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Capital Ideas for Private Business

When it Makes Sense to Sell to Private Equity

A Few Points to Keep in Mind

By David Sinyard , Managing Partner
Atlanta Office, Corporate Finance Associates

private equityApproximately $1 trillion dollars of capital is managed by private equity funds worldwide. Roughly two-thirds of this amount is invested in buyout funds and the balance is devoted to venture capital. As private equity is a significant source of investment capital, how does private equity work and when does it make sense for business owners to seek out private equity to buy part or all of their business?

Private equity is risk capital that is employed in a wide variety of situations and, by its nature, not readily tradable on a public stock market. The majority of the capital in this market is provided by institutional investors who invest as limited partners in partnerships sponsored by professional managers; the general partners, who source the deals, negotiate the capital structure and oversee the operations of the portfolio companies. Returns are provided to the investors in the form of operational cash flows, operational improvements and an exit at a higher multiple than originally paid for the company. The limited partners commit a specific amount of capital while the general partners agree to a specified time period within which to invest, typically five years. The parties further agree that the capital will be returned to the partners in a 10-12 year period from the date of committing the capital.

Industry or strategic buyers buy businesses to add value to their current operations. In executing these deals, strategic buyers are able to pay the highest multiple for their acquisitions. When private equity groups (PEGs) purchase an interest in a business, they buy based on anticipated rates of return for their investors. PEGs are known as financial buyers and they tend to pay less for a business in return for assuming the investment risk. They buy to build the business and then sell it after several years, hopefully at a higher multiple.

Over the course of the life of a fund, a PEG will seek to acquire a portfolio of companies. These are seasoned professional investors who have made it their business to close deals. Their sophistication means issues that a first time buyer might face do not normally appear. Private equity is adept at traversing through the deal maze, and sellers typically benefit from professional advice through the process.

In many cases when private equity buys a business, they only purchase a portion of that business. The rationale behind this strategy is that by keeping a seller involved, there is incentive for that seller to continue to enhance value and grow the company. The seller knows that four or five years down the road there will be a second transaction, and he has the potential of reaping additional rewards when the business is sold again. The seller has reduced his exposure by taking some money off the table and at the same time paved a path for an additional payday with the company’s ultimate divestiture.

One strategy to consider when selling to private equity is improving your business’ competitive position. In the current economic climate, many businesses are cash strapped but if able, would take advantage of the timing to improve their market position by either expanding their current operation or acquiring that of a competitor. By selling a portion of a business to private equity and using the resulting cash position to expand, a business owner could in effect supercharge the company.

One of the many business components that private equity considers before buying a company is the strength of its management team. For the most part, the management team will be left in place and continue its normal function. When strategic investors buy a company, this is not always the case and downsizing and consolidation often occur.

So why should a business seller seek out a private equity group as a potential buyer? In the current economic environment, sellers must look to the sources of readily available capital. Private equity is a significant source of both growth and exit capital. In addition, PEGs have very specific investment time frames that often act as a catalyst for action. Instead of looking long term, results must be achieved within a condensed time frame. When business owners retain a stake in the company they sell to a PEG, they will often reap additional rewards upon the second transaction. When protecting existing management and staff is a consideration, selling to private equity may actually be a better alternative than selling to a strategic buyer. Seeking out a private equity firm with specialized expertise in your specific industry sector may result in the perfect buyer for your business.

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