As you contemplate the world of potential acquirers for your business, you may be presented with the idea of a “financial sponsor”, or private equity investor, being the right acquirer. Private equity firms invest in a number of ways, but most typically via leveraged buyouts, recapitalizations, and growth equity investments. Some of them are willing to take minority positions, but most of them in the lower-middle market will want to take a majority position and control the board of directors to mitigate their risk in investing in a smaller business. They generally aren’t as willing to pay as much as industry (aka “strategic”) buyers, but they can bring their own advantages to the table – particularly if you’d like to retain some ownership and have a “second bite at the apple” with the next exit. Should you choose this route, here are the top five things to expect with a private equity partner.
1. They Will Want You to Stay On Board
First, in all likelihood they will want you to stay on board for the duration of their ownership period, with a substantial minority stake in the business. A major reason why they are investing in your business, is well, you. If you’ve been obsessed with washing your hands of the business and riding off into the sunset with a fat retirement, then 1) be prepared to accept less for your business and/or 2) you’ll probably want to close a deal with a strategic buyer who has managers readily available to step in and take over – although in almost every case your minimum required stay will be six months to a year (with another year of consulting on top of that) to ensure a smooth transition.
A private equity investor as a partner means just that – they want to “partner” with you to take the business to the next level and achieve a meaningful return on investment. While they certainly have the resources to bring in a new CEO, that typically is not in their best interest and is a last resort should things go south.
2. “Mature” the Organization
From day one, the expectation will be that you take greater strides to build out and empower your management team. Private equity investors know that one of the key value propositions for a future buyer will be a strong existing management team. Strong management teams are indicative of longevity and sustainability. Gone will be the days of you, the business owner/CEO, doing everything. You will be encouraged to hire a CFO if you don’t already have one (they often help with that), and you will be expected to mentor and/or hire other key senior managers in both sales and operations.
As part of the new capital structure, a reserve of equity (typically 10%), often called a profits interest pool, will be set aside for the key senior managers to align their long-term interests with the ownership group (including you). This equity is non-voting, common equity that will participate in the profits upon the company’s next exit. The private equity investors will rely heavily upon your input as to whom the profits interests are granted.
This senior management team, now freshly incentivized with an equity stake in the company, will be expected to build out systems, processes and procedures that grow the business, enhance reporting, improve productivity, and create efficiencies … all of which should directly contribute to enhancing EBITDA and/or adding to perceived value for a future buyer. Your management team won’t be expected to recreate the wheel or even to become experts in Lean Six Sigma, but they will be expected to improve performance, with you at the helm.
3. Be Open to Their Input
In all likelihood, you will be on the phone with the private equity partner who led the investment in your business almost daily during the first few months post-close. Over time, as performance builds and trust grows, that will dissipate to once or twice a week. However, the private equity firm has put their investors’ (called “limited partners”) money on the table by investing in you – that relationship with their limited partners is everything to them. It is their lifeblood, it is their reason for being in business, it is their future opportunity to raise a new fund and continue as professional investment managers. They are not about to screw it up by losing touch with what’s happening in the business in which they invested.
As you might imagine, this is typically a shock to the system for most traditional owner operators. They are not used to having someone “all up in their business” (pun intended) to that degree. Without a healthy supply of humility and a willingness to learn, it can easily lead to defensiveness (and sometimes bitterness) for the unexpecting, uninitiated owner operator. “After all,” you might ask yourself, “what do the PE investors really know about running my business? They sit in an ivory tower and are just financiers, right?” Not so fast.
While there will inevitably be disagreements, and PE investors are certainly capable of doing and saying dumb things, it would be wise to remember that outside input and a second opinion are usually good things. And, rest assured, that input will be given. Granted, some PE firms are much more “hands on” as investors than others, but my experience is that most PE investors in the lower-middle market have no choice but to be very “hands on” because of the need to nurture the organization. That’s part of the opportunity for them to add value and drive their return. Furthermore, private equity investors typically arrive in their professions after enduring the furnace of Wall Street investment banking or consulting roles, and with degrees from top undergraduate and graduate business schools – usually finishing at the top of their class. They are very intelligent and have valuable experience. They’ve often seen similar issues as yours in other businesses and will be able to spot very early the onset of a potential problem. They will certainly listen to you as the CEO, and you will be wise to listen to them.
4. Get Used to Board Meetings
If you haven’t had a board of directors (or if an LLC, board of managers) to deal with in the past, welcome to your new world. The board will likely consist of you and two private equity partners, including the one who led the investment. There may be an outside board member, but only if that individual has significant ties to the private equity firm and is a sure bet to vote with them should there be disagreement. In attendance at the meetings will be at least one junior private equity associate (the one who will be assigned to your company), as well as your CFO. Members of your management team will be invited to attend and present from time to time.
These meetings will be held quarterly, either at the PE firm’s offices or at the business. You and your CFO will be expected to prepare and present financial and operational results, as well as expectations for the business in future months. There will be plenty of Q&A and discussion. Minutes will be kept and later distributed. The goals of an effective board meeting will be to have open, transparent discussion on the results of the business and to collaborate on how best to improve the business going forward. If all goes well, trust and idea-sharing abound, everyone is in alignment, and good feelings hold sway. Conversely, if all does not go well, sometimes the best remedy is for everyone to take a step back and breathe to de-escalate the situation, and reconvene at a later time in the coming days to find resolution.
5. The Exit Will Come … Maybe Sooner Than You Think
You know the old adage, “there are two certainties in life: death and taxes.” Well, add this to the list of certainties – the private equity firm will exit your business, either sooner or later. From the day they deem your business attractive enough to contemplate issuing an LOI (letter of intent), they begin “modeling” their potential return on investment, or IRR (Internal Rate of Return). Most PE firms are looking for 20%+ returns, which justifies their limited partners’ investment in them over investing in liquid securities like stocks and bonds. The PE junior associate will be tasked with maintaining the investment model for the duration of the investment period, and they are constantly adjusting it based on your performance and expected market conditions.
Most private equity firms say very similar things when it comes to their investment criteria, time frames, approach to investing, etc. Look up any number of them on the Web and you’ll soon understand what I’m saying. One of those commonly referenced attributes is that they are patient and willing to invest for “longer” periods of time – “longer” meaning up to five or six years. However, what you need to remember is that, in the final analysis, private equity investors will do whatever is required to maximize return on investment – after all, that is their responsibility as fiduciaries of their limited partners’ money. If the opportunity for an attractive exit presents itself within 18 months of their investment, they will want to go to market. And so, you should not be surprised. In reality, you won’t be surprised – if the market is that good and the exit opportunity is there, you will all see it together and begin planning accordingly.
In conclusion, a private equity investor could certainly be the right choice for you as you consider your first major exit opportunity. As with all business relationships, go in with eyes wide open. They will have very clearly defined expectations for their own return on investment, and for what they expect of you and the management team. You will be bedfellows for up to five or six years potentially, so be sure to thoroughly vet personalities and, if possible, get the perspective of the CEOs of some of their portfolio companies. Remember, the relationship will work best when you are interested in staying on board as both CEO and minority owner, continuing to grow and improve the business, and being open to outside input on your operations.