How Private Equity Works

Understanding how private equity works, especially in the middle market or lower middle market, is essential for business owners contemplating selling their companies. This overview will explain the key concepts and strategies used in private equity, providing a clear understanding of how these firms operate and their goals.

What is Private Equity?

Introduction to Private Equity

Private equity involves raising funds to acquire, operate, and eventually sell a series of businesses. The primary focus is often on aggregating smaller companies to create larger, more valuable entities. This process typically starts with a strategic thesis, followed by platform acquisitions, add-on acquisitions, integration, and leveraging these components to achieve superior returns.

Strategy and Components

Private equity firms start with a thesis, which defines their strategic focus. This thesis could be industry-specific or more agnostic, aiming to consolidate fragmented markets. For instance, a firm might focus on aggregating companies in sectors like software, healthcare, or industrial services. The thesis sets the direction for all subsequent acquisitions and operations.

Thesis Development

The thesis is the foundational element of a private equity strategy. It guides the firm’s investment decisions, outlining what they aim to achieve by consolidating specific types of businesses. This strategic focus helps in identifying suitable acquisition targets and structuring the overall portfolio.

Platform Acquisitions

The process typically begins with a platform acquisition, which is a sizable business that serves as the base for further acquisitions. This initial acquisition provides the necessary operational infrastructure and establishes the foundation for implementing the thesis. Platform companies are usually larger and more established, providing a stable base from which to expand.

Add-On Acquisitions

Following the platform acquisition, private equity firms pursue add-on acquisitions. These are smaller companies that complement the platform company by adding market access, capabilities, or geographical reach. Add-on acquisitions help expand and enhance the platform company, enabling it to grow more rapidly and effectively.

Integration

Integration is a critical step in the private equity process. It involves combining the acquired companies into a cohesive operation, aligning people, processes, and procedures to achieve synergies and optimize costs. Effective integration ensures that the combined entity operates efficiently and realizes the full potential of the acquisitions.

Knowing the Acquirer’s Objectives

Multiples Expansion

One of the key drivers of value creation in private equity is multiples expansion. As a business grows, its valuation multiple tends to increase. For example, a small company with $1 million in EBITDA might sell for a 6x multiple, while a larger company with $10 million in EBITDA could sell for a 10-12x multiple. This concept of multiples expansion is fundamental to the private equity strategy, as it allows firms to create significant value by aggregating smaller companies into a larger, more valuable entity.

Leverage

Leverage, or the use of debt to finance acquisitions, is another critical component of private equity. By using debt, private equity firms can enhance returns by purchasing more assets with less equity. Typically, middle market private equity deals involve around 50% leverage. While leverage can increase returns, it also introduces risks, particularly if the acquired companies face unexpected cash flow issues.

Returns

The ultimate goal of private equity is to generate returns that exceed the risk-free rate of return. This is achieved through a combination of strategic acquisitions, operational improvements, and the effective use of leverage. Private equity firms aim to deliver annualized returns in the range of 15-20%, significantly higher than the risk-free rate, making these investments attractive to pension funds, endowments, high-net-worth individuals, and family offices.

Conclusion

Understanding how private equity works is crucial for business owners considering selling their companies. Private equity strategies involve a structured approach to aggregating and integrating businesses, leveraging financial tools like debt, and focusing on key value drivers such as multiples expansion. By framing your business as a strategic solution that aligns with a private equity firm’s thesis, you can enhance its appeal and achieve a higher valuation. This strategic insight is vital for navigating the complexities of selling a business in the middle market.