How to Break Into Commercial Real Estate and Build an Empire
This is a guest post from Mike Moran, CFA, a portfolio manager at a long-only asset management firm. He started Life on the Buy Side to teach you what it’s like working in asset management, hedge funds, and more.
When it comes to commercial real estate, you’ve got two choices: do something extremely risky, or do something boring and conservative.
OK, you could also pick something middle of the spectrum – but what fun is that?
If you have your sights set on building a real estate empire, you’re going to have to take the leap and embrace the risk with open arms.
Here’s how to do it:
Risk, Reward, and Reality
With commercial real estate, it’s easiest to think of investment opportunities from least risky to most risky and then analyze the players in each category:
- Least Risky: Core Investing – Acquire and Operate Existing Properties
- More Risky: Value-Added and Opportunistic Strategies – Improve Existing Properties
- Most Risky: Real Estate Development – Build Completely New Properties
Core Investing is all about stability and getting high single-digit returns by operating existing assets. There’s little risk when a building is already operational and generating rental income – think of the GM Building in New York or a class-A regional mall as example investments.
Since these are stable assets that provide a steady income stream to the owners, pension funds are the main investors in core funds – firms that specialize in acquiring and operating existing properties.
You also see Real Estate Investment Trusts (REITs) – both publicly traded REITs and private REITs – in this space, as well as core real estate funds run by real estate investment managers such as AEW and RREEF.
REITs are like private equity firms but for buildings rather than companies – they acquire, operate, (possibly) improve, and then sell properties to earn high returns.
After you leave this Core Investing space, you get into Value-Add and Opportunistic Strategies – this is where the investors try to make substantial improvements and renovations to existing properties rather than just acquiring and operating them.
Returns are typically in the 15 – 20% range, but may go higher depending on how risky the strategy is. Some REITs and core funds managers dabble in this space, but you mostly see private equity shops like Blackstone here – a high single-digit return is horrible for PE, so it makes more sense for them to focus on riskier strategies.
At the riskiest end of the spectrum is real estate development, and the players there are all over the map.
Some REITs have large development pipelines and invest significant resources into constructing new properties – examples are AvalonBay [AVB] (apartments) and Prologis [PLD] (industrial), which often have multi-billion-dollar pipelines.
Private equity can sometimes be active in development, but usually only as the capital partner to developers.
There are also large private companies like Opus that focus on real estate development without the pressures that come from being publicly traded.
Risk = Reward?
Based on the descriptions above, you might think that real estate development offers the highest potential returns and the highest pay since it’s also the riskiest.
But you’d be wrong: It’s a boom-and-bust business, and developers are also the first people to get fired in a downturn.
While Prologis had a $4B development pipeline at the market peak, it dwindled down to less than $500MM after the market collapsed; three of Opus’ five major subsidiaries filed for bankruptcy in the past downturn.
This is not to say that real estate development is “bad” – it’s just that you shouldn’t jump into it expecting to make bank right away.
It’s great if you’re into the brick-and-mortars side of real estate, but if you’re not, think about the other options above.
There are also asset management firms and hedge funds that specialize in real estate securities, and even shops that invest in REITs – if you want to blend real estate and the public markets, both of these can be good options.
How to Break Into Commercial Real Estate
As with everything else in finance, at the entry-level you’re just a high-paid spreadsheet monkey who works on deals all day – whether that’s at the core funds or at private development companies.
A typical “path” for breaking in is to go to a target school and then get into real estate investment banking – that’s what many of the top people at the biggest real estate firms and REITs have done.
Mike Fascitelli, CEO of Vornado [VNO], is an example of a real estate big shot that followed this path. He went to Harvard for his MBA, started at McKinsey, and then went to Goldman as a real estate investment banker. After several years at Goldman, Steve Roth lured Fascitelli away from banking to work at VNO.
But you don’t have to follow that path to break in – and an MBA isn’t even a prerequisite.
The best example is Jonathan Gray, the co-head of Blackstone’s real estate group – Gray started at Blackstone with just an undergraduate degree from Wharton and worked his way up to become co-head of the entire real estate group by age 35. At age 37, he was busy pulling off the $36 billion Equity Office Properties acquisition, the biggest private equity buyout ever (at the time)!
Yes, Wharton is a target school and it also happens to be one of the top undergraduate schools for real estate – but more importantly, it has a great real estate alumni network.
Just like everything else in finance, leveraging your alumni network is essential to breaking in: I wouldn’t be surprised if Gray tapped his network to land his gig at Blackstone right out of school.
Other top undergraduate schools for real estate in the US include UC Berkeley, USC, and Wisconsin – these are well-known institutions, but they’re not the Ivy League and they’re not the ones that immediately come to mind when you think of a “target school.”
Real estate is very much a “who you know” business and having a well-connected alumni base is critical – if you’re at a school without much of a presence in real estate, your next best option is to get an MBA at a school with a strong real estate program.
If you’re already out of school and working, you could get involved in trade groups like ICSC, ULI, or YREP if there’s one in your area.
Whatever you decide to do, networking is even more important in real estate than in other industries so start pounding the pavement as soon as possible.
Got Real Estate Development?
While many top real estate jobs required work experience and/or more than an undergraduate degree, development is one area where undergrads from all different backgrounds can get in right out of school.
So if you’re in this boat and you’re interested in real estate, you’re better off using your career center and alumni network to break in and focusing on development rather than PE, REITs, or anything else.
Q: Do I need investment banking experience to break into development?
A: No, no, and no. In fact, you might have too much experience if you actually do real estate IB and want to break in afterward – an entry-level development role would be a step backward.
Development is significantly different from real estate IB or PE, and they shouldn’t even be in the same category.
Q: Wait, but what should I do with my life if I don’t do investment banking first?! Otherwise everything is meaningless!
A: Pick a major that lends itself to real estate development. Example majors: Real estate, civil engineering, architecture, or construction management.
Since development is much more bricks-and-mortar than other RE-associated industries, knowing these subjects is valuable for breaking in – and you’ll get the alumni network to help you land a development job.
If you don’t know what major and/or school is good for getting into RE development, just ask around and see what types of jobs most graduates get – if “real estate” is a common answer, you’ve found a good match.
Breaking Into REITs
Real Estate Investment Trusts (REITs) are investment vehicles that are exempt from corporate income taxes as long as certain criteria are met; the main one is that REITs must pay out 90% of their taxable income as dividends, which means they have little cash on hand and are constantly issuing debt and equity to fund their operations.
Historically, REITs were passive vehicles that focused on owning properties and escalating rents over time, but today they’re more dynamic, and many REITs buy, sell, develop, and manage properties and 3rd party joint ventures all the time.
A few of the larger REITs in different segments include the Simon Property Group [SPG] (shopping malls), Boston Properties [BXP] (offices), AvalonBay [AVB] (apartments), and Prologis [PLD] (industrial).
Since REITs use so many different investment strategies, there are all sorts of different job opportunities there.
On the operations side are developers, property managers, and acquisition people that deal directly with properties.
On the capital markets side, you’ll find finance people that work on equity and debt deals to fund the REIT’s operations.
If you want to get into the operations side of a REIT, it’s similar to what you need to break into RE development: Get a real estate-related undergraduate degree and network with alumni.
But if you’re interested in capital markets, you need real estate investment banking experience – REITs are one of the main exit opportunities for RE bankers since you advise REITs all the time as a banker.
Bottom-line: if you’re more interested in finance, go the banking route and look for REIT exit opportunities; if you’re more interested in the bricks-and-sticks aspect of real estate, skip banking and go straight into development or acquisitions.
Compensation: What Compensation?
Unfortunately, there are few good data sources on real estate compensation – but pay tends to be commensurate with risk and expected returns, at least in buy-side roles.
The main exception is development – it’s the riskiest investment class and yet the pay is also the worst.
The real money in development accrues to those that put their money at risk in the developments.
To complete construction of a new property, the developer itself only puts down a very small portion of the total equity – maybe 5% or less.
Many times, the developer simply contributes their land basis as the only equity in the project and then uses debt and mezzanine financing to fund the entire construction cost.
Most of the returns will go to the 3rd party investors that come up with the rest of the funds – and to make things even worse, there’s no cash flow from properties that are under development until tenants move in and rental income starts flowing.
Even the fees the developers charge are not great compared to the overhead, so there isn’t much money left to pay salaries to employees.
So, do not get into development if money is your main goal – only do it if you’re interested in building and construction side of real estate.
You will not make it big until you have enough money to invest in development projects yourself.
For core funds and REITs, pay is consistent with base salaries for recent graduates elsewhere in finance – the main difference is that you won’t receive Wall Street-like bonuses in these jobs because the fees and returns are lower than in PE, for example.
On the private equity, hedge fund, and asset management side, compensation is similar to what you would earn at non-real estate funds. So real estate PE is similar to normal PE, real estate HFs are similar to normal HFs, and REIT-focused asset management is similar to normal asset management.
And on the investment banking side, you don’t see much of a difference at the junior levels between real estate banking and other groups.
As with other buy-side jobs, the buy-side itself is the end-game. Once you get there, it’s just a matter of working your way up until you become the next Jonathan Gray.
Be careful of getting pigeonholed: If you get into real estate and don’t like it, move on as quickly as possible or it will become more and more difficult to find a non-real-estate job.
In addition to moving up the ladder, investing in real estate yourself is another possibility: A number of friends have amassed nice little portfolios of multi-family assets.
And unlike buying entire companies, the capital requirements for real estate are far lower and you don’t need to raise hundreds of millions of dollars just to buy a house.
Raising a small fund of your own is also possible, but just as with starting a hedge fund you need to raise some seed money to get started – you would go to friends and family first, show solid performance, and then approach a broader set of investors once you can point to results.
Whither Real Estate?
It’s a great field, but keep your expectations in check.
Until you have enough cash to fund massive real estate developments by yourself, you won’t see your name on any buildings.
And if you want to become as famous as a certain real estate developer – and maybe even become President of the United States as well – it might just be easier to get your own reality TV series instead.
Even More on Real Estate
If you want to learn more about the modeling and valuation side of real estate, check out the BIWS Real Estate Financial Modeling Course, which covers both individual properties and REITs via case studies of an apartment complex, an office development and sale, a hotel acquisition and renovation, and Avalon Bay, a leading apartment REIT.
There are also real estate private equity case studies based on stabilized multifamily, value-added office, and pre-sold condo development deals.
Free Exclusive Report: 57-page guide with the action plan you need to break into investment banking - how to tell your story, network, craft a winning resume, and dominate your interviews
From Cold Call to Closed Deal: How a Private Equity Investment Comes Together, Part 3 – The Dotted Line
“She thinks $60 million is a discounted price? Can someone shoot her with an animal tranquilizer gun until she snaps out of it?” John says, looking around in disbelief at all the other Partners.
David turns to you and his eyes light up as a new idea percolates to the top of his head, and then sputters out of his mouth.
“You do know about the special analyst bonus, right?”
Everyone else in the room laughs, as you contemplate whether or not they really want you to tranquilize the CEO.
$60 million would be 6x EBITDA – a reasonable price for a larger company – but significantly higher than what you’d pay for a small, Founder-dominated business in a niche market.
David speaks up once again as the laughter subsides.
“And let’s not forget about her other demands: she wants to roll over 20% of her ownership and put aside 5% in an options pool for the management team.”
“So we’re paying for an overpriced business and then giving up 25% for no apparent reason. This sounds like a better investment than finding Google in 1998,” John replies while rolling his eyes.
Everyone else sits there in silence as you weigh your options before speaking up.
“Well,” you say, “On a positive note, I think I could call in a few chips to get the financing in place.”
“What bank would even look at this? It’s too small for any of the usual suspects,” David points out.
“Right now everyone’s desperate for business – in normal times they’d say no, but beggars can’t be choosers.”
Calling in the Chips
You crawl back to your office and wonder if you can pull off the financing for this deal – your line to all the Partners was a desperate bluff, and you don’t actually have much to offer bankers.
Plus, you’ll have to hear even more tales of $1500 bottle service bills now that you’re going back to the usual suspects to ask for help.
“This is definitely below the bar,” says your banker friend after you finish outlining the deal.
“I realize $30 million of debt is on the low side, but with the way the market is -” you respond as he cuts you off.
“Look, even if this were the apocalypse and banks were failing left and right, we still wouldn’t look at this – the fees are just too low and it’s not worth our time.”
“We’ve sent you guys a lot of business in the past few years – probably more than any other firm…”
“Yes, and they were all small deals. I appreciate the effort, but the MDs want us to pursue the big game from now on.”
You’ve left your door open for this call, so your favorite unannounced visitor happens to be walking by, overhears your conversation, and steps into your room.
David motions for you to step away and then puts the call on speakerphone.
“We’re willing to give you all future business from our firm over the next year, including refinancings and all sell-side mandates. No competition at all for you,” he promises without hesitation.
“Can you… actually guarantee that?” the banker asks with a rising tone.
You fold your arms and squint at David, wondering what he’s gotten himself into this time.
“We’re planning to flip it in a year or two, and possibly do a refinancing before that – should be at least $10 million in fees for you altogether,” he states without so much as a blink.
“OK then. I’ll run this up the chain and see what they think. Thanks for the offer,” the banker replies.
You turn off the speakerphone, spin your Aeron chair around to face David, and wait for him to explain what just happened.
“Don’t worry,” he reassures you, “They’re bankers – they’ll all be fired or will be at another firm in another year or two anyway. No harm done, and now this deal goes through if we can work out the price and rollover.”
“Sorry, but we just can’t get our heads around $60 million,” John says to Nancy, who’s sitting at the head of the table in your conference room in front of all the Partners.
“We could get to $50 million max, but even that’s pushing it. Nothing personal, but the numbers just don’t work out in that range.”
Nancy continues staring at the slide presentation in front of her and attempts to make sense of the returns analysis, but it might as well be Martian to her.
“Understood, but $60 really is the bottom of my range here. With the margins we have, I could just keep running this business for years and make more money than what you’re offering. And unless I can retain at least 20% ownership, my incentive just isn’t strong enough.”
Both sides of the table stare at each other for a few seconds before John breaks the silence.
“We’ll be in touch if anything changes.”
Nancy stands up and walks out of the room, waving goodbye to everyone before closing the door behind her.
“It’s 100% posturing,” David points out, “There’s no way she seriously expects to get $60 million for the business and keep 20% for herself. And we know she wants to leave anyway, so it’s not as if she’s seriously considering running it for another 5 years.”
“That may be true,” says John, “But the numbers really don’twork at those levels – there’s so much uncertainty around the exit that this only makes sense at $50 million max. So we either convince her or we don’t do this deal.”
It’s time to don your Captain Obvious Hat and point out what everyone else is missing.
“What if we just flip it after a year or two? It’s much easier to get to a solid return over a short time period, and that way we can even tell her that she can leave the company after a certain period – once it’s no longer owned by us,” you propose.
David sits back in his chair and puts his hand on his chin as he contemplates your idea.
“That’s true – I doubt she’ll even understand why we’d offer that. And she won’t understand the risk to her if she does leave, so it might just work if we pitch it the right way.”
He cleverly fails to mention how the bankers doing the financing are already expecting you to flip it quickly – hearing that might cause John to toss him out the window.
“OK,” John agrees, “Go back to her and propose $50 million with a 20% rollover and say that in exchange for the lower price, we won’t make her stay beyond 2 years or sign a non-compete.”
Limited Partners = Limited Support?
“And we see this as an exciting way to start investing in the technology space – without all the risk that a bigger investment would entail.”
John is presenting IonX and a few other investments they’re looking at – all of which are much further away – and hoping that the LPs remain confident enough to keep investing in future funds.
Most of them produce nothing but poker faces as John goes through all his slides.
“We’re getting this at a discounted price, and we think it could be a quick-flip for a 20% return in less than a year.”
One of the LPs at the end of the table immediately stands up, slams his binder of materials shut, and scurries toward the door.
“Is… something wrong, Paul?” John asks while folding his hands in front of him.
About to open the door and leap away from the meeting, Paul turns around, drops his binder on the table, and grabs the door knob before speaking up.
“Yeah, you. You and your firm.”
Everyone else turns around to face him as whispers fill the crowded room.
“You raised $750 million for your new fund from all of us, claiming that you had all these great opportunities – and what do you do? You sit on that cash without doing anything for a year, and then you finally bring us a piece of dog crap, put a ribbon on top, and try to call it a gift.”
John raises both hand, blinks, and motions for Paul not to leave the room quite yet.
“I understand why you might be upset, but with the way the market’s been lately…”
Paul cuts him off before he can finish, turning around and removing his hand from the doorknob. “Then why are our other private equity funds still doing real deals? I can’t veto this or tell you not to do it, but I’m not happy about it.”
John walks toward him, binder in hand. “Look, I understand why you might not like IonX, but we have plenty of other…”
Paul opens the door, storms out, and slams it shut.
Back at the Office…
You and David are reviewing the loan documentation from the bank and are looking at different financing options for the deal.
“With the margins they have we should just pick the cheapest option – I’m more concerned with broken covenants than with interest payments,” David points out.
You turn toward your monitor and look at an LBO model with the different financing options built in before swiveling around in your chair and responding.
“That’s true, but we still don’t even know if Nancy is going along with this. I’m not convinced she’s gonna take the bait.”
Just as David leans back and prepares to respond, your phone rings. Time for the speakerphone.
“Hi, it’s Nancy,” the voice announces. “I’ve considered your offer and I’m prepared to move forward as long as you don’t make me sign a non-compete.”
You and David look at each other with your eyes widened and mouths gaping open. But there must be a catch – what would it be?
“But,” she continues, “Some of my managers have figured out what’s going on, and they’re not about to accept a new owner. They know me and like me, and they’re nervous about what will change.”
David puts his hands down on your desk and responds, “We’re not going to change a thing. You will still be running everything; it’s just that you’ll have all of our firm’s resources at your disposal…”
“That may be true, but I think they’d be more confident if all of you came to meet them in-person,” Nancy retorts.
“That would be a great idea,” David says while rolling his eyes and searching for your stress relief ball. “We’re all looking forward to flying out and meeting you.”
“I’ll be in touch with some dates,” she responds, “And please make sure it’s everyone – we should plan for at least a week so they can get to know your team.”
As she hangs up, you and David sit there looking at each other and David turns his gaze toward your window.
“Think they’ll have any beaches there?”
One Door Over…
John is cycling through the call history on his phone and looks down at the 15 unreturned calls he’s made to Paul in the past week. Limited Partners might be “limited,” but that doesn’t prevent them from being passive-aggressive and ignoring contact when it suits them.
He walks over to his whiteboard and looks at the pipeline of potential investments, noting that everything else is at least 6-9 months away.
His phone rings and he slides back to his desk to answer it.
“So, John, ready for some more news on IonX?” David announces.
“Can you start with the good news first?” John replies.
“No good news this time. Do you have a free week in your schedule anytime soon? They want us to fly out and meet their team.”
John glances back at his whiteboard and then the call log on his phone. “Whatever it takes – talk to Suzanne about my schedule,” he says before hanging up.
Leaning back in his chair, he dials the main line, finally resigning himself to his “Plan C” option.
“Get me the new guy, Martin.”
A minute later, Martin shows up at John’s door and attempts to open it three times before finally gathering enough strength to push it open on his fourth try.
“You… wanted to see me, sir?” he stutters while wobbling into the room.
John laughs, stands up, and walks across the room to Martin, standing an inch away from him as he recites his speech.
“There’s no need for formalities. I’ve heard good things about your family. I’d like you to tell me more.”
He smiles and stares Martin straight in the eye, waiting for his response.
It’s the next week, and all the Partners have flown out to meet IonX in-person. Apparently “everyone” means “everyone except for the person who’s actually doing the work.”
But the office is quiet again, and no one is checking your calling logs now that you and Martin are the only ones there. You’ve been handing off all the grunt work to him – anytime a banker or lawyer has a question, he’s the one in charge.
David has been updating you the whole time, and it looks like the management team is growing more confident that nothing will change post-transaction.
And you’ve been forwarding the in-progress definitive agreement that the legal team has been drafting.
“You should have seen these guys when they saw us,” David says at the tail-end of one of his update calls.
“It’s like they had never seen people dressed in suits before. They were waiting for us to morph into Gekko or Bateman and start murdering people.”
“Sounds like a fun trip,” you say, putting the call on speakerphone and standing up before moving over to your window. “Is it going to close?”
“90% certain now,” David reassures you, “And since bonus season is only a few weeks away, you can bet that we’ll remember everything you’ve done here.”
Your eyes light up as you peer out the window and see a BMW parking right next to your usual spot.
“That’s great,” you say, “So are there any beaches there?”
Pension Power Play
Paul strolls into the entrance of the Ritz Carlton, going on about another investment on his phone and simultaneously typing like a fiend on his Blackberry.
He’s met by a tall, lanky man walking in with a grey suit and a binder of printouts in his hands. He walks over to Paul but gets rebuffed as Paul points to his phone and rolls his eyes.
Finally the call ends, Paul turns toward him and shakes his hand, and they walk toward the interior of the restaurant.
“I was surprised when you called,” Paul says in a cheery voice. “I didn’t think I would see you again after what happened on the Fincher account.”
“Let’s let bygones be bygones,” says the other man. “We’d both do much better as allies rather than enemies.”
They sit down and order medium-rare steak along with a $1000 bottle of 1982 Haut-Brion.
“So why did you really call me, Simon?” Paul asks as he sips his wine and arranges his napkin on his lap.
“I wanted to tell you about a few new investments we’re looking at. In this market no one’s doing any deals except for the distressed funds, which are a huge part of our portfolio.”
“So you’ve just mysteriously decided to extend the olive branch and give me access to all these funds that are actually beating the market?”
Simon turns to the bottle and pours himself a glass, holding it up and reading off the label.
“This is the 1982. Have you tried the ’72 before? I hear it’s even better.”
Paul rolls his eyes, puts down his glass, and then reaches over and takes the wine bottle out of Simon’s hands and places it down on the table.
“Cut the crap. I know you’re not just giving me this gift out of the kindness of your heart, so what do you want in exchange?”
“I want you to look the other way on John and his firm’s performance over the past year. And when they raise another fund, I want you to invest – and I want you to let me into the deal as well.”
Paul starts laughing so hard that he snorts, with red wine nearly bursting out of his nostrils.
“So John put you up to this. Ignore his horrible investments, and you’ll give me a piece of these distressed funds.”
“I didn’t even hear about this from John,” Simon says, “But word of your… displeasure… has spread. They’ve had great performance in the past, and I want to get in on their next fund. The only way that’s gonna happen is if you continue to support them, and then bring me in as well.”
Paul stops laughing for a second, glances up at the chandeliers on the ceiling, and then over at Simon once again.
“Even if I were stupid enough to do this, what could you give me in return? No fund is up more than 10% this year…”
Simon opens up his binder, takes out a few documents, and tosses them across the table to Paul before he cuts him off with his response.
“Those 3 are up 50% year-to-date. They’re closed to new investors, but I can get you in – if you look the other way and keep investing in John’s fund.”
Paul stares at the fund performance documents before tossing them aside and looking up at Simon once again and smirking.
“This just seems too good to be true. And I don’t know why you’re offering me this deal. You’re sure your son isn’t working for John or something?”
The Dotted Line… and Your Bonus?
You stand outside John’s door, waiting for him to summon you in. It’s bonus season, and everyone in the office is acting like 10-year old kids on Christmas morning.
He opens the door and greets you in a cheery voice.
“Congrats!” he shouts, “We did it. The funds were just wired the other day, the loans are in place, and Nancy hasn’t even run off to a tropical island and abandoned everyone. Yet.”
He waves around the signed definitive agreement while leaning back in his chair and pointing to the dotted line on the page.
“So, about your bonus. We realize how much you contributed to the IonX deal, and we really want to reward you for your performance.”
This better be good – anything less than a 20% raise over last year might cause you to jump out your window after what you’ve been through getting this deal done.
He hands you a slip of paper, and you stare at it in disbelief as your mouth drops open and stays there until you look up to face him once again.
“This is down 10% over last year – I brought in the IonX deal and got it done. Without me, you’d have 0 closed deals this year.”
“We know that. But look at what happened to the market – it’s a train wreck everywhere. Everyone else’s bonus was down 30%. And let’s be fair, David also helped get this deal done. You know we can’t just give juniors arbitrary pay.”
An image of David sitting around on the beach while “getting to know” Nancy and her team pops into your head.
“And if it weren’t for Martin, we wouldn’t have had LP support. He did terrific work for a new guy!”
Up until now, you hadn’t even known that Martin contributed anything aside from confusion and answers to random due diligence questions.
“His family’s very well-connected. But I’m sure you understand that, right? You really have to be a team player to succeed as an investor.”
You thank John, turn around, and leave the room, trying your hardest not to slam the door behind you.
You walk back to your office, slump down in your chair, and pick up the phone to call your friend at a larger fund and learn what bonuses at normal places were like this year.
But as you place the call, you decide that there’s something else you’re more curious about first.
“Hey there,” you say, “Just wanted to find out about bonuses this year. But before we get to that, I just wanted to know – are you guys hiring?”
The Full Series
In case you missed parts 1 and 2, you can get them right here:
- From Cold Call to Closed Deal: How a Private Equity Investment Comes Together, Part 1 – The Idea
- From Cold Call to Closed Deal: How a Private Equity Investment Comes Together, Part 2 – The Deal?
Coming Up Next: The Web Series
I’m excited to announce that we are turning this 3-part short story into a 6-episode web series that loosely follows the storyline here, but is significantly different – “different” as in better.
I (Brian) am writing the series and financing it, and my good friend Goldie will be producing.
There were a few suggestions to write a novel, but I am much more interested in turning this into a series. And if you follow me on Twitter, you also know that I am borderline obsessed with serialized TV shows and films.
We are aiming to film and edit this by the end of 2011, and then release it in early 2012.
There will be a trailer, and if you’re good you might even get to read the script for the first episode.
Free Exclusive Report: 57-page guide with the action plan you need to break into investment banking - how to tell your story, network, craft a winning resume, and dominate your interviews
From Cold Call to Closed Deal: How a Private Equity Investment Comes Together, Part 2 – The Deal?
“No, no, and no again,” shouts John, the Founding Partner.
“This is a crap deal in a tiny market with a Founder who wants to leave in 12 months? She stays, or we don’t even take another look at this. This business is worth $0 without her.”
David jumps in before you can say anything.
“We don’t know how serious she is about leaving. And don’t you think the LPs might like seeing a new industry that we haven’t invested in before?”
“Are you crazy?” John blurts out, “The problem is that she doesn’t know what she’s doing, which is much riskier than if we knew for sure, either way. And there’s no way the new Limited Partners will get behind this – they know jack about technology and don’t feel comfortable with the industry.”
“You realize she’s willing to sell at a 50% discount, right? We could still get a solid return.”
“50% of $0 is $0.”
Everyone turns to David, waiting to see what his next retort will be.
But he comes up with nothing and sits there with his hand to his chin, tapping his index finger on the table and waiting for another response from John.
“If no one has any other business, this meeting is over. Back to work.”
As everyone else shuffles out of the conference room, you sit behind and wait for David to leave first. He rolls his eyes at you and leaves without saying another word.
Meanwhile, on a Yacht…
Nancy, CEO of IonX Solutions, stands silently on the deck looking up as James, her new business partner, shouts orders at the crew below.
“So, James,” she says, “I’ve been thinking of what role I could take on at your next company. I’m happy to continue as CEO, of course, but I’m open to other…”
James cuts her off before she can finish.
“Yeah, I’m not so sure about that anymore. It was just an idea, I didn’t think you’d take it seriously.”
Nancy opens her eyes wide. “What? But you know I’m selling IonX to go do this with you, right?”
James chuckles and fires back, “Oh, really? So who’s the buyer? No other company would buy it, and no investor in their right mind would buy it if you left. They’d make you stay or they’d never invest.”
Nancy turns her back to him and gazes at the ocean. Still facing away from James, she speaks up once again.
“They’ve agreed to let me leave in exchange for a lower price. So I’m moving on and joining you as soon as the sale is done.”
James laughs and casts a smirk across his face before he replies.
“Yeah, I’ll believe that when I see the money in your bank account,” he challenges, “Besides – even if I wanted to give you a position here, fundraising is taking forever in this market and investors don’t seem interested.”
“Then I can invest with the proceeds I’ll get from the sale of IonX. I’ll move this forward even if no one else wants to.”
James looks down at his Blackberry, dashing off a few quick messages and pretending not to hear her. Then he looks up and walks over to Nancy, gently resting his arm on her shoulder.
“If anything changes, we’ll be in touch.”
Back to the Grind?
You’re about to start cold-calling once again, when the phone rings and you hear a familiar female voice.
“Hi, it’s Nancy from IonX,” she says meekly, “I just wanted to call you back and let you know that I’ve decided to stay on as CEO. And I still want to sell, so could you let me know what information I need to send you guys?”
News of this reversal has spread around the office, and others are wondering why you’re spending so much time on a clunker of a deal when there are so many… promising companies to cold call.
But as long as no one else is putting in the hours, they’re not telling you to stop.
You’re requesting everything imaginable from Nancy and her management team: historical financial statements, customer data, sample customer contracts, and a lengthy list of IP for the lawyers to sort through.
And you’ve made some discoveries that might just get this deal done – if someone at your firm will listen to what you’ve found.
Just as you’re about to get started creating 5-year projections for the company, David once again walks into your office unannounced.
“So what have you got for me?”
“Well,” you say, “It’s around 70% recurring revenue, so even if Nancy gets hit by a bus and all their sales reps jump off cliffs, revenue only falls by 30%.”
“That’s great,” he replies, “So there’s a significant chance of the company losing 30% of its value. Good to know for the investment committee.”
“They’d love 70% recurring revenue with any other company.”
“Yeah, except no other company has a Founder with more mood swings than a teenage girl.”
“Her mood could also swing us into a big discount.”
David sighs, puts his hands in his pockets, and walks over to gaze out the window in your office, facing away from you as he responds.
“Some people here are… starting to have doubts about what you’re doing. They wonder why you’re pursuing this. And with the new fund in place, we’re also bringing a new associate on-board so we have more… resources.”
Your eyes widen as you respond, “So now we’re getting a new associate after we no longer need the extra help?”
“I hear he’s very well-connected,” David explains, “And that his father travels in the same circles as some of the new LPs.”
“Is this a warning?” you reply, standing up and facing David as he turns around and meets your eyes with his gaze.
“Not at all,” he denies while smiling at your sweaty hands, “Just a courtesy call. And do make sure you say hi to Martin when he starts here next week. I think that’s his name, anyway.”
The Partners are assembled around the table, and you’re standing in front of them navigating through all the slides you’ve created for IonX. The lights are dim and you wonder if anyone will doze off before you reach the climax of your presentation.
“Even with conservative assumptions,” you reassure them, “We can get a 25% 5-year IRR because the margins are so high. And if she sells at a higher discount, we might get closer to 30% returns.”
You pause on your returns analysis slide while everyone else squints and stares at your work, looking for the hole that will sink your investment recommendation.
“You’re assuming a 10% growth rate each year, how can you possibly call that conservative?” John, the Founding Partner, questions.
“They’ve been growing at 15% the past few years and have 70% recurring revenue from long-term contracts with customers. So it’s not as if they need to go out and sell to completely new customers each year… and the market is only around 25% saturated at the moment, so there’s plenty of room to grow.”
“What happens when that growth rate drops to 5%, though?”
“We could still get 15% returns even with that, if you look at this sensitivity…”
David cuts you off before you can say anything else.
“Forget about these imaginary growth rates, let’s talk about your exit assumptions. Who do you think will even buy the company in the first place, and why would they pay 7-8x EBITDA for this business?”
You flip to your next slide and start to go through recent software M&A deals, pointing out that some multiples have been above even 10x – but that doesn’t satisfy David.
“How can you call those deals ‘comparable’? They’re all much larger companies with at least $100 million revenue in broad markets. That’s like saying a date with your buck-toothed sister is the same as hooking up with Scarlett Johansson.”
Now you’re starting to regret introducing your family to everyone at the last holiday party. But a personal attack deserves a rebuttal.
“Even if you lower the exit multiple to 5x we could still get a 15% return – and higher if we get that discounted price.”
Everyone turns to David and he and John glance at each other, waiting for the other one to speak up first.
“The numbers look decent and it’s not the worst deal I’ve ever seen, but we need to understand the market and the potential buyers better,” John concludes.
Deal or No Deal?
Back in your office, you flip between your YouTube window, your inbox, and the spreadsheet of companies you need to follow-up with.
You hear your door crack open and you get ready to feign stress in case your favorite visitor walks in once again, but it turns out to be someone else scurrying by.
In the clear, you call Nancy back.
“Hi there,” you start out, “Good news for you: the Partners here are much more interested now, and we’re ready to move forward if we can get some more information from you.”
“That’s good,” she replies in a monotone voice.
“Is something wrong?”
“You’ve been asking us for lots of information, and it’s a huge distraction for my managers. They’re starting to wonder what’s going on and if the company is being sold, and I haven’t even told them anything yet.”
You slide open your desk drawer and pull out your stress relief ball, squeezing it a few times before you start to toss it up and down.
“I understand,” you answer, “But that’s just how our business works – we can’t invest in or buy a company without doing our due diligence first. I realize it’s a distraction, but when you work with private equity firms…”
“Just tell me what else you need. Let’s get this over with.”
“We need to know more about the market and what other companies have been acquiring lately – we’re new to this industry and haven’t been able to find much data…”
“Isn’t it your job to find data? What else do you do all day in those spreadsheets?”
You toss the ball across the room, hitting the window with the full force of your throw.
“Sorry about the noise, someone just walked in,” you lie. “Yes, we do have data. But you’ve been in this market 10 years, so you probably have more data.”
“OK,” she says after a long pause, “But I’m getting less and less confident about this deal and I’m not sure how much longer I can keep my managers in the dark. I hope this doesn’t fall apart because of you.”
Meanwhile, the LPs are growing more disillusioned by the day. The Partners had gone around raising a new $750 million fund a year ago because they claimed to have found so many new opportunities.
But since then, the market has taken a nose dive and no one wants to do deals – and the LPs are wondering why your firm is letting so much cash sit there unused.
Technically, the LPs don’t have any say in the management or operations of your firm (hence the “Limited”), but they still look at your investments and may choose not to invest again if they don’t like what they see.
John calls David into his office for a quick chat.
“They want to see something from us soon,” he offers up, “And I want to see something from you soon.”
No closed deals and no exits in 3 years – if that wasn’t a slump, what was?
David pulls out his list of prospects and runs down it from the top, explaining why each one might be a great investment.
“That’s nice,” says John with a smirk, “But you know as well as I do that all of those are at least 9 months away, even if we jump into due diligence right now. You could get pregnant and have a baby in that amount of time.”
David wipes a bead of sweat off his forehead and continues looking down at his list before placing his hand on his chin and looking up at John.
“Then the only other option is IonX,” he admits. “Not exactly the bombshell we want, but at least it will show we’ve made some progress and aren’t just resting on our laurels.”
“Who’s the buyer? And how do we convince the pension funds to go along with this?”
“There are more buyers than I can count,” David retorts, “All we do is flip it to another firm and pitch it as an add-on acquisition – here’s a list of all the funds that have been active with consolidation.”
John puts on his reading glasses and looks at the list, and then lets his eyes wander over to the missed call list on his phone from the eager LPs.
“And I suppose you have a magical list of better comps in the space as well?” he lets out with a laugh.
“Right here,” David replies, presenting the data to John as if he were awarding him the Nobel Prize.
John looks through the stats and pauses for a few seconds at the bottom of the list before looking up at David once again.
“Good data,” he says, “But I wonder: how did you get this on short notice, and why are you now suddenly in favor of this deal?”
As you’re poring through the data Nancy has sent over and double-checking all your assumptions in the model, David walks into your office for his 3rd unannounced visit in the past week.
“Good news,” he chimes, pulling out your chair and sitting down with his arms propped up on your desk.
“John’s behind this now, and so are the rest of the Partners. We’re going ahead with the deal and will start bringing in the accountants and lawyers and negotiating the agreement.”
Your mouth drops open as you squint at him for a few seconds, searching for the proper words.
“So… um… what exactly changed? They seemed not to like the market or the potential buyers…”
David cuts you off, waving his hand in your face.
“It’s not an issue – we have enough data on the market and everyone’s comfortable with the numbers.”
“So you just happened to conjure up the right data to convince John that this is a solid idea?”
“Of course not,” David says, leaning back in his chair and folding his arms against his chest.
“I called Nancy myself and told her that all the Partners were committed to the deal now. She just needed someone a little more… senior. And some… reassurances. Once she had that, she was happy to hand over all the data.”
You look down at your desk drawer, searching for your new Eggshell with Romalian type business cards. In case David whips out his Bone with Silian Rail set, you have an ace up your sleeve.
“Well, that’s great news,” you lie, faking a smile and sipping from the Red Bull can on your desk. “Just let me know what else I can do to help.”
David stands up and walks toward the door, and then turns his head around to face you once again before leaving.
“Oh, I will. We’re bringing in all the troops now, so you’ll have to coordinate that. And by the way, performance reviews and bonuses are coming up in a few weeks – hopefully you’ll do better than the new guy! You have said hi to Martin, right?”
The Rest of the Series:
Check out parts 1 and 3 below in case you missed them:
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