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Exit and Growth Strategies for Middle Market Businesses

What Business Owners Must Know About Private Equity

By Roy Graham | Dec 08, 2015

Private EquityThe PE community has established an impressive record of success in both partnering with business owners to grow the value of their businesses and in returning high rates of returns to their own investors.  Private equity recapitalizations have proven in the aggregate to be a valuable vehicle by which a business owner can capture a portion of his business’s value today while bringing in a savvy business partner who can help create greater business value going forward.  However for a business owner to reap the greatest benefit from private equity it is essential to understand how private equity operates and to use this knowledge to determine how best to find a PE partner.

A paper published earlier this year by Harvard Business School and authored by Gompers, Kaplan and Mukharlyamov provides interesting insight into the operations of private equity via an extensive survey of 79 private equity investors.  When we study these findings, we can glean some valuable takeaways that can help business owners learn how to smartly capitalize on PE investment.It’s extremely important to understand where a business owner’s interests align with private equity and where they diverge.  By understanding these differences you may significantly enhance your ultimate return from a PE partnership.  A lack of understanding will leave you vulnerable and could cost you a lot of money.

PE executives are highly educated.  The Gompers survey found that almost two-thirds have either an MBA or a JD and 71 percent of those with an MBA were from elite schools. As mentioned, private equity performance has been impressive.  This is true when comparing PE funds to public equity markets over the last three decades and it has also shown to be true in several studies that found significant increases in operating performance among private equity backed companies.  To be able to tap into this kind of powerful resource to help drive a business and grow its value is very enticing but before a deal is done a business owner is negotiating against highly sophisticated investors.

Gompers’ survey points out that high-powered incentives provide strong motivation for PE investors to increase value in their portfolio companies.  He surveyed three types of value increasing actions – financial engineering, governance engineering and operational engineering.  Many but not all of these actions align with the interests of a business owner. Let’s look at each.

Financial engineering includes how PE investors value and analyze the attractiveness of a seller’s company, the capital structure that they will employ including the amount of leverage to be used and how management incentives are used.  A business owner’s interests will not be aligned with the PE investor as they negotiate value nor will they be aligned in the discussion of capital structure as they each seek to maximize their own position. A business owner will want an experienced advisory team to work on his behalf.  The use of management incentives however is a powerful tool which generally aligns a seller’s interests and those of private equity and management toward a common goal of driving company profits and valuation.

Governance engineering involves the structure of the boards of directors of PE portfolio companies as well as actions regarding hiring and firing of top management.  A PE investor who has acquired a majority position will want that reflected in the board composition.  The survey showed that PE attitude toward top management reflects a preference (70%) toward investing in existing management.  After an investment, roughly 50% of PE investors end up recruiting their own senior management team.  Since changes in management are made to improve profitability and to drive value, these actions should also be generally aligned with all shareholders’ interests unless it is the seller’s job that is in jeopardy.  If you expect to dial back your drive and take a lot of time off after a PE investment you may indeed find your job in jeopardy.  You will also be missing out on what a PE investment offers.  On the other hand, if you are enthusiastically looking to lead a newly energized company with powerful new resources which can create significant new value then you will probably find a happy partnership that places great value on your contributions.

Finally, there is operational engineering.  Within this area of value creation you will find that most private equity actions align with the interests of a business owner with one big exception.  Actions that will generally align with a business owner’s interests include; increasing sales, improving IT, making follow-on acquisitions, reducing costs, improving corporate governance, enhanced use of incentives and facilitating a high-value exit. The big exception involves deal sourcing.  While most large companies understand that a competitive process is required to achieve their highest value and will thus hire an investment bank to run an auction or version thereof, many smaller companies are not aware of this dynamic.  PE investors know that if they can buy an asset below market they are ahead of the game on the day the transaction closes.  There is nothing wrong with buying low. In fact, a PE investor has a fiduciary responsibility to their investors to buy as low as possible but that is clearly not the business owner’s objective.

Gompers’s finds that, “PE investors claim that an important determinant of value creation is the ability to find or source deals that are proprietary…”  Proprietary deals involve little or no competition and thus lend themselves to lower than market purchase prices.  A glance through industry magazines will likely reveal ads touting a firm’s ability to generate proprietary deals that are not part of a competitive auction and that can be acquired at below market prices. The Gompers survey found that “PE investors considered almost 48% of their closed deals to be proprietary.  He found that, “PE investors do identify buying low and selling high as an important source of value.”

Private equity can provide a powerful resource and potentially significant financial rewards to a business owner seeking growth capital or a partial liquidity event coupled with an ongoing partnership.  Many actions PE investors take will align with the interests of business owners but there are certain areas where a seller’s interests do not align and an uninformed seller can leave a lot of money on the table.  One of the biggest disconnects between a PE investor and a seller is a proprietary deal.  The use of a licensed investment bank to run a competitive process will help to assure a seller that they are receiving a competitive market price along with terms and conditions that reflect the market.

Posted by Roy Graham.

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