Preparing for Private Equity Financing
Recently, typing the words private equity financing into a commercial search engine yielded 1,990,000 entries, more than a few announcing a funding victory.
“There is a significant amount of private equity capital chasing investment opportunities,” says Atlanta-based Fentress Seagroves, managing director in PricewaterhouseCoopers’ Transaction Services group. “And the pace is accelerating.”
Though private equity funds may be interested in a variety of opportunities that fit specific objectives, including turnaround situations, Avery Tuchman, a director with PricewaterhouseCoopers’ Transaction Services group in New York says, “the most marketable businesses tend to be those with solid cash flows, lower capital expenditure requirements, and products and services in markets viewed as growing.”
Of course, the objectives of a business will determine the types of capital it pursues. “If a company can borrow what it needs, a debt facility will ordinarily provide a relatively low cost of capital,” says Seagroves. “However, owners of mid-size companies seeking a way to get additional financing that their asset base or their equity base can’t supportor looking to create a liquidity eventmay want to explore private equity funding. Private equity can provide flexibility to achieve shareholder objectives, but it comes at a price.”
Why not just sell outright to a strategic investor? Again, that decision depends on the company and owner’s needs and objectives. “You have to assess the risk and benefit of taking only part of your money off the table up front, and selling your remaining share of the business laterversus selling the whole business all at once,” says Seagroves. “Private equity financing can be quite flexible, for example for objectives related to succession planning or unique structures, preserving employment for key employees, and other issues. Such considerations may affect pricing, and must be part of up-front discussions and negotiations.”
Since a private equity group is essentially buying into a business, the company needs to prepare itself as carefully as if it were selling the business. Obtaining the highest price in the marketplace hinges on fundamentals such as strength of the company’s financial position, the management team, business plan, customer base, and finding the right match. “You have to have financials that tell a story; a business infrastructure; a proven, capable management team; a business strategy; a growth approach; and specific objectives for the capital, such as whether it is going to provide some liquidity, but also growth,” observes Seagroves.
To find the right match, mid-size business owners must first know what they are looking for, and then do some research to seek out the private equity firms that may be interested.
“The owner’s decision to cash out and exit altogether as part of the financing arrangementor to receive some cash now but continue in a management role, and aim for a future paydayshould go hand-in-hand with the objectives of the private equity firms that are targeted,” says Tuchman. “Are they looking for an initial platform investment, or an add-on investment in a company that already has its management team in place?”
Owners expecting to stay with the business need to understand the fund’s planned ownership horizon, its ultimate exit plan for the business, and how that fits with the owner’s post-deal vision. “The typical private equity ownership horizon is three-to-five years, although it may be shorter or longer depending on a variety of factors, not the least of which will be the availability of attractive exit opportunities during the ownership period,” says Tuchman.
Tracy Lefteroff, San Jose-based global managing partner with PricewaterhouseCoopers’ Private Equity and Venture Capital group has been involved in hundreds of private equity transactions over the last ten years. He observes that the businesses successful in obtaining funding tend to carefully manage the number of firms they approach, the information they provide, and the quality of their presentation.
“Don’t over-shop your deal,” says Lefteroff. “Instead, target your potential investors with an eye toward focusing on five or six, and work through that process before you shop it on a wide basis. Otherwise, some investors could perceive they risk a bidding war, or that the company is encountering problems in the fundraising process.”
This is definitely not a time to save the best for last. When seeking a short list of potential investors, it is essential to research them. “Fund websites generally will tell you the areas they favor, and are most interested in,” says Lefteroff. “You can observe this from the investments they have made in the past, and see if there are either complementary or competitive investments in your space. This could have the added benefit of enabling you to avoid sharing your executive summary with a firm that has a competitive investment, and could use your information to your disadvantage.”
Private equity investors look for the strong qualities of a successful business, including a competitive advantage in the marketplace, a diverse customer base and the typical elements of a solid business strategy. Prepare an executive summary so a potential investor can get the main focus of the investment, and key data that you want to provide, without getting bogged down with extensive pages of detail to digest.
“You need to be able to articulate your company’s strengths and sustainable competitive advantage quickly, and how that translates into cash flow, because these funds are ordinarily looking at hundreds of deals,” notes Seagroves.
“Many investors call this the ‘elevator pitch’,” Lefteroff says. “You’ve got to make your summary brief and compelling enough to be able to say it in an elevator rideand spark enough interest that they would want to take the discussion further.”
Be prepared to back up your summary, as investors typically will expect to go through a comprehensive due diligence process. Tuchman explains: “Begin the exercise of putting together your management and financial presentations several months prior to entering into discussions with private equity firms. Watch for nonrecurring items that might distort your recent historical financial results or new business opportunities that have not yet been fully reflected in the financials, for example: restructuring charges, nonrecurring or non-cash write-offs, new customer wins or new contract terms with suppliers.”
From an overall business and operational perspective, investors will essentially want to understand the following:
- The market(s) in which your business operates
- How your business fits into its market(s)
- What your plans are for the future of the business
On the finance and accounting side, investors typically go through a due diligence exercise geared toward understanding future cash flow, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and the working capital and capital expenditure requirements of the business.
“If you’re going to go through this process, and especially with a private equity player, you need to invest the time and resources up-front, in preparation,” says Tuchman. “Be ready to discuss the financial metrics of your business, such as cash flow and EBITDA, as well as working capital and capital expenditure requirements. Understand it well, and consider whether or not you need to adjust the financial presentation, to adequately convey the earnings and cash flow potential of your company. This is an area where your professional advisors will be critical.”
Unless a majority investor is going to bring in its own management team, it will be focused on the strength of a target company’s management team. “Majority investors want some members of the current management team in the deal, to make sure that they’re as confident about it as the private equity group,” observes Seagroves. “That’s why you typically see them buying less than one hundred percent of a business, up-front. They want to be sure that management has the incentive to see that the business is worth as much as possible when it’s ultimately time to jointly sell.”
Seagroves notes, “To add to the premium a business commands, it will need clean books and its information linked together into an articulate presentation. It will also require a business plan that includes additional growth opportunitieseven acquisitionsto further tweak the interest of private equity investors, who are going to be looking at how to leverage the target company and make it grow.”
When in a position to evaluate offers, next steps include:
- Weigh the Risks and Issues Around the Bids Received Are there financing conditions? How comfortable are you that the deal can be financed at the leverage level the group is proposing? How is that leverage going to affect your business going forward and your ability to achieve your carry goals? Will it be over-leveraged?
- Compare Apples to Apples When You’re Looking at the Economic Risks and Return of Each Bid”It’s important to understand the non-economic issues around the structure of a deal, such as how much is to be put into escrow, and what the earnout is going to be,” Seagroves explains. “A lot of private equity groups will use creative structures including earnouts and convertible preferred investments; some use clawbacks and guaranteed return instruments.”
- Sort Out All the Important Issues Around Employees, Legacy, Operating Approach, and Chemistry with Equity Investors Early in the Process “If you want your management team to be part of the future, that needs to be articulated at the outset, for consideration by the private equity group,” says Seagroves. “But, you must understand there is a cost of special issues to the seller. If your issues weaken the management team, or if for some reason the private equity group thinks they’re being constrained, they’re going to offer less.”
- Understand that the Majority Shareholder You Select is Going to be Your Boss When the economics are equal, be sure to select the private equity group with which you have the better chemistry, the one that’s going to know your industry, or can add some value, as opposed to financial engineering alone. “Private equity is like a marriage,” says Seagroves. “It’s easier to solve problems with a partner if you have good chemistry-and it tends to work a lot better if you address major issues before you seal the deal.”
This article was written by Janice K. Mandel and originally appeared in Growing Your Business, a publication of the Private Company Services’ practice of PricewaterhouseCoopers.
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