The Private Equity industry has traditionally invested majority of its capital in large companies. Recently, however, the nature of Private Equity deals is shifting toward small businesses with the emergence of a new model. Here’s the full story.
The Great Divide – Different Rules of Private Equity
A trend has been emerging among businessmen and strategists, i.e. building to sell. Â Numerous entrepreneurs enter the market and start their businesses with the goal of selling it.
Now, what do you do when despite after years of blood and sweat, you fail to find a buyer? All because you are a small or middle-sized firm.
Some of the best private equity firms involved in leveraged buyouts are more comfortable in investing in large companies. The tendency is so profound in the PE industry that it often presents itself like a bias. Most small businesses face trouble finding appropriate institutional or strategic buyers.
Private Equity associations pay 15 to 20 times more of a company’s EBITDA to big companies, while this figure drops to 5 to 10 times in case of owner-led smaller companies.
Furthermore, many small businessmen who have dealt with private equity investment professionals tell that often most businesses end up settling for two to four times the profit as they sell to business brokers and aggregate websites.
What is the reason for such disinterest of private equity industry toward small or mid-sized companies?
Theories are many, but most argue around the fact that small businesses are subject to much larger risks compared to larger businesses – risks from sudden departure of key customers, suppliers or employees.
Since larger businesses can absorb the risks of a change better, they find favor among Private Equity investors.
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The Rules are Changing – Stanford Search Fund Model
Over 20 years ago, Stanford invented a new model of Private Equity acquisition to solve this bias against small businesses. The model came to be known as ‘Search Fund Model’. Though it contains all the aspects of a Private Equity association, its lesser known among major private equity and venture capital operators.
Search Fund Backed Model, like private equity firms, acquire distressed companies. It involves a couple of ‘searchers’ who:
- Approach Family Businesses for fund-raising; and
- Search for small to mid-sized companies to acquire.
For searchers, it’s a great way to get hands on equity, similar to private equity investment professionals, as well as an opportunity to take over a company as its CEO. Contrary to full-fledged PE deals where the deal team takes their hands off the deck after the acquisition.
For family businesses, it offers a thriving opportunity to deploy capital, while keeping the investments close, and without needing to build a big infra that best private equity firms usually need.
For small businesses, it opens an exit opportunity, often absent due to the nature of PE industry. Additionally, it makes the change much less risky and scary for them, as the search fund teams are the ones who also run the business eventually.
Know the numbers
Companies acquired through Search Fund model have risen over the past few years, with median acquisitions ranging from USD 6 to 10 million. However, companies with revenues ranging from USD 2 million have also been acquired through Search Fund.
Another interesting fact is, contrary to what you may assume, over 70 percent of Search Fund deals are not carried by former private equity investment professionals or investment bankers, but business owners themselves with an actual experience of running a business.
As PE dry powder is rising, the expectations are that even the topmost and best private equity firms will begin to invest in small businesses. However, the past suggests that most PE deals are oriented toward large deal sizes.
If you have been interested in a career in private equity, search fund model is a great way to make an impact and showcase your competence in fund-raising, valuation, as well as portfolio management. Among Search Fund managers, more than MBA, it’s the skill and knowledge to operate in the buying and acquisition market that makes all the difference. Earning professional certifications in Private Equity, such as one offered by United States Private Equity Council (USPEC), may help you gain all the necessary grounding you need to succeed in Private Equity like deals.
Small business entrepreneurs, now, are not so short of exit options.
