As for PEGs, The Wall Street Journal reported that 322 funds raised a record $215.4 billion in 2006, 33% more than was raised in 2005. PEGs are operated by professional managers with backgrounds in finance and/or business who raise and invest pools of capital provided by pension funds, university endowments, wealthy investors, and other institutions.
In order to generate attractive returns, PEGs use leverage to fund a significant part of the purchase price of the acquired business. By using borrowed funds, they can increase the return on the equity they invest. Because of the need to service the acquisition debt, the acquired businesses need to be generating consistent cash flow.
PEGs therefore put their money to work in a rapid but orderly fashion and invest the funds in businesses that will yield attractive sale prices within a three-to-five-year time frame, if not sooner. For those PEGs investing in SMBs, the ultimate exit is likely to be a sale to a strategic buyer or another PEG and not an IPO. If your SMB does not generate significant cash flow to service a loan of as much as 75% of your desired purchase price, it is probably not a good candidate for a PEG buyer.
Additionally, PEGs often restrict their investments to specific industries that they have identified as having the opportunity for strong growth and increasing valuations. If your SMB is in one of these “strategic” industries the PEG will be more interested in learning about you and your company. Retail, restaurants, real estate, and resource extraction (the “four Rs”) are often excluded from consideration by “generalist” PEGs, although exceptions by the generalist PEGs seem to occur on a daily basis.
“Platforms” and “Tuck-Ins”
When buying SMBs, PEGs often target businesses that can serve as “platforms” for growth through acquisition of either competitors or complementary businesses. For platform businesses, PEGs look for strong, ambitious management teams with good internal business processes to absorb fast growth.
If a PEG already owns a “platform” business, then your SMB may be acquired to serve as a “tuck-in” acquisition for its platform—most often to expand the geographic “footprint” or provide access to new goods and services they can sell into the customer base of their existing platform. PEGs are generally less concerned about the management and business processes of a tuck-in and often will fold the customer base and operations into an existing platform company.
PEGs occasionally invest “growth capital” in SMBs whose revenues and earnings can be accelerated organically through the investment of additional capital and management resources without resorting to acquisitions. These investments are less common than platform and tuck-in deals in the SMB marketplace because the capital is subject to “execution risk”—meaning the investment could be worthless if the company does not perform.
Finally, PEGs target businesses with strong cash flows that can be improved through better management practices and thus allow for the rapid repayment of the acquisition debt. In this circumstance, the PEG can re-leverage the business after a number of years and pay itself a large dividend to generate its return.
Building a Consistent Business Model
PEGs look for some other factors when considering the acquisition of an SMB that do not show up as often in their publicly stated criteria. PEGs want to see a consistent business model, with revenue and profits being generated from replicable practices, and not a series of one-off opportunistic transactions.
For example, if a substantial portion of your profits is dependent on your skills as an entrepreneurial “magician,” then your business is probably not the best target for a PEG buyout. Likewise, if every new customer relationship is a long, drawn-out negotiation and your pricing and terms for the same goods and services vary widely to “get the sale,” a PEG will be less enthusiastic about making an investment.
In addition, PEGs focus on businesses that can demonstrate year-over-year revenue growth without diminution in margin. Ideally, your business will show increasing margins as it grows, demonstrating operating leverage as you generate increasing sales on the same base of fixed costs.
Bigger is More Valuable
It is often said that it is easier to finance and put together a $1 billion deal than a $10 million deal. As counterintuitive as this sounds, it is actually true.
PEGs follow a structured acquisition process that includes due diligence conducted by outside experts, such as accountants, actuaries, environmental consultants, and attorneys.
At a minimum, fees for these attorneys and experts easily exceed $50,000. Second, the larger the loan, the easier it is for the lender to syndicate or sell part of the loan to other lenders, thus reducing its risk. Smaller loans have a limited market for syndication or participation. If the lender has to bear the total risk on the loan, then the price of the loan is often higher, thus reducing the return to the investors.
The PEG then takes one or more board seats at the company and an active role in monitoring all of the investments in its portfolio. To do this, it needs to staff up with highly paid professional managers and financial types, many of whom share in the profits of the firm.
As a result, PEGs tend to keep their internal staffs as small as possible and limit the number of portfolio investments. It is easier for a PEG to monitor five $20 million investments than it is to monitor 50 $2 million investments. However, because of the competition for deals in the larger size range, a number of PEGs have been formed recently to look for smaller deals.
At the lower end of the spectrum, PEGs have traditionally needed to put at least $5 million to work in a single deal, and for many PEGs this base-line number is at least $10 million. Because this represents just the equity component of the investment, the deal size that PEGs have traditionally considered has ranged at the low end from $10 to $20 million.
If you want to broaden the group of potential buyers of your SMB in the near future, then you should consider the factors that are important to a PEG in the potential acquisition of your business. You should focus on your business processes, develop a replicable business model, and hire individuals who can sustain your business with or without your involvement. Finally, you should monitor acquisition trends in your industry, because if other businesses are being approached and purchased by PEGs, then there may very well be interest in your company as either a platform or a tuck-in acquisition.
About the Author
Richard Goldman combines financial acumen with business know-how. He has had more than 20 years of experience in the professional and legal services arena and is a recognized industry leader in the human resources sector. He has proven his ability to generate double-digit growth and increase shareholder value, with successes in both fast-growth and turnaround environments.
Goldman’s leadership experience ranges from a $3 billion-revenue public company to a startup with less than $1 million in annualized revenue; he has also worked as a “hired gun” for a family-held business. He is experienced with regulated industries and has served as a regulator and lobbyist. He is equally proficient at recruiting and leading management teams.
Goldman holds a Juris Doctor from Stanford University Law School. He earned his bachelor’s degree from Princeton University, graduating Phi Beta Kappa (top 10%) and with honors. He can be reached at rgoldman@birkman.com.
