Understanding Private Equity Groups

Business owners who plan to sell or recapitalize their business may draw interest from private equity groups (PEGs). In fact, owners sometimes receive unsolicited offers from PEGs that are searching for investment opportunities. Current trends in the private equity industry show that it may be an ideal time for some business owners to consider a sale or recapitalization. However, many owners don’t understand the industry’s goals or how it operates. This article will give business owners an overview of the activities that PEGs perform and discuss why industry trends make it a seller’s market.

What Are Private Equity Groups and What Do They Do?

A private equity group is essentially an investment manager that raises funds to invest in private companies. The typical private equity investment process lasts around 10 years and consists of multiple phases, including:

  • Raising Capital
  • Searching for investments
  • Making an investment
  • Creating value
  • Exiting the investment

To establish a private equity “fund,” PEGs raise capital by securing commitments from wealthy individuals or institutional investors known as “limited partners.” Once the PEG, which is commonly referred to as the “general partner,” establishes a fund, it searches for companies that match size, geographic, and industry parameters defined by the fund’s investment criteria.

When the PEG identifies a suitable target, it uses the funds to acquire full or partial ownership of that company with the sole objective of enhancing the value of its portfolio and earning a sizeable return. The most common types of investments that PEGs make include:

  • Buyout: The acquisition of a controlling interest in a company, typically using a combination of raised funds and significant bank financing.
  • Growth/Expansion: Often a minority investment in a company in need of capital to fund major expansions or restructuring.
  • Distressed/Turnaround: Investment that involves purchasing debts from, or providing financing to, a troubled company while advising the recovery process.

In buyouts, PEGs typically view their investments as either platform or add-on acquisitions. PEGs see platform acquisitions as a starting point when establishing a new fund or entering a new industry/market. An add-on is essentially a smaller acquisition made by the platform company. Through add-on acquisitions, PEGs hope to realize synergies that result in cost savings and/or increased operational efficiency.

PEGs can be considered temporary owners. Once they make an investment, many private equity groups plan to spend a total of 4-7 years managing their portfolio companies and building value before exiting. As general partner, the PEG develops a strategy to build the value of its investments and provides capital to finance growth. A PEG’s principals provide financial support and advise the company’s leadership team on strategic matters in an effort to maximize value.

How Do Private Equity Investors Make Money?

The exit phase begins once the firm believes it has made satisfactory progress growing its portfolio company and can provide investors with acceptable returns. PEGs typically provide returns to investors by:

  • Selling their shares to a corporate/strategic buyer or another private equity firm
  • Paying dividends over the investment period
  • Recapitalizing (incurring additional debt to allow for a distribution)
  • Launching an IPO

PEGs generally collect annual management fees over the life of an investment, as well as a performance fee once they complete an exit. While fees vary by firm, management fees are typically 2% of a fund’s assets under management and performance fees are normally 20% of the profits generated by an exit. Occasionally, investors will set a “hurdle rate,” or a minimum rate of return (usually 8-10%), that must be provided to limited partners before the general partner receives performance fees.

Current Trends in the PE Industry That Favor Sellers

The number of companies owned by private equity firms has increased steadily over the last decade; however, since 2009, there has been a shift in the type of deals closed. PE firms are completing fewer platform acquisitions, but more add-on deals, than in the past. In 2004, add-ons represented 36% of all deals, but by 2013, that number had increased to 53%. In contrast, platform buyouts represented just 32% of deals that year, the smallest proportion on record. Growth/expansion deals have also become increasingly popular, comprising 23% of all transactions last year.1 This shift is due to a number of factors, including the high price of buyout targets, a difficult deal sourcing environment, and a new focus on growth and operation-oriented investing.

In recent years, valuations for both public and private companies have been elevated, making it an ideal time for PEGs to exit portfolio companies, but a difficult time for them to make new investments. Some private equity investors believe the competition resulting from a shortage of attractive platform acquisition targets is responsible for higher valuations. Consequently, as the economy slowly recovers, PEGs have been more focused on “buy-and-build” strategies that involve making less-risky add-on and minority growth investments that complement their existing portfolio companies. This allows PEGs to generate substantial returns by using their capital and operational expertise to integrate smaller acquisitions that provide synergies.

The growing demand for smaller acquisitions should continue through 2014, helping drive middle-market M&A activity. PEGs currently have billions of dollars committed from investors that have yet to be deployed. In fact, the level of un-deployed capital held globally by PEGs reached a record high $1.07 trillion at the end of 2013. PEGs have limited time to invest pledged capital before investors can withdraw their commitments. Therefore, firms will aggressively seek opportunities to invest their funds. A little more than half of un-deployed capital is reserved for buyout, growth, and distressed/turnaround investments.2 With interest rates expected to rise over the next 12 months, increased borrowing costs may cut into private equity returns. As a result, many experts believe PEGs will continue targeting add-on and minority investments that offer significant growth potential.

What Do These Trends Mean for Business Owners?

PEGs currently have a lot of cash and they need to put it to work. The combination of the current private equity investment outlook and PEG’s increasing interest in smaller add-on and growth acquisitions suggests that 2014 will be a strong year for middle-market M&A activity. In 2013, nearly 40% of all private equity deals were valued below $25 million while 60% were valued below $100 million, and deal volume increased each of the first three quarters of the year.3 Competition will rise between PEGs as they continue seeking investments in middle market companies. Most PEGs will be willing and able to pay a premium for strategic acquisitions that will help them achieve their growth objectives.

Many business owners are nearing retirement age, and while some have considered selling their companies, many others aren’t quite ready to exit altogether. Whether you are contemplating a sale or recapitalization, one of the keys to realizing maximum value through the M&A process is to create a competitive bidding market between interested buyers. Due to the high demand for add-on and growth investments and the excess capital currently under management by PEGs, many sellers can achieve this with the help of an experienced M&A intermediary. A team of trusted advisors will help you prepare for the marketing and sale process, attract interested buyers, and represent your best interests in negotiations.

1 Pitchbook PE Breakdown, 2014 Annual Report, U.S. Edition, p. 3-4.
2 Private Equity Industry Ends 2013 with Record $1.074 Trillion of Dry Powder, Prequin, Dec. 2013.
3 Pitchbook 4Q 2013 Private Equity Breakdown, p. 9.

This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.