If you read the Wall-Street Journal or the business section of your local newspaper, hardly a day passes without articles about Financial Buyers or Private Equity Groups acquiring or selling businesses. As I mentioned in last month’s article, “The Six Ways to Exit Your Business,” Private Equity Groups “PEGs” have been active in acquisitions in the Imaging Supplies & Copier Dealer industries (Golden Gate Capital [who acquired Clover Technologies and West Point Products] and CounterPoint Capital [who acquired Parts Now] are examples of PEGs).
Remember when KKR acquired Nabisco? That was a PEG deal. Last year, Michael Dell and Silver Lake acquired Dell Computers, another PEG deal. Also last year, Warren Buffett and 3G Capital teamed up to acquire Heinz, yet another PEG-led deal. Still another mega-PEG deal in 2013 was when two PEGs combined to acquire Neiman Marcus. All of these were multi-billion dollar, blockbuster deals.
However, what most business owners do not realize is PEGs account for approximately 30% to 40% of all transactions in the lower and middle-markets (deals with values of $2 million to $200 million). By definition, PEGs are formed to make acquisitions and, historically and presently, have been active in the imaging supplies/equipment industry.
WHAT ARE PEGs
A PEG (or financial buyer) is an investment group formed with the purpose of making acquisitions of (usually) privately held companies which the PEG will operate and eventually sell. By their structure, the vast majority of PEGs achieve their profits on their investments when they sell the companies they own. That is, PEGs will not take huge profits or dividends out of their operating companies on an annual basis. Rather, they gain their highest return when they sell their businesses.
Generally speaking, most PEGs are not interested in getting involved in the day-to-day operations of the businesses they acquire. They like to help, as we call it, “professionalize” the businesses they own, but you won’t see the staff of many PEGs pitching in to become executives of the companies they buy.
So how do PEGs generate returns on their investment? Most often, this is achieved through the magic of “leverage.” Here’s a quick example of how this works.
- PEG acquires a business for $10 million
- PEG finances the deal as follows
- $7 million of bank debt
- $3 million of PEG’s (and usually, Seller’s) own capital
- PEG finances the deal as follows
- PEG owns the business for 5 years
- Assume profits increase, improving the value of the company
- Over the 5-year period, PEG pays down 70% of its debt
- After 5 years, PEG sells the business for $15 million
- PEG pays off $2 million of remaining debt
- PEG earns $13 million ($15 million price minus $2 million debt) for its initial investment of $3 million
- Assume value doesn’t increase and PEG sells for the same $10 million it paid for the company
- PEG pays off $2 million of remaining debt
- PEG earns $8 million ($10 million price less $2 million debt) for its initial investment of $3 million
TYPES OF PEGs
Just as no two snowflakes are alike, no two PEGs are exactly the same, either. The classic example of a PEG (for example KKR or Golden Gate Capital) is a group of financial executives who partner together and raise capital from pension funds, endowment funds, or high net-worth investors with the idea of investing the capital to acquire businesses and pay the investors a substantial return on their investment. There are also “unfunded sponsors” and many other types of financial buyers. Whatever their types, almost all PEGs have the same credo: use leverage to acquire businesses and realize a gain on investment when exiting the businesses. PEGs come in all different shapes and sizes, but in general, we can break them down into the following different categories:
Traditional Funded PEGs: These PEGs raise capital, as little as $10 million to $20 million and as large as $5 billion, in a Fund earmarked for investments. Usually, the Fund “life” is 10 years, which means the PEG has 10 years to make acquisitions and sell their acquired companies. Some more established PEGs will have multiple “Funds” active and investing at any time. Usually, but not always, PEGs will make investments for the first seven years of the Fund’s life and then use the last three years to “reap” or “harvest” their investments by selling off their acquired companies.
The size of deals funded-PEGs search for is often dictated by the size of their Fund. Usually, the larger their investment Fund, the larger the business the PEG will look to acquire. You can imagine, if you have a $500 million Fund, you would not necessarily want to make 100 investments of $5 million each; a PEG with this size Fund would more likely have 10 to 15 investments of $25 million to $50 million.
Unfunded PEGs: Sometimes referred to as “independent sponsors,” Unfunded-PEGs differ from Traditional Funded-PEGs in that they do not have a specific Fund from which to invest. When an Unfunded-PEG makes an offer to acquire a business, it will need to go out and raise the equity capital needed to close the transaction (Funded-PEGs simply take the equity capital from their Fund). As with Traditional PEGs, Unfunded-PEGs come in a variety of types and sizes, but generally may be sorted as follows:
Pledge Funds are Unfunded-PEGs who have a list of investors who have “pledged” to invest with the PEG in opportunities of interest to the investor. Think of this as a “promise” to pay. In these situations, the PEG has to “sell” its investors on the merits of each investment. Investors do not have to invest if they don’t like the opportunity.
Naked Funds are Unfunded-PEGs who literally have to raise equity for each transaction. Often, the Naked Fund-PEG has no idea which of its target investors will invest. This is different from a Pledge Fund in that the Naked Fund has no commitments from its potential investors.
Search Funds are Unfunded-PEGs who are “sponsored” in a search by investors who will then invest their capital if they like the opportunity. Search Funds are much like pledge funds, except, generally, the principals of the Search Fund are interested in operating the acquired company after acquisition. Furthermore, operators of Search Funds are generally only interested in making a single acquisition. By their nature, Search Funds usually seek much smaller deals.
WHAT ARE PEGs LOOKING FOR?
Unfortunately, over the years, PEGs have received a lot of negative publicity in the press and from the current Presidential administration. Some of the bad press is deserved, but as is true in most cases, most is not. Given their supposed “bad rep,” why would you consider selling to a PEG?
One advantage PEGs give an owner is the opportunity to sell his/her business but remain an owner (though on a minority basis)/operator of the business. Imagine your business has hit a peak or plateau, and you just cannot get over the hump on your own. Or, imagine the owner who is too young to retire, wants to run the business, but also wants to reduce the risk of ownership. Or, imagine the owner who is tired of risking all of his/her own money to continue to build and grow his/her business. Selling to a PEG allows owners to continue to run their businesses as well as taking some “chips” (e.g., money) off of the table, thus helping protect the value they’ve created in their businesses.
Of course, PEGs are not the right buyer for every business. Some companies are either too small or do not have the right characteristics PEGs seek. What are PEGs looking for in the “portfolio” or “platform” investments they seek?
Management in place: While there is always an exception to this rule, virtually all PEGs will require the seller to have an excellent management team in place who can continue to operate the business. Yes, the PEG can help “fill some gaps” by assisting their CEOs with key hires, but if your idea is to retire after the sale and you have no successor inside the company who can replace you, yours is not a candidate for a sale to a PEG.
Customarily, PEGs are not too keen to acquire your Real Property. PEGs are happy to enter into fair-market leases, but usually, regardless of the type of PEG, they are not interested in buying the real estate and/or building used by your business. This is especially true of any business operated in a smaller (less than 2 million population) city.
Good clean Financial Records are paramount for most PEGs. Many PEGs require the companies they acquire to have audited financial statements, or at least reviewed statements. Because PEGs are investing “other people’s money,” they must take great care to perform their due diligence and heavily scrutinize the financial records of the companies they might acquire. Simply giving a PEG three years of tax returns along with internally prepared QuickBooks statements is not sufficient.
PEGs depend on acquiring profitable, well run businesses with stable Cash Flow. If your business does not have positive Cash Flow, you probably are not a candidate to sell to a PEG. Furthermore, PEGs want stable, dependable, predictable Cash Flow.
While there are some PEGs who specialize in acquiring “asset light” service businesses, most PEGs want to acquire companies with assets they can Leverage. As you saw in our example above, PEGs get their highest return when they use leverage to increase their potential returns, strong Cash Flow to pay off/down the debt and a strong Management Team to run the business.
Growth and growth plans are vital to PEGs as well. Most owners want to sell at the top of the market, which usually leaves little growth for the business. PEGs are reluctant to acquire a business if they can’t see continued growth for the next five to 10 years. Growth is critical for two reasons: 1) growth helps pay down the debt incurred in acquiring the business, and, more important; 2) because future buyers will want growth prospects, growth adds value when the PEG sells the business, which brings us to the last characteristic.
As mentioned in my May article, “How To Sell Your Business,” PEGs will not make an acquisition if they do not know how they will Exit the business. Their Exit Plans are imperative to their acquisitions. Since most PEGs make their “money” when they Exit (or “flip”) their holdings, if they cannot see an ultimate Exit, they will not acquire the business.
SIZE MATTERS
What size companies are PEGs generally interested in acquiring? In the PEG world, the common measurement stick is earnings before interest, taxes, depreciation and amortization, referred to as “EBITDA.” Essentially, EBITDA is a Company’s operating profit adjusted for interest and non-cash items (depreciation and amortization) While there are no hard and fast rules, based on our experience (we close approximately 35% of our deals with PEGs), we see PEGs looking for deals of the following sizes:
- Less than $500,000 EBITDA companies are generally of no interest to PEGs except as (potentially) an add-on to an existing holding. If your company is this size, PEGs are probably not an option for you.
- $500,000 to $1.5 million EBITDA companies may be of interest to some very specialized funded-PEGs, but generally will be of most interest to unfunded-PEGs, especially search funds.
- $1.5 million to $3.0 million EBITDA companies may be of interest to some smaller funded-PEGs and most unfunded-PEGS.
- $3.0 million to $7.0 million EBITDA is the “sweet spot” for most funded-PEGs. If your company is this size, you have a very, very good chance of being of interest to a PEG. Based on the research of the 1,500 funded PEGs in our database, the vast majority seek companies of this size.
- Over $7.0 million EBITDA is also a “sweet spot” for many of the larger PEGs (those with Funds greater than $500 million.
SOME CAVEATS
PEGs play a vital role in the M&A industry. PEGs who have acquired companies in the imaging industry have had some major successes and some failures. However, PEGs, both funded and unfunded, provide needed growth capital to businesses in the industry.
However, not all PEGs are created equally. Some PEGs have excellent reputations as managers/partners. Others may not enjoy such a stellar reputation. Any business owner considering a sale to a PEG should do his/her homework or due diligence on the PEG before saying “yes” to any offer. When our clients are considering selling to a PEG, we always request and call on references (CEOs of companies acquired by the PEG) if we haven’t worked with the PEG before; we also speak with our colleagues who have worked with the PEG before.
Also, keep in mind, PEGs will use leverage to buy your business and in the next three to seven years, they are going to sell your business…again. If you are opposed to debt, or don’t think your business will operate well if leveraged, don’t consider a sale to a PEG. If you don’t like the idea of your business going through another sale in the near future, don’t consider a sale to a PEG.
Certainly, there are more factors than these when considering a sale to a PEG. I have been necessarily brief. In next month’s article, we will explore the differences between Strategic Acquirers and PEGs and the benefits/challenges of selling to each type of buyer.
While PEGs may not be the best option for all business owners seeking an exit, for many companies, PEGs provide a very attractive exit option. If you have specific questions about PEGs and whether you should consider a deal with a PEG, please feel free to contact me to discuss your specific situation.
