A New Breed of Private Equity Investors Present More Exit Options Than Ever for Entrepreneurs While traditional private equity investors invest three quarters of their capital in large companies, a new breed of investors are focusing on owner-led small businesses.
Opinions expressed by Entrepreneur contributors are their own.
In 1988, Jon Leonhardt dropped out of college. A few years later, he started taking on projects for insurance companies who were defending themselves against lawsuits. The process of requesting medical records was often a long, drawn-out process, so Leonhardt started taking his own copy machine with him and copying files his clients were asking for. This was the start of what became RRS Medical, which allows hospitals and other authorized users to request medical records in a secure and compliant way. Twenty years later, Leonhardt started thinking about exiting his business, but his options were limited. Leonhardt's story is all too common for entrepreneurs. But with the private equity investment model expanding, entrepreneurs are now finding more exit options for their business.
Why sell to begin with?
Leonhardt found himself stretched thin between RRS Medical, another business he had founded in an adjacent industry, about 70 investment properties and several restaurants. The medical records industry was going through a lot of change, with a stronger emphasis on digitization. Leonhardt was not sure he wanted to make the needed monetary, time and energy investments to bring RRS Medical to the place it needed to be in order to remain competitive.
Why small business owners have lacked attractive exit options
Entrepreneurs who've built large companies have little trouble finding institutional or strategic buyers. Owners of small and mid-sized companies don't have the same luxury. Although private equity investors pay multiples of 15 to 20 times a company's profits (EBITDA) to acquire large firms, they only pay multiples of five to 10 times for smaller companies. Entrepreneurs selling their firms to private individuals through business brokers or aggregate website such as BizBuySell often settle for multiples of two to four times profits. There are many theories around why smaller businesses trade for such low multiples, but one main argument is that they're subject to larger risks if a key customer, supplier or employee departs, while larger businesses can absorb these risks better.
How the private equity model is changing
Private equity firms are sitting on more "dry powder," or un-invested capital than ever before. The amount of dry powder held by private equity funds increased to $2.5 trillion in 2019, up from roughly $400 billion in 2000.
PE funds need to deploy capital to provide returns for their investors, and the current crisis hasn't changed that. My firm recently conducted a survey of over 100 private equity investors to understand how the public health crisis is impacting their investment decisions. The survey showed that private equity investors are reserving 54 percent of their capital for new investments. This is a slight drop from pre-crisis levels — when investors where spending 62 percent of their capital on acquisitions and investments —but not as strong of a drop as some might think.
One could easily conclude high levels of dry powder are good for small business owners exploring exit options. PE firms, however, are moving toward large deal sizes. Before 2000 nearly half of all deals were $100 million or less, but now only about a quarter of deals fall in this category.
A private capital model focused on smaller businesses
For all these reasons, Leonhardt was surprised when he received a call from Zach Perry, who expressed interest in acquiring his company. Perry was not calling from a small business broker, a private equity firm or a strategic buyer. Two years earlier, Perry had set up a search fund-backed entity with the goal of acquiring a company. The search fund model was invented at Stanford more than 20 years ago but is less known than private equity or venture capital. It typically involves one or two "searchers," who approach a group of family offices and ask if they would like to fund them for a two-year period while they search for a company to acquire.
From the searchers' perspectives, the model offers a great way of getting significant equity upside — and take over as the CEO of the company. The owner can feel more confident that the acquirer has the right incentives, as opposed to working with a deal team that hands off the company after the transaction. The model offers a great way for family offices to deploy capital without needing to build the large internal infrastructure that traditional private equity firms have.
Search funds also offer small business owners a new exit option. Companies acquired by search funds have over the past few years had median revenues ranging between $6 to 10 million, but companies with as little revenue as $2 million are typically also acquired under this model. And contrary to popular belief, 70 percent of search fund principals are not former investment bankers and private equity professionals. Most often, business owners are handing the keys to the company they've built to people with actual operating experience.
In many ways, Perry represents how the search fund model is expanding. In the early 2000s, 50 percent of searchers would start their search within a year of graduating from an MBA program, but that number now has dropped down to 25 percent. At the time it was also incredibly rare for searchers to not have gone to business school at all, but 19 percent of searchers now — Perry among them — start a search without getting an MBA.
The reason? Family offices have seen significant historical returns from the model and want to attract a broader set of entrepreneurs to start a search, not just those in MBA programs. And more family offices are getting in the game: The number of search fund-backed acquisitions has tripled in the past 10 years. Some private equity firms, such as Chicago-based NextGen Growth Partners, are now also utilizing the search fund model to deploy capital.
The new breed of private equity investors is providing small business owners with more exit options than ever before. That's a good thing for entrepreneurs, as they can focus on creating long-term value rather than short-term profits, which is what happens when they lack exit options.