Private Equity – how to choose well?

Every entrepreneur developing their company faces two decisions. How to finance the development of their business and how to secure its future, when they decide to give up their daily involvement in its operations. I would like to share with you some thoughts on the former.

Financing is not just about raising capital. It is also understanding the limitations and non-financial benefits of entering the stock market, selling the company in part or in whole to a strategic investor, or inviting in a private equity fund.

Listing a company you built yourself is surely a sign of success, an opportunity to acquire some serious cash, but also a serious commitment.

The process of making a company public can be long and expensive depending on the sector, the size of the company, the state of the capital market at any given time, and all the permits required by law. If our company operates in a sector that has not been previously represented on the capital market, its valuation may be affected by the simple fact that stock market analysts, having no comparison to other similar companies, will value it lower than the entrepreneur would expect.

When the initial enthusiasm subsides, every-day reality begins. Reporting obligations are not just additional costs for the company. They are, above all, a new duty for the entrepreneur and the management board – to make sure that the entire development strategy includes this obligation. The competition will gladly read all communications and analyzes, quarterly and annual reports.

Disappointment can come when, despite the good condition of the company, the market begins to price it below the entrepreneur’s expectations. This affects its creditworthiness. And if a temporary breakdown occurs in the business, stock investors can cause lower quotations, which can have a serious impact on the company’s development plans.

Another disappointment may be the fact that if the entrepreneur is still a co-owner of the company, the value of their block of shares may go down. I know examples when, after a price slump on the stock market, one of the owners publicly accused the management board of destroying the value of the company he built with so much effort. He also complained about the decline in the value of his portfolio, which was supposed to provide a comfortable retirement by gradually selling the shares.

The stock market is a great place to enter and get rid of a significant block of your company’s shares, withdraw from management, have professional managers take your place, and… give them some room, observe their actions from the level of the supervisory board. Few Polish entrepreneurs can do that. But the stock exchange is not a partner for long-term financing of the development of small and medium-sized enterprises, which still face many turbulences on the road to stable development.

A strategic investor is also an ennoblement for an entrepreneur. An international – in most cases – company notices the attractiveness of the Polish market, assesses the costs of entry from scratch, i.e. building their business, assessing the market, creating a professional team, determining the development budget. Then it compares them to the purchase costs of an already operating Polish company from its sector that knows the market and has specialists, but needs capital and professional support for further development.

When selling a company, the situation is similar to going public – the value of the company is established during negotiations, the old owner usually – after a certain period, if not immediately – moves to the supervisory board, and the new one begins to adjust the company according to their own requirements. In the case of a capital increase only, when the old owner still remains in control, it is the requirements of the new partner that can lead to conflicts between the entrepreneur and their foreign partner. We are all reasonable entrepreneurs on a daily basis, but sometimes it is hard to believe how different the business approach of Poles is from, for example, the Italians or the French. Our entrepreneurs very often take greater business risk, act on the principle “maybe I’ll get lucky”, or “everything which is not forbidden is allowed”. Foreign entrepreneurs do not take business risk without the opinion of an expert on a given sector, market research, and opinion of a lawyer or auditor. If they make a mistake, they will say that it was because of a higher power, i.e. the invisible hand of the market. If they notice a loophole, before they use it, they think about whether the legislator also sees it and how soon it will close. In Poland it is enough to look at the legal regulations of other European Union countries to know that some business practices will soon be impossible. Not because the government is tightening the screws, but because it is introducing regulations that give equal opportunities to all entrepreneurs.

And it is the differences in the assessment of these elements that can seriously disrupt cooperation with a strategic partner.

So private equity wins as the best option? Not necessarily. If you have a clear development plan, a good management board that you are a member of, and you need capital to grow your business so that it develops until it becomes a significant player in your market, private equity is the best address.

The fund will assess the company’s value in several years and on this basis it will make an investment and supervise the Company’s financial results, striving to achieve an increase in value. For this purpose, the fund will do four things that the stock market cannot do, and strategic investors can do, but will keep for themselves. First, it will examine the Company’s development prospects and confront them with the plans of the entrepreneur and the management board. This is very important knowledge. Secondly, the fund will introduce a system of monitoring the company’s results, which will give the management board and the supervisory board/co-owners a better understanding of the direction of development, and warn of possible turbulences. Thirdly, using the knowledge and contacts of its team, the fund will help optimize the company’s operations. Fourthly and lastly, because private equity funds usually invest for 3-5 years, the fund will conduct research among potential buyers in order to best sell its shares and, often, also the shares of the co-owner.

If it’s so good, so why is it sometimes bad?

Americans call it “managing expectations”. Both the entrepreneur and the fund make the transaction on the assumption that both sides contribute certain values. The entrepreneur brings in a well-functioning company with good growth potential, while the fund provides capital, the ability to professionalize business operations, and the ability to sell it in a few years.

Problems begin when, on the one hand, it turns out that the entrepreneur did not tell the full truth about the state of their company, about the abilities of the management team, or about their own plans to withdraw from the business earlier than the fund had initially thought. On the other hand, funds also sometimes tend to promise full entrepreneurial support, at times exceeding the capabilities of their small teams that supervise several or even over a dozen portfolio companies.

And here we get to the heart of the matter. An entrepreneur going public will never really know the plans and opinions of their investors, represented by professional advisers. By selling a part of their company to a strategic partner, they will never know who really makes decisions regarding the Polish market and their company. In the case of a private equity fund, however, the entrepreneur will get to know their co-owner and work with them. This person will also be an investor in the fund and their remuneration will depend on the value of shares in your company on sale. So you both have the same motivation.

And if it turns out that you often argue about budget implementation, hiring a new sales director, or not performing another acquisition, that you think is necessary, while working with a private equity fund, and the fund says it will be cheaper to do it differently, it means one thing. That your marriage of convenience is working because you are both building the value of the company. And this is what you wanted.

Author:
Andrzej Mierzwa – Managing Partner of the 21 Concordia Private Equity Fund, a collaborator of the Warsaw University of Technology Business School.

Last Updated on October 28, 2020 by Łukasz