THE DISRUPT METHODOLOGY
Now the Disrupt Methodology has been the secret weapon for accredited and institutional investors looking to deploy large sums of capital; it’s all about filtering out the right projects. This means projects with the highest ROI potential, transparency, and a low-risk profile. We’ve broken down the due diligence process into a few simple steps every investor needs to go through when evaluating these deals.
Do they have truly disruptive products?
This is absolutely crucial because it will impact the economics of the business you are investing into; which in turn will influence the bottom line and your investment ROI. When you evaluate a business, remember there are two types of products; there’s a commodity-type solution and a disruptive product.
The commodity type of solution is a business that competes on price, there is nothing really to differentiate the product or service from its competitors. So what ends up happening is they struggle to raise their prices, and this becomes a problem during inflation and rising costs. The downward spiral this type of business faces can only be combated by increasing the volume of sales, while the profit margins and economics of the business tend to suffer.
Another issue with this type of business is you can usually find dozens of competitors selling an identical product, this makes it all the riskier to invest in these types of businesses as a suitable alternative to real estate assets.
Furthermore, a truly disruptive product can’t be replicated so easily, therefore the brands have staying power and a significant moat around them. This makes these investments more exciting and innovative than anything a commodity-type business can ever compete with.
An example would be a business product or offering that consumers feel they truly need and can’t easily be replaced. This gives these types of assets a lower risk profile that closely resembles more stable real estate assets.
What is their track record?
This is incredibly important, when evaluating their financial statements, you should be looking for deals that have a consistent uptrend in earnings. A consistent improvement in all metrics. If their financial statements have been audited by a 3rd party, and you notice a consistent increase in net profits, then the deal looks promising.
You’ll also want to pay close attention to the track record of management, has the leadership been consistent? Is there a bold vision for the company that they are able to execute on? Has the company shown consistent growth prospects over time? This allows investors the luxury of trusting management in the same way they trust property managers to manage their real estate assets, or real estate investment trusts to pick the right assets. In order for these health and wellness brands to provide a consistent return on capital, paying close attention to track record, transparency, and execution -is key.
How diversified are these assets?
This one is huge because it will determine if the assets have a similar risk profile to real estate and can truly be a suitable investing alternative to real estate.
The top-performing companies or brands typically are real businesses that have built an “audience” of customers are have diversified across a multiple of products (SKUs), services, or ways of engaging with and serving their purchaser. This level of diversification gives these assets incredible upside potential while also maintaining downside protection in the event of a recession. Investors can also rest assured that a brand that is this deeply diversified across so many channels won’t simply “go away” or fail overnight. Nike has had ups and downs but the idea of them deciding to stop selling shoes over the next 5 years is statistically irrelevant.
Are they putting themselves in a position to deliver?
- Have they positioned themselves in hyper-growth markets
- Do they have customers that are naturally buying again
- How long does a customer continue to use the product (Life Time Value)
- Is the product a luxury or easily commodified (Gucci limited edition vs a toothbrush from CVS)
- How can the current customer base be leveraged to raise the valuation (a 4X on EBITDA versus adding recurring revenue for a 7.5X multiple)
AVERAGE RETURNS AND EXAMPLES
According to data from the National Center for the Middle Market, the average annual return for private equity firms investing in e-commerce companies is around 22% to 23%. This is higher than the average return of 17% to 18% for private equity investments in companies across all industries.
However, it’s important to note that these are just averages, and individual returns can vary widely depending on the specific investment. Some private equity firms may achieve returns of 30% or more, while others may have returns that are lower than the industry average.
Additionally, the returns on these investments can vary depending on the stage of the company, the industry, and the size of the company. For example, early-stage companies that are still growing may have higher potential returns but also higher risks, while mature, profitable companies may have more predictable returns but lower potential for growth.
It’s also important to note that private equity firms typically invest for a period of 3-5 years and their goal is to exit the investment by selling the company or taking it public
STRUCTURING YOUR INVESTMENTS
There are several strategies that investors can use to try and achieve better than market returns in their investment portfolios:
- Diversify your portfolio: Diversifying your portfolio across different asset classes, such as stocks, bonds, real estate, and alternative investments, can help to reduce risk and increase the potential for higher returns.
- Invest in undervalued assets: Investing in undervalued assets, such as stocks or real estate that are trading at a discount to their intrinsic value, can provide a margin of safety and increase the potential for higher returns.
- Seek out niche markets: Investing in niche markets, such as emerging markets or small-cap stocks, can provide higher returns but also higher risks, therefore it’s important to do a thorough research and analysis before making any investment.
- Use dollar-cost averaging: Dollar-cost averaging, which involves investing a fixed amount of money at regular intervals, can help to reduce the risk of investing a large sum of money at once.
- Have a long-term perspective: Having a long-term perspective and not trying to time the market can help to reduce the risk of making impulsive decisions based on short-term market fluctuations.
- Have a long-term perspective: Having a long-term perspective and not trying to time the market can help to reduce the risk of making impulsive decisions based on short-term market fluctuations.
TAX ADVANTAGES
Section 1202 of the Internal Revenue Code, also known as the Qualified Small Business Stock (QSBS) provision, is a tax incentive that allows investors to exclude a portion of the gain from the sale of qualified small business stock (QSBS) from their taxable income. In order to qualify for the exclusion, the stock must be acquired at its original issue and held for more than five years.
The main benefit of QSBS is that it allows investors to exclude 100% of the gain from the sale of the stock if certain conditions are met. For example, the stock must be acquired at original issue, the issuer of the stock must be a C corporation, the company must meet gross receipts test, and the stock must be held for more than five years.
This compares favorably to the 1031 exchange, which is a tax-deferral strategy commonly used in real estate transactions. Under a 1031 exchange, an investor can defer paying capital gains taxes on the sale of a property if the proceeds from the sale are used to purchase a “like-kind” property within a certain timeframe. However, the taxes are eventually due when the property is sold or when the investor no longer holds it.
Section 1202 QSBS provides the opportunity to avoid paying capital gains taxes on the sale of qualified small business stock if held for over 60 months, while the 1031 exchange only allows to defer the taxes. This can be a significant advantage for investors looking to invest in small businesses as it allows them to keep more of their profits and potentially re-invest them in other opportunities.
EXIT STRATEGY
A “business roll-up” is a strategy where a private equity firm acquires multiple small companies in the same industry and combines them into a single larger entity. The goal of a business roll-up is to create a larger, more efficient company that can achieve economies of scale and generate higher profits.
The exit strategy for a business roll-up typically involves selling the combined company to another private equity firm, a strategic buyer, or taking the company public through an Initial Public Offering (IPO).
When selling to another private equity firm, the goal is to sell the company at a higher valuation than the purchase price, generating a significant return on investment for the private equity firm. This can be achieved through a combination of organic growth and synergies created by the roll-up.
Selling to a strategic buyer, such as a large corporation in the same industry, can also be an attractive exit strategy, as it allows the private equity firm to realize a significant return on investment and the strategic buyer can benefit from the increased scale and efficiency of the combined company.
Taking the company public through an IPO, is also an option, it allows the private equity firm to sell a portion of their ownership in the company to the public, while retaining a significant portion of the company. This allows the private equity firm to monetize their investment while maintaining control over the company and the potential for future growth.
It’s worth to mention that the exit strategy will depend on the specific circumstances of the business roll-up and the private equity firm’s goals. The private equity firm may also consider different exit strategies depending on the market conditions and the company’s performance.
A business roll-up can result in a higher valuation than selling each business individually, due to the synergies and economies of scale that are created by combining the businesses.
A study by the consulting firm Deloitte found that, on average, a business roll-up results in a 30% increase in enterprise value compared to the sum of the individual companies’ enterprise values. This is due to the benefits of scale, cost savings, and revenue synergies.
In general, private equity firms will pay a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) for the acquisition of a business, the multiple of EBITDA in a business roll-up tend to be higher than an individual business, the range of multiple is from 6x to 15x, it can be higher if the roll-up has a strategic importance for the acquirer, or if the roll-up creates a dominant player in a specific market.
According to data from Pitchbook, in 2020, the median multiple of EBITDA for private equity acquisitions of individual companies was around 8x-9x. For business roll-ups or conglomerates, the median multiple of EBITDA was around 10x-11x. This means that private equity firms were willing to pay a higher multiple of EBITDA for a roll-up or conglomerate than for an individual business.
It’s also worth noting that private equity firms will also consider the terms of the acquisition and the structure of the deal, such as the amount of debt financing used and the length of the hold period, which can also affect the overall return on investment.