For many family business leaders we talk with, “private equity” is a four-letter word. However, a September Wall Street Journal article highlights a recent thaw in the historically icy relationship between family businesses and private equity investors. In 2021, we predicted that non-family equity capital would grow increasingly common in family businesses. This WSJ piece confirms that our prediction is on point.
Of course, family business suspicions of private equity were never completely ill-founded. There are some elements of the standard private equity playbook that don’t sit well with the ethos of many enterprising families. But the WSJ article shows that it’s more complicated than the longstanding caricatures would suggest. In this post, we identify a couple of potential “pros” for private equity that family business directors should be aware of and also confirm a couple of the well-known “cons” to accepting private equity investment.
Pro: Access to Growth Capital
There’s a large body of research literature documenting how family ownership correlates with superior business performance. While this is obviously great, it highlights a more subtle threat: family ownership can actually inhibit the growth of high-performing family businesses. We’ve written before about how family businesses are either “planting” or “harvesting.” For family businesses in “planting” season, the market opportunity may outstrip the family’s capital resources and/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. Bringing in a private equity partner can provide access to the growth capital needed to unlock the true potential of your family business.
Pro: Ability to Retain Ownership & Influence
Many private equity investors are willing to purchase less than 100% of the family business and may even want family members to remain in key management roles. Retaining ownership alongside a private equity investor allows the family to take some economic chips off the table but still benefit 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. The WSJ article we linked above highlights an outlier case in which a founding family benefited from four successive private equity transactions; the family’s proceeds from the most recent transaction (for less than 5% of the company) exceeded that from the initial sale of a controlling interest in 2006.
Con: MBAs Really Don’t Know It All
Money buys influence. Private equity investors providing capital to your family business will, of course, want to make important decisions regarding your family business. The professionals tapped by private equity firms to manage portfolio companies often have great business acumen. However, being an expert about business, in general, does not necessarily translate into being an expert about your business. Greater capital resources – coupled with the hubris that often accompanies large pools of capital – create the opportunity for bigger mistakes.
The WSJ article includes the cautionary tale of Sun & Skin Care Research, Inc., whose new PE-installed CEO promptly made a few key decisions that led swiftly to the demise of the once-stable family business. We suspect that one of the reasons all those academic studies find outperformance on the part of family businesses is that the 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 become more enlightened in recent years compared to the slash-and-burn attitudes of the early corporate raiders of the 80s and 90s, generating outsized returns is still the goal of PE investors. Doubtless, successful enterprising families are also profit-conscious. But private equity returns are not just about being profitable. Many private equity investors like to tout operational savvy as the key ingredient to their returns, but the real secret sauce continues to be the use of OPM: Other People’s Money.
PE 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. Throw in an unexpected recession or another hiccup, and that debt load can quickly raise existential questions for the business. 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).
Conclusion: 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.
Perhaps the most important thing to keep in mind is the natural imbalance in the family-private equity relationship: they buy and sell businesses all the time, and you probably don’t. That is why 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, give one of our professionals a call for an independent, outside perspective.
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