The Private Equity trick investors always miss - until it’s too late

Last week I told you how private equity firms perform magic by “exiting” a deal by selling it to themselves.

I got a lot of replies. Most of them said some version of the same thing:

“Okay, but is every PE deal some kind of financial magic trick?”

Fair question. Let me give you the honest answer.

YES. Private Equity is literally the business of financial engineering.

Every deal I’ve ever seen — and I’ve seen thousands — has some structural element that functions like a magic trick. Continuation vehicles are one flavor. There are dozens of others. Preferred stack engineering. Recap dividends. Waterfall structures that only work if you understand what a “clawback” is. Fee resets. Fund-of-funds Russian dolls.

Every single one of them is designed to move value from one seat at the table to another.

Here’s the part almost no one says out loud:

The magic tricks aren’t the problem.

For example, when you see me below, introducing a magician cutting a lady in half …

You know they don’t actually cut-the-lady-in-half, right?

The lady isn’t cut in half. The investor is.

For example, you know SpaceX isn’t really a 2.1 Trillion asset, right?

Tesla looks like a value stock next to SpaceX; not a sentence any human should be allowed to type.

At 93.6x sales, SpaceX is not priced like a company selling services. It is priced like a company that charges rent on the actual sky.

So you already can see the “financial engineering” is hiding in plain sight -

The question is not, “Is there exotic financial engineering in a Private Equity deal?”

There always is.

The question is, WHICH SEAT ARE YOU IN when the price gets set?

Because in every deal, there are four seats:

• The Banker.

• The Founder.

• The Professional Investor.

• The Retail Buyer.

One of those seats make money on every deal, regardless of whether the underlying company wins or loses. That’s the “magician.”

Take a wild guess which one gets the trick pulled on them.

How you lose this game

Typically, you end up in the fourth seat by default. Nobody puts you there on purpose. Nobody tells you that’s where you’re sitting.

It just… happens, because you’re not the Banker, you’re not the Founder and you’re not the Professional investor.

Here’s the sequence, and see if any of this feels familiar:

• You see a deal that’s already been shopped to twenty PE funds and passed on by all of them.

• You see it because someone in your network “saw the deal” and passed it on.

• The deck looks great. The story is compelling. The numbers pencil out.

• You do your due diligence — which is to say, you read the deck twice.

• You commit.

• Three years later, the deal is being financially engineered (recap, dilution, sold to an affiliated buyer … etc)

• You get a new set of documents. New timelines. New fee structure.

• The people running the deal make money either way.

• You wait.

The magic trick just happened.

How you flip it

The move is not to avoid deals. It’s not to avoid PE. It’s not to go read another article about the yield curve and get smarter.

The move is to change which seat you’re in.

Be not the investor. Be the banker.

You’ve seen me write that before. It’s the same line I put on the cover of every presentation I give. Here’s what it actually means in practice:

1. You enter deals BEFORE the professional investors get in

2. You invest alongside management, not the PE

3. You have direct access to the people putting the deal structure together

This is the operational difference between the top of the food chain and the bottom of it, in every industry that involves capital allocation.

Every PE professional you’ve ever met knows this. It’s the reason they went into PE in the first place — not because they love spreadsheets, but because they understand that the value in this industry is captured at the seat, not at the transaction.

So what are your options?

Really, there are only two.

Option one: keep sitting in the fourth seat, keep hoping the next deal is different, keep being the exit strategy for people you’ve never met. There’s no shame in this — most people spend their entire investing careers doing exactly this. And every once in a while it works out. Rarely though, and most people give up before they hit a big one.

Option two: change seats. Get closer to the deal. Get closer to the people. Get closer to the structure being written before it’s presented to you as a “done deal - love it or leave it.”

GET INVOLVED.

That second path is what my working group is built around. And it’s what I’m going to walk through in detail on July 16.

—

On Thursday, July 16, I’m running a live session with the Bull Street community. It’s not a webinar in the usual sense — no slides pitching you a course, there’s no “$997” anything.

I present a walk-through of exactly how the seat-change works. How my colleagues and I look at a deal in the first 90 seconds. What we look for. What we walk away from. And how you can start operating from a different seat starting the same day you see the presentation.

I’ll send more details next week.

If you’ve read this far, you’re probably the kind of person who should be in the room.

https://orenklaff.com/bullst

— Oren

P.S.

The best question I got last week was from a reader who asked whether I’d ever been the victim of a magic trick myself. Answer: yes, twice. Both in my twenties. Both were educational in the way losing money is always educational - which is to say, I learned my lesson.

More on that in the webinar presentation.