Private equity firms are very active in the collision repair market, and the automotive aftermarket in general. The rapid growth of the large consolidators has resulted in very attractive investment returns for these groups, further increasing the interest of other private equity investors hoping to invest in the industry. Of the “Big Four” consolidators, ABRA, Caliber, and Service King are all majority owned by global private equity groups. Boyd is publicly traded and not private equity backed, but the President of a Canadian private equity firm sits on Boyd’s board of trustees. CARSTAR also is backed by private equity, as is MAACO. Fix Auto recently received debt funding from a large Canadian investment fund that is active in private company investments. Kadel’s, the Pacific Northwest MSO recently acquired by ABRA, was backed by a smaller private equity group. Joe Hudson’s in the Southeast recently brought on a private equity partner as well. Yet for as active as private equity groups are in the industry, these groups are not well understood.
What is Private Equity
In the most basic sense, private equity is a type of investment, or asset class. It can be thought of as a mutual fund for investing in privately held companies. A mutual fund pools together money from many different investors. The fund manager then invests the pool of money on behalf of the investors. Many of us have heard of Peter Lynch, the famous investor of the ‘80s who ran multi-million dollar mutual funds, or Carl Icahn, the famed corporate raider who invests in publically traded companies with the intent on very publicly shaking up management to increase the share price. Both Lynch and Icahn on behalf of investors buy stocks they believe to be undervalued in the stock market and generate millions of dollars for investors as the value of the stock increases over time.
Private equity is similar to a mutual fund, except rather than investing in publically traded companies they invest in privately held companies (hence private vs public equity). Private equity managers pool investment dollars to invest in private companies they believe have significant strategic value or are undervalued and/or underperforming. The largest private equity groups pool investment dollars from large pensions, endowments, insurance companies and investment funds. Smaller private equity groups attract capital from wealthy individuals and smaller investment funds. Some smaller groups, often referred to as family offices, invest on behalf of a single wealthy family.
Investing in private companies is unique. Financial information often is rather opaque, audited financial statements are less common, and determining the fair value of a company is much more complex relative to publicly traded firms. Private companies also are less liquid, meaning that shareholders have fewer options when it comes to selling (liquidating) their shares. As such, it usually takes longer and is more difficult to find a buyer or arrange financing compared to a publicly traded firm. Yet while buying or selling a private company is more difficult than buying or selling stock in a public company, investing in private companies can be substantially more lucrative. Private equity groups provide large pensions and wealthy individuals exposure to an asset class they otherwise would not be able to access.
Leverage, Growth and Operational Improvement: How Private Equity Generates Massive Returns
The most successful private equity groups are famous for generating massive returns on capital invested often in very short periods of time. Private equity firms often express returns in multiples rather than percentages. In other words, these groups return two, five, or even ten times the original investment rather than 10 or 15 percent. Often the way this is done is by employing leverage, otherwise known as debt, to acquire a business. The use of debt to acquire a business minimizes the cash (equity) required to purchase a business and allows the new owners to supercharge the value of equity.
For example, take a business that is acquired for a total of $10 million by a private equity firm. The private equity firm invests $4 million in cash, and uses an additional $6 million in debt to fund the acquisition. A few years later the private equity firm sells the business for $15 million. While the total value of the business only increased 50% ($15 million / $10 million), the private equity firm realizes a 125% return on their investment or 2.25 times the original investment, assuming no debt was paid off ($15 million sale price – $6 million debt = $9 million in proceeds. $9 million / $4 million = 2.25).
But the private equity firm can generate even higher returns. When the private equity group acquires the business for $10 million, the $6 million in debt used for the acquisition is transferred to the business. During the course of normal operations, the business is responsible for servicing and paying down the debt. If the business aggressively pays down debt the private equity group can generate even higher returns. For example, assuming the company pays off $4million in debt principal prior to the sale, the private equity group realizes a 225% return on its investment, or 3.25 times the original investment ($15 million sale price – $2 million remaining debt = $13 million in proceeds. $13 million / $4 million = 3.25).
In both scenarios, the enterprise value of the company only grew by 50% ($10 million to $15 million), but the equity value of the business (i.e. the amount that was left over after paying off existing debt) doubled or tripled in value ($4 million to $9 million or $13 million, depending on the scenario).
Using debt to acquire companies is a proverbial “double edged sword” and if not managed appropriately can cause much damage to the acquired company. Debt used when acquiring a company represents a substantial drag on the cash flow and profitability of a company. Therefore it is critically important for private equity groups to identify companies where they can leverage sales growth and cost reductions. Industries that are highly fragmented (i.e. the entire automotive aftermarket) often are ideal targets for private equity firms. Private equity backed companies are able to grow aggressively in fragmented industries, while also spreading costs over a wider base of sales, otherwise known as building scale.
Compensation: How Private Equity Fund Managers Get Paid
Private equity fund managers have a substantial incentive to aggressively grow their portfolio companies as their compensation is directly tied to the overall financial performance of the fund. Generally, private equity firms are structured as flow-through partnerships with two classes of partners, limited and general. The limited partners are the investors and have limited liability up to the amount they invested in the fund. General partners are the private equity managers, who often take a small percentage of assets under management as compensation plus a significantly larger percentage of fund earnings. A common compensation structure is the 2 /20 approach, where the general partners earn 2% of assets plus 20% of fund returns.
An example better illustrates the incentives of a fund manager. Take a fund with $100 million in assets under management. The fund generates $2 million a year in management fees, most of which goes to compensation for analysts and other staff. However, if the fund is able to generate similar returns as described above and double or triple the value of the firm over five years, the general partners stand to gain $20 to $40 million over the life of the fund. Clearly the senior partners of the fund have a vested interest to see the firms they acquire grow rapidly.
A Second Bite at the Apple: Why Business Owners Sell to Private Equity
Taking on a private equity partner is not right for everyone. Understanding how private equity works is key to assessing if selling a portion of your business to a private equity group is appropriate. However, for an owner looking to grow and take advantage of the thinning ranks of regional MSOs, taking on a private equity partner may be a wise choice.
Taking on a private equity partner is often described as taking a second bite of the apple, or having your cake and eating it too. For many business owners, the vast majority of their wealth is tied up in the value of their business. As such, they have substantial assets on paper, but those assets face a high concentration risk and low liquidity (we discussed concentration risk here). In the collision industry this is especially true as even large MSOs have substantial client concentration risk. Partnering with a private equity firm allows an owner to convert part of the business into cash, while still retaining a substantial ownership position to continue the grow the business alongside a well-capitalized and experienced financial partner.
Because private equity firms are not operating firms, it is important to realize that for most, a sale to a private equity firm requires an owner to remain substantially involved in day to day operations. In the absence of a very deep, experienced and committed management bench, selling to a private equity firm often involves more work for the business owner. In some cases if the business has developed a significant management team ready to take over day to day operations and willing to personally invest in the new business alongside the private equity group an owner can begin to transition away from the business. Regardless, partnering or selling to private equity is very different than selling to a large consolidator.
We will talk more about the opportunities available to companies that are looking to grow in this environment. As the large consolidators continue to acquire the upper tier of regional MSOs there is an opportunity for smaller MSOs that may only have a small number of shops to rapidly grow to fill the void. While the continuing consolidation of the industry will continue to pose an operational and competitive threat, for the astute growth oriented business owner with the right team and advisors there is significant opportunity. And for the right group, there are a number of private equity groups actively searching for investment opportunities in the industry.
I am eager to hear from you. How have you grown your business? What challenges have you had in executing this growth? Have you considered taking on an equity partner? Please shoot me an email via my contact page. I find the transformation in the industry truly fascinating and all communication is kept strictly confidential.
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