Turning Risks Into Reward with Family Businesses

When it bought Harlan Sprague Dawley, Inc. one year ago, LBO firm Genstar Capital made an interesting concession to the owner.

Genstar Chairman Jean-Pierre Conte recalls how the patriarch requested that two of his sons, both in their 30s and both the future beneficiaries of the family estate, be allowed to sit in on Harlan Sprague Dawley board meetings as observers. The aim was to have them learn more about private equity and, by seeing how Genstar operates, learn how to improve the running of their own separate businesses. Since the family was going to be represented on the board anyway, Conte didn’t see the harm.

In another deal, Genstar agreed to let a painting of the founder, the owner’s father, remain hanging in company headquarters for one year. Genstar also promised not to change the name of the company right away.

Welcome to the world of buying small, family-owned businesses. They account for much of the activity in the U.S. economy, but the type of family-run business that private equity firms typically go after aren’t usually of the stature and sophistication of a Wal-Mart or a Cablevision. Instead, these are below-the-radar, lower-middle-market companies, mostly with one location and still in its first generation of ownership. With each day that goes by, more and more aging baby-boomer business owners either want to take the chips off the table or are coping with second and third generations of children who simply are not interested in running these companies.

Recent transactions involving family-owned businesses include BlackEagle Partners’s purchase of Federal Broach and Machine Co., Forbes’s sale to Elevation Partners, Texas Pacific Group’s buyout of Field Container Co. and the Dolan family’s proposed $19 billion take-private of Cablevision, to name just a few.

Bankers have helped to ratchet up the number of companies for sale. John Howard, CEO of Bear Stearns Merchant Banking, reflects, “In the past you could approach a private company and it would be a kind of unique discussion. The owner would say, ‘My kids aren’t interested so let’s sit down and talk.’ Today the conversation starts with, ‘I’ve hired Goldman and you’re number 3,000 in line so here’s the number of my banker.’”

But as the supply ticks up, it is being met by demand from LBO firms, which have been willing to reach down lower and lower into the middle-market and into hairier situations. Some firms, like FdG Associates, Arsenal Capital Partners, Genstar and Bear Stearns Merchant Banking, specialize in dealing with family-owned businesses and like their unique value proposition—part minefield, part gold mine.

The trick with family owned businesses is understanding that what creates the value is also what could destroy it. On the one hand, these are companies driven with passion and creative force by an entrepreneur who knows the products, customers and suppliers like his own children. On the other, it is a business that often has not been run for optimal profit, where managers aren’t used to criticism or change, and where the executive suites are likely stacked with brothers, sons, aunts and uncles who may not be up to the job of competing in a global market.

When Arsenal Capital Partners approaches a business, its pitch typically revolves around moving out of a comfortable region and into the global arena. But change can be a tough sell. “Many of these businesses are like a child. They are part of the family. So many of these situations are emotionally charged,” says Terry Mullen, a managing director with Arsenal. “With family-owned businesses there is a lot of hesitation around change. The issue is whether emotionally a family is ready to make a transaction. Sometimes they are and sometimes they aren’t.”

A few of the challenges and opportunites follow below:

Challenge 1: First Impression

Step one in buying a family business is often the “chemistry test,” which at this level could be a dealbreaker. Each buyout pro has his own tactics of ingratiating himself to a buyer and putting them at ease.

Private equity’s reputation as a company buster can often precede it and, in too many cases, is confirmed by maladroit behavior. One buyout pro described what he called the “masters of the universe” approach that damns LBO firms before they get started. He says, “What happens far too much is the guy flies out on the corporate jet, comes in and tries to understand the business in 30 seconds or less, then at the coffee break tells them they’ve got it all wrong. I can’t tell you how many people do this. And the people who do know a lot about the business are often the worst offenders.”

Jason Runco, of BlackEagle Partners, spoke to Buyouts recently about courting favor from a recent target, family-owned Federal Broach & Machine Co. He ended up taking part in at least one impromptu dinner where the wives of the two brothers who manage the company turned up. Runco recalls that he switched quickly from a beer to a Diet Coke once he recognized that the wives were part of the evaluation team.

Mark Hauser, a managing director at family owned-only FdG Associates, put the chemistry test in near marital terms. “The most important thing that goes on is looking each other in the eye and making sure you have the same values and ethics. Do each of us want to wake up each morning and be happy we’re in partnership together?” He adds, “You’re as much of a psychologist as an investor.”

Challenge 2: Staying Flexible

By now, Genstar’s Conte says, he is used to the terms in buyouts of family-owned businesses. In negotiations, he says, “There are a lot of softer, non economic issues that are potentially very important to the family.”

To get deals done, Genstar has often had to bend terms in strange ways. What this means most often is owning less of companies and letting owners roll over more equity. At times, Conte has gone as low as a 60% control stake to get a deal done. But as mentioned above, there are other “softer” issues that help win companies over.

Even so, Conte says that there are certain requests that must be refused. One of them is when a family member asks to maintain an office at the corporate headquarters. “If there’s a leadership change, you can’t send confused messages about who the leader is. You’ve got to gently—and sometimes not too gently—tell them, ‘We’re not going to be able to attract and retain a great new leader if the previous family leader is still marching around the office.'”

Typically, buyout shops will keep family members on for a negotiated amount of time, between one and three years, and after that, it’s only about performance. Stephen Presser, a partner with Monomoy Capital Partners, says the biggest problem is when the entrepreneur is too attached.

“We will come into a company and find eight members on the payroll. Maybe some are adding value and some are not,” says Presser. “The challenge for us is, what would this company have looked like historically if it was being run for profitability? It’s a tricky line. We’re a private equity firm, we’re tough. But on the other hand, in order to strike a deal we have to modify that a bit, to provide a place for some if not all of the family members.”

Challenge 3: Maintaining the Culture

Changing the composition of family-owned businesses is a tricky matter. First, a great deal of the company’s value is typically tied up with a passionate, highly knowledgeable founder who has intimate rapports with vendors and customers. They know the business cold.

“The top challenge is clearly cultural,” says Greg Feldman, at Wellspring Capital Management. “But the opportunities are the same as the challenges. The company is typically run by an entrepreneur who’s built a culture from the early days and carried a lot of people on his coat tails. Typically there is a very good culture of people and a loyal customer base, all of which is very expensive to replicate.”

Deal pros confessed that even after a company has been warned numerous times that there may be changes in the future, executives can still express shock when a private equity firm makes a move to change the direction of a business drastically.

Bear Stearns Merchant Banking likes taking minority stakes to keep entrepreneurs involved. However, says CEO Howard, “To get them to change what they are doing is difficult, because they’ve been successful and always been right. And you’re a young whippersnapper telling them what to do.”


Of course, the problems associated with family-run businesses also provide opportunities to improve performance. Many often are not run to achieve the highest profit possible. Families often see their businesses as cash cows and as ways to give offspring and siblings a place to work. With so many family members and friends working, not all can be effective or qualified. A CFO with little training can perhaps handle the finances in the early stages of a company’s life (which leads to another all too typical challenge at family-owneds: unreliable financial statements). But that same CFO may be ill-equipped to handle the books after the company takes on leverage.

One of the top reasons cited by LBO firms for the success of most family-owned buyouts is the opportunity to take risks at companies that were, up to the time of the LBO, risk averse. With all assets tied up in “the golden goose,” families are much less likely to try an acquisition of a competitor or to otherwise aggressively grow. LBO firms have capital to spend, which allows the managers to think in a more risky way with chips off the table. “To most entrepreneurs, debt is a four letter word,” says Wellspring’s Feldman. “Typically they are much more conservative than we would be in terms of growth and leverage.”

Overall, the reasons Presser is rosy about buying family businesses are summed up as follows: “Somewhere in this business is someone who cares about it more than anyone in the world. And you just don’t see that outside the family context.”