A business owner who is considering selling their company, or an operating manager seeking to acquire a business for the first time, will likely view “private equity” firms as a possible partner in these sorts of transactions. Both types of entrepreneurs often think of private equity as a homogenous group where all participants apply a similar culture and strategy to growth after an investment partnership is in place. The reality is that the 2,800+ private equity firms in the United States and Canada can have significantly different approaches to value creation.
Many private equity firms create value through creative capital structuring or “financial pyrotechnics” as we often describe it. Two tactics are deployed by firms that use this strategy. The first tactic is using debt to execute the acquisition. Private equity firms are in the business of driving returns. Hence, the use of bank borrowings or other forms of debt to amplify returns is very common. However, some firms use the maximum amount of debt available from lenders without regard for the cash required to grow the underlying business. As a result, it is pivotal for a business owner to be open and realistic about their company’s future cash needs for growth investments and capital expenditures and weigh those crucial needs against the required debt payments.
The second tactic used by the “financial pyrotechnics” firms is the use of preferred equity. This approach allows the private equity group to take a larger piece of the pie in the future than might first be apparent at the closing. Preferred equity is a senior class of equity that can have any combination of features (e.g. dividends, liquidation preference, etc.) not possessed by the common stock. The primary issue with these structures is that they misalign interests between the private equity firm and the business owner. For example, a private equity firm may own 100% of the preferred equity (which typically carries an annual dividend of 12-14%) and only 51% of the common equity.This structure creates issues as the private equity firm can create value for itself and its investors simply by collecting dividends and/or its liquidation preference when the business is sold (often a multiple of the original preferred equity investment – e.g. 3x the face value of the preferred). In scenarios where the business does not grow as expected, this misalignment can be even more imbalanced because the private equity group’s preferred equity value - including dividends and liquidation preference - eats into the common equity value.
Driving returns through a creative capital structure stands in stark contrast to a less common approach used by some private equity firms.This enlightened approach is to be a hands-on partner, whose ownership is completely aligned with management, creating value primarily by improving the operations of the business. However, within this group of operationally focused private equity firms not engaged in financial pyrotechnics, there are two segments.
The first segment contains those firms that label themselves as “operational” simply because they employ “operating – partners”.Operating partners, who are often a different group of folks than those involved in making the original investment, arrive after the closing to work on operating projects essentially as consultants.In some cases, these consultant operating partners replace management.
The second segment of operationally focused firms are more willing, and have the experience, to work alongside their management partners to address the shortcomings of a business or implement new strategies to facilitate growth. Examples of these common goals can include human resources, information technology, inventory control, management depth, product development, etc. Private equity firms in this segment work in the trenches with a business owner and are wired to roll up their sleeves and tackle issues together often by applying lessons learned by the private equity team through similar projects performed at prior companies. This approach is dramatically different from dropping in a group of consultants to accomplish these tasks or simply directing the business owner to solve issues that he or she may or may not be comfortable handling alone.
Business owners that avoid “financial pyrotechnics” or “operating partner” firms, and instead partner with specific individuals they have come to know at operationally focused private equity firms, can de-risk their business and smooth the path to long-term value creation.
Lee Monahan, a Partner at Harren Equity Partners, said, “We believe that, in companies under $200 million in revenues, substantial value is created by growing and improving the business operationally in partnership with existing management. This is achieved without using ‘financial pyrotechnics’ which are unnecessarily complex and create a source of needless friction between a private equity firm and the management or ownership.” Mr. Monahan continued, “This partnership approach creates a situation where both parties are aligned – i.e. ‘we win as a team, we lose as a team.’ While working with a partner requires an open, honest dialogue to be successful, we believe such an approach is more likely to result in a business that outperforms, creating a superior outcome for all stakeholders.”
About Harren Equity Partners
Harren Equity Partners is a private investment firm dedicated to the growth and development of industry-leading companies through the creation of strong partnerships with outstanding management teams. Harren’s unique approach focuses on operational excellence and insightful strategic analysis, rather than financial engineering. The principals of Harren have significant operating experience and work closely with portfolio company management teams to continue to grow companies and improve profitability. Harren focuses on investment opportunities in the lower middle market, defined as companies with US$20 million to US$200 million of annual revenue in a broad range of industries in the United States and Canada. For more information about Harren, please visitwww.harrenequity.com
