Top things to avoid when using private equity

There comes a time in the life of many businesses when owners cast around for ways to borrow money for growth. But those intending to use venture capital and private equity should plan particularly carefully before committing. Many don’t, and the result can be catastrophic.

The challenge is simple enough: to get the best deal whilst surrendering the least amount of control and equity. How to achieve that is less straightforward.

What goes wrong is poor attention put into the three basics: business plan, motivation, and due diligence.

Usually, the fractures start to appear because the borrowing enterprise has just not prepared itself. Unfortunately, the thought of ‘free’ cash in return for a slice of equity can tempt owners to make growth predictions that overreach reality. But the wise tread carefully and take advice. Without careful execution, the deals turn sour, with original management teams seduced into arrangements that end up with them losing both money and control.

There are horror stories out there. One UK business originally worth £5 million saw a £7.5 million private equity investment turn rapidly from a lifeline to a millstone, as it failed to meet challenging targets to which its owner had originally agreed. The software company now owes its backers £22.5 million in unpaid interest and redemption charges. Only one of the original management team is still in place and their stakes are now worth little.

This particular nightmare is neither the rule, nor the exception, but illustrates what can go wrong.

Private equity and venture capital can positively transform the fortunes of a business, injecting expertise as well as cash to help it grow. When it works, everyone benefits from a deal between risk and reward. But when it fails, the biggest loser often turns out to be the original management team.

In the end, the siren call of ceding absolute control for someone else’s financial support is not for everyone. Clients of BKL stepped back from the brink, despite a willing lender. The reason was unease that the lender’s need for a return on their cash over a fixed term was at odds with the more relaxed instincts of the management team to let things in their restaurant chain grow organically.

The business plan is crucial and more than just a calling card. It is the basis on which the institutional equity investor decides how much to lend and what to demand in return. Firms that overstate likely growth to get investment are doing themselves no favours.

This is because valuations, upon which the entire deal will be based, are dependent on cash flow forecasts. Get them right, or better still, set them lower than they subsequently turn out, and everyone is happy.

But if the business has to keep going back to the investor, the lender will gradually wrest away control in exchange for their cash. They will insist, for example, on new agreements that may keep notional share ownership intact, but take control of decisions over fundraising and board membership.

In simple terms, the more a business falls short of an agreed business plan, the more it ends up giving away.

Which brings us to the next important area: motivation. A management team must ask itself what kind of life it wants. Once private equity is on board, a rollercoaster ride starts. Demands are made, targets need to be met. The lender’s need to recover cost and secure a return requires growth at an agreed rate. This can be incompatible with watching your children play sports on a Wednesday afternoon, say. Do the soul-searching.

Nothing will be a problem if your business is growing, of course. But if it isn’t, expect a tough life. The management team must be wholly committed or problems start, particularly when targets in the all-important business plan fail to be met.

The final key component to borrowing money is to carry out due diligence on any lender. Examine the portfolio that every equity house lists. Speak to the firms involved and find out their experience.

Borrowing money from a bank is a far more removed, transactional experience than taking it from a venture capitalist or private equity lender. Their loans come with an expectation of involvement, so personal and professional chemistry is important. The process is effectively inviting a new member on to your key team.

Sometimes organic growth is best – not only because it allows more control to be kept by the original owners, but it can also be better as a fit. The culture of a business can be rudely disrupted by the keenly focused financial demands of an agreement with venture capital and private equity funders.

And choose wisely. The ideal lender will treat your enterprise as more than just a risk to be shared amongst many others. But remember: Private equity wants to have your cake. The trick is to avoid it being eaten entirely.

https://www.bkl.co.uk/insights/using-private-equity/

This article was first published in Finance Monthly’s April 2018 edition and is available on the Finance Monthly website.

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