Green flags: What private equity looks for in an investment

By Joe Morrissey

We believe companies in the lower middle market may have the potential to attract a range of buyers and investors, including high-net-worth individuals, strategic corporate acquirers and private equity firms. To many audiences, the motivation of the private equity buyer may seem the most opaque.  

How private equity works

Private equity firms are typically looking to acquire some percentage stake in a business with the goal of creating value over a timeline of four to seven years (source: Pitchbook 2021 Annual US PE Breakdown). After that, the firm’s most likely move is to sell their shares and return a strong capital gain to their investors.

Generally, private equity employs what’s called a “buy and build” strategy. They acquire companies with synergistic benefits to each other, which creates a larger entity in which the sum is greater than the individual parts. They acquire platform companies — typically strong, market leaders in a high-growth industry — as well as complementary add-on entities. Add-ons may not necessarily be the largest or strongest in their segment, but they may offer something that will strengthen or supplement the group as a whole.

Selling to private equity: Unique value

Private equity may be a good fit for business owners looking for an exit or those looking to recapitalize their operations. This of course depends upon the facts and circumstances of the business.

Partnering with a private equity firm may be an opportunity to help grow your business with new backing and resources behind you. As a hypothetical example, let’s say you sell an 80% stake in your business but stay on with 20% equity. It may be possible that your 20% shares could be worth more in a future sale than in your original exit if the business preforms well over time. This staged exit approach is often referred to as getting a “second bite at the apple.”

Alternately, selling to private equity could be a way to reward and incentivize your leadership team by setting them up with a minority ownership stake.

In our experience, private equity firms are often heavily motivated to keep your leadership on board because they may trust that the current operators are the experts in their businesses. It’s also our experience that it’s not uncommon for deal negotiations to include equity opportunities for your team.

What private equity looks for in an M&A investment

If you’re looking to position your company for private equity buyers, in our experience here’s what private equity generally looks for as they’re considering investment opportunities:

1. A strong management team

Private equity investors typically won’t be involved in day-to-day operations, so they want to see that your management team is capable of running the business and accelerating growth. If your business is heavily reliant on you, and you’re looking for a more immediate exit, you may not be a good fit for these buyers.

2. A mission-critical business

If you provide a product or service that few others in your region can offer — or if you supply goods and/or services necessary to meet governmental or societal mandates — then you’ve created a mission-critical business. A company is recession resistant (or business cycle resistant) when its customers cannot easily continue to do business without them.

3. Secular momentum

In our experience, companies with secular momentum are those benefiting from long-term market trends rather than short-term business cycles. The healthcare sector is one example. Research by the University of California, Berkeley supports the claim that the aging baby boomer generation and general increases in medical costs are pushing money into the healthcare sector.[1]

4. Opportunities for growth

If the private equity firm’s goal is to gain a strong return on investment, your company may be more attractive to them if you have a clear vision for continuing to grow your company. That’s why we believe that it’s important that you keep planning for future opportunity, even as you contemplate exiting the business.

Is there emerging technology that could significantly increase capacity or efficiency if you had the capital? Do you see opportunity to grab greater market share from your target customer base? Do you operate in a fragmented industry that is ripe for consolidation?

Similarly, a strong business with certain operational limitations can be attractive. Perhaps your business has strong customer demand, but you’re not doing customer profitability analysis or using business intelligence to optimize your margins. That’s an area where private equity could add value and build the bottom line.

5. A diversified clientele

Generating income from multiple sources may diversify the risk to the underlying revenue source of the business. Overreliance on any one customer can detract from company value.

On the other hand, if you can demonstrate a high level of “stickiness” (i.e., the customer is both stable and reliant on your business), customer-concentration issues can be overcome.

Likewise, private equity may be willing to overlook customer concentration issues if your customer is a blue-chip operation or operates in a niche market where the private equity firm is eager to build relationships.

How Wipfli can help

If you’re exploring exit or liquidity options, consult with the investment bankers and M&A specialists at Wipfli Corporate Finance Advisors*. We can help you evaluate market opportunities and capitalize on your success.

Begin an exploratory conversation. Proactive exit planning — even years in advance of a potential sale — could help you maximize value and achieve your personal and strategic objectives.

Sign up to receive additional in your inbox, or continue reading on:

• Sellers: Here are 7 ways to prepare for due diligence before a transaction kicks off
• Explore 3 estate-planning strategies to guide your decisions
• Ready to sell: How working capital impacts business value
• Increasing saleable business value: Decreasing a buyer’s perceived risk

* Any opinions expressed herein are those of the author(s) and are for informational purposes only. Any opinions expressed in this material are those of the authors and do not necessarily reflect those of other employees of Wipfli Corporate Finance Advisors, LLC (“WCF”) or RKCA, Inc. The information and opinions expressed herein are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of any specific investor(s). Any factual content in this material was obtained from sources believed to be reliable, but there is no warrantee of the accuracy or completeness of any information contained herein. There is no obligation to update this information if it should change in the future.

Any persons providing the testimonials herein have experience in the services that were provided by WCF and RKCA. Their respective experience may not be representative of all other Clients of WCF or RKCA. Testimonials are not paid for by WCF or RKCA. Testimonials do not constitute a guarantee of future performance or success related to any product, transaction or service.

The information contained herein does not constitute an offer to sell or a solicitation of an offer to buy securities. This information is not and should not be construed as advising, advocating or recommending to take any action or to buy, sell or hold any investment product or strategy. This material should not be considered, construed or followed as tax, legal, accounting or investment advice.

The acquisition and sale of a business or a capital raise may turn out to be regarded as a purchase or sale of a security. Accordingly, your transaction will be handled by our team members who are registered with a broker/dealer with whom we have established a relationship. Our team members who will work on your transaction will do so through an engagement with that broker/dealer.

Investment banking services provided by RKCA, Inc., Member SIPC/FINRA. 1077 Celestial Street, Cincinnati, Ohio 45202. Phone: 513 371 5533. Certain Wipfli Corporate Finance Advisors, LLC associates are registered representatives of RKCA, Inc. Wipfli Corporate Finance Advisors, LLC is a subsidiary of Wipfli LLP.

Investing involves the risk of lost. Past performance is not a guarantee of future results.

Please see our Form CRS here: rkca.com/crs.