Private Equity…..not just for the big companies!

Private Equity…..not just for the big companies!

Private Equity Sunbelt Texas

 

Authored by C. Daniel Elliott
Managing Director
Sunbelt Corporate Advisors
A Southwest M&A, LLC Company

Is your company ready for Private Equity or, more importantly, are YOU ready?

It’s hard to read the business news these days without a high profile story about a Private Equity Group (PEG) buyout of a very large public company. Recent examples include the Chrysler and Hilton Hotels billion dollar deals. While these transactions get all the press because of the BILLIONS of DOLLARS involved, all the real action is in much smaller transactions. Every day PEGs buy businesses with revenue less than 1/100th the size of the big deals mentioned above. PEGs are purchasing many, many profitable businesses with annual sales revenue between $5 million and $50 million.

First, what are Private Equity Groups (PEGs)?

Let’s spend a minute defining what a typical PEG looks like and how they operate. There are many different kinds of groups describing themselves as Private Equity, many really are PEGs….. some are not. The classic PEG operates like this. The PEG is formed typically by a few individuals. These individuals go out and raise money from people, companies and institutions who want to invest some of their money in non-traditional (traditional is public stocks, bonds, real estate, mutual funds) investments which will have a higher rate of return, and higher risk, than they would expect from stocks and bonds. Normally these funds are raised with a specified period for the investment to be returned, 10 years is common but this term varies. These investors are not business operators. The PEG serves as the vehicle to get the money invested, the companies managed and the future transactions executed.

There are more than 1,000 groups in the U.S who define themselves as PEGS. The real PEGS in this group typically will raise a fund of $100,000,000 – $250,000,000 to be used to invest in businesses. A huge portion of this money is invested in purchasing private businesses with revenue from $ 5 million to $30 million annually.

NOTE: Anyone can call themselves a PEG. If you are thinking about investigating the Private Equity opportunities available to you as a business owner, seek advice from a competent intermediary with extensive experience dealing with PEGS. This is no time for a do-it-yourself experiment or on-the-job-training for an inexperienced deal maker. Mistakes in this world are normally very, very expensive.

How do PEGs make their money?

The PEGs are well compensated for this very complex and difficult business. A PEG will typically receive 2% annually on the money from their investors and, if the investment succeeds, the PEG will get about 20% of the profits on a transaction (remember the 10 year investment time mentioned above, it will be important later.)

Why are the PEGs’ investors willing to pay these generous fees? Because the PEGs have been able to deliver consistently high returns that, even after the fees, makes the investment returns very attractive. Most PEGs target a ROI of between 20% – 30% annually for their investors.

What kinds of businesses do PEGs look for?

A common misunderstanding is what type businesses PEGS are looking to buy. Far too many business owners who are unfamiliar with PEGs think that PEGS or “financial type” buyers just want to buy a business, strip it down, fire all the employees, drain the cash and go to the beach…… this is NOT the motive of high quality PEGs. They want to grow and they are partnering with management they feel can grow profitably and quickly.

The majority of high quality PEGS are looking for businesses with the following characteristics:

  • Strong management who is interested in continuing with the business, has a vision for the business the PEG can embrace and the seller retains/receives substantial equity in the new entity. This gives management and PEGS a common interest in the future.
  • Businesses with growth opportunities that are achievable in a reasonable time frame
  • Businesses who have reasonably predictable and growing earnings
  • Businesses not facing a huge unknowns (exotic technology, government regulatory, etc.) that makes the future cloudy.
  • Businesses where the PEG feels they can add value by bringing capital and brain power to an organization.

How does a PEG buy a business?

In today’s market the easiest part of a PEGS job is raising money to invest. The most difficult task is finding good companies with good management who understand the objectives of the PEG and have a common vision for the businesses future. We will talk more about this later in this paper.

Assuming the PEG finds a business with the above characteristic the PEG will evaluate the business from a number of angles but a very important aspect is, after the purchase, the businesses ability to support financing and pay debt.

A PEG will typically put up between 15%- 40% of the business purchase price in equity from the PEGs fund then borrow the difference from various financial institutions. The availability of this financing will drive most deals. Without available financing the deals don’t get done. The reason for putting debt on a business is simple, it increases the rate of return for the equity investors. If the PEG has a goal of 25% ROI on THEIR cash then it makes sense to borrow from someone else at a rate of 8%…..as long as the business can make the debt payments.

The PEGS normally want the seller to “rollover” a portion of the business purchase price into their share of equity in the new entity. This is how the seller will receive his/her equity in the new business.

How and when does a PEG exit the business?

      1. Business pays down the acquisition debt from the cash flow of the business.

 

      2. Grow the business value through increasing revenue and profits often by acquiring similar companies, expanding geographically or adding capabilities to the business.

 

      3. Build the infrastructure of the business (technology, financial reporting, management team, etc.) so as to make the business as attractive as possible to the best buyer when it comes time to sell in the future.

 

    4. Sell the business in 5 -10 years for a substantially increased value.

Assuming the above happens the future value of the business is determined by the market, the same issue as today. If the market is good… the deals are good. If the market turns bad the deals may not be so good.

NOTE – If you are thinking about investigating the sale of your business, timing can be critical for you to maximize the value. In today’s market, debt capital is readily available which means deals can get done at higher prices than would happen in a tighter debt market. What will the market be a year from now or two years from now? If you have the answer please email it to me.

Let’s walk through the options for nearly all business owners and see why a PEG deal might be the best exit plan for a business owner……

The following is not based on any specific deal or person.

Joe Smith (57) started XYZ widgets in 1985. After a few rocky years Joe got on track and has grown a great business. Joe and his wife Mary had early years, like many business owners early years, which included crisis, cash flow problems and debts that kept Joe and Mary awake many nights. Joe never wants to go back there again. Joe and Mary have two children. Both of the children have their own careers and have no interest in taking over the business.

In 2006 XYZ Widgets had revenue of $20,000,000 and EBITDA of $2,500,000. Joe feels like the business has good prospects for the future and no particularly scary issues on the horizon. The business has no debt and Joe makes a very nice annual income. Joe still works 50-60 hour weeks, likes his work, wants to continue working, but isn’t really interested in working any harder or taking any risks. Joe sees opportunities to grow everywhere but any fast growth would mean taking on debt, adding risk and, at this stage in life, Joe has no interest in increasing his risks by taking on debt and working a lot harder. Joe has a pretty good management team but Joe is still involved in the important decisions day to day. Basically Joe is on cruise control, not a bad life.

Some would ask, “Why in the world would Joe consider selling his business to a PEG and going to work for someone else?” Read on my friend, read on……………………

Joe’s financial planner Roger has been talking to Joe about his financial plans and is encouraging Joe to think about his future plans for the business. During their last meeting Roger was able to convince Joe that he won’t live forever and he ought to have a plan for what happens when he is no longer interested in, or capable of, operating the business. Joe agreed he would think about it. Roger recommended that he and Joe meet with Dan Elliott (that IS my real name!) who is an experienced intermediary working with business owners. Dan can review Joe’s options for the future of the business. Joe agreed and Roger set up a lunch meeting with the three of them.

A week later at lunch…….

Roger: “Joe, this is Dan Elliott the intermediary I told you about.”
Joe: “Nice to meet you Dan, I’m not ready to sell my business so don’t waste your time trying to convince me.”
Dan: “Nice to meet you Joe, that’s good because I’m not here to convince you to sell your business. If you like, we can just talk about what options your wife will have if you get hit by a truck.”

There was a little gasp from Roger but Joe got my point.

I asked Joe what he would like to see happen to the business if he was no longer interested in it or able to operate it. After a moment of thought Joe said: “I don’t know.” I hear that a lot.

I then gave Joe a brief overview of some of the options available and some pluses and minuses:

  • Do Nothing – Just keep on doing what he has been doing and hoping something works out later. After all, as he told Roger, he really might live forever. Worst that can happen is the business dies with him, right?
  • ESOP – Sell to the employees. This sounds good on the surface and there are some tax advantages. However, this strategy rarely reduces the risks for the business owner, at least in the short run, because of guarantees on the bank loan the employees would need in order to get cash to pay Joe for a portion of his equity. In addition, do you REALLY want to work for your employees?
  • Sell to a big company strategic buyer – A strategic buyer will often pay the most for a business….. and there is a reason for it. Most strategic buyers will dramatically restructure the business after a sale. Often reducing the seller’s employees, bringing in company people, consolidating facilities, etc. Plus, the odds that Joe, who called all the shots before, could continue with the business as an employee is highly unlikely. So unless Joe is ready for the beach he needs to really, really, think about life after a sale. A truism in the intermediary business is this, “Business owners generally make lousy employees”.
  • Sell a substantial portion of the business to a Private Equity buyer – Although PEGs are unlikely to pay as high a price as a Strategic Buyer this option has some very attractive elements for Joe. First, he could continue to work and remain a significant shareholder (often 20% – 40%) if Joe desires. Second, PEGS are not operators. Joe could still be CEO and run the business as long as things are going well. Third, Joe is 57 and the idea of having 5 -10 years to slowly ease out of the business is really appealing to Joe. Fourth, PEGS want to grow and Joe could capitalize on the growth opportunities with the PEGS money instead of Joe’s money. Fifth, Joe really could use help with infrastructure development. He knows his numbers but he’s not an accountant, computer guru, benefits manager or lawyer, etc. Sixth, Joe could work with the PEGS on more strategic activities like acquiring other companies. Joe would sure get a kick out of BUYING some of the people he’s competed with for the last 20 years. Seventh, if the plan works out Joe and the PEG can sell the whole company 5 -10 years from now when it will be worth a lot more, and Joe’s 30% share might even be more than his take when if sold 70% to the PEG now.

After the summery Joe’s head was spinning. He had never gone through the options before and the stark reality of his situation was staring him right in the face.

Several weeks and a few more meetings later Joe decided to get out in the market and see what the market held.

Sure enough his business was attractive to PEGS. Discussions with strategic buyers didn’t work out (for all reasons cited above) but Joe received several Letters of Intent from PEGS.

A little over 1 year after this all began Joe was able to sell 70% of his business. He received over $10,000,000 cash at closing and he owns 30% of the “new” business. Joe has been able to invest the proceeds of his $10,000,000 and he and Mary are secure for life. In addition, Joe and Mary have identified several charities they plan to provide with meaningful support.

Joe continues as CEO and is having more fun than he’s had in years. But things have certainly changed. He has more reporting to do than in the past and it’s taken a little time for Joe to get used to people asking him about the direction and growth of the business. In the past he held his board meetings while looking in the mirror while shaving.

Joe and the PEG are growing the business with the intent to sell it by Joe’s 65th birthday. If the situation arose, that time to sell could be much sooner or even later but Joe feels very good about his decision. The future of the business is set, he has fun working, has more money than he’ll ever spend and his employees see opportunities for growth. Everybody wins.

Joe and the PEG spent a lot of time together before Joe sold the business to them. It is very important to do this. The good PEGs are very sensitive to making certain that the Sellers are people they can trust and respect. A seller should look for the same attributes in a PEG. As they say, “choose you business partners twice as carefully as a spouse, a spouse can only take half of what you have.”

Summary

Today’s market for high quality private businesses is very strong. Business owners owe it to themselves, their family and their employees to have a viable plan for the business if and when the business owner decides he’s done or circumstances beyond his/her control (health, tragedy, etc) decide the business owner is done. Private Equity might be the answer, but regardless, business owners NEED to have an Exit Plan because as sure as the sun will rise tomorrow the business owner WILL exit one day and what they leave behind will be either chaos and disruption or a well planned transition. Only the business owner can control this result.

About the Author

Dan Elliott is Managing Director of Sunbelt Corporate Advisors and Southwest M&A, LLC. Dan focuses his practice on private companies valued from $1,000,000 – $50,000,000. His 15 years experience in M&A has exposed him to trends in the markets most important to private business owners. Dan can be reached via email at DElliott@sunbeltmergers.com.