Private equity (P.E.) is in the news again, most recently as part of the scrutiny surrounding Mitt Romney’s record at Bain Capital. P.E. firms invested $184 billion in 2011 alone, and are a growing fixture in the private company capital landscape. They were involved in the building of many of our industry’s largest players, including ProBuild, BMC, Builders FirstSource, and US LBM. But in spite of these high-profile endeavors, misunderstandings regarding private equity firms abound.
What Are P.E. Firms? They’re financial institutions that raise money from pension funds, college endowments, insurance companies, family investment offices, and wealthy individuals, and in turn invest this money into private companies that need or want capital. P.E. firms can buy majority or minority equity stakes or buy companies outright. In all cases, P.E. firms seek to grow their investments’ values over time through growth in cash flow and enterprise values of the companies that they invest in. P.E. firms seek to return their investors’ capital—plus profit—when they sell their investments, typically in three to seven years. Those P.E. firms that generate attractive returns for their investors over time will survive; those that do not will perish.
What Are P.E.’s Benefits? P.E. firms play an invaluable role in the economy by funding privately owned businesses that need or want capital but are debt-heavy or leverage-averse, are too small to tap public stock markets, and are too big to rely on angel inves-tors. P.E. capital can provide owners partial or full exits, create ownership opportunities for key employees, bolster balance sheets, and fund organic and acquisition-related growth. P.E. firms can also bring strategic and financial bench strength.
What Are P.E.’s Negatives? P.E. firms provide capital in return for ownership, which carries a higher annual cost of capital than does debt. Further, P.E. firms become your business partner. A misalignment of expectations from the outset (as with any partnership) can be destructive for all involved. In particular, the pressure that P.E. firms feel to generate returns for their investors means they are fiercely focused on maximizing the long-term profit and value of the companies they invest in. If you don’t share this priority, P.E. won’t be a fit.
Is P.E. Right for my Business? Private equity is the best fit for owners that can envision having a business partner and want some “chips off the table”—that is, to sell a portion of their business, Equally important are several other situations, including when owners want capital but don’t want to or can’t add further debt, want to bolster company liquidity, want to transition the business to a management team, and/or could use help with strategic direction or building the business through acquisition. Typically, pro dealers with more than $25 million in sales will be the best candidates for P.E.
Picking the Right Partner. As the number of P.E. firms has multiplied (there are currently 800+ firms raising money), they have diverged into more focused strategies to gain competitive differentiation. P.E. firms employ varying investment parameters (deal size, geography, industry, profile). Further, they differ in management styles, valuation approaches, holding timeframes, levels of day-to-day involvement, philosophies on leverage, and willingness to invest in non-control stakes. Like all businesses, P.E. firms’ track records of success vary greatly. Pick a P.E. partner not just based upon its valuation of your business, but also on its track record and alignment with your strategy, values, objectives, and philosophies. Discuss these items directly, and then trust but verify: Diligently check references, in particular P.E. firms’ past and current partners and portfolio companies, to ensure their past actions fit their rhetoric.
Matt Ogden is managing principal of Building Industry Partners LLC, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: firstname.lastname@example.org. 214.550.0405