Daily, I am contacted by at least one private equity (PE) investor seeking deal flow.  What sort of companies do they seek?  Below is a good, generic example of a middle market private equity investor’s deal criteria. 

Some investors are more specific about industry, geography, etc., but all will dive very deeply into any proposed deal’s specifics.  For instance, the generic description below wouldn’t mean that this PE firm will invest in any company that fits the criteria – only those which withstand their stringent scrutiny.

Platform Investment Criteria (a Platform is an initial investment in a theme, such as an industry)

SALES: $20 million – $100 million

EBITDA: $2 million – $20 million (EBITDA is earnings before interest, taxes, depreciation and amortization)

INDUSTRY: Low-tech manufacturing/distribution and service companies

MANAGEMENT: Founder or family-owned management teams that are looking to grow, but will consider other situations

PROFITABILTY:  Proven profitability for last three years with future expectations of positive, stable cash flows

GEOGRAPHY:     Continental United States with a particular interest in the Great Lakes Region (may consider Canada)

Add-On Investment Criteria (an add-on is a complementary investment to an existing platform)

SALES: $2 million – $30 million

EBITDA: $0.5 – $5 million

GEOGRAPHY: Agnostic

The “Capital Overhang” Encourages Higher Valuations – for “Good Companies”

PE firms have a record $820 billion of money available to invest in private companies — both venture and established companies, the latter accounting for around $500 billion.¹ The term “overhang” is used to describe the surplus of capital supply over the demand to deploy it.  PE succeeds both as a business model and an investment model.

That extraordinary sum is almost as much as in 2001, and for years the number was about half.  The high amount, combined with low interest rates and a declining supply of “good” companies in which to invest their capital has resulted in a seller’s market, with private company valuations for good companies being edged up. 

Importantly, savvy investors still maintain their discipline, and even considering all that money looking for a new home, won’t pay irrationally high prices for “wobbly” investment opportunities.  Lingering fears of global recession and/or disruptions, and perhaps to a lesser extent interest rate uncertainty, discourage taking on too much risk. 

Good companies stand to benefit from valuations being edged up, whereas wobbly ones get edged out altogether or devalued by prospective investors.  If you contemplate the possibility of bringing outside investors into your company’s capital structure, it behooves you to strengthen the fundamentals.

Some Characteristics of Good Companies (Those Which Will Be Most Highly Valued in Investment or Sale Negotiations)

Based on an academic study which evaluated a particular type of successful private equity investments, “Search Funds,” conducted at the Graduate School of Business, Stanford University², a hypothetical model was created that showed what an ideal candidate for investors seeking companies in which to invest would look like.  This model was compiled from the study of failed search funds – “what went wrong?”

An important distinction is that Search Fund investors raise capital to seek and acquire a business they intend to operate, whereas traditional private equity investors typically do not want to run the company but keep management in place to do so. 

Though this is a fairly simple, brief list of attributes, in reality, very few private companies would exhibit all of these traits.  However, the more a company has, the more attractive it will be to outside investors, or in this case, Search Funds in particular.  In other words, their market value will be higher, thus it will be easier to attract PE investors in a competitive environment, and they will likely pay more for a given share of ownership in the company. 

My summary of the study is very abbreviated, I’ve edited some of the wording but kept intended meaning intact, and I’ve added embellishments from professional knowledge.  I could extend this list for pages, as there are far more attributes sought than those listed, but will resist that temptation.

Components of a Hypothetical Model Search Fund Acquisition

Category One: Industry

• Future growth at or above 5% per annum, with preference for >10%
• Gross margins at or above 20%, with preference for 25%+
• EBITDA margins at or above 10-15%

Category Two: Business

• Relatively simple operations, easy to understand and operate within a relatively short time
• Growing at or above industry growth rate
• Differentiated product or service that will remain differentiated over time (strong margins suggest differentiation now, and differentiation protects margins against competitors or substitutes)
• Each customer accounts for less than 25% of revenue (per the study – which puzzles me, as this concentration would scare most investors). If the top 10 customers comprise <50% of revenue, that would suggest a middling valuation, but no customer accounting for more than 5% is necessary for an investor to assign little risk to account loss, and thus a higher valuation.
• Differentiated end markets, with no one end market comprising 100% of revenue
• Located moderately close to attractive geographic area in order to attract and retain top talent

Category Three: Searcher or Operator (I omitted for this discussion)

Category Four: Board of Directors (existing members, investor will take a Board seat)

• Willing to trust, work with, and be transparent with investor
• Board representative skill set includes operating experience
• Ready availability to investor for phone calls, meetings as warranted
• Experience working with professional investors in a growing business with debt

Category Five: Former Owner of Business

• Doesn’t present fraudulent information to investor at any time (this is table stakes!) and held accountable with a seller note, earn-out, or minority equity
• Specifically to a Search Fund, whose objective is to transition former owner out altogether – Former owner remains as employee or outside consultant to business for one year or less
  • Does not hold Board position
  • Does not hold equity, or if so, a minimal amount
• To institutional private equity, if they forge an agreement with the former owner to stay and operate the company as an equity partner (who will typically hold 20-40% of the recapitalized company and a Board seat), their objective is absolutely not to push him or her out.
• Does not start competitive business in same geographic footprint after exit and held accountable with a Seller Note, earn-out, or minority equity (Note: non-compete provision is typically part of the sale terms)
• Has reasonable expectations regarding repayment of seller note or earn-out and understands that temporary stoppages may occur during cash flow shortfalls (and shouldn’t operating management reciprocally expect such understanding from the investor, too?)

Category Six: Capital Structure

• Acquisition is purchased and maintains capital structure with less than 60% debt, including both seller and 3^rd party debt
• Previous owner can hold seller note, and holds if any, only a small equity position (again, this is a Search Fund investor’s objective, not reflective of all PE situations)
  • Earn-out can be used as a financial instrument, but with caution

Please see companion article “Why Your Company Should Consider Private Equity Investors,” too.

1. Does Private Equity Have a Dry Powder Problem?, Krista Lomu, March 9, 2017 http://blog.dealmarket.com/does-private-equity-have-a-dry-powder-problem/ and https://www.preqin.com/docs/reports/2017-Preqin-Global-Private_Equity-and-Venture-Capital-Report-Sample-Pages.pdf
2. Search Funds: Death and the Afterlife, 2012 Academic Study, Benjamin Kessler, Author, Professor Jim Ellis, Advisor, Stanford Graduate School of Business.

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McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC.  He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.

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