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Growing with a private equity investment

Article

Once you’ve sold a portion of your company to a private equity (PE) investor, you need to understand how to be aligned with PE fund and how you can assist in continuing to grow the company. PE offers an exciting opportunity to accelerate value growth. It achieves outperformance by super-charging growth, improving margins, enhancing cash conversion, and reducing risks.

Additionally, depending on the type of PE investor and their selected hold period, you can share in future proceeds if it divests the investment. However, it is important to note that there are no guarantees. Engaging with PE investors always brings change to a business, sometimes revolutionary change. If the process isn’t handled carefully, it can cause turbulence and disruption.

Following on from Demystifying private equity and Navigating a private equity investment, the growth phase represents the chapter of PE ownership where businesses are incentivized to achieve value growth at an increased rate. Below, you will learn more on how to grow the company alongside your PE investors.

PE: an ambitious ownership model

PE investors are laser focused on growth during a relatively short period of time. Businesses and management teams will be tasked with achieving a new level of sophistication and professionalism to meet both party’s expectations. PE investors will typically be very hands-on following their initial investment and will use various levers to increase the value of their investment. These include:

  • Incentivization of the retained management team 
  • Leveraging the balance sheet of the company through different debt mechanisms 
  • Unlocking inorganic growth through M&A opportunities 
  • Identifying and implementing operational improvements  
  • Entry of new market, territory or product 
  • R&D and digital transformation

Whatever the investment plans, it’s certain that management will be under increased pressure in running the business while it implements new strategies and reports on a new growth plan. The challenge is to make sure the interests of the stakeholders (both the company and PE investor) stay aligned throughout the process.

Bridging the gap

Investment from PE is typically followed with rapid change. While it’s often an exhilarating period for all concerned, the needs of the investors mean there will be a relentless and demanding focus on growth, with targets and reporting requirements to match.

The two sides must start by sharing a common understanding and vision, and it’s essential that this remains solid: it’s particularly important in the early days when the impact of the change will be at its most intense.

That’s what this stage is about—helping management teams and businesses get the most out of PE.

Every business is different, and no two PE deals are the same. However, we have observed four fundamental areas that set the tone for every PE relationship. If these fundamental areas are expertly managed, the chances of realizing the full potential of the investment will improve.

The four pillars of a strong aligned relationship

Purpose and intent +
The first step is to define and clearly communicate what success looks like to all stakeholders.

As well as the investors and the company, this includes management and the workforce. If everyone agrees on a common purpose and intent, the all important collective direction of travel is much clearer.
Execution +
Putting purpose and intent into practice.

This is perhaps the single most demanding aspect of a PE relationship. Management must be prepared for the transformation that is about to take place. Collaboration to implement all aspects of the plan will support the overarching goals:
  • Cascading your action plan throughout your team, driving collective responsibilities
  • Incentivizing more than just your top team
Constant/effective communication =
Even the strongest PE relationship will never be entirely smooth sailing.

Key to navigating this is communication: management must be prepared to keep its PE partners up to speed with what’s going on, whether good or bad. Therefore, it’s critical to establish strong channels and reporting mechanisms with the investors.
Trust
There’s a balance to strike between management team autonomy and PE stakeholder involvement, Different arrangements will suit different businesses.

However, every successful relationship shares one essential element: trust.

Accelerating your value growth

Now that you have considered the four fundamental pillars to a strong aligned relationship, it’s important to understand the six tools that PE investors can use to grow the value of their investments.

PE investors seek to incentivize key people to deliver growth in the equity value of an investee company. This is managed through the investment structure (how much and what type of leverage there is) and the all-important sweat equity and the terms attached to it, which can include certain provisions and mechanisms on retention. As well as sweat equity, key people can also benefit from bonuses and option plans. Senior management must ensure each member of the team has clear objectives which, when aggregated, support the overall goals. Getting this right is essential as it drives alignment throughout the senior team.

Using debt lowers the cost of capital. Lowering the cost of capital helps all shareholders get a bigger return. However, this must be balanced with the risk of adding third-party debt to an investment structure: cheaper debt brings covenants that become disproportionately painful in underperformance. Management teams should also be mindful of the split between ordinary shares, preferred shares, and other instruments. If not on equal footing, management teams might be more incentivized but also carry greater risk, which could challenge alignment.

Buy and build is becoming more prevalent as a value growth tool. There is great attraction to follow your money if you are a PE investor. This means putting more funding behind a proven management team in a sector or setting that is already well known. This reduces the perceived risk. Equally, there is the allure of synergies, reducing the average entry multiple (if bolt-on or add-on acquisitions can be purchased at a lower multiple than the original investment), new market entry, and a simple premium for scale—all of which will provide shareholders with the benefits of potential multiple arbitrage (where the exit multiple is higher than the entry multiple).

Teaming up with PE brings two things in abundance. First, the power and wherewithal to invest; and second, experience. All business plans should look at new market entry on top of doing more of the same. This can be adjacent products or services, new territories, or new customer areas or sectors. Each needs to be evaluated against the cost of capital, expertise, management bandwidth, and timeframe. The classic strategy for Canadian businesses is to expand to the U.S. or into the U.S. marketplace. This can be extremely lucrative when it goes right. However, care and planning are required—especially in respect of the human capital that is needed. It’s often the difficulty of finding the right leadership or team in the U.S. that hampers success. Your PE investor should be able to fund such activities and provide guidance from its own investing experience.

Similar to adding value through a buy-and-build program, operational Improvements are strongly sought after by PE investors. For example, if margin can be tweaked up through reorganization or the investment in slicker processes, or risks can be diluted by reducing fixed costs or working capital can be managed more efficiently making the business more cash generative, all shareholders will benefit. Operational improvements are usually incremental and subtle, but they can be profound, (for instance, outsourcing manufacturing in its entirety or switching to an entirely online business model). There is an enormous array of help available in this area these days and you will be surprised how far you can go if you are open minded and prepared to put in the work.

Contrary to what people might think, PE is interested in the long-term prospects of a business. It knows that the visibility of further future growth will help eventual buyers pay more. Therefore, investors are constantly looking to evaluate potential returns from new product development, process automation, and tech enablement as well as the conditions and processes that are needed to build more innovation into an investee company from ideation to execution. All businesses should be spending some time looking at how they can embrace the opportunities that the internet, digital analytics, digital marketing, digital communication, and clever software can provide. No business model is immune.

Exit strategies

You and the PE investor will work together to grow the value of the investment. However, after a certain period of time (typically three to seven years), the investor will want to realize a gain from its investment.

There are usually three common exit strategies: a sale to a strategic buyer in the same industry (known as a trade sale), a sale to a different PE investor (known as a secondary sale), or an initial public offering. The investor will choose the most profitable option.

How we can help

The reasons for embarking on a PE investment may be complex, but whatever your motivation, our Private Equity group can deliver practical solutions for your business. This team has a profound understanding of the PE industry, particularly in the Canadian mid-market space. Our people are part of the process at every level, interacting with funds, advising on deals, and working closely with portfolio companies to help them realize their goals.

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