CFO

How To Determine If Private Equity is a Financing Option

By Megan O’Brien, Brainyard Business & Finance Editor
March 30, 2020
Dollar Rope

In short:

  • For companies looking to unlock value, private equity may be a source of cash and support
  • CFOs must help demonstrate that their companies have the infrastructure, team, strategy and growth potential in place to warrant investment
  • Prior to “tying the knot” with a PE firm, make sure you have a cultural fit and aligned goals

The private equity industry had nearly $1.5 trillion to invest at the end of 2019, according to Preqin. That’s a record, and thus far, investors, while clearly cautious, are not staying on the sidelines: 78% of respondents to a March 17 Eaton Partners survey of leading funding partners say they will not reduce or pull capital out of specific geographic regions because of the novel coronavirus.

PE firms have the funds to alleviate some financial struggles or fuel growth. However, this is not a relationship that either side enters into lightly. Partnering with a private equity firm is often compared with a marriage — and in this analogy, due diligence is the dating period. To ensure a successful union, both sides must know what they are looking for in a partner and what to expect when they tie the knot.

Current State of Private Equity

Let’s address the elephant in the room: PE doesn’t have the best reputation. Nicknamed “raiders,” “sharks” and “vultures,” they’re blamed for the fall of well-known, and sometimes beloved, brands like Toys “R” Us, Nine West and Payless. However, there are vast differences in strategy among PE firms. The ones that make the news are those that conduct leveraged buyouts and work to create value for the shareholders of struggling companies, like those brick-and-mortar retailers. These efforts drive the overhaul actions that PE is infamous for — restructuring, wage cuts, layoffs.

However, deals driven by both venture and growth capital, a form of venture funding for more mature companies, have fueled some of the market’s most notable successes. For example, Airbnb took both venture and growth capital funding. An investment to propel growth for a minority interest is vastly different from a buyout, where a PE firm will acquire a controlling interest in a company and make sweeping changes in corporate management.

The industry is diverse. And that diversity can deliver valuable capital, provided that both sides agree on the objectives behind the investment prior to beginning the relationship.

Common Types of Private Equity Deals
Deal Type Description Targets
Venture Capital Invests in companies with high growth potential that are in the early stages of development. Startup, early-stage and emerging companies.
Real Estate Invests in commercial and residential real estate. Firms will develop, operate and improve properties prior to selling. Land, office, hotels, residential, retail and industrial properties.
Growth Capital Similar to venture capital but for more mature companies. Designed to facilitate accelerated growth through expanding/restructuring operations, funding acquisitions or entering new markets. Somewhat mature companies needing funds to scale.
Mezzanine Financing Hybrid of debt and equity financing that falls between equity and senior debt on the balance sheet. Last stop along the capital structure where owners can raise substantial amounts of liquidity without selling a large stake in their company. Established companies with solid cashflow and a solid expansion plan.
Leveraged Buyout (LBO) Utilizes a significant amount of borrowed money to acquire another company. Large and mature companies with steady, predictable cash flows and opportunities to create value by, for example, restructuring.
Distressed/Special Situations Investments in equity or debt securities of financially stressed companies, with the goal to restructure and return the company to financial health. Financially stressed companies.

What Private Equity Firms Are Looking For

PE firms are different from other categories of investors because of their focus on “buying to sell.” A typical PE fund has a life of around 10 years before funds need to be returned to investors. Accordingly, there is a limited time to identify investments, create value, recognize that value through the sale or initial public offering of an investee, and return the sale proceeds to investors.

PE firms typically hold interest in a company for three to seven years while they work to increase value. According to Bain & Company’s 2020 Private Equity Report, the average holding period in 2019 was 4.3 years; that number may increase in 2020 due to the effects of the coronavirus. PE investors try to maximize the internal rate of return on investment (IRR), so it is in their best interest to sell within that target timeframe before the pace of value creation slows.

Time constraints make a PE firm’s assessment process even more critical. To screen a potential investment to determine if it can provide ROI in the investment timeframe, firms are paying particular attention to five company characteristics.

Growth strategy: Growth is a primary driver of value creation. Strong candidates for PE investment are those with multiple potential avenues of growth. Particularly in today’s rapidly changing environment, a company that is dependent on one strategy is a red flag for PE firms. A diverse growth plan will position a company for success, especially in a time of external factors like economic downturns. When it comes to situations like the coronavirus and the resulting economic impact, private equity will likely be looking at how companies plan to operate through and beyond the crisis.

Management: The management team is of immense importance to private equity firms.

“PE firms invest in people as much as ideas,” said Brian Cairns, founder of ProStrategix Consulting. “Do you have the team in place with the right skill set to accomplish what you say you will?” Depending on the type of deal, the post-acquisition agenda can entail significant change, including optimization initiatives, reorganization, restructuring, expanding, acquiring, executive turnover or even layoffs. PE firms look for teams that can effectively execute growth strategies and lead their companies through change. Executive compensation plans are tailored to align management’s interests with those of the PE firm.

A notable exception? In some cases — particularly leveraged buyouts and distressed private equity — a subpar management team could be seen as the factor that needs optimizing. If the PE proceeds with the deal, it’s likely with the intention of replacing leadership.

Technology infrastructure: This is the heavy-hitting newcomer to the list. Technology plays an intrinsic role in the potential value of a company and the speed at which it can provide return on the PE’s investment.

“What many companies don't realize is that in addition to financial and legal due diligence, if your company has any technology assets, either customer software or just plain IT systems, it is very likely a PE firm will hire a consultant to perform technology due diligence,” says Dominic Holt, CTO of Valerian Technology, which provides such services. “This consultant will put together an extensive report on risks and weaknesses the business has from a technology perspective and provide estimates on how long and how much they will cost to fix.”

A company whose technology could be impeding productivity, efficiency, security or any other sources of value will likely deter potential PE investors — particularly if updates would be time-consuming and expensive. One best practice is to evaluate your own security using a recognized methodology before engaging with a potential investor or buyer.

Solid business strategy and revenue: PE firms look for companies with high growth potential and differentiation in their respective markets. Companies should have competitive and sustainable advantages as well as stable, recurring cash flows, inasmuch as that’s possible given external circumstances.

Runway to improve value: Your company is seeking PE investment for a reason. How exactly is an influx of capital going to help you grow and provide a high ROI? Will it fund an acquisition? Help reach new markets? Have a good pitch around how exactly a PE firm’s capital, expertise and insights will create value.

Ultimately, a PE firm is looking to create an investment thesis. This is a statement that outlines the reasoning behind the investment strategy and how the firm will make the business more valuable within the intended time period. It answers the critical question for PE firms: “How can we grow it?”

Significant Challenges

This thesis and details about the underwriting of a potential deal are presented by the PE firm’s deal team to the PE firm’s investment committee, which is typically made up of senior leadership. The committee critically evaluates the investment thesis and the potential for value creation, as well as underlying risks, before granting approval.

What Companies Should Look for From Private Equity Firms

As we’ve discussed, culture eats M&A strategy for breakfast. The same is true for a PE relationship. Prior to embarking on a partnership, conduct your own research in these areas.

Compatibility: José Morey, a startup consultant for MIT’s SOLVE and the NASA iTech accelerator programs, reinforced the PE relationship analogy.

“At its core, the PE relationship is like a marriage,” said Morey. “So, make sure you are comfortable ‘waking up’ with that person every day. If you don't feel comfortable with the person, then walk away. In the end it is always better to get into the right relationship even if it means waiting a little longer then jumping into the first one that says yes. It is important to ‘date around’ and get to know various potential partners before committing.”

Strong management: Capital isn’t the only benefit of a PE partnership. You also get access to professionals, possibly including operating partners with a range of skills, who have experience working with high-performing teams and delivering on ambitious value creation plans. Ideally, a PE firm will bring skills, connections and expertise to the company that complement management’s skill sets.

Past performance: How is the PE firm’s track record? Have investments led to superior performances and solid returns? Do they have experience in your industry? Cairns advises, “If companies are not ‘graduating’ and leaving or being sold, then you have to question their ability to get you to the next level,” says Cairns. Researching a PE firm’s history can help gauge whether their past performance and methods are in line with your company’s goals.

How To Prep for Potential Private Equity Investment

PE investors want to know that executives, including the CFO, fully understand business fundamentals across the commercial, financial, legal and technological areas of the company. Be prepared to show and tell.

Commercial: A comprehensive business plan must enable a PE firm to easily discern the business value and structure behind your company. It should include a financial model with growth rates that support private equity target returns and leverage structures. How exactly is the investment going to support both your and the PE firm’s objectives?

No company exists in a vacuum. Be sure that you and your team know your industry in and out: competitors, customers, market trends and how you fit into that sphere.

“It’s shocking how many startups and even established companies seeking funding don’t have a firm grasp on characteristics of their market like size and growth,” says Cairns. “Nor do they have insight behind the problem they are trying to solve. Why is it important? Finally, how do they plan to uniquely solve it? Without these three things crystal clear and easy to understand, the rest of the pitch is useless.”

Financial: Be prepared to answer questions around historical and projected income statements, balance sheets, capital requirements of the business, cash flow statements and any relevant information around debt. PE firms will then typically hire accountants and/or auditors to review the financials, operations, customers, markets, and tax issues in detail — make sure the financial health of your company stands up to scrutiny.

Legal: PE firms conduct extensive due diligence into any legal liabilities a company may have. Regulatory risk, threatened or ongoing lawsuits, IP issues and prohibitive contract provisions may not even be on your radar — but you can bet they’ll come up during due diligence.

Once the due diligence process has started, unresolved litigation is much more difficult and expensive to address and will delay and potentially kill a deal. Be sure to work with legal to review any potential or ongoing litigation and resolve it ahead of time.

Technological: A poor technology infrastructure affects competitive edge. It also subjects investors to security risk, as we’ve discussed. If you have doubts, Holt recommends hiring a consultant to assess your company’s weaknesses. Going through the process ahead of time allows your CIO to work through issues in a proactive manner, thus protecting the deal.

Due diligence is the chance to make a good first impression and ensure that your company gets an appropriate valuation. Have an idea of what you’re worth and a handle on growth challenges.

PE is a potential source of capital for many companies that need it. With the right amount of preparation and effort in the dating stage, it can become a rewarding marriage for both the investor and investee.

Megan O’Brien is Brainyard’s business & finance editor, covering the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Reach Megan here

  

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