What Private Equity Investors Want
By Bill Bitterli, Mergers & Acquisitions Advisor
Private Equity (PE) investors have a duty to their own investors to rigorously vet and intelligently structure investments and ensure that the investor has a way out, whether things go well or poorly. Business owners selling their companies should understand the Mergers and Acquisitions (M&A) process and how different types of buyers will view their company.
All investors look for fundamental features – capable management teams, strong earnings and cash flow, sound balance sheets, good growth prospects, favorable market position, attractive valuations, etc. – but PE investors require more for three reasons:
- They are investing mainly in private, illiquid businesses
(versus publicly traded stocks)
- Owner managers usually maintain a substantial ownership position in PE deals
- PE investors are fiduciaries making temporary investments; for the most part, it’s not their money and they need to give it back
These factors force PE investors to place a heavier focus on 4 key issues so it is important that each of these issues are explored early and addressed in a letter of intent.
- Comprehensive due diligence
- Alignment of interests
Comprehensive Due Diligence
Successful business owners generally have an intuitive, rather than a fully documented, grasp of the details of their businesses. PE investors, acting as a fiduciary for their limited partners, MUST dig deep on the diligence so that they can fully understand the risks and opportunities of investing in or acquiring a company. PE investors are making substantial, multi-year investments in an illiquid security, where transaction costs may run six or seven figures. Getting it right up-front is absolutely necessary. By contrast, strategic investors can rely more heavily on their own experience in the business, and their own cost structures, suppliers, etc. if necessary.
PE investors courting you probably like you, trust you and respect you or they wouldn’t be considering an investment, but they simply cannot take your word on the condition of the company. This is a key reason that we recommend a pre-investment or pre-sale internal due diligence review.
Alignment of Interests
PE investors would like their business managers to get rich. Really. Putting in place appropriate incentives is a key part of PE investors' investment strategy. But some issues may arise such as:
- Timing of payments
- Incentivizing the right people
Timing of payments is critical to PE investors. The owner/manager is entitled to the value created before the PE investor invested, but the PE investor will want the management team both to remain “hungry” (pursue upside) and “have some skin in the game” (avoid downside).
Symmetry can be an issue for a business with multiple revenue sources or affiliated companies. PE investors' ears are finely tuned to the sound of money leaving a company to pay somebody else. Therefore, if an owner is looking for growth capital for a manufacturing business but is interested in keeping an affiliated servicing or real estate company out of the deal, the owner faces an uphill battle. It can be structured of course but is likely to be heavily scrutinized. The cleanest deal, from a PE perspective, is one in which owner/managers and investors get paid on the identical drivers of value.
Incentivizing the right people is common sense, but can be controversial. One common issue is continuing ownership. PE investors may want to stage the payout to an uninvolved former owner/manager, but in general, there will be far fewer issues with early liquidity. The continuing manager/owner, being critical to the success of the business, must be incentivized to take the company to the next level and that usually means having him/her leave a substantial number of chips on the table.
Unless the PE group goes into a deal with a new team in mind, the last thing they want to do is to replace an unmotivated management team.
PE investors will carefully weigh the tradeoffs between the return and the investment horizon for a particular investment.
As a first cut, PE investors are measured by internal rate of return (IRR) for their fund against similar funds. However, press releases for PE-backed transactions often refer to its “cash on cash” return. So which do PE investors really care about? The answer is both – IRR and cash on cash return. In order to raise their next fund, PE managers must demonstrate a favorable return on the fund as a whole. Figure 1 shows the interplay of IRR and cash on cash return.
Figure 1: Cash on Cash Returns
From a PE investor’s viewpoint, getting 3 times your money back is a great return if it takes 3 years (44% IRR), less so if it takes 7 years (17% IRR). Conversely, a 50% internal rate of return on a particular investment sounds terrific, but if the money was only invested for 4 months it equates to 1.14 times cash return. This amount will do little to “move the needle” on a 7-10 year fund.
Issues of “control” often give business owners indigestion when dealing with PE investors. But, control or the ability to get control will short-circuit a huge number of issues around exiting the investment.
PE funds are usually established with finite investment periods (e.g. 4 years) and finite lives for a particular fund (e.g. 10 years). At the end of a fund’s life, the PE manager has only a few options when the portfolio company still remains:
- Extend the fund – undesirable, unless the remaining companies have been very successful
- Purchase the companies into a successor fund – suboptimal, due to conflicts of interest
- Distribute the securities “in-kind” to investors – disastrous, unless the company is easily traded
So, a timely exit is a crucial consideration. As a financial investor, the PE manager will almost exclusively focus on getting the best price for his/her shares. On the other hand, original owners and management may have other non-financial considerations (e.g. children in the business, loyalties to the workforce and community, etc.), which could disqualify high bidders. Without control, the PE investor can be at odds with owner/managers and unable to fulfill fiduciary promises to fund investors.
PE funds can employ many mechanisms to attempt to address these issues, such as a “put” option at an agreed upon valuation formula (i.e., the company agrees to buy-back or redeem the PE investment out of a new source of funds). If the company fails to deliver the put amount for a certain period of time (e.g. 1 year), only then does the PE investor gain control. However, the bottom line is that the PE investor absolutely needs a timely exit and when other methods fail, having control may be the only way out.
Before embarking on the sale of their company, business owners should understand the Mergers and Acquisitions process. They must also ensure that key issues – comprehensive due diligence, alignment of interests, returns and exits are reviewed and addressed in a letter of intent. And, lastly they should undertake a pre-investment or pre-sale internal due diligence review.
If you’re getting ready to sell your company, call Jack Lyons at (941) 497-4700.