Eileen P. Gunn
08/01/2005
The Dwyer Group, a family-owned franchiser of plumbing, electrical and other services for homeowners, suffered a turbulent few years after its founder died suddenly and without a succession plan in 1994. But the board weathered the crisis and, by 2001, it had assembled a new management team and cut costs. Sales began to improve, and the company was poised for substantial growth. It did not anticipate that raising the money to finance its expansion and acquisitions would be a problem because Dwyer, based in Waco, Texas, was publicly traded.
But lacking both institutional shareholders and a sexy dot-com concept, the
company’s stock had languished around $4 a share for several years. The board, a
mix of Dwyer family members and outsiders, came to realize that it would fail if
it sought to raise more capital through a follow-on stock offering. “We went
to an investment banker and said, ‘If we’re not going to get what we need from
the public markets, we need to look at other options,” recalls Dina Dwyer-Owens,
one of the founder’s six children and Dwyer’s CEO since 1998.The alternative was to go private. The board assumed this meant selling to a competitor, since such so-called strategic buyers typically offered higher valuations than did financial investors such as private equity firms. The company had even received a few offers from strategic buyers over the years, “but from real bottom feeders—no one we felt comfortable with,” Dwyer-Owens recalls.
Suddenly, in 2002, the company became deluged with offers from private equity firms. “I guess other parts of the market were tough, so they discovered franchises and picked up the phone,” Dwyer-Owens says. “It wasn’t what we’d had in mind, but the offers they were making got our attention.”
One firm, New York-based Riverside, wanted to own the majority of Dwyer, but also wanted the family to continue to manage it. “They recognized how important our culture and our relationship with our franchisees were to the success of the company,” Dwyer-Owens says. The firm quickly became the frontrunner, but with multiple suitors, Dwyer was able to push the bidding upward.
Riverside’s initial offer was in the range of $5 a share, Dwyer-Owens says. The company was eventually able to secure $6.75 per share, a 59 percent premium over the share price and well above what strategic buyers offered.
Awash in Liquidity
The Dwyers did not know it, but they had caught the first ripple of a private equity wave that entrepreneurs and family business owners have since surfed to their advantage. Private equity firms have raised so much capital that they are vigorously competing with one another for opportunities to put their money to work. Entrepreneurs and family business owners, who previously would have had to go hat-in-hand to investors, instead find themselves inundated with offers. Companies with solid balance sheets, good management and strong growth prospects are able to tailor deals to their liking, and to get robust valuations.
“All this money out there means entrepreneurs might be able to get a better value for their company or sell less of it or both,” says Patrick Haden, a partner with Riordan, Lewis & Haden, a private equity firm in Los Angeles. “And it allows you to choose the firm you want to work with, the firm that can help you the most.”
After the economy collapsed
in 2000, private equity firms were able to buy solid but financially strained
companies on the cheap. They invested in these portfolio companies and, when the
economy and markets came back to life, sold them for a significant profit. In
2004 alone, buyout funds (the catchall category for private equity that is not
venture capital) had a one-year return of 14.3 percent, according to research
firm Venture Economics.
| TOP VIEW Rapacious capital-raising by private equity firms has put owners of strong middle-market businesses in the catbird seat. Exploiting the firms’ need to find ever-larger numbers of profitable portfolio companies, owners are demanding better valuations and more expertise, while ceding less control to the funds. But the high valuations offered for smaller stakes in companies make it more difficult for investors to achieve their long-term investment goals. Those owners whose businesses fail to grow as rapidly as anticipated may be shown the door. |
Many of these firms are putting the money to work in equally splashy ways, making bids on high-profile businesses ranging from Toys “R” Us to Warner Music Group and even the National Hockey League. But the capital is also trickling down to opportunities in the middle market, which includes companies such as Dwyer. Indeed, Venture Economics reports that firms specializing in this sector led the pack in performance last year, boasting an average return of 19.3 percent. The trickle is quickly becoming a flood; Riordan, Lewis & Haden is one of several middle market firms aggressively raising capital. It expects its next fund to be twice the size of the $120 million fund it raised in 2000.
Because of the amount of capital chasing middle-market companies, private equity firms are finding it increasingly difficult to pinpoint those that can grow large and fast enough to provide the market-beating returns they seek. “We call it the great alpha search,” says Brodie Cobb, whose firm, Presidio Financial Partners in San Francisco, advises private companies looking for outside investors. “They’re turning over rocks to find companies that will provide the alpha returns.”
Cobb recalls attending a trade show recently for firms that supply rather mundane services such as employee training and back-office support to car dealership owners. “We haven’t seen private equity people there in 10 years,” he says. “This time we saw four top-tier firms on the floor looking at companies.”
Strategic Shortfalls
Cobb explains that before the wave of private equity fund-raising in the past year, strategic investors would routinely bid about 25 percent more than private equity funds for companies. Business owners would typically take the higher offer. But they did so reluctantly. The strategic buyer was usually a competitor seeking to buy the whole company and absorb it into its own business, leaving the entrepreneur to either walk away or work under a corporate parent—an arrangement that seldom succeeds. The process was fraught with worry, Cobb notes, because “the owners often don’t want to show their books to a competitor or even someone who’s close to being in their business,” lest the deal fall through.
Private equity firms, by contrast, can look relatively benign. They
usually want to own more than half of the
company (although these days they increasingly have to settle for less), so they
have the controlling vote should the business not prosper as expected. But if
the entrepreneur plans to remain involved, these firms usually want him to
retain a meaningful stake so that he is sharing the risk. As long as the
business is on the right track, they will often let the former owner stay on—if
not as the CEO, then in whatever role his forte might be, such as sales or
product development. For these reasons, “the business owners prefer the
financial guys,” Cobb says. “Today, they’re your best bidders.” A client of Cobb recently decided—reluctantly—that it needed to bring in an outside investor. The company, a medical equipment maker in the Midwest, had grown faster than the founders had expected, and it needed more money and different management skills than they had. They assumed that handing the reigns over to a competitor was the most likely and most lucrative way to assure that the business would continue to prosper.
That was before they tried surfing the
private equity wave. “I introduced them to some private equity firms, and within
10 days we had 15 offers,” Cobb says. They found a private equity investor that
could provide the money and structure that the company required, but that would
also let them remain with the business. The firm agreed to buy only half the
company, and it paid more for half than the owners thought they would get for
the entire business, Cobb says.
| Middle-market private equity firms have an added advantage: Complex and burdensome Sarbanes-Oxley regulations have made it harder for small companies to be publicly traded these days. And with analysts and institutional investors ignoring them, it is less worthwhile as well. Nearly 150 public companies did as the Dwyers did and went private in 2003 and 2004, according to accounting firm Grant Thornton. Countless companies that might have gone public have been looking elsewhere for the capital they need to grow and make acquisitions or to allow an owner to sell out and retire. |
Noard finds himself working to convince the business owners that his firm will be a good partner for them more than the companies are working to convince him that they are a worthwhile investment. For business owners, this new balance of power means that they can take their time, investigate the private equity firms and negotiate from a position of strength.
Two-Way Scrutiny
Michael Halberda, president of Healthcare Management Solutions, an Irvine, Calif., firm that provides outsourced services for the business side of hospital work, started thinking about seeking private equity about a year ago. The company had begun expanding into other regions by opening a Dallas office. “My phone started to ring at just about the same time with people who wanted to make capital available to us,” he recalls.
There was a steady enough stream of interest that Halberda felt comfortable declining if the fit was not right, and he enjoyed the luxury of being pursued. Talking to all those firms provided a good reference point, he says. “I’ve never had to evaluate potential partners or financing structures. I learned a great deal by engaging in all those conversations and seeing the firms’ different approaches and their mannerisms.”
When Riordan, Lewis & Haden came along, it seemed like a good fit, but Halberda still vetted the firm as thoroughly as they vetted him and his company. “We went through the whole chronology of transactions they’d done over the history of the firm,” he says. “And we asked for access to former CEOs and current CEOs, so we could have a real appreciation for the kind of people they’d worked with.”
If anything seems amiss at any point before the deal closes, a business owner who has had several good offers can walk away, confident that he will find a viable alternative. Doug Bradshaw, chairman of Bradshaw International, a kitchenware company in Rancho Cucamonga, Calif., did just that.
His management team, which includes two generations of Bradshaws and a hired CEO, saw the kitchenware business consolidating a few years ago, and they decided that their company, which had double-digit growth on its own, was healthy enough to be on the buying side of some of those deals. It began looking for a private equity partner in 2000 to finance acquisitions. It nearly settled on a firm, one of several in a close contest. But “the firm started to weasel on the evaluation at the end,” Bradshaw recalls. “We figured if they were going to nickel and dime us, say one thing then change their minds later, we probably didn’t want to be in business with them.”
The offers they received from
others had all been in a similar dollar range, so Bradshaw just called his first
runner-up, Riordan, Lewis & Haden, and asked if that firm still wanted to do
business. It did. Since the deal closed in 2001, Bradshaw’s sales have more than
doubled to about $250 million a year, a result of both internal growth and
acquisitions.
Heightened Expectations
The heady valuations that result from this flood
of private equity liquidity may cause problems down the line for those owners
who would like to remain active in their businesses. Private equity firms,
beholden to their own investors, still need to squeeze double-digit returns out
of their portfolio companies, which is more difficult when they pay a great deal
for their stakes.
“It’s a scary thing for [the private equity] business
generally. The higher the price, the more equity you can put to work—but you can
sacrifice returns,” Frontenac’s Noard cautions. This means firms cannot afford
to give as much breathing room to companies that do not perform as expected.
They might be quicker to take advantage of their majority stake by pushing the
board to make the decisions they want, and they might be faster to push aside a
business owner they had previously supported.
“The private equity guys will
romance the owner and tell him what he wants to hear before the deal is closed,”
notes Joe Meissner, an executive agent based in Portland, Ore., who introduces
CEOs to private equity firms. “But the case where a founder stays with the
company for the long term is rarer than a management change somewhere along the
way.”
Private equity firms have found that they need to differentiate
themselves in order to win the best deals. For many, that means honing a
specific expertise, say in franchises, family businesses or managing
acquisitions. This expertise is often the decisive factor in a company’s choice
of an investor. “We’re asking (our investor) all the time to come in and help
with this or that,” Bradshaw says. For example, he notes, “They have knowledge
of the financial markets and how to do deals that we wouldn’t, so they’ve been
helpful with our acquisitions.”
Bradshaw believes that the complication of
working with the private equity firm is a fair trade-off for the advantage of
having its capital and advice on hand. Before they took outside money, though,
two generations of Bradshaws sat down to talk about all the things that might
happen if they brought in an outside investor. “We all understood that this
would open up new opportunities and options for us,” he notes. “We’re well aware
that the company could be sold down the road. But if you’re dead set on hanging
onto your business in exactly the form it’s in today, then you shouldn’t do a
private equity deal.”
Photography by David Allan Brandt.
Eileen P. Gunn is a Brooklyn-based writer who has written about personal
finance, executive careers and real estate, among many other topics. epgunn@hotmail.com
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