later for $10 million, the carry fee would be 20% of the profit the fund made on the sale of the car wash – or $1.4 million (20% of the $7 million gain) . This is a simplified version, but it gives you the understanding that the fund managers are incentivized to make assets appreciate in the time before they need to return the initial funds to the investors. Sure they could just live on the 2% management fee, but they would be unlikely to raise additional fund pools if their investments didn’t generate much of a return.
So now it’s time for Rina and Greg to line up a dog and pony show – this is a term used for rounding up investors and pitching the investment idea. They need to present their investment ideas to institutional investors, and wealthy individuals/families. These investors would need to be qualified as we discussed in the first article on this topic and their initial investments would need to be significant. In our example of a $100M car wash fund, the GPs don’t want 100+ LPs to communicate with (as it raises the administration costs of the fund) so they would generally seek several anchor investors who will put in $5 million or more and they place investment minimums of $1 million or more.
This courtship of new investors can be long. While Rina and Greg have industry experience and stellar backgrounds with the previous funds they have been involved with, the investors look to do serious due diligence. This means evaluating every aspect of the fund to verify that everything in their private placement memorandum checks out.
After 10 months of fundraising, Rina and Greg have raised $100 million dollars from 25 investors with two putting in $10 million each. They are lucky as many first time funds don’t hit their target raise or even raise money at all.
The life cycle of a fund; from when it is started to the time it looks to return the initial capital plus the appreciation, can vary widely. In many cases, it is common for GPs to spend a majority of their time in the first few years of the fund finding investments. After that, they work to improve those businesses and then exit those investments a few years later. This lock up of the investment capital is typically 3 to 6 years.
Luckily for Rina and Greg, they have 20 target stores and 20 plots of dirt targeted (vetted in all the ways they could think of: traffic, population, competition, etc) so they can move quickly into the acquisition phase.
During the acquisition stage of R & G Capital’s car wash fund, the GPs are knee deep in due diligence, legal paperwork and letters of intent. As you can imagine or have experienced, buying a wash or a majority stake in one is not an easy process. In our example and in 2020’s COVID-19 affected market, it is a space crowded with buyers leading to lofty price tags for businesses with mediocre track records. And remember, the more Rina and Greg pay for the washes or the land, the higher they set the bar with their investors. In other words, overpaying only works if you are very certain you can make up for it with overperformance of the investment. Hence, many PE firms are expert negotiators as their overall performance can be impacted by these initial deals.
After a year and a half, R & G Capital has acquired 15 sites. They funded these investments through bank loans and from the committed capital of the LPs by ‘calling’ the capital. This is an industry term for asking the investors to give all or a portion of their committed money so the investments can be made.
Following the acquisition, the PE firm begins improving the businesses in the portfolio. In our car wash fund example it will include:
- Upgrades of sites and throughput by introducing or revamping the wash club programs and/or adding/replacing car wash equipment including the Point-of-Sale system which is critical to affecting revenue growth through effective marketing and technology automations. For example, leveraging license plate recognition (LPR) to run an automated car wash club program and capture marketing data on every visitor.
- Unify the car washes under one brand to create savings; one HR department, one marketing company, one finance department, bulk buying, shared operations people, etc.
- Change the car wash business models to Express Exterior (from Full Serve or Flex Serve and Detailing services) to reduce labor and complexity while boosting throughput
- Add management and other staff experienced in multi-site car wash operations.
The fund managers are looking to implement improvements quickly so they can increase the value of the investments on their set timeline. They are not the ‘invest and hold’ type. They are looking at the investments with an eye towards future valuation when they will exit as set out in their investment documents known as their private placement memorandum.
Being an LP in a private equity fund is not a liquid investment. Suppose you invest $2 million into a fund and half way through the life of the fund you need your money back for an emergency. The options would have most likely been laid out in your investment paperwork. Overall the possibility of getting some or all of your money out early is challenging (if allowed at all.) The fund manager generally does not have cash on hand to buy out your investment. In some cases, you may be allowed to have another qualified investor take over your investment and cash you out. This is referred to as a secondary buyer as the person taking your spot in the fund and assuming the risk and reward. But this is rare.
In our next article in this series, we will dive deeper into the management of the fund’s investments and what it looks like when your business is part of their investment profile.