A quick definition of Private Equity
Private equity (P/E) is money raised through investment partnerships that is used to buy and manage companies before selling them. Private equity firms raise pools of capital from institutional and accredited investors (often supplemented with debt) to form a private equity fund. Once they’ve hit their fundraising goal, they close the fund and invest that capital into promising companies.
Unlike venture capital, most private equity firms and funds invest in mature companies rather than start-ups. They manage their portfolio companies to increase their worth or to extract value before exiting the investment, typically in a 5 – 7 year time frame. When a P/E firm sells one of its portfolio companies to another company or investor, the firm expects to make a profit and distributes returns to the limited partners that invested in its fund.
Private Equity is Huge!
Over the past two decades, the exponential growth of Private Equity (P/E) investments in businesses has changed how businesses operate and the job market. American Investment Council (AIC), a private equity lobby, estimated that private equity funds invested approximately $1.3 trillion across a number of industry sectors in 2021 and $922 billion in 2022, with approximately 2/3 invested in three sectors, Information Technology, B2B, and B2C. Additionally, the AIC PE Economic Contribution Report FINAL 04-20-2023 states that the U.S. Private Equity sector comprised approximately 6.5% of the U.S. GDP in 2022.
According to AIC, The US private equity sector provides employment and earnings for millions of workers. Overall, in 2022, the US private equity sector directly employed 12 million workers earning $1 trillion in wages and benefits.1 The average US private equity sector worker earned approximately $80,000 in wages and benefits in 2022. For a full-time worker this is approximately $41 per hour.2 The median full-time US private equity sector worker earned approximately $50,000 in 2022.3
The trend toward expanding P/E business ownership is likely to continue based on the P/E fund raising trends shown below:
According to a 2022 US News & World Report study, these are the 5 largest PE firms and each has raised over $50 billion in the previous 5 years:
Why is Private Equity Dominating
P/E firms use effective business strategies to minimize downside risks, guarantee steady cash flow, and potentially achieve huge returns on their investments. A Private Equity executive once told me that if they invest in 10 businesses, they expect to break-even or make a small return across the bottom 5 businesses, achieve a 10-20% ROI on 3, and hit a home run on the top two businesses. They can achieve these results because they have proven business models, provide business and technical expertise, leverage economies of scale, can fund acquisitions to increase market share, receive management fees from their portfolio companies to cover interest on debt, and ultimately earn a potential windfall when they sell a business, take it public, or bring in additional investors.
Growth Equity vs. Private Equity
When Private Equity invests in a business, it’s important to know if it considered a Growth Equity or Private Equity investment. Growth Equity is an investment strategy oriented around acquiring minority stakes in late-stage companies exhibiting high growth with significant upside potential in expansion, in an effort to fund their plans for continued expansion. Often referred to as “growth capital” or “expansion capital”, growth equity firms seek to invest in companies with established business models and repeatable customer acquisition strategies4.
A more traditional Private Equity investment is more like an acquisition or leveraged buyout of a company where the P/E firm acquires full ownership or majority ownership. Private Equity investments target businesses with stable profitability and cash flow, so they can support debt repayment. These are typically more mature businesses that may be undervalued, financially constrained, or mismanaged. The strategy is to implement “Command and Control” leadership to improve operational efficiency, reduce costs and improve EBITDA.
As an example of a traditional private equity investment, a P/E firm purchases majority ownership of a cloud company that has a very “sticky” product such as an ERP suite. The P/E investors know that some cutbacks on innovation and quality of services will not impact revenue in the short term. Even if their customers are not very satisfied with their products and services, it’s not easy for them to jump ship and it will take a long time. Customers may have multi-year contract commitments, or a huge investment is required to purchase and implement a competitive solution. The P/E firm can cut expenses (primarily through reductions in staff), provide just the essential product enhancements and maintenance services, and do the try to retain customers as long as possible. In 3-5 years, they expect the company will be more profitable than ever, which will drive up valuation and then they can sell out.
What to expect when Private Equity takes over your company
I’ve worked for five Cloud/SaaS businesses that were primarily owned by P/E firms. Two companies were acquired by PE firms while I worked there and three were already P/E owned when I was hired. I have not directly invested in any P/E funds, so this blog really is about my experiences as an employee at various levels of a business that becomes majority owned by a P/E firm(s).
When a P/E firm purchases majority ownership, it’s generally promoted as a very positive change to the business. And in many ways, it is. Founders and those with equity in acquired business get a payout. When the transaction takes place, the investment generally provides a much-needed influx of cash, new board members, new executive leadership, and a tremendous network of business, technical, financial, and market expertise that opens doors and creates new growth opportunities. Employees will learn how the P/E team will introduce proven methodology, technology, and expertise that will bring new levels of business maturity and capability to scale for rapid growth. It can be an exciting time.
From an employee perspective, the hardest thing about being acquired by P/E is that there will likely be a reduction in staff (layoffs) announced with the acquisition. The magnitude of the layoff is probably tied to the financial health of the business, expectations for improved operational efficiencies, and the need to cover the management fees the P/E firms draw from the business.
Employees at P/E owned businesses generally have very little or no opportunity to receive equity (e.g. stock options) of any significant value. That is because P/E firms are obligated to their investors. With the risk they take buying majority ownership of the business, their primary goal is to maximize the return for their investors. Consequently, there really is very little equity remaining to share with the workforce. So, unless you are an executive of the acquired company, do not expect any stock options, they just aren’t available.
Business Transformation
In every P/E transaction I have experienced (all where the P/E firm was majority owner), within the first year, the majority of C-Level and V-Level leaders in the company will be replaced or move on. The CEO and key founders of the business typically are replaced very quickly, often at the time of acquisition. However, they may remain involved as advisors for a transitional period of time. It sounds harsh, but it makes sense in many ways. P/E firms will bring in their own proven leaders who understand their business model and who are not caught up in paradigms from the past business strategy. New leaders often recruit proven leaders from their previous experience, and they will rapidly enforce changes that will require their staff to think and act differently. As an employee in a P/E acquired firm, you quickly realize that past success really doesn’t matter to the new leadership.
The biggest change will be an unyielding and razor-sharp focus on Key Performance Indicators, especially top-line revenue growth and bottom-line earnings (EBITDA). P/E firms will provide a transition period for new leadership to assimilate and re-calibrate the business model and forecast. But, in the end, it’s all about making your numbers. You can expect the P/E firm to have very high expectations for the business. They will provide expertise and guidance, and other resources to help support the leadership team. The P/E firm wants your business to be wildly successful. All will be wonderful as long as your company is hitting the key performance targets established by the P/E firm. However, the honeymoon ends if the business falls short of their performance expectations.
If your business misses the P/E firm’s revenue goals or EBITDA targets, they will cut headcount, eliminate perks, and implement tighter controls on expenses. In these situations, expect some Darwinism across the workforce and more extensive use of lower cost resources wherever possible, including sourcing work overseas. There is little tolerance or patience for missing financial targets.
What it takes to survive and thrive in a P/E owned business
1. Accept that past success guarantees nothing.
If you are truly a highly valued employee, you might get a retention bonus for sticking around for a year after the acquisition. Most likely, you’ll be grateful if you still have a job post-acquisition and you will need to prove your value to the business just like you are a new hire.
2. Be part of the solution, not part of the problem.
Be open to change. Sticking to “we’ve always done it this way” is generally fatal. P/E will bring new processes, stricter controls, and different leadership styles. Focus on the skills and solutions you can provide to support the direction and goals stated by the new leadership. You need to be perceived as a willing adopter and flexible.
I can honestly state in my past, I had trouble getting on-board with the new direction and leadership after P/E took over. You cannot hide it and as a result, I decided to move on, or I was told to move on.
3. Avoid the “they just do not understand our business” trap.
Recognize that the new policies, process controls, and organizational changes may seem unrealistic or doomed to fail. It can be very frustrating when new ownership doesn’t appear to understand that you had good reasons for managing aspects of your business as you did. The new leadership may seem indifferent that their changes will have a negative impact on client satisfaction. That’s not true. Their ultimate goal is to get the organization streamlined and thinking differently. They want the workforce to improve operational efficiency without sacrificing quality. If you feel it is necessary to address concerns with changes to staffing, processes, or policies that will negatively impact customer and/or employee satisfaction, be sure to support your cause with facts and data. Focus on how you can influence the best outcomes within the new constraints.
The new leadership does not want your company to fail or for their employees to fail. They want results! They want you to focus on how your actions and priorities align with the ultimate end game for the P/E firm, which is maximizing the ROI for their investors.
4. Maintain a positive attitude.
When one of my former employers was acquired by P/E, I know I fell short in the attitude category. I had my reasons such as having to sign a ridiculously restrictive non-compete agreement, not feeling appreciated for my past accomplishments, and especially because I did not like my new manager. I was fortunate to find a new job and resigned, just before the posse arrived. About 2 years after I joined another company, it was acquired by Private Equity. My role changed (not by my choice) and I did not fit well into their new business model. The posse did find me about 6 months after the acquisition and my position was eliminated.
A key lesson I learned is that my whining didn’t accomplish anything. I thought I was professionally discreet dealing my dissatisfaction, but in hindsight, my attitude did not help me and I probably was a negative influence on my colleagues.
Footnotes:
1 All numbers are prorated to account for cases where private equity owns less than 100% of a company. (AIC Economic Contribution Report FINAL 4-20-2023)
2 This $80,000 is computed prior to rounding the wages and benefits and employment estimates. In particular, the $1 trillion of wages and benefits is approximately $961 billion and 12 million employees is approximately 11.957 million employees (AIC Economic Contribution Report FINAL 4-20-2023)
3 By comparison, the comparable median wage for the US economy is approximately $50,000 and comparable average wage is approximately $73,000. See report for more detail. (AIC Economic Contribution Report FINAL 4-20-2023)
4 Wall Street Prep website: https://www.wallstreetprep.com/knowledge/growth-equity-guide
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