Understanding Private Equity

What exactly is a private equity firm, and what are they looking for when making acquisitions in the pet space?



It is no secret that the pet care category has garnered an overwhelming amount of interest from private equity (PE) firms over the past several years. In fact, I have no doubt that most of you, as pet company owners, get multiple calls per month from investment groups that want to discuss a potential acquisition. 


The thing is, most small business owners are not familiar with what exactly a private equity firm is and what they are looking for when making acquisitions in the pet space.  This article is devoted to educating readers on the who, what and why of private equity.


Let’s start with the definition of private equity: Private equity is capital that is not listed on a public exchange. It is composed of funds and investors that directly invest in private companies or that engage in buyouts of public companies, resulting in the delisting of public equity.


PE firms typically buy controlling shares of private or public firms, often funded by debt (aka leverage) with the hope of later taking them public or selling them to another company in order to turn a profit.  Most PE firms hold their investments for three to five years, a period in which they hope to triple or even quadruple their money. 



Where do PE firms find investment capital?

PE firms generally raise money from pension funds and wealthy individuals. They will generally start out to raise a certain dollar amount—usually in the hundreds of millions—and when they have secured that amount, they form a new “fund” from which they will invest the capital in acquiring companies. 



How do PE firms make money?

The first (and most reliable) method for a PE firm to generate revenue is through fees. Fees are utilized to fund the daily operations of a PE firm, including overhead costs and salaries. Through the years, firms have become quite adept at identifying opportunities to extract fees. First, all limited partners (LPs) have to pay a management fee—usually two percent of committed capital—for the privilege of investing with a private equity firm. Recent reports have highlighted how many firms waive this fee and have it directly invested into the fund, which allows general partners (GPs) to realize revenue at the capital-gains tax rate.


Aside from charging their investors, PE firms also generate capital from their portfolio companies. During the initial deal, the firm takes a transaction fee of around one percent of the deal amount. Furthermore, the PE firm charges portfolio companies monitoring fees for various consulting and advisory services performed during the life of the investment.


For more on PE deal terms, read PitchBook’s latest PE Deal Multiples and Trends Report.


While fees may keep the lights on, carried interest is where PE firms and their limited partners make the real money. Carried interest refers to the PE firm’s share of the capital gains generated by a fund, which are created by earning profits on portfolio investments. Firms typically realize returns on their investments by selling the company or taking it public, but another option is a dividend recapitalization.


Most PE firms are eligible to receive 20 percent of the carried interest according to their limited partnerships. However, firms must achieve a predetermined rate of return (referred to as the hurdle rate and typically set at about eight percent) before taking part in carried interest to ensure investors receive an adequate return. The best performing PE firms are often able to command more than 20 percent in carried interest and negotiate a low hurdle rate—or none at all.



Why is the pet industry so appealing to private equity firms?

I keep waiting for the interest in the pet category by PE firms to slow down, since it has been non-stop since I started my career as a pet-focused investment banker nearly 10 years ago. However, I’m happy to say that it shows no sign of waning. While I believe those of us fortunate to work in this fabulous industry agree that it is the best place to spend a work day, why has the pet industry also piqued the interest of financial professionals?


To get the most valuable answer to this question, I went straight to the horse’s mouth and had a talk with Oliver Nordlnger, co-founder of Monogram Capital. Monogram is a Los Angeles-based PE firm that has been very active in the pet industry, with investments in Chewy.com and Healthy Spot, among others. 


“For us at Monogram, the pet category has long been one of our favorite consumer verticals and where we continue to spend a great deal of time meeting and partnering with entrepreneurs at companies such as Healthy Spot and Chewy.com,” he says. “A firm of pet lovers, we take a great deal of pride in being able to take the mission-driven approach of supporting brands that are porting over many of the same better-for-you attributes that we are enjoying on the human side.  It’s abundantly clear that these brands are increasing the health, wellness, and longevity of our pets, and there is little more rewarding than that. 


“Also, as investors, we’ve noticed anecdotally that returns appear both more consistent and higher in pet than any other consumer sub-vertical.  Much of this consistency and outperformance we chalk up to the clear demographic trends of increased pet ownership and humanization, but equally important is how loyal and sticky the pet consumer is—whether that end consumer is really the pet or the pet parent.”



What are the advantages of selling to private equity?

When selling your company, there are two types of buyers.  One is a strategic buyer—a buyer already in your industry. An example would be when Central Garden and Pet acquired K&H Manufacturing in 2017. The other type is a financial buyer—a buyer not already in the industry but is acquiring your company in order to generate a combination of cash flow and a return on equity. A PE firm that does not already own a pet company is a financial buyer. 


There are multiple advantages to selling your company to a PE firm, including:


• Job Security—You and your team will likely keep your jobs, as they still need you to run the company.


• Increased Value—Many business owners only sell a portion of their equity to the PE firm, leaving the opportunity to significantly increase the value of their existing equity when the PE firm exits the investment in three to five years. For example, let’s say you receive an offer from a PE firm that sets your company’s total enterprise value at $15 million but only wants to purchase 70 percent.  In this scenario, you would receive $10.5 million at the time of sale, making your 30 percent stake in the company worth $4.5 million. If, during the five years the PE firm owns the majority of your company, the value increases to  $45 million, your 30 percent would be worth $13.5 million. That’s the desired PE outcome. 


• Increased Resources—Partnering with the right PE firm not only provides financial capital, it provides intellectual capital as well. There are some extremely sharp and savvy private equity professionals out there who know quite well how to double, triple and quadruple the value of a business in a relatively short period of time. 


There are a few dozen PE firms that specialize in consumer products, and a few that have knocked it out of the ball park in the pet industry. One of the advantages of working with an investment banker on your transaction is that he or she knows which of these firms would make a great partner for your company. 



Is your company a candidate for private equity interest?

Unfortunately for most pet companies, the answer is “no,” unless the PE firm already owns a pet company in its portfolio and it wants to add on through acquisitions. The primary reason that most pet companies don’t qualify is size. Based on my discussions with literally hundreds of PE firms over the years, the vast majority are looking for companies earning at least $2 million in EBITDA (earnings before interest, taxes, depreciation, and amortization) and really prefer minimum $3-5 million EBITDA. So, unless they are highly profitable, companies will usually need to realize revenues of $20 million or more to attract the interest of a private equity buyer. 


There are a few reasons that PE firms need to acquire larger companies.  One is the fact that their fund size is generally in the hundreds of millions of dollars and they need to put that money to work in large chunks. So, they are looking to write checks of $10-$30 million, or more, for the equity portion of the acquisition. As mentioned above, one of the tenets of private equity is using debt to acquire companies, so they are generally putting 20 to 40 percent of the purchase price in as equity and the rest as debt (this varies by transaction). 


The other main reason is that transactions are expensive. Most private equity firms will spend hundreds of thousands of dollars on accounting, legal and other due diligence expenses per transaction, no matter the size. The size has to justify the cost, and small deals do not. 


Again, the one time that smaller pet companies are appealing to a private equity firm is when they already own a portfolio company in the pet space and they are looking for add-on acquisitions. Add-ons still need to generate a decent amount of revenue to justify the time and expensive involved, but they don’t have to have the minimum EBITDA requirement. An example of an add-on transaction would Outward Hound’s acquisition of Bionic Pet Products and Dublin Dog. Both were small companies, but a good fit for Outward Hound.   



Carol Frank of Boulder, CO, is the founder of four companies in the pet industry and a Managing Director with MHT Partners, a national middle-market investment bank, where she specializes in pet sector mergers and acquisitions. She is also a principal at BirdsEye Consulting, the pet industry’s premier advisory group. BirdsEye advises in the areas of M&A and strategy. She is a former CPA and holds Series 79 and 63 licenses.  She can be reached at cfrank@mhtpartners.com.


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