How Do Private Equity Funds Evaluate Businesses?

Hello and welcome to Well Capitalized. I'm your host, Bobby Kingsbury, CEO of MCM Capital Partners. Today we have Mark Mansur, Senior Managing Director and Founder of MCM Capital Partners. Thank you for joining us today. Mike. Thank you. We've been having conversations with some. business owners with Harry, senior operating partner and really what we want to discuss with you today fundamentally is what

private

equity

is, kind of demystifying

private

equity

, so for business owners who are not familiar with private equity , could you provide a rudimentary explanation of private capital and what is private capital generally implies a private fund made up of shareholders, they could be institutional shareholders, such as pension

funds

, university endowments, hospitals tend to be the majority of the capital provided to the fund and may also include high net worth individuals those individuals provide capital. to the fund, which in turn looks for opportunities to invest that capital in private companies, in general terms, they are looking to take controlling positions, some very few will take a minority position, but the majority are looking to make controlling investments and, obviously, to business owners.

Private capital is not the only route for a possible exit. What are some of the other things a business owner can consider aside from private equity? One thing about getting out of your business. Well, you know, it can actually take a myriad of different forms, I guess. I would start by saying that you know that a management buyout is certainly a possibility which usually involves key managers getting the support of the bank to acquire the founder's business and generally the founder at that time will provide the capital as a seller's note. which is paid over time, that could be one option, another option is an esop, so in an esop transaction, effectively all the employees buy the business from the founder, you use the leverage provided by a bank and again Generally speaking, the primary owner stays because in some cases, most of the cuppy declines over time, other liquidity opportunities, you can look for a strategic buyer who is an industry player or in a tangential industry where that strategic buyer, whether public or private, buys one hundred percent. of the company, so there are many different ways to obtain liquidity and each has its own nuances depending on what the seller wants to achieve, so if a business owner decides to go the private equity route, how do they value generally private equity companies? a company, so I would talk more specifically about MCM because of the way we would approach the transaction, but I think the concepts are generally common across the industry, so most business owners have heard of a multiple of E, but DEA is a very common means of valuing the price of the tenant, which is sometimes very scary, so you know, the question is what are the multiples five times abtar' is ten times e, but the DEA and some Of the other factors that impact where multiples are likely to fall and I'll elucidate some of the things that we look at that dictate what we might pay for a business or the value of the business, so I would start at a high level and say that the overall market the company competes in is is a growing market is a shrinking market is a mature market is a highly cyclical market so, for example, the medical device industry tends to be a non-cyclical market and therefore my order is a higher multiple and then you start to move into the details of the company itself where a company is positioned within the market in which it competes what its defensible intellectual property is and it doesn't have to be true intellectual property but technical know-how, etc. , how is your position and the blows, you already know the nomenclature you are talking about. about the moat around the castle, so we started talking about what the company's moat is around their castle and how defensible it is and if it's sustainable in the future, right.

I guess you know the other things that we look at that are perhaps equally important are the depth and breadth of the management team, if you have a company, which we typically get involved in, the owner is the CEO and in fact there may be been the founder, so we looked at how much management talent there is beyond that. an individual and if that individual knows the lead customer, reach out to the lead engineer behind you, knows what the business is doing, that creates a little more risk, sometimes centralized within one individual, so the force and The breadth of the management team are very important and then I guess you I guess not, but you know we also look at certain financial attributes of the business;

Your cash flow efficiency is important to us, so how quickly does the company convert a sale into cash and how well does it manage its balance sheet in terms of capital expenditure requirements? for example, I'll start with that, if you are in a business, you could have two

businesses

that have exactly the same EBIT da1. The business requires $1 million a year in capital expenditures to support its business or operations into the future. Any other. requires half of that half a million dollars, so clearly the business that requires half the capital investment will be more attractive to the investment community and all of those things interact and different companies will value different attributes differently, so if you had than to push it from your perspective from MCM's perspective, what would be one or two things that you would consider keeping them more? wait, it's like asking me to choose between my favorite children, it's really hard, but I guess you should know that it really starts with strength. of the management team and if I had to choose two things it would be the strengths of the management team in its competitive position in the market.

If I could describe, we had talked about other avenues for a possible exit and what situation it would be most suitable for. For a business owner to generally consider a sale to a private equity firm. I would say that what is quite attractive for a private equity firm is when the business owner wants a continued role in the organization in the future and, so to speak, from the business owner's perspective, where the business owner The company highly values ​​the future potential of the company and is doing very prudent financial planning, but wants to ride the wave on that basis and is willing to stay there for a significant amount. equity in general terms, you know, I would say that when the owner of the company wants to retain an active role, you know, contrast it with a strategic acquisition, for example, a strategic acquisition of a public company that he really doesn't want, in general. they don't want a subsidiary to be anything other than a wholly owned subsidiary and they may have very different perspectives on how to staff the organization, so there tends to be a lot more turnover in a circumstance like that, so I would say where you value the owner of the company. really values ​​your affiliation with the company in the future, companies you are convinced or committed to the growth opportunities of the company and values ​​the culture of the organization, who really wants to preserve that, what should a business owner look for because is there a lot of private capital?

There are plenty of people like us, what should a business owner look for and partner with? Because a lot of times it's very difficult to figure out, but between companies, well, I would probably start with something soft and it's very difficult to define and identify the Cultural fit is really important and if there is no cultural fit, there is a significantly higher chance that a party is dissatisfied with the other party at some point after the transaction, so I think it's critical in nature, but you know, if they were. painting with a broad brush I would say you know I would like if I were a business owner or some value add to be put on the table beyond what you know the dollar and I'll put it in an investment account somewhere So that may come in the form of a private equity firm that has experience dealing with companies the size of the seller; it could come from the perspective that the private equity fund has previously invested in the market that the target participates in and therefore as an experienced investor, whether in aerospace or you know something of that nature, then you know You are really looking for help to grow your business and strengthen it in the future, so if I am a business owner, I am looking to sell.

I may have a boss or someone to report to for maybe the first time in my career and now I no longer have control of what happens in the business and for some business owners that can make me extremely nervous, so what? What protection does a business owner have? Do you know how to sell your business? Since you no longer have control. I guess I would start and differentiate between operating day-to-day operational control, particularly for a business owner who is doing a recapitalization and is I will remain involved as a leader of the business and look for a foundation and then governance issues, so these are things that would affect the capitalization of the company or any major asset purchases or dispositions, those types of things, so I would distinguish between those two, but it's always a transition, so a business owner, especially in business that we participate in and that you know are smaller, you think you know between 2 and 8 million EBIT gives and maybe less than 30 million, 40 million revenues, very often these

businesses

.

You are not used to preparing budgets, forecasts and annual strategic plans. The business owner you know may or may not be attentive to preparing monthly financial analyses. Maybe just use your bank account or the company's bank account as a proxy for how well the company is doing with a private equity firm involved, it won't be managed as tightly as a public company, but some of those attributes are adopted from the public company's reports, so for the first time the company owner will have a board of directors who may for the first time be responsible for certain important decisions, such as major capital expenditure additions, will go to the board and at least get an annual budget approved, if not, you know individual pieces of equipment that tend not to work.

This will be the case and the monthly reports will be different than perhaps you were used to before, but it is actually to the benefit of the company because many of the different aspects of the company that we may have done on a more ad hoc basis are being professionalized, sentence from a business owner who, by and large, again hasn't had to tell anyone, if ever in his career, what would be typical of a private equity of what a private equity would be. The company asked what their requirements were for the owner of that business, what can they expect after they get the go-ahead, so I'll start with a sort of mm-hmm annual planning, so we would expect the team to work together with maybe be a private equity partner to develop an annual plan, think of it as an annual budget and we would like to see monthly reports against that plan, so at the end of January, for example, for a calendar year company, we would look at the financial performance of January and we would ask if Ahead or behind, you know the forecast for that year that we put in place and if there is something material that happened during that month, bad, good or indifferent, we would like to know that the numbers are clearly there, but we are not in the company and Therefore, we depend on team communication to tell us what is happening, so that we are informed and can react to any opportunity or circumstance.

Annually plan monthly financial reports, generally those monthly reports will include a one and a half page speech. At the major events of the month, quarterly, we're going to have board meetings, and generally the senior management team participates in those board meetings, so you have high-level sales people on your staff. operating, etc., that participate and finally I would say that you know the obviously, an audited or reviewed annual financial statement, in some cases, will be part of the package, then we will have an annual meeting for our limited partners, in fact, it will be in a couple of days and we will bring executives from our entire portfolio. companies and it gives them the opportunity to present to our shareholders and it gives our shareholders the opportunity to have an unfiltered view of the investments that were being made and I think it's a really great opportunity for the management teams to really hone their message. and really understand the kinds of things that make them unique and can communicate that if you could sit down with a business owner, maybe it's a family member, a close friend,and were looking at Xing's business and considering a sale to a private equity firm.

Would you tell them what the advantages and disadvantages are of partnering with a private equity firm? I think that, well, let's first assume that you chose the right private equity firm because clearly there can be mismatches and those tend not to go well, but I would say that if you choose the right company so that you fit culturally, you have chosen the value-added company that understand your business in your market, the biggest advantage for the entrepreneurial CEO is his board of directors. and the resources go beyond looking in the mirror every morning. You now have several people you can rely on as a source of information and advice, so you are no longer the one carrying the load individually, which can be quite exhausting, so that's something.

Of the positives, I know we're in the private equity business, but again you're sitting next to you know a brother or a close friend and they say these are some of the things to keep in mind when selling to a private equity firm. Private capital. The most important thing is that it can no longer act unilaterally. When it comes to making big bets, it reminds me that several years ago we had a business called microgroup and the owner was a very entrepreneurial guy. We did a recapitalization with him and he took, I think, 25 percent of his company or something like that and we went into a recession not unexpectedly and the company was performing as we expected in a recession and we are not out of it yet and in a meeting of the board of directors the gentlemen were appointed bill bill said, I want to spend a million dollars and for several CNC machining centers and we didn't really have the business to justify it at the time, he said, look, that's what I would do if I had it individually.

I would be and I said, well, I said, I'll tell it. How about instead of buying ten we start with four and compromise roughly? It was over, it was a five hundred thousand dollar investment, so you know, did he get everything he wanted? Hmm, maybe maybe not, I mean, he could have played. He said, "Well, if I ask for ten, I'll probably get four, and knowing Bill, he probably did that, but you can't act unilaterally or without the consent of the board on important issues and that will be the biggest change. Can you move forward?" ?" explain what we're looking for, what private equity firms and we're looking for in a management team, yeah, I mean, I guess you know, obviously, we're looking for encouragement and strength, and the question is what strength do I know what encouragement is right, how many people have reason.

Okay, so what constitutes strength? We're really looking for complementary skills, so I'll give you an example from one of our current portfolio companies. They had extreme depth on the engineering side, so the product development engineering was really good. a very deep knowledge about materials science, the development of the materials science product development process was also a very strong attribute that resides in different individuals, so when we saw that we said this is a business that If we can add some sales marketing experience, they have the skill set to handle a good amount of growth and they have the skill set to handle complicated projects that many of their competitors couldn't, so we're looking for skill sets. unique and could be useful one of the The companies you learn are more of a distribution, it's a hybrid model of distribution and manufacturing where they are quite good at the sales and marketing side and the supply chain side and That is fundamental for the success of that business, so depending on that there are no perfect companies. right regardless of size, but particularly for the size companies that we invest in, there will be gaps in the management team and what we are really looking for are the core strengths of the team, whether it has the right skill set to drive future growth .

Can we build around it? And that tends to be where we focus our attention and I would say that more generally, we use tools, other tools, so we ask the team to take a test if they want. that measures and there is interoperability due to lack of a better behavioral evaluation, a behavioral evaluation of what the team is like. I have this really good guy and I actually had this experience at a previous company, we had an amazing engineer. They were also virtually unmanageable and people hated dealing with them. He had a very inflexible personality. Well, that's the enemy.

It's great that he was an excellent engineer, but he doesn't lend himself much to the team and the strength of the team. I think it would be helpful to the business owners here if you could leave them again based on your experience with some advice, whether they were preparing their business for exit or they think their business is ready and they are thinking about a number of different options, would you? What advice would you give to the owner of that business? Yes, he would if he were a business owner. I would like a very honest self-assessment of my business, as a private equity fund would likely view it. or get a third party and do that assessment and then work for the flat sides of the organization that had been identified.

I would work to mitigate those flat sides and that's how you can actually generate a higher multiple and better value for your business, the other thing that you know I would recommend as you as an individual were very close to an exit or contemplating an exit. , you could think about hiring an accounting firm and effectively making a quality earnings report that basically reflects accounting due diligence. That's likely to happen when you finally meet the right buyer, so there are no surprises. You want to discover those surprises in advance and not be surprised in the diligence process.

That's great, thank you, thank you for joining us today. We appreciate it. Yes I hope. I look forward to the next time