Private Equity Survival Guide Q&A: Critical Insights Before You Sell | An M&A Masterclass

I am Paul Giannamore. I’m an investment banker, and I negotiate for a living. In any given year, more than half the transactions we advise on tend to be with private equity firms. So today I thought I would take the opportunity to have a discussion with you, and I’ve put together a list of the most common questions I’d get from my clients with regard to private equity.

So let’s go ahead and dive right in. How do private equity firms use debt in ways that most business owners don’t? Every private equity firm is a little bit different with regard to their philosophy on the use of debt. Debt allows a private equity firm, or allows anyone, to juice returns, right?

The more debt you put on something, the more returns you get to invested equity. The issue becomes when something is so debt-laden, it becomes quite risky. I find that most private equity firms are still pretty judicious, at least in the middle market, with their use of debt. But private equity firms have the ability to take on far more debt than you do.

So for example, you own a middle market business, you might be able to take on one or two turns of EBITDA in debt, whereas private equity firms sometimes can get 3, 4, 5, 6, 7, 8 times EBITDA in debt. So I do think private equity firms have access to debt capital that you don’t, and are often willing to utilize it, but not to such an extent that I think it puts your transaction at risk.

What should I do if a PE firm starts re-trading on a deal late in process? Unfortunately, this happens. We over here have our own blacklist of firms, so there are certain private equity firms that we feel have played fast and loose with our clients, and we just won’t deal with that. I don’t think a lot of private equity firms do this on purpose.

I think it typically happens out of ignorance. And one of the ways that I see this happen most often is a private equity firm will enter a new industry. They’ll hire outside advisors, industry experts, to come in and help them assess a target company, and they’ll hear things that they don’t like, and they’ll attempt to re-trade.

I think some re-trading — this question really needs to be qualified, because the question is, what should I do if a PE firm starts re-trading on a deal, on deal terms, late in the process? Well, the answer to that question kind of depends on the why. If you’ve either misrepresented anything about your business, if your performance tanks after you sign an LOI, if your numbers are shoddy, you can expect to re-trade, right?

If you say, “I’ve got 5 million in EBITDA,” and they bring in outside advisors and accounting firms to test that, and there’s really 4 million in EBITDA, you should definitely expect somebody to re-trade. A strategic acquirer would re-trade just as a private equity firm would. You or I, if we were buyers, would re-trade.

We were expecting 5 million in cash flow and we’re getting 4 million — we’re gonna re-trade. What I find particularly distasteful, though, is private equity firms try to lock up deals and then re-trade for no logical reason post-close or post-LOI, specifically when it’s proved out, we’ve been forthright with our numbers and the qualifications of the business.

So what should you do? Well, I think it’s pretty simple for me. If they’re re-trading because you screwed up, that’s something you’re gonna have to face, and you’ll be able to make the decision whether or not you want to go through with the deal, right? If your EBITDA comes in short, you’re gonna have to make the decision.

Do I wanna reprice or do I wanna pull out completely? If their re-trading is underhanded, and they were trying to lock, drop, and roll — effectively lock up the deal, drop the price, and then otherwise roll out — if you didn’t acquiesce to it, then I think you play hardball, and you might end up walking away yourself.

What psychological tactics do PE firms use to get owners to accept lower offers? Now, this was an interesting question that I’ve gotten more times than I can imagine. I don’t really think that private equity firms use psychological tricks. I’ve had one guy ask me, “Hey, what sort of psychological tricks are they gonna use on me?”

I don’t really believe that they use psychological tricks. I think they use just standard seduction, really. A private equity firm obviously wants as much proprietary deal flow as possible. And what that means is they want to buy businesses that are not competitively shopped. They want to deal with business owners that don’t have an investment banker out there running a competitive process, because they’re gonna pay a much lower price.

And I think private equity firms are very, very good at kind of just the tip, right? They’re able to track you down via phone or email, or, “Hey, we’re just in the neighborhood. Why don’t we stop by? We’re interested in your industry. Let’s just — we’ll take you out to dinner just to talk.” A lot of times they’ll approach people obliquely, like, “Hey, I’m not necessarily interested in your business, but we’re interested in the industry.

Let’s have a glass of wine, let’s have a steak, let’s talk about this. Maybe we can use you as an advisor at some point going forward,” or so on and so forth. And over time they develop their relationship with you. And then, of course, now you’ve got some investment in the process with them.

You’ve built a relationship. You get to the point where you might have signed an NDA, now you’re sharing information back and forth. You feel comfortable with them, they feel comfortable with you. If you now come to the point where you want to turn around and sell your business — let’s say you’ve spent a couple of months talking to a private equity firm.

They’ve spent a lot of money on you. They’ve taken you to the Knicks game, they’ve taken you out to dinner. You’ve shared some numbers with them, and they proffered an offer that you thought was decent, but you could do a lot better. You might be very hesitant to go out and run a formal process. You might be very hesitant to start talking about other private equity firms.

‘Cause you’re gonna feel like, “Hey, they’ve invested in me, I’ve invested in them, I might offend them.” And so I think sometimes people can slowly slip and slide into a deal that they don’t want to be in, quite frankly. And I’ve seen it happen. They get calls from people that find themselves in that position and say, “What should I do?”

So, again, I don’t know that they use psychological tricks and tactics. I just think they use common sense and seduction to try to get business owners to not deal with any other buyers. And, “Why hire a banker and pay a banker, and why talk to other private equity firms? No one can pay more than us.” And you end up signing away your business for probably a lot less than you ultimately could have gotten for it.

So you need to be cognizant of that. What’s the timeline for a typical private equity investment — multiple years to a few months? If you’re tooling around with a private equity firm on your own, you might have a very long horizon. You might have a long kind of mating dance with them before you consummate.

But typically, when you get serious with a private equity firm, particularly in a formal process, anywhere between three and five months is pretty much what it takes to get a deal done. What should I do if a private equity firm reaches out to me? Now, this is a question I get every single day, because our clients always have private equity firms reaching out to them directly.

And, of course, I’m gonna answer this like I would answer any one of my clients, which is, “Hey, just forward the email.” You can reply to it if you want the private equity firm to know that you’ve hired an advisor. You can reply to the email and say, “Potomac’s my advisor, here’s their contact information.”

That’s one way to handle it. The other way to handle it is, you can ignore it, right? You’re not compelled to answer anyone. And number three, you can just forward the email to us, and we’ll be in contact with them in the appropriate time period. That’s how I would deal with clients. For those of you out there who are not a client and don’t have an advisor and say, “What should I do if a private equity firm reaches out to me?”

Yeah, I mean, that’s kind of your decision. If you wanna meet with private equity and kind of understand their world and how they operate, I don’t see a problem in meeting with them. If you’re actually considering a transaction, I would probably advise you to get yourself an advisor. Don’t meet with the private equity firms, and wait until you get your plan put together.

When I talk about this in the private equity masterclass — you want to be in the driver’s seat. You don’t wanna take a passive approach to this. So instead of fielding inbounds from private equity firms, you should determine what it is you wanna do with your business, when you want to exit, how you’re gonna create value, what sort of firm you want to partner with, and then go out and hunt for the appropriate parties.

And I’ll use the example — it’s like, you don’t often answer the call from telemarketers selling all sorts of nonsense, like a vacuum or a pool cover or whatever, and say, “Oh yeah, you know, I’m looking for a vacuum. I’ll buy it.” No, you find out what vacuum you want, you read reviews, you talk to people, and you go out and buy it.

Now, I know selling your business isn’t the same thing as buying a vacuum, but you get the point. What are some of the key factors in determining the valuation of my company? Now, of course, there’s a lot of consistencies in valuation methodology from company to company, but there are some nuances in various different industries.

I would say at its core, private equity is a cash flow buyer. A lot of you guys out there own businesses, and there’s a lot of rules of thumb related to revenue multiples, irrespective of what industry you’re in. But industries that tend to have recurring revenue, right — software, SaaS, pest, lawn, whatever — tend to focus a little bit more on revenue multiples than they should.

But at the end of the day, cash flow always drives value, not revenue multiples. And private equity firms are cash flow buyers. Key factors in valuation — valuation is inversely related to risk. And so if you can think about all the factors that increase risk in your business, if you can de-risk the business, you’re making it more valuable.

Obviously, cash flow drives valuation. So the greater the cash flow is, and the greater or the faster that stream of cash flow is growing, the more valuable the business will be. What kind of diligence can I expect from a private equity firm? Significant. Private equity firms are in every industry now, and there’s a lot of ’em that are entering new industries every single day.

And a private equity firm that’s entering a new industry tends to do a lot more diligence than private equity firms that are currently operating in an industry, because the new entrant not only needs to make sure that the asset it’s buying is what the seller said it is, but they also have to learn about the industry and how that particular asset fits in the industry, and what sort of acquisition opportunities exist, and so on and so forth.

So, but at its core, you can expect diligence to be focused on accounting and finance. Let’s understand what revenue is, let’s understand what cash flow is, and let’s make certain that what the seller is telling us is true. So we’re gonna bring in outside advisors to deal with that. There’s legal due diligence, right?

Making sure there’s no lawsuits, or understanding the implications of whatever existing lawsuits there are. Making sure that you actually own title to the asset. There’s operational due diligence. How is the business organized? How is it structured? How does it operate? What’s your org chart look like?

How are team members incentivized? What’s the comp structure? How is it harmonized? There is a ton of different work streams in due diligence for any transaction, private equity or otherwise. Private equity, though, tends to be a little bit more difficult, I think, for a lot of sellers than strategics.

But I never really think about the complications of an intensive due diligence session swaying me from whether or not I would do a deal with an acquirer, right? I mean, penny-wise, pound-foolish to think that way. How much control will I have after taking on a private equity investment? Now, this kind of strikes at the heart of what sort of an investment was it.

Is it a control investment? Just by definition, the private equity firm will have control, right? If they own a majority of the business, they will have control. From a minority perspective, if they’re investing in buying a minority stake in the business, now you will have control, but you’ll sign a document that has consent rights on it, and you’ll hand over, or you’ll contractually hand over, some rights that would otherwise be yours as a majority shareholder, to the private equity firm.

Like, for example, you might see that you can’t make an acquisition without the permission of the private equity overlords. You can’t spend X amount in capital expenditures without permission. There’s a variety of different things that you would contract to, and those contracts are largely based upon the leverage you have at the table when you’re closing the transaction, and how

the rights and responsibilities between private equity and you impact the ultimate goals of both parties going forward. But I would say that that question is largely asked by individuals who intend to sell the majority of their business. So 60, 70, 80, 90% remain on as CEOs, and what they’re asking is how much control will they have?

And every private equity firm is different, and there’s a spectrum. Some will pretty much allow you to run the business exactly the same way you are today, and others will require dramatic change. And there’s everything in between. And so that’s one of the things you need to do, and there’s no one answer to this.

As you start getting out into the market and thinking about what it is that you want, you’ll be able to set yourself up so that the private equity firms that are congruent with your line of thinking will self-select. Can private equity help me grow my business faster? It’s possible, right? I mean, it depends upon what sort of resources and capabilities

you need. Do you lack capital? Like, do you have all these great ideas and a great business, you just need more money to capitalize on it? Yeah, they can certainly help you with that. Do you not really understand some of the dynamics of your customers, and you need some data analytics, and you need a chief financial officer, or do you need all sorts of capabilities?

Sure, they can help you with that too. There’s a lot of ways — look, private equity firms are in the business of buying businesses and selling ’em. That’s literally how they make money, right? They buy it for price X and they sell it for price X times three, or X times four, or X times five. So they are probably focused on growing your business more than you are today.

So yes, they can certainly help with that. Will private equity firms put my business in excess of debt? Typically not. We already talked a little bit about debt, so I won’t go back into that, but I think that’s often an unwarranted concern. Although it’s not entirely unwarranted — it should be considered, but I don’t think it should be a concern.

What rights do private equity firms typically demand in a deal? Well, again, this goes back to the prior question. Is it minority? Is it majority? Again, for the majority of you, it’s gonna be a substantial or a controlled stake in the business, and they’re gonna have a lot of control.

They’re gonna be able to fire you. They’re gonna be able to replace you as a CEO. They’re gonna be able to change the board around. Now, they won’t necessarily do that if you’re performing, but they will have a lot of control over you post-closing. Make no mistake. What happens if I change my mind after signing a letter of intent?

I mean, look, some of you do, and when you change your mind after signing a letter of intent, you just write a letter that says, “I’ve changed my mind, and I’m not interested in moving forward anymore” — unless your letter of intent was binding. And I would be shocked if it were, unless you really did not get any good advice and signed a binding letter of intent.

For the most part, it will be non-binding, and either party can walk away. How do private equity firms exit their investments, and how does that impact me? This is a great question. Private equity firms buy businesses, hold ’em for 2, 3, 4, 5, 6, 7 years depending upon market conditions and how they’re growing the business.

Then ultimately, in order to make money, they need to exit their investments. They’ve gotta sell that thing, right? So some years after the acquisition — you know, back during the first part of Covid, when the equity markets were on a tear, in 2021, 2022, primarily in 2021, we saw a tremendous amount of exits.

And those exits took place at an expedited rate. So the hold period for private equity portfolio companies narrowed, right? So they would typically hold for five years; we saw a lot of holding periods for two years, because asset prices went to the moon and people exited. But I would say probably a good rule of thumb is five years for you to kind of think about.

And typically what they’re doing is they’re either taking the business public — and for most of you, that won’t be the case — but they’re selling it to another private equity firm, or they’re selling it to a strategic. So depending upon your line of business, if there’s a large publicly traded strategic acquirer in your industry, they might help you grow it, and then turn around and sell it to that strategic.

Right. You know, you might have a big — in your line of business, Home Depot or Lowe’s might be the big elephant in the industry, and they might be the type of company that buys it. Maybe Apple or Microsoft, if you’re on the tech side. Will I get a second payment after the private equity firm exits? Yeah.

I mean, look, your second payment, the so-called second bite of the apple, will be due to you in a successful exit, provided you rolled equity. Now, I don’t know what the percentage is, but there are a lot of deals that happen with private equity where owners don’t roll equity.

I mean, I would say the extreme majority of the portfolio add-on acquisitions — so say that you’ve got a private equity company that owns a big portfolio company, let’s call it, I don’t know, a big plumbing business, for example. And that plumbing company goes out and makes a bunch of smaller acquisitions.

Now, the owner of the portfolio company, the platform, likely rolled equity, right? He likely is a partner with a private equity firm in that business. The add-on acquisitions, some may have rolled equity, some may not have. I would be willing to bet that the majority of them do not roll equity. They were just a hundred percent change of control.

And if that was you, there’s no second bite of the apple coming for you. But if you rolled equity, if you’re a partner with a private equity firm, when they exit, you too shall exit. What happens if a PE firm sells my business to another investor? That’s certainly their prerogative. If they’re majority — again, I’m talking about a controlling stake — that’s their prerogative.

They can do that. And if they do that, you would likely just get paid out at that point in time. Depending upon what the agreement says — you’ll likely have a shareholder agreement or an equity participation agreement — you might be agreeing upfront to roll equity should they sell to another investor.

Something you gotta look at. Your agreement might say you get paid out in full should they turn around and sell all or any portion of the business. So pretty much anything in life can be contracted to, and that’s why it’s really important to pay attention to these documents. What if I wanted to exit earlier than expected?

Well, again, this is one of those other contract questions. More times than not, you’re kinda shit outta luck. You’re waiting until they exit. Now, there are opportunities for you to put equity to them, which effectively means you could sell that back to them at a predetermined price. I’ve seen that happen.

Again, it depends upon how you contract for this, which is why it’s very important for you to have a sophisticated banking team and a sophisticated legal team to guide you and direct you on this. How can I ensure I get the best possible deal when exiting to private equity? I would tell you that if you’re contemplating selling a majority stake in your business, you would run a formal sell-side process, bar none.

That’s what you would do. If you were selling a minority stake, right — if you were selling a small portion of your business — you would probably skip that formal process and do it more kind of one-on-one. But yeah, I mean, the best way that you could do it is run a competitive process. Don’t be the bonehead that answers the one email from the private equity firm and says, “Yeah, I’d like to sell my business.

I’d like to partner with private equity,” and then do a deal on their terms. No, you take control of the process and you run it yourself. And if you have any questions on that, I go into far more detail on our sell-side masterclasses. We’ve done two of them thus far, and in the description below, we’ll put a link to that playlist so you can get to those.

I would watch those. That’ll tell you exactly how you can sell your business on the absolute best terms. So the last question here — I got a call from a guy about four months ago who said to me, “Paul, what’s the best way I can create a sense of urgency without looking desperate?” I said, “Well, so what are you asking me here?”

He said, “Well, look, I’ve been dealing with a private equity firm for a few months. I really like these guys, and I think they’re willing to put a pretty big offer on the table. They’ve said as much. We’ve had some dinners, we signed an NDA, we traded some numbers back and forth, and they keep telling me that the offer’s forthcoming, although it just doesn’t show up.”

“And so I wanted to give ’em a call and say, ‘Hey, should we get off the pot?’” And, you know, me as an advisor, I look at that and say, I would never wanna be in a position of just dealing with one buyer. It didn’t make sense to me, and I explained it as such. And subsequent to that conversation, he ultimately engaged us, and we’re gonna be taking that business out to a formal process.

And he handed off the contact information to me, that private equity firm, and we gave them a call, and the private equity firm wasn’t nearly as interested in the business as he had thought they were. And, you know, sometimes I think this might be sellers projecting desire. But in this particular case, I do think that they kind of strung ’em along.

I think that they talked some big numbers, talked a big game, didn’t ultimately produce the offer — which, of course, happens sometimes. I mean, this is deal making, you’ve gotta expect this, so you can’t take it too seriously. But when we had the conversation with the private equity firm, they just said they’re not interested in moving forward with us in a formal process.

So that shows me their level of interest. Thank you for joining me today as I discuss my clients’ most common questions regarding private equity. If you’ve got any questions, feel free to reach out to me directly on the contact form in the description below, or join me on LinkedIn. My name is Paul Giannamore.

Thank you for joining me today, and I’ll see you on the next one.