We have all heard the horror stories from lower middle market business owners. Private Equity buyers will come in and get rid of all of my employees, borrow an absurd amount of money to finance the acquisition, thereby straining my company’s balance sheet and income statement, and then, light a match Goodfellas-style when they are done extracting value from it. But, I’ll let you in on a little secret? The days of financially engineering a path to outsized profits are long gone. While there certainly was an era where Private Equity funds looked to lock in a guaranteed “win” by over-levering the balance sheet, stripping the Income Statement of “fat”- read, people- and quickly flipping to monetize the win, those days are largely behind us. Today, most professional buyers value the team in place more so than any perceived competitive advantage with the product or service offering. I’ll say that again, buyers often view the team as the most important determinant of success- more so even than the core product or service offered by the business.
Let’s rewind a bit. The perception of private equity by most of society is pretty negative. And to be frank, that reputation, although dated, is well-earned. Many have read or seen (it was first a book and later adapted for film) Barbarians at the Gate. The book details the leveraged buyout of RJR Nabisco by Kohlberg Kravis Roberts (KKR) in the late 1980s. While there are many takeaways from the book, the one most recalled is the impact that the use of junk bonds to finance the transaction and degree of leverage overall had on the business. Several thousand jobs were eliminated as a result. This deal wasn’t a standalone incident but rather emblematic of a strategy of the times; Finance the transaction largely through debt, thereby requiring only a relatively small equity investment by the buyer and reducing headcount to service the debt and prop up profitability. This is one example of how one might financially engineer their way to a profit. The cost to the business is often catastrophic; still, by the time the downstream issues present themselves, the fund has either sold or doesn’t care as they’ve extracted enough out of the company to more than satisfy their investors (LPs of Limited Partners). So, this negative perception is certainly well-earned. But why is it dated?
I still often hear from clients that they believe private equity funds make their money by financially engineering a profit. They expect that a fund will come in and overly stress the balance sheet and get rid of half of the staff. While most cannot cite specific examples, they have heard stories from friends and business acquaintances. The stories they are referencing were born out of the 1980s and have become folklore. That is how folklore manifests. Stories are told and told until they become part of the fabric. I am reminded of the great John Ford western line, “The Man Who Shot Liberty Valance”. “This is the West sir. When the legend becomes fact, print the legend.” The point to take home here is, the notion that Private Equity is evil and will eviscerate the team and business may be a far more entertaining narrative, but it is far from the current state of affairs. By contrast, today’s predominant strategy employed by private equity funds in the lower middle market is quite different from the aforementioned.
Today, private equity funds tend to back founders and or teams. Their view is that they are buying a living, breathing business, not an amorphous blob of disparate parts. What makes the business a going concern, one meaningfully more valuable than the sum of its parts is the unquantifiables; The leadership team. The overall team. The culture. The collective knowledge and shared history. All of these things are as critical to the value proposition of a business as are the financial components like EBITDA and Revenue and margin and market share. Most PE fund managers don’t view themselves as operators but rather as levers. They bring people, processes, and technology to the fold, each of which can act as an accelerant when paired with the right business. They generally bring a Rolodex that, for example, assists in hiring the company’s first national sales manager. They may have an investment in a vertical market software business that will prove useful in the company. Perhaps they have back office strength that allows for better purchasing power of critical yet non-core functions such as insurance and benefits. They bring governance and strategic planning experience at the board level. Of course, they have deep pockets and acquisition experience that may fuel an acquisition strategy. They view themselves as an additive to the existing team and not as a replacement. Private Equity buyers prove their conviction on this front by often requiring or at least preferring that the founder and or the leadership team maintain a meaningful equity position in the business post-close. Frankly, in their eyes, the business is worth considerably less if they are forced to replace the leadership team. They are backing teams first, generally. If I were to rank the critical factors ordinally, I would rank them as follows: 1. Strength of leadership team. 2. Attractiveness of addressable market. 3. Elegance of product or service. It is your team, more so than your core business function, that attracts buyers today.
The use of leverage is quite different today than 35 years ago. Because PE funds buy companies to grow rather than milk, they tend to be very thoughtful about the degree of leverage employed. Even in the artificially low interest rate environment we’ve experienced for the last decade, it is rare to see buyers use more than 3x (EBITDA) leverage on a deal. While the cost of their equity is far more “expensive” than is the cost of their debt, it is far less burdensome. Equity doesn’t have the covenants found in senior debt that can be easily tripped or breached when cashflow is lumpy. While debt must be serviced, most equity requires no cash payments by the business to the shareholders along the way. Private Equity funds today balance the low cost of debt with the flexibility of equity when determining the optimal capital structure of any deal.
By contrast, during the LBO craze of the 1980s, funds often employed 90% or more debt in their capital stack. It is a very different world.
I wrote this piece not to convince any business owner that a private equity buyer is right for them but rather to dispel some of the myths that pervade the thinking today of many business owners. And this isn’t’ their fault. We all heard the horror stories. We’ve seen stories on the news and heard them told on the floors of congress. But, these stories are largely vestiges of the past. The world has evolved. The stories simply haven’t caught up. Or perhaps the actual story isn’t entertaining enough to tell. Clearly, in this regard, we have printed the legend.
Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com
Europe: Michael Lawrie at +44 (0) 161 359 4400 / Enquiries@BenchmarkIntl.com
Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com
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Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $8.25B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted thousands of owners with achieving their personal objectives and ensuring the continued growth of their businesses.