How a Private Equity Firm Decides on an Acquisition

How a Private Equity Firm Decides on an Acquisition

For the owner of a business looking to exit, there are typically two types of acquirers to sound out. One, a strategic purchaser, an industry player who could potentially be interested in acquiring the business. And two, a private equity (PE) firm which could invest money sourced from institutions and wealthy individuals into buying and selling businesses.

The PE industry is the lesser-understood of the two options, and thus deserves a deeper dive to better understand how it functions. PE firms are essentially professional money managers that raise large pools of funds from private investors.

These investors typically comprise:

a). Family offices

b). High net worth individuals (HNIs)

c). Large financial institutions such as sovereign wealth and superannuation funds

Once the capital has been sourced, it is used to invest in or possibly acquire a suitable target business, and develop its operations such that it can ultimately be sold off to another acquirer at a sizable profit.

How does the money-making work in private equity firms? Investors are offered the potential of higher returns than those typically achieved from the stock market, after allowing for the risk of illiquid and highly-leveraged investments. In return for implementing the suitable methodologies and strategies, the private equity professionals earn the following charges:

1. Management fees

2. Success fees on eventual profits from successful exits

3. The PE industry operates on two main considerations:

4. Investments typically have long (3-7 year) holding periods, but the time capital deployment and exiting investments is predetermined – often 10 years. Because of this, PE firms aggressively pursue deals and each transaction ultimately is to end in an exit.

5. A private equity firm must maintain a successful record. Hence, each transaction is backed up by extremely detailed screening and significant due diligence. The downside of a poor investment is great damage to the reputation of the firm.

Investments are made in firms at different stages of growth:

a). Early-stage:

This is more the target of venture capital, with the company offering high growth potential, typically from life sciences or technology

b). Expansion:

PE professionals tend to look for established firms that require external capital to scale up or for buying out existing owners to build value.

  • The stake could be a controlling one (>50%) or a minority one, depending on the investment mandate and preferences
  • The buyout could be of a private or a public firm, with either existing management backed to continue (management buyout – MBO) or new management brought in (management buy-in – MBI)

Private equity professionals come with different risk appetites, deal size preferences, or industry choices. Nevertheless, some common criteria for choosing the right investment opportunity are as below:

c). A stable track record:

This helps to make a target more attractive for investment, with an inconsistent track record being seen as too risky. However, an underperforming company that offers strong potential for fast growth could easily be picked up.

d). Attractive purchase multiples:

PE professionals look for deals where the opportunity is at a lower multiple but the exit is at a higher multiple. This is the main reason why an underperforming company in a leveraged buyout is a top choice.

e). Potential for strong cash flows:

This offers the comfort of being able to sustain higher debt without any distress to its finances. It also indicates the strong foundations and prospects of the business model of the target company.

f). A strong market position:

This means higher entry risk for competitors, lower substitute risks, and greater pricing power, making for predictable cash flows and thus a lower risk profile.

g). Capability to improve efficiency:

This is attractive when it happens without affecting growth or sustainability. Hence, consulting and operational experience are highly sought out in the PE industry.

h). Low capital requirements:

This indicates higher capabilities to generate cash flows and take on high debt loads.

i). Proven management strength:

PE firms prefer staying away from day-to-day management, which is why a target with a strong management team inspires more confidence as a good investment.

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