Dr Michael Smurfit once said that “equity is blood” and advised business owners to hold on to as much of it as they could. However, it is now recognised that raising capital through the sale of equity can help accelerate a company’s growth. Indeed, private-equity houses have become a critically important source of capital for businesses around the world. So should businesses avail?
What is private equity?
Private equity (PE) is a term used to describe investment partnerships that acquire and manage companies before selling them, says Patrick Spicer, senior partner in Matheson’s corporate mergers and acquisitions group. “Private-equity firms operate these investment funds on behalf of institutional and other investors.
“Private-equity funds acquire private and public companies, or invest in such buyouts as part of a consortium, and are typically differentiated from venture-capital funds in that they invest in or acquire mature companies, rather than start-ups or early-stage companies.”
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PwC Corporate Finance partner James McMenamin says private equity is an alternative asset class which invests in private companies which are not listed on public exchanges. Institutional and high-net-worth investors invest in private-equity funds as part of a diversified investment portfolio.
“Typically, private-equity funds acquire majority stakes in private companies,” he says. “They get involved in the strategic management of the investee companies with a view to growing the value of the business before realising their investment after a period of, say, five to seven years.
“The strategic management can involve moving the business into new product areas or new countries, appointing key executives or digitising the business processes. The private-equity firm will usually use debt as part of the transaction structure which can enhance the equity returns on the investment.”
Why should a company raise private equity?
A business might raise private-equity funding to support the transition of a founder looking to exit or take some money off the table and a strong management team looking to step up to a more ownership role, says John Bowe, corporate finance partner with Mazars. “It can be used for acquisitions or organic expansion plans [for example, investment in new facilities or expansion into new markets].”
David O’Kelly, head of mergers and acquisitions at KPMG, says that having the correct capital structure is one factor that enables companies to maximise their potential. “Often shareholders consider debt as the first option to grow their business. While debt is appropriate in a lot of cases, equity capital can have greater flexibility and enable companies to invest more to achieve an agreed objective.
“In addition, an interesting feature of private equity is that most transactions result in the management team receiving equity to ensure they are aligned and motivated to maximise value on a subsequent sale. This goal alignment can give a wider sense of ownership and the benefits of a common goal.”
He has seen several situations where founders have grown great businesses but feel their corporate decision-making has become risk-averse as their entire net worth is tied up in the company’s shares. “The personal de-risking achieved by taking cash off the table can allow founders to continue to drive their business forward without having to consider the downside risks for their family.”
Peter Bennett, Davy’s head of investment technology banking, says every situation is case specific and in some cases private equity is the right option, while other times it is not. “I would start with asking the question — if you were the owner of a company, what are you looking for? Do you want to sell control of your company, do you want to sell it outright, do you want to bring in a significant shareholder but someone who doesn’t necessarily have control, or do you just want to bring in some investment?
“The answer to that question brings you in different directions but if you conclude that you do want to sell your company and do want to relinquish control sometimes private equity can be a good option for that.”
The pros of raising PE
Bowe explains that “private-equity funds are not operators; they are there to support and often one of the immediate benefits is that it allows founders and management teams to take a little bit more risk because they are not as concerned about getting it wrong”.
“Private-equity funds have taken money off the table, freeing them up to make better decisions. Another benefit is expertise, excellent contacts and experience in what has worked and has not worked in other private-equity funds portfolio companies. Private-equity funds will also put incentive plans in place for senior management, which aligns everyone to drive future growth.”
And the cons
However, it’s not all smooth sailing. Founders are giving up a level of control, says Bowe. “For people who have built their own company up from the ground, handing over shares and relinquishing part of their control can be a difficult part of private equity.”
Alan Kelly, mergers and acquisitions director at Focus Capital Partners, says that by taking in private-equity investment you are usually starting the process of exiting the business. “The founder’s equity will be diluted and with this, generally the control of the company will move to the new investors [unless the PE firm is mandated to do minority investments].
“The previous owner may no longer be the key decision-maker on certain strategic decisions. Often there will be a set of restricted transactions such as key hires or acquisitions which will require investor majority or board approval.”
Choosing the right PE
Bennett says the growth of PE has been astronomical and firms come in all sorts of shapes and sizes. “There are domestic firms as well as international firms, some specialise in particular industries, some specialise in different sizes of transactions.
“If you are considering private equity it’s important to figure out who to target because some firms would be more relevant, and determining who to approach is really important because some will be relevant to you and a good fit and some are not.”