Look out for these red flags when considering a private equity deal.
In recent years, a lot of financing needed to buy or recapitalize middle-market companies has come from private equity funds. For the most part, this has been a positive trend; infusions of cash from private equity have enabled smaller, well-run companies to digitize and automate their processes, diversify into new markets, and expand their geographic reach.
And while private equity investment can be lead to positive outcomes, still it’s beneficial to a CEO to understand how private equity funds operate. You should be aware of the red flags that might indicate that a specific deal might not be quite right if you care about the long-term viability of the company that you or your family founded.
The biggest red flag is short-term thinking. Most private equity groups take money from a pool of investors with the promise of generating a certain amount of return within a fixed time period (e.g. five to ten years).
In some cases, private equity managers choose a specific industry (e.g. printing, packaging, labels, finance, technology, or health care) and use their business acumen to find ways to make the purchased business (or businesses) more profitable. When the more profitable company is sold to another buyer at a higher price, every investor reaps the financial gains.
Private-equity managers have expertise in mergers and acquisitions and procedures for evaluating deals and executing post-sale integrations.
But small-business owners and CEOs are often wary when a representative of a private-equity group inquires about the possibility of buying their business.
Here are three common reasons for their skepticism.
1. Lack of industry knowledge. The managers of a private equity fund typically have more expertise in finance and business management than a specific industry. They are more comfortable talking about spreadsheets and financial strategies than nuances of building workplace cultures and acquiring and retaining the best employees and customers.
Some “hands-off” private equity groups gain industry expertise by investing in a platform company that is already well-managed and poised for growth. The retained leader of the acquired platform company then recommends additional label or packaging businesses that would be a good strategic fit as add-on or roll-up acquisitions.
2. An obvious “build-and-flip” mentality. Thanks to popular HGTV shows like Fixer Upper and Flip or Flop, everyone understands the concept of flipping – generating profits by buying distressed properties and fixing them up. Many “flippers” could care less about the history or original charm of the properties they buy. They simply want to figure out how to get the maximum return on their investment without spending too much money on renovation and repairs.
Private equity groups operate with the same principle. For example, private-equity investors In label and printing businesses know that measures such as digitization, automation, and economies of scale can increase the financial value of acquired properties relatively quickly.
But they have more difficulty assessing the value of well-trained and loyal employees and a good reputation among vendors and the community.
In his book “Selling without Selling Out,” Sunny Vanderbeck of the investment firm Satori Capital notes that, “Sometimes when ownership changes hands, the new owners don’t understand the strong culture they have inherited or the trust the company has earned for its stakeholders. So the new owners seize on quick opportunities to cut costs by reducing employee benefits or community outreach. The company wants to start taking more from its shareholders than it gives.”
He says private-equity companies that have a build-and-flip mentality will already have one foot out the door from the day they buy your company:” Its executives are already thinking about who they might sell your business to, how much they could be paid for it, and when they might get a distribution.”
3. An extremely hands-on management style. If you plan to stay with your company as part of an earnout arrangement, you might not like working for a new boss selected by the private-equity firm. They might institute new policies and procedures that go against your own instincts about what’s best for “your” company.
But no two private-equity groups and acquisition deals are alike. If your shop is purchased as a platform company, the right group might be able to provide assistance in finance and business while trusting your judgment with regards to what’s best for your employees and customers.
According to Vanderbeck, entrepreneurial private equity buyers that employ people who have worked as CEOs may have a more collaborative style: “They can think about your business as it is and as it could be, and they have empathy for what you are going through.”
He adds that, “You will feel like you have a real partner, as long as you understand your newfound partner’s time horizon.”
If you have decided that selling your business to a third party (outside of your family or business) may be the best exit strategy option for you, keep in mind that finding the right buyer can be tricky – especially in an era of economic uncertainty. When the economy falters, the number of sellers looking for buyers will exceed the number of buyers looking for sellers. .
Packed with helpful information, our FREE download “Succession Planning Simplified” will help you get started and answer common questions. Call me at 561-543-2323 and I can tell you more about the pros and cons of different types of business exit strategies and what I have learned firsthand about private equity groups.