Paul Giannamore: Patrick, you are back here in San Juan once again. We just got done with Bubble Trouble. Are you having a good time down here?
Patrick Baldwin: Thanks for having me. The food is phenomenal. The scenery is phenomenal. People, except for one, are phenomenal.
Paul Giannamore: As a deacon, you never touched a drop of alcohol. I've seen it. I've looked around. I haven't seen Patrick sneak in anything. We're going to pipe this right into your congregation.
Patrick Baldwin: Thank you.
Paul Giannamore: What do we have on tap? I know you've gotten a lot of questions from Bubble Trouble. You've gotten a lot of questions on The Buzz line. What are we looking at?
Patrick Baldwin: Paul, it's easy to say that the number one thing that I hear most often, almost daily, is private equity. It's time I start learning something about it. We've had a couple of Buzz episodes about private equity, but the questions aren't stopping anytime soon. It sounds sexy, a second bite of the apple, take some chips off the table. We've heard all the clichés.
Paul Giannamore: All the buzzwords.
Patrick Baldwin: I know no one has more experience with private equity and probably now taking more money from private equity than you.
Paul Giannamore: As I mentioned on Bubble Trouble, I began my career on the sell side at Credit Suisse and then I went to the buy side with American Capital, which at the time was the largest publicly traded private equity firm in the world. We did a lot of roll ups like what you see going on in pest control with Anticimex and Thompson Street Capital Partners. There's a handful. These are great questions because everyone out there gets five emails a day from some buyer, whether it's a strategic, whether it's a broker, a search fund, a pledge fund, a private equity firm. You guys out there always get these emails.
First off, it's important to think about what buyers you have in any process. You have the strategic acquirers. You got Rollins, Orkin, and Terminix, then you have the private equity backed ones. I equate Anticimex not so much as a private equity play as much as I do as a publicly traded strategic like Rollins or Rentokil.
From there, you have a variety of private capital providers. You have a mezzanine fund. A mezzanine fund might buy some equity. If you think about the capital structure of a business, you have senior debt at the top then you have mezzanine debt, then you have preferred equity and you have common equity. Patrick, you were an owner of common equity, right?
Patrick Baldwin: I'm learning. You tell me.
Paul Giannamore: Let's say you and I are partners in a pest control. We'll call it Fat Pat's Pest Control. There's Fat Pat's Pest Control and there's two of us. You own half, I own half. Together, we own 100% of the equity, 50/50. If we want to do a non-strategic deal, we have some options. We can do a 100% change of control transaction where we sell out all of our equity. That's typically with a strategic.
We can also bring in junior capital providers and say, “Patrick, let’s pull out some cash from the business but let's use debt capital instead of equity because it's cheaper.” What I mean by it’s cheaper is whenever you think about an investment in a business, capital providers, whether they're debt capital providers or equity capital providers, are always targeting a return.
What a private equity firm or a mez capital provider does is they look at a business and they say, “I have an internal rate of return target over the next five years,” for example. Depending upon where I am in the capital structure, I'm going to target a different return. I might require 5% for senior. I might require a 15% return for mezzanine capital. I might require a 30% return for equity. Debt is always cheaper. It's cheaper for us to sell debt than it is for us to sell equity. Got that?
Patrick Baldwin: Still trying.
Paul Giannamore: This gets a little bit complicated but let's talk about that.
Patrick Baldwin: I want to wrap my head around this.
Paul Giannamore: That's why we're doing this.
Patrick Baldwin: I've heard you say mez debt before. You've got preferred debt, lower return threshold?
Paul Giannamore: Yes. I'm going to give you an actual example in the pest control industry.
Patrick Baldwin: I'm not pretending to be dumb because I'm getting more sophisticated on learning all this stuff.
Paul Giannamore: Let's go back to Jason Pananos and Jay Davis. Do you remember those guys? I don't remember what episode it was.
Patrick Baldwin: I'm sorry. I don't have the number off the cuff.
Paul Giannamore: There are so many of them now. It was easy when there was 25. Jay and Jason started their career in financial services consulting. They went to business school, they got out of business school, and they said, “We want to buy a company. We don't have any money. What do we do? We had to raise money.”
They became a search fund. A lot of the emails that come into pest control operators are from search funds. The classic giveaway of a search fund is, “We are trying to buy only one business and operate it. We love founder businesses.” They use words like partnering, so on and so forth. The key word is one business. They try to use that to differentiate themselves from a private equity firm that might be buying a bunch of businesses.
Search fund guys neither have a lot of money nor do they have the capacity to pay a lot for a business because they're going to ultimately grow it through acquisition. If you want to make a lot of money when you sell your pest control business, you need to disregard all the search funders. Those guys are the most annoying. They're great people. I love them and I love to sell their businesses once they grow them, but you don't want to be the guy that ultimately sells your business to a search fund guy.
The search fund wants to pay 5, 6, 7 times EBITDA, literally half of what you would get at a prevailing rate in the market. They go out and they buy VDCI, Vector Disease Control International. That's a vector disease mosquito company. They bought that business when it was doing maybe $5.5 million in revenue. They got a great deal on it. They borrowed some debt capital, they raised some equity, and they bought this thing.
Over the years, they grew it. As the value of the business increased, they wanted to go out and make acquisitions. They had an option. When they go out into the market, they could do a recapitalization of the business, using equity using debt, or a combination of the two. If they were to use equity, they would have to give up a lot of ownership.
If you and I own Fat Pat's Pest, we each have 50%. Let's say that our business is worth $10 million and we want to take on a capital provider for growth. If we want to raise $2.5 million and we want that to be equity, now you and I are diluted out. You and I effectively would own 75% of the business and we'd have a new 25% partner. We're diluted. It's expensive for us. We're giving up equity.
Patrick Baldwin: We're talking enterprise value.
Paul Giannamore: $10 million enterprise value. We raised $2.5 million of the money there. Now we own three quarters.
Patrick Baldwin: Between the two of us.
Paul Giannamore: That’s right. Now we've got a new partner and it might be a small private equity firm. Jay and Jason are sophisticated. They went out and said, “We don't want to be diluted. We want to own as much of this business as we can so we're going to use debt capital.” When they use debt capital, they go out to the bank and the bank will give them senior secured lending. We all know in this industry, we don't have a lot of assets so we can't get a lot of senior debt. We might be able to get senior debt in the amount of one times EBITDA.
In our business, let's say that our business is $1 million in EBITDA. We might be able to get $1 million in senior. We might be able to get some mezzanine debt or some subordinated debt. I'm going to make this up because the market changes. Let's say we can do it up to three times EBITDA. That means we can get $3 million in junior capital or subordinated debt. Subordinated debt is subordinated to senior and it's not tied to any assets. It's what we call an airball. It's relatively safe capital, safer than equity, but there's nothing that the lender can grab on to. No fixed assets if we default.
Because the loan is more risky, there's a higher coupon, there's a higher rate of return. On a mez debt, we might end up paying somewhere between 12% and 18% interest, whereas we might only pay 5% or 6% on senior. We might have to give up some warrants. Warrants are options to buy equity at a specific price. Now we've got debt at a higher coupon and we have maybe a little sliver of equity.
Our capital structure looks like this. $1 million in senior, $3 million in sub, and then $6 million in equity. The good news is, you and I both own that equity still 50/50. We haven't given up any equity. On the sub debt, we might give up a sliver on a recap but it's not massive. It might be 1% or 2% of the total equity. Now we've raised $4 million and we haven't given up any equity.
The smaller the business, the more difficult that is to do. When you start talking about $50 million in enterprise, $100 million in enterprise, it's easier. What Jason and Jay did is they said, “At every point in the cap, we want to utilize the entire capital structure and we want to bring on the least expensive capital. We want to be sophisticated about it.”
How do we do that? How Jason and Jay did it and how I've done it my entire life is I never fall in love with any capital provider, whether it's a strategic acquirer like Rollins or Anticimex, whether it's a private equity firm, or it's a debt capital provider. If you want to recap a business, you go out to a competitive process. Sometimes the processes we run might have capital providers at different segments of the capital structure.
Meaning, say you got $100 million business and we're trying to think about how to fine tune the capital structure. The principal said to me, “Paul, we may want to have our cake and eat it, too. We may want to sell some equity and get the proverbial second bite of the apple. We’re not sure exactly what we should do.”
One of the things that I say is, “Let's put together the materials. Let's go out to a full process. We're going to get the strategics involved because they're going to set the investment value. They're going to push the high end and put the pedal to the metal. I'm going to get some price discovery. I'm going to know what this whole thing is worth, then I'm going to go out to some banks. I'm going to go out to some senior lenders. I'm going to say, ‘Senior lenders, I want you to give me the best deal on senior capital you possibly can.’” Now I've got senior lenders competing against themselves.
Then I'm going to go out to mez or junior capital providers and I'm going to say, “I want a $20 million slug of mezzanine debt. What's the best you can do?” Now I've got an auction process on debt capital going on. I've got one provider coming in at 15%, one comes in at 14%, one comes in at 12%. One wants warrants, one wants a piece of equity, one doesn't. Now I've got a competition amongst junior capital providers.
I go out to a private equity firm, the guys that might want to own a majority of a pest control business. Now I'm running a process with actual private equity firms. Right now, there are 60 or 70 of them that are seriously looking at the pest control industry. I would say that there's probably fifteen real opportunities out there as far as firms that want to invest in pest control businesses when the rubber meets the road.
There's a lot that are interested and they're still exploring it, but the ones that I know that are going to put their money where their mouth is, that number is relatively small. When you're running these processes, one of the biggest mistakes most small businesses make is they don't run competitive processes. When I say small businesses, I'm talking about $200 million in enterprise value or lower.
I did this at American Capital. When I was at American Capital, our goal was to go out and talk to companies. We weren't doing pest control back then. We owned Piper Aircraft, Case Logic, and a variety of other like brewing companies and all sorts of stuff. We're in a lot of industries. The private equity firm comes in and says, “We're interested in pest control. Fat Pat's Pest could be a great platform. You guys should deal with us. We're the best because we're patient capital. We're not under any compulsion to do a deal quickly. We bring in all these additional resources.”
Every one of their pitches sounds good but at the end of the day, it is absolutely impossible. I know for an absolute fact that when you deal one on one with a private equity firm without running a process, inevitably you're leaving money on the table. I don't see many indications of that at all. We had Bubble Trouble and we were talking about some transactions that I saw in 2021 that the sellers either used inadequate advisors that have no experience in this or no advisors at all. There was one case where $20 million was left on the table.
Patrick Baldwin: I felt bad when you called me Fat Pat, but when you told me there’s $20 million on the table that they missed out on, I was punched in the gut.
Paul Giannamore: This isn't a sales pitch for Potomac. We are the absolute best at this. We’ve got decades of a track record doing this. In a lot of ways, the results speak for themselves. Whether somebody goes into this process and uses us or not, at the end of the day, you need to find a very sophisticated adviser that understands this and can run these processes.
Clients will call me up and say, “Private equity firms contact us all the time. Is there any problem sitting down and talking to these guys?” I say, “No. You can learn by sitting down listening to their pitch. When you're ready to pull the trigger, you have to run a competitive process. I've been doing this for decades. I myself have learned the hard way. When you try to do a one-off deal with an acquirer, you're always at a tremendous disadvantage if you don't run a formal process with competition.”
We've framed out the capital structure. We understand we got senior, we got mez, we've got equity. Equity is preferred common. We're not going to get into that now. When pest control operators are talking about private equity, usually what they're talking about is a firm coming in and buying somewhere between 60% and 90% of the equity of the business.
A big private equity firm would now own the majority of the business, quite frankly, and the seller or sellers would continue to own a smaller portion. The absolute best candidates for this stuff are the businesses that say, “Transaction multiples are extremely elevated and I want to take advantage of that. I'm 45 years old and I don't want to be done with this. I love my team. I'm having fun. I could grow this. What I could use is some additional capital. I could use some additional M&A expertise to get an M&A engine going. I might need some capabilities. I want a professional board. I might want to partner with a private equity firm that has extensive experience in branding or building residential services businesses.”
“If I can mix all these ingredients up into a stew, not only did I exit today for a huge chunk of money and my family for generations is taken care of, but now I have the ability with the money that I've rolled over into the new platform. I have the ability to make as much money 5, 6, 10 years down the line as I did today.” It's a risk management maneuver. We had Jim on Bubble Trouble as well.
Patrick Baldwin: I'm thinking about Jim. I'm thinking about Jared. Two different exits. Two different ages. Jared has a lot more kids. I don't know if his money's going to go as far as Jim.
Paul Giannamore: I worked with Jim in the early 2000s.
Patrick Baldwin: It was before 2010.
Paul Giannamore: For a long time. Before we did the Anticimex deal and when we ran the full process, Jim says, “Transaction multiples will take care of us. I've got the family situation. We've got all these kids. I'm not going anywhere. I'm in my early 50s. I want to run this. My brothers want out. The absolute best thing we can do is run a formal process and bring in private equity. I own 1/3 of the business. My brothers will be bought out. A private equity firm will own 2/3, and then we'll blow this thing up.” That's the theory we operated under.
We went out to a very formal control auction type process. We brought in the strategic acquirers. We brought in some mez capital providers because I was curious. We brought in private equity firms. There must have been 25 or 30 bidders in this process. In the beginning, we started broad and then we narrowed it down. At the very end, Anticimex’s proposal was one that could not be bid. It didn't start that way.
I remember there being at least a $30 million delta from where Anticimex began at the front end to where they were ultimately pushed to get that deal done. That's how a competitive process works. You have multiple bidding rounds. You're running it either as a controlled auction process. There might be a Dutch auction. It was on Aftermath or on Hinge when I went through the Dutch auction. I don't think we published the whole thing. I haven't used Dutch auctions often. In Macau, we may use the Dutch auction. Wasn't Anticimex ended up being $20 million north of where the private equity firms were? I don't remember the exact numbers. It was quite some time.
Patrick Baldwin: There was a lot of scotch.
Paul Giannamore: It was a significant delta. The problem Jim and his brothers had was that he's not going to sell to a private equity firm and leave $20 million on the table because his brothers need to get full value. In 2018, 2019, when we ran Killingsworth, we did it with private equity. There weren't a lot of frontlines when we did VdA private equity.
Private equity was not competitive with strategic acquirers back in 2017, ‘18, ’19, but I have always kept them in process. Not only do I have a bulge bracket investment banking background but I'm a private equity guy. I always keep them in process. I never make any assumptions as to who the buyer is going to be. You've talked to a lot of sellers. They always say, “Who's the best buyer? Should we deal with this company or that company?”
Patrick Baldwin: It's like question number two.
Paul Giannamore: Do not realize that you have a lot of cognitive biases in your mind. You have absolutely no idea what you're doing. You don't come with any preconceived notions. You let the market speak. You step aside, you let the process dictate what's going to happen, and you let the market speak.
Nowadays though, the majority of the players in our processes now our PE firms. The private equity firms are clearly out bidding strategics. If private equity firms weren't out bidding strategics, you wouldn't have seen us do a Presto deal in 2021 with private equity. You won't have seen us do the Green Deal or the Pointe deal, or the other ones that are coming down the pike. Those wouldn't ever happen. Less private equity can be competitive in process.
Patrick Baldwin: We were in Atlanta in 2021. In Mexico at least, we were in the middle of doing due diligence. Brian Alexson is in town. Jack and Kathy are behind the scenes. If I remember right, wasn't private equity serious about that deal, too?
Paul Giannamore: The day we interviewed Brian Alexson in Atlanta, he was there doing due diligence on Pestban. I talked about how competitive the process was in 2021. That was during the Supernova period or as David Billingsly referred to it as super bad. We had done super bad for buyers. It was in that period where we ran a very broad competitive controlled auction on Pestban. Tremendous amount of private equity involved in that business.
I would argue that was the highest transaction multiple ever paid in the United States for pest control business. We went 25 deep on the front end of that process. It was a very interesting process. Private equity on the margin was more compelling as far as the financial proposition than some of the strategics. Anticimex made sense for the sellers, specifically because they were making the Anticimex platform for the Georgia area. It made a lot of sense for the sellers.
They like Brian Alexson. They love Bill Talon, who's the new president of Anticimex North America. It made sense for them. That was private equity effectively driving up the transaction multiples. That's what I've seen. Private equity and processes have driven up the valuations on strategics. They've put a lot of pressure on strategics.
People always say, “Why do you need bidders in the process? Can't you just tell the acquirers, ‘You got to pay X, otherwise, we're not going to do the deal.’” It's hard to do that. It's easy to be an armchair economist when you're thinking about, “How do I sell my business?” You're not in that very stressful situation of running through the process.
When you are in the thick of it and you've got $100 million or $150 million or $50 million on the line and I'm trying to take the price from $50 million to $55 million, and you say, “That's a 10% delta. It's not huge.” It's an extra $5 million. I would think for most people on the planet, you can buy a lot with $5 million. It is hard to give a strategic acquirer the finger if you do not have a plan B that's extremely credible.
It's easy to fantasize that you can do that but I dare you, to have $50 million on the line with a gun to your head and tell somebody to piss off, you've got to build that competitive process. It's very nuanced and you're always walking a very fine line. A lot of times, sellers themselves can't do it because they don't understand how to do it without blowing up their own deal, even if they've created a competitive process. That's what I have to say on that.
Patrick Baldwin: I'll take the finger was not directly pointed at me. It was the strategic acquirer sitting between us. Thanks, Paul.
Paul Giannamore: Let me think about who it was pointed at today. It was pointed at somebody every day. I’m not sure.
Patrick Baldwin: I know you're serious because I get a peek behind the curtain at summit Potomac. There's one deal that you said, “If we can't get here, the deal's off. It’ll never happen.” You're legit when you said it. The conversation went all the way back at dinner sitting with the world's best bread pudding and ice cream. I now know why you call me Fat Pat.
I don't know how much you can dig into the details, but Anticimex’s way that they've encouraged, stimulated, and developed their people and kept them around, there's a fund there. I know it's not publicly traded but somewhere behind that, there is this private equity that they can use to encourage like, “We need to hit our SMART goals. We need to hit our numbers. In a couple of years, this thing's going to be worth a lot.”
Paul Giannamore: Patrick, that might be one of the best questions you asked. I'm not going to go into Anticimex's specifics, but we'll talk about this broadly with private equity. One of the things that I used to do is when we go out and buy a company, let's say we're going to buy a $50 million and enterprise business, you go out and you say, “We're doing a private equity deal. I'm the private equity firm. You're Fat Pat's Pest Control.”
I said, “Fat Pat, you got a $50 million business. You told me you're super stoked about growing it. You want to take some biscuits, butter mob, and put them in your oven. You want to take some chips off the table.” I said, “Fat Pat, here's what we're going to do. I'm going to buy 80% of the business. I'm going to write you a check for $40 million, then we've got a $10 million rule, which is 20%. You own 20%. You're at the helm. You're keeping your team around.”
Then I say, “I'm not particularly thrilled by the fact that you owned 100% of that business and your team members, you pay them well. I want these guys to cook with some gas because I want to take this $50 million business and turn it into a $500 million business. I want to sell it five years from now.” I might take 10% of the total enterprise value of the firm. If I take 10%, I might take $5 million in equity at the entry price.
I might make a stock option pool. I might do equity grants or I might do stock options. You're going to help me identify the key players in that business. For the top 2 or 3 people, I might grant them some equity, so now they're partners. “You've been around for ten years, Jim. Great job. You're extremely helpful in building the business. I'm going to give you a little equity.”
Patrick Baldwin: Just to make sure I'm following the math here. $50 million business and I gave up 80% equity. You're Paul's private equity and I'm Fat Pat’s Pest.
Paul Giannamore: Let’s use $100 million because it's easy from a percentage perspective. I gave you an $80 million check and you got $20 million. 20% of the equity was rolled. You’ve got a $100 million enterprise business. I own $80 million and you own $20 million. We've loaded a lot of debt on it, too. The enterprise value is $100 million.
Patrick Baldwin: Now you want to incentivize some key people. You're going to give up some of the 80%. Is that where this equity is coming from?
Paul Giannamore: You and I are collectively going to give up a portion of that new co. You've already got your $80 million in cash. That can't be touched. 20% is owned by you. 80% is owned by me. You own 1/5 and I own 4/5. By the time I take a stock option, you're paying for 1/5 of it and I'm paying for 4/5 of it. We're going to be diluted. You and I are going to dilute ourselves down, but we're going to share the love. We're going to give some equity and we're going to set up a stock option pool. It might be incentives-based where, “If we increase the value of the business by X amount…”
When I was at American Capital, we'd market to market value. We had a valuation team that would value each portfolio company on a quarter-by-quarter basis. Because we were publicly traded, we’d market to market. A lot of private equity firms that aren't publicly traded still do that. Sometimes they do it annually. Sometimes they do it only when there's a liquidity event or recapitalization or large acquisition, for example.
For the most part, we're going to keep track of the value of that equity over time. We might say to the management team, “These options that I'm giving you today are worth nothing at $100 million.” If you have a million options, let's say we give Jim $1 million options, at $100 million enterprise value, it does not worth anything. If we increase the value of the business by $100 million, his million options, depending on where they're struck, he might end up with $500,000 in value or $200,000 in value.
The more the enterprise value grows, the more he gets from his option value, the more he gets from his equity interests. You'll find situations sometimes in a private equity deal where somebody buys a $50 million enterprise business and turns it into a $500 million business. You might have certain situations where certain managers walk away with $5 million or $10 million because they've gotten a lot of incentives.
Patrick Baldwin: It’s 80/20, 60/40 preferred. What does all that mean?
Paul Giannamore: Let's talk about our deal. We did our deal. It was $100 million. You're rolling $20 million in equity. I was supposed to write you a check for $100 million, but I wrote you a check for $80 million. You're taking $20 million and you're putting it into a new co. That's Patrick's money, $20 million. I got to come up with some cash as the buyer, the private equity firm. I want to juice my returns. Of course, equity is the most expensive so I want to use debt capital.
Before we close your deal, I take Potomac in and I convert it into a bank book. Now I go out and I auction the debt. I go to all these capital providers and I say, “I got this $100 million business. Here's the fundamentals. How much debt will you give me and at what price?” All the different banks. Fifty of them might come in and say, “I'll give you X amount in mezzanine debt, X amount in senior lending. I might want some warrants and have a bunch of different proposals.” We figure out which works best for us.
In 2021, you could put somewhere around seven times leverage, seven times EBITDA and debt on these businesses. That's changing. When you look at the high yield markets, credit markets are starting to turn over and they're going to turn over badly, which ultimately what is going to impact private equity is its ability to compete with strategics.
We're in this perfect storm where credit markets haven't turned over yet. Private equity has been resilient. Tim Mulrooney talked about it when we had him on the Terminix-Rentokil addition. He said, “The private equity firms are saying, ‘We'll step in.’” I've lived through the dot-com bust and I've lived through the financial crisis when credit spreads blow out. Meaning, when yields spike on things like treasuries, fundamentals change, and we get into a quasi-recessionary environment, banks are not willing to take as much risk as they are today.
We are seeing that as a process unfolds in real time. We've seen spreads widen. The Fed announced the 50 basis point hike when we were doing Bubble Trouble. There was a relief rally. Everyone's like, “This is great. They're not going to use 75 basis points.” As you'll recall, the market shot up and I sold it short. At the end of the day, I shorted everything. Over the night, it rolled over and we lost. The next day, the DAO was down 1,100 points.
That was the Fed relief rally because credit conditions will continue to deteriorate. There are lags to monetary and fiscal policy. At the end of the day, we are in a position where the credit market is healthy enough for financial sponsors to lever. It's going to change. It'll be a very different market environment and private equity firms will be able to not pay as much on the front end. Valuations will go down so it won't matter as much because it's a system.
Patrick Baldwin: Where's the 80/20, 60/40? How's that work?
Paul Giannamore: I don't want to get too complicated. I bought Fat Pat’s Pest and I got bank lending. Let's think about some numbers here. I'm going to use very basic numbers. This is not representative of the real deal from a multiple perspective but from a capital structure perspective, it is. Let's say Fat Pat has $10 million in EBITDA. Let's say I was able to borrow conservatively $50 million. Let's say that our capital structure post close looks like this. $100 million enterprise value, $50 million of that is debt and $50 million of that is equity.
If you think about a home, you walk into a neighborhood and you look at a house and it's got a $500,000 price tag on it. That's the equivalent of the enterprise value of the home. If you've got a $250,000 loan on that home and you've got $250,000 in debt, $250,000 is your equity value in the home. Still, you've got a $500,000 enterprise. Same thing.
Our capital structure is 50% debt, 50% equity. It could be 60/40. It could be 80/20. There's a variety of different things. Let's say in this example, it happens to be 50/50. In the capital structure, you've got equity on the bottom and then you've got debt. We might have preferred equity, but let's not overcomplicate it because I don't think it's relevant for this discussion.
On the debt side, we might have $10 million in senior secured, which is the lowest interest rate, but it's tied to some collateral. Meaning if we go bust, the bank can come in and take our trucks, take our buildings, take all sorts of stuff, so they're covered, lowest interest. Below that, we might have subordinated debt. We have senior subordinated and junior subordinated.
The lower in the capital structure, the return requirements are higher. Senior might be 5% or 7%. Mezzanine might be 10%, 11%, 12%, 15%, 18%, 19%. Junior mezzanine might be 21% required rate of return. Equity, of course, is 20%, 30%, 35%. That shows that it gets more expensive the lower you get in the capital structure because it's more risky.
Junior sub, senior sub, when I talk about mezzanine debt, that's usually a 10% to 15% coupon. There's a million different ways to skin the cat in debt. We've done deals where we borrowed $10 million in mezzanine debt. It's debt, not equity. We have PIK interest, meaning that we're paying interest payment in kind. It's a ten-year term.
I want you to think about this. I borrowed $10 million. I've got to pay principal and interest. What happens if I say, “I want to use this money for acquisitions. I'm going to be tight on cashflow, but I can pay the interest. If you want a 10% interest rate or a 15% interest rate, I'll be able to pay that. I just can't pay that for a few years.” The capital provider says, “I'm going to charge you a 15% interest but it's going to PIK, payment-in-kind.” It means I'm not writing a check every year for that interest. That interest is being tacked on to the principal. If it's $10 million and it's 15% interest, how much interest am I paying?
Patrick Baldwin: $1.5 million.
Paul Giannamore: There you go. Instead of writing a check on a quarterly or monthly basis for $1.5 million in aggregate, at the end of the first year, my balance now is not $10 million, it’s $11.5 million. The negative of that is interest on accrued interest. The benefit of that is now I've created $1.5 million in cashflow. I've got extra money now that I could use.
Let's say I'm paying the provider 15% on that sub debt. If I'm looking and I said, “I got this project where I know I'm going to get a 25% internal rate of return. I'm making the spread so I'd rather push off that interest payment and make that 10% spread. I'm printing money there.” That's how we try to get sophisticated about capital structures.
Patrick Baldwin: This is helpful. Thank you for dumbing it down for me. Questions. Who is private equity for and not for? I'm thinking of two different ways. Size of the business or EBITDA, like, “We're a private equity company and we're looking for businesses that are this much in EBITDA or bigger.” That’s one. The other is the retirement age component. If I'm 70 or 80 and not planning on working much longer, private equity is an option.
Paul Giannamore: Private equity firms are levering. They levered equity bets. Meaning, you're taking equity and you're leveling it up with debt. I know that some private equity firms that are reading this say, “Paul, I disagree with that because we don't use a lot of debt. We're very equity-heavy, so you shouldn't look at that as a levered equity play.” I'm making a broad-based assumption.
Private equity firms typically will need to lever free cashflow. We talked about the fact that it's hard to get senior secured debt for a pest control company because it's very capital light. There are no fixed assets for banks to grab ahold of. We're often leveraging that free cashflow stream. There are all sorts of lenders that will do this, but we're levering an airball. We’re levering just cashflow.
To a certain degree, the pest control contracts aren't collateral because they're very fungible. They can be sold to big acquirers very quickly. I’ve had calls like this every day where lenders are looking at this saying, “Paul, if we loan $20 million and we have to get out quickly, what does it look like? How do we exit?” So on and so forth.
Number one, private equity firms are looking at the cashflow stream above all else. Cashflow is just a result of high pricing, heavily dense routes, so you have a high gross margin. In very basic terms, it's the quality of a business. They're looking at levering cashflow. From a size perspective, most of the private equity firms that are in the space would be preferred to do deals in the $50 million enterprise value or above. We are talking about a minimum $10 million in revenue for a pest control company, give or take.
I always say, “Don't make assumptions. Explore the market.” Thompson Street Capita’s entry acquisition was Ken's business. Presto was maybe doing $6 million in revenue at the time it was acquired. Had I made the assumption, “You're too small for private equity,” then I would have never taken it out to process and we'd never be here where we are. Ken was at retirement age. That was a deal. They’re entry acquisition. They were willing. They loved Ken, they loved the business, and they provided incentives for the management team. It was a great entry acquisition. They allowed Ken to do 100% change of control. Ken's out. He's retired. He's super happy. He's working on his skin cancer by the beach.
I only know things if I go out into the market because what happened last month might happen again next month. I always say and I've said this since the beginning of The Boardroom Buzz and back when I was writing a lot of commentaries, the market is dynamic. For the love of God, pest control operators, realize this, you can't make assumptions.
For once, I took my own advice and said, “I'm not going to make an assumption. I'm running process.” It was a spectacular outcome for all involved. Great for Thompson Street and PestCo. Great for Presto, Ken Fox. On the whole, you want a business that is cashflowing. Ken's business was cashflowing. There are certain door to door businesses out there that have very narrow margins. They're not private equity play as much as they might be potentially some sub debt play.
It gets very difficult when you have a business that's not cashflowing because it's hard to leverage that. The less leverage a private equity firm can use, the lower their returns will be. It's like anything. Let’s say you’re going to buy an office building. Using round numbers, let's say it's $100,000 purchase price and your rents, you're netting $10,000 a year. What's your return?
Patrick Baldwin: 10%.
Paul Giannamore: It's 10% on equity if it's all equity. What would my return be if I use 50% debt and 50% equity?
Patrick Baldwin: 5%?
Paul Giannamore: 20%. Doubles. I'm using 50% debt, 50% equity, and now my return is 20%. The more leverage you can use, it will magnify your returns and it also makes the enterprise more risky because you've got debt service. There's always a balance between how much debt and equity you should use. When you think about corporate finance theory, every college finance book talks about optimal capital structure, using the tax shield of interest. We're not going to get into that. That's how you think about returns. Private equity firms want to use as much debt as possible, but not as much debt that will get them into a dangerous territory of any default or not being able to weather a downturn.
Patrick Baldwin: Paul, it's taking me years to figure out the sell side and buy side, and that's your specialty. I know you have tons of experience on some of the buy side of private equity. I want to know, do you feel these questions were like, “Paul, we're looking to get in pest control. How should we structure debt? Where do we need to raise our debt? I want to run a competitive process so we can have good debt.”
Paul Giannamore: For the larger companies, we’ll run the competitive processes for debt capital. That's starting to change now. It was very rare before. Pest control operators are getting more sophisticated as to their options. We've been doing more and more of that. I've tried hard to educate our clients. Most guys out there don't understand that you could go out to the market and you could find a mez fund or an SPIC that will give you debt capital with a sliver of equity. That's not a private equity firm per se. They might call themselves XYZ Capital and they look like a private equity firm, but they're not investing in equity. They're investing in debt with warrants, for example.
What I often do is after we do a preliminary evaluation, I look at the capital structure of the business. I say, “You’re 100% equity. If you're fine with that, you're fine with that. We could pull out $10 million or $15 million and you could literally use that money to buy a $10 million house in Southern California or you could use that money to grow. Do you want to pull equity out? Do you want to be on 100% equity? Do you want to be 80%? 20%? How do you want to do it?”
I spent a lot of time thinking about the capital structure. I'm not an accountant. I'm a finance guy. Core to finance is thinking about capital structures and returns on those different slivers of the capital structure. Small businesses are focused on growing their business, incentivizing their people, and all those sorts of things. You're not thinking about a capitalist structure at $1 million, $5 million, $10 million. You start to become a $20 million firm, a $50 million firm, $100 million in enterprise value firm, and now you have the luxury to think at optimal capital structure. “Do I want to pull some equity out and replace it with debt? How do I do that?”
I love those conversations. In fact, I used to have those conversations with Orkin or with Rollins. I used to look at their P&L. I remember several years ago, I was with Gene Iarocci who was a former president of Orkin. I remember sitting there at lunch in Atlanta with him. The CFO was there and I said, “Why on earth do you have such an unlevered capital structure?”
Orkin and Rollins used to always boast, “We have no debt. We have no leverage.” That feels great when you pay off your house but when you're a multibillion-dollar publicly traded company, that is a very poor use of capital because debt capital is less expensive than equity capital. Provide your shareholders with a higher dividend and a higher return by pulling out some of that equity and replacing it with debt. That's exactly what they've been doing. Matt Whiting has been instrumental since he came on in 2014 in having these. Matt gets it. He and I've talked about this. He's done a lot to help change and augment Rollins’s capital structure.
Patrick Baldwin: That's fascinating. I didn't know that. I know I'm not allowed to pick your brain. Learning the whole investment side of things, figuring out the 60/40, and running the numbers, I appreciate it. You gave me a glimpse of what's going on with private equity.
Paul Giannamore: I would encourage all of our friends out there in the industry, if you want to explore private equity, it is a far more complicated process than dealing with a strategic acquirer like Orkin or Rentokil. Give us a call. I'm happy to chat with anyone and run through various different options. For a lot of you, unfortunately, it won't make sense for you to partner with the private equity firm.
There is a subsection in the industry where it doesn't make sense. You can't have your cake and eat it, too. You can get a very high multiple, equivalent to what you would get. Sometimes be strategic and take out some equity. It's exactly what Jared did. Jared ran a very formal process. Jared and Kyle are textbook examples of doing a proper levered recap of a business, having their cake, risk-managing their future.
They're not as worried about the markets rolling over this 2022. As things take a deep dive, they've taken their chips off the table. They're going to have a lot of opportunity to reinvest that at lower valuations going forward. Still, they get that upside. Jared might be in this 5 or 10 years and he's going to reap the reward. Track us down. We’re happy to chat with you about it.
Patrick Baldwin: Thanks for having me again. This is awesome. It’s been a beautiful, great week. Great job on Bubble Trouble.
Paul Giannamore: Thanks, Patrick. You, too. Until next week, guys. Thank you for joining us.
Bubble Trouble – past episode
Anticimex
Thompson Street Capital Partners
Rollins
Orkin
Terminix
Rentokil
Vector Disease Control International
Killingsworth
Presto
Brian Alexson – past episode
Pestban
Supernova – past episode
Tim Mulrooney – past episode
