How Do Private Equity Funds Evaluate Businesses?

hello and welcome to well capitalized I'm your host Bobby Kingsbury managing director at MCM Capital Partners today we have mark Mansur senior managing director and founder of MCM Capital Partners thanks for joining us today Mike I appreciate it we've been having conversations with some business owners with Harry senior operating partner and really what we want to discuss today with you fundamentally is what private equity is kind of demystifying private equity so for the business owners who are unfamiliar with private equity can you please provide a rudimentary explanation of private equity and what it is private equity generally involves a private fund made up of shareholders it could be institutional shareholders like pension funds university endowments hospitals tend to be the bulk of the capital provided to the fund and it can also include high net worth individuals those folks provide capital to the fund which then in turn looks for opportunities to invest that capital in private enterprises generally speaking they're looking at taking controlling positions some very few will take a minority position but most are looking to make control investments and for business owners out there obviously private equity isn't the only Avenue for a potential exit what are some of the other things that a business owner may consider other than private equity one thing about exiting their business well I you know it actually can take a myriad of different forms I guess I would start off by saying you know a management buyout is certainly a possibility generally that involves key managers getting bank's support to acquire the business from the founder and generally the founder at that point in time is going to provide the equity visa be a seller note that gets paid off over time that would might be one option another option is an esop so in an esop transaction effectively all the employees purchase the business from the founder you using leverage provided by a bank and again generally speaking the the principal owner is staying in for in some cases of majority of the cuppy and it gets but down over time other opportunities for liquidity you might seek a strategic buyer that is an industry player or in a tangental industry where they that strategic buyer be they public or private buys a hundred percent of the company so there's there's a lot of different ways to get liquidity and they each have their own nuances depending upon what the seller wants to accomplish so if a business owner decided to go down the private equity route how do private equity firms generally value in a business so I would speak most most specifically for for MCM in the way we would approach the transaction but I think the concepts are generally common throughout the industry so most business owners have heard about a multiple of E but DEA is a very common means of valuing the renter price which is a very scary thing sometimes right so you know the question is what's the multiples at five times abtar' is a ten times e but DEA and it's the the some of the other factors that impact where they have multiple is likely to fall and I'll elucidate a few of the things that we look at that that dictate what we might pay for a business or value of business so I would start off at a high level and say the overall market in which the company competes is it a growing market is it a contracting market is it a mature market is it a highly cyclical market so for example in you know medical device industry tends to be a non cyclical market and therefore my command a higher multiple and then you start to move to the specifics of the company itself where how is a company positioned within the market in which it competes what's its defensible IP you will and doesn't have to be true IP but technical know-how etc how's it position and buffets you know nomenclature he talks about the moat around the castle so we start talking about what's the company's moat around its castle and how defensible is it and is it sustainable moving forward correct you know I guess you know the the other things that we look at that are perhaps equally important is the depth and breadth of the management team if you have a business that typically the businesses that we get involved with the owner is the CEO and has been he may have been the founder in fact so we look to how much managerial talent is there beyond that one individual and if that individuals the you know the primary customer contact the primary engineering behind you know whatever the business is doing that creates a little bit more risk sometimes centralized within one individual so strength and breadth of management team very important and then I guess you know not I guess but you know we also look at certain financial attributes of the business its cashflow efficiency is important to us so how quickly does the company turn a sale into a cash and how well does it manage its balance sheet in terms of capex requirements for example I'll start with that if you're in a business you could have two businesses that have the exact same EBIT da1 business requires a million dollars a year in capex to support its business or operations on a go-forward basis any other requires half of that half a million dollars so clearly the business it requires half as much capex is going to be more attractive to the investor community and all those things you know interplay and different firms will value different attributes differently so if I were to push you from your perspective from MCM s perspective what would be the one or two things that you would consider holding them most wait that's like asking me to pick between my favorite children it's really hard but I guess I would you know it start really with the the strength of the management team and if I had to pick two things would be the strengths of the management team in its competitive position in the marketplace if you could describe we had talked about other avenues for a potential exit and what situation would it be best suited for a business owner to generally consider a sale to a private equity firm I would say you know what is quite attractive to a private equity firm is when the business owner wants a continuing role in the organization on a go-forward basis and the so speaking of from the business owners perspective where the business owner highly values the future potential of the company and is doing some very prudent financial planning but wants to ride you know the wave on a go-forward that basis and is willing to stay in for a meaningful amount of equity in generally speaking you know I would say that where the business owner wants to retain an active role as well you know it you know contrast it with a strategic acquisition for example a strategic acquisition of a public company they really don't want typically they don't want a subsidiary to be anything but a wholly owned subsidiary and they may have very different perspectives on how to staff the organization so there tends to be far more turnover in a circumstance like that so I I would say where the business owner values truly values his affiliation with the business on a go-forward basis the businesses he's convinced or committed to the business's growth opportunities and he values the culture of the organization who really wants to preserve that what should a business owner look for because there's many private equity firms out there there's a there's a ton of folks like us what should a business owner be looking for and partner because often times it's very difficult to decipher but between firms well I I would probably start with something soft and it's very difficult to define and identify the cultural fit is is really important and if there's not a cultural fit there's there's a significantly increased chance for one party to be dissatisfied with the other party at some point in time post transaction so I think that's a critical nature but I you know if I was painting with a broad brush I would say you know I would want if I was a business owner or some value add to be brought to the table beyond you know the greenback's and I'm gonna be putting it in an investment account somewhere and so that can be come in the form of a private equity firm that is experienced in dealing with companies of the seller size it could be coming from the perspective of the the private equity fund having previously invested in the market in which the the target is participating and therefore as an experienced investor whether it's aerospace or you know something of that ilk so you know you're really looking for some help in growing your business and in making the business stronger on a go-forward basis so if I'm a business owner I'm looking to sell I may have a boss or someone to report to maybe for the first time in my career and now I no longer have control of what goes on in the business and for some business owners that may make me extremely nervous so what what protection does a business owner have you know when selling their business since they no longer have control well I I guess I would I would start with and differentiate between operate day-to-day operating control particularly for a business owner that's doing a recapitalization and is going to stay involved as the leader of the business and a go for a basis and then governance related issues so these are things that that would affect the capitalization of the company or any major asset purchases or dispositions those types of things so I would distinguish between those two but it's always a transition so a business owner particularly in the businesses that we get involved with which you know are smaller so think you know 2 to 8 million of EBIT da and maybe less than 30 million 40 million of revenues very often these businesses have not been used to putting together annual budgets and forecasts and strategic plans the business owner you know may or may not be attentive to putting together monthly financial analysis maybe he just uses his bank account as or the company's bank account as a as a proxy for how well the company is doing with a private equity firm involved it's going to be run not as rigorous as a public company but some of those attributes are adopted from public company reporting so for the first time the business owner a will have a board that there may be for the first time they're accountable to so-and-so large major decisions like major capex additions he's going to go to the board and at least get an annual budget approved if not you know individual pieces of equipment that tends not to be a the case and the monthly reporting is going to be different than perhaps what he was used to before but it's it's all really I mean it's to the benefit of the company because you're professionalizing a lot of a lot of the different aspects of the company which perhaps we're done on a more ad hoc basis prayer from a business owner who generally again hasn't had to report to anyone if ever in in their career what would be typical from a private equity from what would a private equity firm ask what were their requirements be for that business owner what can they expect after they okay so I'll start out with sort of the annual planning mm-hmm so we would expect that the team would would work in in concert with perhaps it's a private equity partner to develop a annual plan think of it as an annual budget and we would want to see monthly reporting against that plan so at the end of January for example for a calendar year company we would look at January's financial performance and ask are we ahead or behind you know the the forecast for that year that we put in place and if there's anything material that happened during that month bad good or indifferent we would like to know that so clearly there's the numbers but we're not at the company and so we're reliant on the communication from the team to tell us what's what's going on so we're informed and we can react to any opportunities or circumstances so annual plan monthly financial reporting generally that monthly reporting will include a a page and a half discourse on major events for the month quarterly we're going to have board meetings and it with the generally senior management team participates in those board meetings so you have senior sales individuals in your operating person etc that participates and then finally I would say you know the obviously an annual audited or reviewed some in some cases financial statement will be part of the part and parcel then we have an annual meeting for our limited partners in fact it's going to be in a couple days and we bring in executives from all of our portfolio companies and gives them the opportunity to present to our shareholders and it gives our shareholders the opportunity to have an unfiltered view of the investments that were making and I think it's it's it's really terrific opportunity for the management teams to really hone their message and really understand sort of the the things that they do unique and be able to communicate that if you could sit down with a business owner maybe it's a family member a close friend and they were looking at Xing their business and considering a sale to a private equity firm what would you tell them are the advantages and disadvantages of partnering with a a private equity firm I think if well let's first make the assumption that you picked the right private equity firm because clearly there's there's there's can be mismatches and and those tend not to go well but I would say if you pick the right firm so you've got cultural fit right you've got a you've picked the value-added firm that understands your business in your market the biggest advantage to the the entrepreneur CEO is his his board and resources go beyond looking in the mirror every morning he now has several people that he can rely on to as a source of information and advice and so he's no longer the you know shouldering the load individually which can which can be pretty taxing so that's some of the positives I know we're in the business of private equity but it again you're sitting down next to you know a brother or a close friend and say these are some of the things that you'd have to be cognizant of when you're selling to a private equity firm it's the biggest thing is you no longer can act in a unilateral manner as it relates to making big bets so it it reminds me of we owned a business several years ago called micro group and the owner was a very entrepreneurial guy we did a recapitalisation with him he stayed in for I think 25 percent of their company or some such thing and we went into recession not unexpectedly and the company was doing performing as we expected in a recession and we're not out of it yet and at a board meeting gentlemen was named bill bill said I want to spend a million dollars and by several CNC machining centers and we really didn't have the business to justify it at that point in time he said look that's what I would do if I owned it individually I'd be and I was like well I said I'll tell you what instead of buying ten how about we start off with four and we'll commit roughly it was over it was about a five hundred thousand dollar investment so you know did he get everything he wanted hmm maybe maybe not I mean he may have played me and said well if I ask for ten I'm likely to get four and knowing bill he probably did that but but there's you can't act unilaterally or without board consent on major issues and that's that's gonna be the biggest change can you further explain what we look for what private equity firms and look for in a management team yeah so I mean I guess you know obviously we're looking for breath and and strength and the question becomes what strength I know what breath is right how many people right okay so what what constitutes strength and we're really looking for complementary skills so I'll give you an example of a one of our current portfolio companies they had extreme depth on the engineering side so product development engineering was really good the the entrepreneur had a very deep knowledge on the material science material science product development process development was also a very strong attribute these reside in different individuals right so when we looked at that we said this is a business that if we can add some sales of marketing expertise they've got the skill set to handle a fair amount of growth and they've got the skill set to handle complicated projects that many of their competitors couldn't so we're looking for unique skill sets and it could be a use one of the companies that that you learn is more of a distribution it's a hybrid model distribution and manufacturing they're quite good at on the sales and marketing side and supply chain side and that is core to that business's success so depending upon there are no perfect companies right right regardless of size but in particular for the size companies that we invest in there is going to be holes in the management team and what we're really looking for is the core strengths of the team is it the right skill set to drive future growth can we build around it and that's that tends to you know be where we focus our attention and I would tell you that you know more broadly speaking we use tools right other tools so we we ask the team to submit to a test if you will that that that measures and they're there interoperability for lack of a better for behavioral assessment a behavioral assessment what's the team look like I've got this really good guy and and in fact I had this experience at a prior company we had a extraordinary engineer he was also virtually impossible to manage and people hated dealing with them he had a very unbending personality well that's the enemy it's great that he was a terrific an engineer but it doesn't lend itself to you know team and the strength of the team very helpful I think to the business owners here if you could leave them again drawing on your experience with one piece of advice as they were going to either get their business ready for exit or the they believe their business is ready and they're thinking about a number of different options what piece of advice would you give that that business owner yeah so I would if I was a business owner I would want either a very honest self-assessment of my business the way a private equity fund is likely to look at it or get a third party and to do that assessment and then I would work to for the flat sides of the organization that had been identified I would work to mitigate those flat sides and that's how you really can drive a higher multiple and better value for your business the other thing you know I would recommend as you got as an individual was very close to an exit or contemplating an exit you might think about having a accounting firm come in and effectively do a quality of earnings report you basically mirroring the accounting due diligence that's likely to take place when you finally meet the right buyer and so there's no surprises you want to unearth those surprises beforehand and not be surprised in the diligence process that's great thank you thank you well thanks for joining us today we appreciate it yeah I look forward to next time you

Channel: MCM Capital

Views: 12,793

Keywords: MCM Capital, How do private equity firms value a business, what is private equity, two most important factors that affect business valuation, what circumstance does private equity become the best exit option, what should i look for in a private equity partner, What protection does a business owner have after selling to a private equity fund, What type of reporting does a private equity firm require?, What are the advantages/disadvantages of partnering with a PE firm?

Id: Ain2vmmj4t8

Length: 23min 37sec (1417 seconds)

Published: Fri Nov 01 2019