A Suitable Business

Most private equity houses invest in businesses which cost from a few million to billions. Regional funds and business angels often invest in small businesses, so size is not necessarily an issue. A loss-making business is not necessarily unsuitable, but the management team will need to outline a deliverable plan to restore profitability and cash generation quickly. This could involve closing loss making parts of the business, or eliminating group management charges or significant cost reduction. Generally speaking, identifiable ‘cost out’ opportunities are more convincing to private equity houses as a means of eliminating losses rather than sales growth which is likely to take longer to achieve.

The most important requirement for an MBO (Management Buy-Out) or MBI(Management Buy-In) is positive cash generation within the first year or two. As MBO’s and MBI’s are financed by a substantial proportion of debt, it is important to reduce the interest burden as soon as possible by generating cash to repay some of the debt. Consequently, a cash hungry business may well be unsuitable such as a high technology company requiring subsequent injections of cash for research and development.

Tangible assets backing, primarily land and buildings, is helpful because it offers security for the debt finance, but it is not a prerequisite. A service company with low net asset backing, but with good growth and cash generation potential, will be seen as an attractive investment opportunity.

As the private equity house will probably be committed to an exit within five years, they need to be convinced that the business will still have demonstrable future prospects. Also, they will assess the most likely exit route and other possible avenues, including a secondary buy-out to other private equity houses, before they invest.

Interestingly, mature business sectors are quite attractive to private equity houses because the relatively low growth may make them attractive cash cows. Equally, some investors are attracted by a sector which is suffering a downturn because bargain prices may be available and by the time of exit the sector could well be enjoying better times.

Particular dependence on a single customer or product, or vulnerability to technological development or changing legislation will be viewed negatively by private equity investors. They are aware that MBO’s and MBI’s are usually paid for in full at legal completion, because it is not appropriate to give an earn-out deal to the vendors, although a trade buyer would do one to make the purchase price partly dependent on future performance.