How to Choose a Private Equity Firm
- Concerns founders often experience when evaluating private equity firms
- Criteria on which to evaluate potential investors
Whether you find yourself receiving inbound calls from private equity firms, or you’re nearing the end of a competitive sales process and have multiple interested firms, you’re faced with the same question: How do I choose the right private equity partner?
Enough horror stories pervade the entrepreneurship space that every founder is anxious about bringing on a partner—one you’ll be married to for 3-5 years (or even longer) before you can exit the relationship.
This worry is especially acute for founders who have never taken outside investment and have never had an investor on their board. How involved will the investor be in the business? Will you as a founder be able to maintain control? Will the investor add value in the relationship?
Having an outside investor influencing decision-making can be a big change. As a result, you want to make sure you’re aligned with a private equity investor before you partner with them.
Ensuring Alignment Between Founder and Partner
No partner is universally good or bad—finding the right partner has as much to do with you, the founder, as it does the partner.
Behind the investor horror stories (founder being fired, mass layoffs, etc.) are cases of misalignment, where the founder’s goals and management style directly conflict with the investor’s. While no partnership is perfect, doing your research beforehand can increase your chances of a successful partnership.
To improve your outcome, below are some criteria to use to evaluate potential private equity investors and consider how they would mesh with your management style:
- Name-brand vs. under-the-radar firms
- Hands-on vs. passive firms
- Firms with a playbook vs. bespoke strategies
- Firms focused on growth through M&A vs. organic growth
- Firm fit vs. partner fit
Name-brand vs. under-the-radar firms
Name-brand firms are the household names in the investment community. Their funds are large, they have wide portfolios, and they have a huge resource pool to draw from. These are the firms who reach out to you and that you hear about at all the tradeshows.
Under-the-radar firms, on the other hand, have a more limited resource pool and usually target a specific investment niche with their portfolio. Often they have to rely on investment bankers to fill their deal flow.
When evaluating whether to choose a name-brand firm vs. a more niche firm, consider that name-brand firms tend to have the following characteristics:
- More helpful with opening doors because of their wide network
- More beneficial for growing business operations due to larger funds and more resources
- Easier to find and get in front of since they have more marketing resources available
- Stricter in enforcing a playbook for all their portfolio companies
- More disciplined when valuing your business since they have more deals on the table, creating competition for investment dollars (i.e. internal valuation ceiling)
- Tougher to negotiate with since they don’t want to set negative precedents for future transactions
- More insistent on their deal terms
- More likely to lose interest and write-off an investment if it doesn’t go as planned (due to a large portfolio)
On the other hand, under-the-radar firms tend to have the following characteristics:
- More focused on a specific industry or model
- More experienced in working with founders and bootstrapped companies
- More aggressive in winning transactions when they’ve dedicated their limited resources to pursuing a deal
- More flexible with transaction terms as well as with post-transaction relationships
- More committed to the success of your business since they can’t afford to let your company lose
- Unable to always offer the highest valuations due to smaller funds
- May have a smaller team and therefore less resources in-house to help with operational needs (e.g. recruiting, financial controls, business analysis, sales and marketing, etc.)
Unless a founder hires an investment bank to run their transaction, the majority of the firms on a founder’s radar will be name-brand firms—for the sole reason that name-brand firms have the resources to market themselves, while under-the-radar firms do not.
Hiring an investment bank that knows the investor landscape will give you more options to choose from, increasing your chance for finding the right partner.
Hands-on vs. passive firms
Whether you prefer a hands-on vs. passive firm depends entirely on how you hope to run your business post-transaction. Do you prefer to drive, or are you okay with the investor taking the wheel and steering?
If you work with a hands-on firm, you can expect them to:
- Be more demanding from a reporting/board review perspective
- Play a very active role in decision-making
- Replace some of the existing management
Working with a passive firm, you can expect them to:
- Be more listeners than directors in board meetings
- Retain existing management
- Let management set the strategy while playing the role of a check on decision-making
To determine how involved a potential investor will be post transaction, you can:
- Conduct reference calls with CEOs of their portfolio companies
- Ask the firm about the cadence of reports and meetings
- Ask the firm if they have specific metrics/KPIs they expect reports on
Firms with a playbook vs. bespoke strategies
When a private equity firm takes a playbook approach, they employ the same tactics for every portfolio company regardless of vertical or end market. Companies that run a playbook tend to have large portfolios—applying that playbook across a wide portfolio creates scalability.
For example, a playbook-focused firm might, independent of the nature of the portfolio company, always require the company to:
- Move headquarters to a new, less expensive geo
- Replace their entire management team
- Ramp up sales and marketing
- Move R&D overseas
- Cut costs in specific areas/departments
- Acquire businesses to accelerate top-line growth
A bespoke approach, on the other hand, creates a custom strategy for each portfolio company. The firm’s portfolio is usually focused on investment in industries they know well enough to adapt strategies. Usually, a bespoke approach means:
- Keeping existing management
- Taking a situational approach to each aspect of the business
A frustration with the playbook approach is that it is highly prescriptive and often tries to fit square pegs in round holes. However, a playbook can be extremely effective if your company is a round peg to the round hole, as the playbook essentially serves as a map to success.
VC-backed companies tend to fit better into a playbook strategy, while founder-led, bootstrapped companies tend to align better with a bespoke strategy.
Asking firms about whether they look to employ specific playbooks can help you determine the firm’s approach. Of course, when it comes to sales, private equity firms are the best of the breed, so you’ll want to confirm the post-transaction strategy of the investor by making reference calls to their portfolio companies.
Firms focused on growth through M&A vs. organic growth
A specific tactic many investors like to deploy in their portfolio companies is to rapidly acquire other companies to increase top-line revenue growth. A firm who looks to use M&A may:
- Bring in a different management team with M&A experience
- Hire finance, business development, and integration teams to prepare for M&A
- Try to build a bigger platform, grow revenue, and capture market share fast
- Innovate fast through technology purchases
Depending on the nature of the portfolio company, this tactic can work well or not.
If a portfolio company has experience and success in integrating acquired companies, then the company and their investor will be aligned when using this tactic. However, many companies don’t have experience in M&A, resulting in several challenges:
- Strong misalignment in how to allocate management resources. For companies that have been heavily product-focused, a transition to M&A can feel like a distraction for management.
- Unwanted dilution of founder ownership from addition of new capital. Acquiring a company takes capital, and additional capital raises dilute founders’ equity, which can create tension.
Other firms prefer organic growth over M&A. These firms and their portfolio companies are more likely to:
- Keep existing management who has been successful in executing an organic strategy
- Add personnel to existing departments to accelerate growth
- Grow more consistently
- Make slower, more measured platform advancements as they build, test, and iterate from scratch
With an organic strategy, founders experience much lower dilution.
Larger firms are more likely to use M&A as a tactic because they have capital they need to invest. The lower the cost to invest in your company relative to the firm’s fund, the more likely they are to incorporate M&A into their strategy.
Firm fit vs. partner fit
An important point to remember when choosing a private equity firm is that the firm won’t be sitting on your board—one of the firm’s partners will. Partners at great firms aren’t always great matches for companies and founders. Choosing a partner based on the firm alone is a mistake.
Within each firm, the various partners have different personalities, experiences, focus areas, and management styles. In many ways, you’re marrying the partner, not the firm, so you’ll want to make sure you have a good match.
To avoid getting set up with a bad partner, conduct as many reference calls as possible with companies who have worked directly with that partner.
In addition, try to find an investment bank who has worked with a broad swath of partners. Vista Point Advisors has interacted with firms and partners at firms large and small, and as a result has a strong sense of each partner’s personality and management style.
Run a Wide Process to Increase Your Chances of Success
Even if you’re committed to the idea of working with a private equity firm, you might also consider including strategic buyers in the process, as they will give you leverage to negotiate with private equity firms.
Having many firms and companies to choose from is a good position to be in—which is why at Vista Point Advisors we’re adamant about running a competitive sales process and giving you options to choose from, in addition to bringing our expertise to help you understand which firm and partner will best serve your company.