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Overview of Private Equity for Entrepreneurs

By Divestopedia Team
Published: September 19, 2018 | Last updated: March 21, 2024
Key Takeaways

Private equity firms should be seen as an important buyer in the marketplace for good businesses and should also be regarded as a genuine partner.

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Private equity (PE) is for many people seen through the prism of the media, which focuses on the industry only when global firms are undertaking audacious buy-outs or acquiring household brands. Most of the activity though is undertaken by smaller local firms, under the radar.

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For thousands of privately owned businesses, PE firms should be seen as an important buyer in the marketplace for good businesses. They should also be regarded as a genuine partner. This is key to their success. It is well known that PE firms invest alongside management teams, but most firms also offer founders and owners the opportunity to realize some value while retaining a stake in the business.

What is Private Equity?

Private equity firms manage money committed by pension funds, other institutional investors and high net worth individuals. In addition, key PE firm personnel commit their own money alongside their investors. These commitments are pooled into 10 year investment funds, which PE firms then use to acquire portfolio or investee companies. For the sake of brevity, we adopt the shorthand reference to PE firms 'owning’ portfolio companies. In fact, a PE firm manages the fund that, in economic terms anyway, owns the company. PE firms are no different in this respect to fund managers of equities, fixed income and other assets.

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Each PE fund will invest in up to 10 portfolio companies through what is known as management buy-outs, or MBOs, meaning the PE firm invests in conjunction with the management team to buy equity in the company, often alongside existing owners of the business. In broad terms, PE firms make investments in the first five years of the fund, and then sell, or exit, these investments during the second five years. PE firms raise their next fund during the life of an existing fund to smooth the investment cycle for their investors.

The focus of this article is on PE firms who invest in small to medium sized companies, typically with an enterprise value (that is, disregarding the capital structure) of $20m to $150m.

PE firms are professional business owners. Their success is measured in Darwinian terms — their ability to generate returns for their investors consistently. Many PE firm personnel come from investment banking and management consulting. Others have experience as CEOs and line managers in industry roles. They offer portfolio companies both capital and strategic input.

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PE firms generate returns by:

  • Buying companies well, by identifying risk and opportunity through due diligence;
  • Improving portfolio company operations and performance to increase profits, and also to improve the quality, diversity and sustainability of those profits;
  • Putting in place governance structures and focusing on the quality of financial reporting;
  • Injecting equity capital, such as for capex, entry into new markets or acquisitions;
  • Building scale and efficiency through industry consolidation;
  • Targeting under-valued or growth industries; and
  • Skilfully timing the exit of their portfolio company investment.

PE firms deliver value to the management team by:

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  • Advising on strategic and operational aspects of the business, as well as working alongside management teams to develop, critique and execute the company’s business plan;
  • Bringing new ideas, a new network for commercial opportunities, new personnel (often non-executive directors with relevant industry experience) and a new rigour and accountability to portfolio companies;
  • Acting as an informal sounding board for CEOs, invested as they are in the business but at a distance from day-to-day operations;
  • Advising on areas which are specific to their expertise, including 'bolt-on’ acquisitions, financing structures and the exit process; and
  • Introducing new executives and advising on remuneration structures and on hiring and firing decisions.

Like other investors, PE firms will look for operational cost efficiencies. There are natural limits to this strategy, though, and popular perceptions of asset stripping are off the mark. PE firms invest in growth, and the old adage that 'you cannot grow by cutting’ holds true. A report by Deloitte Access Economics commissioned by AVCAL found that during a typical five-year period, revenue of an average portfolio company grew at a compound annual rate of 11%, while the workforce expanded at a compound annual rate of 28%.1

Like other investors, PE firms employ debt finance in a portfolio company’s funding structure. Having said this, no PE firm in Australia achieves its returns by putting its hope into financial engineering, or using leverage (i.e., debt) to magnify equity returns. A report by Ernst & Young found that European PE backed portfolio companies outperformed comparable public companies (of the same size and in the same industry over the timeframe from 2005 to 2011), and that the effect of strategic and operational improvements was far higher than the effect of leverage.2

Private Equity Investment Criteria When Buying a Business

PE firms target portfolio companies with most or all of the following characteristics:

  • Established businesses with a history of profitability and cash flow generation;
  • Strong management team;
  • Significant market share;
  • A convincing strategy based on prospects for growth; and
  • A path to exit.

Two exceptions to these criteria are worth noting:

  • Certain firms focus on distressed or turn-around opportunities, where historic profit growth may have collapsed. For these firms, a more important criterion is a clear strategy to return to profitability;
  • A number of firms look to match industry executives in their contact book with good businesses that require a new leadership team, known as management buy-ins or MBIs. This can occur if a founder/CEO is retiring with no successor, or if a corporate group is selling a non-core asset but is holding on to the executives who have managed the asset.

PE firms invest in most industries, although they do not acquire direct real estate, farming or mining assets as their investors have exposure to these through other fund managers.

During the course of an investment in a target company, a PE firm will generally not want the target company to pay dividends to shareholders. Surplus cash will usually be applied to repay debt or invest in the business to increase its eventual sale value. Management and any owner retaining a stake in the company need to be aware of this, and not expect dividends to fund their own investment in the company.

Distinguishing Private Equity from Other Investors

PE firms can be distinguished from other exit channels, such as trade or strategic buyers and ownership through a public listing, by:

  • Buying well, owning well and selling well. In contrast, a trade/strategic buyer may be more interested in the strategic value of a business or certain of its assets, with less focus on profitability and no view to a future sale;
  • Aligning management teams through equity ownership in the portfolio company. By comparison, a management team or at least certain of its members might not be employed by a trade buyer that has its own management team in place;
  • Understanding PE firms do not manage portfolio companies. They partner with management to set the strategy and monitor its execution. Some take a more hands-on approach than others, but, overall, PE firms rely on management to run the day-to-day business and confer significant autonomy to do so;
  • Realizing PE firms are more flexible in terms of equity ownership and future funding requirements. Corporate or trade buyers usually demand 100% ownership from the outset;
  • Knowing that unlike listed companies with a diverse shareholding base, portfolio companies have a small band of shareholders who are committed to the company’s vision and business plan;
  • Uncerstanding the average investment holding period of PE backed portfolio companies is 5 to 7 years, whereas the average holding period of publically traded shares is much shorter.3

Distinguishing Private Equity from Private Equity — Choosing a PE Firm

PE firms exhibit shared traits; however, no two firms are the same. Different firms target different sized businesses. Some possess the expertise or appetite to invest in certain industries. Some boast offshore networks for international expansion. Certain firms look to put growth capital directly into the target business, meaning existing owners remain fully invested. Some will take a minority stake or invest with no debt. These differences mean owners and managers have more choice in identifying a firm that is the right fit for their situation.

Just as a PE firm will undertake due diligence on a target company, managers should undertake due diligence on the PE firm and its personnel. Firms welcome this kind of enquiry, as it demonstrates a degree of prudence beyond simply looking at the dollars involved. This is equally relevant to owners who are remaining partially invested.

Personal relationships are an important foundation in the success of PE investments. Having worked for PE- and VC-backed companies in commercial roles, we appreciate this from personal experience. Managers and owners should enquire as to how the PE firm makes decisions, and get to know the decision makers. They should determine whether the individuals at the PE firm that they are introduced to will be the individuals that they work with over the investment period. What skills does the business need from a PE firm to complement the skills of the management team? Managers and owners should also request to speak with managers and owners of other businesses in which the PE firm has invested, to verify the firm’s style of ownership and approach to people management in both good times and bad.

1 Deloitte Access Economics report The Economic Contribution of Private Equity in Australia, March 2013

2 Ernst & Young report Branching out – How do private equity investors create value? A study of European exits, 2012

3 AVCAL Fact sheet Private equity and venture capital explained, December 2011

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Written by Divestopedia Team

Divestopedia Team
Divestopedia is a resource for entrepreneurs who want to sell their business for the best price and terms. Whether you are thinking of selling, have started a sales process, or are post-deal, we aim to arm you with the knowledge required to maximize value and limit your downside risk.

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