Lee Monahan, a partner at Harren Equity Partners, believes that business owners often think of “private equity” as a sector where all participants have a similar culture, strategy, and approach. The reality is, the 2,800+ private equity firms in the United States and Canada have a wide variety of approaches to value creation. Harren Equity Partners is a private investment firm dedicated to the growth and development of industry-leading companies through the creation of strong partnerships with outstanding management teams.
Many private equity firms create value through creative capital structuring, or ‘financial pyrotechnics’ as Monahan describes it. Private equity firms employ two techniques in this strategy. The first is through the use of debt or ‘leverage’ to execute the acquisition. Private equity firms are in the business of driving returns for their investors. Hence, the use of leverage to amplify returns is very common. However, some firms use the maximum amount of leverage available from banks without regard for the growth plans or capital needs of a business. As a result, it is pivotal for a business owner to be open and realistic about their company’s growth plans and capital needs.
The second is the use of preferred equity, allowing the private equity firm to take a larger piece of the ‘pie.’ Preferred equity is a senior class of equity that can have any combination of features (e.g. defined or prescribed levels of dividends, liquidation preference, etc.) not possessed by common stock. The issue with these structures is that they fundamentally misalign interests between the private equity firm and the business owner. For example, a private equity firm may own 100% of the preferred equity (which typically carries an annual dividend of 12-14%) and only 51% of the common equity. In this instance, the business owner’s equity is “behind” the private equity firm’s preferred equity. The private equity firm can create value for itself simply by collecting dividends and/or its liquidation preference (often a multiple of the original preferred equity investment – e.g. 3x the face value of the preferred price). This may occur while the business flat lines and the private equity group’s preferred equity ‘eats into’ the common equity value.
Monahan believes that driving returns through the capital structure stands into stark contrast to a less common approach used by private equity firms – to be a ‘hands on’ partner and create value by improving the operations of the business. Some firms label themselves as ‘operational’ simply because they have operating partners who work with their investments or they replace management with their own operating executives. Other firms, however, are more willing and experienced to partner with existing ownership/management to address shortcomings of a business – or areas that have not kept pace with the revenue growth of a business (e.g. human resources, information technology, inventory control, management depth, etc.). The firms that desire to partner and work with a business owner are wired to ‘roll up their sleeves’ and tackle issues together – not just direct the business owner to solve issues that they may or may not be comfortable handling. Using this approach, business owners can truly partner with the private equity firm to ‘de-risk the business’, resulting in long-term value creation.
Monahan, on Harren Equity Partners, “We believe that, in companies under $200 million in revenues, substantial value is created by growing and improving the business in partnership with existing management. This is achieved without using ‘financial pyrotechnics’ which are unnecessarily complex and create a source of needless friction between a private equity firm and the management or ownership. This partnership approach creates a situation where both parties are aligned, in other words ‘we win as a team; we lose as a team.’ While working with a partner requires an open, honest dialogue, we believe such an approach is more likely to result in a business that outperforms and creates a superior outcome for all stakeholders.”
Mark Borkowski is president of Toronto based Mercantile Mergers & Acquisitions Corp. Mercantile specializes in the sale of mid-market companies sold to strategic buyers or private equity firms. He can be contacted in confidence at mark@mercantilema.com or (416) 368-8466 ext. 232 or www.mercantilemergersacquisitions.com
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