Approximately 28% of American middle market companies are wholly or partly owned by private equity investors.  The National Center for the Middle Market defines “middle market” as the 200,000 U.S. companies that generate between $10 million and $1 billion in annual revenue, account for 1/3 of private sector (vs. government) GDP and employ almost 50 million people.  These companies generally have between 10-499 employees.

While private equity investment is not the right fit for all mid-market companies, there is ample evidence to suggest that for many it works extraordinarily well, for both the companies receiving private equity investment and the U.S. economy.  Overall, companies backed by private capital outperform other companies by a wide margin in job growth and revenue growth.¹

Let’s Define “Private Equity”

For clarity, the numbers cited above include all private capital-backed companies, including those backed by venture capital.  Venture capital investors who support the financing needs of young, rapidly growing companies pursuing a very large market opportunity (usually >$1 billion expected market) are technically a form of “Private Equity,” however colloquially the terms “Private Equity” or “PE” refer to investors who invest in later stage companies.  That’s the focus of this article.  See right side of the accompanying graphic.  Within “private equity,” there are further delineations such as “independent sponsors” and “search funds,” but that is beyond this article’s scope.

Are Private Equity Investors Desirable Partners to Bring into the Business?

If a private equity group invests in your company while you retain ownership, you are effectively an investor in private equity, specifically investing alongside that group in your company.  Private equity as an investment class historically shows higher returns than investing in the S&P 500. According to an academic study submitted to the Journal of Finance,

“Performance consistently has exceeded that of public markets. Outperformance versus the S&P 500 averages 20% to 27% over a fund’s life and more than 3% annually…we find that average U.S. buyout fund returns have exceeded those of public markets for most vintages since 1984” ^2.

There are vast cultural differences among these firms.  According to a long time private equity veteran, “PE firms are like tribes.  Though there are some common elements, we’re often quite different in our preferences and our cultures.”  This would help explain the differing experiences among owners of companies backed by private equity – and emphasize the importance of fit, along with negotiating the right deal at the beginning of the relationship.

 A study conducted a year ago by the National Center for the Middle Market of private equity-backed companies³ found a roughly 80/20 split of those favoring PE backing versus those finding it disadvantageous.  Interestingly, the study cited “The advantages and disadvantages are matched,” said Thomas Stewart, executive director of the center. “You like [private equity firms] or dislike them for fairly similar reasons, which suggests to me the ownership or management style of private equity firms varies.”

• 78% said that they saw no disadvantages, citing flexibility in business decisions, freedom from public disclosure of financial performance, easy access to debt and equity, and the ability to expand into other regions as the biggest advantages.
• About 22% of the respondents from companies with private equity backing noted that there are disadvantages to private equity ownership. They include slow decision making, too much meddling from the parent company, an overly short-term focus on earnings and cash flows, too much intervention in the day-to-day running of the business, insufficient equity shares for employees, overly complex capital structures, rich management fees and unrealistic return expectations. 

When Mid-Market Private Companies Should Consider Private Equity – Transaction Type Envisioned

While the list below is not comprehensive, it certainly captures most transaction types.  Part of our role is to guide company owners to the transition mechanisms that best support their personal goals, considering where they are in the Ownership Cycle and the Company’s Development Stage, both within the context of the Business Cycle.  Options may include these below, in addition to others inapplicable to this article.

• Owner(s) seeking the flexibility of harvesting some of their gains now by selling part ownership but continue to run the company and grow it with PE backing over the next 4-7 years. One should expect to sell their remaining ownership stake then, but of a more valuable company. This arrangement creates two liquidity events for the shareholders, with the second often larger than the first.
• Owner(s) seeking to completely divest 100% of their ownership and maximize cash now (one liquidity event)
• Management buy-out – A transition to employees in which key managers from inside buy part or all of the company from its owner(s), often with private equity sponsorship
• Management buy-in – Experienced managers from outside buy part or all of the company, typically with private equity sponsorship. These are typically people experienced in the industry and sometimes involve existing managers in the company, too (a Buy-in/Management Buy-out).
• Family succession – A transition to the next generation in which a private equity sponsor acquires most of the older generation’s shares to allow the younger generation management to continue operating the business and implement growth plans with the sponsor’s support
• Corporate divestiture of “orphan” brands, divisions and/or other assets that are no longer part of the company’s strategic core, but which could thrive under new ownership (they typically do!)
• Need capital for growth

Please see companion article “Does Your Company Have What It Takes to Interest Private Equity Investors?” too.

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1. Driving Growth, The Impact of Private Capital on the U.S. Economy, 2013, Association for Corporate Growth, Inc., GrowthEconomy.org. This very rigorous study compares the performance of 23,211 private capital-backed companies to the universe of 52 million U.S. business establishments from 1995 thru 2010.
2. Harris, Robert S. and Jenkinson, Tim and Kaplan, Steven N., Private Equity Performance: What Do We Know? (July 2013). Journal of Finance, Forthcoming; Fama-Miller Working Paper; Chicago Booth Research Paper No. 11-44; Darden Business School Working Paper No. 1932316. Available at SSRN: https://ssrn.com/abstract=1932316 or http://dx.doi.org/10.2139/ssrn.1932316
3. http://www.middlemarketcenter.org/MM_News/survey-shows-mixed-views-of-private-equity-ownership

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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