By David Toth and Alex Drost
Recent years have seen waves of private equity investment into our industry. These days, it seems there’s a new deal announced every week.
Countless firms are discussing the opportunities PE investment offers. If you’re considering PE, it’s important you explore the different types of partnerships and investments available. By understanding the nuances of the different models, you’ll be well placed to determine the best path forward.
All PE firms aim to invest capital and earn a strong return. What differentiates them is their approach. Below, we take a closer look at some of the different approaches we see in the market today.
Platform Versus Roll Up
In an industry as fragmented as accounting, one of the primary drivers of value is sheer size. A larger firm that throws off a greater level of free cash flow is more valuable than a smaller firm that distributes all its income to partners. It’s more resistant to economic uncertainty, less reliant on a particular industry or geography, and is equipped to work with larger, more valuable clientele.
PE investments typically take two forms: The larger, more well-established firm is known as the platform investment, while smaller firms tend to be viewed as add-on or roll-up opportunities. PE firms typically first invest into a platform firm and inject a significant amount of capital to fuel growth. The platform firm, with guidance from its PE investors, then rolls up smaller firms – often regional or specialized players. In turn, the platform firm grows larger, gains economies of scale, and becomes more profitable by realizing greater synergies.
For example, a $50-million accounting firm might attract $100 million from a PE firm. Of this, let’s say $20 million goes into buying equity, with the remaining $80 million earmarked for acquisitions. At the end of the hold period, the platform firm should be far larger, far more profitable, and therefore, far more valuable to the market – enabling the PE firm to realize a significant gain on its exit.
The Role of People and Culture
It’s crucial to understand a PE firm’s philosophy when it comes to managing people and culture. Many PE firms promise to take a relatively hands-off approach and invest in building out a deep bench of leadership talent. Others might take a more active role in daily decision-making.
Meet potential partners to understand their vision, the personalities on their team and their track record. As discussions progress, ask to talk to other firms they’ve invested in to learn about their experiences.
Aligning on the Vision for Success
Most private equity firms hold investments for four to seven years. Some firms aim for quicker flips, while others may be willing to invest for longer. A quick flip might play out over two or three years, which would demand that a firm would have to roll up a lot of new firms, very fast.
Figure out this strategy in your early discussions. Ask questions like:
- What’s your average hold time?
- How much capital are you investing?
- What size do you see the business growing to before exit?
- What are your target returns?
Investment Strategies Aren’t a One-Size-Fits-All
By far the most common strategy is the majority investment, also known as a controlled investment, where the PE firm acquires a 60% to 80% equity stake. The expectation is the selling shareholders will roll their remaining equity into the new business – ensuring they remain economically incentivized to get a “second bite at the apple” – that is, a second liquidation event upon the PE firm’s exit.
However, what’s often not communicated is that as an equity partner, you won’t be able to divest fully until you reach retirement age. You’ll get some liquidity when the private equity firm exits, but you’ll be expected to continue rolling equity until you eventually retire and cash out. Majority investments tend to be a good fit for firms with partner groups that are nearing retirement age, since they tend to designate more dollars to buy out existing shareholders.
The other option is a minority investment, when a private equity firm acquires a 20% to 30% stake. In these cases, the goal is to inject capital to fuel growth.
Minority investments provide existing shareholders with the potential to capture a greater share of the growth versus through the majority sale of the business. A minority investment might be a good match for firms with younger, motivated partner groups that want to realize more long-term upside and are happy to take on a greater investment risk to do so.
Funding Growth: Scaling Back Partner Compensation and Using Debt
If you’re considering a private equity investment, your partners will have to make sacrifices. Partners are typically expected to forgo some portion of their equity compensation to funnel more cash into growing the firm. This is known as “scrape.”
Say you’re a partner at a large firm pulling down $1 million a year. If your firm chooses to accept investment, you might expect your compensation to drop to $800,000 a year, with the remaining $200,000 used to fund growth efforts and improve free cash flow, which drives enterprise value.
Debt also plays an important role. Every private equity investor will use leverage since it helps create outsized equity returns. Private equity firms are excellent at finding alternative capital structures that allow them to find additional capital through investors in debt markets.
Navigate the Private Equity Process with a Trusted Partner
If you’re a firm leader, it’s crucial you understand these nuances to find the right PE partner.
Take a measured approach. If you’re receiving interest from private equity firms, conduct your due diligence, explore your options and consider working with an advisory team to help you think through the ramifications of accepting investment, introduce you to firms with different models, and counsel you through the process.
David Toth is the Chief Growth Officer at Winding River Consulting, who serves as a leadership coach, digital demand expert, strategic advisor and growth leader.
Consultant Alex Drost works with middle-market advisory services firms on setting and attaining strategic initiatives to unlock growth potential and maximize value creation opportunities. His work includes strategic planning, retreat facilitation and growth enablement services.
