The landscape of business ownership is changing dramatically. As a business owner, you’ve likely heard the term “private equity” thrown around at industry events or in conversations with peers. Maybe a competitor was recently acquired by a PE firm, or perhaps you’ve received calls from PE firms interested in your business. With over $2.5 trillion in private equity capital (“dry powder”) seeking investments as of June 2024, business owners are increasingly likely to encounter private equity firms during their ownership journey. But what exactly is private equity, and what does it mean for your business?
With decades of experience advising business owners, investing from a private equity firm and as CFO for multiple companies, we’ve seen these transactions from both sides of the table. In this guide, we’ll break down everything you need to know about private equity in clear, practical terms.
You’ll Learn:
- The key elements of the PE ecosystem
- An introduction to how PE firms evaluate businesses
- What to expect in a PE deal process
- How value is created after a PE investment
- What this means for you as a business owner
Demystifying Private Equity
There are four core elements to the private equity ecosystem:
- The Firm: A private equity firm is an investment company that raises pools of capital (called funds) from investors and invests the capital in private companies with the hopes of achieving a return on the investment. Think of a private equity firm like a real estate investor who buys houses, renovates them, and sells them for a profit – except instead of houses, they’re working with private companies. The firm itself is the investment company that employs investment professionals and business operators to improve and grow the business.
- The Fund: The Fund is technically the legal structure used to pool all of the investors’ capital together which will then be used to invest in companies. These funds last for a fixed period, typically 10 years, at which point all capital is returned to investors, and the fund is closed out. It’s common for a private equity firm to be managing multiple funds at any given point in time.
- The Investors: The investors who provide capital to these funds are called Limited Partners (LPs). These typically include pension funds looking to generate returns for retirees, university endowments seeking to grow their educational resources, and family offices managing wealth for future generations. As noted above, these LPs commit capital to a fund for a fixed period, usually around 10 years, with the expectation that the private equity firm will invest this capital in the first 5 years and return it, along with any gains, over the remaining period.
- The Companies: This is where you come in. This entire system is built to identify attractive companies, buy them, grow them, and sell them at a profit for the investors.
The uniqueness of this ecosystem is why the process of selling to a private equity firm is often intense and requires an increased level of preparation.
How Private Equity Firms Evaluate Your Business
The evaluation process that private equity firms follow is not all that dissimilar from the evaluation investors make of companies that trade in the public markets. Ultimately, private equity investors are trying to determine a value for your company and a thesis for why it can be worth more in the future. While financial metrics are important, they’re just one piece of a larger puzzle. The financial analysis starts with the basics: revenue growth, profitability trends, and cash flow generation (often short-handed by EBITDA: earnings before interest, taxes, depreciation & amortization). However, PE firms dig deeper, analyzing how stable and predictable these metrics have been over time and how they’re expected to change in the future. For example, they’ll examine customer concentration, recurring revenue percentages, working capital efficiency, and capital expenditure requirements. A business with slower growth but predictable, recurring revenue might be more attractive than a faster-growing business with lumpy, project-based revenue.
Beyond the numbers, PE firms also assess qualitative factors that aren’t always apparent on a financial statement. They’ll evaluate your market position and competitive advantages – what makes your business unique and defensible? They’ll analyze your management team’s depth and capabilities – could the business run without you? They’ll examine growth opportunities – are there untapped markets or acquisition opportunities? These qualitative factors often determine whether a PE firm sees an opportunity to create value.
Bottom line, the PE firm is trying to understand the “story” behind the business which will tie directly to your company’s valuation. Thousands of pages have been written on valuation (reach out if you want book recommendations), so we’ll keep it simple for now; the value of your business will be based on two factors: your earnings and a multiple (i.e. – your company produces $3M of EBITDA and sells for a 8x EBITDA multiple to arrive at a $24M company value). This matters to you as the business owner, because the better the story (meaning, the combination of all the factors that describe your business), the higher the multiple you’re likely to achieve. Understanding the range of multiples for your business and how to achieve the high end of the range is where the magic lies in preparing your business for sale and understanding how to best deliver the results that tell the story of your business.
The Deal Process
Deal structures in private equity can be complex, but they serve a purpose: aligning interests and managing risk. A typical transaction might include several components:
- The majority of the purchase price (usually 70-80%) comes as cash at closing. This is typically funded through a combination of equity from the PE fund and debt from banks or other lenders. The use of debt, or leverage, is a key feature of PE transactions that can enhance returns but also adds risk.
- Many deals include an earnout – additional payments based on achieving future performance targets. Think of this as a bridge between what you believe your business is worth and what the PE firm is willing to pay today. These usually span 1-3 years and are tied to specific metrics like EBITDA or revenue growth.
- Finally, many transactions include rollover equity, where you retain ownership in the business alongside the PE firm. This component serves multiple purposes: it provides continuity, aligns interests for future growth, and can offer tax advantages. The amount varies but typically ranges from 10-30% of the post-transaction equity.
There are many forms that the various components outlined here can take (a seller note that adjusts based on performance as an alternative to an “earn out” that gets at the same net result), rollover equity that vests based on performance, a seller note that is not based on performance and serves as additional leverage in the transaction (enhances equity returns in upside scenarios), the list goes on…having the right team to work through the various components and ensuring that you understand the moving pieces in negotiating the deal is what really matters.
An Overview of the Diligence Process
Once value has been identified and initial terms agreed to, private equity firms need to complete what is referred to as “confirmatory diligence.” Without the ability to rely on the public markets, public audits (and public scrutiny), private equity firms need to confirm that there are no major issues with the business that have not been disclosed and could disrupt their investment thesis. Firms typically work with multiple 3rd party diligence providers in order to further understand the business and ensure there are no unforeseen liabilities that they would be walking into upon closing the deal. These areas of diligence can include:
- Legal
- Accounting (quality of earnings report)
- Human resources
- IT
- Tax
- Insurance & benefits
- Industry diligence (a 3rd party industry report capturing size of market, growth rate, etc.)
- Supply chain
- Operational diligence (how lean is the business running?)
- Environmental
- And more…
The diligence process is typically the most difficult part for business owners because of the level of detail in the process and volume of work created. For example, in the list above, you can imagine 10+ different teams sending diligence request lists asking for information on their specific area. This is not a bad thing or an inherent problem, it just creates a large body of work that requires significant time and attention to execute on in order to get the deal done. This is where we see most owners overwhelmed. Knowing that this is on the horizon and having a plan to execute on the deliverables will greatly increase your probability of success.
Creating Value After the Deal
Private equity firms don’t just buy businesses – they actively work to improve them. Their value creation playbook can span a wide range of topics, including everything from simple operational improvements, to strategic growth plans, to maximizing value through financial engineering. Below is a short list of the example areas where a private equity firm can add value after investing in a business:
- Operational improvement. This might involve optimizing costs through better procurement practices or process automation. It could mean enhancing revenue through improved sales force effectiveness or pricing strategies. Often, it includes professionalizing various aspects of the business through better systems and processes.
- Strategic growth. Many PE firms pursue “add-on” acquisitions, buying smaller companies to combine with their initial investment. This can accelerate growth through geographic expansion, new product lines, or vertical integration. They might also invest in new product development or market expansion.
- Financial engineering. This could include optimizing the capital structure through refinancing, improving working capital management, or implementing tax-efficient strategies to pull capital out of the business.
What This Means for Business Owners
Working with private equity brings both opportunities and challenges. The advantages can be significant: access to capital for growth, professional expertise and resources, and strategic guidance. PE firms can help professionalize your business and accelerate its growth trajectory.
However, there are tradeoffs to consider. Whether you’re still in the business after the sale or your management team is left to run the business, the leadership team will likely have less autonomy in decision-making. There will be increased pressure on performance and more formal reporting requirements. Perhaps most importantly, PE firms typically plan to sell the business again in 5-7 years, which means another transition is inevitable. This may not have a direct impact on you if you’re out of the business at that point, but it can impact the employees and culture of your business over time.
Success in private equity partnerships often comes down to alignment – of expectations, incentives, and culture. Before pursuing a PE transaction, it’s crucial to understand not just the economics, but also how the partnership will work in practice. Do you share the same vision for the business? Are you comfortable with their decision-making style? Can you work effectively together?
Looking Ahead
As the private equity industry continues to grow, it’s becoming an increasingly important option for business owners to consider. Whether you’re looking to fully exit your business or find a partner to help fuel its next phase of growth, understanding how private equity works is crucial for making informed decisions about your company’s future.
Remember, private equity is just one of several potential paths forward. The key is to understand your options and choose the path that best aligns with your goals – both for your business and for yourself.
If you’re looking for more information on how to understand these moving pieces, we’d be happy to engage in a conversation. Feel free to reach out directly or click here to take our COMPASS Score as a first step.
Panoramic Capital Partners (“Panoramic”) is a registered investment advisor.
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