If you’re following Steve Jobs’ advice, you must know the risks to growing

A business owner was happily engrossed by his business and making a great deal of money. Inspired by a speech by Apple founder, Steve Jobs, however, his dream became to grow the company more. This CEO knew that he had the drive but worried about putting so much of his personal money at stake. He could not afford to take the risk, but nor could he go to the public markets at that stage. To help his company evolve, the CEO sold 75% of the company’s shares to private equity partners. They helped build up the staff, create systems, and identify acquisitions. Ironically, his 25% share ownership ended up giving him more financial return than if he had kept 100% to himself. How incredibly satisfying when the difficult course turns out also to be the best! Of course, if you’re following Steve Jobs’ advice you must know the risks to growing. One additional point—Jobs may have lost his spot at Apple for a decade but he says the company made it through that period due to the private equity financial partners in place.

Risk is relative. A medical device company wanted to launch a new product. As the owner knew it would cost $5M to bring to market, he weighed the risks. “Right now, I’m profitable. If all goes well, the product will grow my $10M company to $30M, with a cash flow of $1M. If it does not go well, I’m in the hole for $5M and it will take me five years to break even and get back to where I am now.”

Pass!

But private equity partners will be lured to the possibility of growth. They catch a glimpse of the big fish in the dark water and appreciate the gleam of its scales; they will pick up the harpoon and take on the struggle, bleeding from holding the line, facing unbelievable adversity to bring home the fish others can only admire from the shoreline. That medical device company’s CEO settled on admitting to the conservative nature of his personal and financial goals. “I built this business in my garage and now it has to fly without just me. Let’s get in partners and share the risk.” He got enough cash off the table to cover his retirement and compensate for all the hungry years, but he was still able to stay around to enjoy the new growth with the partners who brought valuable new skills—vision, contacts, and patient capital through the storm.

How to Take Advantage of American Capital Flooding into Canada

In terms of American private capital investors, the U.S. based industry is broadly comparable around the world. The typical private equity structure is 2/20, which means that the fund is structured as a 10 year partnership. The committed capital is provided by an institutional investor such as the Harvard Endowment. The fund managers draw down a 2% fee (used to keep the lights on) and are expected to obtain a 20+% gain over the threshold. In light of the Great Recession, the fee structure has been under much debate.

U.S. funds are able to leverage their U.S. industry experience to help Canadian companies expand their business footprint and help launch them into a market close to home before tackling the worldwide stage. Through an American fund’s U.S. pedigree, a fund can leverage their experience in the American markets to pick out the consumer market nuances and help Canadian businesses expand south of the border.

Many Canadians currently reside in the U.S. as professionals in the private equity industry. With Canadians on the inside of the U.S. based PE funds, there is a natural orientation to help out fellow Canadians and their companies by bringing capital to Canada. However, business owners beware; funds in Boston or Chicago are probably more likely to invest than funds in Houston and cultural fit is a factor that cannot be overlooked. 

What Do Canadian Entrepreneurs Have to Offer?

When the flow of credit to companies dried during the credit crisis, large companies cut expenditures in their Research & Development budgets and hoarded cash. Now that the general economic outlook has eased and companies are starved for innovation, business owners and management are now looking at ways of obtaining growth.

Canada possesses a legacy of strong returns and successful deals. Also, boasting the largest announced leverage buyout of our time.

As Canadians, we live in what is often called the “Great White North”.  Our neighbours to the South and the rest of the world have a common perception that there is less competition in Canada. This is a commonly accepted truth for private equity funds as the U.S. has a greater number of funds with larger capital base. However, there is currently no known analytics verifying the perceived lower level of competition.

Currently, Canadians can also boast about the strength of the Canadian economy. No banking system is fundamentally as sound as ours. Our education system and clusters of innovation across the country provide us with a talented and high calibre workforce. Our legal framework is also well developed to facilitate the growth in private equity. And with the continual “Brain Drain” to the U.S., we have Canadians working on both sides of the border.

As an added bonus, Canadian investments are not counted in “foreign” concentration limits for PE funds. Typically, in a PE fund’s investment mandate, the Limited Partner (“LP”) list restrictions in the types, size, risk level, etc. of investments. Such restriction may include the amount that a fund can commit to one investment opportunity (not >25% of entire fund capital) or foreign investments (not >25% of capital committed overseas). The advantage for Canadian companies is that North America is not treated as “foreign”. 

Private equity--Use it or Lose it

Use it or lose it. That is the choice faced by some buyout firms sitting on piles of capital they have raised but not invested. The firms are unlikely to give it up without a fight. That was the message I heard while visiting Boston last week and speaking with a large number of private equity firms. They definitely are stressing about finding good companies as the American market is over-served and seen to be saturated. The funds had been counting on Europe but now that is a big muddle. Australia is too far and the time distance burns out the teams. So that leaves Canada. 

The Wall Street journal's JOHN JANNARONE  explains the increased pressure in private equity investing which is good news for Canadian business owners.

A fund-raising arms race last decade was followed by a sharp slowdown in investments, leading levels of dry powder to surge. Such undeployed capital stood at a record $280 billion among U.S.-focused buyout firms at the end of 2009, according to research firm Preqin.

The catch is that firms generally agree to invest capital within five years or return it to investors. For some, the deadline is fast approaching. U.S.-focused buyout funds have $51 billion that must be used before the end of 2011, Preqin says. Another $213 billion needs to be invested by 2015.

Raising new money isn't that easy anymore. So, the worry is that firms will lower the bar on the quality of investments to ensure existing funds are put to work. One risk is that firms begin to chase after deals and overpay. 

Why Private Capital?

One of our clients was a Canadian domestic company with large margins and a solid customer base of Canadian banks was looking to enter the public markets.  This would have been a nightmare. The public market option is typically not ideally suited for mid-market companies, often lacking liquidity as investors lose interest after the initial public offering.

In addition to the high initial costs of an IPO, business owners must pay annual fees for audited financial statements and supply quarterly reports to their shareholders. There is often the conflict of interest in meeting short-term expectations with long-term growth plans. The initial sacrifice of payout to the investor should be rewarded with later value from the realized growth potential of the firm.

Furthermore, the lack of privacy of confidential information, once a company goes public, may decrease a company’s competitive edge as margins are disclosed to competitors, suppliers and customers, among other strategic information.

Private capital has the flexibility to meet a wide range of business owner needs, while providing privacy of confidential information and a long term outlook in realizing growth potential. A PE fund provides strong financial expertise to complement the management team. With no short-term external reporting requirements, management is able to better focus their capital on growth opportunities that add value to existing shareholders. PE funds assist in improving business operations through efficiency or by supplying expertise in exploring new markets for growth.

PE funds are also able to leverage their existing relationships with banks and lawyers to provide the business owner with access to a broader base of financing options than they had before. American private capital investors in particular are able to use their relationships with banks and lawyers south of the border to support investment opportunities in Canada. This provides a much larger pool for Canadian business owner’s to dip their toes in and Canadian business owners are no longer restricted to the kiddie side of the pool.

In amidst all the talk of PE funds building equity value, let me  emind the business owner that there is a lot of hype around adding value and that there is often the need to cut through all the clutter. Some PE funds are able to add tangible value to building the business through growth, others are more focused on cost cutting, and others are all about the hype.

It is also important to consider the decision making process as PE financing entails the addition of a partner. It is important to retain the rapid decision making that exists prior to the PE fund investor while incorporating the additional expertise of the board members.

An example of a “Homerun” investment for the Monitor Clipper Partners entailed a small Canadian investment in 2004. The founder owned 70% of a truly amazing business model and wanted to diversify holdings. The fund was able to dissuade the owner from listing on the public markets for the reasons listed above. Instead the individual sold half of his equity position to private equity investors, effectively taking money off the table. With the injection of working and growth capital, the business growth rate was accelerated. The 35% ownership structure and additional capital to turbo charge growth and expand the business footprint into the U.S., grew to become 75% of what the initial business value was, upon exit, three years later. For Monitor Clipper, this was their highest IRR on a three year investment and a Canadian investment to boot!