Why I'm In the Wrong Business

I’m a relative newbie to the financial world, but after nearly a year-and-a-half in the M&A space, I’ve come to realize that I (as well as nearly everyone else on the planet, let alone finance) am in the wrong business. Here’s an example why:

You plan on selling your house. Let’s say it’s worth $500K. A group of investors offers to take it off your hands for 3X its value. “GREAT!” you say. You sell it to them, recouping 2X your initial investment and feeling like a winner. You get $1M net (more if you have no mortgage, obviously).

However, the investors actually took out a loan to buy the house, and their loan was made at a much lower rate than a prevailing mortgage would cost. Indeed, they also took out the loan for 5X the cost of the house (and thus set a new valuation for the house), and after paying you your price, they then give themselves the remaining 2X of value as a “reward”. This gives the investors $1M just for being smart enough to buy the house. So now, the house is loaded with debt to the tune of 5X its original value. No sweat, because the market for this house just keeps going up. Indeed, the new owners intend to sell the house again quite soon, maybe as soon as a year from now. Mean time, the owners give themselves a monthly fee for being such good homeowners; this is akin to major league baseball players receiving per diem food expenses.

A year later, the new owners are ready to sell. They decide that the house will be sold at auction to the public, and whoever bids the highest will get it. Given the “value” they’ve put into the house in the last year – mostly putting their name on the mailbox and loading the house with debt – they believe that the house will be worth 3X its NEW value. Plus, they like the house enough that they want to be able to use it some even after it’s sold to its new owners, so they arrange that they will still own big chunks of it – maybe 1 or 2 of the 4 bedrooms, a bathroom, etc. – even after it’s sold. This not only allows them to take advantage of the house when it suits them going forward, but they can also share in any money made if the house continues to appreciate or is sold later.

Auction day comes, and the house is sold – for $7.5M, or 3X the valuation ascribed to the house given the debt investment a year ago. The owners take a “dividend” of $6M and also repay the $1.5M in debt that helped finance their original purchase. Thus, the owners now have reaped $7M in cash AND retain a substantial portion of the house even as it changes hands. Even better, they invested little or none of their own cash to get the deal done in the first place.

I’ve just described how the recent LBO and impending IPO of Hertz works (not to mention numerous other LBOs done by PE firms and the like in the past couple of years – think Burger King as well). Note: this only works in a market that continues to be flooded with cash, relatively low interest rates, and demand from buyers. Still, being a well funded PE firm is where it’s at today. With cash and debt so inexpensive and abundant, deals of immense proportions are being done…and some of these would have even Michael Milkin shaking his head saying, “Wow, THAT takes balls!”