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— A VPA Perspective

The Reason So Many Private Equity Firms Call You

  • How private equity firms try to avoid competition through direct outreach
  • What founders should do when a private equity firm reaches out

When private equity firms start to reach out to you at your company, you might feel like you’ve made it.

The outreach from PEs will often start around the same time your company reaches a major milestone. If you were recently recognized on a list like the Inc. 5000, or you accomplished a milestone in employee headcount, the emails and phone calls from PEs likely started flowing in.

Having PEs reach out can be flattering. When people with deep pockets suggest they want to invest in your company—a company you’ve worked hard to build up—that kind of recognition can feel special.

But don’t get too excited, because the outreach from PEs might not represent the interest you were hoping for.

Your company is worth investing in, but don’t fall into the trap of thinking that’s why so many PEs reach out. The reason why has to do with the rapid growth of private equity funds.

Private Equity Funds Are Growing Rapidly

Private equity funds investing in technology companies have grown dramatically, almost doubling since 2016. This rapid growth comes as a result of existing firms raising larger and larger funds, as well as new funds sprouting up or spinning off from existing firms.

Private equity funds have nearly doubled in size since 2016

One of the consequences of this growth is that there are fewer companies for PEs to invest in, resulting in an oversupply of private equity money. This oversupply is the real reason PEs are reaching out.

The Underlying Reasons PE Firms Cold-Call You

The oversupply of PE money is good for you as a founder because you have more buyers to choose from and thus more competitive pricing. But it’s bad for PEs. For PEs, competition drives up sellers’ prices and makes it harder for PEs to close deals. Their recourse to this challenge is to start engaging with companies earlier and earlier.

In reality, PEs reach out to a lot of people. The vast majority of our clients have over 30 PE firms emailing/calling them 2-3 times a week and sometimes have even received multiple unsolicited indications of interest (IOIs) from PEs before we ever engage to represent the company.

It seemed like every few quarters that a couple of players would reach out to talk about pursuing a transaction then nothing would really happen.  At this point, I realized that many of these M&A folks were not actively pursuing deals, just kicking tires.

In order to reach out to so many companies, many PEs will hire a huge team of junior-level employees with limited experience (sometimes even fresh out of undergrad) to select and cold-call companies like yours. In doing so, they’re trying to achieve the following objectives:

  1. PEs want to maximize their option value. A large focus of private equity outreach is volume—the more companies like yours a PE can engage with, the greater chance they will have to invest.
  2. PEs want to negotiate directly. When PEs reach out directly, they’re trying to circumvent the competition, negotiating directly with you so they can hopefully buy your company at a discount.
  3. PEs want to increase their chances of participating in the sales process. In the event that you don’t negotiate directly, PEs know you will likely take your company through a structured process with an investment bank. By reaching out early before you begin preparations for the process, they suspect you’re more likely to invite them to participate when the time comes to sell.
  4. PEs want to anchor. Humans are affected by anchors—the first offer or first impression usually sets the tone for the rest of the conversation. If PEs can reach out early in the sales process, they are better able to set an anchor and be involved in the entire sales process. Early outreach means they’ll have more time to develop a relationship with your CEO, or suggest there is a cultural fit, or convince your team that they are the right partner to help you grow your business. In the case where the process reaches a tie, the anchored PE often has a greater chance of winning.
  5. PEs are gathering information. In some cases, PEs aren’t really interested in your company, but are simply out gathering information under the guise of due diligence. In these cases, PEs might be:
  • Making an investment in a competitor
  • Gathering information on behalf of a portfolio company
  • Conducting due diligence on your market space

In any of these cases, freely sharing information with the PE may not be in your best interest.

The Pitfalls of PE Outreach

If your company has the right profile and is in the right space, you could have 30-70 private equity firms reaching out to you directly. But before you start sharing information and assembling the list of PEs you plan to include in an investment or sale process, here are a couple items to consider.

The PEs you hear from directly don’t represent the complete market

Not all PE firms will reach out to you directly through a calling approach. The majority of PEs actually rely on bank-run transactions for their deal-flow and will simply pay the highest price to win. If you only include in your sale process the PEs who reach out to you, you may miss out on other valuable investors.

Private equity firms had been knocking on my door for a while. They’d been sending emails saying, "Hey, do you need any funding? Do you want to talk?"  I mainly wanted to see what the firms thought we were worth. No one came back with anything interesting

The PEs might ask you for information that puts you at risk

As I stated previously, PEs might want your information for reasons other than being interested in your business. Rather, they could be doing diligence on a market/space as they prepare to invest in another firm in the space—potentially even a close competitor. Because you can’t know which PEs are sincere and which aren’t, as a general rule you’ll want to keep your cards close to the chest.

Even if the PE is sincere and interested in your business, you want to be careful about the information you share because you can and will be held accountable for it. Every PE group uses a database/CRM to log information they gather. They will use this information as a measuring stick against your business, as well as an indicator of CEO credibility (a huge valuation factor).

How to Respond When PEs Reach Out

Private equity firms will reach out, and you shouldn’t ignore them if they do. You should, however, be prepared to give the right information and talk to the right people.

Share appropriate data

Some data you can safely share without any future risk. Specifically, you can feel relatively comfortable talking about past financial performance in terms of high-level revenue and profitability. Share these metrics on your terms within context so that PEs don’t misunderstand, because they’re paying attention and taking notes.

Never share raw data with PEs. Sometimes PEs will request raw data (often in the format of revenue by customer by month) because they can calculate a ton of metrics off of that data. They will calculate retention rates from this data and create a picture of your company that may or may not be accurate. If you haven’t adequately framed or cleaned up the data, it may paint an unfavorable picture of your company that PEs might hold you to.

Never share forward-looking statements. Again, PEs are taking notes. They’re paying attention. If the sales process lasts over an extended period of time, PEs are going to follow up on any projections you give them. If you fall short of your projections, then you’ve muddied the water and may have lost credibility with the PE.

Sharing forward-looking statements also increases tension during the sales process because the projections your investment bank helps you put together probably won’t align with what you told PEs, taking another swing at your credibility. You have one chance to make a good first impression, so be strategic about what you share.

Build relationships with decision-makers at PE firms

When PE firms do reach out (because they will), you should take advantage of the opportunity to get to know who you would be working with.

Your first interaction with a PE may be with a junior employee who is probably young and inexperienced. The entire job of these junior employees is to just call, call, call. If a PE is really interested in you, you should be able to pull back the curtain and talk to the partners in charge. Ultimately, the partners or other senior-level colleagues will be the ones sitting on your board and helping direct the future of your business. Get to know them so you can construct an idea of what it would be like to work with them.

Guard your time and test the waters

When 30+ PE firms are following up with you every 2-5 months, engaging with PE firms can be a huge time suck. Make sure you’re not spending your time on activities or with firms that don’t help advance your business’ objectives.

At the same time, you want to have a lot of firms in the process as this creates a competitive process, and competition yields better outcomes for founders.

The beauty of having multiple interested buyers is that we could use their terms and valuations as leverage to negotiate.

Here are some general rules you can follow for guarding your time and testing the waters:

If a PE firm is in town, meeting up with them could be a good use of your time. Face-to-face interaction will help you get to know the person you could be doing business with. Especially if a decision-maker is in town at one of the PE firms known for paying high valuations, you should find time to meet with them.

If a PE firm suggests they are value additive, put them to the test. PE firms will often (more like always) pitch that they are value additive because of their experience in a specific space or because they have certain companies in their portfolio. Put those PEs to the test by asking them to introduce you to some of their portfolio companies.

If PE firms suggest they can help you engage with the right network, put them to the test. When a PE tells you that they can help you scale your management team, ask for an introduction to some of the people in their network and see for yourself.

Seek Out Guides Who Know the Terrain

There are certain investors worth your time. These investors offer premium valuations, high multiples, and are value additive. The trick is that, as an entrepreneur, you don’t have a lot of experience in the private equity space to identify which firms will serve your company best.

Hiring an investment bank focused on sell-side transactions can help you understand what the universe of transaction options are and avoid the pitfalls of engaging directly with buyers.

If you’re preparing for a transaction, be prepared for one of the most exciting, most demanding times of your business career. To handle the demands, you need to approach the transaction with a bank who has the same energy level as you.

Modified on Jun 16, 2020