Private equity investors (also called financial sponsors or buy-out firms) invest in non-public companies and typically hold their investments with the intent of realizing a return within 3 to 7 years. Generally, investments are realized through an initial public offering, sale, merger, or recapitalization.
While venture capital firms tend to invest in earlier stage growth companies, private equity groups tend to focus on more mature businesses, often contributing both equity and debt (or some hybrid) to the transaction.
What do private equity firms look for in a potential acquisition?
- Strong management team.
- Ability to generate cash.
- Significant growth potential.
- Ability to create value.
- A clearly defined exit strategy.
While private equity firms employ various strategies to create value in their investments (such as the consolidation of a fragmented industry), a common strategy is to acquire a “platform” company and grow the platform through further “add-on” acquisitions. Add-on acquisitions are typically smaller in size, but complementary to, the platform investment. Ideally, the synergies of the combined entity create a more efficient whole, both operationally and financially.
LEVERAGE AND CASH FLOW
Private equity groups typically use leverage (debt) to increase the return on the firm’s invested capital. The amount of leverage employed is normally determined by the target’s ability to service the debt with cash generated through operations. The ability to generate cash allows the private equity investor to contribute more debt to the transaction. Because of the aggressive use of leverage, often, the cash flow a business generates in the early years following the acquisition is almost entirely consumed by the debt service. Furthermore, if the strategy is to grow the business, and it usually is, growth also consumes cash. For this reason, private equity investors are keenly focused on the cash flow of the business.
Because cash flow is the basis for valuation, the ability to improve operations to generate increased cash flow will also yield a greater return on investment upon exit.
Private equity groups make money from both the cash flow of the acquired business and from the proceeds generated upon exiting the business. The exit provides the investor a mechanism to monetize the firm’s equity. This is also referred to as “a liquidity event”. The exit provides the financial sponsor with a finalization of the investment and an opportunity to distribute profits. In fact, a significant component of a private equity professional’s compensation is based on this profit distribution, called “carried interest”, or just “carry”. Profits upon exit go to back into the cash account to fund new acquisitions.