What a private equity fund is for. The owner buys experience and pays for it with shares

A company worth PLN 100 million that grows by 10 percent a year from its own profits will be worth about PLN 195 million in seven years. The owner will keep 100 percent of the shares and will make every decision himself. A private equity fund promises faster growth. In return it takes part of the shares, seats on the supervisory board and the right to force a sale after a few years, often of the whole company.

A private equity fund buys shares in private companies, usually for several years, and makes its money when it later sells them. It can subscribe for new shares, in which case its money goes into the company. It can also buy shares from the owner or from one of the partners, in which case the money goes to the seller. An owner who is considering such an investor almost always asks whether it is worth taking its money. He should ask what problem he wants to solve and whether a fund solves it better than other sources of capital. The question about money assumes that only its price matters. The question about the goal forces the owner to name what the company really lacks. It often turns out that the company lacks something other than what a fund provides.

When a fund beats other sources of capital

There are four situations in which a fund is the best choice.

The first is a need for capital on a scale that the company cannot generate from profits and that debt cannot carry. A bank lends up to the level the company’s free cash flow can service, meaning the cash left from operations after paying taxes and funding the necessary investment. If the plan requires an amount at which the bank says no, and growth from the company’s own profits would take 12 years, capital from an investor is the only realistic route.

The second is a partner who wants to leave when the others do not have the money to buy him out. This happens more often than people think, and it can hurt a company more than a downturn. A partner who has already left in his mind, but has enough votes or rights to block important resolutions, holds up decisions and makes the management board’s work harder.

The company can buy back the partner’s shares with a bank loan and redeem them, that is, cancel them. The remaining partners then have full control. The loan, however, burdens the company with debt that does not finance its growth, and a bank will lend for this purpose at most as much as the cash flows can service. A fund buys the stake with its own money and takes no cash out of the company. In place of a tired partner, however, comes a demanding investor with an exit date.

The third is the owner’s personal wealth risk. Someone who holds 90 percent of his wealth in one company makes decisions like a person who cannot afford a single mistake. For strategic decisions this is the worst possible state to be in. Selling a minority stake to a fund gives the owner cash outside the company. He can then think about the company’s growth with part of his wealth secured. I have seen the quality of an owner’s decisions change within a quarter after such a deal.

The fourth situation is the most important. The company faces a leap in growth, such as acquiring competitors or entering foreign markets. It could raise the money elsewhere too, but it lacks people who have made such a leap before.

What a fund brings besides money

Capital is available in many places. A good fund brings things that cannot be bought separately.

The most valuable is experience. A fund team that has taken 40 companies through the stage the owner is going through for the first time in his life recognizes mistakes before they happen. It has this knowledge from repetition, because it has seen the same situation 40 times.

A good fund also has people at hand. It can point to a CFO who built reporting at three portfolio companies, or a head of sales who twice took a company into the German market. The owner would spend a year looking for such people on his own and could easily get it wrong.

A fund brings discipline: monthly reporting, a supervisory board that asks awkward questions, and a budget the management has to account for. For the first year the management board sees this as bureaucracy. Later it turns out that a company that knows its product margin on Thursday makes different decisions from a company that learns it in May of the following year.

A fund that has invested in the sector knows potential acquisition targets, the banks that finance such deals and future buyers the owner would not reach on his own. In some deals these relationships are worth more than all the capital the fund puts in.

I have seen companies grow threefold in four years with a good fund. Their owners say openly today that they would not have done it without the fund.

A fund must be checked as carefully as it checks the company

All this works only if the fund is really good. Funds differ from one another a great deal. I believe the gap between an outstanding fund and an average one is bigger than the gap between an average fund and no fund at all. An average fund takes shares and imposes rules. It brings only money, which the owner could have got more cheaply elsewhere.

Before investing, a fund spends three months examining the company. It reads its contracts, talks to its customers and calculates recurring EBITDA, that is, earnings cleaned of one-off events. The owner has the same right to examine the fund. Before signing the agreement he should check at least three things.

The first is the history of the companies where things did not go to plan. Every fund will show a slide with its results. The cases where the plan failed say more, because they happen in every portfolio. The owner should find out whether, after the first weak quarter, the fund replaced the management board or helped fix the company. He should also find out whether, at a difficult moment, the fund put more capital into the company or used its troubles to take up new shares at a low price and cut the founder’s stake almost to zero. This test shows a fund’s character, and few funds pass it.

The second is how the fund makes money. Some funds build value by growing the company, and years later they sell something bigger than what they bought. Others cut costs and load the company with heavy debt, for example to pay themselves a dividend. They then make money on the cash taken out of the company and on the fact that the company repays this loan from its own profits. The debt falls every year, so when the company is sold for the same amount, more money is left for the shareholders, even if revenue has not grown. Both models are legal and both make money for funds. For an owner who stays in the company, they mean four completely different years. Which model a given fund uses can be seen from what it did in its portfolio companies in a difficult year.

Alongside how it makes money, the age of the fund itself matters. A fund raises money from its own investors for a fixed number of years, and toward the end of that period it has to sell its companies to settle up with them. The owner should check how many years the fund has left, because this determines how much of a hurry the investor will be in to sell the company.

The third is the specific people. Two of the fund’s partners work with the company. They are the ones who will sit on the supervisory board and call the owner. Their experience, and whether they stay with the team for the next four years, mean more than the fund’s brand. A fund with an outstanding reputation that assigns an average team to the project will give the owner four average years. The partner leading the project must first defend the deal terms before the investment committee, the body in a fund that approves every investment. For the owner, the partner’s standing within the fund also matters.

Few owners use the simplest way of checking a fund. It consists of talking to the founders of the portfolio companies, all of them, including those for whom things did not work out. The three the fund gives as references were chosen so that they would speak well of it. An hour of such conversations tells you more about a future partner than a legal review of its documents. In Capital One Advisers projects where we look for a financial investor for the owner, these conversations are part of the preparation for negotiations.

This method has its limits. A founder for whom things did not work out can be biased, and some of the people you talk to have signed confidentiality undertakings. On the Polish market the choice is often narrow, because there may be only a few funds that invest in companies of a given size and sector. The best available fund may turn out to be average. The owner should then work out the numbers on other sources of capital before signing the agreement.

Working together after signing

Even an outstanding fund will contribute nothing if the owner takes the money and shuts the fund out.

I have seen this scenario many times. The owner signs the investment agreement, and the fund’s money goes into the company. For the next four years the owner treats the fund as an intruder. He hides bad news because he fears the reaction. He meets his reporting obligations to the bare minimum. He defends every decision because he takes every comment as a challenge to his competence. He fights for the control he himself sold.

The result is exactly what he feared. He paid with shares for experience he did not use. He took on a partner and got a boss. He brought it about himself.

Working together requires uncomfortable things. The owner has to show the fund the data even when it looks bad. He has to listen to a comment that sounds like criticism and check whether it is right. He has to give up part of the control and not fight for it for four years, because that fight takes energy the company needs. This is the price of access to experience the owner does not have. An owner who does not want to pay it is sensible to give up on a fund. What matters is that he knows this before signing the agreement. Discovering it two years later is the most expensive option.

Other sources of capital

A fund is one of several sources of capital. I wrote about four routes to capital and about mezzanine in June. Each of these sources should be costed before the first conversation with a fund.

A bank loan is the cheapest money on the market and does not reduce the owner’s stake. You pay for it with covenants, that is, conditions in the loan agreement such as the maximum permitted ratio of debt to EBITDA, and with a limit set by cash flows. It cannot finance a leap. But if the company needs money for an expansion it can service from its own EBITDA, a fund is a very expensive solution here.

Mezzanine is financing that is repaid after the bank loan. It costs more than a loan because its provider gets its money back only after the bank. It does, however, make it possible to finance growth beyond the bank loan limit, and as long as the company meets the terms of the agreement, the provider stays out of the management of the company. In return it receives an extra premium for growth in the company’s value, called a warrant. Formally this is the right to take up a small block of shares at a price set in advance, in practice often settled in cash. For an owner who wants to grow the company and keep control, it is often a better instrument than a fund, even though almost no one offers it to him.

A private minority investor provides capital without a set exit date. The owner loses some freedom but gains a partner who may stay in the company for 20 years. A company from the same sector that takes a minority stake usually wants the right to buy the remaining shares in the future.

A company that invests the wealth of a rich family, known in the market as a family office, can be the most patient investor. It is usually smaller than a large fund, though, and less often brings ready-made management support. If the company lacks money but has enough know-how, it is a serious option.

The stock exchange gives the company capital and lets the owner sell part of his shares on the market without letting a single strong investor into the company. The price of going public is full transparency, the disclosure obligations of a public company and the pressure of quarterly results, which can distort long-term decisions. For a large enough company with predictable results, at a time when the stock market is doing well, a share issue can nevertheless be a cheaper source of equity than a fund.

The last option brings nobody a commission, so people rarely mention it: do not take capital, and grow more slowly from your own profits. The company from the start of this article will be worth about PLN 195 million in seven years, because PLN 100 million multiplied by 1.1 seven times gives PLN 194.9 million. The calculation assumes that the profits stay in the company and that the valuation grows in line with results. With a fund the company may grow faster, but the owner will then be left with, for example, 60 percent of the shares and a partner who after four years will push to sell the whole company. The investment agreement usually gives the fund a drag-along right for this purpose, that is, the right to require the other shareholders to sell their shares together with it. Which outcome is better depends on what the owner wants to achieve.

Two questions before the first conversation with a fund

The owner should settle two things before the first fund calls. The first is whether the capital is meant to finance a specific goal that the company will not achieve without this money. The second is whether the owner is ready to give up part of his power and really let the investor into the company’s affairs. At Capital One Advisers we start with these two questions before any list of funds is drawn up.

If both answers are “yes,” and the owner has examined the fund as carefully as the fund examined his company, bringing in an investor can be the best decision in the company’s history. I have seen many companies change beyond recognition as a result. If either answer is “no,” the owner is buying himself a boss for four years and paying for it with shares in his own company.

The hardest case is when the answer to the first question is “yes” and the answer to the second is “I don’t know.” Mezzanine financing combined with hiring an experienced manager from the market gives the company money and lets the owner keep control. The owner, however, has to find the manager himself, and the debt has to be repaid regardless of results. A fund provides people and experience, but it takes shares and sets an exit date. The first route leaves the owner alone with the risk of executing the plan. The second gives him a partner whose exit date may clash with the owner’s plans.

Service: Raising capital and finding an investor