Is Private Equity Money Worth The Hassle?
By Bradley Smith , ATP, CMAA and Hilsman Knight
Volume 4 Issue 17, August 15, 2017
Money is money, right? While that’s undoubtedly true, investment money always comes with strings attached. Private equity groups, venture capital, and personal investors are all looking to achieve certain growth and revenue targets. For example, venture capital notoriously likes the capability to replace a company’s founder if revenue targets are not achieved. Founders looking for investment capital need to be aware of these kinds of stipulations inherent in each investment partner. If you are not careful, those unforeseen nuances can lead to long-term problems.
Similar to venture capital, Private Equity Groups (PEGs) have investment capital that comes with baggage inherent in their business model. For those not familiar with the PEG business model, some PEGs bundle up investment money from multiple wealthy individuals (also known as Limited Partners or LPs) and invest it in various businesses that identify with their investment mandate. With the PEG’s cash injection and strategic leadership they grow their newly acquired businesses at a significantly faster rate than what the businesses would have traditionally achieved. This is typically accomplished through add-on acquisitions. All while the original owner/entrepreneur is running the day to day operations at their side.
After obtaining their growth objectives (typically a 3 to 5 year process), PEGs then exit their business with the goal of selling for a large profit. It’s a sweet deal for the LPs, who typically expect PEGs to significantly outperform the stock market. Due to the stellar returns on investment, there are hundreds of billions of LP capital waiting to be deployed. If the PEGs cannot invest the LP’s capital within 5 years, it is returned to the LP at a marginal interest rate. This makes for a very unhappy LP.
The result is incredible pressure to deploy that capital. A small population of desirable companies and enormous amounts of investment capital creates a market bubble, where companies are selling for more than they’re probably worth.
In a normal market, a business is usually estimated to be worth three year’s EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization). With today’s PEG-driven demand, some firms are selling for as much as six times their EBITDA. Obviously, multiples can vary drastically depending on many variables, such as healthcare vertical, barriers to entry, and economic cycles.
This is great news for business owners looking for investment capital, but it does not come without its pitfalls in arriving at that perfect capital partner. The obstacle with PEGs is that they are bombarded with hundreds of Confidential Information Memorandas and may issue dozens of Indications of Interest and Letters of Intent in a single month.
As a result of the rabid outreach, PEGs can be sloppy when it comes to legal documents. It’s not unusual, to receive a PEG document filled with boilerplate paragraphs where the name of a company has not been changed from the last time they used the document. Additionally, some of the legal jargon may not apply to your business or even industry. Business owners must be cautious that PEGs may be woefully ignorant of the industries in which they’re investing. From their perspective, they’re diversifying their portfolio, but their lack of industry-specific experience, could hurt the companies that they acquire.
While such mistakes seem minor, they can cause incredible headaches for a business owner and their company. With the right preparation and review, business can prevent significant losses in productivity and future headaches.
In conclusion, ideally, PEGs would be offering sophisticated industry expertise as well as capital. They would offer resources that would give a strategic advantage to companies in a specific niche. For example, the right PEG might specialize in bringing together complementary segments of a single industry.
Sadly, though, this isn’t always happening. As things are today, business owners looking to obtain PEG capital need to be observant of these hassles and acquire, or hire, the expertise required to turn PEG money into smart money.
If you would like to personally discuss this article, the value of your company, or how to get the best price when you sell it, you can reach Brad and Hilsman directly at firstname.lastname@example.org /817.793.3773 or email@example.com / 229.669.9613 .