Richard Willsher is a freelance journalist specialising in finance.
Private equity can be a useful option for a family business pondering growth strategies or exit plans. But, as Richard Willsher explains, investors will be looking to gain some measure of control
If the idea of introducing non-family equity into your business has never had much appeal it may be worth giving private equity a second look.
To start with there's an awful lot of it available right now. US investment bank JP Morgan has calculated that private equity played a part in publicly announced transactions worth $353bn in Europe alone since the beginning of 2001. Moreover their research indicates that this far outweighs the $208bn worth of reported transactions in the US during the same period and that private equity firms still have $150bn left to deploy.
Two other important features of the current private equity market is the competition between providers to fund transactions. In addition to which there is a wide diversity in investing preferences and styles among those providers. This spells choice and flexibility, which means that family businesses with particular aims and requirements stand a good chance of finding suitable equity partners.
Private equity has several advantages over the public markets as a source of capital. The public markets have been unwelcoming to initial public offerings since the end of the dotcom era. What moves share prices often has nothing to do with company performance and for smaller quoted companies, gaining any investor interest at all, especially from major institutions is an uphill struggle. Lastly public markets often pressure companies to hit quarterly targets. Longstanding family businesses which have survived the ups and downs in their sector and those in the wider economy know that business don't perform according to a quarterly metronome set at an ever quicker pace by stock market analysts.
"Private equity can be a useful option when the family business is at a crossroads; when it is a business in transition," says Grant Gordon of the London-based Institute for Family Business. "It can, for example, provide an exit route for [family] shareholders who are not interested in remaining in the business."
Typically private equity investors will be looking to gain some measure of control over the business into which they inject funding – this is often between 50% and 80% of the equity. Hence they have become a popular source of funding for management buy-outs and buy-ins where they stand behind the management team, placing one of their own representatives on the board of the investee company. The management team is likely to hold a minority of the stock. Both investors and management will look to make considerable gains from the increase in value of their shares as the business is driven hard for growth, often fuelled by increased leverage. They look to reap their benefits when they sell their holdings as they exit the business.
This is the classic MBO/MBI model. It is one that has benefited many entrepreneurial family businesses but not all. Ceding control, bringing in new management, surrendering a seat on the board and the eventual exit – whether by trade sale or an IPO or even a secondary buy-out or buy-in with replacement equity providers – are all features that a family business has to consider carefully. Often these are the very features that are hard to swallow in a long held and cherished family enterprise.
"Introducing private equity is about how much funding is required, what it's to be used for and what the family expects from it," says Simon Wildig a partner at Close Brothers Private Equity. "A private equity investor will always be looking for his eventual exit and to recoup his investment together with a healthy return. We are after all investing funds on behalf of our own investors," he says. "But we have for example provided funds to buy out a family member's shareholding where one of the family is seeking to cash out, leaving committed relatives to own and run the business. Where we see a business with good growth prospects, cashflows and management capabilities our exit can be achieved by selling our stake back to the remaining family members by means of a buy-out clause five years down the line."
Andrew Harris, a corporate partner specialising in private equity at international law firm DLA, says that private equity is becoming a well-recognised, reliable way in which family businesses can achieve full or partial exits. He adds a list of hard questions that need to be asked at an early stage. "Which family members want to continue to be involved in the business? Who is capable of being involved? Who wants to cash in their shares? It may be helpful to speak to several private equity firms to get a flavour for different investing styles. And one of the big advantages of involving an outside investor is that it can help clarify the family's thinking."
If raising funds for growth but surrendering a sizeable proportion of the equity is a long way from your agenda it may be worth looking at raising mezzanine debt.
This sits between senior (bank) debt and equity in terms of its risk, cost and rights from the provider's point of view. It counts as debt in the balance sheet and tends to be more costly than bank debt. It often has the advantage from the borrower's point of view of not requiring equity to be surrendered although some mezzanine lenders prefer to hold a small equity stake (an 'equity kicker') or look to gain warrants which will have value should further equity raising be envisaged for the future.
The key points are that mezzanine providers will focus carefully on the growth prospects of the business, on strong cash flows and a clear repayment horizon for their lending. "Our typical term is 6–10 years with bullet repayment, ie by one future instalment at a predetermined future date," says Christian Marriott a director of Mezzanine Management, a specialist lender to middle market companies throughout Europe. Although similar in its approach, Royal Bank of Scotland's Debt Ventures operation also focuses on growth businesses with strong cashflows looking to raise senior and mezzanine debt but prefers amortising debt structures with repayments being made at regular intervals throughout the life of its funding. Howard Garland a senior director of Debt Ventures says, "We do not want to control businesses and we understand that a family may want to consolidate their shareholder base, realising value without selling the business entirely. At the same time we want to make sure that there is a clear purpose to the deal we do and align ourselves with the remaining shareholders."
One of the criticisms that is sometimes levelled at private equity providers is that they are short-termist. Maybe not as short-termist as the public markets but with a distinct time horizon in mind. To counter this suggestion Robin Marshall a director at 3i, Europe's largest and most international private equity provider, says that not only have they many family businesses in their portfolio where their own interest is a minority one but also where that interest has been held through good times and bad over many years. "Family businesses can differ enormously and there can be regional differences depending on the country and region where they are based. What is important is to sit down and discuss what it is the family wants to achieve and see how we can structure a deal that will suit them."
That perhaps is the bottom line when it comes to private equity investment for family businesses. The deal has to be appropriate for the business and suit the requirements of the family. What is clear is that there are now a lot of providers in the market with plenty of funds to invest. That means there is a diversity of choice which family businesses may not have enjoyed before – and this alone may make it a funding option worthy of their consideration.