Considerations When Selling to a Financial Buyer
Over the last 40 years, private equity (PE) has emerged as a significant influence in the capital markets and represents an option for selling shareholders that should be explored. In this article, we outline the major features of the industry, what drives decision-making, and the strengths and drawbacks of selling to PE. We hope this aids in decision-making and gives the reader an understanding of the nature and variety of firms in the industry.
Private Equity Industry: An Overview
Private equity has evolved significantly since its inception in the mid-20th century. The origins of private equity can be traced back to the 1946 founding of the American Research and Development Corporation (ARDC), which was among the first firms to raise capital from non-family sources for the purpose of investing in private companies. The industry began to gain traction in the 1980s with the advent of leveraged buyouts (LBOs), exemplified by Kohlberg Kravis Roberts & Co.’s (KKR) 1988 landmark acquisition of RJR Nabisco. This period marked a significant increase in deal sizes and public awareness, as well as the development of sophisticated financial engineering techniques.
Today, the private equity industry is a cornerstone of the global financial landscape, managing approximately $6 trillion in assets. PE firms now operate across a diversified spectrum, including buyouts, venture capital, growth capital, mezzanine financing, and distressed assets. The industry is characterized by its ability to generate superior returns through active management, operational improvements, and strategic oversight. With increasing regulatory scrutiny and heightened competition, PE firms are adapting by embracing Environmental, Social, and Governance (ESG) criteria as well as pursuing value creation in emerging markets. The current environment also sees a robust fundraising landscape, driven by institutional investors' growing appetite for alternative assets, further solidifying private equity's role as a critical driver of economic growth and innovation.
Approximately 11,000 private equity firms are operating in the United States. This figure encompasses a diverse range of firms from large, well-known entities to smaller, specialized ones. Of these, approximately 7,200 are buyout firms, acquiring companies typically with a significant amount of borrowed money and a relatively small amount of equity. The buyout sector within private equity is highly competitive, with both large, well-established firms and smaller, niche players actively participating in the market. When people speak of selling to private equity, it is typically to buyout firms although there are no bright lines separating buyout, venture capital, and distressed investors.
Buyout funds raise capital by forming limited partnerships where the general partner (GP) manages the fund and portfolio company investments and limited partners (LPs) provide the capital. These funds have a limited life, typically 10 years. The investment period is usually 3-5 years and the remaining 5-7 years is the period in which the portfolio company is sold. LPs, institutional investors like pension funds, endowments, and high-net-worth individuals, commit capital based on the fund’s investment strategy and the GP’s track record. Once capital commitments are secured, the GP embarks on sourcing and acquiring target companies.
Post-acquisition, the GP works to create value by implementing strategic and operational improvements in the portfolio company. This can involve restructuring operations, reducing costs, or investing in growth initiatives. The performance of a portfolio company is continuously monitored, with regular reports provided to the LPs. After a typical holding period of 3-7 years, the fund seeks to exit the investment through a sale to another buyout firm, a strategic buyer, or public offering, distributing proceeds to the LPs and GP.
Buyout fund managers are driven by a combination of financial incentives, professional ambition, and strategic objectives. One primary motivator is the potential for significant financial rewards. Fund managers typically receive management fees (usually around 2% of committed capital) and a performance fee, known as carried interest, which is typically 20% of the profits generated by the fund. Carried interest is taxed as capital gains making this compensation even more attractive for the GP managers. This structure aligns the interests of the fund managers (GPs) with those of the investors (LPs), incentivizing fund managers to maximize the fund's performance and achieve high returns.
Professional ambition and reputation also play crucial roles in driving buyout fund managers. Successfully managing a buyout fund and delivering substantial returns can enhance a manager's reputation and career prospects within the industry. This success can lead to larger funds, more significant deals, and increased influence in the financial sector. Additionally, buyout fund managers are often motivated by the strategic challenge of transforming and improving portfolio companies, which involves leveraging their expertise in finance, operations, and strategic management to drive growth and create value. PE has thus become an attractive career path over the last several decades for graduates from top business schools.
Sellers Beware
Selling your business to a buyout firm may have drawbacks, which may impact decision-making and the post-sale experience.
Loss of Control and Influence: Once the sale is complete, former owners and managers often lose control over the strategic and operational direction of the company. Buyout firms may implement significant changes, including restructuring, cost-cutting, and shifts in business strategy, which can be unsettling for the prior owners and employees.
Cultural and Operational Changes: Post-acquisition, buyout firms may impose new management practices, performance metrics, and corporate cultures that differ significantly from the company’s original practices.
Uncertain Future for Employees: Buyout firms often aim to improve operational efficiencies, which can include layoffs, restructuring, or changes in employee roles and responsibilities. The fear of job losses or significant changes in the work environment can create anxiety among the workforce, potentially leading to turnover and the loss of valuable talent.
Seller Notes, Earnouts, and Contingent Payments: In some deals, part of the sale price may be structured as a seller note and/or an earnout. Both are contingent on the future performance of the business. Earnouts can lead to conflicts between the new owners and the former management over how the company should be run to achieve these targets.
A Buyout Firm’s Ideal Acquisition Candidate
The best candidate for a financial buyer has a strong management team, operates in a growing industry, has revenue growth and/or cost reduction opportunities, is efficient in managing working capital, and has low capital expenditure requirements. Each of these characteristics contributes to the company’s ability to pay off debt with free cash flow, an essential element for a financial buyer who wants to maximize profit at exit. Typically, a financial buyer will keep key members of the management team post-transaction. If a seller is thinking of exiting their business and retiring, a financial buyer may still want the owner to remain in an advisory role for a limited period of time in order to provide a smooth transition.
While all deals are different, in most buyout transactions the key management team can purchase or retain an equity stake in the business to get a “second bite” of the apple, that is when the business is sold by the financial buyer in 3-5 years.
Recently, KKR has used employee ownership as part of its private equity strategy. A notable example is their sale of C.H.I. Overhead Door where employees received a substantial cash payout – on average approximately $175,000. This approach appears to be gaining traction. KKR helped to create the nonprofit Ownership Works to encourage other PE firms to adopt this practice. It is believed that when employees are given an equity stake and the possibility of a financial payout it will align the interests of all parties and lead to improved profitability. According to KKR, this approach allows the financial buyer to meet its targeted investment returns and reward the company’s employees. Here is a recent 60 Minutes episode on the subject.
Finding the Right Buyout Firm
Not all buyout firms are created equal. Buyout firms take on the culture and values of their founders and key partners. Finding the buyout firm that best aligns with the company goals and values will help avoid a host of problems post-closing.
When a seller chooses a buyout firm with shared values, it can significantly impact the overall success and satisfaction of the transaction. Several key reasons underscore the importance of this alignment:
Smooth Transition and Integration: A buyout firm that shares the seller’s values is more likely to approach the business with a similar mindset and operational philosophy. A harmonious transition is crucial for maintaining employee morale and productivity, as well as customer and stakeholder relationships.
Preservation of Company Legacy: For many sellers, especially founders or family-owned businesses, preserving the company’s legacy and reputation is paramount. A buyout firm that respects and shares these values is more likely to honor the company’s history, mission, and commitments.
Employee and Stakeholder Confidence: When a buyout firm’s values align with those of the seller, it can instill greater confidence among employees and other stakeholders. Employees are more likely to support and engage with the new ownership if they believe the firm will continue to uphold the company’s values and principles, which will also reassure customers, suppliers, and other partners. In today’s business environment, values related to ethical behavior, sustainability, and corporate responsibility are increasingly important. A buyout firm that shares these values is more likely to prioritize long-term, sustainable growth and ethical practices.
Choosing a buyout firm with shared values is not only about maintaining harmony during the transition but also about ensuring the long-term success and integrity of the business. This alignment can help preserve the company’s legacy, maintain stakeholder confidence, and drive strategic and operational success.
Conclusion
For whatever reasons a company is seeking a sale, financial buyers should be considered. However, finding the right fit is key. For a growing number of sellers, finding the right financial partner is more complex than simply choosing the highest price. Investment bankers are accomplished at maximizing value, for sellers who want to find the most aligned financial buyer, finding an investment banker to help you optimize all your values (financial and organizational core values) is paramount.
About EPOCH Pi:
EPOCH Pi is a Certified B Corp investment bank that serves purpose-driven companies that seek to provide market-based financial returns while considering their broader stakeholders. Our clients range from providers of clean technology and sustainable agriculture to old-line manufacturing companies that create meaningful work environments, have positive cultures, and treat suppliers and other stakeholders equitably. Our services include merger and acquisition assistance, the formation of ESOPs and for-purpose corporations as well as raising capital for growth or generating liquidity for shareholders. In every case, one of our criteria is the alignment of our client’s business purpose and vision with those of their prospective partners. At EPOCH Pi, we have developed proprietary assessment tools that facilitate values and cultural alignment in corporate transactions. Learn more about our services here.