You can hardly open a trade or financial journal without spotting articles on the internet talking about the amount of capital that the private equity firms (PEFs)have allocated for investment, the companies they purchase, and the multiples they pay. You think they could be a great buyer for your company.
Understanding how PEFs work, what they are looking for, what it will take to get through the process, and what life will be like after the transaction is done, will help you determine if they might be a good buyer for your business. Hopefully, this information will help you make an informed decision.
The Private Equity Business Model
Private equity firms are businesses set up to invest in opportunities that generate a return. The firms raise capital from investors and put these investments into “funds”. They use capital from these funds to make investments in companies.
This article will be referring to private equity firms (PEFs) that are investing in established companies but there are firms that invest in real estate and early stage companies. The common thread with these firms is they are using a combination of investor equity and/or debt to purchase assets that they believe will generate returns.
PEFs invest in companies that think they can increase profits and value through organic growth and/or acquisitions to generate the returns they need.
PEFs will invest in purchasing a platform company to build, purchasing add-on acquisitions to build a platform company value, and/or make investments to organically expand a portfolio company they own.
The returns from these investments go back to the PEFs and their investors.
Private Equity Buyers & Risk
A private equity firm, family office, or high net worth individuals are all investment buyers. The most important aspect to understand about the investment buyer is they are buying a company to make an investment and they will expect a return. Like any other investment, past results, current performance, and the expected future performance all weigh heavily in making their decision. Buying your business is a risk vs. reward decision for the investment buyer.
Investment buyers are going to be looking at the business with a focus on trying to figure out the downside, unknown risks, industry risks and considering many factors the business owner knows and is comfortable with. An investment buyer must prove to themselves and their investors your business is a good investment.
The business will be boiled down into the estimated risk/return and a value attached to it. The private equity buyer will likely be concerned with risks the owner has not considered and will have a much lower risk tolerance than the business owner.
Specialty Private Equity Firms
The individuals in these firms often have specific industry/area of expertise or execute strategies, they believe will generate the best returns over time. These factors have created private equity buyers specializing in different ways and types of investment strategies.
Here are some of the specialized private equity buyers:
Search – In recent years the advent of the search fund strategy has become very popular. These firms engage aspiring CEO candidates to help them find, buy, and operate portfolio companies. These candidates are supported through the search process and are given a portion of the ownership for their participation and successful operation of the portfolio companies. This strategy provides a much larger group of potential companies for purchase where the owner or key decision makers are leaving after the transaction.
Recapitalization – These firms are looking for companies where they can invest and help to fund growth and/or the buyout of a portion of the ownership. This is common in companies that have a solid history of performance or have a significant opportunity ahead of them that will require a capital infusion the ownership is not willing or able to provide. These funds will typically receive a minority interest in the company for the investment.
Distressed assets – In businesses that are not performing well but have valuable assets, there are firms that invest in these companies to complete orderly liquidations. These firms can also be portfolio companies looking at distressed companies as a source of the customer base or specialized equipment and human resources.
Turn around – Turn around firms are investing in companies that they believe they can buy and make changes to return them to profitability that will generate the returns they desire. These firms are going to be buying at a very low value. Current ownership is often paid a small amount for the businesses and their remaining payments for the business are based on the success of the turn around efforts.
Private Equity “Funds”
As private equity firms are raising money from investors it goes into specific funds. These “Funds” are buckets of money raised for a specific purpose. Each fund can have a different investment strategies, investment horizon, investment criteria, and industry focus. Small firms may have a few funds while larger firms may have many.
Private Equity Buyer Investment Criteria
When private equity buyers invest their money, they do so with a pre-determined investment strategy that is communicated to investors when they raise the money for the funds. This investment strategy can and probably will affect the way they manage your company after the sale.
Here are examples of the investment criteria used:
Long term hold – Some private equity buyers are looking for a good income producing companies that they can buy and use the income produced for providing long term returns. These firms may be looking to hold 10 years or longer and will invest money to ensure the company performs well into the future. They can hold companies indefinitely if they are meeting the group’s performance standards.
Pre-determined hold – This is probably the most common type of investment strategy for the private equity buyer. They want to buy and hold for 3-10 years depending on their investment criteria. This will dictate a very definite value building timeline. These Firms often look at add on acquisitions and investments which will get a larger short-term boost in value and profitability. The most common hold period is about 5 years.
Desired minimum return – Each fund will have a desired rate of return. This return can come from annual income generated or value growth. It is often a combination of both. We will cover this in detail in a future article.
Ownership position – The amount of ownership the private equity buyer purchases will be set when the investment is raised. Some firms require majority ownership, and some will allow a minority ownership stake.
Private Equity Opportunity Criteria
When private equity firms are raising money, they are explaining to their investors how the money will be used and the expected returns. This criterion can be very specific or broad based on their investment criteria and strategies.
Here are some of the common criteria for private equity firm business investments:
Company size – Small private equity firms may be making investments with companies about $10 million in revenue and/or about $2 Million in EBITDA. On the high end, there are multi billion dollar acquisitions.
Industry – Private equity firms tend to have core industries they invest in. Partners and staff build large industry contact bases to help facilitate the purchase, operation, and sale of companies within a given industry. Larger firms may have a broader scope with the larger teams, focused firms can bring more value to acquisitions if they have deeper industry experience or accretive investments.
Geography – Smaller firms may tend to invest regionally where larger firms can invest globally. Changes in technology are allowing private equity firms to buy & manage companies globally much easier. Smaller progressive private equity firms are using this to their advantage and building value using a global strategy.
Revenue diversity – Private equity firms are looking for companies with customers that do not make up more than 25% of their revenue. If any of your customers are more than 25% of the total revenue it might make it challenging to sell to a PEG. It is best if any single customer is 10% of revenue or less. This is also true for e-commerce companies that sell most of their products through a single platform. Diversity reduces risk.
Management –Private Equity Buyers across the board will be looking for a strong management team from top to bottom that can carry the business forward. Search funds are ready to put an operating partner into the business as the CEO but the rest of the team needs to be solid. Almost every private equity buyer will be looking for the business to be able to run without the current ownership involved (unless owners are going to be active full time in the business post investment.)
Growth and/or profitability increase – Some Firms have a growth rate threshold. If you are not growing enough, they will not consider you. If you have strong growth it will significantly improve your chances of a selling a business to the private equity buyer because it reduces their risk.
If the business does not match the investment criteria closely private equity firms will not consider your business for investment. Nearly all private equity firms will have their investment criteria posted on their website. If the criteria seem broad review their portfolio companies to see what they have in their portfolio. This will give you a much better idea if your business may be a fit.
The “Leveraged” Buy Out
When a private equity firm buys a company, they will use a leveraged buyout approach. This means they will buy the business using a combination of equity and debt to fund the purchase. The money to fund the purchase may come from several sources. Here are the most common sources of capital to purchase a company.
1. Investor Funds
2. Bank Debt
3. Mezzanine Debt
4. Owners seller note or carried interest
A typical funding scenario for the company purchase might be 30% investor equity, 50% bank debt, and 20% Owners carried interest. When needed, mezzanine debt may be used to bridge the gap when bank debt will not fund the entire portion outside of the investor equity and the owners carried interest.
In this scenario, the total funding amount available before any adjustments on the sale date would be 80% of the business value. There may be adjustments may be for working capital, taxes owed, the payoff of debt, escrow for future liabilities, transactional fees, etc. This 80% can be reduced quickly if these are significant.
How Private Equity Firms Make Money
Private equity firms make money in a variety of ways but the most common is a combination of management fees for managing investors’ funds and receiving a portion of the exit value of an investment. For example, A firm may charge 2% of total assets managed and get 15-25% of the exit value of the investment.
If the firm is providing management resources to a portfolio company, they will usually charge ongoing fees for that as well.
Private equity firms can be a great buyer of companies if they are a good fit for the private equity buyer’s investment criteria. As with any buyer, there will be changes after the sale, but for the seller, the private equity buyers will likely have to manage the money well and pay back seller financing to grow their carried interest going forward. They are highly incentivized to grow the business value.