Where Individual Investors Have an Edge Over Private Equity: Access to Cash, Flexibility in Deployment

While the tech industry has become a black hole sucking in talent from all fields in recent years, the financial industry has traditionally been a relatively popular and competitive sector due to the importance of human capital and the fact that talented individuals can leverage other people's assets to pursue great wealth.

So, what path do the smartest and most successful individuals in the finance industry choose? While there are individual differences, the starting point is often Investment Banking. But what about the endpoint? This depends somewhat on the asset class. For marketable assets like listed stocks, is it the familiar hedge fund? While some people may end up in hedge funds, the life is so intense and demanding that it's more common to see it as a midpoint rather than an endpoint. The destination most people prefer is usually Pension Funds, Endowment Funds, or Family Offices managing personal assets.

What about non-marketable assets like private equity? It's probably Private Equity for most. Unlike marketable assets that are quietly and gradually invested in the market, non-marketable assets require a much more complex and sophisticated process due to the nature of large sums of money being invested at once. It's essential for the small, elite teams in Private Equity to possess both intelligence and a strong work ethic. On top of that, they leverage the expertise of various professionals. We call this due diligence (DD), with law firms conducting legal due diligence (LDD), accounting firms handling financial due diligence (FDD), and consulting firms carrying out commercial due diligence (CDD).

And it doesn't end there. To prevent the common occurrence of controlling shareholders backstabbing each other in the K-stock market, all sorts of clauses are included in the contracts. They appoint inside directors within the company and add clauses like "If you sell your shares, you must allow me to sell mine too (Tag-along)" or "When I sell my shares, you must also sell yours (Drag-along)". They also include penalties for deliberately avoiding an IPO, which is a key exit strategy, forcing the controlling shareholder to buy back my shares (Put-option). They also prohibit the controlling shareholder from engaging in side businesses or selling shares, and prevent key personnel from leaving the company. The list goes on and on. In addition, the network of core management, the partners, who lead these Private Equity firms extends widely across domestic and global conglomerates.

Given all this, it seems like Private Equity investments should naturally succeed. After all, intelligent individuals with strong networks come together, invest without hesitation, and leverage professional expertise in their investment decisions. But this isn't always the case.

In reality, leading Korean Private Equity firms like MBK Partners' Homeplus and IMM PE's Hanssem are facing significant challenges. Of course, these are just examples, and there are other problematic portfolio companies. Is it just a Korean phenomenon? Do global Private Equity firms like Blackstone, KKR, and Carlyle have no blemishes on their records? Of course, they do.

Naturally, even the most talented investors can't succeed in every deal. However, there are definitely some cases where you wonder why they made that particular investment in the first place. Why does this happen? I believe the biggest reason is that Private Equity firms often run into trouble when they become overly eager to deploy committed capital quickly and in large amounts. In other words, they sometimes rush into questionable deals in an attempt to quickly use up the funds that have not yet been invested (referred to as "Dry Powder").

Private Equity funds can be broadly categorized into two types: funds with a predetermined investment target (Project Fund) and those without (Blind Fund). From a Private Equity perspective, which is better? Of course, it's the Blind Fund. This is because Project Funds require them to create a new fund and sell it to investors for each deal. Conversely, from the perspective of the limited partners (LPs) who invest? Generally, Project Funds are preferable because they have information to judge the deal. However, if the General Partner (GP) is trustworthy, it might be more convenient to simply entrust them with the Blind Fund. Therefore, while the ranking of Private Equity firms is usually based on total assets under management (AUM), evaluating them simply by 1) whether they have a Blind Fund or not, and 2) the size of their Blind Fund, doesn't result in a significantly different conclusion.

The crucial point is that regardless of whether it's a Project Fund or a Blind Fund, the GP's performance fee is based not on simple return, but on Internal Rate of Return (IRR), and IRR is sensitive to the time value of money. Therefore, to maximize IRR, they need to recover the same amount of money as quickly as possible. But before they can recover the money, they need to invest it, right? This inevitably leads them to want to invest as much as possible, as early as possible in the fund's lifespan.

Since IRR is the core performance metric for Private Equity, when they acquire a controlling stake (Buy-out), they utilize various methods of shareholder return such as dividends, share buybacks, or capital restructuring (Recap). The source of these shareholder returns is cash flow, which is why they place so much importance on EBITDA. Some fervent Berkshire Hathaway followers dismiss EBITDA entirely because Charlie Munger called it garbage. But are the countless individuals working in Private Equity all fools for using EBITDA in their valuations? It simply means that different industries focus on different aspects depending on their specific characteristics.

Compared to the professional group of Private Equity, individual investors are at a disadvantage in almost every aspect: capabilities, networks, professional support, etc. However, they have one significant advantage: they are investing their own money, so they don't need to worry about earning a performance fee. In other words, they don't need to rush to invest as much as possible as quickly as possible.

In my opinion, the ideal mindset for an individual investor is to generally avoid short selling, but to be flexible about their cash position. This means that in certain situations, their cash position could even reach 40% or 50%.

Of course, this doesn't mean holding a large amount of cash at all times. It simply means that when you don't find many appealing companies or when the surrounding environment makes it difficult for you to perform well, you can increase your cash position boldly.Some individual investors feel uncomfortable with increasing their cash position, viewing it as market timing, but setting strict criteria for cash position is abandoning the biggest advantage individual investors have. In a situation where it's already difficult, don't lose your strength while failing to compensate for your weaknesses.