A Second Bite at the Apple [the Ideal Private Equity Scenario]

Private Equity - a second bite of the apple

A second bite at the apple, in the case of Private Equity (PE), means selling part of the business and then working with the private equity partner to create value and sell the remaining holding in the company, which is likely a smaller percentage, at potentially an even a larger amount than the first.

But, before we go there let’s start with some basics.  Private capital falls into two camps: private equity (PE) and venture capital (VC).  Generally speaking, venture capitalists take early stage minority equity positions to help high-potential companies grow, whereas private equity is a much broader category.   Having said that, many private capital companies manage both VC and PE funds which makes it difficult to distinguish between the two.  Two examples of companies that operate both include: Battery Ventures and The Riverside Company

Private Equity Investment Types

Revenue growth will be a requirement in attracting private equity but use of funds can also be to provide partial liquidity for a sole shareholder or, to buy out a second or group of shareholders, or to acquire a competitor.  The part of proceeds that buys out a shareholder is called a secondary (the primary part being funds available to the company) and such a transaction is referred to as a recap.  What PEs and VCs have in common is that they will need liquidity (i.e. they will need to exit their investment) in a number of years and during the hold period they will need to create value to realize a return on their investment.

Many owner-entrepreneurs are cautious about exploring the benefits and opportunities private equity can bring to a growing business.  Entrepreneurs fear losing control and a change in culture.  A common impression is that private equity cuts costs by firing employees and then flips the business for a profit.  In my opinion, this is the exception. 

PE investments are typically:

–       Control positions ranging from 51% to 100% equity
–       Held for five to seven years
–       Part of a strategy to grow a strong competitive position in a certain sector (i.e. a buy-and-build strategy)
–       Will eventually need to be sold again; possibly to another PE

PE investments may be platform investments (a new investment in a new sector) or add-on/tuck-in acquisitions (smaller targets to grow/strengthen the platform).  In a platform investment, the buyer is looking for a market leader that it can use as a platform for growth.  A buy-and-build strategy.  Subsequent acquisitions or “add-on” investments will be one way to achieve this growth.   Platforms are usually more sizable investments and generally have minimum EBITDA requirements in order to fund acquisitions.  Tuck-ins can be very small when they are strategic.  One exception, where small companies are considered as platforms, is in the case of search funds, a recently popular vehicle for an individual to acquire and subsequently operate a single business. 

There is more risk in a platform investment because it comes with the challenges of learning a new sector and the target company’s competitive position in it.  When considering add-on investments the PE is effectively acting as a deep pocketed strategic buyer and looks to exploit potential synergies between the buyer and the target.  Add-on investments are called “tuck-in” or “tuck-under” investments because they tend to be smaller than the platform investment.

A second bite of the apple?

The following is a illustration of a recent transaction.  Jim founded his business, Innovative Technologies in 2000 and grew revenues to more than $15 million by the end of 2017.   Innovative Technologies (“IT”) is an industry leader in the engineering, design and manufacture of custom bearings for the automotive industry.  Its customer base includes some of the world’s leading automotive OEMs.

In his mid-forties, Jim wasn’t looking to sell his business but realized he had a passion for product development and engineering and felt he was missing opportunities to grow the business.  Jim partnered with an investee company of a leading PE company, Loder  Manufacturing (“LM”) which makes complementary precision-engineered parts.  By combining the companies, the larger sales force of LM gained a complimentary product line to sell to its customer base.  Jim sold a controlling position in IT but continues to lead his business as an independent division within LM. 

In speaking to his rationale Jim noted: “We ultimately decided to partner with LM as they share our vision for growing IT and can provide the financial, professional and operating resources required to accomplish our goals and provide our customers with the best bearing products in the world”. “I am also excited to be a shareholder in LM, and I look forward to helping LM accomplish its goal of building a first class manufacturing company.”

Private equity can bring more than cash

Private Equity can be a good partner for a company where a combination of capital and smarts can reinvigorate revenue growth.  In the example above Jim diversified his net worth by partially cashing out, but retains a minority position in the combined entity which is a bigger, more diversified, stronger company that will be monetized (i.e. sold again) in the next five years, effectively providing a second bite at the apple.

Recommended Further Reading

For more on private equity, see: Who Will Pay More – A Strategic or Financial Buyer?

For more on other forms of private capital, see:  Navigating the World of Private Capital