Why Buying a Company from Private Equity Can Be a Smart Move—or Not
An overview of stumbling blocks and tailwinds.
Purchasing a company from a private equity (PE) firm can present a unique set of advantages and challenges. While PE firms often make substantial improvements to the businesses they acquire, there are critical factors to consider to determine if such a purchase aligns with your investment goals. Here’s a detailed examination of the pros and cons of buying a company from a PE firm.
Advantages of Buying from Private Equity Firms
Operational Improvements and Efficiency Gains PE firms typically acquire companies with the intention of restructuring them to enhance operational efficiency. This often involves streamlining operations, cutting costs, and optimizing management practices. By the time a PE firm decides to sell, the company is usually more efficient and profitable than it was pre-acquisition. For buyers, this means acquiring a business that has already undergone significant improvements, reducing the need for immediate overhauls and allowing for smoother transitions.
Stable Cash Flows Companies that have been under PE ownership are often stabilized and generate consistent cash flows. PE firms focus on creating reliable revenue streams and sustainable profit margins, making these businesses attractive for investors seeking stable returns. This stability can provide a solid foundation for future growth or for generating steady income.
Professional Management Teams PE firms frequently install experienced management teams to drive the transformation of the acquired company. These teams are often retained post-sale, providing continuity and experienced leadership. For new owners, having a competent management team in place can ease the integration process and enhance operational continuity.
Enhanced Market Position Under PE ownership, companies often expand their market presence and enhance their competitive positioning. This can involve entering new markets, diversifying product lines, or improving customer relationships. Such strategic moves can make the company more valuable and resilient in the market.
Disadvantages of Buying from Private Equity Firms
Leverage and Financial Engineering PE acquisitions often involve significant debt financing (leverage). When a PE firm exits, the company may still carry a high debt load, which can constrain its financial flexibility. Potential buyers must carefully assess the company’s debt levels and the associated risks. High leverage can impact future investment opportunities and operational agility. Especially in today’s landscape where the costs of capital are high.
Limited Growth Upside PE firms typically extract substantial value from their acquisitions through operational improvements and strategic initiatives. By the time a PE firm is ready to sell, much of the intrinsic growth potential may have already been realized. For buyers looking for high-growth opportunities, these companies might not offer the same upside as businesses that haven’t undergone intensive PE-driven transformations.
Potential for Underinvestment During the period of PE ownership, there may have been underinvestment in certain areas such as R&D, marketing, or long-term strategic initiatives. PE firms often focus on short- to medium-term profitability to prepare for exit, which might lead to deferred maintenance or postponed growth investments. Buyers should scrutinize capital expenditure histories and future investment needs.
Cultural and Operational Fit The changes implemented by PE firms can lead to a corporate culture that is highly performance-driven and focused on short-term results. This culture might not align with the new owner’s long-term vision and operational style. Evaluating the cultural fit and readiness for potential changes is crucial for a smooth transition.
Secondary Buyouts
Despite potential disadvantages, there is demand for the purchase of PE portfolio companies from various types of investors. A more interesting strategy - often due to the supply of poor takeover targets - is secondary buyouts.
When a private equity (PE) firm buys a company from another private equity firm, it is commonly referred to as a "secondary buyout" or "secondary transaction." This type of transaction involves the transfer of ownership of a portfolio company from one PE firm to another, rather than to a strategic buyer or through an initial public offering (IPO).
Key Characteristics of SBOs
Transfer of Ownership: The primary feature of a secondary buyout is the shift of ownership from one PE firm to another. This can be driven by various factors, including differing investment strategies, time horizons, or the desire for the selling firm to exit its investment.
Operational Improvements: Often, the company being sold has already undergone significant operational improvements under the ownership of the initial PE firm. The new PE firm may see additional opportunities for growth or further optimization.
Valuation and Leverage: The valuation of the company in a secondary buyout can reflect the improvements made by the initial PE firm. The transaction may also involve substantial leverage, as both buying and selling PE firms are experienced in utilizing debt to finance acquisitions.
Why PEs consider buying from PEs
Strategic Fit: The acquiring PE firm might see a strategic fit with its existing portfolio or have a different approach to scaling the business.
Investment Cycle: The selling PE firm might be at the end of its investment cycle and looking to realize returns for its investors.
Growth Potential: Despite previous improvements, the acquiring PE firm might identify further growth potential or synergies that the previous owner did not fully capitalize on.
Risk Mitigation: For the buying firm, a secondary buyout can sometimes present a lower risk compared to acquiring a company directly from the founders or from a public market, as the company has already been vetted and improved by a previous PE firm.
My two cents
Secondary buyouts have become more common in recent years, particularly in markets where PE firms have abundant capital but fewer new investment opportunities. This trend reflects the maturation of the private equity industry, where firms increasingly look to buy and sell companies within their network to achieve targeted returns.
Buying a company from a private equity firm can be a wise decision if you seek a stable, well-managed business with solid cash flows. However, it may not be the best choice for those looking for untapped growth potential, as much of the intrinsic value may have already been leveraged. Prospective buyers should conduct thorough due diligence, examining the company's financial health, growth prospects, and alignment with their strategic goals.
Ultimately, understanding the implications of purchasing from a PE firm and carefully weighing the pros and cons can help you make a well-informed investment decision that aligns with your business objectives.
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