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The Tables Have Turned: Private Equity
Eileen P. Gunn
08/01/2005
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After the economy collapsed
in 2000, private equity firms were able to buy solid but financially strained
companies on the cheap. They invested in these portfolio companies and, when the
economy and markets came back to life, sold them for a significant profit. In
2004 alone, buyout funds (the catchall category for private equity that is not
venture capital) had a one-year return of 14.3 percent, according to research
firm Venture Economics.
TOP VIEW
Rapacious capital-raising by private equity firms has put
owners of strong middle-market businesses in the catbird seat. Exploiting the
firms’ need to find ever-larger numbers of profitable portfolio companies,
owners are demanding better valuations and more expertise, while ceding less
control to the funds. But the high valuations offered for smaller stakes in
companies make it more difficult for investors to achieve their long-term
investment goals. Those owners whose businesses fail to grow as rapidly as
anticipated may be shown the door. |
Backed by this track record, private equity companies
have gone on a fund-raising binge. Goldman Sachs announced in April that it had
an $8.5 billion fund ready to go to work. This was within weeks of the Carlyle
Group closing on a $7.9 billion fund and Thomas H. Lee Partners saying it
planned to raise $7.5 billion. According to Private Equity Analyst, a newsletter
the covers the industry, buyout firms raised $53.9 billion in 2004, down from
the industry’s peak of more than $75 billion in 2000, but more than double the
$26.4 billion raised in 2003.
Many of these firms are putting the money to
work in equally splashy ways, making bids on high-profile businesses ranging
from Toys “R” Us to Warner Music Group and even the National Hockey League. But
the capital is also trickling down to opportunities in the middle market, which
includes companies such as Dwyer. Indeed, Venture Economics reports that firms
specializing in this sector led the pack in performance last year, boasting an
average return of 19.3 percent. The trickle is quickly becoming a flood;
Riordan, Lewis & Haden is one of several middle market firms aggressively
raising capital. It expects its next fund to be twice the size of the $120
million fund it raised in 2000.
Because of the amount of capital chasing
middle-market companies, private equity firms are finding it increasingly
difficult to pinpoint those that can grow large and fast enough to provide the
market-beating returns they seek. “We call it the great alpha search,” says
Brodie Cobb, whose firm, Presidio Financial Partners in San Francisco, advises
private companies looking for outside investors. “They’re turning over rocks to
find companies that will provide the alpha returns.”
Cobb recalls attending
a trade show recently for firms that supply rather mundane services such as
employee training and back-office support to car dealership owners. “We haven’t
seen private equity people there in 10 years,” he says. “This time we saw four
top-tier firms on the floor looking at companies.”
Strategic Shortfalls
Cobb explains that before the wave of private equity
fund-raising in the past year, strategic investors would routinely bid about 25
percent more than private equity funds for companies. Business owners would
typically take the higher offer. But they did so reluctantly. The strategic
buyer was usually a competitor seeking to buy the whole company and absorb it
into its own business, leaving the entrepreneur to either walk away or work
under a corporate parent—an arrangement that seldom succeeds. The process was
fraught with worry, Cobb notes, because “the owners often don’t want to show
their books to a competitor or even someone who’s close to being in their
business,” lest the deal fall through.
Private equity firms, by contrast,
can look relatively benign. They  usually want to own more than half of the
company (although these days they increasingly have to settle for less), so they
have the controlling vote should the business not prosper as expected. But if
the entrepreneur plans to remain involved, these firms usually want him to
retain a meaningful stake so that he is sharing the risk. As long as the
business is on the right track, they will often let the former owner stay on—if
not as the CEO, then in whatever role his forte might be, such as sales or
product development. For these reasons, “the business owners prefer the
financial guys,” Cobb says. “Today, they’re your best bidders.”
A client of
Cobb recently decided—reluctantly—that it needed to bring in an outside
investor. The company, a medical equipment maker in the Midwest, had grown
faster than the founders had expected, and it needed more money and different
management skills than they had. They assumed that handing the reigns over to a
competitor was the most likely and most lucrative way to assure that the
business would continue to prosper.
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