PE as Strategic Partner: The Evolving Role of Private Equity in the Middle Market

To outperform competitors and successfully vie against strategic buyers for quality assets, mid-market-focused private equity firms are taking on a new role: strategic partner. This represents a dramatic shift from the go-to solutions of cost cutting and financial engineering.

As Jeremy Swan, a principal at advisory firm CohnReznick LLP, says, “Looking back at the pre-2007 period, many private equity firms relied heavily on financial engineering for their returns. Given the market dynamics, they could go into a deal at 8X times a company’s cash flow, and with little operational effort, the market value could grow to 10X to 12X over a short period of time.”

However, Swan says that, due to the recent high prices and economic challenges, it now takes “some heavy lifting” for an investor planning on selling in three to five plus years to get to that return.

Creating Post-Acquisition Value

Given how much harder it is to earn returns from their investments, private equity firms now have to show their mettle. This is why, over the past several years, almost every private equity firm has adopted ways to try to create post-acquisition value for their portfolio companies.

David Fann, president and CEO of specialist advisor TorreyCove Capital Partners, says that the practice started with large private equity firms “but has now pervaded throughout the private equity ecosystem.”

He adds that private equity firms are now expected “to have a toolbox to grow revenue and cash flow, in order to enhance the quality of the investment exit.“ In some cases, the value drivers could also involve creating new markets, products, or making strategic acquisitions.

Fierce Competition

The value added by private equity firms also matters more today because the competitiveness for each deal is driving valuations to very high levels. “Many private equity firms are getting outbid by the strategics and end up not being able to compete with the multiples strategic buyers are able to pay in today’s market,“ Swan says. Non-financial buyers have strategic reasons to buy including geographic expansion and competitiveness considerations. “With deals selling at over 10X cash flow, in many cases, private equity is not going to get the return that they need without a strategic rational. Every deal has gotten so competitive.”

Not helping matters is the abundance of cash in the market for acquisitions. “There’s more overhang of private equity in terms of dry powder while strategic buyers have capital on their balance sheet,” says Richard Lawson, CEO of middle market private equity firm HGGC. He cites the copious number of non-bank lenders where firms can get above 6X EBITDA in terms of leverage. “Private equity has to bring something to the table to compete,” he says.

PE’s Involvement

With the case for being more involved in portfolio companies already apparent, it’s good to know how private equity’s operational role comes about.

According to CohnReznick’s Swan, most private equity firms will look to acquire anywhere between 51% and 100% of the business, and to stay involved, management usually will be asked to roll over equity. All told, private equity firms may end up owning 80% to 85% of the company. Private equity will likely have control of some of the board seats and many will bring in operating partners as board members to make key decisions, while leaving the day-to-day operations to the company’s management.

The number of these firms choosing to stay involved has increased. GF Data, which has proprietary data on buyouts in the $10-$250 million Total Enterprise Value range, tracks transactions with management continuity and saw that more than 90% of the buyouts in their universe included a post-management solution or continuity in 2015, which is higher than previous years.

Reaping the Rewards

For companies, there are advantages to this arrangement that are not provided by many strategic buyers.

Swan says that for a company sold to a strategic competitor, the chances are good management will lose control of the business.  Meanwhile, he says, “a mid-market company with a strong management team selling to private equity has a lot of chances to bring the company to the next level, retain a stake and have the benefit of additional capital as well as operational and professional expertise.” When the company is exited between three and seven years, the company that retained equity can get substantial value and additional cash.

Taking Over the Reins

With more companies having a continuity plan, the operational role of private equity becomes more important. But do these firms have this type of expertise?

Private equity firms are usually a mixture of both finance and operational professionals, Swan says. On the one hand, there are firms staffed with traditional finance professionals who came from investment banking or business school straight to private equity while other firms have a depth of operational expertise across the investment and operating partners.

But, according to HGGC’s Lawson, who was previously a CEO for a software company, the operational and transactional person should be one and the same. “That’s an evolution that has resulted in great returns. We home-grow our operational team and teach them,” he says.

Looking at mid-market private equity firms, what you find in the top quartile performers are that these firms’ investing principals have operating experience. Lawson says, “Investment teams that are able to generate alpha are usually former operators. They can only do so many deals in a year since they spend a lot of time as chairman of their portfolio companies’ boards.”

He adds that private equity firms that acquire companies and then bring in operating teams is a thing of the past in the mid-market, where there’s more control of the company and investment in personal relationships. “Sellers build a rapport with the private equity’s management team. They wouldn’t want to work with an operating team they’ve never met before,” Lawson says.