What Kinds of Target Firms do Private Equity Firms Seek?

Ripe-Cherries

Satu Teerikangas
Senior Lecturer in Management at University College London


Welcome to the final blog in a four-part series exploring and understanding the human dynamics in private equity buyouts — presented in conjunction with the change management consultants pmX — and based on the research findings from an academia-industry partnership between University College London and Mercuri Urval International.

In last week’s blog—The Human Side Matters – Has the Private Equity Sector Cracked it yet? — I discussed how senior private equity professionals rate their own sector in regards to its ability to facilitate and manage the human side of buyouts.

In this blog, I’ll discuss the type of target firm that is ripe for a private equity buyout: One of the critical success factors in buyouts relates to the quality of the purchase process: private equity firms need to be able to buy the right target, in the right industry, at the right time and at the right price.

Insight #1: Seeking excellent and unique companies

PE houses analyse target companies with meticulous detail. Nevertheless, the interviewed senior professionals highlighted the trickiness of adhering to exact purchase criteria. Whilst these might be published for purposes of external communications and positioning vis-à-vis competition, interviewees concurred that they seek “excellent and unique” target firms with potential that the PE house is able to exploit.

The question of whether PE houses should maintain fixed purchase criteria was raised. In many instances, though published, criteria are likely to be flexed from one case to another, one sector to another, and moreover, be person dependent, in that each partner operates with different criteria in mind.

Insight #2: Targeting different market segments

Instead of seeking set purchase criteria, it is important to observe that PE players operate in well-defined niches. In terms of their focus in buyouts, PE players were found to differ in terms of their:

  1. Focus on one to several industries.
  2. Focus on one to several countries.
  3. Focus on certain types of buyouts.
  4. Focus on deals of a certain size.

Within their respective country, industry, buyout, deal size and purchase focus, PE houses operate with different criteria of purchase.

Insight #3: Purchase criteria

Despite these differences, we observed a generic set of purchase criteria, emphasized across the interviews. These consisted in the following:

  1. What are the opportunities and the potential in the sector? How does the sector operate, what are its dynamics?
  2. The company that is the target of purchase needs to be well understood. What is its position in the industry and the value chain? What is its geographical location? What kinds of growth prospects are in sight? What are the strengths and capabilities in the company? Is there room for transformation, non-linear development, improvement, scalability? Does the company represent complexity that the PE house can help reduce?
  3. The deal’s potential risks need to be assessed, e.g. in terms of market or political risk.
  4. What value added can the PE house provide to the target firm?
  5. Can minority or majority ownership be granted? Is financing available? What deal structure to go for? How ought the parties be incentivized?

Insight #4: Active management teams are sought

In addition to these strategic and financial considerations, human considerations in the criteria of purchase relate to seeking excellent management teams on the one hand, and great, best in class, driven cultures on the other hand. We look at these next.

Interviewees agreed that the quality of management combined with a good mutual relationship was a central purchase criterion. ‘Good’ to ‘great’ management teams were described as exhibiting ambition, vision, drive and proactiveness. These characteristics become critical for firms under private equity ownership, given the high ambition levels.

In addition, the relationship between the target’s management and the private equity house representatives needs to exhibit a strong degree of chemistry, a good mutual association, a high degree of trust, and also, alignment of interests and plans toward the future. These are critical elements, given that the ownership era is largely dependent upon the relationship between the owner and management. Thus, the early seeds of this relationship need to be sewn in the pre-deal era.

active_management

Insight #5: Two views on the role of organizational culture as a purchase criterion

As regards the role of the target firm’s organizational culture as a purchase criterion, we found two views. Depending on the purchase, the sought strategy, the industry and the buyout type, the role of culture as a purchase criterion differs.

The largest category consisted in PE houses that considered great companies to result from great cultures, see figure below. For these PE houses, culture is a purchase criterion. Deals might go astray or un-invested in, unless the sought culture was there.

When culture was mentioned as a purchase criterion, PE professionals seemed to agree that the type of company they were looking for should exhibit excellence (“a best in class mindset”), energy and drive, engagement as in motivation and passion for the profession and the organization being a “good place to work”, as well as a sense of progress in that the organization was ready to learn, develop and challenge itself and thus be also ready for a new owner.

organizational_culture

A second category of PE houses noted that culture was not a purchase criterion. Depending on the buyout type and industry, one can make good investments even into companies without great cultures. Investments into bankrupt or distressed concerns are an example, where a poor, sluggish and in part unethical culture might have prevailed prior to the purchase. Investments into traditional, slower and more hierarchical sectors might consider companies with potential, though with clearly slower, hierarchical and less ‘driven’ cultures.

Thus, the significance of organizational culture depends on the situation and plans for the company, as PE houses can reach their targets, add value and gain effectiveness in numerous ways.

If you are in the process of planning for a buyout, merger or acquisition, then prepare for project change success with this free guide: How to Beat the Law of Inverse Visibility: The Case for Deploying a Transformational Change Diagnostic by the change management consultants at pmX.