1. Do private equity investors really have skin in the game?
One of the common misconceptions about private equity is that investors are simply deploying other people’s money. In reality, the individuals you meet in the investment team (and those outside of the specific investment professionals you are dealing with in the wider PE firm’s team) are going to be expected to invest alongside their funds. That isn’t paper money; it is real cash they send into the firm to go into the deal.
This means that people making those decisions not only have their own capital at risk when they choose to invest, but they know they have all their colleagues’ capital at risk as well. The benefit of this, beyond needing meaningful conviction in the management teams you want to back, is that there is an alignment of interest between investment teams and their end investors (i.e. their LPs – typically funds of funds, endowments or pension managers).
But why does that matter to CEOs? When investors say they care about long-term value creation, they are truly putting their money where their mouth is. Decisions about growth and investment have real consequences for them personally.
2. How do management teams decide how much to roll over?
When a private equity investment takes place, management teams are given the opportunity to “roll over” some of the proceeds from the transaction into the newly backed business. Usually, it is expected that the leadership team does so if they are staying in the business and that they reinvest a meaningful sum (e.g. 50% of their proceeds less tax and fees), as it shows they have conviction and are committing to the next stage of the journey, i.e. they are buying as well as selling.
But how do you decide how much? The investors want management to have meaningful skin in the game, but beyond that it comes down to how much value do you want to realise today versus how much upside do you want to keep exposure to in the future? Tax can also play a role in that decision. For many CEOs, they want to get the benefit of the value creation strategy that the investor is backing; however, it needs to be balanced with appetite for risk. The important part is that rollover shouldn’t be treated just as a financial structuring exercise; it’s more of a strategic choice about how management teams view the next phase of the company’s journey. The best part is, if your growth strategy goes to plan you should get two bites of the cherry either way – some cash out today, and a stake in what will hopefully be a much bigger business down the road.
3. Do private equity investors prefer organic growth or M&A?
Private equity investors commonly back acquisition strategies, so it can lead CEOs to assume that investors prioritise M&A opportunities.
In reality, acquisitions can be an excellent way to accelerate growth, enter new markets, add capabilities or build out your customer base – so it’s no surprise private equity-backed businesses use M&A to create value. However, organic growth is often still viewed as the strongest indicator of a company’s underlying quality. Winning a new customer, increasing market share or launching a successful product is often a cheaper way of generating additional revenue than acquiring it through M&A. For that reason, investors often place a premium on businesses that can demonstrate strong organic growth.
The truth is, we’ve had success with pure buy-and-build businesses, and with companies that have grown purely organically, so any ‘preference’ does not exclude the other. But it’s important that when you see headlines about the number of acquisitions a PE firm has backed each year, it doesn’t mean all firms in the portfolio are going to be pursuing aggressive acquisitive strategies.
4. Will a private equity investor load my business with debt?
Debt is probably the area where private equity attracts the most misunderstanding, particularly relative to our cousins in venture capital. In venture, there is typically no ‘conventional’ debt, as the companies they back are often losing cash, so can’t get a conventional loan from a bank. However, typically venture equity capital money ranks ahead of management via a liquidation preference or participating ‘double dip’ liquidation preference – basically the investor gets a fixed return (1-3x) before management and other shareholders get a pound/euro/dollar. At frothy valuations, that creates a significant hurdle for venture-backed management teams to clear.
If they deviate from plan, venture-backed management teams can and do lose all their value, i.e. these instruments behave like debt with ranking in the capital structure even though they are technically equity. A recent academic study in the US examining the impact of wealth taxes determined that 84% of venture-backed businesses realise zero value and 2% generate 80% of the value, so this is a real risk for 98% of VC-backed companies, not a theoretical one. In private equity, management rolled-over equity typically ranks equally to the investors, so upside and downside risk is shared equally, meaning the value built to the point of a deal is not at risk of being absorbed by an investor’s preferential instruments if there is a rocky patch in performance.
The perception of PE is sometimes that debt is a goal in itself, or that investors seek to maximise leverage wherever possible. It should instead be thought of as a tool – rather than a strategy – and a tool that is designed to benefit all shareholders.
The reason debt is used is relatively simple: it is typically a cheaper source of capital than equity. If an investor puts in £20m, they’re likely hoping to make a return of c.25% IRR (not the same thing, but somewhat akin to interest), whereas a lender would be happy earning c.10% interest. Combining debt and equity can therefore create a more efficient capital structure for the business and improve returns for everyone invested in it, including management teams who hold equity.
Importantly, that only works if debt supports the broader growth plan. Too much debt, and a business will find it harder to invest, hire, innovate or pursue strategic opportunities. That is not in anybody’s interest. As per the above, organic growth is a strategic imperative, so it doesn’t make sense / is counterproductive for debt to stymie profitable growth.
Good investors spend a significant amount of time examining different performance scenarios to ensure a business has the flexibility it needs to continue investing while meeting its obligations. Investors will look to get a level of debt that is appropriate for the company’s size, resilience and growth ambitions – not just to maximise leverage.
Conclusion: It’s all about alignment
Discussions about rollover, incentives, growth strategy and debt structures can sometimes appear technical, but they are all rooted in a relatively simple principle: alignment. The strongest partnerships are built when investors and management teams share a common ambition for the future of the business.
