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While private equity has gone from being an upstart industry to nearly being a household name over the past 40 years, it is still uncommon for those outside the financial services industry to understand what private equity is, what private equity investors do for a living, how they get paid and what the potential benefits and risks are to the companies that they invest in.
At Raincatcher, our primary work involves representing business owners who seek to sell to, raise capital from, or partner with private equity groups. This vantage point gives us the unique ability to see how companies run while the founder is in charge and then see what changes private equity groups make once they close an acquisition or growth equity investment.
In this blog, we will explore the concept of private equity, how it drives growth, and most importantly, how these strategies can be applied to boost the growth of your own business.
What is a Private Equity Firm
Private equity firms are professional investment companies that use their client’s money to invest in or buy privately held companies represented by professional M&A advisors. They aim to generate returns for their investors by strategically managing and growing these businesses.
Unlike public companies traded on stock exchanges, private equity firms acquire ownership stakes in non-public firms, often with the goal of improving operational efficiency, expanding market reach, or growing through acquisition to move up-market and increase the value of a company.
Who Invests in Private Equity?
Private equity firms typically raise capital from institutional investors such as pension funds, and high-net-worth individuals to finance these acquisitions. They then use their expertise to add value to their portfolio companies through various means, some of which we will explore in this article. Private equity firms play a crucial role in the economy by fostering growth and innovation in various industries through their hands-on management and long-term investment strategies.
How Do Private Equity Firms Get Paid?
Private equity firms get paid through two primary mechanisms: asset management fees and performance fees, also called carried interest. Management fees are paid annually and used by the private equity firm to cover the costs associated with running the firm, primarily for salaries. Typically, this fee amounts to 2% of the total committed capital.
Performance fees also referred to as “promote” or “carried” interest, are a share of the profits, typically around 20%, earned after returning the initial capital to investors and achieving a minimum return threshold, often around 8%. This payment structure motivates the firm to maximize investment returns. If private equity investors generate returns that are below average for their clients, the fee will be less than 20%, while those who produce higher returns will receive performance fees of more than the standard 20%.
The Primary Growth Initiatives for Private Equity Investors
There are several different initiatives that private equity investors employ as they seek to drive a strong return for their investors. Some of the more common ones include:
- Digital Transformation and Technology Upgrades: Implementing new technologies to improve the companies’ efficiency, drive innovation, and stay competitive in the market. This can include upgrading IT infrastructure, and adopting or creating new software solutions.
- Revenue Growth Initiatives: Developing new sales strategies, expanding distribution channels, enhancing marketing efforts, and improving customer engagement and retention.
- Streamlining Operations: PE groups will work to enhance the efficiency and effectiveness of a company's operations.
At Raincatcher, we believe that streamlining operations and making the company more efficient is the single best growth initiative that private equity firms utilize. This is because it is not reliant on new products, putting more capital into the business. Furthermore, the average business owner can learn the PE growth tactic and implement it in their own business. We’ll elaborate more on this below.
The 3 Main Ways Private Equity Firms Streamline Operations of Their Portfolio Companies
1. Synergize Operations With Other Companies
Many private equity firms will look to grow their portfolio companies through acquisition (roll-up strategy) and/or strategic partnerships with companies offering adjacent products and services. In pursuing either of these growth strategies, there are often opportunities to consolidate operations and thereby save costs.
For instance, if each company has an outsourced CFO working 30 hours per week, the new company could probably benefit from having one, full-time CFO at 40 hours per week.
2. Carve-off Divisions
Some companies come with less desirable lines of business that may be an undue burden on the management team and on the company's financial structure. In this case, the company would likely be better off spinning off (selling) that portion of the business so that they can double down and focus their capital and expertise on the areas where they believe there is value.
3. Cross-sell Adjacent Products or Services
One of the most common action items that PE groups enact after acquiring a company is to look for adjacent products and services that they could cross-sell to their existing clientele.
This could be other products or services that could be offered by the company, or, the sales team can sell other company's products for a commission. Doing this provides a quick way for the business to more fully monetize their strong client relationships. However, for one reason or another, companies that are not private equity backed rarely come up with the idea to pursue this.
Implementing Effective Growth Strategies to Further the Success of Your Business
If you are a small business owner, one thing that you have no doubt learned is that your business is only as good as your team. We would strongly advise you to line up a rock-star management team and become great at delegating to them before you look to utilize any of these other growth initiatives. Increasing your revenue while lacking the ability to delegate or fulfill your product or service is akin to trying to fill up a leaky bucket.
Assuming you have the right team and processes in place and have successfully delegated so that the business does not require you to be in it for 40 hours/week, you are ready to implement some of the streamlining initiatives that have historically only been used by private equity companies.
Think Like a Shareholder
Get in the habit of viewing your business from an outsider's perspective. Doing this habitually will help you see opportunities that you have been blind to in the past. This could be seeing that your company is spending way too much of its time with the bottom 10% of customers, that there is another product or service that you could be offering that your clients would eat up, that your best sales reps may be stuck behind a keyboard instead of getting in front of clients.
By creating the habit of thinking like a shareholder you’ll develop the ability to see these opportunities, instead of being myopically focused on the list of small tasks in front of you.
Growth Through Acquisition
While growing through acquisition may seem like a growth plan that is only available to private equity groups and their deep pockets, the fact of the matter is that thanks to the SBA, there are better acquisition financing options available for Main Street businesses than there are to larger, private equity owned ones.
While growth through acquisition is not suggested until your current business is proving to be operationally sound and you have disposable income that you can invest, the fact is that you can buy a competitor’s company or a company offering an adjacent product or service to your own with as little as 10% down and finance the 90% for 10 years.
Create Recurring Product and Service Offerings
Many business owners focus solely on creating products and services that they believe their customers will buy. While this is a great way of testing the market and creating a profitable business, there often lies an opportunity to turn these products or services into recurring revenue options that not only your customers will love, but will drive significant value for your business as well.
The fact of the matter is that not all cash flow is equivalent. If you can prove to potential buyers that your business can endure a recession due to its sticky, recurring cash flow and that any new customers they bring to the company will mean parabolic growth due to it’s sticky, recurring revenue business model, there will be a feverish investor market for your business which will cause it to trade at a much higher business valuation.
While there are countless ways to grow any given company, reviewing the past performance of private equity-backed companies with the 80/20 principle in mind will lead you to realize that the bulk of the positive results have come from hiring a capable management team and enacting one or more of the above, business streamlining initiatives.
It is our hope that you will create the habit of viewing your business as a shareholder, not as an operator. By stepping back and seeing your business from this new perspective you’ll develop the ability to see opportunities that you had been blind to previously.
