RSM Resources

What happens when cash-flush investors looking for big returns meet with business leaders seeking new avenues to sell or grow their companies?

In a word? Deals.

According to Thomson Financial, a fast and furious market for mergers and acquisitions(M&As) led to a record $3.6 trillion in closed deals in 2006. Many experts say a key undercurrent driving that explosive growth is cash flow from private equity groups (PEGs), which accounted for nearly 20percent of all M&A activity last year. That’s up from just 4percent of the market during the peak of the technology boom in 2000.

PEGs are investment partnerships that most commonly channel money from institutional investors — such as universities, pension funds and insurance companies — into companies with strong management teams and good growth prospects. Typically, a PEG will buy a controlling position in a company with the intent to hold the investment for three to seven years. During that time, it will work with management to improve operations and profitability. Then, it will seek to profit by either taking the business public or selling it to another investor.

While PEGs are increasingly banding together to fund sizable buyouts — such as the $21 billion purchase of hospital giant HCA by three private equity firms — many experts believe the availability of such big targets may be on the wane. That, in turn, may provide significant funding opportunities for small to midsized companies.

"When there’s lots of deal volume, combined with a lot of private equity money out in the market, that puts a lot of upward pressure on pricing," says Mark King, a director in RSM McGladrey’s transaction support services group. "And, because there are fewer large deals to be had, a lot of that PEG funding is pushing into the small and midsized marketplace."

"Financial" vs. "strategic" buyers

Most industry observers traditionally have viewed PEGs as financial buyers.That’s because PEGs focus on finding and investing in companies they believe they can run more efficiently to enhance profitability and long-term value. Under these conditions, a PEG will partner with an experienced management team — but often change the benchmarks by which the business measures success.

Strategic buyers, on the other hand, have most often been competitors offering deep expertise in a given market. Because of that experience, strategic buyers typically prefer to acquire all or most of a company’s real estate, facilities and other hard assets — but not retain the existing leadership group.Instead, those buyers install their own leaders and operating systems,betting that operating efficiencies and industry knowledge will drive higher margins.

But the phenomenal growth rate of PEGs is rapidly blurring the traditional lines between financial and strategic buyers. Over the past decade, private equity firms have moved to more than $750 billion in closed deals last year from just $35 billion in1996. That sizable cash presence gives PEGs stronger ability to help management teams of smaller firms compete with corporate strategic buyers for acquisitions. Such was the case when Albertson’s, the nation second-largest traditional grocery store chain, was purchased by rival Supervalu and two private equity firms for $17.4 billion in debt and equity last year.

"The primary motivation for a PEG is to increase the capital value of a company," King says. "While the majority of strategic buyers are larger businesses making acquisitions,PEGs are enabling their platform companies to compete for those same acquisitions."

If your company is considering private equity as an alternative to traditional lenders or an initial public offering, experts suggest the following tips:

Understand the potential pros and cons. As an alternative source of funding, private equity carries virtually none of the compliance or regulatory issues associated with going public, and it frequently allows businesses to tap larger amounts of capital than they may find available through conventional means. On the other hand, a recent Standard & Poor’s study found that private equity acquisitions in 2006 contained up to $25 billion in debt simply to cover dividend payments to the PEG as general partner. If the cost of money rises — via higher interest rates or other credit-tightening moves — private equity investors will want to generate returns in a shorter period of time.

Understand the value of timing. As investments, private equity funds must consistently deliver returns that are well above those available in the traditional markets. In the first eight months of 2006, private equity funds generated an average return of 22.8 percent, according to Global Finance magazine.That’s well above last year’s 15.6 percent return by the S&P 500stock index. To keep up that pace, PEGs will continue to raise the ante on strong, professionally run companies.

"In 2002, toward the end of the last recession, many private equity investors were not willing to pay more than a five multiple of EBIDTA [earnings before interest, depreciation, taxes and amortization]," King says. "Now,those same people are having trouble finding deals where the multiple isn’t at least five — if not higher."

Understand that the target market has changed. As cash flow in PEGs has grown, these investors have steadily broadened their interests into areas they believe can generate the best returns.But as more money chases fewer good deals, private equity investors are now looking at non controlling investment opportunities, such as minority stakes in sound midsized companies with strong growth prospects or track records.

"Don’t think that a PEG isn’t interested in your industry, because right now they are interested ineverything — something that wasn’t true just a few years ago," King says. "But if you’re a business owner who is capital-constrained, orone who is thinking about selling out, this is a great time to look at opportunities in the private equity world."