What is it really like working with Private Equity and should you explore this route to sell your business?
Conventional wisdom is that a trade buyer who can gain economies of scale and synergy will pay the most for your business. Today, however, with so much private money looking for yield, Private Equity (PE) is becoming an increasingly attractive option. Trade buyers have lots of options for growth beyond acquisitions, including competing with you. So for sellers, Private Equity can be an attractive option, particularly if they wish to retain a stake in their business and maybe an active involvement and thus ‘elevate’ their deal value significantly over time as the business realises its full potential with capital behind it.
There is, however, scepticism from entrepreneurs about how Private Equity adds value and works. In the early days of institutional money, this was often a fair concern with extensive fees and spreadsheet models. Financiers perhaps just brought money, suits, and little added value. Things have moved on, however, so let us separate the myth from the reality. What is it really like working with Private Equity and why you may want to explore this option to sell your business that would secure capital to grow, or perhaps swap debt for equity rather than a trade deal?
Can ‘value-added’ really match trade deals?
With over £2.3 trillion of Private Equity money in Europe looking for a home, Private Equity can today often compete with trade deals. If you have something unique that drives the ‘we want it, we need it’ motivation in trade buyers then values will always be at a premium. However, there are many great businesses which do have competitors that cannot attract the attention of the larger trade buyers with their deep pockets. In these cases, Private Equity as professional buyers can often be better than trade deals.
They need to deploy funds within set timelines and post Covid-19 they will also now finance businesses entirely with equity rather than debt which enables them to take longer-term views on current cash flows. The fall towards almost negative interest rates may drive up valuations as ‘survivor’ companies become more attractive. The price that investors will pay for a share of a company’s profits is only partly determined by the level of profits today. The potential growth run rate is also critical.
What will happen to my team and me?
If you sell to either trade or Private Equity, there is an inevitable change. If you are exiting completely, this may not be relevant to you, however, if you are going to have some continued involvement, retain some equity or perhaps just concerned about the staff and the legacy you leave behind, this inevitable change is important to consider.
A trade sale could create opportunities for you and your staff within the wider organisation. It might also enable access to new markets and customers or even territories. On the flip side trade buyers will commonly look for economies of scale of which human resource is an easy target. There will probably be cultural differences between the two organisations that need to be managed, which can be difficult and complex. Equally, a need to integrate systems and a loss to the business’s brand and identity should be considered, among many other aspects. Critically perhaps, particularly if you retain an involvement, buying and selling parties may well have different, or even conflicting, agendas in the mid to long-term.
On the other hand, Private Equity has only one agenda; to generate a return for its investors. To do this they need to make the business more valuable when they exit than when they invested. To make this happen it has to grow, become more profitable, de-risk, maybe diversify, invest in R&D, people, process and systems; all of the things that are good for creating successful businesses. Perhaps of most relevance to any seller, your Private Equity buyer or investor, is the value of you and your people. Private Equity buyers will tell you, one of the most important things they look for is to support quality teams.
You should still expect change when selling to or taking investment from Private Equity. Reporting may need to be more robust, they will want a presence on the board, whether it be in an observational or executive capacity. Often it is agreed that existing MD owners will initially hand the business over to a new team and appoint a Chairman.
How does Private Equity drive growth?
All Private Equities want to see high-quality corporate governance and reporting, and will have the experience to help management implement it where improvements are required in these areas. Availability of capital is the other key commonality, which as previously mentioned can be used to drive growth through acquisition, R&D, investment in key assets, bringing in new talent, product development and new territories, to name a few. Under Private Equity ownership so long as the return makes sense, it is “all systems go”. Capital is the fuel that “fires up” growth, and without it, reaching that next level is a real challenge, or takes too long and the opportunity is missed.
Private Equity will typically look to invest in businesses where they feel they can add value, possibly by introducing the right contacts through their network, knowledge of products, or strong experience in areas where a skills or knowledge gap exists in the business. Often of significant importance is their ability to take a business on the journey from cultural to commercial, which is essential for many small and emerging privately owned businesses in growing beyond the talents and capacity of a small handful of key individuals.
What about the ongoing finances?
In the current time of Covid-19, many Private Equity investors will deploy spare cash rather than immediate debt. This is because cash flows have been hit and banks can be slow. At some point, however, Private Equity will usually leverage the asset against cashflow so they can then deploy their capital for other ventures. They see their job as deploying capital effectively.
For businesses used to high bank deposits and significant dividends, this can mean cashflow management becomes tighter. Furthermore, the Private Equity investor may take annual management fees so for sellers retaining stakes, future dividends may be stifled, however, the point of retaining stakes is to invest in the business for acquisitions, growth, talent, and new territories. Future wealth comes from their later sale, not the ongoing cashflow.
Typically, Private Equity firms would rather lease assets than own them, and they will also be very focused on credit and stock control. The mindset is money and assets always require a yield. This can all put extra strain on the finance team, but their expertise is usually bolstered under Private Equity ownership, often in conjunction with updated systems and dashboards. Reporting can seem to become a business in itself, however, this is vital to drive growth as the data shows trends, margins and opportunity.
A typical Private Equity cycle of ownership is three to seven years after purchase, seeking to return two or more times on the initial investment on a later sale. This means PE is effectively the property developer of the company world. They develop then realise. With low yields in other asset classes, some investors are keen to hold assets for longer, patient capital. In this respect they could be compared to property developers turned ‘buy to let’ landlords.
Elevator deals
In the late 1990s, at Avondale, we coined the expression ‘elevator deal’. It described transactions where the seller remained involved with the business being sold or even took a role in the acquiring business and was incentivised to help drive growth and rewarded for doing so. This was great for sellers who felt that they still had something to offer going forward, but wanted to de-risk or perhaps for whatever reason felt they were not the right person to lead the business onto its next level of development.
They do however have one issue; they require a future event that would crystallise the value of the seller’s continued involvement, which can be complex with a trade buyer, either due to different agendas, or simply monitoring and agreeing on the value of the seller’s input.
They are however ideal for Private Equity. Typically, the Private Equity model is to buy or invest at one price, grow the business and then sell at a higher price, therefore providing the future event required to reward the seller. There is a further benefit with Private Equity funding to make ‘bolt-on’ acquisitions, the seller can also share multiple arbitrages achieved. (‘Arbitrage’ means buying an asset for one price and selling the same asset later for a higher price.)
Arguably, the most common influencer of the multiple of profit paid for a business is scale. Statistically, a business with £250,000 EBITDA attracts an average multiple of 4; one with £1.5 million EBITDA a multiple of 6.5 and with £10 million EBITDA a multiple of over 10.
Therefore, if a £1.5 million EBITDA business buys a £250,000 EBITDA business, instantly the target multiple has been increased by 2.5, hence increasing its value from £1 million to £1.625 million. This is before any economies of scale or synergy could be achieved. All of which the original seller, who retains a stake in the platform acquisition, will benefit from on exit.
Larger companies nearly always trade at greater multiples of earnings than smaller ones. Hence so many Private Equity firms are keen on acquisitions or ‘bolt-ons’ to create scale. Private Equity corporate governance and re-positioning a business can also bolster value.
How do PE firms see Covid-19?
All Private Equity houses we have spoken to since the crisis began, see Covid-19 as another factor to consider in the overall economic lifecycle, but that is all. Of course, the correlating economic drag impacts them and those with mature portfolios, where managing and maintaining assets will be high on the list. Nonetheless, with funds raised, capital deployment is their method of wealth creation and therefore Private Equity will continue to invest, particularly in sectors that prove resilient and are likely to emerge stronger after lockdown.
When assessing any investment you do need to understand the bandwidth the investors have to add value to their investment. If they do not have any, then you simply end up with a sale and no help which may not be a sufficient reason to do a deal. Finding the right PE investor, who can play a role in bringing contacts, expertise and hands-on help should be the goal.
We know from experience that beyond adding value, Private Equity is also supportive and with the Covid-19 backdrop, where many singular owners have ended up carrying the crisis into the small hours of the night, Private Equity has helped with financial modelling, debt, contacts and HR support. Collaboration is key to the Private Equity mindset. In some cases, investors have injected additional capital to ensure sustainability. It is expected that there will be a change of emphasis in due diligence beyond historic numbers but also to technology and digital assets as well as customer relationships. A view can be taken on cashflow if the underlying metrics such as customer loyalty can be proven and measured.
Summary
A trade sale may pay off the mortgage and get the holiday home but for many, after the initial six months has passed, surprisingly they miss the intellectual challenge of work. A PE deal can create a hybrid where sellers can de-risk but continue to contribute to purposeful capitalism by holding stakes and using their entrepreneurial flair to take good companies to great. Value may equal or be greater than some trade deals.
Any sale will have change and tension points, whether the buyer is trade or PE, so reverse due diligence is always important, and better understanding the cultural differences in approach and method ensures better deals. The PE firm’s ultimate loyalty is the money and not the business but once you understand that, there is an opportunity. Many sellers have continued to work with PE beyond their entity and continued investing alongside them in other ventures.
It sounds hard if your business is your ‘baby’, but ultimately at some point you are doing your job if you allow your baby to become an adult and forge its own path. The best PE firms and partners will balance yield and business well to ensure they add value and increasingly with so much competition, without this, they cannot deploy their capital.
It should also be remembered that PE comes in different shapes and sizes; growth capital, buy out, sector specialisms, different size transactions, majority and minority stakes, different ownership periods, IPO specialists, supporting MBOs or MBIs and varying levels of hands-on involvement. For both sides, satisfaction is not attained through doing deals, nor simply in the accumulation of assets. It is built around relationships which lead to an enriched inexperience as well as return. If you are considering an exit, it is worth talking to both trade and Private Equity rather than pre-judging either.
For an exploratory discussion without obligation, please contact us on +44 (0)1737 240888 or email av@avondale.co.uk.
We have launched our ‘Lead Ahead’ Webinar Series in line with our weekly articles. Join our ‘Private Equity Sale Myth vs Reality ’ webinar on 23rd July 2020, 9.30 to 10.30 (BST).
For information on other webinars within the series, visit our Webinars & Events page.
