The Three Upgrades Private Equity Make When They Buy a Company

The best private equity funds talk about backing great CEOs, entrepreneurs, and management teams. But in the lower middle market ($2-$15 million in EBITDA), what’s a private equity fund to do when the company they are acquiring lacks resources and the management skills to earn great returns?

What if serious talent doesn’t extend beyond the CEO or founder?

Douglas Song, co-founder of Prodos Capital Management and an investor in lower middle market companies, says that “there’s always a way to think creatively and unlock value in any lower middle market company.” He especially finds common themes among companies where entrepreneurs or families have built a great business over time, but are lacking in certain areas where partnering with additional resources will help them take the business to the next level.

Song says one of the critical areas of focus is the finance and accounting function, noting that “The financial function often benefits from additional human capital as well as enhanced reporting and controls which enable investors and management to have greater visibility into the performance of the business and comply with lenders and accounting standards.” Intuitively this makes sense – what was sufficient for a founder or family owned company might not present the breadth and depth that a professional investor would require.

Brent Paris, a partner with Dubin Clark & Company, agrees, saying “We typically hire a CFO to complement existing management teams, as most companies that we recapitalize do not have one in place.” Paris finds a variety of reasons for emphasizing the importance of the CFO role. “The small companies we’re adding to our portfolio require someone with experience operating in a leveraged environment, including dealing with bank covenants and mezzanine covenants. Most business founders have not worked with private equity sponsors before, so they’re unfamiliar with reporting requirements, including monthly management meetings, monthly financial packages, and quarterly board packages. They’ve also rarely had to focus on add‐on acquisitions, and with most of our companies we’re doing exactly that, averaging three add‐ons per portfolio company.”

The high degree of professionalization required by Dubin Clark, Prodos and many other private equity funds demands more skills and experience in the role of chief financial officer or controller.

The second major gap in management skills occurs in sales and marketing. Paris calculates that “about 85% of the time we’re bringing in the COO or SVP of sales or marketing.” Whether its new and higher expectations, or a skills gap, Song relates the same experience: “Typically, the entrepreneur is the most important salesperson at the company. Sometimes they have a sales force, sometimes not, but almost always the marketing and sales areas are not built-out to get into the next level.”

Expectations and experience play a big part in sales management gaps. From the point of view of a company looking to sell, it’s easy to believe you’ve effectively gone after your market,  doing everything possible to build a great company. But from the point of view of the buyer, it’s always the other way around, spotting new opportunities the seller and the legacy management team may have missed.

The third missing element in companies acquired by private equity funds is often strategic planning and budgeting. Song notes “In many cases, this is the owner’s first transaction and they haven’t really done any M&A activity.”

The need for more skilled management post‐acquisition of lower middle market companies appears to be near‐universal. According to Song, “There’s always a gap somewhere; whether it’s the controller or CFO, or whether you need a head of sales or president, there’s usually a gap.”

Paris added that in many cases it’s a pre‐ordained understanding that there will also be a new CEO. “Two‐thirds of the time there is a new CEO when we exit,” he said. “Almost always, that was the original plan as the owner/operator was planning to retire after selling their business.”

The solution to the ever‐present management gap comes in many forms. For Prodos, the solution is to recruit an operating partner alongside the fund working on the deal. But they won’t go so far as to replace the whole management team. Song notes that “if you have to replace the entire management team, there’s usually a problem.” In many cases, PE funds will take on some degree of difficulty, but not wholesale distress.

For many companies and private equity funds, they’ll address the skills gap with interim management, whether applied before the sale, during diligence, or immediately upon closing, to insure a successful transition and new growth path.