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April 27, 2020

What’s the Deal with Private Equity?

Key Takeaways:

  • Private equity represents a viable source of liquidity for middle market companies.
  • Life with an investor is different but can lead to greater opportunity for companies and teams.
  • Equity groups are not all created equal, each bringing different experiences and personalities.
  • The right partner adds value to a CEO and company beyond a checkbook.

Over the last several years, private equity funds have become increasingly active buyers of small- and medium-sized businesses. With an estimated $700 billion of “dry powder” across U.S. funds – money raised and not yet invested in companies – it pays to understand this significant source of capital, the options it provides and how introducing a private equity investor is likely to impact a company.

For many, the term private equity conjures up images of Gordon Gekko – financial types in pinstripe suits and suspenders aggressively cutting costs and loading on debt. Or, perhaps fast-talking millennials in Silicon Valley espousing the virtues of beanbag chairs and cold brew coffee on tap. While these may still exist within the worlds of multi-billion dollar leveraged buyouts or technology start-ups, the investment groups operating in the private middle-market are a separate and definable category.

Private Equity Basics

Middle market private equity groups raise capital from high-net-worth individuals, family offices and institutions – pension funds, insurance companies, foundations, and university endowments – based on an investment track record and strategy. This strategy includes specific criteria around industries, company revenue and cash flow and situation. For example, some firms invest exclusively in healthcare businesses. Other may focus on wholesale distributors with $5 million or more of historical EBITDA.

Individual private equity groups also differ according to dollar range of investment, whether they require a majority ownership position, targeted geographic locations and requirement for executive continuity through a transaction. Not every investor will fit a company’s size, industry or owner’s personal objectives. It’s important to screen by transaction criteria as well as culture and personality alignment.

Private equity professionals aim to generate an attractive return for their investors (and themselves) by developing and helping execute on growth strategies. Their goal is to build the value of the equity they have acquired in a portfolio company and realize that value – and return their investors’ capital with a profit – through a subsequent sale or recapitalization.

Private Equity Investors Are Looking For:

  • Niche leaders
  • Competitive advantages
  • Diversified revenue streams
  • Sustainable margins
  • Fragmented industry sectors
  • Proven/deep management teams
  • Identified expansion opportunities

Building Equity Value

Increases in equity value can be achieved partly through financial engineering, i.e., introducing debt to fuel growth and paying it down over time. But for businesses with revenues of $20 million to $500 million – generally defined as the core of the middle market – the most direct path to value is through revenue and profit growth. Accordingly, the fundamental prism through which a private equity group views a business is the opportunity for and, predictability of, growth.

Private equity groups generally do not take day-to-day operational control, but rather look to board involvement and regular communication with senior executives to influence a company’s path. They bring experience, fresh perspectives and new priorities to the table, meaning that it is no longer so lonely at the top for the CEO.

Life will certainly change under private equity ownership – increased scrutiny of results and management accountability, aggressive growth expectations and a strategy tied to positioning the company for a sale – but many entrepreneurs welcome this shift as the natural progression towards increased focus, more efficiency and greater professionalism.

Private equity can be an effective option for the business owner who seeks liquidity but does not want to sell out entirely or to an industry competitor. It can be a source of capital when an owner is reluctant or unable to fund available growth initiatives internally. The transaction can be the catalyst for a meaningful equity plan for key management. And, the right private equity partner can help chart a path towards substantial liquidity – a second bite at the apple – down the road.

Where Private Equity Plays A Role:

  • Additional capital to fund growth
  • Reduction in owner risk
  • Buyout of inactive shareholders
  • Alternative to excessive debt
  • New perspectives and ideas
  • Accelerated value creation
  • Position company for future sale

With an abundance of available capital and a broad range of personalities and styles, business owners have ample opportunity to find the private equity partner who brings not only capital but also value – creating direction and support. A two-step liquidity process – sell shares today, retain an ownership stake and work towards a second sale – can be ideal for the owner still several years from retirement who seeks new capital and expertise to maximize the growth potential of his or her company and team.

For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.

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