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The Five Myths of Private Equity

By : Ziad K. Abdelnour| 15 July 2011
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I meet face to face an average of 500 entrepreneurs a year and I keep hearing the same question:

Why is every private equity fund with which we meet trying to take advantage of us?

I will be the first to admit there are some real predators out there looking for an opportunity to take advantage of someone in need of financial backing; however, I don’t believe there are as many sharks as the hysteria-prone financial press would have you believe. If there were, the investment sector would soon be shut down.

As venture capital and private equity continue to make news headlines, some entrepreneurs may find it challenging to distinguish fact from fiction. I always counter these challenges with three simple questions.

1. Do investors always win at the expense of entrepreneurs?
2. Are investors always out to wrest control from management?
3. Finally, is an investor’s sole focus on the final liquidity event?

Misperceptions can prevent an entrepreneur from making rational, fact-based decisions. During my twenty five years as an investor and financier, I have come to identify what I call “The Five Myths of Private Equity.”

The first is that private equity is a win-lose game. In this scenario, investors win and entrepreneurs lose. This is the favorite myth of people who are looking for someone to blame for their bad choices. They didn’t read the contract they signed, they were too lazy to do their due diligence or some other negative outcome occurred which caused them to lose control of their enterprise. They’re understandably angry, hurt and looking to place the blame on someone other than themselves. According to this myth, private investors somehow make off with the value of your company; perhaps buying at a low price and cutting you out of the eventual rewards that you’d earn from going public or selling to another company. The important fact to remember is that private equity investors only make money if the value of your company appreciates. It is also a fact that, in most cases, the entrepreneur retains a substantial interest in the business. After all, it’s in the investor’s best interest to help you grow your company and increase its value. So, by default, if the investor wins, the entrepreneur wins.

The second myth is that valuations are the only consideration when you’re shopping the deal. Valuation is certainly an important consideration. You want to get a fair price when you sell your company; however, it’s equally important to partner with an investor who shares your goals and who will work with you to achieve them. When you focus exclusively on valuation, you risk ending up with a partner who doesn’t understand your company, your growth strategies, or your industry. For example, let’s say you sell your company to an investor whose expectations for your business are unrealistically high. You may obtain a good price for your company, but that relationship is likely to sour as the business fails to meet the investor’s expectations. On the other hand, an investor with a more nuanced understanding of your company would work with you to increase its value in a realistic and sustainable way.

The third myth is that private equity investors don’t add value because they haven’t been in an operating role. This may be true in some cases, but should be avoided as a generalization. Most financiers and professional investors I know have ample experience with operating issues. Also, though they don’t usually try to micromanage portfolio companies; they can look at the operation from an objective perspective and add value by challenging management to think outside the box. Investors who have backed many different companies at rapid growth stages can recognize patterns that may not be obvious to the management team. They may have a network of relationships that can also assist companies in recruiting talent at the board and management level. They can often help companies explore strategic partnerships with other firms.

The fourth most common myth is the taking of venture capital or private equity money means you lose control of your company. This often refers to the sharks and other predators looking for quick kill and smelling desperation. It can also stem from a person who is so determined to get their idea to market that they will accept any terms offered. As an entrepreneur, you cannot abdicate your responsibility for the sake of expedience. Nobody is forcing you to take a deal and surrender control. I have found that the people who recount horror stories of how they had to take a back seat to an investor almost always did one of three things. They either did not contact more than a few investors or took the first deal that was offered to them or they sold more of their interest in order to gain access to some quick money.

The first instance is just plain laziness. The second is desperation. The third, more often than not, is due to the fact that the entrepreneur has exhausted all of his available resources and needs to cover the demands of his creditors.

The reality is that if you take on a minority investment, you can continue to control your company, make all operating decisions and having the ultimate say over strategic issues. It is my experience that the majority of investors do not want to run your company. They are busy running their own. Selling less than half of your company leaves you in charge, while providing liquidity to you and other early shareholders.

The last myth; namely that private equity investors are only interested in your exit strategy is one that ignores some basic realities about investing. When a private equity firm invests in your company, they do expect to exit their investment within the next five to seven years. Since the firm has limited partners who expect liquidity at some point, they can’t hold their investment forever. However, this doesn’t mean that you will have to sell your company or take it public. Alternatives might include recapping the company with bank debt, swapping out one investor with a new private equity investor, or raising capital from a strategic partner. In any event, your private equity partner has a vested interest in growing your company over the next several years up to the exit event. Their goal during this period is the same as yours: to increase the value of your company by expanding the business.

Whether or not to take on private equity financing is a complex decision, requiring in-depth analysis of your personal and business goals, the market environment, and the financing options available. Focusing on these important considerations and avoiding the more common misperceptions will help you make the right decision. It’s time to put the myths to rest.

Your feedback is as always greatly appreciated

Thanks much for your consideration

Comments

  1. RyanRyan

    Interesting thoughts. However, what PE firms do after they have made an investment is what ultimately leads to who will win- the entrepreneur or the investor. And when the investor starts to sense that he might lose, the investor uses its financial clout to change anything and everything that will bring the numbers back in line. And that is where most entrepreneurs lose out. In the end, it is all a massive game – who wouldn’t manage a billion or two on 2% management fees? Could 6 partners at a PE firm not live on $20 million?

  2. Prashant GahlotPrashant Gahlot

    Hello Ziad – Insightful, as always. Cranking up growth numbers, valuation models, strategic plans, etc. (themselves based on few ‘assumptions’) are only a part of the whole equation. However, in a less than perfect world in which we operate, may be the ‘soft’ factors which you highlighted differentiate a success from failure. My hunch is that not many people actually get it or even if they do, they haven’t mastered this aspect. This means only few smart ones win in this game and, rightly so.

  3. Doug FriedenbergDoug Friedenberg

    Ziad, Your comment is in line with something I wrote on my own website, link attached: http://jigsaw-capital.com/generalfinanceadvice/financingrules.html. I attack the problem this way: the entrepreneur looking for funding is generally unaware how the world looks to the funder, and he also doesn’t know that his deal is looked at in the context of HUNDREDS of other deals with equally optimistic entrepreneurs. I figure it can’t hurt to introduce the entrepreneur to the investor world view, and its own inherent logic. Deals are always easier to work out if, at minimum, you understand something about what the other guy’s motivation really is.

  4. Mark BraggMark Bragg

    The philosophy you espouse should be comforting to many entrepreneurs. It is rational, human and realistic. The environment today is more than challenging. Friends and family have stopped investing in start-ups because they are afraid of risk. The risks are much more than business risk. We face dramatic over-regulation of the small businesses that create new jobs while the regulators wonder why there aren’t any jobs being created. Until our government becomes more interested in our success than in their regulation of it, we will continue to see American entrepreneurs leaving the country to create jobs. Someone needs to explain this to our governmental masters.

  5. Nick T.Nick T.

    Assuming that both the both parties are looking to create a win-win situation – which you would think would have the most beneficial long term implications for both parties as a whole, where should the enterpreneur look to see and recognise that the PE funder really want to create a win-win situation, and not simply take advantage? It would help to explain this because it is often easy to spot a ripoff, but often less obvious to see where the PE Fund is indeed trying to create a win-win situation.

  6. Roman KiktaRoman Kikta

    Ziad, thank you for a most useful explanation which should be a must read for every entrepreneur! I’d also like to add that the value proposition of a Venture Capitalist goes beyond simply supplying money. Venture Capitalists have consistently added value to companies by working closely with entrepreneurs in formulating and executing strategies, business plans, including business development. I do believe we can succeed even in this challenging economic environment and despite the uncertainties of these times, we are inspired daily by the perseverance and the talent of entrepreneurs making headway in today’s business world. I believe true entrepreneurs will continue to persevere and Venture Capitalists shall continue to be at their side to help them succeed!

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