In Part I of this series, we provided an overview of the private equity market. In today’s article, we discuss some general characteristics of both private equity groups and the ideal private equity investments. Our focus here is specifically on private equity firms who invest in the Middle Market (which can range from $5 million to about $250 million in revenues). Note that different PE firms will have different investing criteria, so the characteristics discussed in this article are generalizations only. However, they do provide a broad understanding of what private equity firms are seeking when making potential investments.
Robert Slee’s Private Equity Markets lists out four key characteristics of private equity firms. We’ll discuss each one below and elaborate on how this may apply to the average Middle Market business that might be a potential acquisition target.
Limited Holding Period
In general, PE firms hold onto their investments for five to seven years. This means that private equity has a limited time frame with which to make a return on their investment. Almost all PE firms play the game of “multiple arbitrage” whereby they buy a company (at let’s say 5x EBITDA) and then sell at a higher multiple (for example, 7x time EBITDA). They do this through a rigorous process of value creation whereby the business is systematized, management is professionalized, and the overall company is de-risked.
As I noted above, not all PE firms are alike and some will have shorter time frames if they believe they can perform the multiple arbitrage process in a more condensed time span. Some PE firms may target smaller companies and ultimately sell to larger PE firms. Regardless, PE firms implicitly understand the concept of exit planning since this is incorporated into their business plans on Day One.
Higher ROI Expected
We’ll explore the returns on investment expected by PE firms in more detail in Part 3, but generally we can conclude that PE firms seek out returns far in advance of your ordinary equity investment. While the stock market will average returns of 8-10%, private equity firms usually seek out returns of 25% or greater. This high hurdle rate plays a role in the valuations that PE firms will pay. A PE firm that overpays for an acquisition will have a tougher time realizing their expected ROI. Most PE firms are considered to be “financial buyers” in that they value the business solely on the expected cash flows generated by the firm rather than paying additional amounts due to perceived synergies or strategic value.
Existing Management Team is Important
Very often when PE firms buy a company, existing management is expected to continue in the newly acquired entity. This may also include the previous shareholders of the acquired company if they played an active role in management. This is important because the PE firm was initially attracted to not just the products or services of the Company, but also how the Company runs. This is where existing management will have an impact on the valuation. In general, the stronger the management team, the higher the value a PE firm is likely willing to pay. This is because a strong management team will usually indicate predictable cash flows and growth and having one present will mean one less investment required by the PE firm to improve the company during their five-to-seven-year time horizon.
Notwithstanding the above, PE firms also like to roll up their sleeves and become involved with the operations of the Company, either as active employees, consultants, or through a position on the Board of Directors.
Most PE Firms acquire a controlling position (i.e., greater than 50% of the voting common shares) in their investments (although this does not imply it is always 100% since some rollover equity may be set aside for previous shareholders). This is referred to as de jure control, or legal control. In some cases, PE firms will own less than 50% of the common voting shares but may still maintain some (or full) aspects of control through mechanisms in the share agreements. This is referred to as de facto control. In other words, they do not have legal control per se, but effectively have control of the Company. In rare circumstances, PE firms may take minority positions in a Company but will often have certain rights to be able to buy existing shareholders out in the future and will insist on maintaining some presence on the Board of Directors.
Characteristics of Ideal PE Acquisitions
The Canadian Corporate Finance Manual (published by CPA Canada) outlines some key characteristics of PE investments which are discussed further below.
The management team is one of the most critical aspects of a company purchase since ultimately it is the management team that is responsible for creating strategy and executing it. This is one area where many Middle Market firms struggle because it is imperative for owners to separate themselves from the business. Systematizing the business through having an effective management team that oversees the day-to-day running of a company’s functions is important since in some cases, the old owners either will not or do not want to move over to the new company. In general, good management means having clearly defined objectives to create a culture of accountability. It is also helpful that the team have complimentary skills so that there are no significant gaps in terms of experience and competence.
Culture and employee satisfaction are often overlooked in the due diligence stage but private equity likes companies with strong culture and low employee turnover. This is because companies with low turnover have to spend less on retraining employees. This problem is pervasive in high turnover companies where there is a constant “brain drain”. A loyal employee base also indicates a strong and happy culture, an intangible that is otherwise hard to measure, although employee turnover statistics can certainly indicate red flags in this area.
Demonstrated Commitment to the Business
Private equity strongly prefers companies that are committed to the business. That means owners (and ideally management and employees) with a passion for the business. Business often needs a reason to exist and the best businesses are those whereby the business works on solving the needs of the marketplace in some area, every day. Owners and employees who are passionate about their goals and objectives go the extra mile to create outstanding products or services that create value for their customers. This, in turn, can make for a great investment.
The target of a PE firm ideally has something that makes it stand out. This could be market share, unique technology or processes, or intellectual property that can be exploited. Unlike Venture Capital investors, private equity firms are generally seeking out commercially viable technology with documented customer demand. In addition, this technology can provide benefits to the acquirer through providing defined advantages over the competition.
Competitive Market Niche
Targets of PE firms tend to excel versus the competition in many metrics both operationally and financially. This means that PE targets should undertake a key performance indicator (“KPI”) program to continuously measure key metrics both against historical results and against peers in industry. Additionally, companies that understand the key economic forces acting against the firm (Porter’s Five Forces analysis is a great place to start) and then determining a strategy to mitigate these forces will make these companies more attractive to private equity investment.
Focused Business Plan
Private equity firms prefer companies that are hyper-focused on key objectives. The management team of such companies can balance out the risk and rewards and have a vision into the future and can direct the necessary traction to achieve those goals. The business plan can be backed up with financial and operational data and there is a strong understanding of the industry in which the company competes. A focused business plan also deals with realistic timelines and addresses contingency plans. Finally, such a business plan should make a strong business case for growth in both Enterprise Value and equity capital and should include documentation about viable exit plans.
- Private equity firms are generally seeking out investments for the intermediate term of about five to seven years. Because they require a high return on investment, they often attempt to play multiple arbitrage through buying companies, improving them, then selling for higher multiples.
- Private equity firms seek out companies that have competitive advantages.
- If you are a Middle Market company, hoping to exit through a PE acquisition, bolstering your management team, improving corporate culture, and producing best-in-class products or services will ultimately make you more attractive as an acquisition target.
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