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What should a mid-market firm ask a potential private equity investor?

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As equity investors focused on mid and lower mid-market companies, we have many such conversations with businesses and their advisors around the world. Every situation is different but, based on our experience, there are some golden rules for successful private equity deals.

Golden rules

First, never open negotiations without a top-notch lawyer who has a good track record on similar private equity deals. Each situation is different and complex, and many law firms claim to be familiar with private equity. However, we have found relatively few have enough commercial experience to really identify with the management or founder of a business.

This can make a real difference to the outcome so choose your lawyer well, seeking independent references for any potential private equity partners. Whilst this is underway you should do your homework on whichever business investment firm you’re talking to. What private equity deals has it previously done, for instance, and how did they go? It’s important not to rely on press releases and coverage but to find people who have actually worked with them and been involved on some of these.

What is the firm’s focus?

If a potential private equity partner claims to cover all sectors, look elsewhere – specialisation is usually an important precursor of successful investment. It’s obviously important to have good chemistry with the top team, but the senior people who lead the investment decisions are unlikely to be your most regular contacts.

Private equity firms work by appointing an investment manager or an operating & finance partner. These are the people you will most likely work closely to, so be sure you have a good rapport with them.

You should, however, take a deeper look at the senior PE team members. How successful are they individually? In this sector everyone works to make money and, whilst lots of people talk a good game, few have done really well. Try to find out if any of the team has made any real money (let’s say over £10m) because this is ultimately the test of success.

Critical questions

Beyond this, there are some critical questions which should be centre stage in your negotiations.

¬ How much control will management have?

The question of how much control will reside with incumbent shareholders and management after any deal is often the most crucial. You need to know what you can and cannot do without consent of any incoming private equity partner and what the consent process is. For example, which decisions will need to be made at investment committee level rather than by the board?

¬ Is further funding available if needed?

Most companies find they need access to additional funding later, so you must understand if this is available and how this might work. Sometimes private equity firms might refuse to put in additional money themselves and propose other investors. Unless you have negotiated pre-emptive rights, you may not have a say and the shareholding of management further diluted.

¬ What is the exit route?

There will always be a business case around which private equity firms invest. You must ask what happens if the business deviates from that original plan and, if either party wants out, how that might work. Often, private equity firms come in with a fixed investment horizon. You should be sure you understand what this is and what happens if it is extended. If the business is loss-making, many PE firms may not want to sell, as this will force them to show losses and potentially compromise their ability to raise new funds. If they choose to sit tight and simply collect fees, managers and founders can become trapped in a situation without scope for either further investment or sale.

¬ What are the likely costs?

Significant costs can be recharged to the business, not only for due diligence but also management fees to the PE fund team and relating to interest-bearing debt and funding. You need to be clear what the costs are and roughly what they will be. Depending on the size of the business and how many years the asset has been held by the PE firm, costs can easily amount to several hundred thousand per year, which is material for a mid-market firm. Linked to this, you must be clear whether cash generated from the business can be recycled for investments or will go straight back to the fund.

¬ What is the business committing to?

Private equity firms often provide funding in the form of preference shares. These are basically a combination of equity and debt, so the business pays a higher rate of interest on the money invested as well as being diluted on the ordinary shares. Preference shares are also usually first in line for any money paid in the event of a sale, so you need to negotiate pre-emptive rights. Private equity investors put a lot of emphasis on representations and warranties and some firms may intentionally seek to include somewhat obscure clauses which might allow them to make a claim later on. Get your lawyers onto this and be clear to understand the implications.

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