As a business broker that specializes in smaller deals (total deal size between $2,000,000 and $20,000,000) I often see companies at or below the smaller end of our range that have trouble attracting interest from Private Equity Groups. Generally a Private Equity Group wants to invest in companies at least $5,000,000 and to borrow a substantial portion of the purchase price. Even PEGs with lots of money to invest want to leverage the deal.
So, why would a PEG that will happily do a $5MM deal with half borrow from a bank not be interested in doing a $2.5MM deal. Clearly they have the money to do the deal and there is more room to grow the smaller company. Furthermore, the unleveraged company is less risky.
To understand the PEGs motivations you need to look at it from their perspective. Let’s say that a hypothetical PEG has three employees each paid $200,000 a year that will look at deals and oversee the companies that they buy and $400,000 a year in overhead for rent, travel, receptionists, etc. The total amount needed to run the PEG may be $1,000,000 a year.
Let’s assume that our PEG can comfortably oversee 5 companies at a time while also looking for new acquisitions and exiting mature investments. If they buy 5 companies for $2.5MM in year one they have invested 12.5MM. Most of the profits of those companies will be absorbed in the operating cost of the PEG or be re-invested into the operating companies to grow them so if they double the value of those companies over 5 years they have generated a return of 14.8%. That’s not an acceptable rate of return given the risks of Private Equity. Investors in a PEG understand that they are taking large risks in illiquid investments and demand returns commensurate with that risk.
On the other hand, if our PEG buys companies worth $25MM, but borrows $12.5MM and doubles the value of each company over a 5 year period, their return on equity more than doubles to 32%, a far better return. (12.5MM X 1.32^5 = 50MM) Of course the companies will have the additional interest expense and principal repayment as they retire the loan, but the larger companies should generate enough cash to more than cover that expense.
So, to produce a reasonable rate of return the PEG wants to buy larger companies and use leverage to magnify their returns.
There are exceptions to this generalization. Some PEGs specialize in turn-around situations, where they buy companies that are in trouble. These companies can be less expensive and are harder to leverage because banks will not loan against cash flow when there is no cash flow. Most PEGs will consider smaller deals as add-ons to an existing platform company, especially if the company allows them to expand their product offerings or geographic coverage. Finally, PEGs will sometimes buy several smaller companies and merge them in a roll-up. This allows them to cut expenses at the companies, achieve economies of scale, and end up with a stronger company at a lower multiple of EBITDA.