I’ve run several businesses over a long career. A division of a Fortune 500 company. A public company. But what I liked best was running a growth company that was owned by private equity investors. The investors were smart, they gave me great advice, and they always challenged me and my team, in a good way. Our incentives were aligned through real direct equity ownership in the business I was running. I could see every dollar made or saved translate into equity value. My team was tight and motivated. We all made money, had fun, and forged relationships. Everything seemed focused, sharp, immediate and important. That was my favorite.—Portfolio Company CEO, 2006
Executive management teams are expert at managing and building companies. That’s what they’re trained to do. That’s what they love. It is in their blood.
But at least once in the careers of many, and more than once for the successful ones, executive managers get the opportunity to lead or join a buyout. The opportunity may arise when a larger company sheds a division. It may arise when a family sells a business and affords long-time managers the chance to own it. It may arise when a private company seeks a financial partner to help the business “reach the next level.” But regardless of how the opportunity arises, participating in a buyout can represent the opportunity to make serious money as an owner and to lead an executive team through what is often the most electric phase of a business’s growth.
But how does an entrepreneur or manager pick the right partner if given the opportunity, and structure the right deal? An entrepreneur/manager, after all, may lead or join a buyout only once in a lifetime and has, in any case, only one company situation at a time to get right. A wrong choice, especially if coupled with an adverse business climate, can be as unpleasant as a bad marriage. A good choice can lead to relationships, riches taxed at capital gain rates, and a network of future business opportunities. In both robust and uncertain markets, entrepreneurs and managers repeatedly face this important choice. How do they choose?
This two-part article offers perspectives on the issues that matter most in the mating dance among founders, managers and prospective financial partners. Part I addresses the “softer,” relationship-oriented considerations that often are the most important. These are the criteria that can differentiate two prospective financial partners who are willing to offer comparable value, and in some cases even propel a lower bidder to the winner’s circle. Part II offers a summary of techniques—“deal technology”—that can be used to structure win-win arrangements between managers and financial partners. The article focuses on buyouts in the smaller and mid-market sectors of the LBO market and on growth equity deals as well. Many of the concepts also can apply at the large-cap end of the market, but in that sector the freedom to pick a financial partner is typically more limited, particularly if a public company is involved.
Not All Money Is Alike
Investors in the buyout and growth equity markets complain constantly that there is “too much money chasing too few good deals.” Like many clichés, this cliché happens to be true. The corollary is that too many private equity firms are chasing too few great managers and management teams.
Not all management teams get to choose their financial partners. In an auction of a public company, for example, the highest bidder capable of closing typically wins, regardless of issues like compatibility, approach, expertise, track record or network. And, in some cases, most commonly involving sales of 100 percent ownership without an ongoing equity interest for the selling owners, price is almost always paramount. But in the “partner like” arena of growth equity deals, recaps, and buyouts of private companies with significant rollover equity interests, a host of “softer” considerations can and often do make a difference. These also come to the fore when a world class executive weighs an offer to join a particular private equity-backed company.
From the perspective of an entrepreneur, the first and most obvious issue (after valuation) is a simple and basic one: Do I like and respect the potential partner in terms of business acumen, ethics, reputation, ability to add value and chemistry? Financial bidders often seek to cultivate goodwill with founders and other members of management teams by citing their track records and references. Savvy bidders wish to be identified by targets (and their advisors) as the buyer who best knows the target and has done the most work on the project, is most liked by its management, and is ahead of the pack in terms of its readiness to close. The investor/manager relationship is an extraordinarily close one, in good times and particularly in bad. Lack of good chemistry and momentum at the outset can be fatal to a bid.
Within the framework of personal chemistry, many view communication, good disclosure and expectation-setting as the bedrock of a good entrepreneur-financial partner relationship. In most buyouts, first-year performance is a key indicator of ultimate success or failure. Few things are more embarrassing (though there are indeed a few) for a financial partner than to write down an investment shortly after making it. If pre-deal financial and performance expectations have been set honestly and carefully, the relationship is likely to flourish. This is particularly important in light of the fact that the capital structure in a buyout is set based on a set of shared assumptions and is relatively permanent. “Rules of the road” include: deliver bad news early and good news on time; come to the table with solutions, not just problems; under-promise and over-deliver without “sand bagging” projections; and invest in relationships—the dividends will be paid when you most need them.
Beyond personal chemistry and expectation-setting, entrepreneurs and other managers typically think about a series of questions and metrics in considering competing financial bids beyond the usual “big three”—value, terms and certainty of execution. These same themes, in turn, are emphasized by prospective financial partners seeking to gain the confidence of company management in order to capture an insider track in the sale process. Among them are the following:
• Is there a shared vision of a growth strategy, exit plan and management structure?
• Will the company profit from an intensive, hands-on management role from investors that can include on-site “operating partners,” investor representatives in attendance at staff meetings, near daily interaction, and regular use of consultants in search of EBITDA growth, or is a more hands-off style preferred?
• Does the financial partner have unique sector expertise and a network of in-sector companies that can fuel growth?
• When does the financial partner’s fund expire, and how might this affect decision-making relating to the timing of a future liquidity event? Is an intermediate-term liquidity event envisioned, or does the investment approach emphasize long-term ownership of the investment with distributions or long-term compounding of earnings?
• Will the prospective financial partner provide senior level managing director attention or delegate the work to bright but inexperienced professionals who have not experienced business cycles?
• Which are the financial partner’s best references from prior deals? Which are the worst?
• Is the message in the financial partner’s most recent offering memorandum consistent with the message being communicated as part of the wooing process?
• What do the reference checks say about how the financial partner is likely to behave in times of crisis or under-performance?
• If a syndicate of investors is involved, does each bring a unique skill set (e.g., operations, sector expertise), and do they have a track record of working smoothly together?
• How diversified is the financial partner’s portfolio? Will the particular investment at hand be a relatively small or large investment for the firm?
• Does the financial partner have a track record of litigation?
• At the risk of getting far ahead of oneself, what has been the history of entrepreneurs from prior deals of the financial partner in terms of future portfolio company or board opportunities, and what do former managers have to say about their experience in companies owned by the financial partner?
• Does the financial partner have a track record of promoting growth through effective acquisitions, of providing value-added ideas for growth and of providing the resources, both human and financial, to realize the growth strategy?
• Does the financial partner bring value-added structural ideas and reasonably fair terms to the table with respect to rollover equity, management equity pools and other key provisions?
• Does the financial partner bring world class or at least value-added independent directors to the enterprise?
• Are the financial partner’s counsel and other advisers smart, pragmatic, accessible, and easy, or even enjoyable, to work with?
• What is the level of communication? Having the financial partners speak to employees at or immediately after the signing/closing about their expectations can help dramatically with retention and calming the troops. Once a deal takes place, employees may expect a slash and sell-off strategy by the financial partner. Open communications, town halls, and all-employee calls with the financial partner can help set the right tone in the beginning.
• Does the relationship with the financial partner feel like one of ownership or partnership, and does it mater?
From the financial partner’s perspective, the list of questions above can become, in effect, a marketing program for capturing the hearts and minds of entrepreneurs. The growth equity business (and to some extent the buyout business) is, after all, the business of “selling money to people who don’t need it” in the words of a leading private equity CEO. A well prepared financial partner always has its list of references at the ready. It may introduce successful entrepreneurs from prior deals to serve as directors or consulting advisers, helping the financial partner and entrepreneur shape strategy. It will not use legal counsel or other advisers who alienate or condescend to prospective sellers/rollover stockholders. And, of course, it will seek to assure that its valuation is competitive.
What is life like after closing with a private equity firm for a partner? In the words of one executive in a recent large technology buyout (a public-to-private transaction), “What’s really different is the cadence of activity and level of access. It is a 24/7 experience, one of full engagement, all the time. You are directly involved with the board, daily, and they know your business just about as well as you do. The focus is on long-term strategic growth of EBITDA and value at exit, and never on quarterly performance. A company’s incentive plans will often be reset to be closely aligned with the financial partner’s, such as EBITDA, cash and growth, ideally in a collaborative way.”
And there are other, less obvious things to know—how to structure equity compensation for a team based on wealth creation at an exit as contrasted with using it as an aspect of annual compensation, handling of relationships among financial partners, and knowing how to benefit from a financial partner’s resources and network of contacts.
Part II of this article will explore specific strategies, structures and tactics for creating partnerships between private equity investors and management teams in the context of growth equity and buyout investments.
John LeClaire is co-founder and chair of the Private Equity Group at Goodwin Procter LLP; reach him at email@example.com. Michael Wilson is a managing director at TA Associates; reach him at firstname.lastname@example.org.