Sachin Khajuria Eloquently Takes Readers Inside the Heroic World of Private Equity with ‘Two and Twenty’

“If you ever do that to me again, I’m going to kill you.” The late Pete Peterson uttered those somewhat tongue-in-cheek words to Stephen Schwarzman in 1985, not long after they’d founded Blackstone together. They had just exited yet another failed investor pitch for their then-boutique investment bank, and Peterson was frustrated.

Specifically, they’d just met with Delta Airlines. They’d flown to hot and humid Atlanta for the meeting, the walk from where a cab had dropped them to the Delta building had soaked them in sweat, only for their visit to pile insult onto injury. “Delta doesn’t invest in first-time funds” was what they were told.

It’s remarkable in retrospect, but not surprising at the time that Peterson and Schwarzman were told no seventeen times for every time they were told yes in their pursuit of a $1 billion inaugural fund. It’s not surprising because they were investment bankers as opposed to private equity investors, plus private equity in 1985 wasn’t yet private equity. It all speaks to the unrelenting drive and self-belief possessed by both men, but Schwarzman in particular. They ultimately raised $880 million, and never looked back. Today Blackstone manages $875 billion, and the bet here is that one of many reasons Schwarzman continues to show up for work each day has to do with his desire to help his creation leap beyond $1 trillion in managed wealth.

Schwarzman came to mind a lot while reading Sachin Khajuria’s very excellent and very important new book, Two and Twenty: How the Masters of Private Equity Always Win. About this essential read, the title itself requires an early digression that may or may not bring clarity at first. Up front, what you’re about to read in regard to “two and twenty” is a very complimentary narrative about private equity even if it doesn’t come off that way right away.

Two and Twenty. Stop and think about it. It reminds your reviewer of the ludicrous narrative bought into by way too many somewhat wise people about the Fed and “zero” rates of interest. What “zero” rate? As Khajuria surely knows, as Schwarzman and Peterson knew well back in the early days, and as anyone in finance knows nowadays, capital is never costless. Not even close. If the Fed could actually decree credit costless there quite simply wouldn’t be any credit to access. Really, who in their right mind would forego the wonders of compound returns in favor of zero? The answer is no one. In Silicon Valley, credit is so expensive that anyone who wants “money” hands over substantial equity in return. Hollywood is the “Land of No” for even the best of the best in movies and television. Michael Milken’s great fortune (sadly a fraction of what it should be after the feds shamefully destroyed his financial career) is a monument to how expensive credit is for all but the bluest of blue chips….Zero rates of interest is a fabulist notion that could only excite divorced from reality economists, and their sycophantic enablers in the media. In the real world, credit is very rarely “cheap,” and never free. Hopefully readers get where this is going, or maybe not yet.

Because there is still the matter of Two and Twenty. It brings to mind “zero rates” simply because there aren’t enough nines after 99.9 to properly put a number on how few investors rate “two percent in annual fees” along with 20% of any subsequent returns above a pre-set hurdle rate. It’s a long or short way of saying that not just anyone can open up an investment firm only to charge “two and twenty.” Precisely because the percentages read as so enticing, only the rarest of the rare rate the compensation combination. Evidence supporting the previous claim is the wildly handsome pay enjoyed by private equity’s leading light. Yes, “two and twenty” has “zero rate” parallels. And that’s a compliment.

Crucial about the compliment is that it in a sense whitewashes over a greater truth about the genius at the top in private equity. Khajuria is wonderfully blunt in writing that “a handful of the most senior partners” in private equity shops are “the ones who count the most to investors.” Thought of another way, most of the intensely elite talents who work in private equity at its greatest firms similarly don’t rate “two and twenty.” More realistically, they’re part of an investment outfit that’s proven a magnet for investment capital based on the genius of the very few at the top who do in fact command “two and twenty.” There’s properly no “equality” in these rarefied businesses. The business model only works if the lion’s share of the success is owned by just a few. Again, the few are “the ones who count the most to investors.”

This review leads with the rare genius that it takes to command “two and twenty” as a way of stating up front that your reviewer is, like Khajuria, “hugely supportive of this industry.” What private equity investors do cannot be minimized. Think Blackstone again. With $875 billion under management, it’s got firepower that is many multiples of the previous number as it pursues all manner of companies with an eye on improving them. Importantly, it’s not just Blackstone. Khajuria (a former partner at private equity giant Apollo) notes that “private capital” is actually a $12 trillion industry, and that soon enough the previous number will read as small. Thank goodness for that. Enormous sums of money matched with remarkable investing talent is a sign of soaring liquidity for business owners, but more important it’s a sign of serious amounts of wealth being directed toward the betterment of companies around the world. As private equity grows, so will grow the health of the global economy. Khajuria writes that those who command “two and twenty” are “key people in the economy,” and he’s so right.

Which is why Khajuria’s book is so important. Though he’s “hugely supportive” of private equity, he’s also “your insider.” From his book readers can attain a better sense of what private equity means for commerce, and the global economy more broadly. Good. The view here is that the symbol that is “Wall Street” hasn’t stood up for itself enough. There’s been too much sheepishness. Here’s someone who’s an unabashed fan of his industry. With good reason.

It cannot be stressed enough how much this is needed. Khajuria writes that private equity capital “belongs to the retirees of tomorrow.” Some will read the previous line as a platitude, but in reality it’s a positive statement about the beautiful symmetry that exists between savers and investors. The “more money the investors make, the more professionals make.” So true. Private equity investors can only earn the big sums if their investors earn even more, and by extension their pensioners do quite well too.

Put in a way that readers aren’t probably used to have it put, the richest of the rich in private equity are the ultimate servants. In Khajuria’s words, “an ultra-wealthy asset manager in New York [is] working” for pensioners, and in the process making “the math of their pensions work.” And it’s not simple.

Indeed, while the purchase of index funds is a tried-and-true way to amass impressive wealth, this low-risk style of investing is not the stuff of great wealth creation. The latter is a function of intrepid capital allocations. Khajuria writes so eloquently that “being a master of private equity means being drawn to complexity.” Good and great private equity investors achieve remarkable wealth because they’re swimming aggressively in frequently perilous waters. Think 2008 when the conventional in thought felt the world was ending. Not so the courageous in private equity. “While others ran for the hills, private equity ran into a burning building.” Trite? Hackneyed? Maybe so, but sometimes what can read as a little gag-inducing is needed as a way of conveying the style of investing required to thrive in private equity. There’s quite simply no time for worry when all are losing their proverbial heads. It’s when there’s blood in the streets that the intrepid in private equity take some of their biggest, most gut-wrenching risks. Khajuria writes in the first chapter of a prominent firm’s acquisition of public shares in a German television company during the depths of the panic. The shares were down 75%, while the company’s debt was a third of its original value.

The investors would make money on their investment as long as the company (TV Corp. for the purposes of the book) remained solvent, but that was a big if. See above if you doubt the assertion. As evidenced by the direction of the company’s share price and debt, the “market” thought the odds of the company not making it were reasonably high. The investment ultimately paid off big time. Which explains why private equity pays so well. The pay is a function of how few have the nerve to effectively put money to work when the situation is bleak, or when it’s not bleak such that the odds of overpaying in an intense bidding war are enhanced. Index investing this is not. Quite the opposite. A successful career in private equity springs from doing what is intensely difficult. In Khajuria’s words, “easy wins rarely make an individual’s career, let alone a firm’s reputation.”

Khajuria writes that private equity investors “don’t pick stocks or bonds in liquid markets and hope to ride a rising wave of positive sentiment.” So true, but it should be stressed or hoped that he doesn’t mean this as a critique of other styles of investment. Figure that hedge funds and traders in general are crucial “price givers” (the words of economist Reuven Brenner) whose activity in the markets provides price signals that all, including private equity investors, rely on.

Still, his description of private equity investors raises an obvious question about why thumbsuckers in media and politics aren’t more reverential toward them. Lest we forget, politicians, media types, and even occasionally pandering investors lament the mirage that is “quarterly capitalism” whereby investors are said to judge companies solely on quarterly profits, as opposed to more coherent, long-term focused vision. That this characterization is nonsense, that investors are an incredibly patient lot (think the failure rate in Silicon Valley, in the oil patch, in pharmaceuticals, or think the many years investors endured “Amazon.org”), that good investors are very future-seeing simply because it’s the source of their greatness, isn’t the point. What is the point is that per Khajuria, private equity investors “don’t disappear once a deal is done.” Their work is just beginning. “There is an ingrained sense of personal ownership in private equity that doesn’t exist in comparable form elsewhere on Wall Street.” Having completed a deal, private equity investors must then get to work with existing management, or install outside management in order to bring their vision for a company’s improvement to fruition. As Khajuria puts it, success in this world “is not about a system or an investment process; it is about the people in control, the people who make the daily decisions.”

About what the small-minded have reduced to buying and selling companies, Khajuria so thankfully addresses the popular notion that “private equity investors target vulnerable companies to buy, saddle them with debt….” You get where this is going. The previous narrative took flight in the 1980s and has never died despite it being flamboyantly absurd. Oh yes, the markets are thick with investors willing to enrich private equity types through the purchase of companies they’ve stripped of assets while loading them up with debt. Khajuria is clear that “this version of events is nonsense” owing to the basic truth that the next owners “are unlikely to pay for a target that has been window dressed.” Amen.

These people don’t just feverishly analyze businesses ahead of acquisition, they don’t just pick the executive who will execute on their visions, they also become board members and close advisers as they shepherd the purchased company to a better place. They must do this because “the big payout will come when the investment is disposed of,” or when it “crystallizes.” In short, the big compensation in the private equity space is a consequence of improving what was purchased. The incentives are correct, as one would expect. The “two and twenty” that turns off the ankle-biters in the commentariat is the surest sign of how brilliantly the incentives are constructed. To rate this magical compensation combination, you have to be extraordinarily gifted when it comes to improving companies.

It brings me to a line in the book that read as trite, but also realistic. Ahead of what Khajuria wrote, it’s useful to bring up what Stephen Schwarzman tells his charges at Blackstone: “Don’t. Lose. Money.” It’s a blunt demand, but it speaks loudly to Khajuria’s description of meetings inside private equity firms during which deal teams pitch their investment ideas. Khajuria describes the team members as “gladiators fighting for their lives in the Colosseum.” Again, it sounds trite, but realistic at the same time given the culture that pervades the best of the private equity best about not losing money. Which means that those pitching investment ideas must be gladiators precisely because those pounding them with questions are making sure their visions are viable.

How different all of the above is from venture capital. About this, Khajuria is clear. With venture capital there’s an admission and realistically a desire among VCs to back the impossible. They’re not interested in the known. They seek businesses eager to create an all-new future, an all-new way of doing things, and as a result VCs are by definition going to back a lot of loud failures. The private equity approach is very different, and this isn’t a knock on VC. It’s just reality. The idea with private equity investing is “to have a strong chance of winning on every investment.” Again, “Don’t.Lose.Money.” Venture capital creates the future, while private equity improves the present with the future in mind. It’s useful to think about. They’re complimentary.

While failure is a badge of honor, or a sign of a seasoned VC or entrepreneur in Silicon Valley, there’s a more rigid, quantitative quality to private equity. In Khajuria’s blunt words, “You have either produced the output requested of you, or you have not. There is no try.” It brings to mind another Schwarzman line about how “Once you succeed, people only see the success.” So true. No one remembers how many rejections Blackstone endured in trying to build its first fund, or how Schwarzman “began to feel dizzy” one night as he sat alone at a restaurant contemplating whether or not Blackstone would make it given his fear that his creation was “failing on every count.” What fun to see Khajuria interview Schwarzman, or vice versa. Khajuria seems to be saying the same. Though he entered private equity when it was private equity, he seems to be saying with “there is no try” that people only see the success today while not seeing how many hires into this rarefied world don’t make it, or better yet, how many would-be private equity investors aren’t invited into this rarefied world to begin with.

About private equity in the age of publicly-traded private equity firms, it was interesting to read that “the stock price is largely driven by a regular stream of management fees under long-term contracts.” This was interesting in that when Jamie Dimon took over at J.P. Morgan, memory says he rapidly shut down proprietary trading desks since investors weren’t willing to pay for ephemeral trading profits. Ok, it makes sense. But it makes less sense to an outsider here. Khajuria writes that “the fate of the firm’s stock price rests just as much on the growth of its assets under management as on how well the assets perform.” Again, I’m the outsider, but all this read as a false note. That is so because assets under management would logically grow based on how the investments perform. In that case, wouldn’t investors place a higher valuation on private equity companies with impressive exits (the “twenty” in the “two and twenty”) based on an expectation of larger funds and fees in the future?

Mentioned earlier is the false narrative about buying and selling companies. Khajuria is clear that it’s so much more than that. Here Michael Milken comes to mind yet again. He’s known (and rightly so) for seeing clearly how the proverbial companies of tomorrow didn’t attract traditional bank finance. His solution was high-yield finance. To this day the focus even among admirers is on the “junk bonds” without properly respecting how very much Milken understood the businesses the companies he financed were in, only for him to structure their financing in a way to set them up for long-term success. The structure of finance kept coming up in Khajuria’s stories from the front lines of private equity. The players in this remarkable field are doing so much more than buying companies. Like Milken they’re in the business of intimately understanding various business sectors such that they bring remarkable sector expertise to all that they do.

All of the above is crucial simply because the best of the best in private equity are usually competing for the right to improve the companies they’re in pursuit of with other best of the best names in the space. With cookie company “Charlie’s,” Khajuria writes that it was not just “the Firm” (with each case presented, Khajuria doesn’t name specific private equity names or companies) going in with a checkbook. There was a courting process. As Khajuria puts it, “the Founder must also persuade the CEO that the Firm is his best option, more so than rival private equity firms.” It’s all a reminder of a simple truth not understood by economists and their media enablers: money finds you if you’re worthy. Money competes to find you. Economists act as though the Fed “permits” growth, that its lowering of rates and increase of so-called “money supply” instigates economic growth. What a laugh. Credit is produced. We seek money for the real things (and most important of all, human capital) it can be exchanged for, at which point credit is a consequence of production, not central banks. From there, the world is thankfully populated with remarkably talented financial minds eager to match the capital with businesses. The Fed is so very much not a story. Khajuria’s brilliant book shows why. Again, wealth finds the worthy. Always.

Of importance, it’s useful to stress that the global nature of capital means that it finds the worthy in perhaps unexpected ways. Indeed, it turns out Australian financiers understood how to finance infrastructure in ways that American private equity experts initially did not. Just as no one reads the same book, it seems no one sees the same company, or freeway system, or opportunity. Khajuria is clear that while U.S. private equity types were approaching various infrastructure concepts with rather expensive, equity forms of financing, Australians “desperate” to force their way into private equity had come to see infrastructure in relatively low-risk, “safe as a house” fashion. Banks normally left out of private equity dealings based on the risk involved could suddenly be brought into financing impressive income streams, and sometimes even government guarantees (right or wrong) of income streams. This is all mentioned as a reminder to readers to not be alarmed by “foreign investment” of any kind. In the past Americans feared money from Japan, nowadays they fear Chinese money, but actual businesses are in need of capital. They’ll take what they can get. Better yet, the competition to finance American businesses is fierce as previously mentioned. It’s a sign that if “foreign” money is making its way here, it is because there’s know-how reaching us too. Just as Milken didn’t just bring money born of “highly confident” belief in his ability to finance intriguing ideas, neither do foreigners. As the Australian example in Khajuria’s book attests, they bring new sets of “eyes.”

All of which brought up a quibble with Khajuria’s analysis, and which is related to what’s just been written about intrepid investors armed with globally produced capital finding opportunity, only to compete to finance it. Throughout Two and Twenty there were lines like this: “It is 2020. The U.S. economy is weak, kept afloat by government spending and favorable policy moves by the Fed.” No, that’s not a serious view. And it never is. For one, the lockdowns foisted on the American people by panicky politicians were what had wrecked the economy to begin with. To then say those who broke the economy saved it is rather fanciful. Furthermore, politicians only have resources to throw around insofar as they extract them from the private sector first. How then could Khajuria claim that Nancy Pelosi and Mitch McConnell were keeping the economy afloat when he knows that private capital creatively put to work is one of the true sources of economic advance? Better yet, the previous assertion is particularly true during periods of great uncertainty invariably caused by government intervention to begin with. The very notion that government spending lifts an economy ignores what government-consumed wealth could do for growth if kept where it was produced.

As for the Fed, come on. It’s not some other. The Fed is but an outsourced arm of Congress. To pretend that it can alter the cost and amount of capital just isn’t fit for real conversation. No doubt the federal government can change the face of markets to varying degrees (most of all, strangle them), and the Fed is part of the federal government, but to pretend that these interventions lift any economy is utter nonsense. Government intervention is end-of-discussion harmful, and Khajuria’s book unwittingly or purposefully shows why it’s always harmful. There are preternaturally talented investors out there who migrate toward complexity on a daily basis. The only limited factor for them is capital. In that case, let’s not pretend that wasteful spending and attempts to alter the cost of credit somehow enhance an economy. Wise people know better, and Khajuria is wise. Lines like the one in the previous paragraph are excess in the book, and they needlessly contradict the book’s message.

To the above, some will reply that private capital can’t do it all, that as the flow of dollars into the space grows, the result will be a shrinkage of low-hanging fruit….The great Henry Hazlitt once referred the previous notion with something along the lines of “it’s hard to believe even the ignorant could believe something so ludicrous.” Hazlitt was writing about the impossibility of a “savings glut,” and it applies well here. Implicit in the notion that private equity will eventually run out of interesting ideas is the laughable belief that there will someday be a world populated by only well-run businesses, well-utilized land, and that there will be nothing to improve with businesses. Such a future is never. The only limits go private equity are capital, which is why Khajuria is so much better than his comments about government propping up weak economies.

Worse, Khajuria is clear that government is the barrier in good and bad times. Readers will know this because he’s clear that “ordinary retail investors like members of the general public cannot invest in private funds under decades-old SEC regulations designed to protect such non-experts from complex products they might not fully understand.” The “unseen” here is profound. How many businesses are not being improved for the better given these antiquated rules? The number is massive simply because Khajuria is clear about “tens of trillions of dollars of retail money” that is not at private equity firms owing to the rules. Hopefully this will change.

Hopefully also the ridiculous narrative about “carried interest” as income will change. It’s anything but. Once again, there aren’t enough 9s after 99.9 to quantify all the individuals incapable of allocating capital in ways that revive companies. What these investing savants earn is not income. That’s is so because running into a “burning house” is very much a risky move that may not pay off.

In other words, private equity investors are not overpaid, nor are they avoiding taxes on our backs. In reality they’re heroes. Read Sachin Khajuria’s excellent and essential book to understand why.