Three things that can help entrepreneurs avoid a bad marriage to private equity

“I know from having started three companies that getting a private equity deal signed may seem like a goal in itself, but that’s short-sighted,” says Tom Knauff, a Chicago-based entrepreneur and CEO of Energy Distribution Partners. When it comes to entrepreneurs and private equity funding, little thought is given to what happens after the deal closes — including whether your PE partner is focused on growing your company or just getting rich off of their fees.

Those fees range from management fees that cover a PE firm’s operating expenses and usually are from 1.5 to 2.0 percent of assets to performance fees that are usually 20 percent of any investment gains recorded by a private equity fund.

And here’s how PE fees can become a major issue: If a company has a unique product and sales momentum, many PE firms will reduce the sales force and essentially milk the brand. The job cuts bolster EBITDA in the short term and provide a rationalization to increase debt. The earnings to pay the debt service aren’t sustainable because the sales team has been gutted. A move like this is an immediate boost that can net an above average return. Longer term, it erodes the portfolio company’s infrastructure and ability to innovate and even threatens its survival. But the PE firm never loses because it collects fees on the refinancing, diverting millions of dollars that could’ve been used to fund real, sustainable growth.

“An entrepreneur’s goal in getting PE should be to use the capital and expertise of the PE firm to innovate in ways that benefit everybody with a stake in the deal,” adds Knauff.

Like Tom Knauff, Deb Schwarz, chief strategy officer and founder of LAC Group, a Los Angeles-based provider of library and knowledge management services, has used PE to help build her company.

“With PE investment, we’ve been able to innovate in terms of investment in infrastructure technology and bolster our leadership team with talented new-hires,” says Schwarz.

According to Schwarz, entrepreneurs will take risks and double-down on moving forward with innovation, a strategic hire or an acquisition if they are convinced the payoff is worth the risk. But, she adds, PE firms are all about the bottom line, specifically valuation and EBITDA; they may not make an investment based on the founder or the CEO’s instinct. What’s often lacking is chemistry between the entrepreneur and PE firm.

Getting private equity that will help you innovate means finding a PE partner who has a passion for your industry and shares your ambition for growth. While searching for funding, remember these three things:

  1. PE firms need you. Right now, there’s a glut of PE money and a shortage of high quality investments. The PE firms are under pressure from their investors to identify companies that have proven leaders, a strong financial track record and a growth plan that would benefit from capital. If you meet these criteria, you’re in a strong position to obtain funding and you should have the confidence to ask the hard questions.
  2. Ask how the PE firm’s partners are compensated. Both parties should have skin in the game. Ideally, the PE firm partners are sharing the risk by being financially vested in the growth of the companies they fund — rather than being compensated primarily by collecting fees. They should make money if you make money.
  3. Find out the PE firm’s average hold period. A PE firm that has indeterminate hold periods will be interested in funding actual growth versus pulling off short-term balance sheet maneuvers. For example, PE firms backed by family offices (instead of large institutional investors) will analyze an investment for how it can preserve and generate wealth over a range of time periods. Family offices are the financial management arm of the ultra-rich. And wealthy families have a centuries-old tradition of investing in companies over the long term. They typically help fund innovation through key hires, capital expenditures and investments in operations, such as sales and marketing. Hold periods can be five- to seven-years and beyond.

No matter which PE firm you sign a deal with, they’re going to bring a perspective on how to grow your company. As the entrepreneur, you have to make sure the PE firm’s agenda and yours align before completing the deal.

Eli Boufis is co-founder of Driehaus Private Equity, LLC, and executive principal of the firm where he oversees the investment strategy and works with portfolio companies throughout their investment cycle. He is a board member of Utility Pipeline Ltd, Iverify, Syntac Coated Products, GrowthPlay, focus4media, and Innovative Health. Before Driehaus Capital Management, Eli worked at Heller Financial’s International Group and Corporate Finance Group. Eli earned a B.A. from Vanderbilt University, and an MBA from the University of Chicago Booth School of Business. Eli is a co-founder of DePaul University’s Driehaus Symposium and a field director of the Horatio Alger Association. Eli is also a CFA charter holder, a member of ACG, YPO, and the Economic Club of Chicago.