An FD’s guide to private equity
An injection of finance can spur a business onto new levels, it can also revive a flagging enterprise. Private equity is a popular method of boosting spending power, but it comes at the cost of control. So why do so many businesses give up controlling stakes in return for cash?
We explore how private equity works, and when it’s most useful.
How private equity works
A loan, for example from a bank or other financial institution, must be repaid, with interest, usually at regular intervals previously agreed. Private equity investors may take fees and dividends for their work, but the true payoff is realised when selling their stake for more than it was purchased for.
Therefore, investors have a vested interest in the organisation reaching its full potential. A loan, on the other hand, must continue to be repaid, regardless of whether it’s spent wisely or the organisation flourishes or not.
Private equity investors are generally groups of high net worth individuals pooling their resources into a fund. That fund will then seek out opportunities to maximise returns. They are attracted to businesses that aren’t available through the stock market, that have a strong source of revenue and potential for growth. The fund will then buy a controlling stake, hoping to help it grow over a period of usually five to seven years, then selling it on at a premium price.
How private equity can work for you
Private equity can be used to reach a new level of growth, to resuscitate a plateaued or declining business, or even as an exit strategy for the founder or investors.
Used as an alternative to loans, a private equity fund will put cash into a business in return for shares. It’s worth noting that it’s usually only of value to a fund to buy a controlling stake in order for them to have a say in decisions. So beware of what you’ll be sacrificing by pursuing this route.
This does bring advantages, however. The fund may have skilled and experienced directors which can help improve and grow the business. Your business may be able to benefit from their connections, supply chain or economies of scale.
Private equity funds may also be willing to buy out the current ownership completely, particularly useful if the owner is looking to retire, or pursue other interests. The fund may buy out the owner, investors looking to cash out their stake, or both.
This makes it an ideal exit strategy for many. In some cases, the fund may wish to retain some or all of the investors it buys out, at least for a transitionary period. In other cases, the fund will prefer to implement its own management team.
A private equity fund teaming up with existing investors to buy out the current owner is a common form of MBO.
Private equity funding may also be used to rescue a business down on its fortunes. Sometimes a company could reverse it decline, if only it had the cash to do so, and that’s when the fund steps in. A business due a turnaround is ripe for big rewards. But be mindful, this is a bigger risk for a fund – expect their purchase offer to reflect this.
And remember that you’re selling a controlling stake to a fund that may have different ideas about how to make money. You may have to accept that things are about to change, the payoff is that it’s all in the pursuit of success and growth.
How it works
Introducing private equity finance into your organisation is no simple task. After requiring potential investors to sign non-disclosure agreements, they’ll then issue a letter of intent if they like what they see. Then the hard work begins: the due diligence process. This can be lengthy, and even quite labour intensive, as the buyer seeks not only to understand every last detail of the business, but also to assess whether the company is worth their initial valuation. Many businesses hire in specialists at this stage to handle the due diligence process on their behalf. It saves from the management team getting distracted, and specialists have all the expertise.
Private equity can be a great source of finance. There’s a plentiful supply and it comes backed by a team quite literally invested in your success. But it also means giving up control of your business. For that reason, it’s important to look beyond the size of investment, and ensure that you’ve a fund that you’re happy to work with. Personality and values matter in a working relationship this close.
We have previously written about finding the perfect private equity partner (https://fdrecruit.co.uk/news/general-news/pe-insight-finding-your-ideal-private-equity-match) and also detailed what investors look for in a business so that you can broaden your appeal and improve your chances of finding a match (https://fdrecruit.co.uk/news/general-news/what-private-equity-investors-look-for-in-a-business)
Date Posted: October 26th 2016
Posted By: Phil Scott