Private Equity refers to business investment funds focused on making equity investments in non-public companies. For the majority of middle market companies, private equity refers to buyout groups that seek to acquire ongoing, profitable businesses with realistic growth potential.
During the past several years there has been a significant increase in the number of private company buyout groups. The private equity market had traditionally been restricted to acquiring larger companies (over $25 million in revenue); however, several factors have attracted them to smaller firms. These include competition for larger opportunities; greater growth potential of smaller companies and less mature industries; and a clearer path to "exiting" the investment in the future, through a sale to a larger group or strategic buyer.
Private Equity Groups/Funds (PEGS) are organized as limited partnerships that are controlled and managed by the private equity firm that acts as the general partner. The purpose of the fund is to invest in privately held companies with the objective of generating above market financial returns for the investors. The fund obtains commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and, at such time as the general partner identifies an appropriate investment opportunity, it is entitled to draw out the required amount or to "call" the required equity capital. All investment decisions are made by the General Partner, which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund, which often extends up to ten years, the fund will make multiple investments in diverse businesses.
PEG acquisitions are segmented as platform or add-on acquisitions. "Platform" companies must be able to stand alone and provide a strong entry into an industry. "Add-on" acquisitions have a strategic or synergistic fit with existing platform companies. Add-on acquisitions can be significantly smaller than stand alone platform investments, assuming there is a strong "value add" synergy to the existing platform company. This could be new products, expanded geographic coverage, human resource talent, distribution channels, etc.
For PEG’s, the most reliable source of potential acquisition opportunities are merger & acquisition intermediaries that routinely represent small and mid-market privately held firms. Sun M&A maintains current files of more than 500 active PEG’s with their investment preferences and criteria. We also subscribe to databases that enable Sun to target PEG’s based upon existing investment portfolios.
The strategy and focus of these groups varies widely, with different groups having varied investment philosophies and transaction structure preferences. Some prefer complete ownership, while others are happy with a majority or minority interest in acquired companies. Some limit themselves geographically, while others will buy anywhere in the US. There are those that require platform companies to generate a minimum of $20 million annual sales, while others will consider candidates in the $10 million sales range. Some will consider distressed companies, but most require steady historic cash flows.
PEG’s tend to have certain things in common. They typically target companies with relatively stable product life cycles; avoid leading-edge technology (this is what venture capitalists want); and have a preference toward stable and established product lines or services. Most prefer a qualified management team that will continue to run day-to-day operations while the group’s principals closely support them on the Board of Director level. The fund’s "value add" is to provide insights and expertise; structure further add-on acquisitions; and provide access to capital, to increase market share and operating efficiencies. PEG’s commonly pay substantially all cash for the acquired company since they are well-qualified to get their own primary and secondary financing.
Buyout group investments take many forms and vary depending upon the fund and the Seller’s preference:
Outright Sale. This is common when an owner wishes to sell his ownership interest and transition into retirement. Either existing management will be elevated to run the company or an acquirer will bring in additional senior management. A critical factor is whether the company can continue to thrive without the current owner. If not, a mid-term transition period may be required to train replacement management and transition key relationships.
Recapitalization. This is an ideal alternative for an owner who wishes to sell a portion of the company for liquidity or estate planning purposes, while retaining equity ownership to participate in the company's future upside potential. This structure allows the owner to achieve personal liquidity; eliminate personal guarantees; retain significant operational input and responsibility; and gain a financial partner to help capitalize on strategic expansion opportunities.
This recapitalization structure works well when an owner wants to diversify financially and take a significant amount of money "off the table" that is currently locked into the business. A major benefit of a recapitalization structure is that the Seller can retain an equity ownership position and continue running the business, while having the opportunity to take a "second bite at the apple" in the future by selling their smaller remaining stake in a much larger company. It is not unusual for the retained minority interest to yield a greater value than the original sale, due to the expansion of the company.
Growth Capital. Growing a business often strains cash flow and requires significant access to additional working capital. A growth capital investment provides access to non-recourse capital and permits management to focus on running the business without constantly having to be concerned with cash flow matters. Capital is also available for future synergistic acquisition opportunities.
Family Succession. Often this type of transaction involves backing certain members of family management in acquiring ownership from the senior generation or from outside shareholders. By working with a PEG in a family succession transaction, active family members secure operating control and significant equity ownership, while gaining a financial partner for growth. In addition, selling shareholders achieve liquidity to meet personal estate planning and net worth diversification objectives. This type of transaction also ensures that the family business stays in the family and maintains its identity within the community.
Management/Key Employee Buyout. PEG’s can partner with key employees in the acquisition of the company in which they currently play a key role, but do not own. Sellers can receive an all cash price since PEG’s tend to not rely on seller financing. Key employees receive a generous equity stake in the conservatively capitalized company while retaining daily operating control. Management has the PEG as a well funded, knowledgeable partner to consult with and help them grow the business. As an experienced partner with a strong track record, the PEG adds financial and management credibility to the employees, which can also help with perception in the marketplace.
Buyout groups have become a major force in the acquisition arena. Buyout groups can also be thought of as strategic type acquirers in certain instances, when they own portfolio companies in your industry or a related area that addresses the same customer base. These buyers may be in a position to pay more than an industry or strategic buyer that does not have this financial backing.
Stephen Goldberg is the Managing Partner of Sun Mergers & Acquisitions located in Hasbrouck Heights, NJ. Sun Mergers & Acquisitions specializes in the sale, merger and valuation of privately held small and mid-market companies throughout a variety of industries. Sun M&A represents business owners of entrepreneurial companies that are considering an exit strategy through the sale or merger of their company. Stephen has been specializing in this arena since 1985 and has participated in more than 200 closed transactions.
Stephen may be contacted at sg@sunmerger.com
