By SVenkat
All privately owned businesses are comfortable with the idea of borrowing from banks. Several businesses that have either maxed out limits with banks or find it difficult to raise traditional bank funding, raise funds from NBFCs. However, when it comes to private equity, business owners often struggle with how to make the decision to raise funding, what are the right valuations etc.
PE funding is an excellent financing option that has opened up for owners of mature SMEs in the last 20 years. While returns to PE funds are not guaranteed, a typical firm will expect IRRs in excess of 20 per cent. For sure, PE money is not cheap. But for entrepreneurs who want to scale up their business and want to cut time to scale, and are not able to raise debt funding, PE is a viable alternative.
Right Size
While there is no universal rule, most PE players in the market would look to invest between $10 million and $100 million. Assuming they take a minority stake of 30 per cent in the company, we are looking at a minimum Enterprise Value of $33 million on a pre-diluted basis. Assuming a business is valued at 10x EBIDTA, the company will have a minimum of $3.3 million of EBIDTA, and assuming a 12 per cent profit margin, a minimum revenue of $28 million (around Rs 235 crore).
The reason why PE firms look at a minimum size is that their efforts and costs involved in identifying the investment opportunity, doing the diligence, consummating the transaction and managing the investment are the same, regardless of whether the company is big or small. Also, most PE firms will target between 8-12 companies in their portfolios.
If you are an SME business owner with revenues of more than $28 million, PE funding is a viable, relevant and real financing opportunity for you. It is a good idea to start engaging with PE firms from the time you are about $20-$25 million; PE firms like to do transactions with companies that they know, have interacted with and have had the opportunity of tracking over say a 12-24 month time frame
Right Reason
PE firms provide growth capital, that is, they put money behind proven companies that need the ‘equity booster’ to expand their revenues, profits and enterprise valuations. It is critical for the owner and the PE firm to be aligned on the ‘why’ of the fundraise. PE money is high-cost, high-risk capital, and is best deployed in areas like new product development, new geographical markets, new distribution channels, new manufacturing facilities, acquisition of other companies in the same or related space etc.
Retiring high-cost debt and providing full or partial exit to current owners are usually not the right reasons, as PE firms like their money to be retained in the company and used for expansion, rather than giving an exit to banks or current shareholders. Using PE money for working capital is also not a good idea, this is best financed using bank loans
Right Mindset
Owners need to be clear that PE money is ‘active’ money and ‘informed’ money, that is, PE firms will have rights to regular data, participation in Board meetings, oversight into end use of funds, appointment of key personnel etc. Most PE firms will actively exercise these rights while allowing the owners to operationally control and run the company. This approach is very different from say Banks which only require periodic CMA data or credit rating updates.
The one thing that will change in the SME owners’ lives for sure, is that, post PE funding, there will be massive rigour on the pace of growth, improvement in quality of earnings, strong focus on profitability and cashflows and on building a professional performance culture. The reason is that PE funds look for exit within 3-5 years of making their investment. The owner needs to be willing to run at the same pace as the PE.
Owners should be comfortable with the notion that they will have an active financial partner who has a ‘seat on the table’ and will actively contribute to the growth of the company. Several owners like the money that the PE brings, but don’t like the oversight that comes with it! PE is a good option for SME owners who understand that it is better to have a smaller share in a bigger pie growing quickly, rather than the whole of a smaller pie that is growing slowly.
The PE market in India is mature, with over 500 active funds. The good news for SME owners is that there is no dearth of equity money for well-run businesses that have a good track record and have aggressive yet achievable plans for growth. Just remember that PE money is expensive and comes with strings attached. SME owners need to make a conscious decision between the trade-off of accelerated growth in enterprise valuations, on the one hand, and the cost of financing and controls exercised by PE funds on the other.
SVenkat is the Founder of performance improvement consulting firm Practus. Views expressed are the author’s own.
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