Private Equity Misconceptions – How Getting Over Negative Biases can Create Excellent Exit Options

I continue to be amazed about the misconceptions some private business owners have surrounding the Private Equity (PE) industry and how they typically operate.  Perhaps it has been the negative media coverage on the greediness of Wall Street (or Bay Street) and the perception that investors promote the use of unethical tactics to line their own pockets at the expense of workers, the environment and society in general.  Perhaps it is the perception that PE firms use too much debt to finance their transactions, or that by working with them will create too much conflict around major decisions. Maybe it’s the perception that they add little value or won’t pay what a business is worth and are simply focused on buying cheap and flipping businesses for a profit.  This blog article addresses these misconceptions and provides private business owners some “food for thought” on whether they should include a “PE recap” as an exit option worth considering.

Any concern around tactics driven by greed is likely as much of a myth today as it was a reality in the past.  It is true that the typical “corporate raiders” of the 80’s bought distressed businesses to outsource operations and liquidate assets despite its impact on other stakeholders.  Most modern PE firms nowadays focus on backing entrepreneurs to help them build a better business, and to share the financial rewards with them through aligned incentives.  They also often put plans in place to reward staff and lower-level management to create alignment across the organization.

It is also true that some deals are highly leveraged and can put the business at risk if things go south, however this is much more likely to happen in the “mega-deal” space, than it is in the lower-middle market.  Lower-middle market PE firms carefully assess the cash flow risk associated with any investment and use conservative amounts of debt to leave some “wiggle room” should things not go as planned.  Also, as the debt is paid down and the comfort level around the business improve over time, they often invest additional equity to help accelerate growth.  So, while it is important to get off to a good start whenever a PE group invests in a business, the risk of debt-induced insolvency or restrictions on funding attractive opportunities is quite low.  It is also not uncommon for some PE firms to use all equity to fund deals, particularly in high growth businesses that need capital to capture attractive opportunities or to establish leadership market positions in growing industry segments.

Selling all or part of your business to a PE firm will often mean some significant changes in how major decisions are made.  Most PE firms do not want to run the business, but everyone has a different viewpoint on what that means.  To the PE firm, that means that they won’t be fielding orders from customers or making hires for the plant floor, but they expect to be involved in strategic decisions.  For example, hiring a new sales manager or CFO would likely be expected to trigger an in-depth discussion, as it would in any respectful partnership.  The key here is to have clearly defined roles and decision-making processes agreed to upfront, as the level of passive versus active involvement is highly dependent on the PE firm and the skill set of the management team.

Finally, the spread between the value paid by industry buyers (strategics) and PE for quality firms is often very narrow or even nonexistent.  In some instances, strategics pay more for rare assets that are a perfect fit for their business by sharing with the seller a portion of the expected synergies.  However, on the flip side, PE firms only make money when they successful invest the capital entrusted to them by their investors, and many have large amounts of uninvested capital to deploy.  This has driven up competition between PE buyers and between PE buyers and strategics in recent years.

The primary objective of most Private Equity firms is to put their investment capital to work by 1) buying/investing in good businesses at a reasonable value, 2) working closely with the management team by supporting and helping them to build a much larger, more profitable business within a few years, and 3) monetizing their investment by selling it once it is worth a lot more, and finally, 4) returning the capital to their investors at an attractive rate of return.  For sellers, the opportunity to roll equity in a professional partnership with a PE firm can be very attractive even if they sell their initial stake at a slightly lower value than what the highest bidding strategic will pay.
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In the end, it is quality businesses run by entrepreneurial owners, with aligned incentives and clearly defined roles and responsibilities that produces a successful outcome for all parties.  Considering a sale to a PE firm, with an equity roll, can be an excellent way to implement a two-step exit plan for entrepreneurs looking to maximize value, but only for those that are patient and open to changing how they operate and how they make key decisions.

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