Understanding How Private Equity Groups Approach Value
How PEGS Value Your Company
By Sunrise Equity Investors
Dallas, Texas
It behooves Private Equity investors
(PEG’s) to work with business
owners who understand a
deal from the PEG’s perspective. We
hope this article helps any potential
seller better understand the mindset
of Private Equity Groups.
Obviously, the end analysis of value
is driven by the Internal Rate of
Return (IRR) a PEG wants to receive
and that they have touted to their
Limited Partners. Understanding
how they work through that analysis
is helpful to a business owner
thinking about selling to, or taking
equity dollars from a PEG.
How do PEGs build their IRR models?
First, many will assume a five year holding period. They will
plan to sell the company in about that time
frame, so they will build a model
that looks at current EBIDTA and cash flow and build their
perception of growth on top of that. This is a different
approach than a corporate buyer; since a corporate buyer will
-
have synergies he believes will impact the future profitability,
and
-
will plan on merging that into his current operations, with no
defined exit strategy.
The Return (R) in IRR will be generated primarily by the exit
value they believe they can get in five years. A secondary
consideration is the cash flow generated by the company during
the holding period.
Valuation Driver
The exit value is all crystal ball gazing,
but it is the foundation of their
valuation process. If purchased at
a fair price today, and sold at a fair
price in five years, a company that
grows at only 15%, and uses all of its
cash flow for growth and debt repayment,
still generates a healthy 40+
% IRR to the PEG’s investors, plus a very healthy return to the
General Partner. Sellers can and should participate in that
return by reinvesting a portion of their newfound liquidity.
That is why a buyer will spend so much time asking about a
seller’s growth potential.
Looking Back, Going Forward
So, if the future is where the value
comes from, why does everyone talk
about “multiples” of current earnings?
There are several reasons:
-
It determines the amount and
structure of debt a company
can reasonably support. This
impacts the leverage they can
use to maximize their return by
minimizing the Investment (I).
-
The lenders tend to lend a
certain multiple of EBIDTA on
each deal, so any increase in the
multiple demands that the difference be all equity. This can
have a significant impact on IRR.
-
Using a multiple of earnings
(usually EBIDTA) tells the pro
spective buyer whether he can
buy this company at a valuation
range that will allow him to
hit his IRR targets with reason
able growth.
Another Piece of the Puzzle is Risk.
Riskier investments require higher
returns, so a company with a low
risk component will command a
higher multiple. Risk comes in
many forms. Some are internal,
such as the risk of customer concentration;
some are external, such as
being in a cyclical industry. While PEG’s are not typically in the risk
business, there is always an acceptable
range of risk that is simply a
value question, not a deal killer.
Having digested all of that, what can a business owner do to get a higher “multiple” than the next company with the same earnings?
-
Develop research and support a plan for growth after the acquisition. Give your prospects
the ammunition they need
to build an exciting growth
model. Be specific about how
you will grow and what it
will cost.
-
Make the analysis of your company simple. Give them a
concise package of information
that whets their interests, but
also gives them an easy under-
standing of what you do, how
you do it, and for whom do
you do it. The quicker they
can get through this, the faster
they can focus on the future.
-
Analyze the risk factors of your business. Address and repair
those you can impact and explain and minimize those you cannot.
Remember that they will see your risks differently than you, so look at
those risks through their eyes.
An example is audited financial
statements. You are confident
your books are right, so why get an audit? A buyer cannot
“take your word” that your
books are right, so an audit reduces their risk, raising your multiple. For those risks that
cannot be eliminated, address them early and openly. Risks you
explain seem much smaller than those the buyer finds on his own.
-
Do your homework. Find buyers
with synergies that enable them to
project higher growth in their
internal models. PEG’s with
synergistic holdings may be the
best prospect.
-
Plan your exit timing. If you
wait for the peak of a growth
curve to approach buyers, how
can they build a growth model
that maximizes your value?
In summary, demonstrate how a PEG
can maximize his IRR, and you can have a significant impact on
how Private Equity Groups value your company.
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