October 2016 was the best ever month for M&A with the US alone boasting half a trillion dollars in M&A transactions during the course of the month. And it doesn't end there. Many Private Equity Groups (PEGs) are flush with cash, desperate for the next deal and actively hunting down new prospects.
But is selling to a PEG right for your client?
PEGs make for some of the best buyers of businesses. And business owners love selling to PEGs because they can sell at substantially higher valuations - several multiples of what they'd get with any other buyer. However, there are important distinctions with a sale to a PEG.
- PEGs want to buy only established, high growth businesses;
- They want businesses that have a full and competent management team in place to drive growth;
- They want to initially acquire only a portion of the business while the original owners continue to hold the majority share and take responsibility for growth;
- PEGs then assist the management to scale up (and charge management fees for the privilege) and
- PEGs expect to exit the business by selling their stake in 5-6 years or so (and which time the majority owner can sell as well).
When selling a business to a PEG, rather than a financial or trade buyer, the main difference is that the sale is staggered, it's a longer term plan . Owners get a bite of the apple in the first stage i.e. cash for a portion of their shares, but with the majority of the payoff materialising only when the entire business is sold at the time of the PEG's exit. So, selling to a PEG is not for everyone.
What does a PEG look for in a business?
All investors tend to want the same things. That said, while a trade buyer may fill gaps in management - and may even prefer gaps in management so they can install their own under-employed staff - PE firms do have a strong preference for a good management team and often seek to incentivise management by giving them a share of equity. They also like sound systems, scalability / high growth prospects and, importantly, a clear route to an exit in about five or six years. They want solid, established businesses that have great prospects and that can demonstrate these great prospects beyond doubt. (Because, let's face it, every vendor thinks his business has great prospects, but not all businesses are on the verge of explosive growth!)
PEGs prefer businesses that have a platform that can be easily used to sell other products. And businesses that can be easily expanded through technology or by entering new markets / new geographical territories.
These investors tend to rely heavily on their risk vs reward assessment and vendors can play this to their advantage. For a PE firm to do a deal they need to see a certain level of return for the risk they perceive in the business. For a higher level of risk they require a higher return. To the extent the vendor can influence the investors' perception of risk he may be able to benefit from a higher price (i.e. lower rate of return for the PE firm).
PEGs are hard negotiatiors and will be looking for and exploiting every trick in the book to get the price down. Their staff are very experienced in chipping away at the price and every vendor would be well advised to be properly represented when dealing with these professionals and to use a business broker or other intermediary.
When should your client sell to a PEG rather than a trade buyer?
A PEG makes sense if the owner wants to extract a lot more money from the business and is prepared to a) continue running the business for a few years and b) take part of the payment now and part when the PE firm exits.
Where the business has a strong management team committed to long term success. If some of the team are likely to leave post-sale, that's not an attractive proposition for PEGs and it might be better for the vendor to consider targeting trade buyers.
A business is suited for pitching to PEGs if there is sound control, good systems in place, staff are regularly appraised, KPIs are being met, accounts are computerised and lend themselves to easy extraction of relevant data (good management accounts), accounts receiveable / aged debtors are tightly controlled, costs are under strict management, efficiencies have been extracted wherever possible and, all in all, the team is running a tight ship. Why? Because these are attributes PEGs examine very closely.
If the owner wants out within a short, fixed handover period, say a year or so, it's unlikely the business will be of much interest to most PEGs.
If the business needs growth capital, or one of the partners wishes to retire, or the owner wants to take a bite out of the apple and not lose control of the business (or where the owner wishes to diversify his personal financial risk by cashing in some equity in his business to invest elsewhere) it would be suitable for pitching to a PEG.
While popular opinion has it that PEGs are awash with cash, and it's usually true, it's not always the case. Some PEGs claim to be funded but in reality do not have liquidity. If they have to go hunting for capital after agreeing a deal with the vendor, there are several risks. First, they may not be able to raise the funds and that could put the transaction in jeopardy and second, the funds supplier may impose conditions that force the PEG back to the negotiating table even after a deal has been agreed with the vendor. The vendor should ask for assurances in writing that the PEG have 100% of the funds to cover any bid made and that they have the authority to complete. (If any third party, any PEG's internal investment committee, any bank or any other partner needs to approve the deal then that, too, could cause a hold-up at the last minute and/or a re-negotiation.)
A business broker or business transfer agent should be able to advise on the background of a PEG. The vendor should look at the PE firm's track record and whether their modus operandi is to strip assets, initiatiate large scale redundancies or otherwise seek to make a quick buck from some sharp financial engineering (loading the company with debt, for example). These PEGs are obviously to be avoided - they could over leverage the business and put the vendor's retained stake at risk. The vendor can ask to speak with owners of previous companies the PEG has acquired ...to get references.
Good questions to ask
Outside of the headline price, if the company need cash (working capital) - or management expertise - can the PE firm provide for those needs? What is the PE firm bringing to the table other than cash? What will they charge for whatever they're bringing?
As the old M&A cliche goes, time kills all deals . The vendor should ask for and get clear time scales. PE Firms can move faster than trade buyers. Vendors should take advantage and hold them to a quicker pace.
About Clinton Lee
Clinton founded The Exit Firm to assist business owners extract maximum value from their businesses whether selling through a business broker or independently. He set it up after a 30 year career building, buying and selling his own businesses.
He also writes on his areas of expertise for various business websites including AccountingWeb's sister publication in the UK.