One of the main premises behind a Private Equity Group (PEG) acquisition is to use debt to amplify the returns on the equity portion of it.  In layman’s terms, equity is the down payment the PEG makes for an acquisition while the rest of the funds are provided in the form of debt from banks and other lenders.  Typically, the down payments represent 25% and 50% of the value of the transaction.  By owning the business while simultaneously paying down the debt, the equity portion of the investment becomes a much larger percentage of the value of the business, usually yielding annual rates of return to equity of 25% to 30%.  As a result, PEGs often triple the value of their original equity investment. If the firm is growing, these returns become even better because growth allows debt to be paid more quickly while also improving the company’s underlying value.   Therefore, the degree to which opportunities for growth exist is one of the more important criteria a PEG needs to understand when evaluating any acquisition.

What do PEGs wish to know about growth?

If revenues aren’t growing, can a growth strategy be developed?  A strategic plan that yields even moderate growth rates of between 5% and 10% will provide for much better returns on equity over the hold period of an investment.

Does the business have the management in place to sustain or execute a growth strategy?   Whomever remains with the company post transaction will play an important role in maintaining a company’s growth or in executing a growth strategy.  PEGs want to make sure they are capable.

Is the revenue high quality?  Is it recurring or based on proprietary products and services that are protected?  It is no good to have a growth strategy that is not sustainable in the long run.

Any firm that satisfies these criteria will play to a PEG’s most basic investment thesis.  Given that the private equity community now plays a dominant role in the lower middle market transaction space, owners need to understand this to tap this large pool of buyers.  Expected multiples from a growing business could be:

  • Businesses with adjusted Ebitda between $1 and $5 million are 4.5 to 7 times.
  • Business with adjusted Ebitda between $5 and $10 million are 5 to 8 times.
  • Businesses with adjusted Ebitda of $10 million plus are between 6 and 10 times.