Authored by: Benjamin Misner
Private equity is one of the most lucrative forms of finance. There is a multitude of acquisition strategies utilized by PE firms and acquisition entrepreneurs. This article will cover what private equity is, business acquisition strategies that create value, and the most common types of acquisitions.
Firstly, it is important to cover what Private equity is, and how these strategies rose to prominence. Private equity is understood as an "alternative investment class and consists of capital that is not listed on a public exchange. Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity. Institutional and retail investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and bolster and solidify a balance sheet." -Investopedia
The reputation of private equity firms for drastically raising the value of their assets has aided this expansion. Private equity firms have access to an array of powerful incentives that help them generate superior returns. These include high-powered incentives for both portfolio managers and operating managers, aggressive use of debt, tax benefits, and a determined focus on cash flows and margins.
Private equity firms buy stakes in private companies by purchasing those shares with the expectation that the shares will be worth more than the initial investment by a specified date – called the exit date. These firms allocate money from institutional investors, including mutual funds, insurance companies, and pension plans, and wealthy individuals. Some examples of PE firms include The Riverside Company, Blackstone, Platinum Equity, EQT Partners. Private equity firms buy just to sell, they aren't enticed by the allure of sharing costs, capabilities, or consumers among their portfolio companies. Their management is lean and focused, avoiding the loss of time and money that corporate centers typically suffer in a futile search for synergy while responsible for a variety of loosely related firms and trying to justify their retention in the portfolio.
In the past decade, private equity became more and more important. An example of this is the amount of dry powder (the amount of committed, but unallocated capital) a firm has on hand. By 2021, there was an estimated $1.78 Trillion of uncommitted capital to private equity firms.
In the past few decades, private equity firms have become increasingly important players in the global economy. While there are many different types of private equity, all share the same basic structure: a firm buys an existing business, usually with the goal of improving its financial performance. After the purchase, the firm takes steps to help the business grow, often through acquisitions and restructuring. Once the business reaches a certain level of profitability, the firm sells it back to the original owner or another investor. Private equity firms have become particularly prevalent in recent years, especially among larger companies that need to raise capital. These funds are also attractive to investors looking for higher yields than other asset classes. Public companies often acquire other public companies. However, there is another way to think about this acquisition strategy. Private equity firms are actually buying companies that they will then sell to others. That means that they must understand what those buyers are looking for. For example, a firm might purchase a company because its management team knows how to run that business well. Or it could buy a company because it believes that the market for that product is growing rapidly. If the buyer does not share the same beliefs as the seller, however, it may not be successful.
There are now thousands of PE firms around the globe competing for investment opportunities. There has been a massive influx of private equity investors. Pension funds are starting to invest more in private equity funds, as well as sovereign wealth funds and family offices, and individual investors. The increase in private equity investments is also driven by the fact that pension funds are increasing their allocations to private equity. There is a denominator effect at play here as well. The main reason private equity firms and acquisition entrepreneurship have risen in popularity is mainly due to the hefty return on investment. The "secret" to garnering these superior returns is through their use of leverage which provides them with a high return on equity; and fees on assets under management.
There are many ways that PE firms and Acquisition Entrepreneurs create value in the acquisition target that they acquire. The best way to create value is to have a business acquisition strategy and a well-thought-out strategic rationale that will be implemented after acquisition.
Below are some of the most common types of strategies used to create value:
The major goal of this approach is to minimize costs by employing economic methods. Rollups also rationalize market rivalry by limiting the number of participants. If an investor is willing to invest in the merger of two competing companies, his or her risk exposure may be minimized to a bare minimum. Roll-ups use economies of scale that can be explained by referring by cutting the costs and merging with different competing and opponent firms. By consolidating several types of companies in the firm itself you can get the services cheaper than what you would get outside.
When a firm acquires another company solely to prevent another competitor from doing so or to protect its future market position, it is referred to as a defensive acquisition strategy.
This is one popular value-creating strategy for acquiring companies. One of the ways is to figure out ways to cut costs to boost profits and cash flow. Sometimes it means upgrading the systems and technology used in the company to help boost performance.
Examples of other changes to improve a company's performance are:
It is sometimes necessary to replace the management of a company, and bring on proven innovators in the industry space you are acquiring the company.
You will need to get from the seller a list of the inventory on hand, and any other details regarding inventory. Check to see what is old and aged. You can choose not to buy this or carve it out of the deal.
With the maturation of industries, new competitors enter the market. Simultaneously, mature companies devise new techniques to boost output from current facilities.
This combination raises supply while lowering profit margins across the board. By shutting down a few plants and cutting excess capacity, the combined firm can become more profitable.
A company may have earned a strong reputation in a specific geographic area and now wants to expand its concept to a new area. If the company's product line necessitates local assistance in the form of regional warehouses, field service operations, and/or local sales reps, this might be a serious issue. Because the company must build this infrastructure as it grows, such product lines can take a long time to launch. The geographical expansion approach can be utilized to speed growth by acquiring another firm with the geographic support features that the company need, such as a regional distributor, and then rolling out the product line through the acquired company.
Many technology-based businesses acquire other businesses that possess the technologies they require to improve their own goods. They use this to obtain technology faster than they could develop it themselves, avoid paying royalties on patented technologies and keep the technology out of the hands of competitors.
Internal growth, also known as organic growth, is often difficult for a company to achieve because of several impediments and bottlenecks. In such cases, it is sensible to make an acquisition to speed up the growth rate.
This technique is distinct in that it begins with the PE firm acquiring a majority share in the company's equity rather than a minority stake in its debt. A firm using turnaround tactics will usually acquire 100% of the company's equity. Then they might start negotiating with lenders to restructure the debt so that it is easier to service. Simultaneously, they would begin to undertake significant operational adjustments, such as those indicated above. The PE firm will sometimes buy the company before it files for bankruptcy, and other times it may buy it during the bankruptcy process. Because most troubled companies are insolvent, private equity firms rarely employ debt in the original acquisition.
This strategy is more common in the tech space. Acqui-hire refers to buying a company for its employees' skills and proficiency rather than its products or services. The acquisition is when one company buys another, and hiring refers to taking on employees. Acquihire is a strategy that helps companies grow by bringing in new employees with specialized skills. When a large company purchases a smaller company without any employees other than its founders. Typically, they buy them for their expertise.
Buy-and-build strategies have been around since buyout firms were first formed. However, they haven’t really taken off until recently. One reason is that they require a lot of capital. Another reason is that they are very risky. If you buy an asset that doesn’t grow fast enough, your return will be lower than if you had invested in something else that does. Finally, there isn’t always a clear path to value. You may need to invest heavily in infrastructure before you see any profits. When we say “buy-and-build” we don’t refer to companies that acquire other companies after they have already built something valuable. We are talking about companies that have a strong platform that allows them to make multiple acquisitions of small businesses. These companies are often referred to as “platforms” because they offer a unique service or product that lets them make many different types of purchases. Platforms are usually very successful in the short term because they can quickly grow their customer base and revenue. However, platforms are often not sustainable long term because they tend to become reliant on a few large customers.
Buy-and-build tactics are attractive because they provide a strong counterbalance to rising deal multiples. They allow GPs to take advantage of the market's proclivity for assigning higher valuations to larger companies than to smaller ones. A buy-and-build approach allows a general partner to justify the initial purchase of a very expensive platform company by tucking in minor add-ons that can be acquired for cheaper multiples later. These many arbitrages lower the company's average acquisition cost while putting capital to work and increasing asset value through scale and breadth. Simultaneously, serial purchases enable GPs to generate value through synergies that cut expenses or increase revenue. The goal is to put together a formidable new team.
The Vulture strategy is focused on getting inexpensive bargains by focusing on businesses that financial institutions (FIs) are unwilling to lend to. After failing to get credit or funding from banks and/or other investors, a struggling business is typically forced to accept whatever assistance is offered.
The vulture capitalist will put together aggressive financial targets once on board. They begin by seeking to resurrect the company by slashing costs wherever possible in order to increase earnings; this includes laying off a majority of the workforce and striping the balance sheet of unneeded assets, such as selling off land, buildings, and machinery.
A well-known private equity firm that specializes in using vulture strategies Paul Singer's firm Elliot Management.
The industry analysis and valuation stage is usually done during the preliminary due diligence phase, but further detailed analysis can be done during the due diligence phase after the LOI is signed. Not only is it important to collect all information pertaining to the ins and outs of a company; but it is important to have an understanding of the industry you will be purchasing the target company. Remember, the best company in a bad industry will still fail.
For example, let's say you are doing due diligence on a target company that is in the defense industry that produces weapons and ammunition. The first step in your industry due diligence would be to get an overview of the industry and the key metrics. North star metrics are always industry-specific.
Involve the buyer in purchasing individual assets and liabilities from the target company in exchange for cash, shares, or a combination of the two. After closing out its liabilities with asset sale proceeds and delivering the remaining assets and cash to the target's shareholders, the target firm may dissolve. A target shareholder vote is not usually required for asset acquisitions. Asset sales are preferred by buyers because they allow them to "step-up" the asset values assumed. Assigning a higher value to the assets after the acquisition allows for larger depreciation payments, resulting in near-term tax benefits. Asset sales are frequently preferred by buyers since they can avoid taking on the target firm's responsibilities, particularly contingent liabilities.
The acquirer purchases the target's stock by a tender offer, either in stock or cash and subsequently operates as a subsidiary. Because the buyer buys shares directly from shareholders, target shareholders are not obligated to vote. Stock sales are preferred by sellers due to their favorable tax status (typically incurring capital gains taxes only as opposed to corporate and income tax rates). Licenses, contracts, permits, and intellectual property, as well as tax attributes (assets or liabilities of the target firm), transfer smoothly to the buyer during the stock sale, without requiring numerous conveyances on individual assets because the title to the assets is held by the target corporation.
Leveraged acquisition, commonly known as a leveraged buyout (LBO), is when a company buys another company with borrowed funds. The parent firm must borrow a large sum of money to fund the acquisition costs, and the target company's assets must be used as collateral for the loans. The leveraged acquisition is one of the most common investment strategies.
Tuck-in acquisition occurs when a large business entity acquires a smaller one in the same or related industry. The large company absorbs the smaller company and the acquired company does not retain its individual structure.
Because the target firm's management does not want the purchase to go through, hostile acquisition happens when the acquiring company tries to acquire control of the business without the target company's cooperation. The hostile acquisition can be performed by going directly to the target company's shareholders and purchasing their shares, or by engaging in a proxy war to replace the current management.
Killer acquisition happens when a large company acquires a small startup with an innovative product solely with the purpose of discontinuing the innovative product and reducing future competition.
This situation happens when a company thinks that the new product can compete with its own product. It then acquires the new company and terminates the development of the new product, thus killing competition and innovation.
An add-on acquisition is a common private equity strategy, which occurs when a PE firm or other buyer purchases a business and integrates it into the parent company's portfolio, which is known as a portfolio company. Add-ons are typically smaller, strategically positioned, and sought out by larger, more established platform companies to add value and promote growth. This is commonly referred to as a "purchase and build" strategy. Add-ons can also be used to increase the value of a platform company prior to a sale.
Carve-outs are popular among private equity investors. Corporate carve-outs are a type of private equity acquisition that provides greater returns to discerning investors.
Essentially, a major organization with several business units decides to sell one of them. As a result, the divested segment is "carved out" of the parent corporation and becomes a separate entity. The carve-out segment can be "spun-off" as a separate business, with shares allocated to the parent firm's shareholders. It could also be purchased by a strategic or financial buyer (PE firm).
In a carve-out deal, the private equity company will make a bid to buy the divested business. The offer will be evaluated by the parent company's board of directors, and if it is acceptable, it will be accepted.
This article covered what private equity is, the strategies used, and the most common acquisition methods used by private equity firms. Many of these strategies are not only used by private equity firms but now family offices and independent sponsors (Acquisition Entrepreneurs).
One of the hardest parts of the business acquisition process is finding the right deal, especially with more money than ever in history chasing business acquisition opportunities. It takes an average of 19 months for search funders/Acquisition Entrepreneurs to find an ideal target company to acquire. Here at iGOTHAM, we help acquisition entrepreneurs, private equity firms, and family offices source acquisition opportunities; by automating the deal-heavy origination process by leveraging our proprietary technology to discover, extract, and engage with owners of companies who are considering selling.
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