How to choose the right investor

Introduction

If you have built a company fast, with good revenue, margin levels and have a great profile in the market It will only be a matter of time until Private Equity investors start to hunt you out. If they do, or you are interested in some additional capital and support, I would initially suggest reading my first article entitled ‘A Primer on Private Equity’ as choosing the right investor to fund your business growth is both a critical and huge decision. The brief article below will help you to identify which firm best suits you!

Key considerations

• Understand why: To date you have been pretty much master of your own fate with little if anyone walking over your feet. You need to fully understand the implications associated with investment and your own motivations for taking investment and you will then know what kind of partner you want working with you. At a basic level are you looking for:
  • Liquidity: The proceeds from a transaction are used to cash out the existing owners. This can be a full sale, or a partial sale, which is known as a recapitalization. Recapitalizations are either majority sales (>50% ownership) or minority sales (<50% ownership).
  • Growth capital: Is used to fund growth initiatives for the business. Many private equity firms will provide a combination of growth and liquidity to entrepreneurs.
• Type of investment – Equity and/or Debt: Equity is probably the most common and possibly also the most complex to review as it is dilutive to the business owners and you need to build a capitalization model to fully understand the implications of share allocations, classes, divestments, acquisitions and the impact of potential further funding. Debt by contrast is non-dilutive to the existing owners but comes with an interest rate and principal repayment requirements.
• Pool or pledged capital: The funding may be sourced from committed pools of capital, and those that have pledges of capital. The key distinction is who makes the investment decision. In the case of a committed pool, the fund managers have the authority to invest capital on behalf of partners. In a pledge fund, the manager offers an investment to the pledge group of investors and they individually make the decision whether or not to invest. Depending on the particular relationship between the manager and its pledge partners, dealing with a middleman may make the transaction far more difficult and time consuming to complete as it will require a very comprehensive and expensive due diligence exercise prior to fund approval and all those costs will be loaded onto the ‘NewCo’ which translates to your business!
• Does the prospective fund fit the target transaction size: An equity fund will expect 60% – 80% of the transaction to be funded with debt and the remaining 20% – 40% will be equity. A fund will limit its investment in a single transaction to 10% – 15% of its committed capital. Hence for a $100M fund the maximum investment will be $10M – $15M and this means a total transaction in the range of $30M – $45M.
• Does the firm’s investment size align with your business: As a general rule most Private Equity firms invest up to 10% of their total fund in each portfolio business.  If a Private Equity firm has a $100M fund they are looking to put $10M to work in each deal they do. They may go less or higher depending on the opportunity presented but it needs to have a clear and compelling rationale.
• Further funding: Does the Private Equity firm make sure you understand whether or not the Private Equity firm you select has the capacity to invest additional funds in the business when either unexpected opportunities or stumbling blocks present themselves. If you are one of their last investments as part of an investment fund they may have or be about to run out of cash for new investments when additional capital investment is needed In this scenario the potentially uncomfortable and expensive alternative could be an untimely sale of the business. It is important that the partner you select has the capacity and willingness to invest additional funds in the business when either unexpected opportunities or stumbling blocks present themselves. The potentially uncomfortable and costly alternative could be an untimely sale of the business.
• Change to harvesting: Private Equity firms earn fees as a percentage of the total committed capital. When their committed capital is substantially deployed their emphasis turns to managing and harvesting their portfolio of investments,  the management fee is reset and linked to the actual funds invested. From that point in their revenue stream declines as the investments mature and are harvested. If the fund’s investments are successful the Private Equity firm earn a percentage of the upside which tends to be around 20%. If a firm is unsuccessful there will be pressure to reduce costs and this could directly affect the support you recieve.
• Style: I have worked with a few Private Equity firms and about all they share in common is the same title! Some firms like to embed themselves into the business and become a very active part of its work and direction. Some may split the board into operational and strategic and effectively manage the board of directors. Others may be very passive investors who leave running the company up to the management team. My personal preference is where an investor is prepared to roll-up their sleeves and get involved as it demonstrates tangible ‘skin in the game’!
• Governance: Most Private Equity firms will insist on at least one board seat and some may ask for a lot more! There is also probably going to be a far more rigorous form of management reporting required on an annual, quarterly or possibly even monthly basis. Many business owners find this a bit of a shock so ask for an example of existing portfolio reporting packages to help you understand the commitment and resources needed to comply.
• Strategy: It is important that you clearly understand the Private Equity firm’s strategic intent which may involve acquisition, divestment, revised product or services portfolio’s or reduced costs etc. You need to be on the same page and to work together on the growth strategy!
• Will you enjoy working with them: Possibly the most important question of all. It will be a long and possibly bumpy road ahead and you need to be bonded at the hip through the good and bad times. Think carefully re each interaction you have had with them and also ask for references from existing portfolio teams to hear about their experiences.

Lastly…

Treat the whole exercise a bit like a sales process and use those investor details to create ‘leads’ that you can review, and look to qualify out not in as you don’t want to waste time trying to fit a square peg into a round hole! Take a good look on Google to find out all you can about different investors. If you have other board members or colleagues working with Private Equity firms then ask them to share their experiences and take on board all advice. Does the Private Equity firm have a track record of success and have they profitably invested in and helped build a number of businesses in your market sector? Overall, determine their high-level investment profile and criteria and look to qualify out not in!

Develop a balanced scorecard that makes tangible sense to you re what kind of Private Equity partner you ideally want to work with, how you would envisage a successful outcome and then use it to assess and evaluate.