In all of the options
we’ve looked at so far in our eight-part series on Funding a Business, there
have been strings attached.
With private equity, those strings can get very tight indeed. You could raise huge amounts of money—private equity deals run into millions or even billions of dollars—but you may end up losing control of your own company.
It’s quite a complicated area, but in this tutorial we’ll break it down and make it easy to understand. We explain how it works, look at the pros and cons of private equity as a way of financing a company, and talk about how to find, approach and deal with private equity firms.
By the end, you’ll know a leveraged buyout from a mezzanine financing deal, and will understand how private equity works and how it compares with other ways of funding a business.
1. How Private Equity Works
In the last tutorial, we looked at venture capital. Private equity works in a similar way: a private equity fund invests in companies and looks to sell its stake about five years later for a substantial profit.
But whereas venture capital is focused on early-stage companies with high growth potential, private equity firms invest in a much wider range of companies. Often they’re mature firms that have been trading for a long time, but need access to funds either to fuel growth or to recover from financial difficulties.
Another big difference is in the amount of funds available. Most of the other funding options we’ve looked at have given access to sums ranging from a few thousand dollars to a few million. But according to Bain & Company, most private equity deals are for between $500 million and $5 billion. Deals below $100 million are rare.
This is a major financing option, then, more suitable for larger companies than the other ones we’ve looked at. The structure of the deal is also different. In return for this large investment, private equity firms expect a large stake in the business. They don’t want to be passive minority investors. They generally want a majority stake, and want to take the reins of the business so that they can generate value from it.
Private equity firms invested $347 billion in 2,083 U.S. companies in 2012, spread across different industries and in different states—the biggest recipient of private equity funding was Texas, followed by California, Colorado, Illinois and Florida. Private equity funding is also available to companies in many countries around the world.
The deals can take several forms. Here are some of the main ones:
The private equity firms often boost their returns by using leverage, i.e. borrowing money. This kind of deal is called a “leveraged buyout.” The private equity firm borrows money from banks or other lenders, and adds that money to its own funds to allow it to buy a majority stake in a company. It uses its controlling position to restructure the company and make it more valuable, so that it can sell its stake later at a profit.
This form is most commonly used in turnaround deals, where the company is in financial trouble and the private equity firm uses its money and expertise to return it to profitability.
In this kind of deal, the private equity firm takes a smaller stake, and the objective is growth rather than a turnaround. It’s similar, then, to venture capital, and in fact venture capital is often regarded as a subset of private equity. What’s different about growth capital (sometimes called “growth equity”) is that it’s focused on larger, more mature companies, not the early-stage companies that venture capitalists look for.
It sounds complicated, but actually it’s quite simple. Mezzanine financing is simply a form of debt. Some private equity funds will lend money to companies, either as part of an existing deal or as a separate transaction. If your company goes bankrupt, the mezzanine debt gets paid off later than other debt, so it’s more risky, and therefore commands a higher interest rate.
In this tutorial, we’ll concentrate mostly on the leveraged buyout, since it’s the most common form of private equity.
2. Advantages of Private Equity
Private equity financing has some distinct advantages over other forms of funding. Here are some of the main benefits:
Large Amounts of Funding
Of all the options we’ve looked at so far, private equity can provide by far the largest amounts of money. As we saw, the deals are measured in hundreds of millions of dollars.
The impact of that kind of money on a company can be massive. In 2009, The Delaware City Refinery had to close its main refinery and lay off most of its employees. In 2010, private equity firm Blackstone invested $450 million in the company, enabling it to reopen the refinery and rehire 500 employees.
With many of the other funding options we’ve looked at, the investor or lender has only minimal involvement in the running of your business. Private equity firms are much more hands on, and will help you re-evaluate every aspect of your business to see how you can maximize its value.
This can lead to problems, of course, if their idea of maximizing value doesn’t match yours, as we’ll see in the next section. But having experienced professionals intimately involved in your business can also result in major improvements.
Private equity firms have a lot of skin in the game. As we’ve seen, they often borrow a lot of money to make their investments, and they have to pay that back and generate a return for their investors on top of that. In order to achieve that, they need your business to succeed.
Individual partners in the private equity firm often have their own money invested as well, and make additional money from performance fees if they make a profit, so they have strong personal incentives to increase your company’s value.
This combination of major funding, expertise and incentives can be very powerful. A 2012 study by The Boston Consulting Group found that more than two-thirds of private equity deals resulted in the company’s annual profits growing by at least 20%, and nearly half the deals generated profit growth of 50% a year or more.
3. Disadvantages of Private Equity
Such large amounts of money, of course, come with strings attached. Here are some of the downsides of private equity funding:
Dilution/Loss of Your Ownership Stake
This is the big one. With the other funding options we’ve looked at, the investment came at a cost, but you still stayed in control of your company. With private equity, you get much more money, but usually have to give up a much larger share of the business. Private equity firms often demand a majority stake, and sometimes you’ll be left with little or nothing of your ownership. It’s a much bigger trade, and it’s one that many business owners will baulk at.
Loss of Management Control
Beyond the money, you can also lose control of the direction of your business. The private equity firm will want to be actively involved, and as we mentioned in the previous section, that can be a good thing. But it can also mean losing control of basic elements of your business like setting strategy, hiring and firing employees, and choosing the management team.
Some of the other options involved relinquishing control, but because the private equity firm’s stake is usually higher, the loss of control is much greater. This is especially true when it comes to the PE firm’s “exit strategy.” That may involve selling the business outright or other options that don’t form part of your plans.
Different Definitions of Value
A private equity firm exists to invest in companies, make them more valuable, and sell their stakes for large profits. Mostly this is good for the companies involved—any business owner would like to create more value.
But a private equity firm's definition of value is very specific and limited. It’s focused on the financial value of the business on a particular date about five years after the initial investment, when the firm sells its stake and books a profit. Business owners often have a much broader definition of value, with a longer-term outlook and more concern for things like relationships with employees and customers, and reputation, which can lead to clashes.
Private equity firms are looking for particular types of companies to invest in. They have to be large enough to support those major investments, and also they have to offer the potential for large profits in a relatively short time frame. Generally that either means that your company has very strong growth potential, or that it’s in financial difficulties and is currently undervalued. A business that can’t offer investors a lucrative exit within about five years will struggle to attract any interest from private equity firms.
4. How to Deal with PE Firms
In this section, we’ll look at how a private equity deal gets done, and what you need to know about each stage.
Finding a PE Firm
In the other options we’ve looked at, you have to go out and pitch potential investors or lenders to persuade them to part with their money. With private equity, it often happens the other way around. PE firms are actively looking for investment opportunities, and often approach firms that seem to fit their profile.
If you haven’t been approached, but you believe your business meets the criteria of private equity investors and you could benefit from the funding, then of course you don’t have to sit and wait. You can look for a private equity partner yourself. There’s a listing of more than 800 PE firms here, covering both the U.S. and international markets.
It’s best to use personal connections if you can, though. Remember that you’re inviting a private equity firm not just to invest in your business, but also to play a large part in running it and deciding on its future direction.
So while the money is important, it’s also essential that you find a firm that you trust and can see yourself working with. Research by the Wharton School at University of Pennsylvania found that less than half of private-equity financed businesses selected the investor offering the highest valuation. Relationships trump money, so try to get personal recommendations from your advisor, accountant or someone in your network.
Doing the Deal
With such large amounts of money at stake, of course the process of negotiating a deal is a very complex and thorough one. It’s advisable to have a team of experienced lawyers and advisors helping you through it.
It starts with a detailed business plan on your part, laying out your company’s story, the reason you’re seeking funding, the amount you’re seeking, and the opportunity for the PE firm. Be sure to give detailed, realistic financial projections over the next three to five years, showing how you can deliver the returns and the profitable exit they are looking for.
If you’re successful, you’ll get a memorandum stating the broad guidelines, and you’ll begin negotiating the details of the agreement. The most important element, of course, is how your company is valued. Negotiating is a tricky area, because the private equity partners are very experienced at doing deals like this. Here are a few tricks to watch out for—notice that several of them involve delaying payments and taking advantage of the time value of money, which we discussed in a previous tutorial.
When you’ve finalized the details, you’ll get an offer letter, and then the private equity firm will begin a very detailed due diligence process. You’ll need to be prepared to give full details of your business, and have every aspect of your business scrutinized not only by the private equity investors but also by teams of external consultants and accountants. If everything checks out, then you’ll agree on the final terms and sign the agreement.
Working With a Private Equity Firm
After the agreement is signed and the funds have been transferred, you’ll start working with the private equity firm. The terms vary, but generally they’ll want seats on your board and a say in all your major decisions, as well as putting strict controls on what you can and can’t do.
Generally they won’t get involved in the day-to-day running of the business, but they might insist on appointing particular people to the management team. It’s important to get all these details worked out before signing, so that you know what to expect.
Then you’ll begin working towards the exit. Here are some common ways that a private equity firm can exit from an investment:
- Repurchase: You repurchase the private equity company’s stake and take back control of your business. This is an attractive option, but keep in mind that the value will usually be a lot higher by this point, so it can be expensive.
- Secondary Sale: The private equity firm sells its stake to another PE firm or financial investor.
- Trade Sale: The business is sold to a competitor or other company.
- IPO: The company goes public, and the private equity firm sells its stake in the process. We’ll look more at IPOs next week.
5. Next Steps
So private equity is another very different type of funding option, with its own unique pros and cons. It can give a company access to large amounts of funding, and the expertise of the private equity firm can help it to grow or return to profitability. But you’re placing a very large portion of your business in the hands of outsiders whose interests are partially but not perfectly aligned with yours.
If you’re looking for other options, read the earlier tutorials in our series on Funding a Business. We’ve got one more option left to look at: initial public offerings (IPOs). We’ll explain everything you need to know about IPOs in next week’s tutorial.