Private equity firm (PEF) recapitalization has become one of the top reasons that businesses valued at $2-50 million are going to market, according to the Market Pulse Report, which is published quarterly by the International Business Brokers Association (IBBA), M&A Source, and the Pepperdine Private Capital Markets Project.
Private equity is definitely an attractive possibility for some owners who are looking to transition out of their businesses. With the PEF injection of capital into the business, the owner cashes in some of his or her equity (usually a majority stake) but also maintains some ownership. The owner usually stays on to help grow the business under the supervision of the PEF and bolstered by its financial and business resources. However, as with any sale transaction, there are a lot of complexities that owners need to understand before exploring this business transition option.
Financial buyers such as private equity firms are looking to invest in businesses and get a handsome return. Their goal is to scale the company, increase its value over the next three to five years, and then sell it in the future at a much higher value. If things go well, this two-step process can result in a second payday for the owner when the business is sold again.
Financial buyers typically invest in companies that have a capable management team, a solid team of employees, and high growth potential. A private equity sale almost always involves the owner remaining involved, generally in an operational capacity. This type of sale can be beneficial for owners because it reduces their risk and allows them to sell a portion of the business, but still retain some equity that may grow in value.
Who Are Good Candidates for PEF Investment?
This type of transition isn’t for everyone, and there are a few things you need to consider:
- It may be difficult to find a PEF with the right resources and expertise to help you grow the business.
- You have to be ready to work for someone else and be accountable to them for at least one to three years.
- You and your team have to be fully committed to operating and growing the business for the next several years.
A 2014 article “Equity-worthiness and equity-willingness: Key factors in private equity deals,” published by the Kelley School of Business, Indiana University, reports that “less than 3% of pre-negotiations between privately held companies and PEFs lead to a closed deal. This means that the process is exacting; roughly 97% of negotiations initiated by PEFs collapse.” It is important for business owners to understand what makes a company an attractive target for private equity firms and what goes into making a deal successful.
What Private Equity Firms are Looking For
PEFs are looking for good investment opportunities that are “equity-worthy” and will produce solid returns. They expect the value of their stake in a company to increase significantly as a result of their efforts to increase capacity and revenue, provide complementary resources and capabilities, and improve corporate governance and processes.
Increasing Your Business’s Equity-Worthiness
PEF investors are looking for future return on investment and growth potential, so remember to emphasize this rather than dwelling on past performance. Growth opportunities, reputation, and industry leadership are some of the many qualities investors value. Other ways to increase your business’s equity-worthiness include:
- Documenting improvements that can be made with new capital
- Providing clean financials
- Reducing the risks in your business
- Understanding your competition
- Setting specific goals to improve your business and drive to achieve them
As you can see, the process will likely be time-consuming, intensive, and not of interest to an owner who wants to walk away from his or her business.
Determining if a PEF Sale Is Right for You
There’s no guarantee that there will be a second pay day for the owner as the result of a PEF sale. If it’s something you’re considering, you will need to do your own due diligence and look for PEFs that have a track record of success with similar companies. And, because you’ll most likely be heavily involved in day-to-day operations for some time, you want to make sure that your vision and goals for the company are closely aligned with those of the PEF. Start the process well in advance to achieve the best outcome.
Before going down this path, we suggest that owners:
- Develop a Business Ownership Transition Plan that allows you to determine which transition options are right for you
- Understand prospective PEF buyers and what they are looking for
- Work with business advisors who can assist you with improving your business and presenting it to PEF investors
- Determine what is attractive about your business in light of PEF buyers’ unique considerations, and position your company in the most beneficial way
If you are thinking about selling and realize you need outside capital and expertise to significantly grow the value of your business, you may want to consider a private equity investment. However, we encourage owners to seek independent and objective advice before making any decisions. There may be other ownership transition strategies that will enable you to achieve your goals. You want to be sure you consider all of them before taking this big step.