Neil Patel

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Private equity M&A is quickly gaining interest and attention because of their potential to fuel rapid growth. Regardless of the sector, private equity has the ability to achieve high returns and increase the value of their investments.

The last few years have seen private equity (PE) firms acquiring large targets and walking away with significant profits. Several factors contribute to this phenomenon as these firms purchase companies and take them through rapid performance improvement.

Private equity experts anticipate robust growth in private equity M&A activity to continue in the next few years. PE deals have shown consistency through 2023. During Q3, deals worth $101B were done in the third quarter. This value is similar to the deals in the first two quarters of the year.

Statistics also indicate that private equity firms worldwide have pumped a record $2.49 trillion worth of cash or highly liquid securities into M&A in mid-2023. These private equity funds not only promote mergers and acquisitions but also assist small and distressed businesses scale quickly.

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    How Private Equity Firms Work

    Private equity firms or funds comprise a pool of funds collected from various investors. This pool of capital is deployed toward acquiring private companies that are not yet publicly traded on the stock exchange.

    PE funds have highly-qualified portfolio managers on board who work with the operating managers of the businesses they own. They may also hire private equity consultants to track down and vet viable investment opportunities for acquisitions.

    Private equity M&A typically involves purchasing companies that have some value and demonstrate potential for improvement. Or that are facing issues and are distressed.

    These target businesses have been underperforming because of a lack of aggressive management. They are undervalued since their potential is not readily apparent.

    Next, private equity firms use an array of strategies to enhance the acquisition’s performance and profitability. Such firms hold the companies for a short term which can be anywhere from four and seven years. They restructure the company and make a clean exit once it starts generating profits.

    Various factors enable them to achieve high returns including offering attractive incentives to their portfolio managers. They leverage debt aggressively to obtain financing and tax advantages, and their focus is primarily on improving cash flows.

    In this way, PE buyers realize one-time, short-term to medium-term value-creation opportunities. But to do that, they must take ownership and control of the business operations.

    PEs leverage effective strategies to transition their investments through accelerated growth such as a blend of business and investment portfolio management. That’s how PEs hope to raise their margins.

    Investors participating in the fund may share the profits, both operational or after the acquisition’s sale. An added advantage is that PEs are exempt from restrictive public company regulations.

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    Why Private Equity Firms Engage in M&A

    Private equity M&A has various advantages for both–investors and their acquisitions. Here’s how:

    Improved Performance

    PE firms acquire stagnating and troubled businesses to improve their performance quickly. Their managers implement strategic changes to improve the target’s profitability and growth prospects. PE firms work with top-notch management teams that are agile and can facilitate upgrades efficiently.

    Struggling companies typically run into trouble because of scarcity of cash flows, which is something liquidity-rich PEs can quickly cover. That’s because PE funds have multiple sources of capital, such as paid in-kind financing, elevated equity contribution, seller’s notes, and private credit markets.

    Improved cash flows can result in stronger relationships with the key stakeholders of the acquired organization. This improved communication channel helps with integration and aligning the private equity firm’s core portfolio strategy. Getting assistance and support ensures that the business grows quickly so the investors can realize value from the sale.

    Generating Returns for Investors

    Private equity M&A opens up avenues for generating returns for investors. PE firms can buy ailing companies at low prices and sell them at premiums to earn capital gains for their investors. They are flexible when it comes to the capital they invest, the business verticals, and investment structure.

    Although the ground rule is for PEs to invest for limited time frames, they may be open to long-term opportunities. That is if the investment demonstrates the potential for transformational change and potential for rich returns.

    Portfolio Improvement

    Private equity M&A enables the PE firm to add new products and services and grow its portfolio. They can expand the customer base and build a presence in new and unexplored markets and locations.

    Strategic bolt-on acquisitions are quickly gaining attention with larger companies keen on buying out smaller firms. Private equity firms primarily focus on companies that can help them offset ESG risks and provide insulation against inflation.

    Staying competitive in an economic landscape where the stress is on decarbonization, digitalization, and uninterrupted supply chains is a bonus.

    Industry-Specific Expertise

    The key differentiating factor that sets private equity firms apart is the exceptional expertise they bring to the table. PEs have an in-depth understanding of how M&A deals progress. This is why they can initiate and conclude deals quickly and efficiently.

    PEs perform extensive and substantive research and analysis on the industry and competition before identifying targets for acquisitions. Vetting targets well-positioned for growth with extensive due diligence processes is within the scope of their operations.

    Not only are they adept at making strategic decisions, but they also have a hands-on approach which enables decision-making. Capabilities for swiftly executing their decisions also ensures rapid growth for the targeted company.

    PE managers are known to work extensively with the target’s executives and board of directors to guide them. Their exceptional leadership skills and expertise in allocating resources is invaluable.

    Selling the Now-Profitable Company Has Its Advantages

    Acquiring businesses for the purpose of selling them in a short time has several advantages. As an acquirer, know that the acquisitions typically have a rapid increase in value. You can expect that the company will generate an investor return of around 25% per year.

    These returns will likely sustain through the initial three years. After that, it may continue to generate returns of 12% per year. A private equity M&A transaction will allow the PE firm to exit after earning a 25% annual return.

    However, a public company that holds the acquisition for an extended period can expect the returns to depreciate over time. Even if the value-generating changes don’t dilute, they’re only likely to remain at 12%. The final buyout return could be far lower than in the case of a private equity firm.

    Since PE firms purchase companies only for the purpose of a sale, they are not primarily concerned by long-term scalability. PE managers run lean and focused operations without emphasis on sharing costs, technical know-how, IP, or a customer base.

    Eliminating the need for synergy or the objective of long-term retention allows them to conserve time, money, and resources. In this way, managers can maximize returns for their investors. Since the turnover time of businesses and investment is short, gaining expertise is quickly done.

    Downsides of Private Equity M&A

    Although private equity acquisitions have multiple benefits, they also come with their downsides. For one, these firms leverage debt financing to purchase companies. This factor can raise the risk of financial difficulties not just for the PE firm but also for its portfolio of investments.

    As with any other acquisition or merger, differences in company cultures can lead to challenges with integration. The possibility of conflict and resistance to changes can lead to missed synergies. The biggest issue can be the private equity firm’s objectives from the acquisition.

    PE managers may take decisions that align with their short-term investment strategy. However, their approaches may not be suitable for the long-term prospects of the acquired company. Especially when it comes to raising funding to scale the company.

    Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

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    How Private Equity Firms Structure M&A Deals

    Structuring private equity M&A deals are very similar to conventional mergers and acquisitions. The entire process includes a series of M&A procedures that aim to maximize alignment of dealmakers’ interests. That’s how the deal can result in successful outcomes for all the stakeholders.

    Vetting Targeted Companies

    As with all other M&As, private equity firms meticulously vet potential targets and evaluate them. Before considering them as potential targets for acquisition, they’ll ensure that its financials, mission, and culture align with their objectives.

    Also expect PEs to conduct detailed analysis on the company’s business vertical and its competitors. Identifying opportunities for growth and potential synergies in the target’s portfolio are among the other considerations.

    Pre-Deal Due Diligence

    Having vetted the candidate, the next step involved due diligence where expert M&A advisors and other teams conduct research. They examine the financials, legal documents, and other information the management shares to confirm its veracity.

    Attorneys, counselors, auditors, and other experts on the team dig into the financial statements, IP and asset titles, and documentations. Examining the company’s projections and understanding the issues why the company is stagnating or failing is high on the list of priorities.

    Getting the relevant information together helps acquirers make informed decisions about purchasing the company. Due diligence teams also gather details of the USP, market position, pending litigation, and any other liabilities the company faces.

    Interacting with the management and top executives may reveal additional information pertinent to the final decision.

    Negotiating the Terms of the M&A Deal

    Companies coming up for acquisitions can safely rely on the expertise of private equity firms and their professionals. Sellers can get assistance with drawing up the relevant paperwork and crafting the structure that is most beneficial.

    Tapping into this know-how helps them negotiate mutually beneficial terms and conditions. Managing potential risks also becomes much more streamlined when working with private equity firms.

    When negotiating the terms of the deal, sellers should know now to share information with potential investors. If you’re not quite sure how to do that, check out this video I have created. I have out together detailed information you’ll find helpful

    Merger Agreement and Investment Proposal

    Drawing up the merger agreement and investment proposal again needs the advice and supervision of professional teams. These personnel specify the various aspects of the deal, making sure to address the expected synergies and growth strategies.

    The document also specifies the rationale behind the acquisition and expected return on investment (ROI). Other inclusions are representations, warranties, and covenants, as well as specific conditions that allow either of the participants to walk away from the deal.

    Indemnification clauses, applicable taxes, liabilities, and escrow terms are some of the other details in the investment proposal.

    The Takeaway!

    Private equity M&A play a crucial role in helping stagnating and distressed companies scale quickly. They bring exceptional expertise, industry-specific knowledge, and efficient risk management to the table. Their management teams collaborate with the portfolio company managers to assist and train.

    The most significant resource PEs provide is financial support that helps stabilize cash flows to get the company back on its feet. PE firms manage every aspect of the ailing business and resolve its issues so that it quickly generates profits.

    Private equity firms acquire companies as short-term investments and typically have an exit plan ready. Their operating model is entirely unlike public companies that acquire businesses with the objective of retaining the investment over a long period. Acquirers integrate the company into their operations to take advantage of the synergies.

    Depending on the type of company they’re acquiring, PE firms may also opt to retain the company for longer periods. That is, if the target demonstrates viability and potential for long-term growth. In this way, private equity M&A is transforming the business landscape to give small companies a boost.

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    Neil Patel

    I hope you enjoy reading this blog post.

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