Preferred Return Private Equity Preferred return is the part of the distribution waterfall and it gets calculated on the Invested amount based on no. of days until …
What is Preferred Return?
Preferred Return, often called ‘pref’, is a minimum return that Limited Partners in a fund must receive before any carried interest can be distributed to General Partners. A preferred return is expressed as an annual rate of return and can be thought of as the minimum expected return for the investment.
Limited Partners will receive 100% of their gross distributions until they have reached a certain rate of return on their investment in the fund. Once this rate of return has been met, General Partners will start to earn carried interest.
How is Preferred Return calculated?
Each Fund’s Preferred Return calculations are defined by the Limited Partnership Agreement that governs the fund. Fund’s calculations can vary in several ways. The most common variations are in the compounding periods of the preferred return rate, and the method for calculating elapsed time between periods.
For example, Fund A might specify that preferred return on any given capital call starts accruing when the call is funded and stop accruing when the applicable distribution of preferred return is made. Fund B might specify that for preferred return calculation purposes, any capital call or distribution is said to have taken place on the last day of the calendar month in which the capital call or distribution occurred. Now imagine a scenario where both Funds call capital on January 1, 2020 and distribute proceeds on December 31, 2020. In this scenario, Fund A investors are receiving preferred return based on 365 days of accrual, while Fund B investors are only receiving 335 days of accrual since the capital call is considered on the last day of the month.
Investor A contributes $1MM into Real Estate Fund 1, LLC on December 31st, 2020. On December 31st, 2021, Real Estate Fund 1, LLC announces a distribution. Investor A’s gross share of the distributable proceeds is $2MM. Assuming the following structure, what Investor A’s preferred return, and total distributions?
Dr. Patrick Maurenbrecher is the Managing Partner and CIO at Kontora Family Office.
Kontora Family Office is a multi-family office based in Hamburg, Germany. Established in 2006, the firm provides services to families, single-family offices, and non-profit organizations such as foundations, associations, and religious institutions, especially as an organized institution assets in Germany. Following the American Family Office business model and operating fully independently.
In this interview, Dr Maurenbrecher and Cliff discuss:
• What distinguishes Kontora from other advisory services in the space.
• Kontora’s approach to investing.
• What Dr Maurenbrecher means by “thinking and working in modular units”, and the benefit of that approach to his clients?
• How to identify the most objectively, suitable financial and service partners, for your clients.
• The main differences in the private equity markets in Asia, America, and Europe..
• Identifying risk factors that can lead to permanent impairment of capital.
• How to achieve transparent planning, analysis, and implementation without conflicts of interest.
• The key benefits of illiquid assets?
• The factors that determine or effect an asset’s liquidity or illiquidity.
• How Illiquidity Reflected in in Expected Returns.
Cliff Locks 0:00 Welcome to the private equity profits podcast. I’m Cliff Locks. your host, with me today is Dr. Patrick. He’s the managing partner and CIO of Kontora. family offices in couture family offices is a multifamily office based in Hamburg, Germany, established in 2006. The firm provides services to families, single family offices, and nonprofit organizations, such as foundations, associations, religious institutions, especially as organized institution assets in Germany. It follows the American family office business model, operating fully independently. Welcome, Patrick, thank you so much for taking the time let’s start a conversation with a personal note. How did you get started in private equity space?
Patrick Maurenbrecher 0:44 Hi, Cliff. Thanks a lot for having me on. At Kontora. We’ve been investing in private equity for 16 years now, actually, before I did my PhD on productivity aspect, while it was basically turnaround management in small and medium sized companies in Germany, so I’ve been attached to the space for many years, probably most of our families are invested in a with about 20% of their net worth in private equity. So it’s something that’s very close to us.
Cliff Locks 1:17 What distinguishes Kontora from other advisory services in the space,
Patrick Maurenbrecher 1:21 put it this way, I would say we don’t discriminate, distinguish ourselves a lot from the standard American model of the single family office or the multifamily office, it’s very different in Germany, most people get a financial advice in the banking space, they would go to Deutsche Bank, or to Goldman Sachs, or to some of these names, or a local regional bank, and just do some some bond and stock portfolio. And that’s that will be it at Kontora be very much believe in illiquid investments. So an allocation of our clients could be 60%, illiquid. So you will find a lot of real estate project development, you’ll find venture capital, you will find private equity, you will find some funny alternative stuff like, like a container portfolio based in Singapore, or we are invested in cocoa plantation in South America. So you will find a very international diversified portfolio and we we try to drive down the correlation between the assets to get robust portfolios for our clients, I suppose that’s the main difference to the other German players in the field,
Cliff Locks 2:36 you’ve carved out a very unique business model there, I want to salute you for that that’s a breath of fresh air, we take it for granted here in the US. But in Germany, it’s very, very different. It’s a privilege, and learning and listening. Can you summarize your approach to investing?
Patrick Maurenbrecher 2:52 Absolutely. Well, when it comes to investing, it’s basically two areas that we draw ideas from. The one is, when it comes to financial returns, the most important question you have to ask yourself is how do you divide your wealth between the different asset classes. So the so called strategic asset allocation is the the main driving point for robust and stable returns. So that’s the main thing and we look at the US, especially to the endowment model that has been pioneered by David Swensen at Yale, but also others, Notre Dame, MIT, and Seth Alexander’s also a big Professor hero. So we very much look at these guys, what have they done. And then we kind of adapted it a little bit for for Germany. But in the end, it’s the same ideas. That’s the strategic asset allocation. And when it comes to picking individual investments, we very much bottom up guys. Well, I would say it’s the value investing philosophy that is very at the at the heart and core of what we do. But we try not to stay at, you know, what has been Graham said, and what his numbers that he looked at, we try to like most good value guys nowadays, look at what does it mean going forward? For example, most guys look at what is the moat doing in the future. So we look at how will the competitive advantage develop over time? For example, if you look at the business model, like like Google, say, okay, is that moat growing? Or is it shrinking? Or is it staying where it is? And when it’s growing, it might, it might be a value perspective to say, Well, if this is actually a very undervalued company, versus the traditional value guy would say, Oh, that’s a very expensive company for some reason. Yeah. These are the two areas where we draw most of our ideas from Yeah, looking around Seth, Seth Klarman for example, speak here of US based in Boston very much looking at margin of safety for each and individual investment. We try to find investment with big monitor margin of safety. So mostly what we do actually, we always look at what can go wrong, and then try to get good returns from that.
Cliff Locks 5:08 So consistent solid returns. And looking at the risk profile, very good.
Patrick Maurenbrecher 5:14 Yeah, the funny thing is, when you when primarily look at the risk side, you end up with really good returns, we track it by, you know, precisely. So in the history of controller, we have advised our clients on 169 investments. So we can pretty much say what what are the returns of these four lots of the illiquid stuff that they still run. So I mean, if you do a product refund, and that runs for 10 years, and we’ve done the investment five years ago, we can’t finally say where the where the IRR will be. But for the for the investments that are finished already the IRR is at 14%, after after coffee, it seems to work
Cliff Locks 5:56 very positive. What do you mean by thinking and working in module units in what is the benefits of this approach to your clients?
Patrick Maurenbrecher 6:07 Yeah, that that might be an advantage we have here in Germany, because most competitors, they have a model where they say, well, client, I will do everything for you, please come to me, I do the number crunching for you, you can do investments with me, and you have an all in fee model, we adjust, we do all the administration and the investment, etc, etc. everything for you all model is different. And that we say it’s fine that people also single family office can come to us and say, you know, we have the administration in place already. But we really need deal flow for private equity or real estate in the US, for example. And then we could say yeah, that’s no problem. You just we show you our deal flow, and then you just pay for these services. And others might say, you know, we do all our investments ourselves, and we have 70 p phones funds, for example. And could you just do the administration for us. So we are basically there workbench, providing them with all the all the numbers and and you know, we we get the, the the quarterly results, and we do all the bookkeeping for them. So that would be a different approach, working with Kontora. And then other families come and say, you know, we have four kids, they have no idea about investing, we are all fine, you know, maybe the husband, he has built up his wealth. And he says, well, but my kids will inherit this at one day. And but they have no idea about investing, can you teach them? that’s actually quite a big thing in our whole portfolio of services that we provide an academy program where we vary individual, you know, some some say, Can you just do some education in the different asset classes? And we would say, okay, there’s one module where we explain how does listed equity actually work? And one will explain Well, how do you invest in real estate? And one would say, what about private debt, we would then go about explaining all these things, because we very much believe actually also be a German thing over here. Most asset managers, they come to the clients and say, it’s great that you’re here. It’s wonderful. Now you don’t have to worry about anything, just give me your money, and I will take care of it. And the typical entrepreneur in Germany will panic at this sentences, because, I mean, usually he did the decisions, and he was very good at deciding stuff. And now there’s somebody coming along who wants to take all this away from him, Well, we tried to do is say, look, what you’ve always done. I mean, this, this is for the kids, but also for for the for the guys, for the successful entrepreneurs, you have done your decisions very well in your space. And now suddenly, you want to invest in venture capital, for example, or real estate, which you have never done before. So we will kind of teach you all you need to take the decisions in the future on the same solid ground. Yeah, that’s pretty much our approach.
Cliff Locks 9:02 Prouty, what is your approach to identifying the most objectively suitable financial service partners for your clients?
Patrick Maurenbrecher 9:11 I think it’s a it’s a two way process. On the one hand, of course, when it comes to investments, like private equity, for example, you have your league tables you have you know, everyone, it’s very transparent. What’s the best track record? Who are the guys who want to invest in? I don’t know, for example, venture capital, well, you want to invest with Andreessen Horowitz or Sequoia or benchmark. And then your only problem is, will they give you allocation or not? Well, that’s the easy part. So you work on your network, you try to you know, get the connections to be able to invest with the best guys on the planet. But then, when it comes to stuff like listed equity, we are more contrarian in the contrarian side of of who we like to give money. So for example, most asset managers I think that’s actually globally will say Well, you know, we have a diversified portfolio of 30 to 50 companies, and that’s a very concentrated portfolio. And then that’s when I panic because a concentrated portfolio is something between 10 and 15. Companies, you don’t find that in the in the normal institutions like a bank, or a huge asset management firm, but you do find it with one Captain ships, we look for these guys who, who, you know, have a setup, where they do their investments, but basically, they concentrate on investing in a concentrated portfolio. And they have spectacular returns. This is purely basically getting to know the guys trying to find these guys at conferences value x in going to Omaha, I mean, I didn’t go the last two years. But you know, we go to Omaha, meet guys at the Berkshire AGM and and you you get your network of guys who actually do these style of investments have to do a lot of explaining when when the families come to us at first, because I mean, they have heard the whole day year all their life, that you need 30 to 50 companies in a portfolio for it to be meaning portfolio. And so that takes a lot of education, actually, but most most families end up in the style of investments.
Cliff Locks 11:22 That leads me very nicely into what are the main differences in private equity markets in Asia, America, in Europe?
Patrick Maurenbrecher 11:29 Well, that’s a very broad question. But very good question. I mean, for me, the the best private equity managers are still found in the United States. I mean, this is where it originated, this is where the best guys are, and where the innovation Actually, I mean, the structural innovation, how to invest in the private equity space comes from, I would always tell our families, when you want to invest with the best productivity guys, you need allocation, the United States, then in Europe, you have some very able managers, probably the markets are not priced to perfection, the way it might be in the United States. But then again, I always think most of us, most families have a home bias that’s everywhere on the globe. But we have the same in Germany. So I always tell the families rather do a little concentrate your productivity portfolios, rather, in the in the United States or in Asia, because you have enough assets in Europe anyways. So So I always work against the home bias and try to I mean, that’s a very personal thing. I mean, you have people, they say, Well, the only place to invest money is in the US. And others say, Well, you know, this is this is all cowboy country, and I don’t like to invest in the United States. And well, for me, for me, personally, I would always feel very comfortable having at least 30% of my worth in North America. So I rather have an over allocation in the United States and in Asia. And then I mean, you also asked about Asia, in Asia, it’s definitely still an emerging base there. But that can give you spectacular returns, we had the experience. Also, like 678 years ago, when I talked to clients about investing in Asia, they were like, well, if I invest in Asia, it’s more risky than investing in Europe or in the US. So I want more return. I totally understand this thinking but it was not possible, you could not get a higher return in Asia. And nowadays, the discussion is totally different. It’s more risky not to invest in Asia than to be invested. We go there we we do due diligence in in Hong Kong in Beijing. And we try to get a feeling on the ground for the right teams. And yeah, we found some really good managers, large and small. So we we do quite some allocation over there.
Cliff Locks 13:58 Like I’m sure. What is your approach to identifying risk factors that can lead to permanent impairment of capital?
Patrick Maurenbrecher 14:06 Oh, that’s a very good question. Also very difficult question. Yeah, I’m sure you have. You’re familiar with the Warren Buffett quote, rule number one, never lose money. Rule number two, never forget rule number one. I mean, that’s just the art of compounding. And if you want to do compounding, he should not lose money on the way. So that’s very difficult. And that’s where the margin of safety comes comes into, into play. It’s at the heart of what we do try to identify what can go wrong. And that that doesn’t matter if we’re talking about product which he or listed equity or real estate or whatnot. It’s always the same question, we have to look at eight factors that we always apply no matter which asset class and for example, one first question that we always ask, does the manager that we give money to has skin in the game I mean, this very old, silly in a way aspect, but it’s the one that is so important. And if you get the right answer on that, and then you have alignment of interest, that’s a very, very positive. I mean, in Hamburg, you know, we are shipping city. And I mean, it’s a very good example here, because we have lots of shipping companies here. And they used to be a time when the guys who run the shipping companies, they would run, for example, 20, or 30 ships, and then they would have the equity and three of these 30 ships, and the rest would only be with other people’s money. Now, you guess, which ships never lost money, you know, and it’s, it’s so funny. I mean, even in the biggest crisis, the ships that had the money of the of the of the entrepreneur somehow came through, and the others didn’t. And it’s a simple, simple factor, but we always follow this. So we probably lose quite a lot of interesting deals, because there’s no skin in the game or too little. But we’re fine with that. Because the risk side is so important for us. Well said,
Cliff Locks 16:12 How do you achieve transparent planning, analysis and implementation without conflict of interest?
Patrick Maurenbrecher 16:19 And that’s a easy question for us. Because it’s at the heart of our business model, we are not an asset manager. I mean, that’s the problem. When you For example, it’s about listed equity portfolio, and you go to a bank and say, well, is your is your portfolio the best? Of course, it’s the best when you come to us. We are an independent advisory firm, you know, we don’t take any kickbacks, the only guy who pays us is our clients, they asked us question, we do a very neutral and independent screen of what’s available, who can kind of fulfill the the required criteria, and then we present them to our clients, whether, you know, if they get a 30 page analysis of what what are the risks, what are the chances to give this guy or that gay guy money with a strategy, and then it’s our clients who will decide there’s actually no conflict of interest involved.
Cliff Locks 17:11 So being independent is very, very positive. And that’s different than most firms sitting in Germany at this point.
Patrick Maurenbrecher 17:16 Absolutely. And, and also, also the, the structure of our company is kind of working in our favor. I mean, we are just three guys owning the company, nobody else has shares, we will try to give more people in our company, and we’re 70 people now. So we will try to give more people shares of the company, but nobody from the outside. It’s the entrepreneurial families that are our clients, they they’re very much like that, because it’s kind of from, I don’t know, they feel at arm’s length. They like to talk to other entrepreneurs in a way. And so it’s Yeah, it’s it’s, it’s an at the same level field somehow.
Cliff Locks 17:58 Sometimes, it’s also very interesting to look at deals that have not worked out the way you had hoped at the beginning. Could you tell us about the worst deal and what you’ve learned from that experience?
Patrick Maurenbrecher 18:10 That’s a great question, Cliff. And I love it. Because actually, that’s the way we think. I mean, you always have to try to learn from your mistakes. And well, there’s one example that comes to my mind, because it’s, it’s kind of the, I mean, it’s a real estate project that we did. And it looked really nice, it was building with the hotel, and it had some apartments, and it had a cinema, and it had parking spaces. And it sounded also good. And every one of these aspects had a manager who actually knew the field, the guy who did the cinema is kind of the leading cinema guy in Germany, etc, etc. And it all made a lot of sense. And then it all fell apart at some stage. And the main failure or the or where we didn’t kind of understand enough of the project was a was too complex. And when it came, came to building this. Yeah, this project. It was too complex to handle. So the costs were running out of the budget, and at some stage, they close the they made a forward deal. And so the project, but they hadn’t closed, all the cost side, the cost side was still open, but the sold already. And that was a huge problem. And I mean, we do manage a selection. So it was it was too late. We saw too late, the complexity of the project and the calculation could not work out. I was a big problem. And we’re very, very aware of this now and I’m sure that will not happen again. But that was the was really a big learning experience and we lost money on that. And and it, it felt really bad and it was bad for our clients. And yeah, it’s always nice to talk about, you know, 1420, whatever percent are good investments. But I mean, we have actually I, you know, we have six investments of the 169, that didn’t work out. And this was the worst. And then is one is minus 2%. And one was minus 15%. And it’s, I think, overall, it’s okay, but still, those were mistakes that we made.
Cliff Locks 20:36 Let’s go back to one of the earlier conversations we had Tell me more about the controller Academy, specifically the structure of the content and who is it for because I was excited to hear this, I think it’s really advantageous when I find a leader like you and your team, putting an academy together and what they can bring forth to the client in the community. Tell me more.
Patrick Maurenbrecher 20:59 Yeah, I love I love to talk about it, because it’s basically what makes us go round. I mean, we it’s all about learning, it’s about also teaching, but also we learn a lot from our clients. They’re very driven and intelligent and great guys, investing as a difficult area. And funnily enough, at least in Germany, investing is not taught at any university. Yeah, you have finance courses, etc, etc. But, I mean, something like what Columbia school that does not exist over here. So we have modules, where you learn about what is private equity, we have modules will learn, you know, all the different asset classes. But then most important module, from my point of view is the one that the co founder, Stefan book world health, and that’s about, is there something that over centuries, the successful families all done, you know, are they are there common rules that you can follow? And yes, they are common rules. And if you look at what families who have built huge well done over centuries, you always come to the same conclusions. And that’s so funny you don’t have to you know, advantage for you, you just have to be very disciplined and look at, you know, what others have done in the past and then try to apply it with the same discipline and for example, one thing that that you you’ll find that an old Jewish families, you will find that and, and and, you know, all over the world is the same principles, for example, diversification and trying to drive down on the correlation between risks is something that has been done for centuries. It’s all I mean, they had different names, it wasn’t called alternative investments, maybe it was the land you know, you have to own land or what what now for for us for example, listed equity, private equity or direct investment in companies is basically the same risks that you buy you you buy into future cash flows of companies find that family Fugu is a is an old German family, who he they made deals with the with the pope at one point, I mean, centuries ago. But that’s the same principle. They had some of their money in land some of the money in real estate and some of the money and companies. That’s what they did. And basically, it’s the same idea that we try to tell our clients or try, our clients try to have real estate than corporate cash flows and alternative investment, which is basically the bucket of everything else. It’s working fine. That’s great.
Cliff Locks 23:42 What are the key benefits of illiquid assets?
Patrick Maurenbrecher 23:46 I think it’s a bit counterintuitive, because most people think it’s great to have liquidity. But when it comes to successful investing, the biggest problem is not the market and it’s not intelligence or something. It’s having your own behavior in check. So illiquid investment help you because you’re stuck. For example, how many people have sold stock in in spring 2020 when the Coronavirus said a lot, a lot and then it took them and then they sold and then it took them a lot of long time before they re entered into the stock market. Well, that that there? Yeah, they messed it up. Because I mean, nobody could have foreseen that we get such a quick rebound, we see the illiquidity premium as something really valuable and it’s it’s helping everyone to have their own feelings and check in a way. So that’s what we try to, to to teach in a way most entrepreneurs that they they grasp this immediately. And I mean in their companies they’ve they’ve done it for years, because It’s, it’s what they do they always think long term and suddenly only because it’s possible to trade every day. People think that the stocks, it’s just a financial product, but it’s basically having a share in a business. I mean, you wouldn’t have the idea of because the prices of your apartment went up to sell your apartment The next day, you wouldn’t do it. But we’re starting to do it. It’s It’s funny, but that’s how human nature is. And I mean, Daniel Kahneman and others have shown as all that’s it’s all the problems are always. So yeah.
Cliff Locks 25:36 What are the factors that determine or effect the assets, liquidity or illiquidity? Okay, could you elaborate? When you look at an asset or an asset class, we look at liquidity, and then the illiquidity so you know, you look at it some private equity and venture capital. Some of the capital, it’s at points for the high net worth or ultra high net worth individual has a timeline the way they want to put those assets to work. So liquidity and illiquidity at this point does come into rolls. When do they need those proceeds returned to them? Where do they? So when you Yeah, okay, balance that takes place?
Patrick Maurenbrecher 26:18 Yeah, it’s all it’s always important. I mean, we advise our families to generally have at least 10% of a net worth and cash, no matter where rates are. That’s very important. And then, of course, you have to manage your liquidity. I would say most of our families, they, they they have about 50 to 60% of their investments in illiquid investments and the rest and liquid investments. And that kind of I mean, I’m well, but I must say, I’m talking about families with net worth north of 50 million euro, you know, so I mean, that’s a different kind of
Cliff Locks 27:01 problem. Burberry good. How is illiquidity reflected in the expected returns?
Patrick Maurenbrecher 27:08 Yeah, I’d say the I mean, we talked about it’s a it’s a illiquid premium. And and, I mean, I wouldn’t say it now is 1%, or it’s 2%, or how much it is. But it’s important, very much believe in the illiquidity premium. And that’s what our results for last 16 years have shown. I love investing in the stock market. So I I’m not a purely liquid guy, but you know, but I treat it pretty much like an illiquid investment.
Cliff Locks 27:38 Very good. What are the personal rewards for you in doing what you do? And what do you love about your career choice.
Patrick Maurenbrecher 27:48 It’s basically working with these hot driving entrepreneurs. And and that was makes me get up in the morning. And if I know I ever have a call, I have a strategic meeting with, with, you know, one of my clients, it just, it just makes my day because I always learn a lot from them, they make me think and you ways, I figured out a great investment, and I presented to them, and they they really get get to the heart of the investment and the risk reward profile within minutes. And then kind of getting them to, I don’t know, agree with me or disagree with me as something that that is very fulfilling for me.
Cliff Locks 28:31 So it’s a friendship, and a business relationship. It’s together.
Patrick Maurenbrecher 28:36 Yeah, I would say so. I mean, some of our clients are definitely in the in the top five. table for me, of people from whom I’ve learned the most definitely
Cliff Locks 28:47 very positive. Tell me about your legacy you’ve built?
Patrick Maurenbrecher 28:52 Well, I’m at the beginning of our conversation, I told you about the financial situation of financial market in Germany and the situation we have here, where I always feel very, very much behind what’s just the normal stuff in the US and and just, we’re just not a leading nation when it comes to investing. And if, if I were controller can help kind of do a bit of education that people over here also invest their money. Yeah, with the ideas that have worked for centuries. That will be great. If we could have, you know, that level of impact and help on that front.
The Private Equity Profits podcast with Seth Greene Episode 007 with Andrew Busser,
President of Family Office at Pitcairn For almost a century, Pitcairn has partnered with some of the world’s wealthiest families to meet their needs and drive better outcomes year to year, decade to decade generation to generation.As President of Family Office, Andy Busser leads Pitcairn’s exceptional team of relationship managers, analysts, and client communications professionals, ensuring that the Pitcairn client experience sets the standard for families of wealth. People who know Andy describe him as curious and enthusiastic, with a passion for solving complex problems.
Andy brings a commitment to objective analysis and holistic solutions to the Leadership Team, and he is known for building successful relationships with clients and employees. Throughout his Pitcairn career, Andy has spearheaded the development of the Pitcairn Experience. He continues to position Pitcairn as a leading innovator among family offices. Before joining Pitcairn in 2015, Andy was a partner at Symphony Capital, a healthcare-focused investment manager of private equity and hedge funds. Previously, he was a management consultant at The Wilkerson Group and its successor, Wilkerson Partners.
Andy holds an AB in History from Colgate University. He has served on multiple boards, including the Colgate University Alumni Corporation and Lincoln Center Education, and Andy is currently a trustee of the National Committee on American Foreign Policy. Creative by nature, Andy enjoys painting, in particular, landscapes. He is an avid reader and can usually be seen traveling with a book on history or economics.
Originally from Columbus, Ohio, suburban Philadelphia is now home for Andy, his wife, and two sons. Whenever possible, he can be found skiing in the Rockies or fishing the waters off Cape Cod.
Listen to this informative Private Equity Profits episode with Andrew Busser about maintaining and protecting generational wealth.
Here are some of the beneficial topics covered on this week’s show:
Providing a comprehensive service experience across all the dimensions of family wealth.
What it means to truly be an advocate for clients. • The one thing that can destroy generational wealth.
The importance of understanding family dynamics. •
Pitcairn’s Gen 7 research hub.
Communication in teaching generations what it means to be responsible with money.
Larry Kaplan, Managing Director at CSG Partners, LLC.
Larry has built the nation’s leading leveraged employee stock ownership plan (ESOP) practice. His expertise in capital structure and ESOP optimization has led to hundreds of successful liquidity transactions and numerous accolades from industry organizations. He is also the owner of Synergy Capital I, LLC, a broker-dealer that provides corporate finance, liquidity and M&A solutions for private companies.
Listen to this informative Private Equity Profits episode with Larry Kaplan about identifying risk factors that can lead to permanent impairment of capital.
Here are some of the beneficial topics covered on this week’s show:
Does ESOP give shareholders more after tax value more than private equity?
How to determine whether it’s worth exploring an ESOP transaction.
Analytics and data that drive the ESOPs recommendations.
Employee stock ownership plans and how they are funded.
Operating as industry agnostics. Firm philosophy and culture.
Cliff Locks 0:01 Welcome to the private equity profits podcast. I’m Cliff locks your host and with me today is Lawrence Caplan Founder and Managing Partner at CSG partners LLC. Larry has built the nation’s leading leveraged employee stock ownership plan. It’s an Aesop practice and is actively involved in all aspects of csgs investment banking activities. He helps owners of private middle market companies achieve equity monetization, while addressing personal goals such as business continuity, legacy and estate planning. His expertise in capital structures and Aesop optimization has led to hundreds of successful liquidity transactions in numerous accolades, industry organizations. Tell me how you got started, Larry, and what led you to private equity?
Larry Kaplan 0:47 Sure, I was working at a middle market accounting firm in New York in their Consulting Group, doing some general consulting we also have m&a side of our business. And I was working with one young individual that started a company was 34 years old was constantly reinvesting in his business and wanting to sell the company and we had taken the company to market he’d gotten some bids from private equity, a few from strategic and they were really low three, let’s say four to four and a half times Eva Dodd is about 21 years ago. And at the same time, we were doing some work for the garment center company, Bill Blass here that he had passed away and his estate was selling their interest. And I found out they had an employee stock ownership plan, bill actually actually sold a piece of his companies earlier. And he used that money to fund which now I think the name has changed, but was then bill Blass Reading Room at the New York Public Library. And I became interested in the Aesop I knew nothing about it. And I started talking to people that were involved in that Aesop. I spoke to their attorney, and they were telling me the tax benefits that you receive when he sold to the sap. And I knew nothing about that. And I said, That’s amazing. Actually, I said, these tax benefits are really encrypted, you don’t pay capital gains taxes, the company receives tax deductions equal to the sale value. And so I started going around to the partners at this firm, which was an excellent firm, and I started asking them what they knew about Aesop’s and everything that they knew about Aesop’s was completely wrong, because they just didn’t have any of the facts. And these are very smart audit and tax people. And I said, Look, there’s this major disconnect in the marketplace between what’s reality and what this product actually is. And so we then took this company down the road of selling to an iOS app, he got as much money after tax if he would have sold the company. And it became a huge success. Because Three years later, he sold to the software initially for like, value the company was $40,000,000.03 years later, he ended up selling the company for $140 million. He walked away with a ton more money, the employees walked away, I think there are maybe 50 of them with over $40 million. It was a major success. And that’s what led me to say there is this opportunity in the market because business owners don’t understand Aesop transactions, nor do they’re professional advisors, the one that I came across, and that’s how I got started.
Cliff Locks 3:08 I appreciate that. Tell me about your employee stock ownership plans and how they are funded.
Larry Kaplan 3:14 Sure, we like to tell business owners that any doing an Aesop is doing a leveraged buyout of your own company, right, just like a private equity firm is gonna go in, and they’re gonna put some equity to the transaction and go to the capital markets to raise debt to finance the transaction. We’re doing the same thing, right. And initially, we had to educate the banks as to Aesop’s, we had to educate the funds to ethos, we had to educate all parts of the marketplace as to why they should be lending into an Aesop transaction at terms similar to what the private equity firms are doing. And so now we got the same access to the capital markets as a private equity firm doing up and down the markets. Last year, we closed our first high yield leverage bond offering to financing ease up which was we raised over $500 million for that transaction. So we’ve got in and said to these business owners, you could do it and we’re going to help you do it. And that’s where the money comes from. It’s a debt driven transaction. There’s no equity in the deal. But since the owners aren’t paying capital gains taxes when they receive those funds, that’s the equity piece that we’re able to fill in the gap.
Cliff Locks 4:21 Isn’t Aesop give shareholders more after tax value more than private equity?
Larry Kaplan 4:26 Well, a couple of things we’re going to talk about after tax value number one, just from a strict monetary perspective, right when you sell to an ISA, under Section 1042 of the code. When you receive those proceeds, if you reinvest into qualified replacement property similar to a 1031. In real estate, it’s much more flexible. You could defer paying capital gains taxes. As long as you hold that replacement property. There’s a whole industry that’s popped up helping business owners satisfy that qR p requirement, but number one right off the bat, you’re not paying these taxes. And that’s kind of like the great equalization factor with what you’re going to see with the private equity deal. But in addition, right, how does it give them more and this is really, sometimes we go into a transaction and the private equity offers are more than what they’re going to be able to get from selling to an ease up. Most of our deals are done directly, though, with private, family owned businesses. And they could be a business in Des Moines, Iowa, or remote portion of Iowa. And they’re the private employer in that town. So when these companies start looking for liquidity strategy, these employees have been with them. In some cases, since they’ve been in that community since the 19th century. While they want to get the value for the company, getting the absolute maximum last time off the table is not what’s driving most of the people that are doing any stuff. They want value. They want strong value, but they’re also looking at their community and what’s selling to a third party could ultimately do to their community.
Cliff Locks 5:54 Well said, What industries do you serve?
Larry Kaplan 5:56 We’re industry agnostic. So right now we’re probably working on 30 or 40 different transactions. We’re working with companies in the construction industry, manufacturing, distribution, transportation, services and consulting. We’ve got a large medical practice. Aesop transaction right now, you’ve probably done some episodes on the healthcare industry. And we’re offering Aesop’s to medical practices, the same kind of a structure that they’re getting through private equity. They could do it through an Aesop. So you name any attack, we’ve got accounting firms, we’ve been uncertain specialized law firms, you name any type of an industry. And as long as those companies are paying taxes, then Aesop could be an alternative structure for them.
Cliff Locks 6:41 Very interesting. What are you most proud of in your career to date?
Larry Kaplan 6:45 Well, I think in general, we’re both proud of we’ve probably made hundreds, if not 1000s of employees, millionaires through use of putting these up in place. And I’ll just give you one quick story. One of the earlier, Aesop’s, I did turn out extremely well. And it was limited workforce. So most of the most of the top executives at the company when the company was sold four or five years later, walked away with north of a million dollars in their retirement account. And independent of this, I was playing in a casual poker game with my brother in law and some of his friends. And there was one of the guys who I’d never met before who said, Yeah, my wife worked at that a special needs child that really needed a lot of care and it was very expensive. And he said my wife worked at me SATCOM, through the sale of her stock. When the company was sold, she was able to fund the care for the rest of his life through the proceeds that she received from the Aesop. And to me, that was amazing. And we see this time and time again, now that we’re really transforming not just the selling shareholders, right, they’re happy, and they’re getting great deal. But it’s also the people that helped build these companies that are now getting dissipate in capitalism and ultimately sell and get this money. So it’s a nice thing to do very positive.
Cliff Locks 7:59 What is your approach to identifying risk factors that can lead to permanent impairment of capital,
Larry Kaplan 8:04 just like everybody else, right? So anytime we’re going into a company, we’re going to be the liaison between the company and the credit markets. And so we try to do the same type of due diligence and stress testing as any type of private equity firms come into a company and do right, what could happen to impair this company’s future cash flow. And of course, because of the ISA up in the company not paying taxes, they’re always gonna be better off at least there’s some positive cash flow. So when you stress testing and Aesop, even if the company is performing, you know, 50% less, they’re still generating the same after tax cash flows. So you’ve got more buffer in your ability if things go wrong, but it’s the same thing, right? How How big is your order book, how sticky is your clientele, the same kind of stuff that our private equity firms gonna go when we try to analyze and the better companies could get, you know, six, seven times, even puddings that don’t have that, you know that you get two times EBIT, done alone. So it just runs the gamut. And it’s the same analysis than any private equity firm will come in and do. How
Cliff Locks 9:05 do you help clients determine whether it’s worth exploring an Aesop transaction?
Larry Kaplan 9:09 Right, so we do a lot of right. So we’re a very quantitative driven firm, right? So the first thing that we go into a business owner is that we say, look, you have all these other options, right? And which is the best option for you. We’re gonna run financial models, and we do this virtually every day, we’re gonna say, what does an Aesop look compared to private equity day one? What does it look like in years 345? What does it look like and compare it to a strategic value strategic buyer. So we’re running all these different models with different assumptions and then we come through and we work. Normally we’re introduced to these clients through a trusted advisor, whether it’s their accountant, their lawyer, or some other type of their financial wealth manager. And so we’re including them in the process and collectively, they look at it and you also need to include estate planning, all the things that you look at in any type of asset. sale gets incorporated into the analysis very, very positive.
Cliff Locks 10:03 What kind of analytics and data drive the SOPs recommendations? Number one, you
Larry Kaplan 10:09 start with the same thing. So we start with the same base financial models, they would with the private equity, you can have a low growth, moderate growth, high growth case, looking at the cash flow of the business. Is it cashflow intensive? Is it not cashflow intensive, we have to look at factors that lower taxable income such as a cubii deduction, depreciation, and then we look at the company and saying, Okay, how much the bottom line driver with does the E sub really make sense? Higher the taxes that those companies are paying? When I say to companies, they’re usually pass through entities 95% of the time, either an S or an LLC, paying taxes at the personal level? And then we say, okay, when we layer on the ISA, right, how much better off of those companies be? And then we say, how much money Can we borrow, right? What’s the value of the company for Aesop purposes, so all these when we do analysis, it’s usually a 60 page analysis that covers value, capital, raise cost of capital, the ability to pay that down based on various assumptions. So again, it’s a lot of modeling. And that’s where people appreciate the detail that goes into this analytical exercise,
Cliff Locks 11:17 very professional. Describe the culture and philosophy of the firm.
Larry Kaplan 11:22 You know, our culture philosophy is always do the right thing for the client, right. And so number one client comes first, second, and third, always, you know, tell the good news and the bad news, if it makes sense. Let’s go for it. If it doesn’t, it doesn’t, then let’s not waste everybody’s time and, and try to put a square peg in a round hole. Most people at CSG have been with us further, you know, for the last 20 years, when they start coming very few people leave most of our managing directors now they become a Managing Director Emeritus. So even though they’re not working full time anymore, what ex partner who is now in his 80s, and he’s still bringing in business. And so who worked with some of the younger people, they’ll run the deals, and he’ll do it. So we have no stop limit, you know, you could continue working. And then now what we’ve really done over the last five years is bringing a real good core group of younger people that are gonna be the future of this for I think we give the best training. I mean, we know that because a lot of times, historically, they kind of target our employees and take them over the bigger banks. And then sometimes we just hired our new head of capital markets, have worked with us 15 years ago, went to work for the major banks, and then we brought him back in, and he’s been a phenomenal help for us opening up new sources of capital that we could never have touched by ourselves. So that was great.
Cliff Locks 12:39 I’m proud of you and your team a continuity, yeah, and flourishing, and really the doing the training with internal. And then the mentor. I think it’s very, very positive. And I wanted to ask you, what do you love what you do in what do you find most rewarding personally?
Larry Kaplan 12:53 Yeah, so I’m not a normal person. Because I love I mean, I love what I do, right? I mean, we’re working with different business owners in different businesses all around the country. And one thing I really didn’t love was I was on a plane, you know, usually two or three days a week. Now I bow under COVID, I sit here, we’re doing a meeting in Los Angeles, I’m doing a meeting in Phoenix, and I don’t have to travel as much, I enjoy that. But I enjoy working with business owners, right. And I enjoy working with the companies and then seeing them transform, and then seeing the success that comes out of these businesses and how successful they could become and how value how wealth is a tremendous wealth creator, not just for the few people on top, but for all of the employees at the company. And it really is great when you start to see some of these companies in the success they’ve had. Since I’ve been doing this now it’s our 21st year, you know, we see some major, major success stories.
Cliff Locks 13:46 It’s exciting. It’s not just the top sea level, the really it’s the employees at that point. And it’s
Larry Kaplan 13:51 we’ve got, you know, hourly employee workers at companies that have got retirement accounts that are in the seven figures, tremendous, what would be your personal legacy? Well, my personal legacy, just that this see our firm and the work that we’re continuing to do, to see and continue to see that, you know, we’re out here and do more of them. Unfortunately, Aesop’s are, you know, a backwater area of finance, most people don’t know them. So when you look at the benefit they bring versus the amount of market penetration they have. We’re just scratching the surface. My what I would like to see is a company that hopefully this year we’re going to do 25 to 30 of these transactions, but in five years, we’re doing 150 to 200 of these transactions and just to continue what we’re doing but in a bigger, more broad based way. Very positive. I truly appreciate you spending the quality educational time with our listeners today, Larry. Larry, can
Cliff Locks 14:47 I share your contact information with our listeners? Absolutely. You can reach Larry by email at info at CSG partners comm which is spelled info inf o at CSGP ar T and ers.com you can reach Larry by phone at 212-433-5500. Again that’s 212-433-5500 Thank you for our listeners. I look forward to being back with you shortly for another episode of the private equity profits podcast. This show has been produced by market domination, LLC.