By Robert Rough and Bernard Carrico
An Alix Partners survey found private equity groups (PEGs) replace 58 percent of CEOs within two years of buying a company and 73 percent of CEOs during their ownership period. While the survey was small and of larger companies, there are important takeaways for owner/CEOs of lower middle market companies selling a controlling interest to a financial buyer.
Companies acquiring smaller companies usually purchase 100 percent of a target’s equity but few PEGs do because lower middle market companies (valued between $10 – $50 million) are dependent on the CEO, often the majority owner, for success. PEGs usually buy 60 – 80 percent of the company. This gives the buyer management continuity and reduced risk inherent in replacing the owner. This strategy provides the owner liquidity, asset diversification and “another bite at the apple” when the financial buyer resells the company in 3 – 7 years.
Most literature addresses preparing a company for sale and the sale process. Little focuses on the period of PEG ownership. Owner/CEOs focus on price and transaction terms but do not properly research the new partner/boss they will be working with for the next few years. The sad result is many partnerships fall apart, leaving both parties frustrated and potentially destroying company value.
A successful post-transaction partnership requires up front planning, understanding the differences among PEGs, and performing due diligence throughout the process rather than just at the end.
Potential Buyers List
The process starts during the goal setting sessions with an investment banker (IB). Good IBs make it their business to know many PEGs and their operating style. Using the owner’s goals for their post transaction role, for their company and its employees, the IB assembles a potential partner list. Some may be less well known to the banker but have a strong interest in the industry, others may be well known and worked with the IB in the past. The owner and banker together refine the list before the marketing phase begins. The banker will use knowledge of the chosen firms to tailor the marketing documents, pitch and process accordingly.
Owners and the IB develop questions for PEGs. These questions are raised during the process as the PEGs perform their due diligence. Some question areas are best handled by the owner alone, some by the owner and banker together and some are best addressed by the banker one on one with a senior representative of the PEG. Choosing an IB who knows how PEGs operate after the transaction makes a big difference in the quality of the questions generated and response interpretation
What are their goals? Knowing the PEG’s goals and how they will be achieved help the owner project how much change will be needed. Knowledge of PEG modus operandi is critical in probing this area. In the survey 78% of PEGs listed “pace of change” as the biggest source of conflict with CEOs. Learn what that really means.
- What is the exit? PEGs have exit plans up front, which should be explored.
- How will performance targets be set? PEGs are results driven. Their goals and how that translates into performance targets are critical. Not surprisingly, this is the second biggest area of conflict.
- What are the firm’s communication expectations and style? PEGs differ in their reporting requirements, meeting or contact frequency and availability expectations. For example, 31percent of CEOs wanted scheduled monthly meetings as standard contact while that was acceptable to only three percent of PEGs. Fourteen percent of CEOs expected to be available 24/7 while 33 percent of PEGs hold that expectation.
- What does the PEG offer other than capital? Know the role the PEG will play in different situations and in different areas of the company.
- Post transaction contact person or team? Some PEGs separate transaction teams from portfolio management teams. Specific questions will get this answer but also knowledge about how the PEG operates that could have a substantial impact on the CEO after the transaction closes.
- What is the firm’s track record? The transaction community jokes that all PEGs are in the upper quartile of performance. Getting specific details on this can be difficult and requires careful interrogation.
- Will the team be enjoyable to work with? Owners spend a lot of time with PEG partners, especially if company performance lags expectations. Do they respect you, your achievements, management team, and treat you like a partner during the transaction process? In the modern world, technology reduces face to face time. A good banker finds ways to increase time spent with each other.
References. This critical step is often done too late. Don’t wait until a single PEG has been selected. Start making calls when the field has narrowed based on indications of interest.
- Contact current CEOs, exited company CEOs, and fired CEOs. Unlikely a PEG will provide this complete list but the response might be enlightening.
- Test PEG answers to questions with the references. Understand PEG behavior under different circumstances.
- Develop independent references. The banker should try to provide useful sources of information beyond what the PEG offers.
Nothing guarantees a good outcome but these steps should greatly improve the odds. And yes, it is a lot of work. Just keep in mind that closing the deal isn’t the end of the story, it’s the beginning.
Robert Rough and Bernard Carrico are Managing Directors of Telos Capital Advisors, LLC in Dallas. TCA is a middle-market investment banking firm helping business owners achieve their goals through a sale or recapitalization. www.teloscap.com