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The surprise of private equity

Last week, the Conference Board of Canada released a major new study on the private equity experience of Canadian business.

During the research phase for this report, one of the things that most surprised me and my co-authors – Catharine Johnston, an independent business consultant, and Kirk Falconer of Thomson Reuters – was just how few recipients of PE investments were aware of this form of risk financing prior to their experience.

Our study was chiefly based on 35 in-depth interviews with senior executives of companies that had obtained control-stake or significant minority PE investments. Typically, such businesses are looking for sources of capital to facilitate growth or to allow founders to monetize their equity. A great many are medium-sized, private, family-owned entities. Up until the time they sought external capital, they had little reason to know much about private equity. That’s because these companies are most often financed through internal cash or bank credit.

When seeking external capital, some businesses will consider launching an IPO. But IPOs are not ideal for many privately-held organizations. Public equity markets tend to be interested in issues with straightforward value propositions. Canada’s small-cap equity markets are dominated by resource issues, because investors generally understand how those businesses work to create shareholder value.

The value proposition of private equity is quite different. Private equity is interested in uncovering value, often in companies in which the growth and value proposition is not readily apparent. Our study found successful PE deals in industries as diverse as retail fuel distribution, cosmetic manufacturing, airlines, bakeries, waste management, film production and cinemas. We found that, in the end, the sector was less important than the opportunity for discovering and unlocking specific business value.

In fact, PE firms deliberately seek out deals that “fly under the radar.” They are more interested in making financial and organizational changes to portfolio companies to realize their full potential. In our study, we detailed three case studies that demonstrate how PE investors uncover and maximize value (Bluewave Energy, Knowlton Development and MEG Energy). This may involve injections of new capital, changes to senior management, changes to cost structures, or new strategies for value creation and growth. This is what is meant by the vaunted “active management” style of private equity.

Obviously, active management does not suit every business enterprise out there. Existing owners and operators have to be willing to let go and have PE professionals “do their thing”. We found that the best deals were those where the investors and senior managers at PE-backed companies spent a lot of time getting on the same page.

One interviewee I spoke with contrasted private equity with public equity. He pointed out that the former requires more time and expense at the front end (deal negotiation), while the latter is cheaper at the front end but much more expensive in the long run because of all the complicated governance rules and procedures.

In our study, we also found that the best deals were those where both sides were clear about what they needed. This approach set the strategic framework for the partnership and shared performance goals. Smart private equity firms focus on creating alignment between their goals and the goals of senior executives, ensuring that compensation is geared to the successful achievement of business objectives. In the words of one interviewee, the managers of PE-backed companies must have “skin in the game”.

Once this strategic framework is in place, the senior executives at PE-backed companies are usually left to their own devices, and to run operations on a day-to-day basis. This allows them to focus on what they do best – operational excellence – while PE professionals focus on providing advice on issues pertaining to finance, overall strategy and governance.

By defining roles and responsibilities at the outset, private equity firms help establish trust between themselves and their portfolio company partners. At this point, there are no more surprises, and the elements necessary for a profitable relationship are fully in place.

Michael Grant is the director of research and capital markets with the Centre for Business Innovation at the Conference Board of Canada. He specializes in the relationship between capital markets and public policy. 

Financial support for the report was provided by Canada’s Venture Capital and Private Equity Association. 

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