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Nine myths about private equity finance

Mo Merali Mo Merali

The economic turbulence caused by COVID-19 has left many mid-market business leaders finding access to finance restricted. Mo Merali explores nine of the common myths we come across when speaking to mid-market businesses about PE investment.

Myth 1: I will lose control of my company

Many CEOs and business owners are wary of pursuing private equity finance (PE) investment, fearing it will result in a total loss of control of their business. However, the objectives, strategy and day-to-day involvement of PE firms varies significantly. Investors may take a minority stake in the business with the previous owners maintaining overall control.

Undoubtedly, investor firms will introduce new reporting requirements and will play an essential role in company decision-making – even more so during the economic downturn. Typically, they will place an investment director on the board and, for many in the mid-market, this can be a welcome partnership, with the PE representative sharing experience and expertise from other sectors or portfolio companies.

Dinesh Anand, Global Head of PE and Partner, Grant Thornton India

"You're bringing in a partner who is going to bring a high level of operating efficiency and ideally provide you access to new talent or access to certain geographies you don't yet have."

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Myth 2: I'll gain short-term income not long-term capital

PE investors aim to buy equity stakes in businesses, actively manage those businesses and then realise the value created by selling or floating the business. The focus of most PE investors is on achieving capital gains, and there will be greater opportunity to achieve this as the economy recovers post coronavirus. In the mid-market, this will involve pushing organic growth strategies as well as seeking add-on acquisitions over the life of the investment.

Since the financial crash PE investors have an on average increased the investment timeframe, and many pursue environmental, social and governance agendas across their portfolios. Expect this trend to continue as we recover from lockdown. 

Meeting, negotiating and building trust with potential PE investors is one way of understanding what is achievable and desirable for your business.

Dinesh Anand, Global Head of PE and Partner, Grant Thornton India

"PE wants to do more value-driven business transformation, rather than purely come in and exit in the short term. The exit window for PE investment has grown on average to about five years from three to three and a half years. They're looking for a transformation to enable long-term growth and better return rather than just doing a cost stakeout and quick exit."

Myth 3: It's only an option if traditional financiers won't lend

While the volume of funds available is attractive, sometimes PE funding requirements are more suited to certain businesses over traditional lenders. Business leaders should consider the added benefits of sectoral, geographical experience and the extended network that potential PE investors might bring to the table.

Meanwhile, it should not be assumed that access to PE finance is particularly quick and straightforward, even when, as in a crisis, there are plenty of opportunities for PE houses; the average time to complete a deal is around six months and can take much longer. Although PE is currently sitting on a lot of liquidity and very active in seeking out the right investments, the criteria for investment remains high and requires significant due diligence.

Cyril Swale, Partner, Grant Thornton Channel Islands

"PE is a very efficient industry compared to what it was 15 or 30 years ago. There's a lot of PE chasing a finite number of good companies to invest in. We hear them talk about developing relationships with the owner, the family and the CEO, in advance of any formal, offer of investment. These guys are out looking for companies to develop relationships with, and they might not transact with them until five years down the road."

Myth 4: They're only interested in technology and biotech

High-tech sectors get a lot of media attention for the amount of venture capital they attract at a smaller scale. However, PE, which is more focused on larger businesses, is active in most sectors, including some very traditional or even struggling industries (like retail).

In Europe, healthcare and home care services are interesting to PE on the back of an ageing population, the growing market for these services and the disruption caused by coronavirus. In the US, food and beverage businesses are popular among PE with food tech and food delivery drawing particular interest in response to lockdown behaviour changes. Ultimately though, if the business can demonstrate that finance can achieve a robust return on investment over a period of time, investors will be interested.

Wilhelm Mickerts, Partner and Head of PE, Warth & Klein Grant Thornton Germany

"German automotive suppliers – part of the traditional German economy – are still very attractive to private equity, for example."

Myth 5: My business is too traditional for private equity

Businesses do not need to be the most up-to-date, using the latest systems. Finance itself can address some of those issues. However, businesses can take measures to make themselves ready for PE investment. Critically, you will need the right management in place, robust reporting processes, and a good understanding of the figures – all made more vital by lockdown.

Carlos Ferreira, National Managing Partner, PE, Grant Thornton US

"As a middle-market business, you don't have to have a perfect business to transact with private equity. PE firms like the middle market, and there are usually some issues in a middle-market business that need resolving. It might be a customer concentration, supply chain, professional management or systems issue. You don't have to have a perfect business to transact with PE. Good PE firms have a whole network of people to resolve some of these things."

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Myth 6: They are only interested in companies in distress

For the most part, PE investors are looking at businesses with demonstrable potential and a good price, which they can double or more over the time of the investment – even if the financials have taken a short-term knock owing to coronavirus. Some PE firms do specialise in buying distressed companies to turn them around, but this is more a niche.

Myth 7: They make their returns through asset stripping

PE's reputation is better than it was, and while firms with majority stakes have the power to asset strip, it is not usually their aim, and those types of scenarios are the exception and not the norm. Investors focused on growth businesses are looking to increase the value of that business so they can sell their equity at a much higher price than that at which they bought it. This is achieved in many ways through financing a growth strategy, such as new products, new territories, acquiring new businesses and transformative technology.

Some investments may involve reducing costs, but this tends to be about improving efficiency and rebuilding for a more stable sustainable business over the longer term.

Carlos Ferreira, National Managing Partner, PE, Grant Thornton US

"PE investors are great at identifying good businesses that need some help and investment to take them to the next level. That benefits everybody: the employees, the customers and the investor. PE firms are looking to grow and build businesses and get a nice return at the same time."

Myth 8: It will limit my exit options

Depending on the stake the business owner retains in the business, several options are open, including buyback of shares, selling to another PE or an outright sale to an existing investor. It's essential to begin the process with the end in mind. It is fair to say that historically there were only three exit possibilities generally available, these were: sale of the business to a corporate acquirer, flotation on a stock market or receivership and liquidation.

However, as the PE industry has evolved over the past few decades, a broader range of options have emerged. Notable among these is secondary buy-outs, which involve the sale of the assets to another private equity business.

In recent months, coronavirus has slowed the market for secondary buyouts with the reduction of large auction processes lining up five or six bidders. But there are still many exit routes for PE-backed companies. There is a colon at the end of this para rather than full stop:

Ultimately, for those business owners who enter into a PE investment with a clear sense of an exit strategy, the options need not be limited. Market conditions and valuations may dictate timings, but many owners and entrepreneurs that see private equity as a viable route to growth have realised significant returns across a range of exit routes.

Wilhelm Mickerts, Partner and Head of PE, Warth & Klein Grant Thornton Germany

“Transactions are still taking place and we are also seeing exits, albeit they are largely going to strategic investors rather than secondary funds. That comes down to PE investors on the buy side being more careful than they were 12 to 18 months ago.”

Myth 9: It's too risky

This again depends on the PE firm. There is an element of risk in any deal, but businesses looking for investors need to look at their track record, portfolio, consistency of returns and market conditions. Many leaders are anxious that PE investors will use excessive leverage to maximise their return on investment, which could put their business at risk. However, leverage is a common practice, and the proportion of PE-backed businesses that use leverage and end up in formal distress is small.

A lot of private equity firms actually take a prudent approach to finance and don’t want to try to over-leverage the business. In many cases, they want to use funding that’s available to them to develop and grow the business. This has been especially true in recent months where many PE firms used lockdown to de-risk their portfolios and shore-up companies for long-term security.

A successful deal requires entrepreneurs to change their mindset around bringing a private equity partner on to their business journey, rather than being concerned about the risk element.

Michael Neary, Partner, Corporate Finance, Ireland

“Many private equity firms have a preference to use low leverage in structuring transactions. This type of financing flexibility has proven to be beneficial to portfolio companies that have been severely affected by the impact of the COVID-19 pandemic. When assessing their PE funding options, many entrepreneurs and business owners are effectively choosing a partner to join them on their business journey.”

Speak to Mo Merali to discuss your private equity finance requirements.