The Mechanics of Growth

The Mechanics of Growth

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Private equity partners have a vested interest in growing companies they buy into, in the years up to their exit. Their goal during this period is the same as yours: To increase the value of your company by expanding the business.

Entrepreneur spoke to Jeff Bunder, a private equity specialist, about the relationship between PE and entrepreneurs. He stresses that whether or not to take on private equity financing is a complex decision.

It requires profound analysis of your personal and business goals, the market environment, and the financing options available. Focusing on these important considerations and avoiding common misperceptions will help you, the business owner, make the right decision.

What are the benefits of a private equity deal for the entrepreneur?

Private equity can be a highly effective way of generating business growth – PE firms not only inject capital into growing businesses, but they also provide broad networks and experiences from working with and growing other similar businesses.

Experienced PE professionals will analyse and provide input to improve on business plans, operational strategies and financial modelling in order to meet set return or hurdle rates for the benefit of the business and their own investment.

They will also examine the industry in which your business operates to improve on competitive strategies and supplier relationships. Traditionally, PE firms have far longer investment horizons than traditional financial funders such as banks and therefore provide the business with time to execute their growth strategies.

How have private equity investors changed their thinking post the global economic crash?

Today, private equity firms have pivoted from cost-cutting and value-preservation to more of a growth agenda for the companies they back. This shift has set the stage for positioning companies well at the outset of the deal to achieve successful, higher value exits while also driving higher returns.

 

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PE investors are able to capitalise on high growth markets and areas for product offerings, make fundamental operational improvements to companies, back the right management teams and effect sustainable value creation.

 As the average holding period for portfolio companies exceeds five years, PE firms have expanded their skills to focus more on growth agendas to ultimately create sustainable value in these businesses.

PE firms have pivoted the way they work with companies. Cost-cutting and efficiency gains were imperative in the immediate aftermath of the financial crisis, but PE firms are increasingly focused on organic revenue growth as the key means of creating value.

PE firms are concentrating their efforts on investing in portfolio companies to support growth in new markets, product lines and business areas and through add-on acquisitions – cost-cutting is no longer an imperative.

PE firms continue to reinvent themselves in a challenging economy, using the time to regroup and redirect efforts. The key factors of success for PEs are still the same – buying well, executing well and selling well – but the processes and resources have been strengthened to ensure portfolio companies are in the best shape possible, positioned to capitalise on an improving economy and ultimately exit.

Meeting With Investors? Don’t Do This! 

Why do so many entrepreneurs believe that private equity funders take advantage of them and that it’s essentially a win-lose game where investors win and entrepreneurs lose?

A bank loan is paid off over time whereas a shareholder has to be serviced in perpetuity or until that shareholder exits the investment. For this reason equity is expensive versus other forms of capital.

In addition, an equity investor is after the best return possible and will push the business to deliver on its promises. And, your investor will be looking to exit the investment for a profit once their own return criteria have been met. This may disrupt management attention in that they may need to buy those shares back at the now inflated price or spend time finding a replacement investor.

Essentially, if a business owner makes a bad choice, they will blame the private equity funder. But this can be avoided by reading the contract you sign, doing the due diligence, and ensuring that you understand how control of the business will change and shift.

Private investors do not simply make off with the value of your company. The key point here is that they make money only if the value of your company appreciates. It’s also a fact that, in most cases, the entrepreneur retains a substantial interest in the business.

After all, it’s in the investor’s best interest to help you grow your company and increase its value. If the investor wins, the entrepreneur wins.

What does an entrepreneur have to have in place to attract private equity?  

The business needs to have demonstrated success and have a sustainable growth plan in place that can use assistance with professionalising infrastructure and project management and developing strategic execution skills.

The growth plan will be thoroughly analysed by the PE firm before they decide to risk their capital and management expertise. An entrepreneur needs to be thoroughly prepared to have his firm undergo a full due diligence, including strategic, operational and financial detail.

Often, entrepreneurs are extremely good at growing businesses up to a certain size, but they begin to struggle to deal with all the administrative necessities of running a much larger business. These include corporate governance policies and procedure, risk administration, financial systems and HR systems, to mention a few.

These policies and procedures are vital to minimise risk and ensure that plans can be efficiently executed. After all, if you can’t measure it you can’t manage it.

When is it the ‘right’ time to think about private equity for your business?

Private-Equity_Attracting-Investors_Funding 

As a business grows, a revolving line of credit gives  it the cushion it needs for working capital. Down the road, the company may have tens of millions in revenue.The founder sees new opportunities, but does not have the cash flow to finance new developments.

They may not want the burden of a bank loan, especially when the company itself may be worth quite a bit. Once the business reaches a level at which it’s stable, but lacks a growth agenda or the capital required to invest in expanding the business, it’s worth looking at a private equity partner.

Entrepreneurs generally reach out to private equity when their business needs capital from investors who are prepared to wait longer than a bank for their returns. The PE firm will also provide the business with strategic, structural and operational input to grow the business.

Most PE investors have plentiful experience with operating issues. Generally, they have little interest in micro-managing and are only too keen to look at the operation from an objective perspective. They can add value by challenging management to think differently from how they normally do.

Investors who have backed many different companies at rapid growth stages can recognise patterns that may not be obvious to the management team. They may also have a network of relationships that can help companies to recruit new talent at board and management level.

What do you need to know about letting go when it comes to PE?  

Partnering with PE is not letting go, nor does it mean losing control. PE investors do not come in to run the business – they are backing entrepreneurs and management teams they think can deliver the growth objectives set for the companies in which they invest.

The entrepreneur will have to allow the PE team full access to its business plan and financial information. They have to understand that the PE firm as a shareholder has the right to guide strategy and execution plans.

To prevent conflict between the management team and the PE firm, entrepreneurs should perform an extensive due diligence on the PE firms and find the ones where there is a good fit in terms of both personalities and business objectives.

The entrepreneur needs to understand how long the PE firm intends to remain in the investment or what point return criteria will have been met. It is vital to have all expectations set right from the beginning. It’s critical to timeline the investment and set expectations with investors upfront.

Do not make the mistake of expedience – of being so determined to grow your business that you will accept any terms as long as you can get to market. Ultimately, you cannot make anyone responsible, other than yourself, if you agree to a deal and surrender control.

The reality is that if you sell a minority investment, you can continue to control your company, make all operating decisions, and have the ultimate say over strategic issues. Once again, remember that most professional investors do not want to run your company.

They are busy making their own money. By selling less than half of your company, you can remain at the helm, while providing liquidity for yourself, the company and other early shareholders.

When It Comes To Investors, the Less Risk the Better. Find Out How To Minimise It Here.

Does PE always mean that you will have to sell your company at some point?  

The PE investor will always need to exit its investment – that is its business model. Since the firm has limited partners who expect liquidity at some point, they can’t hold onto their investment in perpetuity. Their exit is traditionally through either a sale or IPO. In many growth investments, the exit can be a sale back to management.

Alternatives might include recapping the company with bank debt, swapping out one investor with a new private equity investor, or raising capital from a strategic partner. The entrepreneur does not always have to exit as well.

Various exit scenarios should be discussed upfront in order to allow management to prepare for the exit.

Financial considerations should be included in the financial modelling to protect the entrepreneur’s business at the time of that exit.

What are the biggest pitfalls of PE?

Management clashes. Feelings of being interfered with. An important consideration is whether or not the PE firm will be expecting specific returns or dividends at specific times.

The entrepreneur needs to understand the implications of what will happen should these returns or expectations not be met within the required time period. The contract with the PE firm needs to clearly articulate action that will be taken for any foreseeable problem.

The entrepreneur also needs to ensure that remedies are in place should they wish to force the PE firm to exit at any particular stage. In worst case scenarios, the private equity investor buys control of the company, cuts lots of jobs, and loads the new company with a ton of debt.

Then they pay themselves huge management fees, and sometimes manage to cash out before the company turns around. That leaves other shareholders to suffer if the company doesn’t make it.

What tips do you have for companies looking to go the PE route?

Entrepreneurs should always do a due diligence on their prospective investors and select the one where there is the greatest organisational and cultural fit. You will be working alongside these people as partners over a number of years.

Getting a fair price for your business is certainly an important consideration, but it’s equally important to partner with an investor who shares your goals and who will work with you to achieve them.

If you focus only on the valuation of the business, you risk ending up with a partner who doesn’t understand your company, your growth strategies, or your industry.

If you sell to a private equity investor who has unrealistically high expectations of the company, the relationship is likely to sour when the business fails to meet the investor’s expectations. An investor with whom you can forge a sound relationship based on an in-depth and detailed understanding of your company will instead work with you to increase its value in a realistic and sustainable way.

It’s also imperative to align expectations of timing and exit upfront. Make sure you are ready to exchange equity in your company for funding and bring a new voice into strategic decisions. Failure to communicate openly with investors is often where you run into problems.

 

 

Monique Verduyn
Monique Verduyn is a freelance writer. She has more than 12 years’ experience in writing for the corporate, SME, IT and entertainment sectors, and has interviewed many of South Africa’s most prominent business leaders and thinkers. Find her on Google+.