The Smart Money in Private Equity

If you bring private equity investors into your business, the contract you’re entering demands sustained high performance and good returns. Given that anything else will be deemed a failure, it’s surprising how many management teams accept PE backing without understanding how these investors operate and whether they are the right partner for delivering success.

The financial firepower that PE carries does matter, but there’s a whole lot more to it when it comes to growing a company. Nicola Mendelsohn, Executive Chairman of Karmarama, part of the PE-backed Karma Communications Group, explains: “It’s a really good model, if you get the right partners. It allows you to dream big and accelerate the ambitions you have and that can only be a good thing. But it comes down to doing your homework in the early days to make sure that the company and the people are the sort that you want to be tied to for quite a long time.”

In other words, the due diligence has to be done by management on potential PE investors and not just the other way around. There are questions to be asked about the lifecycle of a fund a PE firm may be drawing on to invest in a business, sector expertise and it never hurts to get references from portfolio companies (not necessarily those recommended by the PE firm).

Geoff Brady, Chairman and Non-executive Director of Harvey Jones Kitchens and until recently Chairman of Robert Dyas, says: “Probably half of the time, the board that is going out to get private equity investment does not necessarily understand the PE market. So [they don’t understand the need for] questioning what their normal churn lifecycles are, what fund it’s coming out of or when that fund is due for repayment, or the chemistry and whether you can work with these people… You need to talk to people they’ve done deals with before.”

According to Chris Hurley, UK Portfolio Managing Director at PE firm LDC, it is important for the management team to scope out how an investor responds when KPIs aren’t being met and dreams are turning to nightmares, as can happen in any business. “I’d want to know how a private equity house would deal with bad news. Would they be supportive if things got tough? If you ring someone up as a reference, and they’ve made five times their money on an exit, they’re going to say nice things.

“The best references, and the ones we give, are from people where things haven’t gone quite according to plan, but we’ve been supportive. It’s those companies, where we’ve seen them through the tough times, that we always use as the best references because they’re real.”

Iain Robinson, Managing Partner at consultancy AMG and former Chairman of business travel company Reed & Mackay during its sale to ECI Equity Partners, says: “A key question to ask the PE firm is around the specific experience and contributions made in successful investments with identical or similar businesses, and what criteria they are using to judge ‘similar or identical.’”

Launch pad

Once both parties are satisfied, the hard work can begin in scaling a business. Nicola says: “There’s no question that PE does bring a lot of strategic advice and support as well as the financial side. Obviously the money is a driver, but there is huge value in people that do this on a daily basis. I found their desire to make us more ambitious to be absolutely brilliant.”

The elements for achieving ultimate success (i.e. a lucrative exit) are the same as for building any good business. Chris comments that, certainly when evaluating a business to work with, there has to be a compelling profit story, a robust business model, a respectable market position and for management to possess both a strong track record and to be highly motivated going forward.

Tim Irish, Non-executive Director at the venture capital-backed healthcare concern Nexstim, comments: “There aren’t many young businesses with strong cash flow, and debt obviously increases the risks for your business, so patient investors who want a dividend or a crystallised sale at a later stage [are attractive]. You also get access to experts and networks, and a good PE or VC name backing you ups the interest in your company tremendously.”

In terms of exit timelines, market conditions in recent years have made trade sales or secondary buyouts harder to come by. Geoff says: “PE houses are taking a longer view. Whereas it used to be three to four years, I think now most of them have had to extend their investments because they’re waiting for some GDP growth and better news in the economy before selling.”

Horror stories do exist where businesses have been bought or invested in by PE houses at too high a price. As a result, they’re over leveraged and management and investors are simply running to stand still, unwilling to take the inevitable haircut.

Chris states that this must be watched carefully. “The business has to have the capital and cash resources to enhance its strategic journey by investing in people, products, plant and equipment or whatever it is the business needs. It can’t be about ripping every last penny out of the business to repay interest and to stay on the right side of banking covenants. It’s crucial you have a capital structure in place that doesn’t strangle the business and its strategy for growth.”

Again, the management team needs to take responsibility here when terms and conditions are being agreed to at the beginning. It’s all too easy to be blinded by year-on-year double-digit growth predictions and champagne visions of a wealthy post-exit lifestyle.

John Allbrook, Executive Chairman of IT financiers Syscap, comments: “People that I’ve spoken to very often find that the reality of private equity ownership is somewhat different to what they were expecting, so you need to go in with your eyes open. This isn’t just free access to capital.”

The rewards are there, provided you’re not blasé about the risks. “You can’t lock everything down before signing as the world doesn’t work like that, but there are more bases that you can cover than perhaps you think of,” says John. “The value creation strategy needs to be agreed, the board composition needs to be discussed early, alignment of interests needs to be determined and the exit strategy needs to be planned.”

If something doesn’t seem right, then walk away and look elsewhere as high-growth businesses will get backing given the money that a number of PE firms still have to invest. Paul Brennan, Chairman of cloud storage provider OnApp, says: “Go after the smart money. If they have limited experience in your sector, then they’re not going to help you very much [with the] industry experience and connections that could open doors… Just having good financial people inside the PE house is not enough.”

Derek Neil, Corporate Finance Director at professional services firm BDO, says: “They should bring more than just money to the table. Sector expertise is interesting as if they happen to have had a successful exit in the same industry, then they’re likely to understand it and the business you’re selling. Likewise, if you’re a retailer with five outlets and want to take it nationwide or international, then a PE house with a track record of going through that is likely to add value along the way.”

PE continues to be an effective accelerant for companies that are serious about achieving scale and growth, be that organically, acquisitively or a blend of both. From the perspective of management, it may be flattering to know that an investor is interested in the business, but you have to understand that, in the final analysis, the route to exit is what matters.

As Nicola puts it: “Your choice depends on how interested they are in your business. You want to know that they care about the opportunity as well as the very important question of whether or not they do really have the money.”

Please get in touch if you have any comments about the issues raised here.

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