Mark Hauser, co-managing partner of Hauser Private Equity, highlights what evaluation criteria investors look for, and how private equity transactions are facilitated.
The highly diverse investment industry encompasses multiple types of investment entities and objectives. Private equity firms have carved out their own corner of the investment arena. In contrast to stock market investors, who buy shares in individual stocks or funds, a private equity firm purchases (or acquires) an entire company. For perspective, over 50% of private equity investment deals range from $50 million to $1 billion.
Specifically, the private equity firm executes a leveraged buyout of a growth-focused business. The target company typically has a successful business model but needs additional investment and/or strategic management to propel the firm to the next growth level.
Private equity principal Mark Hauser explains that a leveraged buyout refers to the utilization of leverage (or borrowed funds) to execute a purchase. In this case, a private equity firm uses leveraged funds to buy a controlling share in a company.
Private equity firms are singularly focused on earning a return on each investment. To accomplish this goal, the private equity investor must ensure that they select an investment target that can deliver that return.
The private equity firm finds potential investment targets via three avenues. First, the company’s reputation may spur a business to contact the firm about a potential acquisition. Alternatively, an investment bank that represents a certain company may contact the private equity firm. Finally, the private equity firm could learn about the potential acquisition through its networks or other proprietary means.
Before making its purchase decision, the private equity firm performs thorough due diligence on every aspect of the target company. Mark Hauser notes that the due diligence takes place in phases that match the bidding process. During each phase, the company discloses more operational and financial details to the remaining investors.
The private equity firm’s due diligence encompasses three key areas of the target company. Analysts (including paid consultants) spend most of their time in the commercial arena. Financial and legal due diligence are equally important and involve confirming specific facts rather than investigating them.
Commercial Due Diligence involves an analysis of the company’s industry trends and market position. Analysts also examine the business’ value proposition and historical performance. The analyses’ results enable the private equity firm to gauge the company’s ability to deliver on its projections.
Financial Due Diligence seeks to confirm the accuracy of the company’s financial information. The private equity firm hires accountants and/or auditors to review the business’ financials, operations, and tax issues.
Legal Due Diligence seeks to confirm that the company is not involved in potential liability issues. Examples include unusual or undesirable contract clauses, threatened or in-process lawsuits, and regulatory issues.
If the private equity firm’s analysts do not find any red flags, the firm’s investment team will present the deal to its investment committee. Assuming this group approves the deal funding structure, both parties’ lawyers negotiate the final transaction terms. The deal is finalized with the release of funds and transfer of company equity, concludes Hauser Private Equity co-managing partner Mark Hauser.
After the deal is finalized, the acquired business joins the private equity firm’s portfolio companies. Next, the private equity investor (the general partner, or GP) begins taking actions to make the company operate more efficiently. Although the GP may take a board seat and realign the management structure, they have no interest in running the business.
Instead, the GP methodically lays the foundation for the company’s expansion. The GP’s level of involvement typically corresponds to their stake in the acquired company. During the process, the GP is required to file regular operational and financial updates along with company valuations.
A successful private equity transaction includes a timely, profitable exit. The private equity firm often makes its exit during the three-to-seven-year period after its original investment. However, Mark Hauser says the firm’s exit could take place in more or less time depending on the specific scenario.
Most private equity firms’ exits result from an acquisition by another company. Alternatively, the targeted company might be positioned to file an initial public offering (or IPO) that will take the firm public.
The private equity firm generally coordinates its own acquisition sales. However, the company may hire an investment bank to handle the transaction logistics. This is especially the case with complex or very large transactions.
Mark Hauser states that the private equity firm considers eight distinct factors relative to the target company’s operations. After gaining a thorough understanding of these issues, the firm decides whether to acquire the business.
Private equity firms typically hold their portfolio companies for several years. Therefore, the private equity investor tends to select businesses that operate in non-cyclical, non-volatile markets.
To illustrate, the private equity firm would likely not invest in a seasonal business that only generated reliable income during a certain period. A retail business in a summertime vacation market would fall into this category.
Further, private equity firms often gravitate to industry innovators that capitalize on emerging market trends. These companies may also introduce disruptive technologies, such as artificial intelligence, with the potential to effectively transform the entire industry.
Businesses that have adapted to changing demographics or consumer behavior are also in demand. Companies that demonstrate one or more of these capabilities are strongly positioned for market growth and excellent return of equity.
A desirable acquisition target will be a strong competitor in its industry. The company must have a proven track record and have demonstrated the ability to maintain an industry leadership position. The business must also show that it can sustain growth given the current and projected market environment.
Businesses with several active income streams can be desirable acquisition targets. A forward-thinking company investigates new locations or markets. A growth-focused business also employs new sales and/or customer acquisition strategies.
Private equity firms will notice an innovative company’s mindset and determination to aggressively pursue new business. The investors also analyze each company’s past achievements, customer base makeup, and current and projected market sizes.
Private equity firms seek out established businesses that should only require one investment round. This allows the private equity investor increased flexibility in capital allocation and business operations logistics. The company can expand its core operations, invest in additional growth, or issue shareholder dividends.
In contrast, venture capital investors understand that start-ups and newer companies will need multiple cash infusions. Private equity firms generally view these companies as carrying too much financial risk and avoid these investments.
Each private equity investment candidate must have a visionary business plan that sets it apart from its competitors. This document must contain detailed short- and long-term projections along with a detailed risk management plan.
A thorough SWOT analysis is another important business plan component. This well-known acronym refers to (internal) company strengths and weaknesses along with (external) opportunities and threats. Most importantly, the business plan must be supported by realistic facts, figures, and other documentation.
Private equity firms remain “hands off” in their portfolio companies’ operations. The private equity investor provides ongoing strategic direction while relying on the business’ management to handle the operations aspect.
Although the private equity firm can insert its own management team, the firm rarely takes that path. Instead, the private equity investor seeks companies with a solid organizational framework plus operational and fiscal discipline. These businesses should have also demonstrated a proven ability to act decisively on appropriate opportunities while addressing relevant risks.
A company’s well-coordinated research and development (or R&D) program can help the firm achieve a good competitive position in its industry. Private equity firms often evaluate a target company’s R&D program against that of its competitors. The business should also know how much R&D money is required to increase revenues and drive further growth.
Specifically, companies in the technology and healthcare industries must have a well-structured, well-funded research and development plan. An effective R&D plan is essential for success in these two highly competitive arenas.
The private equity firm performs extensive due diligence to ensure it invests in the right company. The firm also wants to know how easy it will be to exit the investment once it has achieved its predetermined goal.
Sometimes, the private equity firm’s analyses lead to the conclusion that a smooth exit is simply not possible. In that case, the firm may turn down the investment opportunity.
If the private equity firm’s due diligence does not uncover any “red flag” issues, the firm may elect to proceed with the transaction. As the investment cycle proceeds, the firm continues to reassess the target company’s performance. Mark Hauser emphasizes that the private equity firm has the latitude to make necessary adjustments.
June 9, 2022