A guide to private equity investments

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A private equity investment can help to grow your business, generate long-term gain and drive capital growth. In this episode, Kate Richards, Legal Director in our Corporate team, joins us to talk about private equity investment further.

In this episode:

  • An overview of private equity
  • Advantages and disadvantages of taking a PE investment
  • Implications for management within the business when taking a PE investment
  • A breakdown of the investment process
  • Insight into investor expectations and proving ROI
  • Top tips when taking private equity investment

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This episode is part of our straight talking business success podcast series. Learn more about the series and what we cover. This podcast is available on iTunes, Spotify and Soundcloud.

Read the transcript:

Host: Welcome to Straight Talking Business Success, your guide to growing and developing your business. Today I'm joined by Kate Richards, a legal director in our corporate team. We're going to be talking about private equity and the things that businesses should be considering if they are looking to take on private equity investment. So to begin with, what is private equity?

Kate: Private equity is basically a form of finance for business and unlike a bank or a traditional debt provider, the equity house will take a share of the company share capital and it often takes debt at the same time. It's often seen as an alternative to just traditional debt finance, because they're in it for the long-term gain and trying to grow the business and getting the capital growth out of the business rather than just a return on debt. There's various different types of private equity.

Kate: You've got your traditional funds where the PE house has gone out and raised money from pension providers, wealthy individuals, insurance companies. They form a limited partnership, which is then run by a fund manager. The fund manager then invests that money into the various companies. Then you've got some more modern ones. We've got VCTs and we've got EIS funds. Slightly riskier investments, but they get tax breaks given to them by the government. And more increasingly, we're seeing private wealthy individuals forming their own funds, because they can get better returns through investing in businesses than they can for instance in the capital markets or in loans or bonds.

Host: Excellent. Okay. So what type of company do funds typically like to invest in?

Kate: Very much depends on the fund and what that fund's portfolio or their USP is when they raised the money. Typically they all have investment limits. So you'd see people raising money up to 4 million, four to 10, 10 and upwards, and you see the seed funding, which could be as low as 50,000 pounds start-up money that came from the European funds. You do have sector specific funds. So biotech tends to be very much focused from specific PE funds that do that. We've obviously got seed capital, and on the other side we have got people that specialise in turnaround and distress funding. What they're generally looking for all PE houses, is are they backing a business that's going to grow? So are they looking for a business that can either has a niche growing sector that they can expand into or is there a buy and build type strategy there? Then finally, the other things they're looking for are obviously the exit strategy. Are they going to get their money? Because they are in for the longterm gain, management teams, and is there something interesting and different about a particular company?

Host: Okay, so from the company's perspective, what are the advantages of taking a PE investment from fund?

Kate: It's often viewed as an alternative to taking debt funding, particularly since 2008, where debt funding became more restrictive and difficult to obtain. It's very flexible. It's a short, quicker process to get the funding in place. The terms which you can get are more flexible than with a traditional bank. In terms of running the business going forward, they have access to funds to do acquisitions for instance, or to do roll-outs of investments. The other big benefit you get with a PE house is the expertise of your investor directors in the funds. So they can help with the CF, they can help with the strategic advice, they'll introduce you to chairman and other non-execs, because they work in the sector and they have access to these people. I suppose the big advantage as well is that they're looking in the longterm gain. So it's all about getting an exit which is aligned to the manager's interest of ultimately realizing money on the shares.

Host: Okay. Thanks for that Kate. So we've talked through the advantages. Are there any disadvantages?

Kate: Obviously you're giving away part of your equity share capital. So your ultimate return would go down in terms of your percentage shareholding. But hopefully the money from the PE house will enable you to grow the business and therefore you'll ultimately get a better return on your investment. Other things that PE does, there is a perception about loss of control, because an investor will typically look for matters which require their consent and their seat on the board, although practically, day to day and the operation of the business, this isn't something you would notice. And then finally, I guess it's when you want to do an exit. Now in my experience management and PE are always aligned on when they're ready to exit, because it's when the market is right, when the price is right, when you've got the CF advice that's telling you that this is the right time to go and the right time to sell. But there is the argument that there could be a difference between the two, but ultimately the investor does need to have an exit within a given timescale.

Host: So you mentioned controls a moment ago. What controls will the investor expect in return for their investment? Are there some examples that you could run through for us?

Kate: Yeah, the main thing they're looking for is they want to have a right to be on the board. Most PE houses take up that right and actively involved themselves in board meetings and have the observer rights. As I said, there are investor consent matters. So there are very high level key decisions that would need the investor consent. Things like refinancing bank debt, hiring very senior employees, appointing directors. But these aren't day to day matters, these are key strategic matters. They do want information so you have to deliver your accounts, management accounts, agree the budgets with them. And ultimately, they will want certain key share rights to do with how they exit the business and appointing corporate finance houses to assist with that process.

Host: So what are the implications for management already within the business who are accepting the investment?

Kate: The big issue that you see when you're negotiating a PE transaction is what happens if an employee shareholder leaves, and what happens to his shares? And these are called compulsory transfer provisions. So points where we discuss with management and with the PE house is first of all, where you've got a very key or substantial shareholder, are they required to sell all of their shares? And more importantly for all management, what's the price they get for their shares? So we have this concept of good and bad leaver. There are some variations on that theme. So good leaver, where you get your market value for the shares would be things like death, incapacity and where the board agrees to do so. And then generally all of the circumstances we'd be treating as bad. There are obviously variations on this for things like wrongful dismissal and redundancy. Then increasingly coming into the market is working out when you will be paid for your shares if you leave.

Kate: And the difficulty that businesses have had is where someone's left and receives market value, the business when someone exit often doesn't have the money to pay people out. So those are interesting areas that PE lawyers are looking at the moment. Other things to look at is obviously the returns. PE houses may incentivize management with what's called a ratchet. So once they've got say three times their investment back, you'll get a greater share of the equity return over that. And then finally, restrictive covenants. So restrictive covenants run from the date that you cease to be an employee in the business, and they're there to protect the exiting employee from being involved in competing business, taking the staff, taking the customers, using the IP. They run for a period from leaving the business. So which is slightly different from when you're doing a sale process where they'd run from the points that the money is coming in.

Host: Okay. So once the investment is complete, it is accepted. What happens next?

Kate: Not a lot really. You would see your investor director would start coming to your board meetings. They would be there to offer strategic advice, but they're not interested in running the business day to day. So as long as you're hitting your plan, things are going well, they're not actively involved in the business and they don't want to be actively involved in the business. You'll obviously have strategy days with the investors which are beneficial, because they can bring sector experience and CF experience to the table. And the only time you'd see something else happening is if things are going wrong and events and default are starting to come in where they step up but their aim is always to help you, because you have an aligned interest in realizing value.

Host: Okay and I guess on the flip side really, what happens when the investor wants to exit the business?

Kate: Typically an investor has a three to five year exit strategy. Although in practice an investor will exit when it's right to exit the business. And you'll see that will be driven by market factors, the business and where it's got to, where the need for growth is. And I've always seen that part from in distress situations being a joint process with management, because you all know with CF advice when is the right time to go for the exit. They all have their own investment criteria. Practically, they will include what's called a drag along provision in the articles, which allows them to force an exit if you get to a certain period of time, or if there's an event of default. Those are very rarely used. Sound more scary than they are. They're very rarely used and generally they're used where you've got small minority shareholder that's outside the business and the reason the comfort management have, is if you're going to sell your business, management know that business best. So they're the ones that will provide the information to the buyer, engage with the buyer and are often involved with the buyer going forward.

Host: Excellent. Thank you. That's useful to know. So coming on to our wrap up question. Private equity I think is synonymous with jargon. It's a long list of abbreviations and acronyms that are used. Could you run through a few of the key ones and give us some background on those?

Kate: Okay, so looking management buyout is probably the starting point. That's where the investor is buying the business, but management are going to keep a stake in the business. Increasingly we're seeing secondary and indeed tertiary buyouts. That's where we get to an exit point, and another private equity investor is effectively taking the role of the outgoing investor. At that point you often see managers taking a little bit of cash out at that point, but then reinvesting proceeds going forward. Commonly at the moment we talk about strip equity and sweat equity. Strip equity is effectively your investment stake. So if you're exiting, if you're selling the business, but then carrying forward, if you take some of your cash and subscribe for shares, that will be your strip equity. Sweat equity is given to you as basically reward for getting to the exit. So that's your incentive pot.

Host: I see, okay.

Kate: And then as I say, drag along rights is the right for a majority to force a minority to sell their shares in the company and a tag along is the opposite. So the minority can join in a sale with the majority.

Host: Okay. So if someone were looking at taking private equity investment, what should they do?

Kate: I think if you're looking to take private equity investment, the two key things the PE house will look for is a strong credible management team. And ideally that you started to grow a management team below you for succession planning. So if you haven't got someone in a key position, you need to be able to address that and why and what you're going to do. The other absolutely key thing is get your business plan ready, because they're going to be funding the business plan effectively. So involve the accountants at an early stage to get the business plan drawn up. And then obviously, when you start talking to the private equity house, Gateley is up for a range of private equity houses. We can give you some advice about who to approach, what sorts of terms you'll see and trying to agree the terms of the investment up front is so beneficial. I can't stress how much easier the process is by trying to getting things like compulsory transfer, ratchets, exit provisions right at the start.

Host: Excellent. Thank you very much Kate. Thank you for listening to Straight Talking Business Success. To find out more about the series, please visit From here you can subscribe for updates, meet our speakers and get more information on all of the topics that we've covered.

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