KEY ARTICLE TAKEAWAYS
Learn how private equity firms structure their deals and how this can help and harm you as an owner
Understand how the use of debt can enhance the value of your “second bite at the apple”, while understanding the risks of debt
Learn what life is like post-closing with your new private equity partner – from additional reporting, to fees, to what help you can expect from them
What is private equity?
When it comes time to sell your company, you might sell to a strategic buyer or a private equity firm.
- A strategic buyer is normally another business (usually larger) either in the same industry or perhaps a different industry looking to enter your company’s market.
- A private equity firm invests capital for other institutions and individuals and is active in the private markets. A private equity firm raises money from insurance companies, endowments, high-net-worth individuals, and other institutions, and then invests that money in other companies. The private equity firm usually charges a management fee of 1-2% to its investors, and will typically take 15-25% of the returns generated by its investments (this is called the firm’s “carry” or “carried interest”).
In this article we will cover what to expect when selling to a private equity firm.
Want to get a sense for what it takes to sell your company? Start with this exit checklist.
How private equity works – deal structures
Who owns the other 20-30%? In most cases, the existing owners (or a subset of them).
Why does the private equity firm not want to own 100%? Many private equity investors feel better if the existing owners re-invest some of their proceeds (sometimes called a “rollover investment”) into the business.
When the prior owners stick around and remain invested in the success of the business it helps ensure a smoother transition, thereby lowering risk. In addition, it signals to the new investors that the existing owners remain confident in the business’s prospects. Some private equity groups will not do a deal where the existing owners are not rolling forward a meaningful investment (although different firms have different definitions of “meaningful”).
How private equity works – debt financing
Most private equity firms will utilize some component of debt financing to complete the acquisition (what is sometimes referred to as a “recapitalization”). In some cases, the amount of debt financing might constitute up to half of the purchase price. This has pros and cons.
Enhanced Equity Returns. When the private equity firm uses leverage (debt financing), it reduces the amount of equity investment required to complete the recapitalization. For a business that continues to perform well, this can have a very positive effect on the equity holders’ returns.
For example, assume ABC Private Equity firm is recapitalizing XYZ Company with an enterprise valuation of $100 million. In this case, ABC has requested that the owners of XYZ roll over (or reinvest) 15% of their proceeds. Given the gross proceeds of $100 million, the owners of XYZ would be reinvesting $15 million.
But ABC is going to use $40 million of debt financing to complete the capitalization, which leaves $60 million that the new equity investors will need to invest. Given the shareholders of XYZ are going to re-invest $15 million of this $60 million, that means that ABC only needs to invest $45 million.
Because the shareholders of XYZ are reinvesting $15 million of the total $60 million in equity, they will own 25% of the equity in the business (not 15%), and take home $85 million in cash ($100 million less their rollover investment of $15 million). ABC will own the remaining 75% of the equity.
Sometimes this is reflected in a Use of Proceeds table like this:
Debt financing – no risk, no reward – the “second bite at the apple”
Using debt financing allows the selling shareholders to own more equity for less cash investment than if the buyer were not debt financing. Similar to buying a house using mortgage financing, the equity holders’ investment returns can be enhanced with the use of debt financing.
In our example, assume that XYZ sells again four years later for $220 million. Further assume that the company has not paid off any of the debt financing in those four years (it was an interest-only loan), so at closing the lender will be paid $40 million, leaving $180 million for the equity investors, or a tripling of their initial $60 million investment (a 200% return). The rollover equity of the XYZ shareholders would be worth $45 million.
If ABC had not used any debt financing, the XYZ rollover equity investment would represent 15% of the total equity ($15 million out of a total of $100 million of equity). In this case, the XYZ selling shareholders would have 15% of $220 million, or $33 million (a 120% return). As you can see, when ABC uses leverage, the XYZ shareholders’ returns can be amplified.
Of course, if the business does poorly, and the business is not worth what ABC paid for the business initially, the use of leverage can make the equity returns much worse. No risk, no reward.
Debt financing – cash flow implications
Sellers should also know that when a private equity buyer uses leverage, the business will need to service that debt (interest and principal), which reduces the amount of cash available for distributions or to invest in future growth.
Make sure if you are selling to private equity that you understand how much debt they intend to use and the terms of that financing so you will not be surprised post-closing when a portion of your company’s cash flow is used to service debt rather than be distributed to you or used to invest in growth.
Your new “partner” – what to expect when selling to private equity
Hit your numbers, and all is good.
Business owners who have “run their own show” sometimes have challenges operating with a new private equity partner. In our experience, this happens most often when the company’s performance after closing does not meet the private equity firm’s expectations. In other words, if you hit your numbers, the relationship with your new partner will likely be positive.
Miss your numbers, and you will get “help”.
If you don’t hit your numbers, almost all private equity firms will feel a need to “help” you. This help could be constructive, or it could end up feeling like a distraction when you need it least. When your new private equity partner has actually operated a business of their own, it is more likely that their help will be constructive.
On the other hand, when the experience of a private equity investor has been strictly financial as an investor and they have never operated a business, they may be less well-equipped to help you and their efforts could frustrate you. This is not always the case, as there are plenty of private equity investors who have lots of experience working with companies and can be great sounding boards, but when evaluating potential buyers of your business, ask about their prior experience and insist on talking with prior owners who have worked with them.
How private equity works – those damn reports…
When you owned your business, you basically reported to yourself. When a private equity firm owns your business, the partner responsible for overseeing the firm’s investment in your business must report to his or her firm’s investment committee and must also generate financial reports for lenders on a monthly, quarterly and annual basis.
It is likely that they will expect you to generate significantly more (and potentially different) periodic reports than you have done in the past. This can feel like a distraction and unnecessary, but you must remember that you are now responsible for managing the investment for other investors. With this investment comes more responsibility and accountability. Having a talented Chief Financial Officer can help immeasurably.
How private equity works – those damn fees…
One of the big surprises for business owners are the fees charged by private equity firms to their portfolio companies. While some firms don’t charge any fees, others charge a management or board fee (which can range from a flat quarterly fee to a percentage of profits). On a larger business, these fees can run into the millions.
In addition, some firms charge additional fees if they help you with specific tasks like recruiting, acquisitions, financial analysis or other services. These fees might be hourly or in the case of an acquisition of another company, they might be a percentage of the total deal value. These fees can also run into the millions.
Some private equity firms will add a lot of value to you as an operator – they can provide sage advice based on years of experience, and when they have the appropriate personnel, they can be invaluable in your efforts to grow your company. They have obligations to pay their personnel just like you do, so this is one reason they charge these fees.
Our advice to you is to grin and bear it. It won’t feel great, and should you ever feel like you are not getting value for those fees, by all means have a discussion with your private equity firm. But in general, expect that you will be paying these fees out of the operating cash flow of the business. It is simply the price of doing a deal with a private equity firm.
Your new private equity partner – the good stuff
Selling to a private equity firm can be a great experience for you. With the right partner, you will get a great sounding board, someone who has had lots of experience growing companies, and someone who can help you weather the inevitable storms that come with running a business.
In addition, having the right partner can help take your business to new heights and make that “second bite at the apple” financially rewarding for you. We have seen some of our clients make more money on the second sale of the business with their private equity partner than they made in the original sale. We have also had prior clients tell us they learned more in a few years operating with a private equity partner than they learned in all their previous years running their own company.
Selling to private equity can be rewarding, but be sure to enter into your new partnership with your eyes wide open and make sure to ask the right questions so you are not surprised after your sale.
Looking to prepare your business for a sale?
Business owners and business investors often have different perspectives on what makes a company particularly valuable or risky. One of the best ways you can prepare your business for a sale to a private equity or strategic buyer, is to evaluate your company’s risks and attributes through a buyer’s lens. After taking our 30-minute survey, our CoPilot report will provide you with custom generated attributes and risks, in addition to different risk fix, mitigation, and market preparation strategies for each of your risks. If you are preparing to take your company to market in the next couple of years or looking to simply position your business for long- term growth, we highly encourage you to complete our free CoPilot assessment to better reduce your risk and build sustainable value.
As an Associate at Class VI, John is responsible for deal execution and board advisory services for clients in several industries including business services, food and beverage, distribution, consumer products, and energy. John also assists in Class VI’s marketing efforts through content development.