De-mystifying private equity: delivering returns from driving business value

IN recent years, private equity has had something of a bad press – from the highly leveraged mega deals of the boom era, saddling some businesses with heavy debts, to the recent collapse of City Link following its failed turnaround. Unsurprisingly, this has made some management teams wary of seeking private equity backing for growth capital, equity restructuring or an MBO.

It’s time to tackle some of these concerns head-on, to allow management teams to make informed choices about whether private equity funding is the right route for them, and so FDs in particular can see how it could impact their role. With this in mind, I’m focussing on the lower-to-mid market deals involving businesses requiring equity of £2-20m, rather than the big buy-out funds.

The first thing to say is that private equity exists to support business growth particularly at this smaller end of the market – this is how it makes it returns. Private equity investors are looking to back established, growing, profitable businesses, which they can help to realise their full growth potential. Although keeping control of costs in any business is important, PE investment is not about generating a profit through cost-slashing or asset stripping, it’s about building value by helping management teams to position their businesses to be ready for growth before it happens and then exploiting opportunities when they arise.

In this context a private equity firm brings more than just money to the table. Private equity firms need to work closely and constructively with companies, sharing the same goals. They need to create strong relationships of mutual trust and respect with management teams so that they can pro-actively support them as their business develops. Private equity backers don’t just seek out perfect businesses where they sit back watch their investment grow – they look for opportunities with potential, providing expertise and advice where appropriate and crucially a fresh perspective too, to help take the business to the next level.

Clearly, this will usually involve some hard work and tough challenges for management teams, whose assumptions and internal systems may be scrutinised or questioned. While this may involve a period of adjustment for all concerned, the aim is to create an effective and efficient company structure for the long-term, in which decision-making is based on sound principles and strong fundamentals – particularly financial ones

For finance directors, this is where private equity can be a really positive influence, particularly in smaller, growth businesses. Often in SMEs, finance is seen as a support function, a necessary evil, with many having no FD or CFO at all. Private equity backers want to see finance taking a core role within the business, with financial as well as operational KPIs underpinning management decisions. This could mean enhanced financial reporting is required to give greater clarity and in-depth insight or simply that existing financial information is used more effectively when assessing new opportunities. Management information may need to be more detailed to provide the visibility senior executives need to identify what’s really driving the business. Improved forecasting and budgeting will help ensure that the business doesn’t rest on its laurels – but doesn’t overstretch itself either. While again, this can be challenging, the goal is to reduce risk and future-proof the business, ensuring that the choices it makes are fully thought through and assessed.

Having private equity backers on board also provides an extra layer of credibility with external stakeholders – which can be crucial to success. Knowing that an institutional investor has run a slide rule over the business gives bank lenders confidence. Suppliers are more likely to provide better credit terms and landlords are more likely to view the business as a better covenant. Private equity involvement can also bring the businesses useful contacts or leads, and help provide strategic direction by introducing non-executive directors who bring appropriate experience onto the Board.

Of course, every private equity funder is different, and it’s vital that management teams identify one they feel they can work with, whose culture and approach are both aligned with their own. This may not be an easy choice and crucially, should not simply involve taking the best financial deal on offer- investment models can vary, as can personalities and levels of expertise, both of investees and investors. Private equity funds may have maturity deadlines to meet which could impact on their exit strategies, so management teams need to understand how they fit into investors’ portfolios. Management teams need to know that their business – as an individual entity, not just as part of a portfolio – really matters to its investors.

Taking on private equity investment should not be entered into lightly and like any business decision, comes with risks and benefits. But for ambitious firms with strong business plans and a real appetite for growth it can offer not just the funding required, but the credibility and strategic support the business needs as well. For Finance, it can transform its role, putting it at the heart of the business.

Ultimately, private equity in the lower-mid market is about helping management teams grow businesses, not squeezing value out of a balance sheet. Business owners and managers may be reluctant to relinquish their hard-earned equity or to cede control, but when private equity-backed businesses become a success, it’s they that profit most. And that’s got to be a good news story for everyone.

Miles Otway is a partner at Connection Capital