In 2021, private equity buyouts totaled a record $1.1 trillion, doubling from 2020, and the market continues to grow as investors and firms improve their approach. The recent growth in the number of private equity firms often makes private equity capital a commodity, presenting business owners with just two institutional alternatives: sell a minority equity interest to a passive growth investor, or hand the keys and control to a buyout firm in an exit transaction.
Some investors desire capital solutions for their business that go far beyond just dollars. Others seek a true partnership with an institutional investor that enables diversification of personal net worth at inception of the partnering and brings resources, strategic input, and operational support in anticipation of the next larger transaction.
Many business owners and their advisors are unaware of the partner equity capital solution. Here’s what business owners in search of equity capital need to know to understand their full range of alternatives and when a partner equity transaction could be the best capital solution for them.
Evaluate Stakeholder Motivations
With partner equity, the motivations of a stakeholder should determine which financing alternative is most suitable. For example, if retirement is the primary stakeholder motivator, handing off the keys and control in a full exit transaction with a buyout firm might be most appropriate.
Additionally, for stakeholders whose businesses need just a small amount of capital to pursue new initiatives and are beyond their borrowing capacity, a passive growth equity investor might be best.
In a situation where the stakeholders see tremendous company potential that can’t be unlocked without making operational changes that they may consider to be risky, a partner equity transaction could be attractive.
Create Incentive-Aligning Capital Structure Consistent with Objectives
The two traditional institutional financing options typically result in 20% to 30% ownership for a growth equity investor and 85%+ in the case of a full buyout. That makes sense given the objectives of the stakeholder in each case. Craig Dupper, founder and managing partner of Elan Growth Partners, says that growth equity investors are relatively passive, although some utilize ‘ratchet’ provisions, which give them governance rights if the business fails to perform relative to agreed-upon metrics.
A full buyout is just that, with typical stakeholder retained ownership of just 5% to 15%. Most sellers in this scenario ascribe little future value to this retained interest and instead focus on maximizing the value they receive at closing. This is understandable, as they are most often no longer active in the business and have little, if any, governance rights following the buyout.
In the case of a partner equity investment, post-transaction stakeholder ownership ranges from 35% to 49%. A capital structure designed this way allows a stakeholder to have an up-front liquidity event that diversifies their personal holdings but leaves very meaningful skin in the game for the next liquidity event. The up-front cash and resulting diversification changes the risk calculus for the stakeholder partner, and since they now have some financial stability independent of the business, they are more comfortable with the decisions and changes required to unlock value.
Incentives are perfectly aligned given post-transaction ownership, and the partner equity investor is typically focused on executing growth strategies on an accelerated basis, adding a positive sense of urgency. It’s worth noting, the partner stakeholder is often still involved either in a direct operating role, or on the board where they have an ability to influence company governance and strategic direction.
Manage Process and Expectations
The pursuit of any equity transaction can be a stressful process for business owners. No matter what alternative a business owner selects, the due diligence process is extensive, thorough, and often intrusive. Often, a business owner should count on four to nine months from the point they begin searching for an equity partner to the close of a transaction. However, some of the variables impacting this timing are in the business owner’s control, including status of books and records, financials, and customer and vendor contracts.
While growth equity and buyout investors will be highly focused on the past and near-term forecasts, the partner equity investor will focus as much on the future and how the parties will work together. They will often create a pre-closing strategic plan with business owners to help demonstrate the process and set expectations regarding partnership.
During this phase, they ask questions such as: How will we adjust our plans to respond to changes in the market or divergences in our forecasts? What tools and processes will we utilize to work through any potential strategic or operational disagreements? What are the agreed upon milestones indicating it is time to pursue a second exit transaction? As a business owner, it’s worth the time to think through these situations.
Establish Collaborative Dynamics for the Partnering
Many growth equity investors position themselves as ‘value add.’ However, the nature of their investment is passive by design. There is typically not a lot of close collaboration contemplated by the parties, especially if the company continues to perform. Likewise, in a buyout transaction, the business owner exits with no further participation required nor expected.
By contrast, in a partner equity transaction, good chemistry between the investor and partner stakeholder and the collaborative dynamic between the two are critical, as the partner stakeholder stays involved post-closing. Dupper describes the relationship as comparable to a marriage. He says, “it is important that a business owner evaluate whether the institutional investor shares their values, operational philosophy, and vision for the partnering. Communication styles and interpersonal skills need to be compatible in order to effectively execute the plan, work together through inevitable challenges, and ultimately maximize value at the second, hopefully larger transaction.”
In an increasingly commoditized private equity marketplace, a partner equity investment structure stands out as unique. For business owners seeking a hybrid capital solution that facilitates asset diversification and the ability to participate in future growth of the business, partner equity could be an excellent fit. Business owners and their advisers should understand that there are hybrid investment alternatives, like partner equity, in addition to traditional passive growth and control buyout transactions.