RSM Resources

With money to spend and the motivation to get deals signed, private-equity groups, or PEGs, are emerging as some of the most aggressive suitors of midsized firms in a surging mergers and acquisitions (M&A) market.

PEGs are a good fit for companies that have growth potential but need an infusion of money and expertise to achieve that upside,according to experts in capital markets. Typically, PEGs use funds raised from institutional investors — such as universities, pension funds and insurance companies — to buy into businesses they think can go to the next level.

After several lean economic years with relatively low M&A activity, many PEGs are sitting on a lot of cash and are increasingly willing to pay full price for firms that fit their parameters.That, in turn, is fueling a rise in prices.

"It’s good news for sellers because historically, private-equity groups weren’t willing to pay as much as corporate buyers, who could fold the seller into their existing operations and achieve some cost-efficiencies," says Melissa Link, vice president of buyer relations, RSM EquiCo Capital Markets.

Most often, private-equity deals are channeled through 10-year funds that the PEG administers as general partner. Investors join as passive limited partners. The funds buy companies in the first half of the 10-year period, then resell them or take them public for a profit over the latter years.

More than 4,000 PEGs exist in the U.S., including a handful of giants that broker deals like the $11.3 billion SunGard Data Systems purchase earlier this year. However, the vast majority are smaller firms with $100 million to $200 million in reserves, plus the ability to raise additional capital through debt financing. While most PEGs focus on companies at a particular development stage, experts say about 80 percent of private-equity funding goes to established midsized or smaller firms.

PEGs target well-run companies with solid track records that may be too small to consider an initial public offering (IPO) or attract interest from a big strategic buyer, says Hector J. Cuellar, president of RSM EquiCo Capital Markets. He notes that a private-equity deal can be very attractive to a company that has aggressive growth potential but lacks the planning or financial resources to help get it there.

"That can include everything from funding for new-product development to strategic help in areas such as using debt effectively or managing other financial issues that come with growth," Cuellar says.

A private-equity buyer may bid to buy the seller outright or, more typically, to take a controlling interest in 60 to 80 percent of the company. If the deal moves ahead, the PEG works with management to increase the company’s value over several years prior to reselling. This arrangement, referred to as a "leveraged recap," can help ownership achieve goals such as:

• Cashing in on the equity they have invested in building the firm, while reducing personal risk.
• Satisfying the need for additional capital to fuel growth.
• Maintaining an ownership stake in the firm, helping to guide its future growth and eventual sale.

When is a private-equity buyer the right solution for a seller? Experts say there are several issues to consider:

Evaluate your goals. Experts say a private-equity deal might make sense if your company is struggling with growth issues in areas like human resources and financial management, or if you’re ready to pull some net worth out of the firm in an attempt to diversify but are not ready to exit the business entirely. Key questions to ask include:

• How far and fast do you hope to grow? If you have relatively modest goals stretched over several years, a line of credit or other financing solution might be more attractive than a private-equity arrangement.
• How prepared are you to work with a partner and to cede at least some control over operations to your new investors?
• Does the potential buyer’s time frame for reselling the firm or taking it public —typically five to seven years — fit with your own financial goals?

In general, working with a PEG can be a smart move when you want to take some chips off the table but don’t want out of the game entirely. There are also risks. For example, private-equity deals often involve a significant amount of debt, which can leave you exposed financially in the event of a slowing economy.

Evaluate your financials and business plan. Before you ever start meeting buyers and vetting proposed deals, take time to ensure all your accounting and financial procedures are in order. If these processes are informal or undocumented, get them in writing.And consider paying for a financial audit as well as an evaluation of your company’s worth so that you’re on solid ground, number-wise, from the first day of negotiations.

In a PEG transaction, where the buyer is betting on your firm’s potential, it’s particularly important to have a detailed business plan that spells out not only the level of growth you anticipate, but where you see it coming from — a plan that addresses new products and markets, how new sources of funding would fit in, and other information that adds depth to your financial projections.

Evaluate the potential buyer. The number of PEGs quadrupled between 1992 and 2002 and continues to grow. Some firms pursue deals in a variety of industries, while others focus on highly specialized industries like biotechnology. With those issues in mind, experts suggest that potential sellers talk to peers who have closed (or chosen to back away from) deals with a PEG, while evaluating the group’s track record in building up businesses. Consider engaging a financial advisor with ties to high-quality, strong-performing equity groups to help identify those firms likely to be good partners.

Evaluate the personal fit. One hard-to-quantify but essential part of any prospective deal is an evaluation of the chemistry between you and a buyer. Assuming you’ll continue to hold a stake in the business once a deal is signed, consider if you can work closely with the PEGs’ key investors for a period of several years.

Evaluate the deal. In most private-equity deals, the purchase price is paid through a combination of cash, seller notes, a continued equity stake in the business and, frequently, performance incentives called "earn-outs."When negotiating terms, be sure you know what level of liquidity you want and assess your comfort with varying levels of debt. Additionally, spend time reviewing the buyer’s proposed business plan and exit strategy.

Another variable in any deal is how active or passive the buyer will be in guiding the firm forward. While some will want to be highly involved, particularly early in the relationship, others may prefer to participate mainly as high-level advisors and board members. Address the level of involvement early in the negotiating process.

By reviewing these steps, you can assess whether your company would benefit from participation in today’s strong M&A market and make good decisions about how to move forward with a prospective buyer.