Why Private Equity Firms Look for these Specific Traits in a Target Company
The 4 Most Common Traits of Private Equity Targets
The world of private equity (PE) can seem like a black box. But it’s inescapable and all encompassing. Headlines of mega deals are often plastered across The Wall Street Journal, Bloomberg and The Financial Times, and six- or seven-figure purchase prices are commonplace. However, PE surrounds you more than you think. The high-end restaurant that’s popular in your city? It’s likely owned by PE. The private hospital you went to last month? It’s likely owned by PE. And your favourite football team? Yep, it’s probably owned by PE too.
But, little is publicly known about what exactly makes a specific target company so attractive that a PE firm is willing to part with a scrumptious sum of money to acquire it. What is the secret sauce that this target company had that fits the bill? Is there a pattern when it comes to the traits PE firms look for in their acquisition targets?
In this article, we’ll identify four key traits that almost all PE target companies possess. But, to understand why PE firms look for these specific traits, we will need to look at how PE works.
Private Equity in a Nutshell
Buy — improve — sell
The crux of PE is to acquire or invest in promising target companies with the goal of implementing changes through value creation. In other words — buy, improve and sell. Broadly, the PE approach to an acquisition will involve the following steps:
1 — Deal Sourcing: PE firms have an investment thesis and will identify potential target companies that fit within this strategy.
2 — Due Diligence: Once a potential target company has been identified, the PE firm and its advisors will conduct due diligence to assess the company’s financial health, market position, and potential for growth.
3 — Acquisition: If the PE firm decides to move forward, the deal will typically be financed using a combination of debt and equity.
4 — Value Creation: After the acquisition, the PE firm will implement a value creation plan to drive growth and generate returns for the investors. This may involve operational improvements, management changes, and capital investments etc.
5 — Exit: PE firms hold their investments for a set period of time, after which they will seek to exit the investment through a sale or IPO.
A Note on Why Private Equity Exists
PE funds are established using large pools of capital from limited partners (i.e. investors). This capital is then managed by PE firms, who will use it to acquire controlling stakes in target companies to generate positive risk-adjusted returns for limited partners.
There are three ways that PE firms can generate these returns:
1 — Multiple expansion: Buy a dollar cash flow today at a value lower than what you would sell it for a future point in time. How do PE firms do this? Proprietary deal flow. Meaning — they have access to deals to which other dealmakers do not. This usually comes from a PE firm’s internal team scouring the market for potential opportunities or through relationships with investment banks, lawyers and other advisors. Since the PE firm has access to the deal before others, the sellers will not (in theory) know whether other buyers would be willing to pay a higher multiple. Therein lies the advantage.
2 — Leverage: If the debt markets are accomodating, and interest rates are advantageous, PE firms can generate returns through leverage. By using as little equity as possible, PE firms can maximise their return on equity (ROE) with the use of leverage. Not to mention, the use of leverage provides an extensive tax shield.
3 — Operational improvements: Possibly the most important means of generating returns and value creation is through providing operational improvements to acquired target companies. Through the use of expertise, both through internal teams and external advisors, PE firms implement strategic changes to accelerate revenues, streamline product/service lines, eliminate excess costs, and geographical expansion. Unlike multiple expansion and leverage, generating returns through operational improvements are more sustainable and unlikely to diminish through competition.
Traits of Private Equity Target Companies
Trait #1 — Historically Profitable with a Track Record of Cash Generation, but Currently Underperforming
A track record of success matters. PE firms want to know they are acquiring a target company which has a history of profitability and cash flow generation. This type of company is seen as a more stable and reliable investment with a higher potential for value creation. Even if a company is currently underperforming relative to peer benchmarks, a strong track record of profitability and cash generation suggests that the company has the underlying business model and financial stability to recover and achieve future success. After all, this is exactly where PE firms step in.
Target companies may be profitable and cash-generative, but might lack incentive to decrease excess costs and invest to innovate their product and service lines, specially in markets and geographies where competition is not fierce.
As an example, PE firms may look to acquire target companies that are facing challenges such as succession issues or a lack of capital investment, as well as subsidiaries that no longer align with their parent company’s strategic direction and have not received sufficient investment or operational improvements. As such, PE firms will identify and address inefficiencies, leading to improved performance, thereby increasing value.
To identify value creation opportunities, a thorough analysis of the target company will be conducted, exploring both operational and structural issues that may be contributing to underperformance. Specifically, this might involve issues such as cost control, failure to enter new markets, failure to integrate new technologies, or lack of capital expenditure.
Here is a good example of this trait in action.
Enter — The Carlyle Group and Moncler.
Background: In 2008, The Carlyle Group (Carlyle) acquired a 48% stake in luxury fashion brand, Moncler, known for its iconic down jackets. At the time of acquisition, Moncler distributed its products in high-end departments stores in Italy and other countries, with only 6 of its own retail stores.
Value Creation: During the holding period of 2008 to 2013, which was in the aftermath of the global financial crisis, Carlyle’s value creation strategies resulted in the following changes to Moncler:
- accelerated geographical expansion of retail channels by increasing the number of retail stores from 6 to 135 stores
- commenced e-commerce online trading in the US/Europe in 2011 and Asia Pacific in 2012
- strengthened management team by hiring new senior executives
- increased revenues and EBITDA by 206% and 311%, respectively
- increased direct retail sales from 13% of total sales to 58% of total sales
- increased sales in Europe, Asia and North America by 4.1x, 5.9x and 9.1x
Takeaway: Moncler had a track record of profitability and limited excess costs. However, its weakest link was distribution channels. Carlyle’s capital investment and expertise allowed Moncler to penetrate new markets and distribution channels resulting in significant growth.
Trait #2 — Low Failure Risk with a Strong Tangible Asset Base
PE deals are often financed through a combination of debt (leverage) and equity. Specifically with leveraged buyouts (LBOs) deals, as much as 70–80% of the purchase price could be made up of debt with the 20–30% made up of equity. The use of high levels of leverage in an LBO increases the risk for the PE firm and the banks providing the debt, as the target company will need to generate sufficient cash flow to pay back the debt. And so, PE firms will seek out target companies that have sufficient interest coverage.
If the target company’s financial performance deteriorates or if interest rates rise, it could become more difficult to service the debt, potentially leading to default or financial distress. If this happens, the bank would suffer significant losses. And, what’s worse? The bank won’t be willing to provide this PE firm with any future debt financing. To protect themselves, banks will conduct due diligence on the target company, but also, will require collateral and covenants on the loans they provide. They’ll want to identify the presence of sufficient value in the target company’s assets to provide security for the debt financing.
Cash flow stability is critical for meeting regular interest payments, and given the PE firm’s role in reducing the default risk of the target company, it’s more likely to invest in companies with assets or collateral for raising debt and the ability to generate cash and profit to cover interest payments. In essence, PE firms are want target companies to have low failure risk.
Therefore, preferable target companies will be those with (i) a strong tangible asset base (over which the bank will take security) and (ii) stable cash flows (which will provide sufficient interest coverage), as these characteristics reduce default risk and ensure access to future loans on favourable terms.
Here is a good example of a target company with strong tangible assets.
Enter — The Blackstone Group and Hilton Hotels & Resorts.
Background: In 2007, the Blackstone Group (Blackstone) acquired Hilton Hotels & Resorts (Hilton), including more than 3,400 hotels and various assets related to the hotels such as the Hilton brand. The acquisition was completed through an LBO, which comprised of $20.5 billion (78.4%) debt and $5.6 billion (21.6%) equity. This seemed like a risky deal for two reasons — (i) it occurred during the global financial crisis (when the population had limited disposable income to spend on luxuries such as hotels) and (ii) it was highly leveraged.
Key Points & Value Creation:
- The debt financing was provided by seven well-known financial institutions including Bank of America, Goldman Sachs, Lehman Brothers and Morgan Stanley.
- Hilton’s assets served as collateral to secure the debt financing.
- During the holding period, Blackstone doubled the number of hotel rooms in Hilton’s portfolio to over 1,000,000 rooms.
- Blackstone added new brands such as Curio Collection, Tapestry Collection, Tru by Hilton, and Home2Suites to the Hilton portfolio.
Takeaway: Blackstone completely exited its investment in Hilton in 2018 with the firm realising a total of $14 billion in profit.
Trait #3 —Low Productivity Providing Opportunities for Performance Improvement
PE investments are short-term in nature, and so PE firms are subject to short-term performance pressures. They have to acquire the target — immediately roll out strategic changes — realise efficiencies and improvements — then, exit. This limited time horizon results in PE firms targeting underperforming target companies with lower-than-average productivity, so that PE firms can generate performance improvements. One of such means is increasing productivity through capital expenditure on improving product lines and internal processes.
It’s not necessarily the case that these target companies are struggling or performing poorly overall. They may, in fact, hold strong market positions or possess other attractive qualities that make them appealing to PE firms. The potential for improvement through increased productivity is what makes these firms particularly attractive.
Target companies with lower-than-average productivity may operate in markets that lack the competitive pressures that drive efficiency and innovation. Without this pressure, target companies may be less motivated to continuously improve their productivity and instead may focus on maintaining their current level of performance. And so, an opportunity is created. PE firms step in and provide the necessary capital and expertise to drive productivity improvements.
Productivity improvements can be implemented in many forms including streamlining operations, investing in new technology and equipment, exploiting new markets, targeting new customer segments and improving management and leadership practices. These efforts can lead to significant improvements in efficiency, resulting in increased profits and stronger growth for the company.
Here is a good example of improved productivity.
Enter — The Carlyle Group and Dunkin Brands Group.
Background: In 2006, Carlyle alongside Bain Capital and Lee Partners acquired a 33% stake in Dunkin Brands Group, the world renowned quick service restaurant serving coffee and baked goods. At the time of the acquisition, the Dunkin Brands Group was a regionally focused with its core market in the Northeast US.
Value Creation: During the holding period, Carlyle’s value creation strategies resulted in the following changes to Dunkin Brands Group:
- entered new US markets and expanded to Asia and the Middle East — ultimately resulting in 2,125 new stores domestically and 2,800 new stores in China, India and Latin America
- implemented menu innovations with a focus on increased coffee/beverage sales to increase repeat customers
- optimised store level unit economics by lowering cost of goods through streamlining the menu
- operational efficiencies decreased store build out costs by 24%
Takeaway: Dunkin Brands Group was well recognised and regarded in its core market, but lacked global reach. However, Carlyle’s operational productivity changes were not limited to global expansion, it also resulted in stronger franchisee demand yielding further store growth and economies of scale synergies. By 2013, the Dunkin Brands Group had 11,000 Dunkin Donuts restaurants and 7,300 Baskin Robbins restaurants.
Trait #4 — Operating in Defined Markets with Uncomplicated Products or Services
Target companies that operate in well-defined markets with uncomplicated product or service lines tend to be attractive for PE investment. PE firms often avoid companies predominantly comprising of large intangible ‘knowledge-based’ assets (i.e. knowledge, expertise and relationships).
The rationale for this approach is as follows:
- valuing and performing due diligence on target companies with complicated products and knowledge-based assets can pose significant challenges, and traditional valuation methods may be unreliable when there is an information gap regarding the adoption rate of the product and the potential market size
- PE firms have financial expertise and may not possess the knowhow to analyse and add value to target companies with intangible knowledge-based assets
- target companies operating in defined markets with uncomplicated products or services tend to have predictable revenues, and as such, PE firms can more easily forecast financial performance and determine their potential return on investment
- target companies with uncomplicated products will often have simpler business models with few moving parts, and so, it is easier for PE firms to implement operational improvements and expand to new geographies
- knowledge-based target companies require extensive investment toward intangible assets, and under a longer time horizon, before they are able to generate stable revenues and access traditional financing for growth
Given these challenges, it is not surprising that PE firms tend to target companies outside of knowledge-based industries. Exceptions to this may include ventures with identifiable and saleable assets, such as manufacturing technologies or services with well-established customer bases. In general, however, PE firms are are attracted to target companies with tangible assets and straightforward service or product lines, rather than those with primarily intangible knowledge-based assets.
