Why Private Equity Groups Prefer to Buy Larger Companies and Use Leverage

As a business broker who specializes in smaller transactions (total transaction size between $ 2,000,000 and $ 20,000,000), I often see companies on the smaller end or below our range that have trouble attracting interest from groups. of private equity. Generally, a private equity group wants to invest in companies at least $ 5,000,000 and borrow a substantial portion of the purchase price. Even PEGs with a lot of money to invest want to take advantage of the deal.

So why wouldn’t a PEG who would happily make a $ 5MM deal on half a bank loan not be interested in making a $ 2.5MM deal? Clearly, they have the money to make the deal and there is more room to grow the smaller company. Also, the company without leverage is less risky.

To understand the motivations of PEGs, you need to look at it from their perspective. Let’s say a hypothetical PEG has three employees paying $ 200,000 a year each who will scout for bargains and oversee the businesses they buy and $ 400,000 a year in overhead for rent, travel, receptionists, etc. The total amount needed to run the PEG can be $ 1,000,000 per year.

Suppose our PEG can comfortably monitor 5 companies at once while looking for new acquisitions and exiting mature investments. If they buy 5 companies for $ 2.5MM in the first year, they have invested 12.5MM. Most of the profits of these companies will be absorbed in the operating cost of the PEG or will be reinvested in the operating companies to make them grow, so if they double the value of these companies in 5 years they have generated a profitability of 14.8%. That is not an acceptable rate of return given the risks of private equity. Investors in a PEG understand that they are taking great 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 much better return. (12.5 MM X 1.32 ^ 5 = 50 MM) Of course, companies will have the additional interest expense and principal repayment as they withdraw the loan, but larger companies should generate enough cash to cover with you grow that expense.

Therefore, to produce a reasonable rate of return, PEG wants to buy larger companies and use leverage to magnify their returns.

There are exceptions to this generalization. Some PEGs specialize in turnaround situations, where they buy into troubled companies. These companies can be less expensive and are more difficult to leverage because banks do not make loans against cash flow when there is no cash flow. Most PEGs will view smaller deals as add-ons to an existing platform company, especially if the company allows them to expand their product offerings or geographic coverage. Lastly, PEGs will sometimes buy several smaller companies and merge them into a roll-up. This allows them to cut corporate expenses, achieve economies of scale, and end up with a stronger company with a lower multiple of EBITDA.