What You Need to Know About Private Equity

If you're a growing company looking for funding from angel, venture, or other private equity investors, understanding their objectives will help you find the right match.

If you're a growing company, or you're partnering with other growing companies, you're likely dealing with private equity investors. These days, it's common for an entrepreneurial or middle market company to have some private equity ownership, either in whole or in part. If you are engaged in growing a company, it's important to understand how private equity investors have evolved and what is driving their behavior.

Why is everybody "owned" by private equity these days?

Prior to 1995, companies had raised less than $100 billion in the U.S. for private equity-funded buyouts. Not per year, but total. Beginning in 1995, however, buyout funds have raised more than $50 billion per year, every year, with the exception of 2003, which was just below $50 billion. In 2007 alone, almost $250 billion was raised for private equity funded buyouts.

All this cash had to go somewhere, and it led to more buyouts and higher valuations of companies. The biggest effect was on growing companies in the middle market. Entrepreneurs who had grown a company to a level of sustainable profitability were able to easily raise growth capital or cash out at attractive valuations.

What are private equity investors aiming to do?

The objective of private equity investors can be boiled down to one word: returns. In the early 1990s private equity funds were sporting average annual returns as high as 30-50%. This, of course, attracted even more investor money, most of which came from institutional investors, such as pension funds and foundations, seeking higher returns than what they were receiving in the public markets.

However, as simple economic principles would dictate, private equity funds that were flush with cash paid higher valuations, which led to lower returns. So much so that after 1995, U.S. buyout funds saw only one year of greater than 20% returns. Overall, investing in private equity wasn't any better than investing in the stock market.

As a result of these lower returns, private equity investors have become a bit more selective, which requires entrepreneurs to be more proactive and better prepared when seeking funding.

What should you do about it?

Most importantly, a growing company needs to understand the motivations of private equity investors in order to find the right match. Angel, early-stage venture, late-stage venture, and buyout funds each have different motivations.

For example, if you are looking for growth capital to fund long-term investments, but your private equity partner needs to return capital to investors in five years, it's likely that you will soon be at odds with their motivations. Funds with 5-10-year life expectancies will need to cash out of their investments to show returns to their investors. Often, it's more important to them to get a 10% return on capital in the short term than to create a 20-30% return over 20 years.

Finding the right partner, however, can help drive your growth, so it's important to match your motivations with your capital provider's. Ask detailed questions to find the right match, and by all means, don't just take money because it's available.

These days private equity investment is often a necessity for growing companies. It's important to understand the motivations of your capital partners and ensure you are working together for common goals.

Share your experiences with private equity partners with us at karlandbill@avondalestrategicpartners.com.

Karl Stark and Bill Stewart are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark