Is Private Equity the Answer?

A Question Family and Management Owners are Asking as They Get Closer to Selling

There comes a time during the life of many family and management-owned companies when the owners and management consider pursuing a sale of the business.  This typically occurs at a point when the business needs additional investment for growth or development, yet the owners are at a stage of life (or risk tolerance level) where they are becoming more focused on estate planning or wealth diversification. 

Business owners have several options to consider at this point in life, including a sale to a competitor or some other industry participant (or “strategic buyer”), a sale to the employees (perhaps by using an ESOP) or a sale to a private equity investor.  Each have their pros and cons.  For example, while a strategic buyer typically offers the prospect of a 100% sale of the business, it can often lead to uncomfortable situations, such as undue confidentiality risks during the due diligence process before a transaction closes (that can impair a business should the transaction not close) or many terminated employees or closed facilities afterwards.  And, while ESOP’s can provide meaningful ownership to the employees who helped create the value to be realized by the sellers, such transactions can be complex to manage, do not typically provide market valuation or complete liquidity for sellers and usually leave the business with substantial debt.  Private equity offers an interesting alternative but, business owners should note that private equity owners are diverse and approach the process of creating value differently.

Private equity investors come in many different forms.  There are those who like to buy 100% of the business, some that want to buy a minority share (less than 50%) and many that prefer something in between.  There are those that use a lot of debt to finance a transaction and some that use mostly equity.  As a result, selling owners should think through their overall goals and objectives, and while price is always an important factor it is not the sole determinant to consider.  Some key questions to answer include:

  • Do I want to sell 100% now, or would I like to sell enough to diversify and de-risk my wealth and keep some equity invested in the business?
  • How do I feel about staying invested in a business that may have a lot more debt on it than I am used to?
  • How strongly do I feel about providing a strong future for all the management and employees?
  • Am I ready to fully retire, or do I want to stay active with the business for a while longer?
  • If I want to stay, what additional resources would be helpful in growing the company?

If the owner wishes to remain active (at least for a while), provide the employees an opportunity to continue the business as an independent enterprise with its existing culture or maintain an equity stake to participate in future value creation, partnering with a private equity investor can be an ideal solution. 

Most private equity firms that focus on buying family and management-owned companies (including us) prefer to partner with existing owners and management teams (no one knows more about the business, its risks and opportunities after all).  In most situations, the private equity investor buys a controlling interest (greater than 50%) and controls the board of directors going forward, but the existing management team and employees remain in place (and manage the business day-to-day) and the selling owners maintain a minority equity stake.  If done well, this arrangement can achieve many objectives of a selling owner, including:

  • Providing the owners meaningful liquidity on their investment and diversification in wealth;
  • Enabling the company to pursue strategic growth initiatives that have been postponed as a result of the owners’ concern with taking on such risks without more diversified wealth;
  • Allowing management and employees to retain roles and company culture;
  • Bringing on a value-added partner to assist in strategic planning and other key areas (add-on acquisitions, for example);
  • Providing the opportunity for the selling owner to realize an upside return on the equity they retain along the private equity partner when the business is sold again.

The most common private equity investment approach has been to try to maximize the use of debt when buying a majority share of a private company and then seeking to increase the size of the company by using operating partners to drive internal growth and make rapid add-on acquisitions.  This has been a successful approach to creating investment value in expanding economies and with under-managed companies.  However, it can be a troublesome approach when the economy cycles down or when the company has a solid management team that has been successfully growing its business. 

While less common, some private equity firms, like ours, finance their purchase transactions with a higher level of equity and modest level of debt.  Our multi-decade experience has demonstrated the ability for a private company to expand and create greater value with a moderate level of debt providing the ability to aggressively pursue internal growth avenues and take advantage of add-on acquisitions even in tough economic periods.

As a good example, we acquired 70% of a food processing business from four owners (two active in management and two passive) who were seeking to realize a return on their investment as they had all reached their early 60’s and were thinking about estate planning.  Further, due to their success, the business was running into capacity constraints and needed additional meaningful capital expenditures in the coming year or so and they were concerned with taking that on that kind of risk by themselves at that stage in life.  But, they did see the opportunity for the business to continue to grow after the capital expansion was completed.

Upon closing the transaction, the 30% equity position retained by the sellers was in the same equity as us (side by side with the same terms) and all employees remained in their roles.  We moderated the debt borrowed (and invested a higher level of equity) to provide the business a strong balance sheet from which to execute and to withstand unforeseen issues.  A plan was developed and implemented to complete the capacity expansion over the coming year. 

A couple years later, after the expansion was complete and the business had grown, the CEO-owner was ready to step back from his day-to-day leadership role.  We worked with him and the team to develop a succession plan.  While external candidates were evaluated, one of the internal sales executives was promoted to President and the CEO was elevated to a mentoring Chairman role.  At the same time, a new equity incentive plan was developed and implemented for the new President and other members of the senior team to more fully bring them into the ownership of the company.  

Several years later, after exceeding growth objectives, the business was successfully sold and the 30% retained equity stake of the sellers had yielded them enough such that they rolled over a meaningful amount into the next transaction.

If a family and management business owners carefully think through their overall objectives in realizing a return on their hard work of building their companies, pick a private equity partner who offers a solid value, but also aligns with their other important goals, such transactions can offer the best overall outcomes.