Type of Companies in Favor

Many companies are seeking growth capital.  A large percentage of them have major problems with their top line performance and saw their profitability drop in 2008.  There are a number of industries that private equity and mezzanine funds are still interested in funding into.  These include healthcare, telecom, food related, government contractors and other defensive businesses.  There is little to no appetite right now for company’s whose demand is consumer driven. Given the consumer pullback and the need to save more, there is no saying when the consumer spending will pick up again to historical levels.

Retail, real estate and building products are also not in favor.  Our view is that the retail consolidation underway will go on for many years and result in fewer stores and many vacant storefronts.  Many companies that struggled in 2008 need to raise more capital to reload their depleted working capital.  Most investors get that 2008 was a tough year and many of them having an understanding view.  If you were flat in 2008 – that is a great performance and is the “new up”. If you were down 5% to 10% – that is a good performance and you were the “new flat”.

Investors are preconditioned to expect 2008 and 2009 underperformance and are pricing that into their deals.  They understand that even really good companies cannot shine in a really bad economy. However, really good companies can still grow their market share, add new products and find new ways to position themselves for strong growth once the good economic days return.

Importance of Relationships

A casualty of the financial crisis is reliance on predictable models and big brand names in the financial world. Most risk modeling was way off in 2008. All asset classes – stocks, bonds, commodities, real estate were all down in the 4th quarter of 2008 despite copious financial statistics showing that many of these assets were cross correlated. Many previously prestigious and well thought of firms have lost money to the point of embarrassment. As a result, people no longer wholly rely on spreadsheets or the reputation of a firm when making important strategic decisions.

Nowadays people are turning away from big brand names to small, new names for assistance. They are using their personal extended networks – people they know such as family, friends and business associates to help find the best resources for them. They are less likely to think that only a big, well known firm can meet their needs. This is a healthy transition in the market.

Many of the large financial firms were too big. They were inwardly focused and no longer provided good customer service. In retrospect, they were not only too big to be managed effectively but also too big to compete effectively. People are back to relying on people that they know and trust to help them figure out the best path to take. Independent, small firms are a beneficiary of this trend.

The Overfunding Payoff

In many cases, the success of a company rests on the amount of growth capital vs. the cost of the growth capital.  Many owners get hung up on how much they are paying in terms of equity give up or interest rates when they raise capital. The key is to see the investor in a win-win context. If you do not see the new investment as dramatically expanding your capital resources and enabling you to do things previously unthinkable, then the deal may not make sense.

Overfunding your company allows you to have a cash safety reserve to ride out bad times and the ability to opportunistically acquire at the best prices.  Private equity investors have annual return requirements of between 25 to 35% per annum.  If you can use their money to more than double the size of your company and your equity value, then this is a great way to go.  Private equity investors like to partner with companies. You can use their cash to fund all of those small and large areas of growth in your company that may have been neglected. In times like these, overfunding is an insurance policy on the future as well as a passport to building value.

How to Pick the Right Investor

Investors come in all shapes and sizes.  They generally fall into several categories related to deal size, preferred type of deal and preferred industries.  Most private equity and mezzanine lending firms are small businesses themselves.  They may control hundreds of millions of dollars or even billions of dollars.  The total revenue size of their portfolio companies may be quite large.  However, when you boil it down, these firms are small groups of investment professionals with their own culture and investment style. How they think and how they relate is what differentiates them.

Some firms are very impressed with their ability to intellectualize business models and critical success factors. . Other firms are more pragmatic and understand that business is less theoretical.

I have always advised clients that the best way to gauge the true colors of a firm is to see how they behave once the deal is done. Are they intrusive, are they supportive, are they consistent, and are they communicative? These are all good ways to judge whether or not you want to do business with them when selecting an investor.  Trying to see them as they are vs. the way the market themselves is important.  If you do your homework on this subject and find the right investor, like any partnership, it will pay dividends.