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Advisors

3 Private Equity Red Flags

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Private equity is a wonderful go-to source to generate activity on behalf of our sell-side clients. As a banker, I am blessed with a number of deals that were completed with some truly excellent PE firms. Then there are those PE firms who cause me to sometimes wish I was in another line of work…

When bringing a new client to market, we put a teaser on Axial, send out a mass email to our own contacts, make some calls. We are quickly besieged with a hundred or more inquiries from PE firms. Half of these will negotiate and sign an NDA to receive a CIM.

We have now entered the PE mill and must figure out how best to separate the wheat from the chaff. The wheat are the serious contenders: private equity firms who are very likely to give us a decent expression of interest. The chaff are the folks who are merely going through the motions, wasting their time and mine. Here are three of the red flags I look for when weeding out the chaff:

1. No time of day from partners.

An associate responding after receiving the CIM is a bad sign. I’ve found that if a partner or at least a seasoned principal isn’t showing immediate interest, there is little point in taking the phone call. I have wasted hundreds of hours educating often disinterested associates about my client, the industry, the market, and the numbers.

The calls always end the same way. “We will present this at our Monday partners’ meeting and get back to you.” I don’t hold my breath. Sometimes an on-the-ball associate will have the courtesy to drop me a line to say, “not our cup of tea,” but too often, we are left dangling.

2. No industry interest.

Based on their websites, it seems like many PE firms pride themselves on not being experts in any industry. My firm specializes in telecommunications and homeland security. Any industry has its quirks, which can turn off someone who isn’t familiar with the lay of the land. Ideally, the interested PE has a foundation of knowledge about my client’s industry. Then we can talk about substantive issues specific to my client and not waste time fumbling with the basics.

3. Talking growth, but really meaning historical EBITDA.

There are some truly excellent PE firms out there who are willing to place value on topline performance. Many others will give lip service to the concept but will not honestly factor it into the valuation equation.

Why? A rapidly growing business eats up EBITDA. Lenders lend against EBITDA multiple covenants. And most PEs love the kick that leverage gives to their ROI.

These PEs are stuck on using EBITDA multiples to value a business. They ignore the valuation generated by a discounted cash flow. And I am stuck trying to explain to my client why a much slower growing business with a better EBITDA margin will get a better valuation from financial buyers than my client’s rapidly growing firm, which has kept EBITDA margins low in favor of funding growth.

“Don’t think twice, it’s alright.”

As a side note… PEs sometimes turn off on a deal for the strangest reasons. Here are some real quotes from some real PEs:

“After much discussion, we think that telecom services are like the auto business; everything becomes a commodity.”

“We’re out — We heard from a former CTO [retired 15 years ago] that the wireless industry is going to become as obsolete as buggy whips.”

“We think the Department of Defense will be getting out of managing their own cyber security and thus stop buying software like your client produces.”

Continuing with the Bob Dylan analogy, I end this blog post with this: 

I ain’t a-saying you treated me unkind

You could have done better but I don’t mind

You just kinda wasted my precious time

But don’t think twice, it’s all right.

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