Guides
Your insider guide to private equity
How to evaluate a private equity firm
An entrepreneurial analyst from a private equity firm has contacted you through your PA or mutual connections. You are flattered that your business has received attention from a PE firm.
So, how do you evaluate this firm – are they credible, and is it worth your time to engage them? Before proceeding further, you may want to learn more about determining a PE firm’s credibility.
Business owners engage with private equity firms for a few reasons:
- You, and/or your business associates are looking to sell the business and retire.
- You are looking for capital to grow.
- You hope to hear fresh ideas on expanding your business. The well-paid and starry-eyed PE analyst has a good idea or two that you have not considered despite your decades in the business.
In all 3 cases, it is worth understanding the different private equity investment styles before deciding to engage further.
1st question to ask: Does your firm do mostly buyouts or growth equity?
Investment style Buyout Growth equity
Level of control You give up control to the private equity firm.
They may retain you as MD/CEO via golden handcuff (paying you an indecent amount of money to make sure you stay) but will not hesitate to replace you should there be disagreement in strategy or execution.
You will still be in control of your business as they take a minority stake.
Here, chemistry with the deal principal is important as you will be ‘married’ to him or her throughout the tenure of the investment.
Capital paid to business vs. shareholder Most of the capital will be paid to you as they are buying control.
Often, there will be a portion of capital to be injected into the business to fund growth opportunities.
Most of the capital will be injected into your business.
They may consider buying a small amount of equity from you as a ‘sweetener’.
Most PE firms specialise in buyouts or growth equity, as the required skill sets to succeed differ. Some PE firms do both, although it will be interesting to ask them about the relative proportion of deal types.
Going back to the 3 primary reasons for engaging a private equity firm, a buyout-focused private equity firm may be a more suitable counterparty if you are looking to retire and hang it up.
If you’re looking for capital to grow your business but want to remain firmly in charge, you may look for a growth-equity-focused PE firm.
After ascertaining the investment style of the said private equity firm, you will want to know the deal principal with whom you will negotiate and, if things go well, who you will work with in the years ahead.
The second question is: Who is the deal principal in charge? Please provide me with referrals for CEOs or business owners with whom he or she has previously worked.
When hiring lawyers, it is common to hear people say: ‘I’m hiring so and so lawyer, not his firm.’ A similar principle applies to the private equity principal you work with. You are looking for someone experienced, reasonable, trustworthy and with whom you do not mind being in the trenches for the next few years.
Even in the case of a buyout deal where you may sell a majority or the entirety of your business, you want to leave your employees in the hands of a good owner.
It is possible that the analyst has reached out to you at an early stage of engagement without getting any of the senior deal principals involved. A good analyst will want to ensure your business is of good quality and that a deal is on the table before getting the principals involved. In such cases, you may ask him who will be the likely deal principal.
Usually, there will be someone in mind because he or she has experience in your sector or because he or she has a good working relationship with the analyst.
Besides meeting him or her, the best way to learn about a deal partner is to talk to the CEOs or business owners he or she has previously worked with. How has the principal behaved when times are tough, when business forecasts are not met, or when there are strategic disagreements in the business? Tough business environments and operational challenges are inevitable—you want to understand the principal’s thought process and behaviour in such circumstances.
Also, it is worth asking whether the principal you are negotiating the term sheet with will be the same principal post-investment. It is common to have one principal in charge of making investments and another of monitoring post-investment.
Likewise, it is worth asking how many years a principal has been with the firm and whether he or she has equity in the GP (industry term for private equity fund manager). Equity principals tend to stay.
Occasionally, you would hear stories about how the relationship between private equity principals and owners deteriorated to the point of outright hostility and, in some cases, lawsuits.
Marriage
A seasoned industry player once told me that every PE deal is like getting into a marriage – things can be wonderful if there’s trust and respect on both sides. If you do not do your due diligence on the principal, you risk getting into bed with an abusive partner – it’s just not worth it!
3rd question: What kind of value add can you and your team bring to my business?
If you need capital, bank financing is usually the cheaper alternative although it may not be available for certain kinds of businesses (Malaysian banks mostly practise asset-based lending). Why should you choose the more expensive equity if a cheaper financing alternative is available? Increasingly, it is table stakes for private equity firms to offer value-added services for their investees.
When asked, popular responses from private equity firms include:
- Strategy and operational team with functional expertise (e-commerce, logistics, finance, HR, marketing, purchasing etc.). Ask them for the profiles of the operational team, examples of successful implementation, and if they charge for these services. 😊
- Guidance on cross-border expansions. You can leverage the knowledge and connections of private equity firms with offices in Southeast Asia, especially when they have local team members familiar with a country’s laws, customs and practices to expand your business overseas.
- Assistance with M&A, identifying complementary businesses for acquisitions. Popular targets include similar businesses in neighbouring states or countries, suppliers, customers, etc. Since most businesses do not have an in-house M&A team, it is a good opportunity to leverage the private equity firm’s expertise in buying and selling businesses.
- Preparing and guiding the firm for listing. Most business owners underestimate the preparation and heartache of the IPO process and may not realise that an investment bank’s interests may not fully align with theirs. Private equity firms, especially those with multiple IPO experiences, can act as your consigliere and trusted sounding board when making key decisions.
There are many other creative ways for a private equity firm to add value, such as:
- Repositioning a business to be perceived as operating in a more attractive industry. For example, selling less attractive businesses in a diversified group and keeping the ones with high growth and high margins, which therefore deserve a valuation premium.
- Eliminate or mitigate key risks to increase the attractiveness of a business to buyers. For example, eliminating or reducing commodity pricing risk through the substitution of materials or through hedging.
- The monetisation of assets. For example, hiving off properties of underperforming outlets (the value of a property may be higher for another business than yours) or doing a sale and leaseback for factories and warehouses.
There are multiple ways in which private equity firms can bring value in addition to providing capital. Take what we say with a pinch of salt and always ask for concrete examples of successful value-adding exercises in the past.
Having asked the 3 questions above, you can proceed to the courtship stage (commonly known as the initial due diligence stage).