Private Equity…Demystified

A few days ago, I participated in a panel discussion with two other Colorado CEOs for the Denver Chapter of the Association for Corporate Growth.  The panel topic was “Private Equity Demystified.”  As a post-private-equity-deal CEO, it’s interesting to hear people’s questions and comments about life after “The Transaction.” It’s also interesting how many folks, even otherwise savvy business folks, don’t fully understand what it’s like being on the leadership team of a private equity (“PE”) owned company.

I’m not sure whether we demystified private equity that day or re-mystified it, but I captured below a few of the more interesting private equity “myths and annoyances” from the event.  [Note: Certain of the comments below are those of other panelists and the event moderator (a PE principal himself) and do not represent the author’s personal opinions or experiences.]

Myth No. 1 – “Wow, you guys must be rolling in the dough!”

Reality – Immediately following a private equity deal, about the only folks that are flush with cash are the former owners! The private equity group likely utilized a combination of first lien bank debt and a layer of more costly second lien debt (sometimes called “mezzanine” debt) to finance the acquisition. Right out of the chute, there are new debt service obligations and lender debt covenants that must be closely monitored.

Myth No. 2 – “Have they replaced the management team with their own folks?”

Reality – As a general rule, private equity groups are financial investors, not business operators. One of the most valuable assets a company has is a professional and sustainable management team. That’s one of the things the private equity group pays for. Sure, private equity groups will occasionally make adjustments – for example, if an acquired company was founded and formerly managed by an entrepreneurial designer or engineer (no disrespect intended – remember, they just got a nice payday!), perhaps the private equity firm will install a CEO or COO with prior executive management experience.

Myth No. 3 – “It must be nice to have capital to invest in new products, growth and acquisitions.”

Reality – This one’s actually true, with a caveat. While’s it’s true that private equity firms want to “buy and build” companies for future sale, this generally must be approached incrementally.  This is where we need to refer back to “Myth No. 1.” Right out of the chute, financial resources can be tight.  Management’s first goal after transaction closing is to establish credibility with the private equity group and the company’s lenders.  Next, it’s time to generate strong cash flow and EBITDA growth pursuant to a credible business plan. This will give the company resources to invest in organic growth initiatives or strategic acquisitions.  Alternatively, a strong cash flow track record may enable the company to refinance high-cost mezzanine debt with a commercial bank, providing an even greater return to the company’s stockholders.

Annoyance No. 1 – “Too many cooks in the kitchen.”

This one requires little explanation. One of the panelists commented that in some cases, putting too many ideas on the table, second guessing the management team and questioning the team’s strategies and tactics became a significant distraction that sidetracked the team from pursuing agreed goals and strategies.  This leads to….

Annoyance No. 2 – “The question that leads to the wild goose chase.”

One panelist, CEO of a service organization, related an experience in which one of their PE reps mentioned reading something in a magazine and asking in front of the management team:  “Do we offer something like that?”  This led to a scurry over the next several weeks to respond to the question and identify alternatives. Before long, the management team concluded that the service offering was way too “out of core” for their company and represented a distraction that was not consistent with the company’s strategic goals.

Annoyance No. 3 – “Do more of the same, but better.”

One thing that was discussed at length was the tendency for some PE folks to seem disinterested in “breakthrough” initiatives the team thought were important for long term growth.  This led to a discussion about a focus on near term “base hits” rather than bigger bets to win the entire series.  Interesting, but I can get it – it’s easier and safer to drive growth by focusing on what you know and do well rather than making bets with unclear future outcomes.

So there you have it – private equity demystified!