In today’s competitive investment landscape, private equity firms are increasingly setting their sights on founder-owned companies as key targets for lucrative exits.
But what makes these businesses stand out in the sea of investment opportunities? And more importantly, how can private equity ensure that these companies reach their full growth and value creation potential?
Founder-owned companies, with their unique characteristics and untapped potential, represent over 56% of US private equity deals in Q4 2023, up from 45.5% in Q1 2021. This notable shift towards non-backed targets, primarily founder-owned businesses, underscores the growing recognition of the superior outcomes these companies can deliver. A recent Morgan Stanley report highlights that deals involving a founder achieved approximately 50% higher increases in revenue and 80% higher EBITDA growth from entry to exit compared to other mid-market deals.
However, unlocking the full potential of these businesses requires a nuanced approach. Given their distinctive features – from leadership structures that need reinforcing, to a personal attachment that founders and family members have with their companies – private equity firms must tailor their strategies before and after the deal. This includes understanding the readiness for change within the organization, revealing the true potential that may be hidden beneath unaudited operational and financial information, and executing tailored improvement plans that align with the company’s capacity for transformation.
Distinguishing Features
There are four main areas where founder-owned businesses are often distinct from other kinds of companies, and these can affect the approach a private equity investor should take both before and after a deal.
Leadership may need restructuring and/or strengthening.
The motivations for partnering with private equity can vary, from succession deals that require new management teams, through to the founder seeing scope for further growth but recognizing the need for both capital and expertise to achieve this. Whether the founder intends to take money off the table and leave or to remain involved in the company’s expansion, the leadership challenges in these transactions can often be more complex than in other deal situations. A common issue is that management team members wear several different hats in the organization, so untangling the roles to create a clear governance and responsibility structure can be difficult. There may also be a need to upskill or train existing team members or to bring new capabilities to the leadership bench.
Founders may have a personal attachment to the business.
Founders and family members are likely to be emotionally attached to their business. After all, they will have spent years—or even decades—building it. They are likely to want a new owner to continue looking after employees, some of whom may fear the changes to come. Private equity firms, therefore, need to take time to build trust with the management team and beyond to reassure employees that their investment and support will result in a more resilient, faster-growing business.
Not all founder-owned businesses will be open to change.
Improvements to the business clearly need to happen at a rapid pace under private equity ownership. Firms, therefore, need to understand how ready the organization is for change. One issue we see commonly in founder-owned businesses is a lack of structured investment in skills and people development. While this can be remedied, it can mean there is less of an understanding among staff of why change is necessary and what that could entail. Potential private equity investors need to understand whether there is fear of or resistance to change, where in the organization this resides and the extent to which they can bring people along with them in a change management program.
True potential may be well hidden.
In many founder-owned businesses, operational and financial information is not readily available, which can make it challenging for private equity investors to identify and then capture a company’s true potential. Few founder-owned businesses, for example, have the processes, systems or KPI performance data needed to provide a full picture, while the metrics they use may not be focused on creating value. These companies can also often lack the skilled resources to gather this kind of information.
All this means there is a great deal of heavy-lifting required to first, determine the true potential of a founder-owned business and then, to realize it during a typical private equity holding period.
Before The Deal – Approaches That Build Trust and Identify Potential
As we’ve noted, gathering the necessary information from a founder-owned business can be challenging. However, it is still possible to look under the hood of a company to understand its true potential before a deal is completed.
Bring in the operators — early on.
Advisors with operational expertise and experience working alongside founder-owned businesses can be invaluable before a deal closes. They need to be people who have walked factory floors, can identify inefficiencies, and deploy evidence-based solutions that begin building trust between the private equity firm and the founder’s team.
The impact can be significant. In one example, TBM conducted operational due diligence on a company carrying an $80 million production backlog while running at less than $10 million in monthly output. The improvement plan — covering efficiency gains, a daily management approach, and the team’s openness to change — gave the private equity firm a clear picture of the company’s true potential. Once the deal closed, the facility increased monthly output to $13 million in just four months.
Be clear about capacity for change.
Understanding change-readiness before closing is critical — it defines what the firm is actually buying. In rare cases, resistance among key personnel may be intractable, and it’s far better to know that before committing. In most cases, however, advisors who earn management’s trust and use facts rather than opinions to make the case for change can bring employees along effectively.
In a recent example, a prospective private equity buyer engaged TBM during due diligence to assess a food safety business. When the work was complete, the management team requested a copy of the report so they could begin implementing improvements immediately — a clear signal of genuine openness to change.
After The Deal – Approaches That Achieve True Potential
Many founder-owned businesses have not had structured processes or plans for growth. They may, for example, have developed a great product and the business has simply responded to some of the demand for it. However, in these situations, the business is unlikely to be achieving full growth potential because of a lack of capital and/or a plan that creates the foundations for future growth. Many founder-owned businesses will therefore need support to build a high-performing organization and to add capability.
Align interests to accelerate change.
Creating the right governance structures can help build capacity. Many founder-owned businesses grow at the pace set by the founder; private equity investors, meanwhile, clearly require fast-paced change and growth to ensure they meet their return objectives.
One way of aligning the expectations and interests of private equity investors and management teams is to engage a third-party advisor to create independent timelines for transformation that are built on the facts before them. If engaging advisers to help implement change, they should be working together with board-level decision-makers and creating a steering committee that reports back regularly to the private equity backer. This provides a layer of separation between private equity and management to keep things moving in the right direction without the investor having to micro-manage.
Don’t dictate, demonstrate.
Simply devising a plan for improvement and then expecting teams to implement it is unlikely to generate much, if any, change. The people helping to implement change need to roll up their sleeves and work alongside the people at the point of impact, such as the management team and sometimes those on the factory floor, if they are to deliver benefits from actions within a short timeframe. This is also important for building trust between the private equity firm and the management team and employees, while demonstrating what is possible so that change can be sustained over the long term.
Build institutional knowledge.
We commonly encounter “tribal knowledge” among employees in founder-owned businesses. They are the sole keepers of know-how in the company since processes and procedures are frequently not formally documented. Yet this stifles growth – that knowledge can walk away and find a new job – and it makes it much more difficult to onboard and train new people. By helping to implement systems that are proven to be effective and that are written down, private equity firms can help businesses grow more quickly because it becomes easier to make new hires to expand capacity.
Consider the transition.
Even if a founder is not exiting the business when the deal completes, many opt for a phased approach. The right advisers that have built trust with the management team can facilitate and smooth a transition to new leadership, while also identifying any training or coaching that may be needed to ensure the company has the right skills mix for growth. It’s also worth keeping in mind that the arrival of new leadership can help bring about further change and improvements.
A recent assignment we have worked on demonstrates the value of laying the foundations for growth and working alongside people to generate lasting change. We helped a founder-owned business structure a plan for growth through M&A. However, the first phase was not seeking out acquisitions; rather, it was working collaboratively with the management team to create the right company, site and leadership structures that would underpin growth while also strengthening the team and building on marketing strategies. Other capacity-building initiatives included putting in place a robust talent management strategy to reduce staff turnover and establishing the right KPIs and reporting methodology to focus the business on value creation and growth. With all this implemented in the space of a few months, the company is now in a position to focus on its long-term strategy of acquiring up to 30 smaller businesses over the next five to seven years.
The Power of Strong Partnerships
There is significant untapped potential in most founder-owned businesses that, if unlocked, could generate attractive returns – to the benefit of private equity firms, founders and the companies themselves.
Achieving this requires relationships built on trust between founders and their employees, private equity backers and any advisers hired to produce and implement an improvement and growth plan. This is why it is vital to get the right advice and ongoing support from seasoned operators with a long history of working successfully with founder-owned businesses. This is true before sealing the deal – so that the private equity house understands clearly what it is buying and both investor and management teams know what they need to implement – and after the transaction is complete so they can translate the plan into fast-paced action for improvement.
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