The How-To: Building Fruitful Relationships Between Entrepreneurs And Private Equity Firms
When it comes to the relationship between entrepreneurs and private equity (PE) firms, it is, more often than not, tensed and tangled. On one hand, we have entrepreneurs that aspire to become the next Bill Gates, and on the other, we have the reality of PE firms fighting over control of the companies they invest in, and eventually alienating the founders. In between the two scenarios lies a hazy area of conflict that transcends into admiration with time. This dilemma stems originally from an inner conflict within the entrepreneurs themselves: they are trapped between turning their innovative ideas into profitable businesses, and maintaining control over these businesses at any price. Until the two parties find common ground between them, entrepreneurs won’t be able to realize their dreams, while PE firms won’t be able to facilitate the path to those dreams.
Entrepreneurs live by a belief that goes something, like, “I came up with this revolutionary concept, and I’m the most suitable to manage it.” This belief is true at the initiation of any venture, since the entrepreneur is the concept generator, and he/she is fully aware of the market needs for this concept. The entrepreneur is also the founder of the first business environment of this concept by employing a team and forming an organization at its early stages. It is this strong level of involvement and commitment that makes the entrepreneur deeply attached to his “baby,” and be willing to sacrifice time and income just to see his dreams of future wealth and leadership materialize.
Not long after setting up their establishments, entrepreneurs start to realize that their passion, commitment and financial resources are not enough to lead these establishments. Once the first product of the organization is launched, entrepreneurs find themselves in front of a new business challenge. It’s a challenge that requires a completely different set of skills than what was needed for innovation, and requires an environment with a high level of managerial and administrative skills in marketing, financial planning, customer services and corporate governance- most of which are lacking in most first-time entrepreneurs. It is at this moment, entrepreneurs start looking for outside investors starting with friends and family, moving to angel investors, and eventually entering the domain of PE firms.
It is very natural for entrepreneurs and PE firms to start off their relationship on the wrong footing. After all, entrepreneurs initially view PE firms as having a completely conflicting agenda to theirs- they think PE firms are expected to acquire a substantial stake in the business at the lowest possible valuation, they will seek to influence decision making, they want to attempt to control any major spending on manpower or capital items, and they will overburden the business with debt. These expectations push entrepreneurs into the “stay alert” mode, and make them wary of dealing with PE firms. However, reality forces entrepreneurs who seek to substantially grow their business into one of two directions- either shake hands with a PE firm and take the challenge of working within their system of high-risk high-reward, or insist on being the “kings” of their home turf and risk getting stuck in the minor leagues, if not striking out altogether.
PE firms as plenipotentiary investors
Once entrepreneurs decide to work with PE firms, these companies engage in a long process of restructuring the business, corporatizing it and infusing it with as much efficiency as possible. But this process tends to add fuel to the fire in terms of the relationship between these two entities- at least until positive results start to show up. It is only then that entrepreneurs start truly appreciating the role of PE firms in taking their dreams closer to reality. But until then, many businesses along with their entrepreneurs keep challenging the efforts made by the newcomer in their midst- the PE firm. The main areas that usually result in serious challenges can be categorized into three groups:
1. Organizational restructuring
Entrepreneurs start off their dreams as a one-person-show effort, more than a structured set of processes. This is where PE firms contribute immensely in transforming individual entities into profit-seeking corporates through:
• Introducing governance structures for a board of directors that address nominations, evaluations, remunerations, and resolving any conflicts of interest for board members
• Setting clear guidance on investment policies and risk tolerances
• Introduction of periodic monetary as well as operational performance reporting systems
• Evaluation of executive management’s performance against a set targets, and deciding on appropriate compensation programs
• Introduction of operational manuals for different divisions of the business and proper distribution of responsibilities
We at First Equity Partners have had a rich experience in this area. We are present at the boards of all the companies under our management, and we are actively pursuing corporate governance programs at these boards. We have also introduced comprehensive reporting systems at our managed companies that range from monthly, quarterly and annually keeping us on top of both the operational as well as the financial performance of these companies.
Preparing tomorrow’s entrepreneurs and management teams
Entrepreneurs often refuse to face the reality that their skill set does not match the needs for growing their businesses to the level they desire. It is this deficiency that makes them seek the help of experts such as PE firms. The other side of the story is where PE firms start grooming a second line of management. This grooming process has an economical as well as an ethical angle to it. PE firms make it well known to all parties that they are not seeking to become a permanent investor in the business, and thus will ultimately seek an attractive exit at some point in time in the future. Once an exit event takes place, PE firms need to prove that upon their departure, the business can function just as efficient as it had under their management. This can only be proven with a second line of management that is trained, equipped and exposed to the challenges of decision making.
We at First Equity Partners have allocated extensive resources to setting up a second line of management in most of the companies under our management. We have even gone beyond that by liaising with higher education institutions to nurture several graduates through an entrepreneurship program that could produce a new breed of young and talented individuals who can one day, in the not so distant future, lead world-class organizations.
Entrepreneurs sometimes turn to PE firms when they face financial difficulties or when growth stall. Both of these scenarios could be linked to management style. To make a change in these areas, a change in management might be required, and PE firms are ready to take such harsh decisions even if the change entails limiting the entrepreneur’s role to the Board of Directors and assigning their hands-on management roles to new executives. This is why many PE firms insist on acquiring a majority stake or a blocking minority in order to enforce decisions.
Entrepreneurs set up their businesses with a certain approach towards work ethics, work execution and personal interaction. As PE firms come into the picture and start to bring a change, resistance heightens from employees loyal to the founders. Cooperation in sharing information can be minimal, interaction with the PE management team can be unproductive, and commitment to new strategies can be half-hearted. If PE firms aim to succeed, they need to address this resistance, and win back the attention of their audience.
2. Financial Restructuring
PE firms use their financial size and vast contact network to secure competitive finance facilities for smaller entrepreneurs. In the last five years, First Equity Partners has arranged close to US$1 billion in debt for the benefit of our managed companies. This funding is essential in growing them to become influential players in their industries and markets.
Increasing revenues and controlling costs
Even prior to investing into the companies, PE firms thoroughly study potential options for increasing revenue and cutting costs. Once invested, they start implementing these strategies in an attempt to unlock more value. PE firms allocate resources to improve the financial position of their investee companies as they seek a future exit event at attractive returns. This is the key driver for PE to gradually start showing improved financial results. Over time, entrepreneurs start to appreciate the management style of PE firms.
Expansion through acquisitions
It is not uncommon for PE firms to seek mergers or acquisitions into competing or complementary business lines. Many PE firms step into investments with a vision of creating an industry leader born out of the amalgamation of several smaller businesses that share clear synergies among them.
Our experience in First Equity Partners, and specifically in the building materials sector, include the creation of a dominant industrial group in the GCC with formidable market position. This group was the result of several rounds of acquisitions of several smaller companies some of which were distressed and then ultimately operating them under a single vision and strategy.
3. Operational Restructuring
In order to achieve financial improvements, corporations usually require process enhancements and productivity improvements. This is an area where PE firms tend to put a lot of efforts trying to optimize the processes and increase productivity levels.
When entrepreneurs start to believe in the miracles a PE firm can achieve, and the business transforms into a successful venture, that’s the moment when PE firms decide to cut the cord. By all means, not all ventures are successful, and not all relationships end happily ever after. But there is enough academic research that documents the substantial value that PE firms bring to their investee companies. Entrepreneurship starts with a vision, but needs a lot of hand holding to be transformed into a successful reality. This is the true role of PE firms.