September 21, 2015
The Family Office Alpha Report by Witherspoon Partners, September 2015
By Keith Danko
The lower middle market in private equity is brimming with opportunity, with an abundant supply of small- to medium-size private businesses available for potential acquisition (see our July-August 2015 issue of The Family Office Alpha Report, which discussed direct private equity investing opportunities). It is not difficult for investors to find reasonably valued companies that are seeking to hand over the reins. What is not as easy is going the process alone. The best way to maximize success—and upside—from these investments is to bring a highly competent and experienced operating partner into the venture.
The lower middle market, particularly the $15M-$200M range, has plenty of untapped value, but attempting to invest directly in a private company can be complicated for investors who do not know the waters. Unless you have firsthand experience in running a business or enterprise, joining forces with an operationally focused partner who brings expertise and perspective to the transaction is a more prudent, and potentially more profitable, tactic.
A partner who has been working on the ground level of the space with a proven track record of success will have different yet important concerns. In contrast with key top-down equity investment metrics like EBITDA, IRR, and entry or exit multiples, an operating partner will have a more granular, bottom-up feel for fundamentals like operational efficiencies, inventory management, and marketing channels.
When investing in the lower middle market private equity space, a major benefit of involving an operating partner is the acquisition of industry sector know-how—the “boots on the ground” value. Business operators are more familiar and fluent with the daily operations, processes and dynamics of their verticals than an equity investor is likely to be. Purchasing a privately owned business in a niche industry that involves manufacturing, for example, with logistical concerns like purchasing, labor, and materials, is more challenging without a partner who has hands-on operational experience.
Operating partners can also help identify financial drivers on both the cost and growth sides; given they will have a stake in the investment, their goals will be aligned with those of the capital partners. Business process improvement, overhead cost reductions, and streamlining activities are all best tackled from the ground level and from professionals who know a specific industry inside-out.
The ability to identify efficiencies from the operational side matters substantially these days, as the financial engineering tools of the past are less impactful. Most businesses have been forced by the 2008-2009 financial crisis and by increased transparency to make themselves more efficient in terms of financing. Today it is often through finding better systems to produce in a leaner way or to market using lower cost methods that creates value. Bankers who source deals for direct investment have begun to recognize that the potential contributions of operating partners are unmistakably increasing.
Networking is another key advantage that an operating partner brings to the lower middle market private equity space. Having a partner with an operational vantage point and with industry connections can help in the sourcing of future private equity deals, and can assist in acquisition and divestiture strategies. Having pre-established relationships in any field is almost a prerequisite for successful investing; the valuable relationships of an operating partner are no exception. In a small private company buyout, an operating partner’s network can also be key in helping to recruit additional professionals during growth and/or restructuring stages.
The benefit of an operating partner is most easily exemplified in commercial real estate investing, particularly in secondary markets. Lower middle market real estate investing is heavily reliant on local knowledge: understanding the trends of a specific metropolitan area, the nuances of various property types, demographics, and capitalization rates. A real estate operating partner in a specific market will have a better grasp on bidding processes, forms of ownership, debt instruments, and even zoning and construction challenges.
Operating partners add a layer of due diligence and help mitigate risk in both private equity and real estate investing. An operating partner of a smaller business is likely to have a better ear to the ground for positive or negative developments in the industry or business. Engaging an active operating partner also gives capital partners increased flexibility to replace incumbent management of an acquired company, if necessary. Should this be the case, the operating partner is in the ideal position to generate the strongest growth for the company.
Ultimately, the best investments are made when investors are armed with the most knowledge. The alternative space has become increasingly fragmented, and private equity in particular has become more specialized since the financial crisis, offering exciting opportunities for direct investment. Along with these opportunities, however, comes an increased need for efficiency across operations, and for investors to bring experienced players into the game who can smoothly manage the day-to-day challenges. As long as goals and philosophies are shared up front with capital partners, employing operating partners in lower middle market investments can be the wisest route to a successful investment.