A CFO’s Life in Private Equity – Part I – Introduction
CFO.University note: In this 5 part series Kevin shines a bright light on the world of private equity that every small and middle market finance leader can learn from. His series provides insight that will help you do your job better, whether or not you ever do a deal with or work for a private equity firm. Here is part I with Kevin. Enjoy.
With over $1.6 trillion dollars available and returns that tend to be better than public markets, private equity firms are looking even harder and deeper at companies they can invest in. Many private equity firms are focusing on mid to lower mid-market companies as places to invest. These companies make up a significant portion of the economy and can generate attractive cash flow and returns for investors.
For many mid-market companies there are a variety of reasons why they would be interested in private equity investments:
- upcoming retirements of key senior managers
- capital constraints to grow the company
- the existing management team does not have the skill to take the company go the next level
- obtaining feedback on their business from a professional buyer
For the finance department, and most importantly its leader, an investment by a private equity firm usually results a dramatic shift in the way in which finance activities are done and the role that the finance leader plays. This change can be tough for some and unfortunately some do not make the transition successfully. But for others, their career can go to the next level as they suddenly have a very qualified finance partner who is motivated, has the influence with the leadership of the company, and the analytical “chops” to make some of the attractive financial decisions that many wish were made long ago!
However, many finance leaders are unaware of what happens up to, during, and after a private equity investment. As a result, many are caught off guard from the volume of work and magnitude of changes that are required only when the massive pile of work is in front of them! Over the next four articles we will review the phases of a private equity investment cycle and what it means to you, along with some tips on how to either get ready for the change or excel with the change. And even if your company never gets an investment from private equity, the improvement in processes, people, and technology that usually goes along with a private equity partner has real financial benefits to the company you work in. In fact, you may find that the new processes, financial disciplines, and additional insight may result in your company being more efficient and having additional cash that you can grow the company on your own!
Article #1 – Some of the Ground Rules of Private Equity
Since the 2008 financial crisis, the private equity industry undergone some significant changes. Most notably, it is evolving from being a largely debt driven buyout vehicle to a very active investor that often generates rates of return greater than public markets. Private equity firms are now going through the next evolution through leveraging their analytical skills and abilities to use data to further improve the returns from their investments.
Today, the majority of the value creation in a private equity firm comes from several steps:
- Purchase of significant ownership of a good business at a multiple of EBITDA. This becomes a known as a platform company.
- The private equity firm adds value to the platform company through improving processes, profitability, and the capability of the management team. If you were working with me you would see an initial focus on making your financial processes and controls more efficient so we can spend more time on value added activities such giving management insight as to where Return on Invested Capital (ROIC) can be improved, improving the financial processes around the management of working capital, and optimizing your cash flows.
- Purchasing smaller companies that are complimentary, but smaller, to the platform company. These “bolt-ons” are usually purchased at a lower EBITDA multiple than the platform company so the value added processes of the platform company and private equity firm can dramatically drive growth and profits.
- Selling the platform company and associated bolt-ons to a strategic buyer, another private equity firm, pension fund or in rare occasions, take the company public. This transaction usually happens with higher absolute earnings and increased EBITDA multiple than what the private equity firm bought the companies for. To generate the return the investors are looking for, this sale is targeted within five to seven years. Recently, some private equity firms are shifting to longer time frames as the time to create value takes longer due to a more competitive landscape. A few private equity firms, like the one I work in, invest in companies and do not seek to sell the company in the future.
- A private equity firm will look at hundreds to thousands of potential deals every year and close only a very small number of transactions, the majority of which are presented by a sell side advisory company. Some of the reasons why companies don’t make it through the filter of a private equity firm:
- Interesting business but no upside: A target return for a private equity firm is usually above 15%. If the company can’t grow significantly over the next five years even with focused execution and bolt-ons, it isn’t going to be an attractive investment.
- Problems with leadership. If there is no one ready to succeed the owner it means it is likely the first three years will be spent teaching a new leader about the company. As the investment timeline gets extended and the associated extra risks accounted for, the rate of return the private equity firm can offer its investors declines.
- The leadership transition has started late. Many business owner(s) decide to retire and want to sell the company within a year. But if there aren’t good people to step in behind and take ownership of the company, it can be difficult to attract a buyer with such a short transition period. While private equity firms will brag about their network and knowledge of the industry, no one can step in to your company tomorrow and run it nearly as well as it is being run today. This additional risk and time makes it less attractive for a private equity firm to make an investment in your company.
- The sale process is tough and often takes a long time. A former leader of mine called it the “treacherous walk up a narrow path on a mountain.” Anything can happen along the way in the deal cycle and most people come out of the process tired, whether a deal happens or not. There are a lot of traps along the narrow path that can kill a deal – from valuation to negotiations to risks being exposed in due diligence. These barriers can show up anytime in the process and kill a potential deal.
- There isn’t a match between the company and the private equity firm. Just as we don’t hire people because we don’t see a fit in culture and personality, this often happens in the filtering process where the culture of the private equity firm does not match with the potential portfolio company.
- Valuation Gap. Most often there is a gap in valuation between the seller and the private equity firm. The management team selling their company has worked hard to build their business and often see what other “comparable” businesses get sold for, believe their company is worth more, and often ask for a pretty high, or higher, earnings and EBITDA multiple. To create value a private equity firm has to increase the earnings of the company and the multiple paid on those earnings has to be higher than what they paid for it. If the seller has unrealistic expectations or is not willing to move on their valuation, it can easily kill the transaction. Further, I have seen companies represented by a sell-side company that has promised a very high valuation and multiple which makes it almost impossible for a private equity firm to see how they are going to make returns for their investors. So be very careful in giving guidance as to what a normal earnings profile looks like and the expectation of an EBITDA multiple as it is usually the first, but yet most important, hurdle in a deal.
- I Can Do This Myself. Many owners try to represent themselves in the sale process or hire someone who really isn’t familiar with the sale process for a company. As a result, the entire process is overly difficult from initial valuation and presentation to finding a potential investor to closing the deal. There is a lot of money at risk in the transaction and if the process isn’t run well, it significantly reduces the likelihood of a deal being completed or the seller’s target price being realized.
- Retirement isn’t easy. A lot of entrepreneurs are facing the facts about their own retirement when going through the sale process. For the unique group of individuals that entrepreneurs are, this can be a difficult life transition as well!
For all of these challenges, this is where you first job as the finance leader kicks in. Your job is to be the coach, provide guidance, engage the right advisors, and gather copious amounts of information to provide to potential private equity suitors. You will likely also have to provide some “tough love,” backed by numbers, to your current company ownership as to what their company is truly worth and if they want to realize a higher value in the sale what has to be done to create that value. Most importantly, this work has to start a couple years before you are serious about selling.
During the sale process most finance leaders are the go to person for almost everyone involved in the process. Being in finance, you “speak their language” in the company and you “speak their language” of the private equity firm. Your experience with lawyers, bankers, and contracts makes your insight and feedback invaluable to a transaction occurring. The majority of the confidential information in the sale process will be prepared and vetted by you. You will be called upon to give your opinion on the private equity firms that are brought in to look at your company. As a potential deal comes together you will have to bridge between maximizing the value for your current employer while not pushing too hard which may kill the deal. If you are not experienced in any of these activities, it can be a demanding job and even more so if you are not prepared or do not have the information ready.
And once the sale is done, you are now in the toughest job in finance! You are the natural conduit of information from your company to the private equity firm. Lots of requests will come back through to you while other requests, which can be different, will flow through the president. You will be helping the private equity firm really understand your company while performing analysis and insight in to areas of growth now that you have a new partner. Many finance leaders say this is the toughest part of the deal process as they feel like they have two bosses.
Over the next five articles we will review the key tasks you need to do as the financial leader in the private equity process:
- Get your financial house in order
- Survive the transition
- Onboard and get used to a new dance partner
- Experience the Bolt-on ride
- Get ready to do it all again
While each deal is unique, the final outcome is usually the same – increase the understanding of your company’s performance, make decisions on where additional value can be created, and ensure that the necessary processes, systems, and insight are in place to realize that value.
Part II of Kevin’s series, A CFO’s Life in Private Equity – Getting Your Financial House in Order is now available.
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