Looking at what happens after the initial change of control transaction — the first time the private equity comes in and buys out a privately held company.
During the Nashville Smart Business Conference panel on Exploring Exits: How to evaluate your sell-side options, Bass, Berry & Sims M&A Partner Tatjana Paterno led a discussion about what goes into the decision by the private equity firm to monetize their investment in their portfolio company.
Capital Alignment Partners Director John Pontius says most of the time his firm is looking at companies that are two to seven of EBITDA as a platform. Once they're able to get them above 10 EBITDA, the firm starts to review market dynamics and management team.
"In this part of the cycle where we're able to get a lot of multiple expansion once we get above that, we've sold," he says.
Council Capital Vice President Nick Cooper says every situation is different for his firm.
"At the start of every investment, we sit down as a team and say — the team meaning us and our partners — what does a good deal look like for us?" he says. "And it's some of it is MOIC and return, but a lot of it is what do we want to accomplish with it."
In one example, the firm owns an autism services company that it acquired in 2018 when it was just a neuropsych practice diagnosing children. The underwriting strategy was to take the diagnosis and expand that to clinics so services could be provided immediately after. While COVID made it difficult to prove out the new economic model of these, over the last several years that information has come through and now they have five open with 10 more coming down the pike next year.
"So, we know that unit economic model work," he says. "We've been able to replicate this. The management team is in place. Now we can look up and say, let's look at the market conditions and try to time it appropriately. But it's all variable based on individual circumstances with your partner, what they're looking for, what you're looking for and then where the company is in its lifecycle."
RiverGlade Capital Vice President Kevin McGrath says the management team is always an important part of the equation when considering exit decisions. When investing with founders and entrepreneurs, over the course of the investment there is some professionalization of the business and trying to shift a lot of the responsibility from the founder who is often wearing all the hats to being a business that can stand on its own. But usually towards the end, the founder is still an integral part of the business. Even though a lot of time it involves management giving up control of the business and they may only own 20 to 40 percent, the investor isn't bringing full management teams on board.
"The management team is an integral part of the business and the value that the next buyer is buying," he says. "And so, you're going to have to be aligned with them when it comes to exit because otherwise you don't really have a full business to sell. Some people are nervous about giving up control. You're not really giving up as much control, I would say, as you think or may be legally represented."
When it comes to roll over equity for business owners, Whistler Capital Partner Darshan Prabhu says where his firm spends time from a size perspective, the conversation around rollover rarely comes up at the LOI stage, which he says for the size company they're focused on is the right approach.
"Between management teams, leaders and founders that we're contemplating partnering with, the most important questions they have to answer is, who's that right next partner?" he says. "Monetizing in a transaction is one component. But depending on where the individual or group of individuals are from a value creation perspective, some want multiple bites of the apple post a transaction. And so in those conversations a rollover discussion is actually extremely easy because alignment becomes such an important component of the transaction. As investors, we all have to remind ourselves that we are one part of the team. We aren't the drivers of the discussion. So, if we aren't aligned with what that outcome is, and when it happens, I think it adds for more awkwardness in that roll-over discussion."
Sometimes when founders are not continuing on with the business, there are questions that get raised at committees and even with LPS as to why the founder is leaving and whether that is an indication there is something wrong with the business.
"It's a very negative lens to take but unfortunately, as fiduciaries of capital, we have to do that to ensure that every stone is unturned," he says. "So, it's not always from the standpoint of you have to have funds in. It's a question of if you're not involved do key clients walk away because of the relationships you've built since founding the business? Those elements are hard to diligence. They don't show up in a P&L and it's really that risk that the investors are underwriting that we have to be cautious about."
Pinnacle Financial Partners Managing Director Tyler Morgan says one of the things he and his firm talk to private equity buyers about is to understand what they're able to offer the sellers who are owners and also their management teams so that when the sellers begin to communicate with their management teams and further down, they can tell their people, their key people, that it's all about people.
"What's in it for you?" he says. "Don't be afraid just because there's a change of control. But you want buy-in and you want alignment. And so get your questions asked and answered early and understand what's in it for your team so that you can communicate with them successfully and get buy-in at an early stage."
Morgan says he understands sometimes a premium means the owner or founder needs to get an earn out and the roll back of equity is certainly important for alignment of interests moving forward. But where some buyers miss an opportunity is explaining to the sellers who are going to be investors why this is a good investment, and helping them understand what the vision is and understand — knowing you can't share all of the strategy at this stage — why rollback is a good investment for them. And then for the non-owners who are going to be key moving forward, understand what you can offer them in terms of equity or options and bring them in and help them understand why that's good for them going forward.
"At the end of the day, it's all about people," he says. "And for these people, they have families to think about. And so they need to know about their own financial security and what this transaction means for them from a wealth management standpoint, and for financial security for themselves and their families moving forward."