At ROND, we see the private equity world a bit differently. We believe our industry needs more transparency and business owners deserve more information when deciding whether or not private equity makes sense for their businesses. To help crack open our industry and shed light on the way private equity firms do business, we are launching a private equity blog called PE Insider. This post answers the question: “What makes an attractive private equity investment.”
Before we dive into the specifics, let’s set the context by walking through a situation that many business owners face.
John Smith (made up name) is the CEO of ABC Company (obviously made up). John founded ABC Company ten years ago, and it’s grown into a successful and profitable business. Like many CEOs, each week John deletes emails from private equity firms who want to learn more about his business. John has a company to run. Why would he spend time talking to private equity firms when he doesn’t need capital?
Then, one of John’s friends sells her company to a private equity firm. John’s friend was able to take a lot of capital out of her business, retain a meaningful ownership stake, and continue running the company after the transaction. John is intrigued. Suddenly, the idea of a private equity investor doesn’t seem so crazy. It may be nice to take some chips off the table or have capital to pursue the growth initiatives he’s always wanted to.
John takes a few calls with private equity firms; however, he consistently receives the same message: “John, thank you for your time. You aren’t quite a fit for us right now, but we would like to stay close to you as the business grows.” What the heck. Why would these people hound him for so long only to pass on an investment opportunity? He has a great business.
The answer to John’s question is simple. His company doesn’t meet the private equity firms’ investment criteria. Investment criteria are a set of parameters used to evaluate an investment opportunity. Each private equity firm has a different set of investment criteria and lists these criteria on firm websites. You can view ROND’s investment criteria here.
But here is what the websites don’t tell you. Those publically listed criteria are just the tip of the iceberg for private equity firms. We have a much more robust set of criteria we mentally walk through every time we evaluate a new business. I’ve summarized this expanded criteria into eleven buckets to give you an insider’s perspective on how private equity firms evaluate businesses.
What makes an attractive private equity investment?
A+ management team
A strong management team is the most important element of an attractive private equity investment. We spend a lot of time getting to know management and evaluating their strengths and weaknesses. Strong management teams have proven executives, strong leaders, and industry experts. Most private equity firms will do a full background check on key executives before making an investment.
Strong market position
Private equity firms prefer to invest in market leaders. We want to invest in companies who are best positioned to lead the market and win new business. Companies should have strong products with meaningful value propositions that compete effectively with other industry players.
Track record of growth
Most private equity firms (turnaround firms excluded) want to see a history of growth. As a general guideline, established (non-startup) companies growing north of 25% are strong growers.
Multi-pronged growth strategy
If you want to get a private equity firm excited about your business, discuss your multi-pronged growth strategy. Companies that have the opportunity to become much larger companies get private equity firms excited. The prongs of a growth strategy are: 1) More sales of existing products to target customers, 2) Selling existing products into new customer segments or geographical regions, 3) Launching new products to the market and 4) Acquiring other businesses that achieve either one of the above or open up a new transformative opportunity.
Attractive customer dynamics
Private equity firms want to invest in companies with a diversified base of happy customers. We want to see low customer concentration among your top customers (limits the risk associated with losing a customer), increased same-customer revenue, and low customer attrition. Well-known customer names is a bonus and point of credibility, but not the end all be all.
The ability to forecast and predict future revenue gives private equity firms more confidence in ongoing growth. Companies with multi-year contracts, repeatable sales cycles, and recurring subscription revenue tend to be most attractive to private equity firms.
Ample free cash flow
Debt is often a component of a private equity transaction and paid with cash flows from the company. Since this debt is senior to a private equity firm’s investment, we seek to avoid companies with limited cash flow as they won’t be able to pay down debt, interest payments or cover operational costs.
Limited operational risk
Private equity firms evaluate the operational risk of each process and department within a company. Companies with high concentrations in suppliers or channel partners, with no available substitutions, are riskier. Companies without internal processes to manage sales, marketing, customer service, IT, etc., are also riskier.
Favorable industry trends
Private equity firms want to see a large, growing industry with favorable regulations and trends. We prefer to invest in industries that will exist for years to come, vs. industries that could become obsolete with new technological innovation.
Reasonable valuation expectations
Private equity firms invest other individuals’ capital, who expect a certain return. If we pay a high valuation for a company, we will have to get an even higher exit price to satisfy investors. Regardless of how great a business may be, if we don’t have a path to hitting our return threshold, we won’t be able to do the deal.
Multiple exit/return opportunities
Private equity makes most of its money when we exit companies. To sell a company, there has to be a buyer. We will evaluate the logical buyer universe before investing. An ideal scenario is a wide landscape of potential strategic acquirers as well as other private equity firms.
Why Does It Matter What Makes an Attractive Private Equity Investment?
While the above points are the elements most private equity firms look for in a business, there is no company that meets every criterion. However, if you understand how a private equity firm evaluates your business, you can better position your company for a more favorable private equity process.