My last article discussed how strategic investors typically choose acquisition targets; this article does the same for private equity investors.

Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:

• Nature of investments. Some funds like high-growth companies, others prefer investments with stable cash flow or dividends. Still others prefer turn-around situations.
• Geographic scope. Many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
• Preferred sectors. Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
• Investment size. Most funds will specify a minimum or maximum investment size (e.g. €5-25 million).
• Ownership interest. Some funds insist on control, others will take minority interests.
• Fresh equity. Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth). Others will consider a combination of fresh equity and buying out existing shareholders. Buyout funds will want to buy 100% of a company.

It is therefore important to find a good match between a private equity fund and a company. It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors. Business owners should therefore do a little homework before approaching funds – the investment criteria are usually on the fund’s website.

The average private equity fund in Central Europe will typically screen a few hundred investment cases every year. Not more than a few will actually become the object of an investment. The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee. Hence the owner of a business must first convince the protagonist of his investment case. The owner of a business seldom, if ever, communicates directly with other members of the investment committee. Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.

A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.)

So what does a private equity firm look for in its investment choices:

 

• A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
• Exit strategy – who are the likely buyers for the company? What are the chances for a successful exit?
• A strong management team, who is prepared to stay until the exit of the fund. (An owner-manager who is cashing out is often too high a risk for the private equity investor – please see my earlier article on the “One Man Show,” available here and here.
  
• Strong corporate governance – good decision structures, reporting systems, and strong documentation. Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious goals, and are prepared to work extraordinarily hard to achieve significant financial gains. Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
• Manageable risks. No actual, pending or potential litigation, or the potential for surprises on the downside;

After the due diligence, the investment committee (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.

Sometimes private equity firms will purchase what they call “bolt on” investments. Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.

Private equity firms have taken an ever-larger share of the M&A market in Central Europe. They are an important potential source of financing for mid-sized firms that must not be neglected.

A strategic investor uses a very different process to identify acquisition targets than that used by financial investors (the subject of my next column). For a strategic investor, as the name implies, identifying an acquisition target must flow from the acquiring company’s strategy.

The worst methodology that a strategic investor might use to identify targets is to respond to the acquisition opportunities that it finds on an ad hoc basis. This simply will not work for two major reasons:

• First, responding to opportunities on an ad hoc basis typically means that deep strategic thinking has been short-circuited.
• Second, if a strategic investor acquires a company that it came across merely on an ad hoc basis, how does it know that there were not better acquisition opportunities elsewhere in the marketplace?

It follows from the above thinking that a strategic investor, before embarking on an acquisition, should have a clear definition of its overall corporate strategy, and from such a corporate strategy should flow its acquisition strategy. (Of course it is ideal to have these in writing: there is nothing that focuses the mind as much as putting something in writing, an approach which also helps to ensure that the different parts of the organization are also in consensus).

Some of the elements of an acquisition strategy might include definitions of the following:

• The rationale for the acquisition (e.g. vertical or horizontal integration, expanding into newer high-growth markets, acquiring technology or know-how, etc.)
• The precise profile of the target companies sought
• The geographic range of possibilities
• The financial criteria (revenues, profitability, etc.)
• The type of management or skills which may be required
• The type of clientele which the target company should have
• The valuation range in which such acquisitions may make sense

A company may choose to create a strategy broader than an acquisition strategy, namely an M&A strategy. Such an approach would also cover the criteria which a company would set for divestiture of its subsidiaries.

Once the strategy has been defined, the acquiring company should engage in a systematic search for and assessment of all those companies that fulfill the criteria (as opposed to an ad hoc approach). If there are a very large number of candidates, the list might be shortened by selecting only the most attractive ones. The most attractive ones might then be approached to ascertain whether they are willing to talk about a strategic partnership or acquisition, and with an eye to further fact-finding about the company. It is often useful to use an independent third party intermediary for this approach, as it allows the approach to be anonymous, keeping the name of the acquiring party out of the market.

Failure to apply the above approach may result in a bidder finding itself among a herd of bidders in a frothy, overpriced market, competing for a target company that might not even be the best strategic fit.

Some of the more astute strategic investors have been monitoring their potential acquisition targets for many years, sometimes even decades, and are ready to make a move on short notice if the owner of a target company becomes willing to sell or if price expectations are reduced. However, it is usually only a small percentage of potential target companies that a strategic investor is willing to acquire – the majority of potential targets quite often simply do not make the grade.

Central Europe is often an attractive area for acquisitions for global investors because most investors believe that Central Europe is on a convergence path with Western Europe, meaning that GDP per capita, incomes, consumption, etc, will catch up to Western European levels. This is based on the belief that, “A rising tide raises all ships.”

Nevertheless, different countries move at different speeds at different points in time, depending on their political and socio-economic environments, and some companies are better acquisition candidates than others. The importance of country and industry-specific knowledge at the local level cannot be over-emphasized.