Wednesday, December 08, 2010

WHY A PRIVATE EQUITY PARTNER IS YOUR BEST GROWTH OPTION

When working with corporate executives in the capital raising process, several told me that, to their knowledge, few senior corporate executives were aware of the opportunity to partner with private equity firms to acquire their own company. Thus, this Guide sets out to help those business executives who want to run their own show or for those corporate CEOs who need expansion capital to grow their business faster than might otherwise be possible using only bank debt or internally generated cash. In both cases, the Guide is aimed at those who need a basic grounding in the equity capital raising process because they may have not undertaken such an exercise before.

For the former group who seek to achieve the American Dream of owning a business, private equity is the only real alternative. With a small amount of personal capital relative to deal size, executives can buy out the company they work for or acquire a company they’ve targeted in their industry and do so with relatively little risk. This is due to the fact that when raising debt capital, banks require a personal guarantee. A private equity partner does not require a personal guarantee, thus eliminating the risk of losing personal assets. Personal risk is limited to the amount of personal capital invested in the deal along with the time invested to manage the company for several years.

A common misconception is that in order to participate in a private equity funded transaction, a fixed percentage of personal capital---as with a bank loan which typically requires 20% down payment---must be invested in the transaction alongside the equity group. For example, if a transaction is valued at $10 million, many entrepreneurs believe the equity group will require, say, a 5% or 10% investment by the entrepreneur, thus putting the transaction out of reach of most executives. But that is simply not the case. While equity groups almost always require the entrepreneur to have “skin in the game,” they don’t expect him or her to risk everything they own. Rather, they expect the entrepreneur to have a “meaningful” amount of personal capital relative to their net worth. Thus, someone with a million dollar net worth would be expected to invest significantly more personal capital than someone with a $250,000 net worth.

For corporate executives who seek to grow their business faster, but are capital constrained, private equity is the only answer. Partnering with a private equity group provides additional working capital for every day operation in addition to capital for acquisitions. In exchange for private equity capital, ownership control, but not operating control, of a business must usually, but not always, be relinquished to the equity capital provider. Principals of the equity capital group will become board members to provide guidance and direction in the operation of the business. They will also introduce additional industry resources and relationships, such as attorneys, accountants, joint venture partners and acquisition possibilities. The advantage to current shareholders is the company can grow faster and generate wealth more quickly than if the executive or company goes it alone.

To be sure, private equity is not for everyone or every company. Notwithstanding the substantial ownership control trade-offs, private equity is very particular about who it partners with and where it invests. The private equity firm is charged with investing its limited partners’ (LP) capital in companies in such a way that the return on the LPs’ capital exceeds the return which can be achieved through more traditional and less risky investments. Therefore, companies in which private equity firms seek to invest undergo stringent due diligence and financial analysis with the objective of achieving extraordinary returns at the time of exit three to five years subsequent to the private equity firm’s investment.

On the other side of the coin, the upside potential is significant when partnering with an equity group compared to what an entrepreneur or a company can accomplish using their own, more limited, resources. Once the equity group has made its investment, the CEO has the resources---and is expected---to grow the business as quickly as possible through both organic growth and acquisitions. Growing with acquisitions is the quickest way to increase revenues and earnings. As the firm grows, the integrated enterprise will multiply in value, and, at the time of ultimate sale, equity ownership will be multiplied several times over. This is a true wealth building opportunity.

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