Private Equity Search Funds – The Good and The Bad
I received an email today from a business owner that has a letter of intent to sell a majority interest to a private equity group, but he is having second thoughts about how professional the PEG really is. After looking into it, he is probably involved with a small search fund. Here’s the scoop on them.
We probably have one of the best if not the best middle market private equity database because of our deal flow and marketing efforts. There are currently around 2,800 PE firms in our database, but this PEG was not listed. I went to their website (new) and they did show one transaction, but the business owner said that they actually didn’t directly execute that transaction. The PEG is made up of two guys looking for smaller deals (about $1mm).
This is probably a “search fund”, where the guys don’t actually have money in hand, but get commitments for the funding after they have already located and negotiated an LOI with a company. Some of them work with larger private equity groups, some have arrangements with wealthy investors, some even use family money. The important thing to realize is that they don’t actually have the money, and it is possible they never will.
The quality and professionalism of these search funds ranges from opportunistic sharks that are purely acting like deal finders to trusted industry experts that are as good as gold in terms of raising the funds, and that also add great value post-transaction.
It is my job as advisor to point out the differences, and when meeting with PE groups, to ask some pointed questions to ferret out the answers. Some, obviously, would be more than happy to keep quiet on some things.
If you are working with an equity fund, ask these questions yourself. Ask them in plain English, and if you get investor-speak back, ask them to clarify. I’ve seen many business owners pretend to understand when I know they don’t. There is no reason you should know all the terms these guys use, so just ask them to explain. I'm a pilot and its great to know and be able to use pilot-speak to keep things concise, but when things get confusing sometimes the best thing you can do is drop back to plain english and simply ask the air traffic controller what you need to know.
Here are some questions to ask:
- Ask them directly who their investors are; are they private individuals, friends and family, larger PE funds?
- What is the process and under what conditions do they get the money? Ask for this in detail, as some will say, “really, it is no problem”.
- Try to understand if they have to pitch this opportunity from the ground up to investors, or if they have some latitude in finding certain types of deals.
- Do they plan to use any debt, and if so under what conditions will this happen. Are they dependent on raising debt?
- Be very clear on the terms in the LOI. It is common for private equity to present an offer in terms of total value or cash payment, then mention that the seller would retain equity in the form of an equity buyback. An equity buyback uses some of that cash, sometimes a lot of it.
Remember, you usually want some added value besides their money. If they are industry veterans that can pull together a good board, add key employees and use their knowledge to grow the company, that is great. You can both win. That is why it can be important to talk to their references of past deals.
This is also why it can be important to get someone like Woodbridge involved. We bring in in almost every case multiple offers from PE groups. I have a client now that is not PE material (we spent more time searching for strategic buyers). He is a distributor that carries one product from one manufacturer, and that is just too much risk for most professional investors. Still, I had over 100 PE groups take a close look, and we ended up with three offers from private equity. One of these was a search fund with a relationship with a larger San Francisco based fund, while two were larger funds.
