As a business owner in the lower middle market, it’s vital to keep your options open when it comes to funding your business. One such option is private equity groups (PEGs).
This article will walk you through everything you need to know about PEGs, including the different types of private equity groups that exist in the lower middle market, how these groups work, and the advantages and disadvantages of pursuing one for your business.
What Is a Private Equity Group?
In broad terms, a private equity group is a private company (typically structured as a limited partnership) focused on investing in companies for profit. The most common examples of PEGs include private equity funds, hedge funds, angel investors, and venture capital firms, though these groups don’t necessarily operate in the lower middle market — that is, businesses that have between $2 million and $25 million in annual sales.
Private equity firms provide businesses with working capital that’s necessary for things like:
- Research and development
- Restructuring operations or management teams
PE firms work with businesses that meet their investment strategy or with companies in which they see high growth potential and likelihood of a strong internal rate of return (IRR). Rarely do PE firms branch into new markets. They tend to have a niche or a clear-cut vision of the type of investments they are seeking.
While many PEGs jump at investment opportunities when startup companies are looking to raise capital during early-stage fundraising, others prefer to invest in mature companies with a strong track record. As a business owner in the lower middle market, PEGs can be a potential buyer for your company.
What Types of Private Equity Groups Exist in the Lower Middle Market?
Although groups like hedge funds and venture capitalists are some of the most common types of private equity investors, they’re not necessarily the ones that exist in the lower middle market, as their private equity strategies are typically not a match.
Venture capital funds, for instance, tend to focus on public companies that have gone through an initial public offering (IPO), or those who are preparing to enter the public market. They may also provide debt financing in exchange for a minority stake.
Providing this equity capital improves the company’s cash flow and valuation as they prepare to be listed on stock exchanges. The investors are limited partners who don’t always desire to have much of a role in the day-to-day operations of the company.
Also not common in the lower middle market are leveraged buyouts (LBO), which take place when a smaller company is acquired using borrowed money. The borrowed funds typically come from banks or in the form of mezzanine financing. Various asset classes from the acquired company may be used as collateral.
The private equity strategy behind an LBO is typically to take a public company private or to spin off portions of a large company. These often don’t exist in the lower middle market, which is why LBOs are not common in this space.
Instead, the PEGs that typically operate in the lower middle market are:
- Operationally-Focused PEGs
- Family Offices
- Search Funds
These three types of PEGs can be a particularly great option for companies that have the potential to scale quickly with more resources, whether that be both capital or more sophisticated management expertise.
Working with a PEG allows you, as the owner, to have a partial exit. The PEG may take over the general operations of the company and will often sell the company in a few years after growing it and increasing its value. At this point, you as the owner would have a full exit and a second payday, commonly referred to as the “second bite of the apple.”
If you’re a business owner who has not yet reached the point where you’re ready to leave your business ASAP and would still like to be involved somewhat in building the company, then partnering with a PEG could be a viable option. You’ll be tied to your business for some period of time after your sale, both from a financial and operational perspective.
PEGs focused on operations see the opportunity for improving a company based on the state of its current operations. For instance, the PEG may see that you have strong assets in place and a diversified customer base, but that your current management structure is holding you back. Perhaps you’re understaffed or need more expertise to take your company to the next level.
That’s where Operationally-Focused PEGs come in. These firms offer growth capital, also commonly referred to as expansion capital. The funds are for mature companies that need assistance expanding or restructuring. They provide professional resources to implement growth strategies and improve your operations.
Family Offices are PE funds that represent high-net-worth individuals. They operate as a bit of a hybrid between venture capitalists and angel investors. Family Offices do not have as much cash as institutional investors but do tend to have more than angel investors.
Family Offices tend to also be more focused on strategy or a company’s specific mission. The high-net-worth individual who the Family Office represents may have mandates in place about what industries they can invest in.
Search Funds are a type of PEG in which an entrepreneur — or team of entrepreneurs — seeks out one company they want to run. An example would be a young, hungry individual who wants to build a company but does not necessarily have a strong idea to build around.
This person (or group) brings other things to the table, such as an entrepreneurial or creative mindset. The team of investors may add your company to their portfolio and trust that the entrepreneur they’ve backed will grow it by stepping into the owner’s shoes and assuming the CEO role.
The entrepreneur raises funds from investors and then seeks out — searches — for a company that’s a good fit. Search Funds are different from Family Offices, in that the latter is typically sponsored by an individual with a high net worth who is looking for a growth opportunity. On the other hand, a Search Fund is an individual who doesn’t necessarily have a high net worth but is backed by investors who’ve added your business as a portfolio company.
What Can You Expect During the PEG Process?
Selling to a PEG is much like selling to any other type of buyer. There will be an initial phase of negotiations where both sides agree to enter into a deal. The purchase price will also be discussed during this time and a Letter of Intent will be signed. At this point, negotiations will intensify.
There will be a due diligence stage where the PEG will be able to view sensitive financial information, like your tax returns, incomes statement, and balance sheet. Further discussions will take place, such as your payout schedule and any management fees that you’ll receive for staying on board. From there, the two parties will sign a Definitive Agreement.
It’s critical to be clear about your goals as a selling owner when talking with a PEG. Similarly, PEGs have their own investment criteria and metrics they need to meet. Selling to a PEG is all about fit.
You should also remember that PEGs are professional business buyers. They are quite experienced and do this for a living. They will not invest in a company if they don’t think they’re getting a fair deal or will have a strong rate of return.
As such, it’s crucial to surround yourself with a strong team during the negotiation and selling process. Having a team of trusted advisors can help you navigate the sales process and ensure your best interests are protected. Your team can also help close the valuation gap, which can slow down a deal if not derail it completely.
Consider PEGs as a Source of Funding for Your Business
When it comes to selling your business, you have many options. One choice to consider is private equity groups. Though traditional private equity firms like venture capitalists don’t work in the lower middle market, the three types of private equity firms that do are Operationally-Focused PEGs, Family Offices, and Search Funds.
PEGs could prove to be a fruitful partnership, allowing you to maintain a somewhat active role in your company while others work to grow it. In this relationship, both parties have a vested interest in seeing the business succeed. That’s one of the main reasons why it’s important to select the right PEG when selling. Putting a trusted team of advisors in place can help protect your business interest and ensure you secure a deal that benefits you.