Getting ready for private equity investment

At a time when access to finance is proving critical to many, mid-market businesses are looking beyond traditional sources and turning to private equity to fund their growth.

Our specialists explore how private equity firms are now working with their portfolios and how the mid-market can benefit from investment.

As global markets grapple with the impacts of COVID-19 and face an extended period of uncertainty, mid-market businesses have growing concerns about their ability to raise finance to invest in growth. As a result, leaders are increasingly looking to alternative finance like private equity (PE) to achieve their strategic ambitions.

PE investment has long been seen as a potential source of capital for the mid-market. Indeed, for many firms, finding the right PE partner – aligned to their goals – has acted as a growth catalyst and helped the firm to its next stage.

That trend may continue. The latest Global Business Pulse following the first wave of COVID-19 lockdowns, showed that 46% of global business leaders viewed a shortage of finance as a constraint on growth – a jump from 37% in the previous half. Figures from H1 2019 also showed there was a considerable appetite for private equity investment in the mid-market with 37% of businesses looking at PE to fund international growth. When it came to M&A, 36% were thinking of PE while 29% of businesses aiming for organic growth expect to support their strategy via PE investment.

However, although mid-market leaders are increasingly amenable to exploring PE investment, many remain reticent about partnering with PE finance, put off by some of the less frequent examples of negative outcomes. As a result, some mistaken notions have grown around the industry (see our private equity myth-busting article for some common misapprehensions). Fully understanding the benefits of PE, how they operate, and how your business can prepare for equity investment will be critical to devising your finance strategy.

Private equity offers funds, expertise and experience

As businesses review their strategies and where they need to make investments for growth in the wake of COVID-19, private equity is becoming a more interesting finance option. Dinesh Anand, global head of private equity and partner at Grant Thornton India, says: "There's a lot of liquidity. Private equity funds are sitting on huge amounts of dry powder, and they have the money to invest."

PE investors are proactively searching for the right businesses either to buy outright – in the case of succession and the owner exiting – or to transform the growth prospects of those assets through investing in organic and buy and build strategies.

Many owners are drawn to PE because of the expertise an investment partner can bring as part of the transaction. Anand says: "In a way, the cost is much higher because you're giving away some equity. But while the cost is higher, so are the expectations. You're bringing in a partner who is going to provide a high level of operating efficiency and ideally give you access to new talent and/or provide access to certain geographies you don't yet have."

With leaders keen to get ahead of competitors, and attract new customers and suppliers, they are forced to look further afield. Wilhelm Mickerts, partner and head of private equity at Warth & Klein Grant Thornton, says: "Many business leaders think: 'I need to go to China'. But they do not know how to do it. They recognise they need money for it, but equally important they require experience. Money for growth funding is always, for me, connected to operational expertise, networks, sector knowledge, and also cultural knowledge in the country the business wants to invest in."

Private equity is evolving to meet the needs of its assets

PE still makes some business leaders nervous – losing control of the business is a significant psychological barrier. And while businesses that seek PE investment for growth can retain control by relinquishing a minority stake – concerns about tension between management and investors still exist.

Following the financial crash, the PE sector has rebuilt its reputation away from the perceptions of buccaneering and asset-stripping.

Firstly, operating talent has come to the fore. More firms have put considerable effort into creating teams of operating professionals that can advise and support their investments better. That bank of talent is increasingly being used to attract companies looking for finance, as well as practical hands-on experience to ensure firms can drive the best performance from their investments.

Secondly, many firms have introduced environmental, social and governance (ESG) factors into their portfolio companies, due diligence and operating plans as they look to create benefits beyond financial returns, which ultimately point to more sustainable growth.

As a result, the length of investments is expanding. Anand says: "Private equity wants to do more value-driven business transformation, rather than purely come in and exit in the short term. The exit window for private equity firms has grown on average to about five from approximately three years. They're looking for a transformation to enable long-term growth and better return rather than just doing a cost stakeout and quick exit."

As a result, the length of investments is expanding. Anand says: "Private equity wants to do more value-driven business transformation, rather than purely come in and exit in the short term. The exit window for private equity firms has grown on average to about five from approximately three years. They're looking for a transformation to enable long-term growth and better return rather than just doing a cost stakeout and quick exit."

The scope of PE's interest remains broad. Despite some misconceptions, PE is not mainly focused on cutting edge technology or distressed assets. Mickerts says: "In the last three years healthcare, in general, has been attractive to private equity. For example, home care equipment and service providers that deliver services such as oxygen devices to the patient have increased dramatically, as the market grows for services due to ageing populations."

In the US, life science and technology are popular among PE. While in Australia, most mid-market funds have already “pivoted in their later structures to more tech-enabled businesses,” says Paul Gooley, partner and national head of corporate finance, Grant Thornton Australia. “Some e-commerce businesses have seen volumes double. Other sectors, such as education, which compared to the US has very low IT integration in Australia, is also seeing more deal flow for online learning platforms.”

Successful PE investment follows rigorous preparation

While PE firms have a lot of liquidity and eagerly hunt promising assets among the mid-market, the criteria for investment is high. Carlos Ferreira, national managing partner of private equity at Grant Thornton US, says: "Debt underwriting is still very strict. There's a general presumption that because investors are sitting on dry powder, they have to put money to work. And, while PE firms are making investments, there are still companies that are difficult to finance.” He adds: "Ultimately, investors want to know that they will receive a robust return that is proportional to the risk.”

There are plenty of things a successful mid-market business can do to attract PE interest and increase the chances of following through with the right deal.

1. Be clear PE is right for you and get internal buy in

The first step is clarity. Are the owners and business leaders clear that private equity investment is the right route forward for growth and have the key stakeholders got buy-in? According to Thierry Dartus, Partner at Grant Thornton France, if an owner decides to do a deal off the back of an opportunistic offer, it can take much longer to conclude if, for example, family members and other critical parties require convincing. Negotiations and due diligence can be more straightforward if private equity has already been properly considered as part of the growth strategy.

2. Ensure you have the right financial information available

Indeed, the due diligence process can be onerous and time-consuming. Ferreira says: "Private equity investors are going to seek a considerable amount of information. The majority of it financial, but they'll also want to know what the customers look like and what the supply chain looks like; what intellectual property and facilities the business has.

"The starting point is having good financial information, good financial records and detailed information." Investors want to know what the business operations and accounting look like and what kind of reports can be produced.

"We go to companies long before a private equity firm is even at the door and we take them through a due diligence process from a sell-side perspective. This approach has been around for a long time in Western Europe, but in the US it is relatively new. It's designed to get businesses ready to provide information when they need to."

"Often, in the middle-market space, they may not have the technology, processes and systems to produce all the financial information and business metrics to analyze the historical performance or build projections,” says Ferreira.

Businesses sometimes lack the capacity to produce the volume of analysis and information that PE firms are looking for, so when a process starts the businesses management team, finance, accounting and reporting function can be overwhelmed.

3. Have the right management in place

Mickerts says: "Management is key. Private equity firms always look at the management and will want to meet several times. They like to see a clear split of duties and responsibilities. The CEO normally drives the top line, growing the business whether by products or by country. They want to know there is a vision to develop the company over the next five years and spend the money in a way that supports growth."

PE firms will also take a close look at the CFO and will want to know they have the numbers ready and understand them. Ferreira says: "That individual may not have the background, education, experience or level of analysis that a private equity firm and their advisers want to see when they're considering buying the business. Businesses will understand that if they are going to sell part of the company in a year or two, they may need a CFO that has experience going through a transaction."

4. Seek support from trusted external advisers

Critically, outside of the management, businesses also need the right external support, including lawyers and investment bankers to help assess the merits of any potential PE partner and subsequent deal. Mickerts says: "Those trusted advisers are also able to say: 'I know several good Mittelstand (mid-market) private equity players; they're very experienced people with a long-term investment and growth perspective "

Today, there is much more opportunity to make that assessment. PE firms are competing for assets and are more focused on building relationships and trust with potential partners, understanding what the target business is looking to achieve and establishing whether they can make an appropriate return through supporting them.

Preparation is key

PE is certainly one avenue to consider as businesses pivot to grasp opportunities and adapt to the new world of COVID-19 and its impact. But ultimately, mid-market businesses need to be sure of the strategic path PE presents and have a full game plan to ready themselves for that investment. As Ferreira says: "The more prepared you are, the greater the chances that you're going to get a deal done."

To explore how private equity finance could benefit your business, speak to your local Grant Thornton expert.