Navigating the path of equity funding

Graeme Smith, Managing Director of Corporate Finance at AlixPartners, discusses private equity funding.

AlixPartners has advised a number of companies on raising private equity funding. Graeme Smith, a Managing Director specialising in corporate Þnance, outlines some of the key considerations for business owners looking to take this step for investment.

Private equity (PE) is becoming an increasingly active investor in the foodservice, hospitality and leisure sectors. The investor industry has been attracted by the success and roll-out potential of the casual dining market for many years, but more recently has also been attracted to foodservice and hospitality businesses, such as Westbury Street Holdings, Vermaat and CH&Co given the fragmented nature of the market both in the UK and in Europe. PE investors are attracted by the success of previous investments in the broader sector, the defensibility of food and by the continuing strength and growth prospects of the sector’s most profitable operators.
Preparation

There are some fundamental questions that all owner-managers must ask themselves when they first consider bringing in new investors. The first is Ð is the business sufficiently differentiated, niche or special, when compared to the competition and in the context of the market? Prepare a clear articulation of why the business is different and what its competitive strengths are. These strengths should also be apparent through strong financial performance. In our experience a full-time Finance Director can be crucial to successful capital raising and serves to provide investors with confidence in the historic financials. Ultimately, the worst thing that can happen is for a potential investor to question the numbers in the business plan because of a ‘nasty surprise’ that emerges in the course of due diligence.

Develop an aggressive but supportable business plan

When working with entrepreneurs, we often talk about the need to present an aggressive but supportable business plan. It has to show a sensible balance between offering attractive returns to investors at exit and a realistic rate of growth. As a general rule, PE firms like deals that return at least 2.5 times their original investment. If the business plan shows that this level of return is only achievable by winning new business or opening new sites at an unprecedented rate it will likely be viewed as overly aggressive.

The team is all about the right people, in the right roles, to deliver the plan. Investors will review the current head office cost with interest and interrogate the business plan for the timing and cost of future hires.

Consider investment structure

Traditionally, PE money comes in via a new company specifically set up for the transaction. The majority of the capital is usually invested in the form of loan notes, which attract a fixed interest rate (coupon) that rolls up until exit or some future date. This approach helps de-risk the investment for the investor, as loan notes are paid out prior to any equity distributions. The benefit to the owners of ordinary equity in this structure is that value achieved in excess of the loan note value (including accrued interest) is all paid to them. If the business hits its plan this will typically result in returns to ordinary equity of many multiples of the original investment.

The key issue in any structure with significant amounts of loan notes is the interest rate rolling up on those loan notes. Loan notes typically attract annual interest of between 8% and 12%, and through compounding can materially increase in value through the whole course of the investment period.

Concluding on the split of loan notes and ordinary equity will usually be driven by risk appetite and strength of belief in the growth projections in the business plan.

Don’t forget tax – take specialist advice

In any M&A transaction tax invariably plays a big part. In a PE transaction it comes into even sharper focus as you need to consider personal as well as corporate taxes. There are multiple technical issues that require expert input to successfully navigate. The ultimate objective of the process is to deliver an amount of money, whether today or at exit, into the ownerÕs bank account, and tax will play a huge part in determining that final figure. With this in mind, specialist tax advice is normally money well spent.

Legal considerations

From a legal perspective, the biggest issue that entrepreneurs face is loss of control. Recognising the difference between economic ownership and control is important and entrepreneurs need to go into legal negotiations with their eyes open. In exchange for investing a significant amount of capital into the business, PE investors will typically require several key elements of control to protect their investment. These include; Drag Rights (the investorÕs ability to ÔdragÕ other shareholders into a transaction to sell the business at some point in the future), Leaver Provisions (what happens to the shares of key managers who leave the business) and Investor Consents (consent rights on big decisions).

You need to ensure you use a lawyer who is experienced in PE transactions. An experienced lawyer in this field can expedite the process by striking a good balance between protecting the entrepreneur’s interests and adopting a pragmatic approach.

Choosing a funding partner

Put simply, this is the most important consideration when raising PE capital. The type of investor you select should be driven by the needs of the management team and the business. Entrepreneurs should ask themselves whether they are looking for an active investor that has been there, done it, and can add material value. On the other hand, you may feel that too many cooks spoil the broth and just want the cash. You will likely be working with the PE investor for a number of years so it pays to spend time picking the most suitable partner.

Conclusions

Bringing PE investors into a successful company often takes owner-managers way beyond their comfort zones, and is plainly not for everyone, or every business. But, for the right business and management team, it can deliver game-changing growth and has proved to be a successful strategy for a large number of businesses in this part of the market. Following the steps set out in this article will help you deliver the right deal for you and your business.

Disclaimer: The opinions expressed are those of the author and do not necessarily reßect the views of AlixPartners, LLP, its a.liates or any of their respective other professionals or clients. This article is the property of AlixPartners, LLP, and may not be copied, used or distributed to any third party without the prior written consent of AlixPartners.