Since I’ve been cycling in Europe, I’ve learned a lot about riding etiquette.
The French hate the wheel suck. He lurks in the back of the pack, benefitting from the shelter provided by the lead riders, who work about 30% harder than the guys at the back of the peloton.
The ultimate sin of any wheel suck is to embarrass the guys who have been pulling for him by sprinting past them on a climb.
Up until recently, I thought of Private Equity (PE) companies as the business world’s equivalent of the gloating wheel suck. The entrepreneur does the hard work, only to have a PE firm swoop in for the last leg of the journey and enjoy a disproportionate share of the rewards.
In the typical PE deal, the business owner does the sloppy job of getting the business off the ground and puts in the first ten or twenty years of hard labor. He/she grovels for money, lays people off when necessary, stands around embarrassed at trade shows when nobody visits their booth, and also collects the stubborn receivables. And the founder is the one who re-invents the business model year after year trying to find something that sticks.
The All Stars
Just one out of roughly three thousand businesses in the United States rises to a point of throwing off two to three million dollars of pre-tax profit. These are the all stars – the best of the best. Then all of a sudden, a PE company offers to buy the company.
The private equity guy is slick; he went to the right school and knows the right people. He offers to buy half of your business for a low multiple and then promises – through his Harvard savvy and father’s connections – to sell your company a few years down the road to a bigger business for a higher multiple. As the owner, you’re tired and eyeing the finish line, and since you’re keeping half the equity, you figure you’ll benefit from the “partnership” of Mr. PE.
My first-hand experience came when a couple of PE companies expressed interest in buying my last business. I met with partners from two firms and neither was able to articulate how their expertise would help my business nor answer my softball questions. They were book-smart MBAs who couldn’t sell ecstasy in Ibiza.
I’ve also personally known two entrepreneurs who took private equity money, and both recount their own version of a mercenary boss who put short-term profit for their shareholders over culture and vision.
Admittedly, I have a biased and mostly second-hand view of life inside a PE deal, so I was keen to see how Bob Pullar would rebut my pointed criticisms of the industry. Bob is a partner in the PE company Axis Private Equity Group (APEG) and he approached me to see if I’d like to write about his latest venture called The Owners University.
I believe Bob is one of the good guys and he has helped me develop a more positive view of the PE world. I haven’t totally changed my opinion, but Bob has helped me see that in some cases – if you find the right PE firm – they can, in fact, add value.
Here’s our unedited exchange
What are you seeing these days in terms of multiples being paid by PE firms for good quality mid-market companies? For example, imagine a company with $2M in EBITDA growing 10% a year – what would you expect it to command in the market?
Bob: Everything is dependent upon the industry and the specific situation of each company, but assuming a company is operating in a mainstream industry and the company doesn’t have negative aspects (i.e., customer concentration issues, inconsistent operating performance, or management succession concerns), companies with $2M in EBITDA can expect to see a purchase multiple of 2.5 to 4.0 times EBITDA. The range in the EBITDA multiple will be impacted by the percentage of the company that is purchased and the amount of bank and seller debt that can be leveraged in the transaction. The breakout of the purchase price in terms of proceeds to be paid to the seller is likely to fall in the following categories and ranges:
(i) Cash – 2.0 to 3.5 times EBITDA;
(ii) Seller debt – 0.0 to 1.0 times EBITDA; and
(iii) Earnout (1 to 3 years of future operating performance) – 0.0 to 1.5 times EBITDA.
Companies with less than $5M in EBITDA have seen a contraction in purchase price multiples paid by PE firms over the last several years. The reason for this is twofold. First, banks are less willing to lend to these lower size deals because there is less room for a downturn in the operations of the business before the company would be in default under a bank debt covenant. Second, PE firms are looking to achieve a targeted return on their capital; and if they can’t use debt to facilitate that return, then by default, purchase multiples are reduced in order to achieve that return. We’re not saying that is fair, but it is reality.
Are PE firms typically buying all of the company or just a portion of the business? And how long is the owner expected to stick around to get their earnout or “second bite of the apple”?
Bob: For many deals under $5M in EBITDA, a PE firm won’t buy 100% of the company but will look to buy a majority interest in the company. By buying less than 100% of the company, the PE firm ensures that the current owner remains involved to help keep the business on track, and that any transition issues are handled appropriately. This also affords the current owner an opportunity to participate in the “second bite of the apple” as the company grows in value in the future. The current owner will likely be required to continue to hold on to the percentage interest of the company that is not sold to the PE firm until the PE firm exits the investment. Any earnout will typically be determined in the first three years post-transaction, and the current owner may need to stay involved in the operations of the business during all of the earnout period.
Can you explain the strategy of taking “two bites of the apple” and how this is a good thing for an owner looking at exiting over the next few years?
Bob: If a business owner believes that there is upside value in the operations of the business, and that a new owner with greater financial resources and more business acumen can unlock that future potential better than the current owner, the current owner may want to consider retaining a portion of their existing ownership interest so that when the value of the business increases in the future, the current owner will be able to participate in a portion of that increase.
An owner may be willing to do this if they are bullish on the future prospects of the business and especially if they are going to be staying involved in the business to help drive that future value. This can enable the owner to achieve more total proceeds than if they sold 100% of the business at the time of sale.
This is a favorite subject at The Owners University. Most owners have managed their businesses to protect their nest eggs so they have steered away from risky market opportunities. But when we explain that a PE partner can offload a major share of that risk and work together with the owner to capture that untapped opportunity, the wheels really start spinning. We then help our owners create a business case that outlines the potential upside of having additional capital to capture a need they have identified. Depending on what the owner wants to do with his company and his career, the prospects of selling to a PE can become very attractive.
What would you expect our hypothetical company generating $2 million in EBITDA to garner if the buyer were a strategic and not a PE firm?
Bob: Again, everything is dependent on the industry and the specific situation of each company, but for a company with only $2M in EBITDA, a strategic buyer may not pay any more than a PE firm in terms of total purchase price as a multiple of EBITDA, and may actually pay less than the PE firm. However, the purchase price is more likely to be all cash at closing with no opportunity for the owner to participate in the future upside of the business. Although this may seem surprising, a strategic buyer will compare the purchase price of the company to what the strategic buyer would have to invest in their own business in order to achieve the same $2M EBITDA impact. Most strategic buyers will consider there to be less risk in investing in their own businesses as compared to acquiring an outside entity. Also, if a strategic buyer realizes their competition for the acquisition is a PE firm, they will have a good idea what the PE firm can pay for the company, and there would be no need to offer more total purchase price than the competition, especially if the strategic is proposing to pay a higher portion of the total purchase price in cash at closing. This logic changes dramatically, however, as the EBITDA of the selling company increases above $5M and especially as it exceeds $10M.
As business owners, we hear a lot about the downside of selling to a PE firm – so what’s the upside? Why would someone agree to sell their company to a PE firm if they have an offer in hand from a strategic?
Bob: It is unfortunate that business owners hear so many negative comments about selling to a PE firm. Savvy PE firms have access to the operational expertise and financial backing that can enable the business to grow much faster than it can under the current owner. The key for the current owner is to find the right PE firm that is a good fit with his or her vision of the future capabilities of the company. If the current owner and the PE firm are in agreement as to this future potential, they are much more likely to negotiate purchase terms that work for both parties. Selling to a PE firm can usually be structured so that the current owner participates in the future upside of the company, whether that be through retained ownership, earnout, continued employment in the company, or a combination of any or all of those factors. Selling to a strategic usually means more cash at closing but no opportunity to participate in the future upside of the business and potentially no opportunity to remain employed by the company.
What an owner wants to do in the future, and if they want to continue to remain involved in the business, should really drive their decision about which type of buyer is appropriate for their needs. We have discussed this in depth during one of our monthly webinars for our Gold and Platinum membership levels. Because understanding the differences between the two buyers is so critical, we now offer that content to everyone.
We would also recommend a book that outlines the value of the PE firm’s approach: “Lesson From Private Equity” by Orit Gadieah. It is an excellent discussion of the PE’s ability to grow companies.
A lot of people see PE firms as simply financial engineers (mercenaries?), adding little value. How would you counter this stereotype?
Bob: This comment may have been closer to reality a decade ago, but certainly not today. Because of the new bank reqs, PE firms now have to risk – in every deal – a higher percentage of their funds’ capital than they had to ten years ago. So they have become much more cautious in evaluating potential investments. The PE firms have created funds that limit the type of industries they can invest in and that align them with operational partners and investment partners who understand those industries.
In terms of returns, PE firms’ investments vastly outpace those of strategics year over year. One of the reasons for this is the PE firms’ laser focus on positively affecting the EBITDA of their portfolio investments. Net profits are important and can be attained in different ways, but driving cash flow is a lot different than driving profits. Warren Buffett views investing through the lens of compounding cash flows, and a PE investor is no different. The focus on cash flow results in better performing companies and is a key lesson we teach at OU.
If an owner was considering an offer from a PE firm, how would you coach them to do their due diligence on the PE firm? What questions should they be asking?
Bob: Great question. The first thing we advise business owners to do is talk to a few existing portfolio management teams and talk to them about a few investments that the PE firm has sold. A PE firm should certainly understand and honor that request, and the former owners are likely to be very honest in sharing their experiences with the PE firm. But, again, back to why we started OU. The amazing thing is that most owners never consider to ask these questions; they are often times too overwhelmed by the process to perform any meaningful due diligence.
As suggested before, the primary due diligence should focus on determining if the PE firm is a good fit for the owner and his or her plan going forward. Understanding the fund structure, investment objectives, and target industry are key aspects. But the primary consideration should be to determine who will be the lead partner or bench manager, and to see if the owner will be likely to have a good working relationship with them going forward. If the owner and the partner/manager can have a good working relationship, the chances of shared success are increased dramatically.
We have been running a very popular blog post series that details how PE firms make their acquisition decisions, and we outline the action steps an owner needs to take to better understand the PE firms’ approach. The first part of the series can be found at this link.
Given that strategics are awash in cash and capable of outbidding PE firms on quality deals, how sustainable is the PE business model right now?
Bob: PE firms have a lot to offer in terms of how they can package their deals, their access to operational personnel, and their extensive financial resources. PE firms will always compete because their investments can better meet the diverse investment profiles and the risk/return appetite of their Limited Partners. PE firms are the first ones to recognize a situation where they believe they can’t compete against a strategic buyer, so they typically won’t compete for those deals. However, most strategic buyers can’t compete with the returns achieved by PE firms.
Many owners tend to have a negative view of PE firms, which is unfortunate, and more importantly, highlights the fact that many owners aren’t aware of what they need to know about preparing their business for sale. PE firms are astute buyers and account for a fair percentage of total acquisitions in the middle market space.
In 2012, PE firm deals accounted for almost 18% of activity (1,334 in total) in the middle market space. These firms still have around a trillion dollars in dry powder to deploy (see PWC Report). By not understanding how a PE buyer can be beneficial to an owner, a company essentially wipes out a major percentage of potential buyers who are well funded, educated, and experienced.
Can you describe your vision for The Owners University? Are you intending it to be a profitable stand-alone business or a feeder of high quality deal flow to your Private Equity (PE) Firm?
Bob: The vision of OU is to be the “go to” resource for any business owner who wants to learn how to properly prepare their business and themselves for a sale or ownership transfer process. Our approach teaches an owner:
(i) the factors that drive business valuation;
(ii) what an owner can do to increase the value of their business; and
(iii) what to do when it comes time to sell or exit their business.
The OU approach applies whether a business owner ends up selling their business to a financial or strategic buyer, or transferring their business to other owners or family members. Our model allows an owner to begin preparing their business and themselves for exit in a private, self-paced environment that is accessible on any device and in any internet-enabled location.
OU is a standalone business and it is not a feeder of deal flow to our PE firm. OU was started because we realized there was an unmet need in the marketplace for teaching business owners about preparing themselves for exiting their businesses. Our experiences within our own PE firm and long time corporate development roles have confirmed this need.
Can you describe the ownership structure of The Owners University? Who are the owners and what are their “day jobs”? How much of your time do you personally spend on OU vs. your PE firm?
Bob: OU is owned 100% by Dick and myself personally and has been our primary focus over the last year. During that time we have concentrated on designing the underlying technology (content delivery, devices accessibility, peer interaction capabilities, etc.) and working with focus groups to determine the best content and delivery method. We have had feedback from business owners and trusted advisors, including CPAs, wealth managers, and exit planners; and through this, we have been able to develop a solid, unique program that is easy to understand and can be implemented by a business owner from day one.
We still spend time evaluating deals for our PE firm to invest in, but OU has become a passion. The prospect of teaching countless business owners how to improve their businesses and increase their chances of exiting their businesses on their own terms has proven to be incredibly exciting. Recently we have focused on our Gold and Platinum membership programs (for firms over $20M in revenues); forming partnerships with CPA firms, wealth managers and exit planners; and preparing to launch our Bronze (for firms with revenues of $5M and under) and Silver (for firms with revenues between $5M and $20M) memberships.