Equity firms hungry for investment opportunities but business owners must be cautious
With startling figures emerging about the contraction of the UK economy as a result of the lockdown implemented to limit Covid-19 infections, many businesses will be facing the toughest times in many years. According to the Office for National Statistics, the economy shrank during April by as much as 20,4%, April being the month in which the tightest lockdown regulations applied. Although the restrictions were eased from May, there’s every reason to expect that the poor economic figures will continue for some time yet. In fact, even prior to April’s lockdown, the UK economy was showing signs of strain. In addition, economists expect the downturn to continue during the April to June quarter as well.
The worst-hit businesses include pubs, firms in the vehicle sector, and those in the construction industry. Services make up a significant portion of the UK economy, and so a range of service businesses will be struggling to survive. Although restrictions on movement are generally seen as the major cause of the negative impact on various sectors, a fall in demand by consumers is also causing destruction, especially in the manufacturing industry which has at times experienced a loss of 75% per day.
Overall, it’s fair to conclude that those businesses that are thriving are few and far between – which creates unusual opportunities for investors looking for solid businesses to put their money into. More established businesses are likely to be looking for both injections of cash and e
xpert business guidance in order to weather the current economic storm and survive into the future.There is, in fact, a great deal of private equity money available globally, and the depressed economic conditions mean that the biggest barrier to deal-making – high valuations of businesses – is less of an issue now. These conditions are well summarised in the conclusion made by Euromoney that “Private equity has never been so cash rich. Assets have rarely been so cheap.”
Private equity vs pirate equity
These opportune investment conditions, however, also create a risk for businesses that are struggling and whose survival may mean that they need a significant injection of cash. As Bryan Turner, partner at private equity firm SPEAR Capital, explains, it is vital for such firms to be discerning about possible investors, particularly if they have been left economically vulnerable by the COVID-19 pandemic and associated down markets.
While private equity may be preferable to other options, such as expensive bank lending, for instance, businesses should go into such deals with their eyes wide open. Private equity may offer an attractive solution to a business looking to expand or which may need additional funds merely to keep afloat during a period of economic stress, especially where the investor can provide valuable strategic input. However, there is a very real risk that private equity could actually be ‘pirate’ equity.
Turner cautions that businesses currently feeling severe pressure could run the risk of jumping at any opportunity, especially if the investment is geared to offer a bailout in the current stressed economic conditions. “Be absolutely sure about the details of the investment and of the crucial elements of your business because this is the exact time when unethical investors could be preying on firms desperate for survival,” he warns. “Should the wrong type of investor come along, the business may find itself even worse off in the long-run than in the current scenario, since the wrong type of investor could lead the business into a situation of severe debt or carry out certain actions that would depreciate the value of the business over time. Understanding this in detail is an important first step in choosing the right investor for your company.”
In instances of ‘pirate equity’, where the focus of the investor is more on self-aggrandisement than on the well-being of the business or where they take a short-term view, the investor may end up dramatically cutting company costs to achieve quick returns, significantly harming the sustainability and credibility of the business over the longer-term. It’s also possible that the ‘pirate’ investor will take much-needed cash out of the business for personal use, money that could have been utilised for the expansion of the business. “Aside from the sustainability of the business itself,” Turner comments, “the security of employees’ jobs comes into question. In addition, benefits previously offered to workers may be slashed, which will not augur well for employee happiness or their commitment to the business.”
A suitable and ethical investor, on the other hand, should bring more to the deal than funding only. The right private equity firm will also provide numerous additional opportunities geared to assist the business, such as creating opportunities to attract new markets; increasing the pipeline of business, especially during slower periods; greater market penetration; added knowledge about the industry and the business world; and improving the features that give the business its competitive advantage; as well as developing systems and processes to run the business with greater efficiency.
How to avoid being ‘pirated’
Turner advises that: “A business looking for investment should analyse its long-term strategy – which may need to be amended to take account of the impact of lockdown – and then clarify how the investment will assist the business. A business needs to be certain of its rationale for raising capital, be it for liquidity, growth equity, a management buyout or even a combination of various reasons. Once this is fully understood, the business-owner or the executive team will be well positioned to identify the most suitable investor.”
He adds that a thorough due diligence process is crucial for a business to identify the right type of investor. “This applies whatever the motivation is for seeking an investment,” he says. “Due diligence must be carried out by both parties and, if there’s anything that comes up during the due diligence investigation which suggests questionable activities or dubious motivations by either party, proceed with caution. Or, in many instances, it may be advisable not to proceed at all.”
The focus should be on investigating and analysing the information at hand about the stability, size, track record and capital resources of potential private equity partners. Turner explains: “As the owner of the business – and possibly its founder – you need to confirm for yourself what elements you would be looking for in a prospective investor. Then decide on a benchmark for these elements which you can use to measure potential ‘suitors’ against. Keep records as you meet these investors, so that you have a basis for comparing them before you decide which one would be best for your enterprise.
“Having an understanding of a firm’s level of experience and success within your sector is important, as is having a clear picture of the returns it has been able to generate, for business owners as well as investors. For this reason, it’s advisable to assess the investor’s track record.”
When looking for an investment partner, the terms of the relationship between the two parties must be thought through well in advance. The founder of a business, for instance, is unlikely to want to give up management control – unless the individual’s personal circumstances dictate the need for this. The extent of operational involvement by the investor in the day-to-day activities of the business must be clear from the outset. In many instances, the private equity partner’s role is restricted to providing capital
Of equal importance, Turner notes, is agreement on the nature and working culture of the investment partnership. “It’s important to ascertain whether you’re looking for an investor who will be directly involved in the operation of the business, or an entity that will provide assistance without operational interference. Depending on the nature of the agreement, you may opt to leave the business’s management in charge of executive decisions and the day-to-day running, while the private equity partner concentrates on providing capital, consultation and a contact network.”
The right financial partner will bring with them a proven track record of success and will help to grow the company through mutual opportunities. Selecting the appropriate private equity partner requires thorough investigation and common understanding, with similar or clearly defined objectives in mind. Choosing a private equity partner reactively or hastily, however, is choosing the road to potential ruin – a scenario that no company can afford at the best of times, let alone in the midst of the current unprecedented financial crisis.