Private Equity Funding: Looking for Investment Targets

by FEI Daily Staff

Though not easy, financing in this post-recession period can get done — particularly since private equity lenders are sitting on cash as they wait for the right opportunities to invest in and take businesses beyond the new business norm.

The recent recession produced numerous consequences. Rampant unemployment, plunging stock values, greatly reduced product demands and an over-abundance of financially strapped companies combined to create a risk-averse marketplace devoid of a steady flow of new capital. Throughout the past two years, investors of all types — private equity, venture capital and angel investment sources — have shown a greatly diminished interest in overly leveraged transactions. Although the record for the most lucrative buyout has been broken repeatedly over the past 10 years, many companies — especially those representing the industrial and retail marketplaces — have had a great deal of trouble finding new methods of funding since the economic decline began in 2008. Conversely, the downturn did not tarnish investor interest in several categories, including aerospace and defense, energy and health care. In fact, this was stated in a recent article in Becker’s Hospital Review, “Private Equity Funds Are Changing the Face of U.S. Hospitals.” And, they’re doing so by increasing their interest in nonprofit organizations, which have been challenged in their efforts to gain traditional funding to subsidize new information technology acquisitions and prepare for the costly onslaught of health care reform mandates. In addition, profitable hospital networks have also shown a growing interest in gaining funds to expand services into new communities through the purchase of non-profitable competing facilities. A recent Pepperdine University survey revealed that 11 percent of private equity investors polled intended to invest in health care — a significant increase over last summer’s results, when just 4.8 percent of PE managers reported an interest in health care investments.

Searching for the Right Investments

Similarly, other conditions and variables have demonstrated a ripening marketplace that has private equity fund managers actively searching for the right investments on behalf of clients. For instance, in the early 2000s there were approximately 3,000 PE funds supported by about $150 billion in capital in the United States. In contrast, new reports estimate there are now more than 4,000 mature investment portfolios with firms worldwide accumulating nearly $500 billion in “dry powder,” or cash reserves kept on hand to cover future obligations. PE fund managers that have been sitting on this extraordinary amount of capital for the past few years are now beginning to overcome their fear of risk and are actively searching for deals that will maximize client investments and legitimize their annual performance and management fees. The 50 largest funds account for approximately 70 percent of all PE funding. Of course, these banks and funds typically only focus on high-profile deals valued in the billions of dollars with major corporations. Lower-middle to middle-income companies have been traditionally underserved, given that there are normally significantly more sellers than experienced PE professionals who truly comprehend the potential of these performers. However, this trend is rapidly dissipating as PE managers are increasingly expanding their search for acquisitions with enterprise values ranging from $10 million to $500 million per transaction. This is especially true for organizations that can satisfactorily demonstrate high levels of customer service, the ability to respond to challenges and leadership qualities that inspire loyalty, forward thinking and the potential to drive greater profits at the next level. A recent survey of general managers by national accounting firm EisnerAmper LLC revealed that private equity firms are “racing to shape up portfolio companies to entice limited partners to put money into those new funds.” Furthermore, the same study by EisnerAmper stated that “most shops expect to see more acquisitions than exits in the first half of 2011 compared with the first quarter of 2010,” while 82 percent of the general managers surveyed were “eyeing assets in the business services industry and 81 percent targeting health care plays.” These findings have been reinforced by the general belief that PE professionals are actively searching for new deals and value-enhancing initiatives since many funds are facing investment deadlines over the next few years. Pitchbook, an independent and impartial research firm dedicated to providing premium data, news and analysis to the private equity industry, also recently reported that “U.S. private equity activity during the first quarter of 2011 remained steady with 377 completed PE deals involving $28 billion of invested capital.” According to Pitchbook, the middle market was also the leading driver behind this funding, “accounting for over 53 percent of the deal activity in the first quarter of 2011.” Other significant findings illustrated that most of these companies were the recipients of “their first outside institutional investment as their owners looked to private equity investors for growth capital, liquidity and operational experience.”

The Path to PE Funding

Private equity funds provide an infusion of needed cash into businesses, companies and operations with the intention of improving earnings and yielding favorable returns for investors. One difference is that private equity firms are relatively focused on mature businesses rather than early-stage companies or start-ups. Another is the primary goal of PE fund managers, which is to acquire the equity ownership of companies for the express purpose of growing that investment and then preparing it for purchase at a significant profit within the usual span of three to 10 years. In many cases, this could include the sale of the entire organization or individual business units bolstered through the incorporation of new IT and machinery, best practices, new strategic directions and enhanced management teams. In recent years, investments in middle-market companies have also provided private equity owners with relatively high returns, due to their ability to provide niche products and service offerings to markets that are relatively untouched by major corporations. Typical strategies entail working with management to jumpstart the company’s ability to reach the next level of productivity and significantly growing key metrics such as earnings before interest, taxes, depreciation and amortization (EBITDA). Specific infrastructure enhancements can range from the development of new distribution channels, products and services to the acquisition of other companies to fill voids. However, in the end, it’s all about the exit. PE fund managers are driven to increase the value of acquisitions as well as the prospects for high returns within the average of five years.

Weighing the Options: PE Pros and Cons

The expected expanse of private equity investing activity in the coming year is likely to provide many benefits to both corporate leaders and society at large. This new source of capital is expected to support numerous industries that are still reeling from recessionary woes and have yet to reap the benefits of governmental stimulus packages. For these companies and the communities they serve, renewed PE funding can be a vast and extremely valuable source for job growth, invigorating depleted markets and helping health care organizations to deliver advanced services to struggling areas. On the corporate side, there are also many reasons why a company would agree to sell all or part of its operation to a PE fund. First, corporate balance sheets often lack the growth capital needed given today’s economic climate. Even if capital is available, the timelines for new capital can prove too long for mature organizations on the cusp of discoveries or companies that are eager to seize opportunities in unique product sectors. For these operations, the prospect of capturing unclaimed markets or launching new therapeutic innovations is worth the sale of corporate interests to responsible PE partners that can help them excel in a particular industry. Second, public companies can be quite profitable, but they come with a burden. Shareholders can be extremely demanding, especially if they have a controlling interest in the organization’s day-to-day operations or are more concerned with short-term gains than long-term strategies. Conversely, PE funding can ensure that private companies stay private and grow according to the plans of current management, while aiding public companies in their efforts to buy out shareholders and reestablish private control. In addition, PE can also assist the company owner who simply wants to initiate his or her own personal exit strategy. Tired of the grind and wanting to spend more time in the pursuit of individual or other corporate interests, these executives often view PE as a method for maximizing growth and securing the funds necessary for the next stage of the business or their own life. But private equity funding can also have significant drawbacks. Most PE fund managers are interested in above-market-rate growth based on rigorous growth strategies developed in conjunction with corporate leadership. This process is often the best for inspiring the highest possible returns within the shortest timeframes. As a result, many responsible company owners have been burned throughout the years by PE funds driven by hyper-growth expectations. Sometimes this means investing as little as possible and “flipping” the company at the first opportunity with little regard to the operation, management, employees and even the public interest served by the operation. Other considerations can also include a greatly enhanced emphasis on accountability and oversight, which can be accompanied by the installation of detailed accounting and reporting timetables, investor veto rights, board involvement and managerial covenants, among other heightened obligations to the PE partners.

Due Diligence Works Both Ways

Private equity firms can spend anywhere from three months to several years to consummate a deal after first engaging an interested partner. Of course, this time can vary given their extensive due diligence process. As a result, it’s always prudent to plan for the sometimes lengthy transaction process involving detailed analyses of management, business strategies, competitive positioning, financial performance and profitability forecasts. Once this stage of the deal is completed, an offer is then submitted to the seller. If it is agreeable to both parties, the due diligence phase is initiated to verify previously presented corporate details and identify potential deal breakers such as unstated liabilities and risks. Subsequently, corporate owners should never consider this process a one-way street. In fact, due diligence should be performed by both parties to ensure acquisition interest is serious and that everyone involved is on the same page regarding corporate enhancements and oversight, reporting measures, new product and IT expenditures, cultural synergies, timing and exit strategies. This includes asking some very pointed questions. Among them: “Does the PE firm understand my business and industry? What is its track record with companies like mine? Why is it interested in my company? How will its investment change the operation and direction of the organization? What are the costs at every level in exchange for its funding?” Furthermore, there are numerous steps companies can take to position themselves to secure the best deal at the right time and under the best terms that offer the seller the greatest potential for successfully meeting their goals. This includes:

■ The detailed, quality presentation of professional business plans and financials that appropriately position the company’s growth potential, competitiveness, dedication to innovation and ability to produce the desired return on investment;

■ Outreach with M&A intermediaries, investment bankers and consultants, who can provide the proper introductions to PE fund managers that have demonstrated success working with companies representing specific industries and operational cultures;

■ The ability to listen and learn. Even unsuccessful business presentations contain lessons. It is essential to use both the negatives and positives to better prepare for the next meeting; and

■ Realistic assessment of the company’s financial situation. Don’t wait until the last moment to secure needed funds. It’s hard to broker the best possible deal when patience is no longer an option.

Staff Losses and the CFO Role

The ability to deal with employee defections is critical to organizational growth and sustainability during any period of change. Unfortunately, senior support staff that represents every level of operations often moves on, leaving chief financial officers and other C-suite executives in a lurch at the most inopportune times — including mergers, acquisitions and other intensive transition periods. In such instances, corporations are then forced to scramble for new talent to accommodate the stringent demands of PE fund managers, compile the necessary financials needed to finalize deals or even help implement the agreed-upon processes and procedures once the final terms of a PE takeover are reached. IT, accounting and nearly every other operational phase are not immune to the exodus of employees once ownership changes hands. Ideally, the perfect replacement candidates would not only be readily available to step in and seamlessly fill the void left by predecessors, but also bring fresh skill sets to deal with potentially frantic situations and at a price that is well within corporate budgets. But reality is seldom that kind. Such searches can prove costly and timely when both are nothing more than luxuries and the demands of new partners are pressing for results according to pre-determined timelines. In the absence of full-time assistance at a moment’s notice, or at least a matter of weeks, options should be considered on both a part-time and interim basis. Many times neglected as a viable option, replacements that do realize the parameters of their tenure before they arrive can prove especially advantageous to companies that need immediate expertise in numerous areas. During a massive restructuring, it’s important to acknowledge the success and failure of most businesses is largely determined by people. Once ownership is assumed, no matter the degree or percentage, PE fund managers will expect ongoing accountability for the length of their involvement. CFOs then have an obligation to meet those demands with the best available resources. An equally important consideration of all PE managers is the leadership qualities demonstrated by the company’s C-suite. This is especially true of the CFO and the entire accounting support staff, which will be directly involved and accountable for ensuring that the EBITDA and other significant financial goals are met during the investment horizon. Of course, a failure of confidence often coincides with the rapid replacement of senior financial personnel. As a result, CFOs and their staff must possess specific qualities if they are to succeed in a private equity environment. Generally, the most successful CFOs are extremely adept at teaming with CEOs and PE partners to achieve common objectives in a risk-filled atmosphere, demonstrating the ability to adapt to challenges and driving new organizational and technological solutions.

Though the world’s economy appears poised for better and more productive times, there is still an uncertainty about the future and the new level of business normalcy that will emerge. As a result, opportunities are beginning to develop for corporate leaders and private equity fund managers, who are painstakingly looking for smart, strategic and visionary ways to align resources and enhance profitability. Knowledge is still the primary factor for separating success from failure. Never underestimate the power of information and the capabilities of reliable partners that are available to help companies, no matter their current state, to grow responsibly in this highly competitive and still potentially volatile marketplace.

This article first appeared in Financial Executive magazine.