Understanding private equity investment

From: alexhormozi

The majority of millionaires are created through real estate, while the majority of billionaires are made in private equity [00:00:00]. Private equity utilizes a specific money-making process that accelerates value in businesses, generating significant wealth for investors and owners [00:00:06].

Contrasting Real Estate and Private Equity

Real Estate Investment

Real estate investments typically generate money in two primary ways:

1. Appreciation: The value of the property increases over time [00:00:25]. This can be natural appreciation (happening over time) [00:00:49] or “forced appreciation” through improvements like renovations (e.g., adding a kitchen, cleaning windows) [00:00:51].
2. Rental Income: Regular payments received from tenants [00:00:32].

Real estate is considered a relatively simple business model, making it accessible for many to become millionaires [00:01:09]. As long as population growth continues, real estate is often a good investment because land is finite [00:01:27]. However, this is a significant risk, as demonstrated by Japan’s declining population affecting its real estate market [00:01:35]. There’s also an upside limit to real estate; it’s unlikely to achieve a 100x return [00:04:10].

Private Equity in Business

Private equity offers more diverse ways to generate wealth [00:02:08]:

• Acquisition Opportunities: Businesses can sometimes be acquired for very little, even “given away for free,” unlike houses which rarely sell for a dollar [00:02:13].
• Rapid Value Acceleration: A business can go from being worthless to worth hundreds of millions of dollars in as little as 12 months, especially with breakthroughs like new technology, patents, or reliable customer acquisition channels [00:02:46].
• Risk Transformation: In private equity, “forced appreciation” often involves taking a negative (a business risk) and transforming it into a positive, making it a “pillar of value” [00:03:20]. This process of identifying and flipping risks can double the perceived value of a business [00:03:39].
• Higher Multiples: Private equity deals can achieve 100x returns, which is why the wealthiest individuals often operate in this space, reliably generating 10x-50x returns [00:04:14].

The Mechanism of Value Creation in Private Equity

Value in a business is largely determined by its profit (often referred to as EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization [00:09:00]) and the multiple applied to that profit [00:09:41]. The multiple is directly correlated to the perceived risk of the business; lower risk leads to a higher multiple [00:06:17].

Example Scenario

Consider a business with $3millioninannualrevenueand$1 million in profit [00:04:39]. This business might not be attractive to institutional investors due to its small size and potential keyman risk [00:04:47]. A savvy private equity investor recognizes that with a few strategic moves, this business could become much more valuable [00:05:17].

By implementing changes such as hiring a CEO, COO, or marketing director, updating sales operations, and adjusting pricing, the business could grow to $12millioninrevenueand$5 million in profit within 12-24 months [00:07:09]. If this improved business, now more reliable and growing, receives an 8x multiple, it becomes a $40 million asset [00:08:09]. This transformation from nearly zero cost to tens of millions in value highlights the arbitrage opportunity in private equity [00:08:30].

Two Identical Businesses, Different Values

Two businesses can have the same revenue ($10million)andprofit($3 million) but vastly different valuations based on their reliability and growth [00:10:09]:

• Business 1 (Transactional, Declining):

  • Purely transactional with no recurring revenue [00:10:25].
  • Founder is integrally involved in delivery, marketing, and operations [00:10:33].
  • Revenue and profit are declining (e.g., from $20M/$6M to $10M/$3M) [00:10:47].
  • This business is essentially unsellable to an outside buyer, having a value of near zero to the marketplace [00:11:03].

• Business 2 (Growing, Reliable):

  • Showing significant growth (e.g., from $5Mto$10M to pacing $20M revenue) [00:11:50].
  • Composed entirely of annual recurring revenue [00:11:59].
  • Margins are expected to expand with economies of scale [00:12:01].
  • This reliable, growing business might receive a 12x multiple, making it worth $36 million [00:12:11].

The key takeaway is that the more profit a company makes and how reliable and growing that profit is, the higher the multiple it will receive [00:09:44].

Factors Influencing Business Value

To maximize a business’s value, investors focus on two main variables: increasing profit and increasing the reliability of that profit [00:09:44]. This is achieved by:

1. Increasing Customers: Acquiring more clients for the business [00:14:06].
2. Increasing Customer Value (LTV/LGP): Making each customer more profitable over time [00:14:10].
3. Decreasing Risk/Increasing Reliability: Making the business operations and future earnings more stable and predictable [00:14:22].

When allocating time or money in a business, it must contribute to one of these three objectives [00:14:31].

Additional “big league” ways to increase business value and multiples:

• Debt Capacity: A business’s ability to carry debt is a function of its cash flow [00:15:45]. Unlike fixed down payments in real estate, business debt varies based on cash flow, allowing disproportionately higher debt for cash-rich businesses [00:16:11]. Leveraging debt can significantly amplify returns for investors [00:17:07].

• Organic Growth: Consistent organic growth (through marketing, sales, pricing, etc.) indicates a healthy, expanding business [00:16:28]. If a business can consistently grow by 20% annually for five years, it will more than double in value, leading to substantial leveraged returns for investors [00:16:47].

• Categorization: How a business is categorized impacts its multiple [00:17:13]. For example, transforming a traditional service business into a “tech-enabled service” or a true “SaaS” (Software as a Service) business by integrating technology can significantly increase its multiple [00:17:23]. A $100,000investmenttostreamlineprocesseswithtechnologycouldyielda30xreturnbyincreasingthemultiplefrom5xto8xon$1 million in profit [00:18:03].

• Size Premiums: Larger businesses command a disproportionately higher multiple than smaller ones [00:18:36]. A business doing $100millioninprofitisworthsignificantlymorethanonedoing$100,000 in profit [00:18:55]. This is because large institutional investors (like BlackRock, Blackstone) have minimum check sizes (e.g., $150million)andwillpayapremiumtoacquirelarge,aggregatedassetsratherthanwastingtimeonsmallerdeals<aclass="yt-timestamp"data-t="00:19:05">[00:19:05]</a>.Aninstitutionallevelisgenerallyconsideredaround$5 million in annual profit [00:20:16]. Crossing the $10 million profit mark further increases the multiple, creating a double multiplier effect [00:20:30].

• Age: The age of a business also adds to its value [00:21:16]. A 10-year-old business with consistent numbers is generally perceived as more reliable and therefore more valuable than a one-year-old business with the same numbers [00:21:20]. A business’s value increases each year it continues to grow or even maintain its position [00:21:44].

The Importance of Patience and Focus

Building significant wealth through private equity is not a “get rich in six weeks” scheme, but rather a “get rich in six years” strategy [00:22:40]. The compounding effect of focusing on and improving a single business over an extended period unlocks immense value [00:21:03].

“A mediocre opportunity executed to infinity is going to do better than an inferior opportunity that you consistently switch to over and over again.” [00:24:39]

Many people fail to achieve wealth because they lack the patience to stick with one endeavor, constantly seeking new “opportunity vehicles” instead of dedicating full attention to their primary business [00:23:24]. All the factors that create more enterprise value in private equity—increasing cash flow, fostering organic growth, improving categorization, achieving size premiums, and building age—take time [00:24:50]. Understanding where value is created and consistently applying effort to those areas is crucial for building generational wealth [00:14:58].

Acquisition.com, a family office functioning like a private equity firm, offers workshops for business owners to learn how to make their companies more valuable [00:15:19]. More information is available at acquisition.com/scale [00:15:40].