The Tech Entrepreneur’s Journey – Private Equity Buyouts
This article is the third in a series of articles mapping out The Tech Entrepreneur’s Journey (following on from previous instalments on (1) The Capital Requirements and (2) Venture Capital), which considers the possible milestones that lie ahead of a tech entrepreneur relating to funding the capital requirements of a business venture over the course of its corporate life cycle.
This time we look at how an entrepreneur can use private equity to raise capital and hopefully drive growth and profits.
What is Private Equity?
Private equity (or PE) in its simplest form is the ownership of, or interest in, a company that is not traded publically or otherwise listed . PE could also be seen as a medium to long-term finance option provided in return for an equity stake in suitable companies.
Private equity funds operate by PE managers (Fund Manager) aggregating capital from various sources, including institutions and high net worth individuals, into designated or segregated funds, each of which are to be applied in the acquisition of, or investment into, suitable companies within the sector(s) specified in its investment policy. Each of the funds will have a prescribed term, which is typically between 8 and 10 years and a fixed investment period of 3 to 5 years. Investments are made during the investment period (with some flexibility for follow-on investment after its expiry) and the balance of the term is used to “harvest” the investments, with capital being returned to the underlying investors as and when investments are disposed of.
This means that PE funds have a clear life cycle and a fixed term in which to deliver a return on investment to the underlying investors. This timeline is a relevant consideration for any entrepreneur considering PE investment, and is considered further below.
Fund Managers operate in various ways, but their principal activities relate to:
- Fund constitution and management: Fund Managers will need to settle upon the key terms of the new PE fund to be created and will then need to approach potential investors in order to agree capital commitments. A fund will then require oversight and reporting throughout its lifetime.
- Investment discovery and execution: once a fund has achieved first close (i.e. it has firm capital commitments from a number of investors), it will be for the deal teams at the Fund Managers to acquire potential investments required by the fund that fit the parameters, some of which are likely to have been identified during the establishment of the fund. Detailed due diligence will precede any investment and the deal teams will be involved in creating models and projections relating to a target company in order to make the financial case in support of the investment. The deal team will also assist in the completion of the investment itself.
- Supervision and operation of investments: following a fund investment, it will be necessary to monitor the performance of the investee company against certain pre-agreed financial metrics. The PE fund is likely to have the right to appoint one or more directors and in any event will have rights to speak and vote at company board meetings in order to influence decision-making. In the case of poor financial performance by the company, funds may also have the right to step in and take over control of some or all of the management functions.
The previous article in this series (The Tech Entrepreneur’s Journey: Venture Capital) examined the key aspects of venture capital (VC), which might be defined as financing for early stage companies which are either pre-profit making or loss making, but which have the potential to be successful. PE can be distinguished from VC in a number of key ways:
- Financial maturity: when identifying potential investee companies, a Fund Manager will seek to establish that the target can demonstrate several years of profits (which would ideally be growing year on year) and has scope to accelerate this growth trend. VC may be willing to make more speculative investments without the security of established financial performance.
- Investment composition: A PE fund typically uses a combination of equity and debt to make investments in order to leverage the transaction. VC typically uses equity only (although they may also use convertible debt securities).
- Stake: A PE investment typically results in the PE fund, often together with other funds managed by the same Fund Manager and with other co-investors, acquiring a controlling stake in the company. VC investment typically takes on a minority stake.
- Rollover / Reinvestment: the monies forming a VC investment typically all go into the investee company. When it comes to a PE investment, the PE fund will invest larger sums and also tend to buy out some, or potentially all, of the shares from existing shareholders, thereby enabling them to realise a partial return on their original investment, with the balance “rolled over” or reinvested in the PE “newco” structure.
When is Private Equity appropriate?
An entrepreneur should consider the following key characteristics of a desirable investee company from the perspective of a PE fund:
- Duration: PE are typically targeting an exit from their investments within 3 and 5 years, depending on the constitution of the fund and, sometimes, the founder’s desire to exit. This timeline has to suit the PE fund and the management team for the investment to make commercial sense. Similarly, if growth forecasts are beyond this timeline then a company may not yet be suitable for PE investment.
- Strategic: PE can assist where, whether a company is part of a group or otherwise, management do not feel they have sufficient financial resources available to them in order to grow the business (whether organically, or, as is often the case, through a buy and build strategy to add scale and complementary strategic capabilities), especially when they feel that growth is being stifled as a result.
- Record of financial performance: PE investments are seldom made in companies with a loss-making track record. Fund Managers will typically want to see a profitable business trend and a history of consistent financial performance, often underpinned by recurring revenue streams; this is the foundation of the PE investment.
- Consolidation: PE funds often look to invest in sectors which are fragmented and therefore capable of consolidation and present scaling-up opportunities. That is, there are a number of disparate entities in the same or adjacent sectors that can be brought together and strategically consolidated in one larger group under a single holding company owned and controlled by the PE fund. Consolidation often results in value increasing as a result of the shared synergies and cross-selling of the consolidated group’s acquired service(s) and the higher EBITDA multiples this can bring, compared to if one investee company remained as a standalone entity. On a sale, that one consolidated group can be sold on more easily by virtue of the transfer of shares in the holding company.
Benefits of Private Equity
Where a company meets these outline criteria, the PE fund is able to inject growth capital and leverage the expertise of the management team in order to accelerate growth and to deliver a return on its investment within the prescribed timeline.
The market experience of the Fund Managers is intended to compliment the specific expertise and ambitions of the management team in order to deliver growth. Fund Managers are often able to help in streamlining and optimising existing operational protocols in support of this goal. It is worth noting for any entrepreneur considering PE investment that it is likely to be a relatively hands-on process, and some management discretion will be ceded to the PE fund; this is the trade-off in order to secure the capital and is the protection that a PE fund will require in order to commit capital to the investment opportunity.
Like their counterparts in the management team, the individual in Fund Managers will have ‘skin in the game’ typically equal to between 1% and 5% of the PE fund’s total capital commitments. This means they also have capital at risk, and this helps to align the Fund Manager’s interests with the management team as well as those of the fund investors. The minority stakes held by the management team in the investee company ensure that they are personally incentivised to develop the company and meet the investment targets.
Implementing a Private Equity investment
PE investments fall within one of three ‘traditional’ structures:
- Management buy-outs: whereby the existing management team at the investee company, funded by the PE fund, buys out the existing owners’ business. This typically results in the PE fund holding a majority stake alongside the management team’s minority stake, with the founder sometimes retaining a stake.
- Management buy-ins: whereby the Fund Manager assembles an external management team for the purposes of making an acquisition. On completion, this external team replaces the existing team and will work with the Fund Manager over the life of the investment. Just like in a ‘buyout’, the management team will typically be incentivised with a minority equity stake.
- Buy-in/management buyouts: whereby a combination of existing and external management team members is put in place on completion of the investment.
Each of the structures outlined above will normally be implemented by establishing a new group (or Stack) of companies. Whilst structures vary from fund to fund, a simple example could be as follows:
- The parent company of the Stack (Topco) is majority owned by the PE fund itself alongside the minority management stake;
- Topco’s 100% subsidiary (Midco) often holds the transaction debt and this segregates the debt and equity structures within the Stack; and
- Midco’s 100% subsidiary (Bidco) is typically the entity that will actually acquire and hold the shares in the target company.
A Stack can be simplified or can include further subsidiaries between Topco and Bidco, depending on the PE fund’s preferred approach and the overall structure of the transaction. In general terms, a PE investment will normally be comprised of the following work streams, which run concurrently throughout the transaction process:
- Acquisition: this is the process of acquiring the requisite shares in the target or investee company. Supporting due diligence will be completed prior to completing the acquisition;
- Investment or ‘equity piece’: this work stream concerns the PE fund and the management team and will establish the terms on which each party will invest into the Stack and also regulates how the company is managed following the transaction; and
- Banking or ‘debt piece’: this aspect is closely tied to the investment piece and is the means by which third party debt capital is injected into the investment structure; to partly fund the management “cash-out” component and fund growth going forward. The more complicated deal structures can include multiple tiers of debt, being senior debt (first ranking and secured), mezzanine, high yield bonds and loan notes. More basic deals can be completed with just senior debt.
PE can represent a key milestone in the funding cycle of a tech entrepreneur’s business and a significant driver of growth. Set out below is an overview of a typical business corporate life cycle. The first three articles of this series have now addressed each of the first five stages of this life cycle.
The next, and final, article in the series will discuss the various options open to a tech entrepreneur when the time comes to realise value for their business by seeking an exit.