The Private Equity Playbook: Management's Guide to Working with Private Equity, by Adam Coffey
Is your company a medium size business and doing well? Does your business have space to grow? Have you received 'the call'? "Hi, I represent XYZ Private Equity firm, and we have an interest in your business. Can we have an informal conversation about this?"
A Private Equity firm is not like a business brokerage that wants to facilitate a deal to sell your firm to an interested buyer, or to find you an interested buyer. 'Private equity' in the context of this book refers to firms or funds that use private money to purchase companies. Their interest in acquiring businesses, is to expand them, strengthen the balance sheet and sell them.
A Private Equity play involves a set of rules that you may not be prepared for. Knowing the rules will allow you to decide whether you wish to play the game. Played well, there are significant benefits for you that you might not find anywhere else, with paydays that can repeat.
Author Adam Coffey has been on the receiving end of 'the call' from Private Equity recruiters several times and didn't turn them away. That decision has been highly profitable for him, and he didn't own the company. The opportunities offered by Private Equity are open to senior executives as well as owners, and this should be understood. This book will equip you to ask more educated questions and to make better decisions.
To understand Private Equity funds, think of a Mutual fund which aggregates money from a variety of investors and pools that money together. The fund manager then decides what shares to buy on behalf of the investors in the fund. A Private Equity fund is very similar, but not the same.
Firstly, it is private, so shares in it are not easily traded and capital pledged to the fund must stay there for a specified amount of time. Investors in a Private Equity fund are called Limited Partners.
As the fund finds investments, it will call for the money needed for the acquisition. When a Private Equity firm buys a company, they use the maximum amount of leverage or debt they can, based on the cash flow of the company they are going to acquire.
Private equity differs from Venture Capital funds who typically take a minority stake in an investment that shows potential. Private equity differs from Buyout Funds who purchase a company to control it themselves.
During the 1980s, less than 1% of mergers and acquisitions in the US involved Private Equity. In 2018 that percentage had grown to about 35% and the estimate is that within five years, that number is expected to eclipse 50%.
What is behind this growth spurt is how significantly Private Equity outperforms the S&P 500. In fact, Private Equity funds typically beat most benchmark indices. In the US today there is almost $1 trillion in capital looking for investments, so it is no surprise that the investment vehicle that outpaces the rest would be favoured.
How do Private Equity funds achieve this result?
Put most simply, they buy equity in a company with good potential and good management. To make the purchase they use as little of the Limited Partners' funds as possible and borrow as much as they can based on the cash produced by the acquired company. Example: they buy 50% of the company and only put down 20% and borrow the rest. When they want to sell, the debt has been repaid and their 20% down-payment now owns 50% of the company.
To achieve this, they will drive the company as hard as possible, so they can pay off the debt and increase the potential sale price of the company.
There are two metrics they will focus on. One is EBITDA (pronounced as three syllables: e-bit-dah), how much you earn before taking into account how much you must spend of that on interest, taxes, depreciation, and amortization. How much they will pay for your company will usually be a multiple of EBITDA and how much they will be able to sell it for.
The second is IRR, internal rate of return, which is the net return that the Limited Partners whose money was invested in buying your company earned over the time it was invested, expressed as a percentage.
This is important for two reasons and explains a large part of how Private Equity firms operate.
Firstly, they will often want to retain the team that made the company valuable in the first place. The second is that since one of the metrics they use is IRR, time is critical. If it will take the executive team 10 years to grow the company by 30% that is a vastly poorer performance than if the executive team achieved this growth in 5 years.
When you, as an owner, get your pay-out for the company you have built so well over the years, there won't be time for a well-deserved break in the Bahamas before getting back to work. You will be expected to start the business sprint (not jog,) immediately.
As the owner and/or chief executive, you will be answerable to a board. It is therefore as critical that you do your due diligence on how they will relate to you. Some Private Equity firms are very helpful and will use their vast experience across multiple businesses to assist you to achieve their expectations in terms of EBITDA and IRR. Others might be very uninvolved with only a monthly status call.
How they relate to you, will be relatively hands-off if you perform well and relatively very hands-on, if you don't.
When the Private Equity firm exits at a premium, your share rises with the same tide. If you are not an owner, but an executive you can also ensure you benefit when that time comes. That is how the author acquired significant wealth without being an owner.
That said, when you get 'the call' take it seriously, whether you are an owner or an executive.
Readability Light --+-- Serious
Insights High -+--- Low
Practical High +---- Low
*Ian Mann of Gateways consults internationally on strategy and implementation and is the author of 'Strategy that Works' and 'The Executive Update.' Views expressed are his own.