What Is a Private Equity Firm?
There are many types of potential buyers for your business. Learn what private equity firms are and how they invest in private companies.
If you are looking to sell your company, you may want to consider a private equity (PE) firm as a potential buyer. Most company owners are not familiar with PE firms and how they can help business owners realize their exit goals. This piece provides a general overview of PE firms, their investment philosophy and how PE firms are compensated to determine if they are a good fit for you.
PE Firms Defined
A PE firm is a financial buyer that invests in private companies of all sizes. Some firms invest across many industries, while others are focused on specific industries such as technology or energy services. They are a good alternative if you want to sell your company without inflicting severe and immediate change.
They typically raise funds via general partnerships from institutional-type capital sources such as pension funds, endowment funds, family offices and high net-worth individuals. The typical structure involves a limited partnership where the PE firm acts as the general partner and the investors are the limited partners. The partnership has a finite term, usually 10 years, at which time the PE firm will sell all of the investments in order to return the original capital plus gains to the limited partners.
In addition to capital, PE firms provide other resources to their investees such as access to customers, industry expertise and strategic direction, which can be invaluable for company owners looking for support in a capital partner.
What Private Equity Firms Look for in an Investment
PE firms look for companies with solid management teams, dependable and recurring customers, high margins, strong balance sheets and the ability to generate significant free cash flow. The best candidates are private companies that are experiencing rapid growth (organically or through acquisition), a management buyout or expansion into a new market.
They usually have a leading position in their industry, significant barriers to entry for competitors, and a differentiated product or service that commands a pricing premium over the competition. PE firms look for companies with solid management teams, since they are made up of passive investors that expect management to run daily operations.
PE firms may bolster the existing management team by replacing or adding specific positions such as a CFO to manage the company's financial affairs, improve operating procedures and internal controls, and serve as the financial representative when the firm is looking to sell the investment.
The Investment Structure in a PE Firm
PE firms may acquire 100 percent of a company or invest as a minority shareholder. The investment usually involves owning at least some common voting stock. This ensures that the PE firm has company ownership, and usually requires board representation. However, PE firms also use different equity instruments to invest, including non-voting preferred shares or subordinated debt with an equity kicker.
PE firms like debt because it allows them to earn an annual return on their investment from the related interest payments. The equity kicker, which is usually in the form of a convertible feature or warrants, then provides them the "pop" when the company is sold.
The Private Equity Compensation Model
How PE firms are compensated is important to understand before you sell your business to one. Some PE firms generate income by charging their portfolio companies management fees or financing fees. However, the primary way that PE firms earn money is by charging a 2 and 20 management fee to the funds that they manage. The "2" is the annual management fee charged to the fund to cover the PE firm's annual salaries, overheads and profit. The "20" is the percentage success fee, or "carry," earned if returns exceed a certain threshold.
For example, if the general partner (GP) manages a $200 million fund for a 10-year duration and the return threshold is 10 percent, or $20 million, then the GP would get paid $4 million annually, assuming the full $200 million is invested (2% x $200 million). If all of the investments are sold for $300 million, then there would be a $100 million gain realized. The gain would be $80 million above the return threshold. In this case, the carry would kick in, and the PE firm would get 20 percent of the $80 million, or $16 million.
It is therefore very lucrative for PE firms to maximize the exit value of portfolio companies, since the 20 percent carry can result in a significant bonus. This carry structure ensures that PE firms are aligned with getting the most value out of their investments at exit (which is good for a company owner who has kept some equity in the business). However, the exit timing and approach is ultimately decided by the PE firm, which means you may not be in control. This timing or approach may or may not line up with your own timing and approach based on your changing lifestyle requirements. This may create some conflict for you.
Is a PE Firm the Right Investor for Your Business?
PE firms are more like a marriage rather than a quick exit. As a result, they aren't right for every business. However, this marriage can yield significant benefits in the right situation. If you are an owner who is not yet ready to let go but wants to take some chips off the table, then PE firms provide an excellent exit alternative.