Private equity firms use pools of capital that are raised from a variety of sources. This capital comes not only from wealthy individuals, but also from insurance companies (that pay retirement plans and annuities) and pension funds.
As a result, school teachers, police officers and others often have a portion of their retirement assets allocated to private equity, which bolsters the overall investment returns of the fiduciaries that run these funds. These higher returns are increasingly important in today’s low interest rate environment. Private equity firms use this capital to invest in all sorts of companies, creating jobs and economic growth along the way.
“Private equity firms are easily and inaccurately portrayed as corporate pirates,” says Jackie Hopkins, managing director, Sponsor Finance Group, at FirstMerit Bank.
“But these firms are willing to invest in businesses that need capital to grow as well as companies that might go bankrupt if not supported with new capital in exchange for ownership. In order to induce them to accept the risk of these investments, private equity firms need high returns. Sometimes the returns are very large. Sometimes the firms lose their investment. Either way, they provide critical capital that allows the economy to grow.”
Smart Business spoke with Hopkins, who lends to private equity firms, about how these serial entrepreneurs operate.
How does the private equity world work?
Private equity companies use pools of capital from investors, called limited partners. The general partner of the private equity firm is tasked with finding good investment opportunities to generate above average returns. The partner is usually paid operating expenses and a portion of the profits earned. In most cases, the general partner buys a controlling interest in a company with a leveraged buyout (LBO), and uses his or her expertise to improve revenue and profitability, such as helping a Midwest firm expand product sales internationally. After three to seven years, the company is typically resold.
What is a leveraged buyout?
In an LBO, an investor uses debt to finance a portion of the purchase price of a company. Depending on the underlying business risk of the transaction, the amount of debt can be very low or up to 65 percent of the purchase price. Using debt allows the investor to amplify his or her return. In addition, interest costs are deductible while equity capital is not, providing a built-in bias toward debt financing in the capital structure.
The debt to equity ratio changes depending on market conditions — today, the average equity investment for a middle market company is 40 to 45 percent in a LBO. For larger companies, it is usually less, because a bigger company can absorb more financial risk.
How is private equity financing different than traditional middle market bank loans?
Traditional middle market loans focus on the balance sheet —assets, inventory, receivables, equipment, real estate, etc. — so if the company is unable to service its debt out of earnings, the collateral can be sold to repay the debt.
Private equity financing tends to be enterprise value loans, looking at the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Financial institutions look at selling the entire company as an enterprise for a multiple of EBITDA. They consider how sustainable the EBITDA is to figure out how much debt the company can safely carry. So, if you think the average multiple of a middle market company is six times (that is, its total value is six times its most recent EBITDA), the bank might lend up to three times. The inherent risk is the possibility that EBITDA will decline or that the prospects for the company or the industry lead to a lower multiple. So to qualify for this type of enterprise loan, a company should have a sustainable level of EBITDA that is not too concentrated in terms of customers, products or suppliers, and is not prone to cyclical swings.
Jackie Hopkins is managing director of the Sponsor Finance Group at FirstMerit Bank. Reach her at (312) 429-3618 or firstname.lastname@example.org.
Website: Get information about FirstMerit’s Sponsor Finance Group services.
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I was recently having lunch with a private company CEO and the topic of private equity came up. When asked if he had ever considered seeking a private equity partner to fund and support his planned growth initiatives, his answer was expectedly, “No, we don’t want to sell the business yet. We want to focus on growing the business.”
While I can certainly appreciate his perspective, that opinion is consistent among many business owners and leaders. Namely, that private equity is primarily a liquidity mechanism, not a preferred tool to fund and support company growth. Moreover, many business leaders often see their growth plans as incompatible with private equity, which they associate with high leverage and limited financial flexibility.
This perspective of incompatibility was also on display during the recent presidential election. Private equity firms were broadly characterized as opportunistic value extractors, rather than enablers of company growth and job creation.
While the purpose of this article isn’t to defend private equity (there certainly are some firms worthy of this negative characterization), significant evidence exists to suggest that, in general, private-equity-backed companies experience proportionally greater growth. This is particularly true for small-to-medium-sized businesses.
Private capital a key to growth
According to studies performed by GrowthEconomy.org between 1995 and 2009, U.S. private-capital-backed business grew jobs by 81.5 percent and revenue by 132.8 percent, compared to 11.7 percent and 28.0 percent, respectively, for all other companies.
In California, over the same period, the story was even more favorable to private equity. Private-capital-backed businesses grew jobs and revenues by 123.1 percent and 155.2 percent respectively, compared to 11.3 percent and 26.4 percent for all other California businesses.
While each situation is unique, there are many reasons why private-equity-backed companies experience greater growth.
Access to capital
With the continued tightness in the credit market for small-to-medium-sized businesses, private equity can be a source of capital to support growth initiatives.
Additionally, private equity firms often have preferred relationships with lenders, giving businesses more access to attractive and flexible debt financing where appropriate. With greater access to capital, companies can more quickly, nimbly and opportunistically implement growth initiatives.
Strategic guidance and ongoing operational support
A private equity partner can provide much-needed strategic and operational resources to support the company’s growth initiatives and ongoing operations. This often leads to more thorough and refined growth strategies, as well as more effective plan execution and implementation.
Private equity firms often have large networks of industry experts and experienced operators that they can bring to bear to support company growth and operations.
Increased capacity for acquisitions
Private-equity-backed companies are significantly more acquisitive than other private businesses. Acquisitions can be an attractive source of growth, allowing companies to increase their customer footprint, expand geographically, create greater scale and enhance capabilities in a relatively short time frame.
However, successfully identifying, executing and integrating acquisitions can be very difficult. Many business leaders don’t have the time or experience to effectively pursue acquisitions. Private equity firms generally have expertise executing acquisition strategies and can be valuable partners in supporting companies as they identify, negotiate, execute and integrate acquisitions.
Private equity can be a compatible and effective tool to support and achieve company growth — not simply a mechanism to achieve liquidity. While private equity is not appropriate in every situation, and not all private equity firms are growth-oriented, business owners and leaders should carefully consider a private equity partnership when evaluating their ongoing growth initiatives and funding options.
Josh Harmsen is a principal at Solis Capital Partners (www.soliscapital.com) a private equity firm in Newport Beach, Calif. Solis focuses on disciplined investment in lower middle-market companies. Harmsen was previously with Morgan Stanley & Co. and holds an MBA from Harvard Business School.
The role that private equity firms play in our economy through business growth and job creation is fundamental. However, the general public — and many astute business owners — mistakenly think of private equity firms as if they were Gordon Gekko, character from the movie, “Wall Street,” taking over businesses, eliminating jobs and trying to make money by shutting down companies and selling assets.
“I’ve often been astounded by the disconnect between the actual performance of private equity-backed businesses and the general public’s perception of what private equity is all about,” says Scott McRill, CPA, director in transaction advisory services at SS&G’s Cleveland, Ohio, office.
As a result, the private equity industry has recognized the need to be more open and vocal about what they are, what they do and the positives they bring to the economy, he says.
Smart Business spoke with McRill about the misperception of private equity’s role and how companies can benefit from this type of capital.
How has the private equity market evolved into what it is today?
In the 1970s, many business owners who started companies with family money in the post-WWII era had limited choices if they wanted to grow their business. They could take the company public through the public equity markets, infuse more family money or sell the business outright to a larger company. Private equity capital became a viable alternative, giving business owners another option. If you compare the job growth of companies owned by private equity to the overall economy over the past 10 to 15 years, it’s pretty astronomical. From 1995 to 2009, private capital-owned companies produced job growth at a rate of 81.5 percent compared to only 11.7 percent for all other businesses. Similarly, in the same period, private capital-backed companies produced sales growth of 132.8 percent compared to 28 percent for all other businesses, a surprising statistic to many.
How have lending policies driven more businesses toward private capital investment?
The lending environment always goes in cycles, and the involvement of private equity as a rule hasn’t gone away. However, the ratio of how much funding comes directly from private equity firms in the form of equity versus from banks and lenders in the form of debt has changed.
In the mid-2000s, there was a lot of economic growth and private equity investment, but the amount of money private equity firms were required to put into deals was less as a percentage of the total capital required to get a deal done than it is today. For example, 80 or even 90 percent might have come from lenders in the form of debt and the remaining 10 or 20 percent in the form of equity capital.
After the credit markets froze in 2008, private equity continued to invest in businesses but became more cautious and were required to put more of their own money into deals. In 2009 and 2010, it was not uncommon to see 50 to 75 percent of the capital coming from private equity firms, and lenders only providing 25 to 50 percent.
The lending environment has loosened some in the past couple of years, but it’s still relatively difficult, which can be partly attributed to the uncertainty regarding tax laws, interest rates, etc. Deals in the past 12 months might have a leverage model that is, for example, one-third equity, two-thirds debt.
Where does the negative perception of private equity come from?
There are always risks from private equity, and news stories are often negative about a private equity-backed business shutting plants down or a company that went bankrupt. Of course that happens, but the raw statistics show in many more cases private equity helps grow businesses, make them more profitable and create more jobs over the long term.
Other negative connotations can be attributed to the misperception that private equity is a secretive ‘club,’ which is highlighted by the nature of the word ‘private.’ Private equity firms receive a management fee for their expertise, but make the majority of their money by growing companies, producing more profits within those companies, and typically selling that company to another investor and sometimes taking the company public. Many have assumed bad things are going on behind the scenes at private equity firms, but private equity firms normally want the company to expand and become more profitable.
How are private equity firms responding to the negative bias, along with pressure for more disclosure?
The private equity industry has realized that the negative perception has to be dealt with, and industry professionals are trying to open up a widespread dialog about the industry and the positive things it has done for the economy. At the same time, they recognize there is going to have to be more, rather than less, disclosure and transparency about the industry. By the nature of the ‘private’ equity investments, the specific details of individual deals are private and confidential and probably won’t ever be disclosed widely by the industry. However, the inner workings of private equity firms — how they operate, the management fees they charge and, most importantly, the story about the economic growth engine they provide for small businesses — could become more widely available, especially with the political pressure for disclosure.
Many very entrepreneurial and talented business owners or operators are really good at what they do. They are really good at making widgets, selling certain services and serving their customers. But, the private equity world is foreign to many of them; it’s not something that they’ve ever really needed to tap into, so all they’ve heard is the negative soundbites. A faction of very talented business owners still need to be better educated about the good things the private equity industry does to expand companies and create more jobs.
Scott McRill, CPA, is a director in Transaction Advisory Services at SS&G’s Cleveland, Ohio, office. Reach him at (440) 248-8787 or SMcRill@SSandG.com.
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