The phone rings. You’ve received yet another call from Such-and-Such Capital or So-and-So Partners, looking to discuss your long-term business plans and have a “conversation about partnering.” They send you a shiny PowerPoint presentation (“slide decks”), take you to lunch, and hope to “continue the conversation” at a future date.

Let’s cut to the chase — they, being private equity and institutional investors, want to buy your family business.

We’ve written on this phenomenon in the past, with Travis Harms correctly predicting back in 2021 that the number of family businesses raising non-family equity capital will grow dramatically in the coming years. I asked him to predict how my Tennessee Vols would fare this upcoming football season, answering, “Reply hazy, try again.” Not good.

From Wall Street to Main Street

According to a Bloomberg report (subscription required), smaller firms currently account for the biggest share of acquisitions by private equity funds and their portfolio companies since the late 2000s, per industry data from PitchBook. Smaller deals make up more than 61% of all private equity deals in the first quarter of 2023, compared with an average in the mid-50s over the past decade. A recent Wall Street Journal article (subscription required) cites data from Refinitiv that private equity-backed deals through June 2023 have an average value of $65.9 million, the smallest for the comparable period since the global financial crisis. Higher interest rates and lower valuations have led larger companies to hold off on selling, drying up activity for larger deals and leading the “sharks” to swim downstream.

According to the same Bloomberg report, purchases of founder-owned businesses, typically valued at under $100 million, are on the rise. According to PitchBook, founder-owned deals accounted for more than 43% of deal value in the first quarter of 2023, well above the typical levels in recent years. Buyers have been industry agnostic, attempting to gobble up lumber yards, accounting firms, plumbing companies, and dental practices. As one owner in the report said, “If you want job security, save me from these calls and these emails.”

The Pros and Cons

Despite some negative connotations, private equity does present an interesting opportunity for family businesses. What are the pros and cons of selling at least part ownership of your family business to private equity or outside buyers?

Pro: Access to Growth Capital

Bringing in a private equity partner can provide access to the growth capital needed to unlock the true potential of your family business. For family businesses in a “planting” season, a market opportunity for your company may exceed the family’s capital resources or willingness to use debt financing. In such cases, the family business may be prevented from reaching its potential (to the detriment of its employees, customers, suppliers, and other stakeholders) because of the capital constraints of the family.

Pro: Ability to Retain Ownership & Influence

Many private equity investors are willing to purchase less than 100% of your family business. They may even want you to remain in key management roles, presenting a win-win: taking some chips off the table but still benefitting from the foundation for future growth laid by the family. When private equity investors grow the family business successfully, the value of the interest retained by the family can eventually exceed the value of the entire business at the time of the private equity investment.

Con: MBAs Really Don’t Know It All

Money buys influence and the captain’s chair. The professionals tapped by private equity firms to manage portfolio companies often have great business acumen. However, being an expert in business, in general, does not necessarily translate into being an expert in your business. Greater capital resources — coupled with the hubris often accompanying large pools of capital — create the opportunity for bigger mistakes.

Family business outperformance tied to company and industry-specific knowledge that accumulates and is retained in the business over the course of decades and generations is hard to match, no matter how fancy a newcomer’s degree (or pedigree) may be.

Con: It’s All About the (Portfolio) Return

While private equity firms have reduced their Gordon Gekko tendencies compared to the slash-and-burn attitudes of the 80s and 90s, generating outsized returns is still the goal of private equity investors. The real secret sauce for high returns continues to be the use of OPM: Other People’s Money.

Private equity firms use financial leverage to generate a multiplicative return on their equity. So long as the operating reality matches the Excel model, it all works out. But, in quoting his business partner Mr. Munger, Warren Buffet quipped:

“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is — the first two he just added because they started with L — it’s leverage.”

A family manages a business like its fortune depends on its continued existence (because it generally does); a private equity firm manages a business like it is one part of a diversified portfolio of winners and losers (which it is).

What to Do When Private Equity Knocks on Your Door

Private equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.

It’s essential that you have a trusted team of professional advisors to help you engage with potential investors. If you have received  — or expect to receive — an investment proposal from a private equity firm, call one of our professionals for an independent, outside perspective.