Over the past several months, I've had the opportunity to work with a wide variety Private Equity Groups (PEG). I believe there is a lot to be learned if you're a business owner interested in selling your business, but also from the buying side as an investor. In this article, we'll dive into the learning for both sides.
What is a Private Equity Group (AKA: Private Equity Firm)
Before moving forward, let's define what a Private Equity Group is, what it does, and also talk briefly about its distant cousin, Venture Capital (AKA: "VC Firm").
If you've heard these terms, they are often confused, but they operate in vastly different ways. VC, or Venture Capital firms typically invest in Start-Up or Early Stage companies. Many times, these are companies which haven't established a proven business model. For this reason, this type of investment is high-risk and VCs take a large stake of ownership for taking their investment risk.
Unlike Venture Capital (VC) firms, PEGs tend to invest in businesses which already have a proven model, established revenue and some degree of profitability. It is more common for PEGs to come in, inject additional capital and business systems to further drive revenue, before they exit (sell) the business.
In both cases, VC and PEGs are sophisticated groups of investors. For the most part, business owners and everyday investors have a difficult time interpreting a VC or PEG financial analysis. If you are a business owner who has been approached by either, you will want a solid, well informed group of advisors to help you along the way — don't try to go at it alone.
How do Private Equity Groups Invest?
Now that we have that out of the way, let's delve into how PEGs operate. PEGs are investment management companies that pools money from investors to buy shares in private companies. Thus, the name, Private Equity.
There are a wide variety of PEGs across many different industries. If there's significant financial upside in an industry, it's highly likely that PEGs have entered or will enter the industry to capture some of the potential value.
One additional detail that makes PEGs unique is that their shareholders are generally Accredited Investors. The US Securities and Exchange Commission (SEC) defines an Accredited Investor as someone who meets certain criteria to invest in complex or sophisticated securities that are not closely regulated as publicly-traded companies.
This big takeaway here is that both the shareholders (investors) in PEGs and the PEGs themselves are sophisticated investors. The PEG management are professional financiers and thus have access to knowledge and tools that the average business owner does not.
If this makes you a bit nervous, that's good. I always tell my clients that there's no competing with PEGs in terms of financial analysis. If there's discrepancies in your accounting records, they'll find them. So, it's always best to be transparent when dealing with PEGs. However, some of the nicest people I've met in this business are PE people.
What can we learn from Private Equity?
During the last year, I've begun documenting some of the learnings I've had with my dealings with PE firms. Here are some of my top takeaways:
PE firms think in terms of EBITDA, not Net Profit or SDE. Lots of letters in that first sentence - let's dissect it a bit:
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
SDE = Seller Discretionary Earnings
Seller Discretionary Earnings is a metric commonly used in the process of valuing a Main Street business — one with less than $1M of Seller Discretionary Earnings and Revenue of up to about $10M. Once you get into the lower-middle market, EBITDA typically is used during the valuation process. The lower-middle market ranges starts at about $1M EBITDA.
Private Equity Groups will always conduct a "Q of E" analysis. A Q of E, or Quality of Earnings analysis is conducted by a third-party and is a review of the seller’s financials and the structure of the deal. Third parties are independent and have no stake in the game, so they are generally unbiased and not influenced by any pressure to do a deal. The big takeaway here is that PEGs dedicate substantial resources to uncover and understand just how solid a business opportunity appears. While they will certainly take detailed notes of all conversations with a business owner, the Q of E analysis often reveals what can't be seen on the Profit and Loss Statement.
Private Equity Groups have fiduciary duties.
PEG directors have fiduciary duties owed to their shareholders and the corporations they work for. So, as personable as they may be, it's important to remember that they work for their investors, not for you. Often, PEGs will end up not submitting a Letter of Intent or Offer to Purchase after they've conducted a thorough analysis of a business. If this happens to you, don't take it personally — know that they are required by law to serve their investors' best interests.
Private Equity Group Analysts are the cream-of-the-crop.
Remember that math and finance whiz you met your freshman year of college? The one that seemed to just "get" all of the numbers during Corporate Finance 101 and Calculus 210? Well, after college she went on to get her MBA from Yale and is now sitting across the table from you. On a serious note, I've always found PE Analysts to be some of the nicest people in the world. But, they're scary smart! The takeaway on this point: don't be shy — ask them questions if you don't understand something they present to you. Or, depend upon your team of advisors to help during the process.
Private Equity Groups walk more often than they make offers. One distinct advantage PEGs have is that they analyze deals all day, every day. They are disciplined practitioners of Finance and Accounting and while they may like your deal, they won't fall in love it. If you are a business owner, it's tough to not fall in love with a buyer (figuratively speaking). The personality profile of an entrepreneur/business owner couldn't be more different than that of a PEG Analyst. However, it's important to note that having the discipline to walk from a deal is almost always a strength for a business owner.
Conclusion:
If you are a business owner that has been engaged by a Private Equity Group, it's important to educate yourself in a number of areas including the topic of business valuation. Engage a team of experts to guide you during the process: your accountant, attorney, business broker, and key mentors in your social circle. It's a rare event to have the opportunity to sell to a Private Equity Group — so, come prepared!
To your success,
Jason Huett Business Broker | CEO
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