Any entrepreneur will tell you that there is always an element of uncertainty when it comes to managing a business. Macroeconomic challenges like heightened volatility in markets, supply chain issues, economic twists and turns are always going to test us. 

Yet, concerned business owners can look to an unexpected source for inspiration: Private Equity firms.   

What is private equity (PE) and what do PE firms do?

Private equity is an investment class where money (or capital) is invested into companies. Private equity investors will raise pools of money from limited partners to form a fund – this is known as a private equity fund and is used to invest in private companies. These firms will then hold the companies for a period of time, often providing a range of support to help the business grow, before they exit the company by taking it public (called an Initial Public Offering or IPO) or selling it to another player in the similar industry — often called a 'trade sale'. At 'exit', they will then distribute profits to the investors in the fund.   

Interestingly, PE firms can play an integral role in the economy — while the goal of the PE firm is to ultimately generate returns for investors, the process by which they do this involves buying companies and helping them grow and prosper. In times of economic crisis, these firms can also play a pivotal role by providing companies with capital and sector expertise to help them navigate the challenges.  

Following the 2008 Global Financial Crisis (GFC), a study was conducted (and supported by Harvard), which confirmed that Private Equity-backed companies tend to fare better during economic turmoil, and they can act as a stabiliser during recessions.     

So, what is the PE model secret to success?     

Here are three important takeaways we can learn from Private Equity firms:   

PE Firms are astute investors focused on accelerated growth   

Private Equity firms are astute buyers of businesses. When assessing companies, these firms really know how to hone in and identify an opportunity. If one of your goals is to grow via acquisition, then there are plenty of lessons to be learnt from PE firms.     

A common misconception is that PE firms only like to target larger companies, but they have been increasingly looking to the mid-market for their next opportunity. The mid-market has become very attractive because of the lower valuations and the fact that there are more companies to choose from in the $10M - $250M bracket. Many PE firms also acknowledge that they have a greater capacity to make value-added improvements to mid-sized firms versus their large-cap counterparts.    

PE firms are constantly scouring the markets for opportunities in all conditions, which presents good opportunities for business owners looking to exit. But make no mistake, PE firms are 'seasoned buyers', and while you may expect them to operate ethically, you can be certain they know how to negotiate. After all, this is what they do every day. But if you understand your value and can clearly articulate the opportunity, then PE firms can be an ideal option for would-be sellers.    

What makes a company strategically attractive to PE firms?   

This comes down to the investment mandate of the fund — another key success factor for PE firms.    

An investment mandate is a framework that directs the fund managers when choosing assets to buy, hold or sell. It keeps them focused on the goals and ensures the investment is always strategically motivated.     

Mandates include factors such as:   

• Investment size and scope  
• Performance benchmarks  
• Priorities and goals  
• Investment focus: Regions, industries, sectors, talent, valuation levels, Environmental, Social and Governance (ESG)    
• Acceptable levels of risk  

An example of how private equity firms may focus their attention is shown in the diagram below.  

A recent M&A survey on mid-market M&A pointed to a very positive outlook for PE firms looking to buy Australian companies. There is particular interest in Australia rather than other markets in the Asia Pacific for several advantageous factors. Australian mid-market companies have good client bases, established trust with the market, and favourable market conditions. Business owners in this space are getting ready to retire, and the market is characterised (at this point) by cheap debt.

Related: Industry In-Focus: The Sun Is Shining On The Solar Energy Sector in Australia

PE firms know how to build wealth by building company value  

PE firms seek businesses that they can buy, build and then sell for a good yield. Interestingly, many PE firms have been rebranding themselves as 'patient equity' recently, suggesting that they have a longer investment horizon. This is a welcome shift for business owners looking for an investment and growth partner. But ultimately, most funds will need to pay out their investors at some point, and PE firms make the bulk of their money when they exit these investments. So, you should still expect to have a clear exit strategy on a specified timeline.     

It is often said that opportunity and risk are flip sides of the same coin, and this is made abundantly clear when you see how PE firms can capitalise on what might be seen as 'uncertain times'. Their ability to access capital and bring their expertise to bear has delivered significant growth through various trading environments. In fact, according to Ernst and Young, the last ten years have seen 'unprecedented growth' for PE, managing more than US$3.6 Trillion.   

How do they manage this?    

PE firms usually stick to what they are good at. Often it is a niche market or could be a style of business model, as they know how to grow this type of business, giving them a strategic advantage.     

As sector specialists, they can see what's on the horizon, know how it will affect their unique market and know what contingency plans to deploy. This innate knowledge allows PE firms to take advantage of capital when terms are most attractive and weather storms when they are not.     

Most PE firms make hiring key people a top priority by striving for continued growth. This deep bench of talent allows them to leverage any operational or strategic expertise to grow, thereby using this knowledge to combat a downturn effectively. But they also understand the importance of culture in driving sustainable results.    

The Harvard study notes that during the GFC, PE-backed companies came up against fewer financial constraints than their counterparts, which allowed them to both grow and increase market share. And it helped financially. Loans to these companies were more than 50% more likely to be renegotiated than non-PE-backed companies, meaning that they could use their banking relationships to access more credit, invest more, and continue the cycle of growth.  

What is the outlook for PE firms in Australia?

While many portfolio companies would have been negatively impacted through Covid, significant lessons have been learned from events like this and the GFC. One might argue that PE firms are in a better position to navigate the current economic climate despite some short-term impacts and portfolio adjustments than they were a decade ago.

Firstly, the industry has much more capital at its disposal from the diversified investment base of family offices, sovereign wealth funds and high net investors. With these additional investments, PE firms have a significant amount of immediately deployable funds or 'dry powder'.     

According to McKinsey Global Private Market Review 2022, private markets saw a surge after COVID and have been busy deploying $3.5 trillion across asset classes.     

They also have a wealth of learnings from the GFC that even non-PE-backed firms can take advantage of. Namely:    

1. Don't halt progression. PE firms were overly cautious during the fallout of the GFC. For companies who are fuelled by growth, being too cautious can undermine opportunities, resulting in lost capital. So, PE firms are now more prepared for this type of environment.   
2. Access to capital is a huge advantage. During the GFC, many non-PE-backed companies were constrained by capital, whereas PE firms had access via their fund and long-standing relationships with lenders and investors. This allowed them to stabilise and diversify their portfolios in ways that other businesses could not. We've seen from previous downturns that the PE model provided flexibility and capital access even during economic and financial market distress. This outcome can be reasonably expected to play out once again when capital markets adjust.   

In Australia, PE firms are attracted by abundant opportunities and the resilient businesses they see in the mid-market. Many firms have planned to increase their investment, focusing on mid-market targets.     

We can expect PE firms to hunt for available opportunities in growth sectors and resilient assets. Even with some of the uncertainty in the market, PE firms continue to assess and acquire businesses to pick up good quality assets. With their ability to withstand the short-term fluctuations of markets, it's no wonder they're out hunting for strategic acquisitions.    

Similarly, PE can present a great opportunity if you have been thinking of selling your business. Although, if this is a serious consideration, it's recommended that you surround yourself with a good 'deal team' to navigate the journey successfully. As mentioned earlier, PE firms are seasoned acquirers, and it's in your best interest to have seasoned advisors on your side of the negotiation.  

Simon Bedard

CEO and Founder, Exit Advisory Group

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