Too often private equity firms are criticized as moneygrubbing corporate raiders that buy businesses, leverage them to the hilt, fire employees, break up different operating units and sell off crown jewel assets – all for a profit. The deals that are covered by the public press are frequently skewed toward the billion dollar plus public company “take private” transactions involving the megabuyout funds. Rarely are private equity firms that specialize in buying and growing companies in the middle market covered. This article will address the circumstances under which a private equity fund can be the best buyer for a middle market business (typically, a business with an enterprise value ranging from tens of millions to $1.0 billion) and the key terms and considerations that a seller should expect from a private equity fund buyer in that market.
Seller Circumstances Ripe for Private Equity
Private equity can be the best buyer of a middle market business if the owners are seeking to sell a controlling stake in the business while maintaining some ongoing ownership to reap the benefits of future growth and success. Circumstances where private equity can often be the best buyer include:
- There are multiple owners of the business with different investment horizons. At least one of the owners may be looking toward retirement with the desire to exit his or her ownership completely. Another owner may seek to diversify his or her holdings so that not all of the owner’s net worth is tied up in the enterprise. Still others may seek to stay wholly or partially invested and remain involved in the ongoing management of the business. (Any owner who remains invested in the business is referred to as a “rollover investor”).
- The company is at a turning point and needs additional capital and business expertise to gain a competitive advantage and expand to the next level. Alternatively, the business is in a disruptive industry or may be facing operational difficulties and needs an experienced partner to work with it to overcome near-term challenges while developing new long-term opportunities.
Benefits to the Business from Private Equity
A business with owners who are experiencing any of the scenarios listed above should strongly consider a private equity buyer over a strategic buyer. The private equity buyer will strive to partner with strong management teams, while providing those teams with additional industry and operational experience and potential opportunities for add-on investments. The key for the current business owners is not necessarily to select the private equity buyer that will provide the highest price for the business today, but instead to partner with the fund that will provide the owners with the opportunity for the highest overall proceeds – i.e., today for the initial sale to the private equity fund and in the future when the fund sells its and the rollover investors’ remaining stake in the business at an exit down the road. In addition, the ongoing management team must share the same vision for the future growth of the business with the chosen private equity fund buyer so that the proverbial “second bite at the apple” can be even bigger than the first.
Partner With Strong Management Teams
A private equity fund will almost always require that a strong management team stay in place (or be put in place) before it is willing to invest in a business. While private equity funds may have substantial operating experience, they are not operators – they are investors. Since the private equity fund will not direct management regarding how to run the day-to-day operations, the management team’s job will remain largely unchanged. If the rollover investors do not have a strong desire to stay actively involved in the daily management of the business, they should make their wishes clear from the outset, or the new partnership will often falter out of the box. (Private equity funds sometimes buy businesses with management teams who seek to retire, but will only do so if the fund has lined up a new management team in advance to quickly take over the operations and management.) Key due diligence items for the management team include making certain that the target company’s “management culture” lines up with the private equity fund’s style and expectations and that the private equity fund and the management team have an agreed-upon strategy for the business. As part of this effort, the management team should seek to speak with past and present management teams of the private equity fund’s portfolio companies.
Provide Industry Expertise
Private equity funds (or teams within a private equity fund) often focus their investments in a few select industries or sectors. As such, a private equity fund usually knows the players, customers, suppliers, competitors, products, technology, systems, processes and other movers that drive the industries in which the fund specializes. With this extensive industry expertise, the private equity fund partners with management to scale the business within that industry or sector. A key due diligence item for the management team is critically evaluating the private equity fund’s industry expertise and determining if that experience is not only relevant to the target company’s business but also value-adding and capable of driving future growth.
Focus on Operational Improvements and Drive Strategic Initiatives
The professionals at many of the private equity funds have been operators or have experience working closely with operators in the industries and sectors in which they invest. With this operating experience, private equity funds can help management successfully execute on key initiatives within their companies. Examples of these efforts include geographic expansion, entry into new end markets, new product development, accessing or expanding distribution and/or manufacturing capabilities domestically or abroad, managing and refining the supply chain, improving technology systems and logistics, and building exceptional research, development, engineering and/or sales resources. A key due diligence item for the management team is assessing the private equity fund’s operational expertise in the relevant areas and determining if the fund’s experience and network of strategic resources and relationships are sufficiently strong to support the long-term strategy of the target company.
Augment Growth with Add-On Acquisitions
Many private equity funds will seek to augment growth through selective, highly strategic, accretive add-on acquisitions both domestically and overseas. Typically, the private equity fund will wait some period following its initial buyout of the business before it pursues addon acquisition opportunities. Nonetheless, private equity’s ultimate goal is to expand and grow the business profitably, and one avenue to do that is through add-on acquisitions – often in the same or adjacent industries or sectors, in complimentary areas, or in areas where some element of the business is needed to further the company’s long-term goals. In cases where growth through acquisition is a strategic goal, the fund will bring its extensive deal resources and experience to manage the acquisition transactions and post-closing integration processes. For those companies where add-on acquisitions are anticipated, a key due diligence item for the management team is determining the fund’s experience and success in these types of add-on acquisitions and later integration into the overall business.
Key Deal Terms to Expect from Private Equity
A private equity fund buyer will likely seek the terms for its ownership listed below. Any rollover investor needs to understand and come to terms with its loss of control and decision-making in these areas – all of which, directly or indirectly, relate to the private equity fund’s ability to realize on its investment and maximize its return for its limited partners.
Private Equity Will Take a Control Position
The private equity fund will typically control all aspects of its ownership – through the voting power contained in the terms of its equity and through its representatives’ membership on the board of directors or board of managers. If the private equity fund is not purchasing a controlling stake in the business that provides it with complete voting control, the fund will nonetheless have a series of negative control items (essentially veto rights) over material actions with respect to the business (e.g., hiring or termination of senior management, acquisitions or sales of material assets, incurrence of indebtedness, entry into a new line of business, and issuance of new equity).
No Future Payments to the Rollover Investors Unless and Until Private Equity Has Received Payment
Following the private equity fund’s acquisition of the target company, the private equity fund will almost always prohibit any distributions, dividends or other monies to be paid to the rollover investors prior to any payments being made to the private equity fund. This may mean that the private equity fund has a “preferred return” (allowing for its investment to be repaid first, along with an agreed-upon rate of return, before any funds are paid to the rollover investors) or it may mean that the private equity fund and the rollover investors are paid at the same time on the same economic terms.
When Private Equity Sells, the Rollover Investors Will Be Required to Sell and May Not Sell Before Then
Unless the private equity fund purchases a minority stake in the business, the private equity fund will demand complete control over the decision to sell the business – including what to sell, how much to sell, when to sell, to whom to sell, at what price to sell and on what terms to sell. The rollover investors will have both the right (and the obligation) to sell their position in the business at the same time and generally on the same terms as the private equity fund. Further, even if a rollover investor desires to transfer some or all of its ownership interest in the business before the private equity fund does so, it will need the consent of the private equity fund (other than for a short list of permitted transfers primarily for estate planning purposes). This means that the rollover investors will not be able to select the next owner, the timing of the sale or the terms of sale. Note, however, that if the private equity fund and the management are not aligned on the future decision to sell, it will be difficult for the private equity fund to maximize value on that sale without a cooperative management team supporting the sales process.
Management Team Will Be Incentivized with Equity
Any senior management team member without a meaningful ownership position in the company will almost always be granted equity incentives in the business, sometimes in exchange for a cash investment in the business and sometimes as incentive equity (e.g., an option). If the management team member paid the same price for its equity incentive as the rollover investors (on a per share or pro rata basis), the management team member’s investment is often on the same economic terms as the rollover investors. If the management team member did not pay the same price (or did not pay a price at all because it was granted an option, restricted stock or a profits interest that currently has no value), the management team member’s equity will often be on different economic terms. And, it is not uncommon that those differing economic terms will provide for an interest in the business that gets paid to management only after the private equity fund has met or surpassed a designated rate of return on its investment.
Sellers and Rollover Investors Will Provide Meaningful Non-Competes
All sellers will typically be obligated to agree to a noncompete covenant for a meaningful period of time – typically three to five years from the date of the sale and sometimes longer. It is also customary for the sellers to provide non-solicit and, in jurisdictions where enforceable, no hire-of-employee covenants – often for the same period of time as the non-compete. These restrictive covenants are critical terms for the sale of the business and will typically apply to all sellers (whether or not a seller is rolling over its investment). The private equity fund will also typically include an additional non-compete covenant that would apply to all rollover investors throughout the period of their rollover investment and for some period of time thereafter – typically for an additional three to five years following investment – for no additional consideration beyond what the private equity fund paid for its initial investment in the business. Since a private equity fund is in the business of selling the companies it buys, the private equity fund will include these non-compete provisions for its rollover investors so that a non-compete will be in effect at the time of any potential future sale (essentially delivering a pre-negotiated non-compete to the next buyer).
The Company May Be Operating With Leverage for the First Time
Many (but not all) private equity funds will cause the target company to borrow funds to pay a portion of the purchase price for the underlying business. Those borrowings often will have a “term” feature with principal payments typically made at regular intervals starting at some future period (for example, annually beginning after the second year) and a “revolver” feature (for the ongoing working capital needs of the business). This may mean that, for the first time, the business is operating with leverage and that cash flow from the business will need to be deployed to pay down (and eventually pay off) the debt. Any interest or debt payment obligations and/or cash flow implications should be considered in light of any management incentives that may be included in any bonus or equity programs in place for the management team. The debt will typically have quarterly financial covenants that need to be met and negative operational covenants restricting management from taking certain actions. Management should understand how those financial and operational covenants work, particularly in light of any projections or strategic growth plans that are being developed with the private equity fund for the ongoing business.
Maximization of Long-Term Proceeds to the Owners
Selling a business to a private equity fund provides the current owners with cash today while allowing some or all of those same owners to retain a meaningful ownership stake, positioning them to enjoy an even bigger second bite. Sellers and management teams should understand that private equity funds are first and foremost financial investors that make their decisions based on their projected returns on invested dollars, and a partnership with a private equity fund will be driven by those principles. With private equity as a partner, a business and its management can meet operational challenges, navigate future growth, scale the business, and obtain a broad perspective on how to position a company for a strategic sale in the future at an even higher valuation. Ultimately, the benefit to the owners who stay partially invested and to any new member of management who chooses to invest is an opportunity to maximize profits for all of the business owners – old and new.
This article originally appeared in Transaction Advisors.