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Understanding Private Equity Acquisition Criteria for Middle Market Business Owners

Every middle-market business owner grapples with the inevitable question of exit strategy. Whether you’re considering a transition due to retirement or seeking growth capital, understanding the landscape of potential investors is critical. Among these, private equity (PE) firms stand out as unique and often rewarding partners. In this comprehensive guide, we’ll explore the principal factors that PE firms consider when acquiring middle-market businesses, helping you understand their investment criteria and the features they find most appealing.

Defining the Middle Market

Before we delve into PE acquisition criteria, it’s essential to understand what we mean by ‘middle market’. Middle market companies bridge the gap between small businesses and large corporations, with annual revenues generally between $50 million and $1 billion. While sometimes overlooked in the buzz around startups or the stability of large corporations, the middle market is a powerhouse of potential growth and resilience. Its appeal has not gone unnoticed by private equity firms.

Decoding Private Equity Strategies

Private equity firms are not created equal. Each employs a unique mix of strategies depending on its focus, expertise, and investment philosophy. Broadly, the strategies can be categorized into three types: organic build-up, buy-and-build, and growth equity investment.

Organic Build-Up: This strategy involves acquiring a ‘platform’ company and stimulating growth through operational improvements, market expansion, and product or service enhancements. The process often includes a leveraged buyout, where the PE firm purchases a majority stake, funded by a blend of equity from the PE firm and debt. The journey of Dunkin’ Brands, acquired by a PE consortium including Bain Capital, Carlyle Group, and Thomas H. Lee Partners in 2005, offers a compelling illustration. This partnership led to Dunkin’ Brand’s successful public offering in 2011, showcasing how private equity can transform and accelerate a company’s growth trajectory.

Buy-and-Build: In this model, the PE firm acquires a platform company, then purchases additional businesses in the same industry. These supplementary acquisitions are termed ‘add-on’ or ‘bolt-on’ acquisitions. The goal is to enhance the company’s market presence, diversify its product offerings or customer base, achieve economies of scale, and expand its geographical reach. This strategy is particularly potent in highly fragmented industries ripe for consolidation. The Dwyer Group’s journey under The Riverside Company serves as an excellent case study of the buy-and-build strategy. Despite being a significant player in the repair and maintenance services sector, Riverside identified potential for further growth and expansion. They made 15 add-on acquisitions under Dwyer’s umbrella, culminating in a record $1.45 billion acquisition by Harvest Partners in 2018.

Growth Equity Investment: This strategy aims at injecting capital into businesses poised for accelerated growth, often without changing control. The partnership between cybersecurity company AVG Technologies and TA Associates exemplifies a successful growth investment. By aiding AVG’s expansion internationally, TA Associates helped the user base skyrocket from 44 million to 187 million, culminating in AVG’s successful IPO.

Factors that Drive Private Equity Investments

In their quest for significant returns for their investors, private equity firms scrutinize potential investments based on several key factors:

Financial Performance and Stability: A track record of consistent profitability, positive cash flows, and a robust balance sheet are coveted by PE investors. Financial metrics, like EBITDA, often serve as the yardstick for gauging a company’s operational profitability.

Strong Sector Fundamentals: Private equity firms prefer to invest in sectors that have strong fundamentals and favorable growth dynamics. This may include industries that are relatively recession-resistant, capitalize on a demographic trend, or benefit from technological disruption.

Recurring Revenue and Customer Retention: Companies with a recurring revenue model are particularly attractive. This might include contractual revenue, subscription models, or simply a history of high customer retention. This revenue predictability enhances the value of a company.

Scalability: Companies that can grow without equally significant increases in costs have an advantage. This could mean a software company that can add new customers without incurring significant cost or a manufacturer with excess capacity in its factory.

Delving Deeper into Private Equity Acquisition Criteria

Now that we’ve covered the basic factors that private equity firms consider, let’s delve into a deeper understanding of the primary categories.

  • Financial Performance and Stability

A history of strong financial performance is a significant attraction for PE buyers. They look for businesses that exhibit consistent profitability, positive cash flows, and solid balance sheets. The adage “past performance is not indicative of future results” may not fully apply when it comes to private equity. PE firms heavily rely on a company’s historical financial performance to predict future cash flows. They’re interested in revenue growth rates, gross margins, EBITDA margins, and the predictability of these metrics.

When PE firms look at financial performance, they don’t just consider the raw numbers but also compare these to industry peers. For example, if a business has a 10% EBITDA margin, that might look good on the surface. But if the industry average is 20%, the company may have efficiency issues.

It’s also worth noting that PE firms often use a measure called “adjusted EBITDA,” which adds back one-time costs and owner expenses that wouldn’t continue under new ownership. This approach gives them a clearer picture of the business’s underlying profitability.

  • Market Position and Competitive Advantage

PE firms look for businesses that have a strong position in their markets. Market leadership can lead to superior financial performance and create barriers to entry for competitors. A company’s competitive advantage might come from its brand, unique technology, cost structure, or customer relationships.

For example, a branded consumer goods company might have a loyal customer base that repeatedly buys its products, leading to predictable cash flows. A technology company might have a patent that gives it exclusive rights to a profitable product.

  • Growth Potential

While current profitability is important, private equity firms are also looking to the future. A company’s growth potential is often more important than its current size. PE firms will assess the trends in the company’s industry, the size of the market, and the company’s growth strategy.

They’re especially interested in industries that are growing faster than GDP. For example, sectors like technology, healthcare, and certain service industries have seen higher growth rates. Within these sectors, PE firms look for niches where a company can carve out a significant market share.

  • Management Team

A successful investment isn’t just about picking the right company—it’s also about partnering with the right people. PE firms often prefer to keep the existing management team in place, especially in family-owned businesses where the owners have a deep understanding of the industry and company. They look for managers who are motivated, have a significant stake in the business, and are willing to stay on during the transition.

However, private equity firms also have the resources to strengthen the management team if needed, by bringing in industry veterans or specialists in areas like supply chain management or digital marketing.

  • Exit Opportunities

PE firms always have an eye on the exit. Before they invest, they consider who might want to buy the company in the future. This could be a strategic buyer (another company in the industry), a financial buyer (another private equity firm), or the public markets through an IPO.

The timing of the exit is also important. Most PE firms aim to sell their investments within 5-7 years. If they believe it could take longer to realize their investment objectives, they might pass on the opportunity.

The Value of Preparing Your Business for a Private Equity Acquisition

As you can see, private equity firms have a comprehensive and specific set of criteria when evaluating businesses for potential investment. If you’re considering selling your business to a PE firm, understanding these criteria can help you prepare your business and potentially increase its value.

In the end, the most attractive businesses to private equity firms are those that combine strong historical performance with significant growth potential, have a competitive market position, and are led by an experienced, committed management team. By understanding the private equity mindset and preparing your business accordingly, you can put yourself in the best position to achieve a successful outcome.

The world of private equity can seem complex, but with the right guidance and understanding, it can open up significant opportunities for middle-market business owners considering their exit strategies. Remember, the partnership with a private equity firm doesn’t just represent the end of a journey, but rather the beginning of a new chapter, one filled with the promise of growth, transformation, and lasting value creation. At Astria LLC, we are committed to providing you with the expert guidance and support you need to navigate the world of private equity. Contact us today to unlock the potential of your business and embark on a new chapter of growth and transformation.

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