What happens to companies when they get bought by private equity?
2021 saw a surge in private equity deal-making. Some transactions have generated negative headlines, especially in the UK. But what’s actually involved in a deal? And what is the first thing that private equity executives do once they’ve bought a company?
Private equity investors once had an unsavoury reputation as “asset strippers” whose modus operandi involved taking on too much debt, firing staff and selling off a company’s most valuable assets. The industry has changed significantly since then and bears little resemblance to this stereotype.
However, there’s an echo of these early criticisms in recent coverage of takeovers of UK public companies by private equity firms – most notably of supermarket chain Morrisons. It is sometimes suggested that private equity buyers are unfairly taking advantage of public market investors. This looks misplaced.
"It is rare that public markets have got it totally wrong” explained a UK private equity specialist we spoke to. “Managers generally don’t buy a company at a 30-40% premium to the prevailing share price and think they’ve snagged a bargain… they will have a specific strategy in mind to increase the value of that business.” It may be much harder for a listed company to execute this strategy, given the need to juggle the demands of many different shareholders and manage market expectations.
The key point is that today’s private equity firms look to strategic and operational improvements as the main way to increase the value of a business. If nothing else, the relatively high valuations in today’s markets mean that “the days of private equity being able to make good returns from cost-cutting are pretty much over… you really need revenue growth and margin expansion as well,” according to the UK specialist.
That could come from building out the sales and marketing function or moving into new products or markets. Making further acquisitions can also help drive growth, as we explore below.
"A business needs growth and attractive margins when you are looking to exit,” explains Ethan Vogelhut, Head of Buyout Investments Americas at Schroders Capital. “It is key to achieving a good valuation – and great returns”.
What happens after a deal?
Little is left to chance when private equity firms agree a takeover deal. Typically, they will have spent months analysing a business, working with industry experts and conducting detailed due diligence. And they tend to know exactly what they want to do once the deal completes.
"The first few months are crucial – it’s a key principle across private equity”, explains Ethan. “We will typically go into a deal with a 100-day plan, setting out the early impact we hope to achieve.”
In other words, it is not the time to take a break. “There’s a lot of work to get to this point, but it's when you have the most momentum,” explains a UK private equity veteran. “And it's imperative to use that momentum to get the early building blocks in place.”
Dealing with issues identified during due diligence is often top of the list. "Getting the right reporting in place quickly is really important,” says Ethan. “To move the business forward, we need to be able to track the performance drivers we’ve identified. The existing reporting may not be adequate – especially in the case of smaller companies.”
Then come bigger, strategic issues. This might include making new hires or disposing of non-core businesses. It could also include testing and refining ideas generated during the research and diligence process. Pricing strategy is one example. “You may go into a deal thinking that a company could raise prices. But you can’t prove this during the diligence process… you need to validate it later on,” explains another executive.
Capital and expertise are key
Private equity managers we spoke to all expressed the view that access to capital is a crucial tool in the industry’s armoury. This is especially important for smaller companies that may find a lack of capital limits their strategic options. Existing shareholders may not be in a position to provide additional funds and, on their own, smaller firms may not be able to access bank financing on attractive terms.
One approach often used by private equity firms is known as “buy-and-build.”
Smaller European deals are mostly sourced from families and founders
Transactions with families and founders dominated small European buyouts
Source: Schroders Capital
Essentially, it involves buying a small or medium-sized business, expanding it through further acquisitions and making operational improvements along the way. The larger business may, for example, be able to offer a wider range of products to a broader customer base or negotiate better supplier terms. The case study below offers an example of how a buy-and-build strategy works in practice.
This model of expansion may not be available to smaller firms operating independently. “It is not just about capital – it is also expertise,” notes Ethan. “Private equity firms have bought and sold businesses many times over – but most smaller companies have never been through the process,” he adds.
Access to funds can also be a crucial advantage when things aren’t going so well. Managers can support portfolio companies with additional equity. And they will typically have strong relationships with lenders, who may be involved in a number of a firm’s deals. This means banks are more likely to work with managers to try and help a portfolio company through a rough patch.
Where are deals coming from?
The UK saw a large number of public companies being acquired by private equity firms last year. However, in reality, these “public to private” deals account for a relatively small share of private equity transactions. This is especially true at the smaller end of the market in Europe, as the chart below shows. Managers are more likely to buy businesses from family owners or bigger companies selling a division that is deemed non-core.
“There are a lot of businesses founded and still run by “baby boomers”. As they look to retire, private equity provides a natural exit,” suggests Ethan.
Private equity firms can use their capital and expertise to generate attractive returns. A recent Schroders Capital’s transaction is a good example of this. It also demonstrates the benefits of investing at the smaller end of the private equity market.
Schroders Capital co-invested in Heartland in 2017. It is a Michigan-based provider of nondiscretionary residential home services like heating, ventilation, and air conditioning replacement and repair. The company operates in a fragmented market, with several different competitors in the same region.
Over three years, the investor group acquired multiple competitors, creating a regional powerhouse with leading brand recognition. The firms knew of each other’s existence previously, but none of them was in a position to drive a combination.
"We were able to see the opportunity and provide the capital to make it happen” explains Ethan Vogelhut of Schroders Capital.
Heartland grew its profits nearly fivefold over the three years and was ultimately sold to a larger buyout fund for a highly attractive return.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
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