Private equity (PE) investments slowed in 2023, but experts project a pickup in activity for the rest of this year. That’s good news for CFOs who need the one thing these firms have in abundance: capital. KPMG estimates private capital players, including venture and buyout funds, have about $4 trillion in dry powder to deploy.
However, adding a private equity investor to the cap table requires some strategizing. The CFO may want more than capital from a PE investor. Is it worth possibly giving up a chunk of the company to get it? For CFOs wanting a passive partner, how do they assure the new equity holder won’t meddle?
Our Katie Kuehner-Hebert interviewed Bob Feller, CFO of cloud-based network management provider Auvik, to clarify the different types of private capital providers and their investment goals. In his nearly 28 years in corporate finance, Feller has worked for multiple private equity and venture capital-funded companies.
What advice do you have for growing companies interested in working with a PE firm?
First, agree on the kind of PE firm that suits the company’s long-term strategy. Private equity is a catch-all name for all kinds of investing entities. The general categories are venture capital, growth equity, leveraged buyout, distressed debt and real estate.
While venture capital (VC) firms differ from PE firms, almost all VCs are “private” equity. They generally invest in early- and mid-stage startups as well as high-growth companies. They can take minority and majority stakes in companies at early stages of growth, and they generally assume more risk in exchange for cheaper shares. Some VCs invest in late-stage companies and even some public companies via so-called “crossover” funds.
Growth equity firms invest in established businesses where they see the opportunity to grow revenue and increase profitability by applying their expertise across their investment portfolio. While they use debt to help finance and leverage their investments, they are more focused on increasing their portfolio companies’ valuations via revenue growth. Growth equity firms take both majority and minority stakes.
What kind of investments do leveraged buyout and distressed-debt firms target?
LBOs generally use more debt to acquire companies and want to generate higher cash flow, so they focus on profitability more than growth. They can generate substantial returns through fixed management fees paid by their portfolio companies, independent of revenue or profit growth. Most commonly, LBOs invest in unprofitable and struggling companies to make them profitable and generate cash. LBOs almost always take a controlling stake and change the company’s strategic direction.
Distressed-debt firms specialize in turning around troubled companies with poor credit ratings, including those in bankruptcy. Real estate PE firms raise capital to acquire, develop, operate, improve and sell buildings to generate investor returns. Both have their role in the right business model.
What are the benefits of bringing on a PE firm as an investor? What are the critical considerations before going this route?
Founders and management need to be clear about the company’s stage and what it’s trying to accomplish. For example, founders who have put a lot of time and energy into their companies over many years may be ready to cash out. In that case, they should prepare to leave the business—it does not matter whether they sell to a growth equity or LBO firm. The goal is to maximize the immediate cash value of the sale.
On the other hand, many founders and executives want to generate cash returns for themselves and stay with the company for future growth opportunities. In growth equity transactions, that is very common. However, the target and the investor should discuss and negotiate that before the sale. If the founders leave the business, they can retain minority equity stakes and make even more money when the PE investor exits.
Sellers need to understand the new investor’s (or owner’s) intended level of direct involvement. At one end of the spectrum are hands-off PE investors who buy well-run businesses and assist with growth opportunities. At the opposite end are very regimented PE firms that come in with a “playbook” and are very hands-on. The spectrum of investment models has pros and cons.
What questions should CFOs ask to determine if a partner will be a good fit?
- Why is the PE firm interested in the company, and what growth opportunities do they see?
- What size and stage of company does the firm usually invest in, and does your company fit their profile? If not, why are they interested?
- Do they have an industry or geographic focus? I am generally more attracted to industry-focused investors who can help establish best practices.
- What is the firm’s usual time horizon for an exit, and what holding period does it anticipate for your company?
- What type of exit do they see for the company? IPO? Strategic sale? Another PE buyer?
- Where are they on the continuum of hands-on to hands-off investors?
- Do they want to keep the founders or management, or both? Will there be a retention bonus, and what kind of equity stakes will the investor offer management?
How does a CFO find a PE investor?
Companies find PE investors in two ways: passive and active. The passive route tends to be an ongoing process. PE firms are very good at constantly finding and reaching out to private growth companies at all stages to learn about them and gauge their capital needs. Companies should be familiar with the PE investment landscape and where their company stands with potential buyers. Management must continually develop and hone its time horizon for possible next-stage investments or an exit.
Once a company is ready to sell a minority, majority or full stake, it must actively search for a PE investor. Typically, management should select an investment banking partner with experience selling to PE firms.
