Big Small Offers | Growth of the middle market
The novelty of private equity is not a new type of business or an innovative technology, it is a change of control. More and more sponsors are adding minority investments to their strategies as the competition for deals continues to intensify and the founders wield more negotiating power.
According to a recent Mergermarket survey, 98% of respondents in the private equity industry said they had taken a non-controlling stake in a company. Of that group, 85% said the level of minority transactions they conduct has remained constant or increased over the past 12 to 24 months. In some cases, GPs also choose to retain a minority stake when exiting a company they already have in their portfolio.
These data correspond to what Nicolas Stone, Managing Director of Cyprium Investment Partners, sees in the market. Chicago-based Cyprium specifically focuses on minority investments. “We have seen a number of GPs extend their investment strategies to include minority investments as an alternative,” he says. “I think part of it depends on how much capital is currently available in the market that needs to be used, and that may be a way for some sponsors to widen their funnel.”
Not all minority investments are the same. For example, sellers should not be confused that club agreements are necessarily minority agreements.
Chairman and Managing Partner, Pritzker Private Capital
David Magdol, president and chief information officer, Main Street Capital Corporation, agrees. He noted that not all activities are sponsored by sponsors; More founders are considering minority investments before the capital gains tax changes proposed by the Biden administration go into effect. If passed, these tax increases could impact the economics of a minority investment if a founder profits from the transaction.
“We’ve seen increases in M&A activity like this in the past,” says Magdol, whose company focuses on the lower middle market and makes investments with and without control. “Business owners who have reinvested in the business time and time again are starting to look for minority investments and other growth alternatives before a tax change so they can have a liquidity event now and benefit from the hike / of business growth. “
With all of this activity, it can be tempting to assume that this is the next phase of a mature private equity market. While this is largely true, there are still risks for sponsors and founders.
Always read the fine print
As mid-market companies already know, any time new private equity sponsors come into an established part of the market with the aim of expanding their strategies, it can have a ripple effect on the flow and terms of transactions.
Cyprium’s Stone notes that many of the larger funds that have added minority investments to their menu of options often use the idea of a non-controlling stake to try to convince founders to sell directly or to agree to a controlling deal. workforce – an arrangement that essentially gives a sponsor control through other means, such as adding additional board seats, financing acquisitions through debt, or selling the business to the end of the investment period. In some cases, the sponsor will decide to pass on the transaction at the last minute. Taken together, these moves can have a cumulative effect of making founders more skeptical of working with private equity in general, even companies specializing in minority transactions.
“The problem for a lot of these sponsors is that if you are a controlling investor, it will be very difficult to relinquish that control,” Stone said. “So they include conditions that give them control of the board even though they only have a 45% stake, or they have other conditions that put the company on the path to a sale. based on their timeline, which might not be what a founder ultimately wants to do. In a true minority investment, you don’t exert that level of pressure. You work with the founder on growth of his business, not on setting up his sale.
Paul Carbone, chairman and managing partner of Pritzker Private Capital, a family office that makes minority investments through its own investment vehicles, adds that sellers should also consider the rise of the “club deal”.
“Not all minority investments are the same. For example, sellers should not be confused with the fact that club agreements are necessarily minority agreements, ”he says. “If you have three companies each holding a ‘minority’ share but they share common approaches and goals, then you could have a club structure that collectively owns the majority of a company – and that’s the end of it. account for a control investment. Sellers need to be aware of how the economy is going, the interests and motivations of their partners, and what is actually being negotiated. “
At first glance, a minority investment may not seem as complex or comprehensive as a buyout, but that doesn’t necessarily help matters. Depending on how a deal is structured, the ultimate endgame for a minority investment may be more open than a control deal. It’s a shift in perspective that can be difficult for GPs used to strict limits on holding periods and a finite set of exit strategies.
“Minority investors have a lot of options available to them as to what they want to do in a partnership,” says Magdol. “We have worked with companies in the past where we made an initial minority investment and over time became majority investors. If you work closely with a company’s management team and have become their partner, that relationship can evolve.
Family office investors like Pritzker Private Capital who are willing to take a minority position have a similar set of options for choosing to continue investing in a company if that makes sense. “Our investments are not structured in the same way as a private equity firm,” explains Carbone. “We also have a different time horizon from that of traditional private equity,” he adds. “We can afford to be patient and continue to work with companies that we believe are on the path to strong growth. Traditional private equity is tied to a shorter-term business model which often results in a very different approach and mindset, and often requires a short-term exit in about three to five years.
All other factors that contribute to the success of any investment always apply to minority holdings. And in some cases, they have a bigger impact. Since minority investors will work closely with management to grow the business, personalities and motivations need to be aligned as well. Anthony Maniscalco, managing partner and head of Investcorp’s strategic capital group, says these factors often make or break a deal.
“If we are looking at two very similar transactions, chemistry can often be the deciding factor,” he explains. “We also want to understand why someone is making a deal. If you have a young founder who wants to take money off the table right now because of tax changes, for example, that could be a red flag for us. If it’s an older founder who wants to do something like this, it might make more sense if he’s closer to retirement, for example.
An investor market
Even if the era of easy money and low capital gains taxes comes to an end, it seems unlikely that minority investment will slow down.
The amount of capital that investors invest in private equity has broadened the market significantly and in the long run. Additionally, feedback from LPs suggests they are open to working with sponsors who focus on minority investments, provided the rates of return meet or exceed expectations. On the LP side, working with a company like Cyprium or others that focus on minority positions is just another kind of private equity.
There is a lot of attention being paid to minority equity agreements right now due to proposed federal tax changes and the economic recovery.
President and Chief Information Officer, Main Street Capital Corporation
Sponsors who do this type of deal say they anticipate greater opportunity in the long run. “Much attention is currently being paid to minority share transactions due to the proposed federal tax changes and the economic recovery, but these are not the only factors that business owners take into account when deciding to invest. explore an investment, ”says Magdol. . “At the end of the day, tax rules have a much smaller impact on the ultimate value they can receive than if their business could grow faster with the right partner. This is really what they should consider when deciding to pursue a minority investment.
Cyprium’s Stone adds that minority investing is first and foremost a type of growth capital, and minority investing can work with almost any type of business. Because it’s so wide open, uncontrolled investors don’t often run into the hurdles that controlled investors face when trying to identify targets.
“At the end of the day, we’re working with companies toward a specific goal,” he says. “Maybe it helps them in an acquisition, helps them achieve a growth goal, whatever it is. And our goal is to help them achieve the goal without having to sell the business or lose control.
Whether control funds keep minority stakes on the menu is an open question. Using a minority transaction as an incentive for a larger transaction or as a business development strategy is a tricky bet for control funds, as it raises issues of transparency and trust. If a founder sits down to a table with a sponsor only to find they are being pushed into effective control or a buyout, it can damage the relationship. This is especially true in a market where capital is readily available for genuine minority transactions that do not include control style terms.
But when it comes to investors who genuinely work with the founders to achieve their goals, the unchecked approach will likely carry weight. “It’s a storyline that the founders enjoy and it’s a tool available throughout the cycle,” says Stone. “So from our perspective, we think this is a long term investment strategy.”