Do SMBs Have a Viable Exit Strategy Through Private Equity Buyouts?

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1 Do SMBs Have a Viable Exit Strategy Through Private Equity Buyouts? By: Stephen Boane In 2007, not a week has gone by without a news headline announcing a buyout by a private equity group (PEG). Whether it is the purchase of Affiliated Computer Services by Cerberus Capital for $5.9 billion or Kronos for $1.8 billion by H& F Capital Partners, the velocity flow of transactions is increasing. But are PEGs potential buyers for your small business or are PEGs only for the big guys? For PEGs, the Wall Street Journal reported that 322 funds raised a record $215.4 billion in 2006, 33% more than was raised in Historically, PEGs were only for large corporations, but an overabundance of capital has shifted the capital market dynamics. PEGs often restrict their investments to strong growth industries and businesses that have increasing valuations. If your SMB is in a strategic industry PEGs are interested in learning about your company. By looking at a PEG website s Portfolio webpage one can determine where the PEG is investing. For instance many PEGs are investing heavily in companies in business process outsourcing, human resource services, and healthcare administration. SMBs Defined For purposes of this article, we will consider an SMB to be a business that has between $5.0 million to $50.0 million in revenue and between 5 and 500 employees. The Census Bureau estimated that in 2004 there were approximately 2M companies with five to five hundred employees. A substantial number of these companies are owned by the baby boomers rapidly approaching retirement age and are interested in sale and/or other liquidity event to fund their retirement and estate planning needs. PEGs Defined PEGs are incentivized to put their money to work in a rapid, but orderly fashion, and to invest the funds in businesses that will yield attractive sale prices within a three to five year time frame, if not sooner. For those PEGs investing in SMBs, the ultimate exit is likely to be a sale to a strategic buyer or another PEG and not an IPO. Ephor Group 1 (800) Westoffice Suite 114 Houston, TX 77042

2 Retail, restaurants, real estate and resource extraction (the four r s ) are often excluded from consideration by generalist PEGs although exceptions by the generalist PEGs occur seemingly on a daily basis. A good rule of thumb is to ask yourself: Is the business profitable and the business model scalable without the owner? In order to generate attractive returns, PEGs use leverage techniques to fund a significant part of the purchase price of the acquired business. By using borrowed funds, they can increase the return on the equity they invest. Because of the need to service the acquisition debt, the acquired businesses need to be generating consistent cash flow. To a lesser extent it helps if the SMB has hard assets to serve as collateral for the lenders as well. Currently, in the smaller end of the deal spectrum that includes SMBs, lenders are looking for an equity investment of between 25% and as much as 50% of the purchase price. Thus, if an SMB generates significant cash flow it has a higher probability of being a PEG target. Platforms and Tuck Ins When buying SMBs, PEGs often target businesses that can serve as platforms for growth through acquisition of either competitors or complementary businesses. For platform businesses PEGs look for strong, ambitious management teams with good internal business processes to absorb fast growth. If a PEG already owns a platform business, then an SMB may be acquired to serve as a tuck in acquisition to its platform most often to expand the geographic footprint or provide access to new goods and services they can sell into the customer base of their existing platform. PEGs are generally less concerned about the management and business processes of a tuck-in and often will integrate the customer base and operations into an existing platform company. PEGs occasionally invest growth capital in SMBs whose revenues and earnings can be accelerated organically through the investment of additional capital and management resources, 2

3 without resorting to acquisitions. These investments are subject to execution risk meaning the investment could be written down if the company does not perform and thus typically require backing by an established and credible PEG or advisory group. Finally, PEGs target businesses with strong cash flows that could be improved through scalable business model management processes which facilitates the rapid repayment of the acquisition debt. In this circumstance, the PEG can re-leverage the business after a number of years and pay itself a large dividend to increase the investment return. Typically a PEG will only consider investments in companies that are consistently profitable and generating positive cash flow over several years. The only exception is a unique business model. Almost all PEGs will state their minimum investment size and target company revenues on their websites. Additionally, PEGs want to see a consistent business model, with revenue and profits being generated from replicable practices and not a series of one-off event oriented transactions. For example, if a substantial portion of your profits are dependent on your skills as an entrepreneurial magician, then your business is not a target for a PEG. Likewise if every new customer relationship is a long, drawn out negotiation and your pricing and terms for the same goods and services vary widely to get the sale, a PEG will be less enthusiastic about making an investment. If, on the other hand, revenues and earnings come from a cadre of trained employees already on your payroll, who execute defined processes like selling new business and servicing the customer profitably. Most PEGs will have an appreciation for your business model. In addition, PEGs focus on businesses that can demonstrate year-over-year revenue growth without diminution in margin. Ideally, your business will show increasing margins as it grows, demonstrating operating leverage as you generate increasing sales on a base of fixed costs. Bigger is More Valuable The three primary reasons that PEGs target larger deals are: 3

4 (i) (ii) (iii) Transaction costs incurred by a PEG are substantial and for small deals are not significantly less than the costs of larger deals; The debt market for smaller transactions is less developed and the terms are generally more onerous, and PEGs have a limited group of internal managers to monitor its portfolio of investments. PEGs follow a structured acquisition process that includes due diligence conducted by outside experts. The PEG takes one or more board seats at the company and an active role in monitoring all of the investments in its portfolio. To do this, it needs to staff up with highly paid professional managers and financial types, many of whom share in the profits of the firm. As a result, PEGs tend to keep their internal staffs as small as possible and limit the number of portfolio investments. It is easier for a PEG to monitor five $20 million investments than it is to monitor fifty $2 million investments. At the lower end of the spectrum, PEGs have historically needed to put at least $5 million to work in a single deal. Because this represents only the equity component of the investment, the deal size that PEGs have traditionally considered ranged at the low end from $10 to $20 million. It is often said that it is easier to finance and put together a $1 billion deal than a $10 million deal, and because of the structural factors discussed above, there is much truth in this statement. However, because of the competition for deals in the larger size range, there have been a number of PEGs recently formed to look for smaller deals. The PEGs that focus on these smaller deals are still considered boutiques and there are fewer of them, thus limiting the competition among potential SMB buyers. In addition, they still have to contend with the three main factors militating towards larger deals and one way for them to contend with these factors is to offer a lower purchase price for targets. Another way that size matters is in the way PEGs value deals. For the most part, PEGs value companies as a multiple of earnings before interest, taxes, depreciation and amortization ( EBITDA ). For businesses that have EBITDA less than $5 million, the multiple that PEGs are 4

5 willing to pay range between three and five times EBITDA. Thus, if your SMB generated $2 million of EBITDA over the last 12 months, it would fit the PEG model at a purchase price of between $6 million and $10 million. Given a minimum deal size approaching $10 million, there is a very limited market for businesses generating less than $2 million in annualized EBITDA. On the positive side, if your SMB consistently generates at least $5 million in annual EBITDA, then there is a broader group of potential PEG buyers. Due to the competition among PEGs, the ability to absorb transaction costs over a larger deal size, and the willingness of lenders to finance a great portion of the purchase price, currently PEGs are willing to pay between 4.5 to 7.0 times EBITDA for an SMB generating EBITDA above $5.0 million. Due to "multiple expansion based on size, a business generating $5 million of EBITDA may attract offers for up to $35 million, while another enterprise in the exact same line of business, but generating only $2 million of EBITDA might attract an offer of $6 million, if it finds a PEG buyer at all. To broaden the group of potential buyers of your SMB in the near future, consider the factors that are important to a PEG in the potential acquisition of your business. Focus on your business processes, develop a replicable business model and hire individuals who can sustain your business without your involvement. Cash flow and EBITDA are the key factors in your business valuation, not assets on the balance sheet. Thus, if owners have opportunities to invest in your business to support additional growth, so as to generate additional EBITDA in the near future, this is a better use of funds than purchasing a new office or distributing funds to purchase a vacation home or fund other personal expenditures. Finally, monitor acquisition trends in your industry, because if other businesses are being approached and purchased by PEGs then there may very well be interest in your company, either as a platform or a tuck-in acquisition. Did you enjoy this article? Drop us a line and let us know your thoughts on solving the value equation at ephor@ephorgroup.com. 5

6 About Ephor Group Ephor Group increases equity valuations for technology and service based businesses. Our approach is proven, pragmatic, and performance oriented. Our methodology Perform Business Process fills in the gaps where functional expertise, intellectual capital, or domain expertise are not available internally. Ephor has a history of success, creating over $3.5 billion in shareholder value. For a pragmatic, no-obligation assessment of your situation contact us at About the Author: Stephen Boane Stephen has a unique background that combines both operational and financial leadership with consulting, investment banking and private equity. As a former investment banker turned President and CEO of two service firms, he provides practical solutions and a proficiency for strategic, operational, and financial engineering that leads to intense value creation. Mr. Boane has provided operational and financial leadership and management services since 1989 with significant experience in strategic positioning, operational improvement, capital sourcing, restructuring and bankruptcy. Today Mr. Boane works with technology and service based businesses to drive increased equity value. Ephor Group Assessment Overview Ephor Group identifies the underlying issues fundamentally constraining the business. An action plan is then developed which provides clear roles within a structure matched to the size and needs of the business (accountability), articulates a compelling vision for the future (direction), and develops an environment that supports the employees (culture). Applied using the Perform Business Process dynamic results are realized. Many owners struggle to design scalable organizational structures, create reporting relationships, and develop evaluation systems that hold people accountable and compel them to higher challenges and goals. Giving individuals clear roles and goals is a great place to start. For example, the executives of an HR services firm, took greater individual responsibility for their individual functions performance increasing the scope of their operational accountability, but were supported with standard back-office and control processes and systems. The results demonstrated higher job satisfaction and performance levels. 6

7 Our assessment process reveals strategic alternatives typically unforeseen by owners who develop blinders in the daily fight for their organization s survival. Our experience reveals that companies that set broad, stretching aspirations aligned with employee interests and incentives are more successful. Furthermore, growing companies are better equipped to incent high performance behavior by its employees. Our research, experience, and learned lessons have taught us that our Perform Business Process compliments businesses current competitive advantages and helps shore-up non core areas such that the organization outperforms its industry peers and achieves higher than average returns. 7