Micro private equity + real estate

Hi all,

I currently buy distressed properties and renovate them to hold or sell, backed by 2 investors I know personally (the only people I know with money, 1 family, 1 family friend). I have been looking into what I believe is classed as micro private equity, doing the same thing I am doing with properties, buying businesses worth around 700k-1M with leverage and seller financing not necessarily distressed, using profits to pay debt down whilst looking for bolt-ons, organic growth and margin expansion etc.

Properties I am buying to hold either take 30 years to pay off, or on interest-only waiting till the market rises to shrink the principle, Meanwhile, I'm seeing small businesses for sale at 3-4x earnings, essentially paying themselves off in a fraction of a time. I am thinking If I can find some stable businesses and have management in place, along with my improvements, after the first couple are paid off this could snowball into larger and larger deals. Is anyone else doing this or have any drawbacks/advice on this?

 

I've been thinking about similar opportunities. Businesses are generally more work than real estate and there are more ways for things to go wrong both on the buy and over time. I am leaning towards real estate but the prospective cash flow / returns will be nowhere near a business at 3x earnings (assuming everything goes right). Problem with lots of these companies is that the secret sauce of the business = the departing owner. Can you talk a bit about where you see opportunities in real estate? What's the hardest part of pulling off a good deal and what kinds of returns do you target?

 

This is the exact strategy I would like to pursue: initially run three to four restaurant / services franchise chains (Jersey Mikes, Great Clips, etc) until debt is paid off then focus on small RE retail developments near anchor sites or growing periphery markets where I can franchise an additional unit of the chain(s) I decide to focus on and lease the other bays to other complimentary tenants. Rinse and repeat.

I have not seen this strategy widely used before so am wondering what drawbacks there that am blinded to...?

 

Do some reading into search funds. These are people that specifically look to capitalize on the low multiples that small businesses trade at, both due to market illiquidity and a general disinterest in the space.

The Invest Like the Best episode with Harvard professors Yudkoff and Ruback is a fantastic introduction to the micro PE area. They specifically teach a class on search funds and have backed some of their students. They also have a guide on buying small businesses, though I have not personally read it.

 

This is moderately common at LMM firms here in TX. They typically start out as real estate firms and branch out into adjacent spaces once they’ve had some success and built up a balance sheet.

Some examples:

  • Lantern Asset Management - started out in real estate / distressed real estate, moved into distressed corporate debt / M&A
  • RSF Partners - commercial real estate and SNFs (integrated real estate / operating companies)
  • NRD Capital - Atlanta-based real estate investor who started getting involved in the operations of retail / restaurant franchises, recently acquired (the equity of) Ruby Tuesday
  • Trinity Private Equity Group - started out in real estate, moved into owning the operations for manufacturing companies whose industrial RE they were buying
  • OTH Capital - started investing in real estate in Austin, got to know the founder community and started making VC / angel investments as well
 
Most Helpful
apemonkey

I am thinking If I can find some stable businesses and have management in place, along with my improvements, after the first couple are paid off this could snowball into larger and larger deals. Is anyone else doing this or have any drawbacks/advice on this?

If, man. If.

I spend a lot of time on this end of the market. I think it's the last great inefficient marketplace for investors to find alpha. The problem is, because the opportunities are so small, you can achieve great IRRs consistently and just not end up making that many dollars. Then, once the deals are larger, the playbook doesn't work anymore because the market tightens up (or maybe the inefficiencies are just different).

There's no free lunch. I would suggest that people spend time in micro-cap if they love working with small companies and how to use playbooks and structure to squeeze better performance out of everyday folks. If that's not appealing, then this is going to be an awful grind.

To be successful in the micro-cap arena, here are a few things you need to be very comfortable doing:

  1. Evaluating deals with very little information. Diligence is never going to be satisfying. You're going to have to "feel" your way through the performance of a business to get to the truth, as the financials are never going to be robust enough to provide a detailed picture to support (or disprove) your thesis. You also will need to do almost all of the diligence yourself, as additional deal fees are such a high percentage of the purchase price that they'll murder your base case.
  2. Assessing the replaceability of the owner. Almost all of these deals are with a retiring owner. Very rarely has an owner built himself out of a job, and the infrastructure remains to keep humming along without him. There are also tons of these businesses that rely on the owner's customer relationships -  I've seen plenty of instances where a contractor or machine shop or other project-based business that's lightly differentiated with a quick backlog runoff changes hands and implodes because customers walk. The owner also barely ever salaries themselves appropriately, and there are an awful lot of $300K EBITDA businesses who, after hiring to truly replace the owner, are now $180K EBITDA businesses.
  3. Supporting the new manager / team. Regardless of if it's someone within the organization or a new hire you're bringing in, talent at this size needs a lot of help. If you're a college football fan, think of it like this - these business can get two-star athletes, because three-stars and above don't take these jobs. So you need to be very comfortable sifting through the two-stars and picking overlooked / underappreciated people (sales guy in a small town is charismatic as hell, but dropped out of college because he's dyslexic) and figuring out how to support them (pair him with an inside sales support that handles his paperwork so he can road warrior his way to victory).

All in all, it's a viable strategy for someone managing their own money, and it gets tougher when it's someone managing outside money, because there just aren't enough dollars to go around. For the sake of argument, let's say you put $5M to work into five deals over two years, and then got a 25% IRR for a five-year hold and tripled-ish your money. Depending on your LP/GP structure, that's probably $1.5M-2M to the GP for seven years of work. Even if you do it all yourself, that's $200-300k per year, and someone with the skill set to do this well isn't working for $200-300k per year. So the only way to juice that is to find higher returns (aren't we all) or to do larger deals (like all the other fundless sponsors).

If it's your own money, then the model works way better. I'd happily pay myself a few hundred k a year to manage my own money.

"Son, life is hard. But it's harder if you're stupid." - my dad
 

What are your thoughts on the permanent equity model that seems to be trending in the micro space?

 

I don't know how much it's trending - I know Permanent Equity (that's actually their name) has a 25-year fund to invest in lower middle market businesses, but I don't know of anyone else who has that arrangement. I think plenty of small family offices have that vision, they just don't necessarily say it in those terms.

As I said above, it's a vertical integration question. If I have capital, and I'm an investor, then if I invest it on my own, then I get both the returns on my capital and the carry / "gross margin" that I would have captured if I were a GP investing other people's money. That could be a compelling equation to me on a dollars-per-time basis.

"Son, life is hard. But it's harder if you're stupid." - my dad
 

Micro PE is hard, there are soooo many tiny under $1m - $5mm businesses that aren't worth the headache. 

But I can provide my take. 

I opened up a M&A shop and sold it at a 6.5X EBIT. The only reason I was able to get it sold at that price vs a 1.5X EBIT was because I convinced my Executive team to stay on for 2 yrs while I took a consulting position at the PE firm. 
Making over $15m off the 5 yr run I had, 
I also realized how hard it is to find a good business or property, a serious seller, & at a good price. 
SO I started to pursue minority stakes in $10mm business (ie - 10 to 25% stakes) This strategy allowed me to make deals happen.
I'm able to achieve a cash on cash ROI (pretax) of around 25% annually. 

But lately I started to think about acquisitions in countries outside USA  & Canada. 
For example: There are good logistics companies in the UAE and the UK that have a lower EBIT multiple. 
 


 

 

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