How a private equity investor chooses acquisition targets

by Les Nemethy	CEO of Euro-Phoenix

Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:

· Nature of investments.  Some funds like high growth companies, other prefer investments with stable cash flow or dividends.  Still others prefer turn-around situations.
· Geographic scope. many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
· Preferred sectors.  Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
· Investment size.  Most funds will specify a minimum or maximum investment size (e.g. EUR 5 to 25 million).
· Ownership interest.  Some funds insist on control, others will take minority interests.
· Fresh equity.  Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth).  Others will consider a combination of fresh equity and buying out existing shareholders.  Buyout funds will want to buy 100% of a company.

It is therefore important to find a good match between private equity fund and the company.  It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors.  Business owners should therefore do a little homework before approaching funds—the investment criteria are usually on the fund’s website.

The average private equity fund in Central Europe will typically screen a few hundred investment cases every year.  Not more than a few will actually become the object of an investment.    The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee.  Hence the owner of a business must first convince the protagonist of his investment case.  The owner of a business seldom, if ever, communicates directly with other members of the investment committee. 

Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.

A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.) 

So what does a private equity firm look for in its investment choices:

· A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
· Exit strategy—who are the likely buyers for the company?  What are the chances for a successful exit?
· A strong management team, who is prepared to stay until the exit of the fund.  (An owner-manager who is cashing out is often too high a risk for the private equity investor—please see my earlier article on the “One Man Show”, available at www.europhoenix.com/library);
· Strong corporate governance—good decision structures, reporting systems, and strong documentation.  Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious, and are prepared to work extraordinarily hard to achieve significant financial gains.  Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
· Manageable risks.  No actual, pending or potential litigation, or the potential for surprises on the downside;

After the due diligence, the investment committee  (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.

Sometimes private equity firms will purchase what they call “bolt on” investments.  Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.

Private equity firms have taken an ever larger share of the M&A market in Central Europe.  They are an important potential source of financing for mid-sized firms that must not be neglected.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”