David Sinyard, Managing Director and Principal in the CFA Atlanta office, recently wrote a newsletter article based on his doctoral work done at Georgia State University discussing affect heuristics and the role it plays when private equity investors make decisions. Interestingly, the article was referred to in a recent blog article written by a private equity investor. Check out David’s newsletter article on private equity decision making…
How do Private Equity Groups Assess Potential Investments?
Before Private Equity Groups (PEGs) invest, they review a significant number of proposals hoping to find that diamond in the rough, that perfect addition to their investment portfolio. Three a day is not unheard of, so the annual volume can easily be 700-1000 proposals. Of these, the majority of PEGs typically close on 2-4 deals per year. There is a great deal of time and work involved in reviewing and ultimately deciding which deals to pursue. How do PEGs decide which deals to pursue? Their due diligence costs often exceed $100,000 per transaction. Before they commit the time and money, they have to be convinced that this is a company that they want to own.
The review procedures utilized by PEGs differ significantly and range on a continuum from a very formal process to an informal review practice. When PEGs follow a formal process they may have evaluation criteria and will use a checklist for each submission they review. It is scored and in order to move to the next step in the process, a company would need a minimum score to advance. The majority of PEGs use an informal review process and based on time and experience, the business development officers will “know” whether it’s something of interest. Evaluations of specific criteria appear to exist for every deal and most PEGs tend to look for strong, stable cash-flow, low debt levels, leading market positions, and niche products or services. But one variable stands out to separate the proposals into “yes” and “no” piles – the management team.
The management team is a fundamental issue in a proposed transaction. Is the management team still hungry to grow the business? Does the management team have depth? For most PEGs, the more in-depth the team, the better. The relationship between the management team and the PEG is important. Does the chemistry work? PEGs view an acquisition as building a partnership where value is created. Is the management team willing to adapt or change if necessary?
Most PEGs do not expect any business that is acquired to have a perfect management team. They look to supplement and plug gaps in management. PEGs will buy a business knowing full well that they need to change out the management team. Most don’t get involved in a deal unless they augment the senior team. The function that is most focused on is finance, as the incumbent typically will not have the qualifications and skills to handle the role. The PEGs will put in new CFOs to upgrade the position, particularly in terms of reporting.
Data indicates that the importance of retaining the existing management team varies, but continuity tends to be the key. One person, not necessarily the CEO or CFO, needs to stay. Most PEGs really desire an understanding of who is going to lead the company forward. It can be the founder, an heir or someone in the organization already.
Many PEGs prefer privately owned businesses to private equity-owned businesses or to corporate divestitures. This favoritism is due to the understanding of the dynamic of the interpersonal issues, the family’s name on the door, and the loyal customers that trade with the firm. It leads in some cases, as reflected above, to significant commitment to family owned business. Awareness that family business owners make decisions that may not maximize shareholder value provides opportunities for operational improvement. The goals of these managers are different than those of PEG owned firms who are seeking an exit within a five to seven year period. In order to facilitate these exits, the business needs to double or triple in size during the hold period. PEGs believe that they understand what these investments entail in terms of working with management and taking advantage of opportunities. The PEGs view the family owned business as offering significant financial returns due to the belief that these businesses offer the opportunity to easily improve operations by providing capital, adding processes, or enhancing management.
Private equity firms will be an important source of funding for business exits as baby boomers retire. Knowing how they evaluate the investment merits of the companies they ultimately add to their portfolios is the important first step in tailoring your proposal for a PEG buyer.