Private Equity – What now?
Private equity firms, sidelined by a lack of debt capital are sitting on cash – where will they put it?
The capital crunch has had a negative impact merger and acquisition activity across North America as leverage ratios have gone down and the amount of equity required to complete a transact-ion has gone up. Because of the trend to engineer transactions with debt and having a clear path to liquidity, private equity M&A activity has been particularly hard hit. Standard & Poor’s reported only US$200 million of US leverage buyout loan volume for the first half of 2009 compared with US$3.1 billion in 2008 and a scorching US$10.5 billion in 2007. US leveraged loans with a sponsor (typically private equity) amounted to just US$100 million for the first half of 2009, compared with US$5 billion in 2008.
While private equity has been on the sidelines, corporations and other strategic buyers have taken advantage of favourable prices and, in some cases, once-in-decade opportunities. In the first nine months of 2009, worldwide M&A amounted to almost US$1.5 trillion, down almost 38% from the third quarter of 2008. However, financial sponsors that include private equity groups (PEGs) accounted for a measly 4.9% of overall activity in 2009, the lowest since 2000 and down 67% from 2008, according to Thomson Reuters.
The potential to realize significant synergies coupled with a long-term perspective has made the current environment very favourable for certain strategic buyers. Canadian examples include Tier 1 automotive-parts supplier stalwarts Matcor Group and Van-Rob. These companies teamed up to buy the assets of Brown Corp. of America, a 55-year-old manufacturer of automotive instrument panel reinforcements, stampings and welded assemblies with a total of seven manufacturing plants, five in the US and two in Mexico. Despite being in the worst automotive slump in decades, these Canadian companies had the foresight and the cash to take advantage of a transaction that will expand their business and increase their market share. Few, if any, private equity buyers acting on their own would have been successful on this complex transaction that was impacted by a variety of customers, including automotive original equipment manufacturers.
So where does that leave private equity? There are varying accounts of just how much cash private equity firms are sitting on, but by some estimates it’s as much as US$1 trillion. The question is, where and how will they invest it?
To a degree, PEGs have been busy with their own problems, shoring up investments where it makes sense and trying to preserve capital. But that is not a long-term recipe for growth — or existence for that matter. The real opportunity for private equity in the near term may be participating with strategic investors on a minority basis or bridging transactions that are difficult to finance in the short-run. That having been said, there is an abundance of capital waiting to be invested and assuming pricing expectations can be bridged, there may be a plethora of opportunities for companies seeking to make acquisitions that at first blush may not seem financeable. PEGs may be the answer. They have the capital to invest and continue to look for business acquisitions and investments.
One of the major market shifts for private company owners seeking to monetize their shares over the past decade has been the increased activity of PEGs and their acquisition of and investment in private companies. PEGs number in the thousands across North America and manage money for insurance funds, pension funds, charitable trusts and sophisticated investment groups. Despite the downturn in the Canadian economy, the appetite for Canadian companies remains strong and the relatively better performing Canadian economy has been attracting capital from all over the world, including Asia. Even early stage businesses are sought out.
PEGs are key players when it comes to business transactions. They offer flexibility as a liquidity source, giving entrepreneurs the ability to take some cash off the table, recapitalize their company or simply sell and move on. Private equity refers to buyout groups that are looking to acquire or invest in ongoing, profitable businesses that demonstrate growth potential.
Increased competition for larger operations (with EBITDA greater than US$20 million), the greater growth potential of smaller firms and an easier path to exiting the investment of smaller firms in the future have played a role in driving PEGs to smaller companies. PEGs are typically organized as limited partnerships controlled and managed by the private equity firm that acts as the general partner. The fund invests in privately held companies to generate above-market financial returns for investors.
The strategy and focus of these groups vary widely in investment philosophies and transaction structure preferences. Some prefer complete ownership, while others are happy with a majority or minority interest in acquired companies. Some limit themselves geographically while others have a global strategy. PEGs also tend to have certain things in common. They typically target companies with relatively stable product life cycles and a strategy to overcome foreign competition. They avoid leading-edge technology (this is what venture capitalists look for) and have a preference for superior profit margins, a unique business model with a sustainable and defensible market niche and position.
Other traits that appeal to PEGs are strong growth opportunities, a compelling track record, low customer concentrations and a deep management team. Most prefer a qualified management team that will continue to run the day-to-day operations while the group’s principals support them at the board of director level.
Private equity buyouts or investments take many forms, including:
• Outright sale: this is common when private shareholders want to sell their ownership interest and retire. Either existing management will be elevated to run the company or management will be brought in. A transition period may be required to train replacement management and provide for a smooth transition of key relationships.
• Employee buyout: PEGs can partner with key employees in the acquisition of a company in which they play a key role. Key employees receive a generous equity stake in the conservatively capitalized company while retaining daily operating control.
• Family succession: such a transaction often involves backing certain members of family management in acquiring ownership from the senior generation. By working with a PEG in a family succession transaction, active family members secure operating control and significant equity ownership, while gaining a financial partner for growth.
• Recapitalization: this is an option for an owner who wants to sell a portion of the company for liquidity while retaining equity ownership to participate in the company’s future upside potential. Such a structure allows the owner to achieve personal liquidity, retain significant operational input and responsibility and gain a financial partner to help capitalize on strategic expansion opportunities.
• Growth capital: growing a business often strains cash flow and requires significant access to additional working capital. A growth capital investment permits management to focus on running the business without constantly having to be concerned with cash flow matters.
PEGs have become a major force in the acquisition and investment arena. They can even be thought of as strategic acquirers in certain instances, when they own a concentration of portfolio companies in a certain industry or a related area that addresses the same customer base.
Mark Borkowski is president of Toronto based Mercantile Mergers & Acquisitions Corp. He can be reached at firstname.lastname@example.org; (416) 368-8466 ext. 232 or www.mercantilemergersacquisitions.com