Why private equity groups prefer to buy larger companies and use leverage

Why private equity groups prefer to buy larger companies and use leverage

As a business broker specializing 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 having trouble attracting interest from equity groups. investing. Typically, a Private Equity Group wants to invest in companies at least $5,000,000 and borrow a significant portion of the purchase price. Even PEGs with lots of money to invest want to take advantage of the deal.

So why would PEG, who would happily do a $5 million deal with half a bank loan, not be interested in a $2.5 million deal. Obviously they have the money to close the deal and there is more room for the smaller company to grow. Also, an unleveraged company is less risky.

To understand PEG’s motivation, you have to look at it from their perspective. Let’s say a hypothetical PEG has three employees, each paid $200,000 a year, who will look at deals and monitor the companies they buy, and $400,000 a year in overhead for rent, travel, receptionists, etc. The total amount needed to run a PEG can be $1,000,000 per year.

Let’s say our PEG can comfortably monitor 5 companies at once while also looking for new acquisitions and exiting mature investments. If they buy 5 companies for $2.5 million in the first year, they have invested 12.5 million. Most of the profits of these companies will be absorbed by PEG operating expenses or reinvested in the operating companies to grow them, so if they double the value of these companies in 5 years, they have generated a return of 14.8 %. This is not an acceptable rate of return given the risks of Private Equity. PEG investors understand that they are taking on large risks in illiquid investments and require a return commensurate with that risk.

On the other hand, if our PEG buys $25 million worth of companies, but borrows $12.5 million 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. (12.5MM X 1.32^5 = 50MM) Of course, companies will have additional interest and principal repayment costs when they take out the loan, but larger companies should generate enough cash to more than cover this cost .

So, to achieve a reasonable rate of return, PEG wants to buy larger companies and use leverage to increase their returns.

There are exceptions to this generalization. Some PEGs specialize in turnaround situations where they buy companies that are in trouble. These companies can be cheaper and harder to leverage because banks won’t lend 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 sometimes buy several smaller companies and combine them in a roll-up. This allows them to reduce costs in the companies, achieve economies of scale and ultimately get a stronger company with a lower EBITDA multiple.

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