A private equity investment has the obvious advantage of bringing money to a company. Most company owners are not aware of all the implications – beyond the money – of bringing on board a private equity investor.

Taking your company to the next level
Private equity investors are financially driven. They ambitiously target high levels of return – generally an Internal Rate of Return of 25% or more. Shareholders and managers must convince the private equity investor of the potential and strategy for value creation, and management’s ability to execute the strategy. Private equity can be a partner for taking the company to the next level. For example, a private equity investor may be an excellent partner for helping to take your company international, or take it onto the stock exchange.

Mid-term time horizon
Private equity investors do not want to be invested in a company forever. A four- to seven-year time horizon is typical. One of the first questions they will ask when considering investing into a company is: “What is my exit strategy?” The lack of a credible exit strategy is almost always a deal breaker. So don’t expect private equity to be invested forever.

Management must generally stay
Owner-managers looking for a total exit will be disappointed. Private equity will generally want an owner-manager to retain a significant minority interest in a business, and to remain committed as a manager, for at least the our- to seven-year investment cycle mentioned above. (One exception is where private equity makes a “bolt-on” acquisition, where they buy a company to add to one of their existing holdings).

Emphasis on corporate governance and financial management
Very often private equity investors will want to appoint the Chief Financial Officer. They will want to have a properly constituted and active board. Decisions will need to be well prepared, transparent, and documented. This can be an important part of the maturation of a firm. Private equity investors, via the board of directors, will want to be involved in decisions with respect to strategy, business plans, major investments, hiring or firing of senior staff, etc., while leaving day-to-day operating decisions to management, so long as management is performing according to plan.

“Carrots and sticks” with respect to achieving plan
Private equity generally allow for generous bonuses when plan is met or exceeded. On the other hand, private equity will ask for the owner-manager’s remaining interest to be diluted if the company does not achieve the business plan provided at the time of investment. Also, private equity investors generally insist on having the right to dismiss the owner-manager (e.g. assuming he or she stays on as CEO), in the event that plans are missed by a certain margin.

Drag along and tag along rights
Private equity investors will often insist on having the right to sell the remaining shares of the owner-manager at the time they are exiting. Usually this type of clause only takes effect after a good many years (e.g four or five years from the time the private equity firm invests into a company). Before such period, the parties may investigate options for the private equity firm to exit without triggering the exit of the owner-manager, if the latter does not wish to exit. In other words, the drag along rights may become a default option, to be exercised only after a certain period if private equity cannot exit without dragging the owner-manager along. These provisions may be a problem for those owner-managers who wish to hold their equity stakes for the very long term.

Variations among private equity players
I do not mean to create the impression that all private equity firms are identical. While most will insist on taking a controlling interest, some will accept a minority interest. While most will insist on injecting money into the company, many will also buy shares of the current shareholder(s). Some private equity funds are more “hands on” than others. Some will have sector focuses and expertise. Some will be more compatible with the personality of the current shareholder(s) and manager(s) than others. Some will prefer larger or smaller transaction sizes than others. It pays to do your research and talk to different players.

In a nutshell, a private equity investor may be a very appropriate partner for an owner-manager who has a reasonable degree of confidence in achieving high growth in the value of his or her firm with a capital infusion, and is willing to go along with the aforementioned way of doing business of private equity investors. But it is not for every business owner.

Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt to equity ratio that best fulfils the objectives of owners and managers and which depends on a number of factors.

There are numerous advantages to financing via debt. Debt has the advantage of generally being tax deductible (although tax regimes in some countries do set a limit on the amount of debt which is deductible), and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.

However the big disadvantage of debt financing is that it increases the level of risk in the corporation (i.e. there is a higher risk of default). Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.

There are also a number of cyclical factors that may have an impact on the debt to equity ratio. The expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed whether a company is in an early development phase or at maturity.

During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control and interest was tax deductible.

However, during the current recession, earnings are much more difficult to predict (companies often have trouble forecasting the coming quarter, let alone for the year) and debt is less readily available as a result of the much more conservative lending policies the banks are adopting. While interest rates such as Euribor, Libor, etc. have decreased by several percentage points, the spreads over Euribor or Libor have generally increased by anywhere from 100 to 400 basis points for most companies, meaning that the real cost of debt financing (after adjustment for inflation) has generally increased.

The word ‘deleveraging’ often arises during the current recession. The dynamics described above often force companies to substitute equity for debt. However, equity has also become more difficult and costly to source compared to 18 months ago. Despite this, beefing up the balance sheet with a healthy dose of equity is an option that the majority of business owners and managers should be considering today.

In addition to the option of equity injection, hybrid instruments (which contain features of both debt and equity) may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares (which have an obligation to pay a certain dividend rate) and convertible debt (where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date). Hybrid instruments typically have a level of risk that is higher than debt but lower than equity, and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity. (Hybrid instruments will be the subject of subsequent columns).

A strong balance sheet can be even more of a source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks such as HSBC are raising equity, not because they are undercapitalized, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that could help companies weather a deepening recession in the event that the much-touted recovery does not occur as soon as expected.