Part 3: The Down and Dirty on PE Acquisition Targeting
Thrive Blog Series: Private Equity is not a Black Box
Acquisition Targeting
We've discussed the importance and advantages associated with developing a well researched, specific investment thesis. Ensuring that you acquire the right companies related to each investment thesis is ultimately a key determinant driving the success of a fund.
As a quick aside, it’s worth mentioning that the first company acquired to support an investment thesis is called a “platform” company, aka, it serves as the platform for growth. Companies then acquired by that platform company are often called “bolt-ons”, “add-ons” or “tuck-ins”. Typically, private equity firms need that platform company to be big enough to serve as the mother ship, especially in the early days of acquisition. It needs to have enough existing free cash flow to service the original debt from the initial acquisition and it needs to have a management team in place (or recruited) and systems capable of integrating new bolt-on businesses. You can imagine, without a platform, trying to acquire multiple mom and pop businesses at the same time in order to achieve scale would make it super difficult to execute a very efficient growth strategy. Many entrepreneur- or family-led businesses come into the process with their own complexities (think family dynamics plus needing to build scalable systems from scratch). Thus, trying to acquire enough of them quickly in order to achieve the scale needed increases the risk that the PE firm may not ultimately be able to execute the strategy successfully in the timeframe it has. Hence, the platform company approach. If you buy a company big enough to carry the weight, especially initially, things get started much faster and the process is more efficient. You can more easily bolt on smaller companies that then adopt the systems and often the management team of the platform. It’s also worth saying that this model offers a great succession exit opportunity for small companies that have grown but either don’t have that next level of family to take over or just want to monetize for one reason or another.
I see the private equity acquisition targeting process as akin to real estate. Firms come up with a list of ideal “wants” but then they go to market to see what can actually be found and they end up having to compromise on some of what they want. Sometimes they may have to settle for a smaller company, one that comes with some “hair”, has no compelling leadership team, a company slightly tangential to the perfect sector, or one that has other divisions that will need to be spun off etc. My family just bought a house in Florida during one of the craziest real estate markets ever. We knew what we wanted but reality dictated what we could get. A pool was very high on our list. We got the space and the neighborhood we wanted, but alas we did not get a pool! It’s no different for the firms buying companies. They have to determine their dealbreakers versus their “nice to haves”. They essentially look at what’s available in the market and assess each potential target against their own parameters for fit.
How Private Equity firms find acquisition targets can vary. Those that are well-established and well-known with solid track records attract companies to them. That said, most private equity firms have to do some work to compete for deals, aka company targets, successfully. They develop extensive relationships with investment bankers who represent selling companies; when the companies want to sell, the bankers pitch these potential “deals” to appropriate private equity firms. As well, private equity teams attend all kinds of trade shows, join industry associations, and network like pros to uncover hidden gems just waiting to be acquired. Many have a Business Development professional or two on board whose job is to go find companies. Sometimes lawyers make introductions, other times, long standing relationships are tapped to assist with succession planning. And of course, there are auctions - when a company decides to sell itself, it typically hires an investment bank to represent it in the market, and run an auction process. The banker invites certain qualified bidders into the process and they then compete with other bidders until a winning buyer emerges.
Once they find their target platform company, they begin an extensive due diligence process and ultimately either walk away or end up signing a “Letter of Intent” (LOI), committing to buy the business once the inspections are successfully completed. The LOI is essentially the same thing as the Sales Contract we signed pre-inspection when we were buying our house. Regarding due diligence, it’s funny to me that the physical data rooms which buyer teams used to spend weeks (or even months) culling through are long gone. It’s become entirely digital which has reduced cost, improved speed, and made the process so much more efficient. And just like real estate, often thanks to due diligence, the negotiation period can get pretty interesting. But crazy private equity stories are a topic for another day!
Stay tuned for Part 4: The Be All and End All - Otherwise Known As EBITDA.