Private Equity as an Exit Option for SMBs during Inflationary & Stagflation Environments

Introduction

Having been advisors, operators, and investors in technology-enabled service businesses since 2001, Ephor Group, Inc. has participated in and provided guidance and governance over many “turbulent & disruptive” economic cycles, government regulatory changes, and business cycles. As a result, we have done a lot, and learned a lot over our nearly 21 years of service and support to the sector.

Our Strategic Practice Lead, Garry E. Meier has been actively involved in advising the US government as a Senior Advisor, now for over 10 years to address the needs of the small business sector of the economy. His guidance to the government during the pandemic cycle is reflected in many of the attributes of the CARES ACT, the SBA EIDL Loan programs, in addition to many State level programs, especially in the states of Florida and Texas.

Based on that knowledge and perspective, we have created the below information and guidance document to assist you in understanding and evaluating Private Capital (“Private Equity”) as a “Liquidity and Exit Options for you and your Shareholders.

Defining the sMB

In this article, we will consider an SMB to be a business that has between $4 million and $75 million in revenue and between 20 and 1,500 employees. In terms of order of magnitude, the Census Bureau estimated that, in 2019, there were approximately 3.9 million companies with10 to 1,500 employees.

A substantial number of these companies are owned by baby boomers who, are rapidly approaching retirement age, and have hopefully benefited from the Payroll Protection Program (PPP) & EIDL Loan Programs and other government subsidy funding during 2020 and 2021. Potentially in late in 2022 and early 2023 is a good time to be thinking about exiting your equity holdings in your business.

Defining the pEG

Private Equity, or PEGs, are incentivized to put their money to work rapidly, but orderly, and to invest their Limited Partners’ (LP) capital in businesses that will yield attractive exit enterprise valuations (EV) — generally within a 3-5-year timeframe.

For those PEGs investing in emerging SMBs, their ultimate exit is likely to be a sale to a strategic buyer or another PEG, and not an IPO. The IPO market for SMB business will be almost nonexistent over the near-term due to the inflationary pressures and the political disruption of recent.

In any event, and in the best of capital markets: IPO’s will be reserved exclusively for the best and most efficient scalable business models.

are PEGs potential buyers for your small emerging business?

Private Capital & PEGs historically and often restrict their investments to strong growth industries and businesses that have scale and thus illustrate increasing valuations. If your SMB is in a “strategic” and growth-oriented sector/industry, and has illustrated impressive revenue and profitability growth, most of the middle-market-oriented PEGs will likely be interested in your company.

Simply by looking at a PEG website’s “Portfolio” section, one can easily determine where the PEG is targeting its investing activities. For instance, many of the middle-market-oriented PEGs are focused on investing heavily in companies in “business process outsourcing,” “human resource services,” “healthcare business services,” and other technology-enabled services (Useful Capital). 

A good rule of thumb the PEG’s ask about your company is: Is the business profitable and is the business model scalable without the owners’ involvement?

Why Would PEGs Be Interested?

The Importance of EBITDA Performance and Cash Flow

To generate attractive returns, PEGs use leverage (debt) techniques to fund a significant part of the purchase price of the acquired business. By using borrowed funds, they can increase the return on the equity they invest. Because of the need to service the acquisition debt, the acquired businesses need to be generating consistent, definable, and predictable cash flows.

Currently, in the smaller end of the deal spectrum that includes SMBs, lenders are looking for an equity investment from the PEG of between 35% and as much as 50% of the purchase price. Thus, if an SMB generates significant cash flow, it has a higher probability of being a PEG target because the cash flow can support more debt.

Business Model Scalability and Performance

In general, PEGs are interested if the business is consistently profitable and the business model exhibits scalability, a portfolio of revenue sources, utilizes effective Management Science, is process-driven and, most importantly. if their leadership and management practices go far beyond the skills and capability of the founder or CEO Entrepreneur. Stated differently, can the business continue to create institutional-worthy wealth without the Founder/CEO Entrepreneur?

Potential to Be a Platform Investment or Tuck-In

When buying SMBs, PEGs often target businesses that can serve as “platforms” for growth, through the acquisition of either competitors or complementary businesses. For platform businesses, PEGs look for strong, ambitious management teams with good internal business processes to absorb fast growth, and a proven business model and business process that are underutilized and capable of a lot more.

If a PEG already owns a “platform” business, then an SMB may be acquired to serve as a “tuck in” acquisition to its platform – most often to expand the geographic “footprint” or provide access to new product and services they can sell into the customer base of their existing platform. PEGs are generally less concerned about the management and business processes of a tuck-in and often will integrate the customer base and operations into an existing platform company.

See Ephor’s Attributes of Useful Capital for Service Businesses

Why PEGs Think Bigger is Better

More Scale = Less Risk

Unique Business Model with Potential for Exponential Growth

PEGs recently have targeted and have increased their allocation of “growth capital” to emerging SMBs whose revenues and earnings can be accelerated “organically” and candidates for “consolidation activities” through the investment of additional capital and management resources, without resorting to acquisitions. These investments are subject to “execution risk,” meaning the investment could be written down if the company does not perform, and, thus, the involvement of a proven, sector “grey hair” executive, who is institutionally known, "backable” and credible to the PEG is a requirement.

Often to mitigate and to spread the “investment risk,” these situations generally involve significant debt level as part of financial engineering. Therefore, PEGs target businesses with strong cash flows that could be improved through scalable business model management processes that facilitate the rapid repayment of acquisition debt. In this circumstance, the PEG can re-leverage the business after a number of years and pay itself a large dividend to increase the fund returns.

The three primary reasons that PEGs target larger deals are:

• Transaction costs incurred by a PEG are substantial. For small deals, these costs are not significantly less than the costs of larger deals;

• The debt market for smaller transactions is less developed and the terms are generally more onerous, and;

• PEGs have a limited group of internal managers to monitor their portfolio of investments, known as operating partner programs.

The PEG Business Model: Why Size/Scale Matters

PEGs follow a structured acquisition and capital deployment process that includes due diligence conducted by outside experts. The PEG takes one or more board seats at the company and an active role in monitoring all of the investments in its portfolio. To do this, it needs to staff up with highly paid professional managers and financial types, many of whom share in the profits of the PEGs. As a result, PEGs tend to keep their internal staffs as small as possible and limit the number of portfolio investments. Obviously, it is easier for a PEG to monitor five $20 million investments than it is to monitor fifty $2 million investments.

Another way that size matters is in the way PEGs value deals. For the most part, PEGs value companies as a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”). For businesses that have EBITDA of $2 million or more, the EBITDA multiple that PEGs are willing to pay in the current market conditions is between 3x to 7x EBITDA. For example, if your SMB generated $3 million of EBITDA over the last 12 months, it would fit the PEG model at a purchase price of between $9 million and $21 million. Given that most PEGs illustrate a minimum equity investment of $10 million, there is a very limited market for businesses generating less than $2 million in annualized EBITDA.​

​Conclusion

Reflecting on our nearly two decades of operating, advising, investing, and stewarding service business models, Ephor provides the following summary guidance on the utilization of Private Equity or Private Capital as an exit option:

• Have a “Backable,” Proven, Experienced & Known Executive in the Sector as a Executive Chairman or Chairman of the BOD or Advisory Board.

• The CEO Entrepreneur’s job is to broaden the group of potential buyers for his or her SMB on a timely basis.  Therefore, it is imperative to consider PEG trends, important factors, and the attributes of the business that are attractive to PEGs. If you as the CEO Entrepreneur are not comfortable or skilled to this this: “Get Professional Help!”

• Attracting significant PEG interest in your business can best be accomplished by focusing on the development of a replicable business model, its business process and its scalability, and the development of its management/leadership team, who can sustain the business without your involvement.

• Remember, cash flow and EBITDA are the key factors in your business valuation, not assets on the balance sheet.

At Ephor, we successfully have used a methodology entitled Organizational Clarity to develop several successful business models that have commanded impressive enterprise valuations upon exit. 

Our exists have represented ~$2.2 billion dollars over 6 investments in 21 years.

At Ephor, one of our goals for all of our clients and investments is to provide you access to “The Best” financial partner for you.