If you’re a financial executive considering private equity (PE) funding for your business, you’re likely well aware of the media attention around the pros and cons of PE firms and investments. But beyond the headlines, the decision-making process can be complex and challenging.
To make an informed choice, financial executives need to understand the potential value of a partnership with a PE firm and how it compares to a strategic buyer relationship. This requires a deep knowledge of various investment and exit strategies, as well as operational expertise.
Private equity and strategic buyers have their own objectives that will impact the transaction and the company’s future operation. It’s crucial to align these objectives with the owners’ goals to ensure a mutually beneficial partnership.
Before making any decisions, financial executives need to identify their company’s objectives and define what success means to them. Owners’ objectives may differ, so reconciling these differences is essential.
Strategic buyers are companies already in similar lines of business. Their primary focus is enhancing their existing business model and financial return to shareholders from the target company purchase. This type of buyer also includes portfolio companies of PE firms that function as acquisition platforms.
Private equity firms and other financial buyers may have experience in a similar industry but are not currently in the target company’s line of business. Their focus is looking at the company as a standalone investment with potential for internal growth of revenue, earnings, and free cash flow. External growth by converting the company into an acquisition platform is also a secondary focus.
Addressing Strategic Issues
Financial executives have several strategic issues to address regarding the sale of all or a portion of their company’s ownership. What are the prospective buyers’ financial and ownership objectives? How do these compare to the owners’ definition of success? Aligning or reconciling these objectives is imperative.
Changes Any transaction will inevitably bring organizational changes and dislocations. To ensure a successful partnership, financial executives must be part of the planning team that identifies and develops solutions to these issues.
Valuation: Balancing Upside Potential and Downside Risk
Strategic buyers are often willing to pay a premium for a company due to the potential operating synergies they can achieve. Additionally, they may be willing to accept lower returns on investment or cost of capital, as they already have an established business that can offset any potential losses. However, it’s important not to oversell your company’s value, as this can lead to unrealistic expectations and increased downside risk.
On the other hand, private equity firms typically offer a lower initial purchase price, but with the prospect of higher long-term gain based on the future sale of retained ownership. They may also be more cautious in their valuations, as they don’t have the same level of operational expertise as strategic buyers.
Deal Structure: Flexibility and Financial Leverage
Strategic buyers typically acquire 100% of the target company for cash or a combination of cash and stock. Private equity firms and other financial buyers, on the other hand, may offer more flexible deal structures that can meet the divergent needs of the ownership group. For example, they may offer all-cash deals or partial cash-outs for owners who wish to retire but want to leave some equity in the business.
However, private equity firms often use higher levels of debt in the capital structure of acquisitions than strategic buyers. This can lead to over-leveraging of the business, reducing the ability to reinvest operating cash flow into the business for growth. The financial executive of the target company should carefully analyze the debt load in comparison to projected operating cash flows to ensure the capital structure fulfills operating requirements.
Time to Close: Expertise and Due Diligence
Strategic buyers often have industry expertise that can shorten and simplify the due diligence process. However, financial buyers may not have the same level of industry knowledge and may need to bring in outside consultants to perform part of the due diligence. This can lead to a more drawn-out process, delaying the closing of the deal.
While consultants can be inconvenient, they can also help the management team of the seller identify and develop solutions for post-closing disputes that may result from organizational restructuring.
Investment Criteria: Understanding the Buyer’s Strategy
When evaluating prospective buyers, it’s important to review their investment criteria carefully. For private equity firms, this includes understanding their stated industry preferences and experience, as well as their ability to add value based on previous transactions. You should also evaluate whether the proposed transaction structure is consistent with previous transactions in their portfolio.
It’s also important to understand whether the private equity firm has sufficient “dry powder” to make incremental investments in the business or if they will need to raise additional capital. Reviewing previous acquisitions made by the firm can indicate its strength in the follow-on investment stage.
Previous Transactions: Uncovering the Truth
One of the most critical factors to consider when evaluating potential buyers is their previous transactions. Business owners need a realistic assessment of what happened in the past with the private equity firm’s prior deals. However, every transaction is full of “happy talk,” and it’s crucial to get the whole picture, which is only achievable through careful due diligence and analysis.
Uncovering any issues with disruptive potential before closing the deal is the paramount objective of this process. If successful, the happy talk will soon turn into real talk, separating the sales pitch from the reality.
Strategy and Vision: Making the Right Choice
Another essential criterion to consider when evaluating potential buyers is their strategy and vision. Aligning strategies and visions may be one of the most important factors in selecting among strategic buyers or choosing private equity funding.
Although strategic buyers may already have their own plans, the company is tasked with clearly explaining its vision and strategy for success. Communication is key, and nobody is a mind reader.
Employees, Culture and Legacy: Minimizing Disruption
Minimizing employee disruption and maintaining the culture of the business is crucial when selling a company. Private equity firms are more likely to partner with the target company and preserve its management and culture.
Good strategic buyers understand the importance of figuring out the essential cultural attributes that led to profitability and innovation in the acquired company, with the goal of preserving those attributes after the purchase.
Cultural or legacy attributes that inhibit integration and operational improvement will be quickly eliminated. Financial buyers, on the other hand, will have a greater tendency to maintain the culture of acquired companies and preserve the legacy of the business.
Control and Governance: Negotiation and Compromise
The seller is in the position to make many of the initial decisions that will determine how the relationship proceeds, despite being met with some resistance. Strong negotiating skills and willingness to compromise will be key during this stage.
If the company wishes to sell 100 percent ownership interests, the transaction with strategic buyers will be more straightforward, as they typically acquire full ownership. Private equity firms, on the other hand, are open to other options that may entail retaining a minority position.
The financial executive is in the position to help the company sort through the theory and practicality of these options so that successful growth of the company is ensured post-closing.
Formalization of Corporate Governance
Regardless of the alternative chosen, corporate governance will almost always become more formalized in a PE-backed company. This entails formal board meetings held on a recurring basis, complete reporting packages submitted to all directors, board approval of changes to executive compensation and hiring of executives, board approval of significant capital expenditures, board approval of acquisitions, implementation of financial dashboards to monitor the business, and an increase in consulting projects designed to improve operating processes. This formalization can help increase transparency, improve decision-making, and ensure compliance with regulatory requirements.
Management: The Importance of Promises
In the process of acquiring a company, it’s in the best interest of the buyers to tell sellers and management that they are a partner in achieving long-term financial and operating objectives. They promise to work on strategic decisions together and to let management run day-to-day operations. Normally, those are true statements – but due diligence will reveal the extent to which that will remain true, post-closing.
Management should be prepared for the somewhat laborious phase following closing, when the focus is on achieving operational excellence and organic (or internal) growth. Growth through acquisition will only occur after the platform company achieves operational excellence.
Exit Plan: Selling to Strategic Buyers
History has shown that the leading exit strategy for a PE firm is to sell to a strategic buyer. The second leading strategy is to sell to another private equity firm or other financial buyer focused on larger companies.
Therefore, even if the first transaction is completed with a financial buyer, the target company and the managers with retained equity interests are more likely than not going to sell their ownership in a subsequent transaction to a strategic buyer, even if the managers would prefer selling to a financial buyer.
The Bottom Line
Before seeking private equity funding through a partnership with a PE firm, companies must understand the complexities of these deals, which range from accounting to counseling opposing personality types.
Financial executives play a crucial role in facilitating and navigating this terrain on behalf of the target company to foster a strong, productive relationship among all parties. Ultimately, corporate governance is a critical factor that can impact the success of a PE investment, and companies that take steps to formalize their governance processes will be better positioned for long-term success.