One increasingly attractive option for Middle Market business owners is to sell their business interests to private equity. But what is private equity and what do SME owners need to know if they are considering transitioning in the next two to five years? This is the first part of a series where I will explore private equity and why it could potentially be a good exit option for an SME business owner. In Part II, we will discuss key components of a good PE investment, in Part III, we will explore expected returns on investment by PE investors and in Part IV we will conclude by discussing the relevant statistics on hot sectors and current valuations.
Private equity can involve any group of investors that seek out to buy closely-held private firms. Usually, they will own not just one company, but a portfolio of companies to help diversify their investing risk. Private equity can be contrasted to other types of buyers such as corporations seeking strategic investments or individual owners looking to essentially buy themselves a job. Each of those groups will have specific time frames in mind, expected involvement in the business, along with expectations for return on investment. In addition, each will view their exit options in a different light.
What are the general characteristics of private equity investors? Let’s first define three types by using their more commonly used names. Angel investors often focus on start-ups and many times represent the primary or only source of outside investment for company founders. In contrast, Venture Capital investors are primarily investing in young companies with high prospects for growth. Lastly, Private Equity is a term generally used to refer to investors of established private enterprises.
Let’s first start by exploring the various stages in the business lifecycle target companies can reside and how this relates to the investor profiles discussed above. These stages can be broken down as follows:
- Seed Stage—These companies are most likely only at the “idea” stage, perhaps sporting some prototypes or demos. The most common type of investor at this stage are Angel investors.
- Start-up Stage—Companies at this stage have begun formal operations and have most likely incurred expenses, although not necessarily generated any revenues. The most common type of investors for this group are late-stage Angels or early-stage Venture Capital investors.
- Early stage—Companies in this stage are growing fast and likely have a marketable product or service and most likely have started to generate revenues, which are now growing at a fast pace. The most common type of investors in this category are Venture Capital investors.
- Expansion stage—Companies in the expansion stage have a viable product or service, some corporate history behind them, along with a well-defined business plan that they are executing. The most common investors here are late-stage Venture Capital investors or Private Equity.
Mature—Mature companies have a long history behind them (at least five years and in some cases decades) and have viable products and services. While their growth rate is lower than younger, higher-growth companies, it is still growing at a moderate rate with potential for more expansion. The most common investors here are Private Equity.
Since SME owners are mostly concerned with Private Equity investors, our remaining focus will be on that investor profile.
Types of Private Equity[ii]
The world of Private Equity is diverse and contains many different types of groups, each with different objectives and time horizons. Here is a discussion of the most common:
Private Equity Groups (“PEGs”)—Sometimes referred to as Private Equity Funds, PEGs are the most common form of private equity investor and often involve multiple professionals looking to invest substantial amount of funds. Amongst this group are numerous sub-groups, which are described as follows:
i) Growth funds–As the name suggests, growth funds seek out companies with high levels of growth rates. Some growth funds may specialize in a particular industry while others have more broad investing criteria.
ii) Buy-out funds–Buy-out funds (sometimes referred to an LBO or Leverage Buy-Out funds) seek out attractive companies and acquire them with a heavy reliance on debt and collateralization of assets. Leverage is used to increase the prospective return on investment when the buy-out fund eventually exits. One the down-sides of this approach is if the investment does not work out as intended, the high degree of leverage will also increase investor losses.
iii) Recapitalization Funds–Recapitalization funds focus on making investments in less than 100% of companies. In some cases, the funds will have either de jure or de facto control, although there is an increasing number of funds that take minority interest provisions in certain circumstances. In a recapitalization situation, the legacy shareholders will likely receive what is referred to as “rollover” equity in the new business. This rollover equity allows the legacy shareholders to accrue increases in value thanks to growth in the newly structured company, thus benefiting from the experience and expertise of the Recapitalization Fund principals. Eventually, when the Recapitalization Funds exits, the legacy owners have a chance to “get a second bite of the apple” when they sell their shares.
iv) Mezzanine Funds–Mezzanine Funds are more focused on investing through mezzanine debt and/or preferred shares. Often, their investment will be hybrid instruments with both characteristics of debt and equity. Business owners will often use mezzanine debt or investment in preferred shares to invest in people, capital assets, and infrastructure to help the company grow.
v) Distressed Funds–Distressed funds seek out companies that have struggled and may otherwise be on the verge of bankruptcy. Distressed fund investors tend to be specialized in this area and often will take a hands-on approach when buying out companies. Distressed funds will often maintain their investments until a turnaround is complete, many times exiting to other private equity groups or corporate investors who are interested in a now healthy company.
vi) Endowment Funds–Many educational institutional funds invest endowment money. In the last decade or so, it has become more common for Endowment Funds to directly invest in companies as they seek out higher returns than can be found in more conservative investments.
2) Family Offices–Family Offices have grown substantially over the past twenty years. Family offices can be broken down into two main types: i) multi-generational families with accumulated wealth looking to diversify their portfolios, and ii) first-generation families that have exited their business and are now investing the proceeds into private companies.
3) Independent Sponsors–This is a growing group within North America that consists of individual groups of investors who are seeking out higher returns through investments in private companies. In many cases, independent sponsors intend to take control of the companies they purchase and operate them. Independent sponsors may be already be pre-funded, but many do not seek out funding until targets are identified and at least an Intent of Interest (“IOI”) has been made. This group represents an increasingly important one for Middle market business owners.
[i] This section adapted in part from “Private Capital Markets”, Chapter 24: “Private Equity”, Robert T. Slee.
[ii] This section adapted in part from “Private Capital Markets”, CM&AA Slides, Chris Blees
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