Why business owners partner with private equity firms

Many stereotypes have been associated with private equity firms, such as reducing employee count to save costs, shutting down locations and making decisions only on financial metrics. While these situations happen sporadically, the vast majority of private equity firms focus on growing businesses, increasing headcount, expanding product lines and growth through acquiring additional related businesses.

When it comes time to think about succession planning and long-term business planning, there are many benefits of partnering with a private equity firm. Private equity firms seek to invest, grow and return capital to investors in private equity funds, which essentially are pools of capital that get raised from a variety of investors in the market. These investors are typically segmented into two types: institutional investors, such as pension funds, insurance companies, and endowment funds; and non-institutional investors, such as high net worth individuals and family offices. While access to investing in these funds can be somewhat limited as an individual, many investors look at private equity investments as another method of portfolio diversification, as it offers a different risk/reward profile than more generalized investments in the public stock or bond markets.

Like any other business, a private equity firm’s primary goal is to make money, and they do that by purchasing individual businesses and selling those businesses in the future for more money than the original purchase price. A simplified way to think about this is the “revenue” of a private equity firm is the enterprise value of a business when they sell it, and the “costs of goods sold” is the enterprise value of the business when they purchase it. In practice, there are many ways private equity firms can accomplish profitability and thus generate a return for their investors:

Earnings expansion: Purchase a company at eight times earnings, grow earnings, sell at eight times earnings.

Multiple expansion: Purchase a company for eight times earnings, improve non-earnings aspects of the business, sell at 11 times earnings.

Debt paydown: Purchase a company with 50% equity and 50% debt, pay down debt to zero, sell the company for same price and generate a 100% return on equity.

In an ideal scenario, private equity firms will attempt to execute on all three of these approaches, among many other more niche strategies to maximize the return for their investors.

Aside from generating a return for their investors, private equity firms also need to earn money for the firm itself, accomplished primarily via annual asset management fees and performance fees. Asset management fees are usually around 2% of assets under management. For example, a $500 million fund would earn $10 million in these fees per year. Performance fees, or carried interest, typically average around 20% of profits from investments after a certain baseline rate of return is met for limited partners and even higher profits when higher return hurdles are achieved. This profit flows to the general partner (GP) entity of the fund and results in long-term capital gains tax rates of 20% for the GP.

While some business owners fear the impact a private equity firm might have on their business, the right private equity partner can use its experience and expertise to greatly benefit a business. Successful private equity firms often will provide strategic and operational support following an acquisition that can help businesses with developing a detailed growth plan, process improvement, labor challenges and more. Some examples include:

Strategy development: Private equity firms can aid significantly in setting the short- and long-term strategy of the business. Short-term strategy typically focuses on low-hanging fruit, such as cost savings initiatives and infrastructure development where the private equity firm might have experience and/or advantages of scale through existing companies/relationships that smaller single business entities might lack. Long-term strategy focuses on what the company looks like in five years and the specific avenues to get there.

Knowledge sharing: Private equity firms often will host periodic meetings with leaders of their portfolio companies to share strategy and best practices. These meetings can help companies improve by learning from others facing similar challenges in the market.

Establishing a board of directors: If not already in place, private equity firms will seek to establish a board of directors for the company. Leveraging industry and business connections, they are able to recruit board members who have extensive insight into areas such as the company’s end markets and customers that can help improve the business going forward.

Capital for growth: Private equity firms often will earmark additional capital in a specific deal to invest in growth for a portfolio company. Examples include acquisitions, new machinery and equipment, facility expansion, increasing the geographic footprint, and additional people/talent.

Dedicated M&A support: Private equity firms significantly aid in all aspects of inorganic growth for their portfolio companies. From sourcing and executing add-on acquisitions to integration support, private equity firms help drive growth outside the core business.

Equity incentive programs: In a private equity transaction, the buyer typically sets up an equity option pool for a mutually determined employee group. While some firms focus primarily on providing these option pools to company leadership, others will open it up to the broader employee base. Specific structures can vary, but most plans allow employees to share in financial upside if business value grows above and beyond a predetermined value range upon the private equity firm’s eventual sale of the company. This helps align incentives for all parties and can provide meaningful compensation for the employee group at the second sale.

Private equity firms generally view their portfolio companies as partners. While the private equity firm can provide significant strategic, operational and financial support, they still need a management team to run the day-to-day operations of the business post-close. So outside of the incentive equity program, what strategies can the private equity firm use to keep those people motivated?

One of the most popular strategies is “rollover equity,” or the concept of the existing ownership group effectively reinvesting a portion of their proceeds from the sale back into the business in the form of minority ownership. This allows owners to realize a significant liquidity event and also provides monetary upside for a seller as they get a “second bite of the apple” when the private equity firm eventually exits the business.

For example, where 50% of the $100 million initial purchase price is being funded through debt, a 30% rollover only requires reinvestment of $15 million, or 15% of the business owners’ total pre-tax proceeds. Assuming 50% of the initial debt is paid down, and the equity value of the business has doubled to $200 million by the time of the second exit, the business owner stands to increase their initial $15 million investment to around $53 million, earning a three-and-a-half times multiple on invested capital.

Note: Rollover of equity does not guarantee profits, and use of leverage can accentuate gains and losses.

Final thoughts

To some people, partnering with a private equity firm is synonymous with large-scale negative change. The private equity “do anything for profit” mindset implies headcount rationalization and restructuring, facility relocation, etc. But in reality, today’s private equity firms are focused on driving value through revenue growth vs. cost reduction while offering people, processes and technology that can help owners and entrepreneurs to grow businesses, increase headcount and generate a return for all parties involved.