Reading an article about Kansas based Payless Shoes this weekend, I was reminded of a presentation I recently gave to local financial executives about what they needed to know when working with Private Equity (PE) firms, challenging perceptions versus reality.
The article portrayed Private Equity firms in a very negative light, telling a story of how, in one two-year period, Payless’s PE owners were able to deliver $249 million of EBITDA, $352 million in one-time dividends, and made $94 million in interest payments, but that this (and not the rapidly changing retail landscape, international trade factors, and management missteps) led to multiple bankruptcies and the liquidation of all its US stores in 2019, putting 16,000 people out of work. After reading it, I was left with this question: Was this perspective fair and reasonable?
Typical reasons for wanting to work with PE firms include getting access to outside capital and other resources, monetizing an owner’s investment in their business, and allowing owners to achieve a successful business exit. So, companies with capable and experienced management teams, solid and consistent cash flow, limited customer concentration and other risks, solid growth prospects, and a willingness to be sold or recapitalized after a period of PE ownership are a good fit. Other reasons for wanting to work with PE, or companies without these characteristics, are generally the companies that do not prosper under PE ownership, and typically these issues would have influenced performance with or without Private Equity investment, and existed long before any acquisition.
My presentation focused on the fact that Private Equity is neither good nor bad. I made the argument that the issue most business people have with Private Equity is that they didn’t really understand it.
I went on to cover a few key points, which I have summarized below:
- Private Equity firms seek excellent investment returns…
…and excellent investment returns are not always equal to making a company more valuable in the long term. I made no judgement about this, but I did make sure the audience accepted that PE firms are in business to make money for their investors.
- ‘Cash is King’
Everyone says that they understand this, but after walking the audience through some PE acquisition, investment, and cash flow examples, the importance of thinking through business decisions in terms of cash required and returns on cash invested (how PE firms think) was emphasized.
- Embrace LBO (Leveraged Buy Out) Economics
The other takeaways from the examples covered were equally clear for all in attendance: Expect any PE owner to manage working capital aggressively, be disciplined with capital expenditures, and to ‘sweat’ the balance sheet HARD.
Knowing this, the key point I made was that Private Equity firms, and experiences with them, are entirely predictable, and can go one of two ways: if you understand how they work and know what to expect from the get-go, it’s far easier to get along with them, but if you are unprepared, there will be a steep learning curve and you will likely always be “behind-the-8-ball”.
The presentation concluded with:
The six things Private Equity Board members like to do:
- Communicate Timelines and Milestones (as opposed to visions and expectations)
- Engage Directly with Management (as opposed to engaging only with the CEO)
- Seek Information Updates as Needed (versus only relying on regular, scheduled reports)
- Exercise a bottom-up scrutiny of initiatives (versus only approving top-down activities)
- Support management in the “how” (not only in the “what”)
- Be present, active thought leaders, even if not asked (as opposed to only communicating incentives and consequences)
Common occurrences in relationships between Private Equity and PE owned businesses:
- Founders and Key Employees: the PE firm will want to keep them around after the sale, with “earn outs” common
- Leadership Turnover: some of the Management team will not like the changes, and will quit, leave, or be fired
- Debt: PE firms use debt to maximize their cash returns. This leverage may feel uncomfortable
- No Sacred Cows: things you may have always considered important might not look that way to analytical PE outsiders. Everything is on the table for analysis
- Assets will be made to ‘sweat’: PE firms manage balance sheets and margins aggressively as they focus on cash-flow
The four secrets for success with PE Firms:
- Be ‘Self-Sufficient’ within the first 90 days
- There is no ‘Honeymoon Period’ (and the importance of a ‘fast-start’)
- The importance of planning (obsessively)
- Stick to (and deliver) the plans
At Core Catalysts we have significant experience advising Private Equity firms and helping companies work with them, from exploring Private Equity investment to performing (and preparing for) financial and operational due diligence, and from pre-acquisition planning to post-acquisition implementation and management. If you would like to find out more, please give us a call!
– Mark Jacobs, Client Service & Delivery