25/05/11

By Daniel Sasaki, MD of the London arm of LDC, one of the UK’s leading regional mid-market private equity houses

As SMEs ponder their funding options, approaching private equity providers is possibly not top of their list.

Often management teams think their companies are simply too small as they read in the media of multi-billion pound private equity deals. Others may be worried that the eager focus on profitability, the supposed watchword of private equity firms, may be too tough a medicine for their companies.

However, these myths should not deter SMEs especially if they are looking for funding support for a forward focused and ambitious business plan. In a tough business environment, in which many sectors are starved of other funding options, private equity may be the most viable and supportive option.

Many businesses need funding to help them take advantage of the opportunities that the nascent recovery presents, but having focused so strongly on the fundamentals of cash flow management and selling their products and services during the recession, marketing themselves and their firm to investors is an art that needs to be revived and re-learnt for the current business climate. So how can SMEs best present themselves to attract private equity support?

The first area a private equity arm will review is a company’s financials, the fundamentals of any business. Such areas as the robustness of your business model and how critical is your company/product to your customer’s existence and whether the sector you are in is cyclical are all key financial factors that will be considered. In short, this equates to an assessment of quality of earnings and revenue.

Having assessed the financials and the concept and had answers to more detailed questions, such as what pricing power your company has and are margins sustainable, investors will then want to see evidence of past success, what has been achieved so far and what is the company’s five year plan.

Following this, the next aspect that will be analysed is the sector in which you operate and the potential it has to rebound. Some sectors are obviously more attractive to potential investors. For example, the publishing sector has enjoyed strong growth in recent years. According to the Publishers Association, total sales of books increased year on year in 2010 to £3.1bn. UK sales of digital books alone increased by 20% to £180m last year. Digital publishing is growing at an impressive rate as innovation in the marketplace has allowed publishers to develop digital formats to reach wider audiences. It is this kind of potential for growth in tough economic conditions that private equity investors seek.

As well as the potential for a sharp rebound, private equity investors also look for sectors that are in the grip of some major transformational change, which gives the opportunity to earn strong returns. An example of this is TMT, an exceptionally dynamic, innovative and fast-moving sector. A range of factors are transforming the sector, such as the emergence of new products and services, including cloud and tablet computing, a greater variety of software as a service and an explosion in social media. The opportunities brought about by these trends are vast and there is huge potential for companies to enhance their revenues.

TMT deal value rose last year to close to £800 million compared to just over £600 million in 2009, reflecting the increasing value seen by private equity houses in this sector. TMT is an important sector for LDC London and over the next 24 months the team will be looking to invest in excess of £200million into this arena.

In addition to assessing the strength of the sector, understanding the abilities and ambitions of the incumbent management team is another key criteria that private equity houses will look at. At LDC, in particular, we believe in backing great management teams and this is a prime factor in every transaction we undertake. Therefore a starting point would be to assess your own management strength and review whether the firm has the right individuals in place to actually deliver on its strategy.

Non executives can also play an important role in a private equity transaction. LDC’s approach is to identify and recruit additional non-executives to help bolster the management team but they must be a positive, supportive and complementary addition to an existing strong management foundation.

Two other qualities in a business that private equity investors look for are ‘niche’ and ‘scale’. Companies that have built a strong defensible niche have a valuable proposition. It is even more valuable if it is scalable, and if management have identified a clear path for growth. For example, outsourcing is one sector in which scalability is a hallmark of many company profiles, making them very attractive to private equity firms.

Outsourcing has risen from being a mere cost cutting tool, to becoming a powerful weapon that is often one of the central elements of a company’s business strategy. With corporate budgets still tight, outsourcing is recognised as a more cost-effective, less structured, more flexible solution and is being embraced not just for one or two back office tasks, but increasingly for a wide range of business functions including procurement, technology and human resources. This scalability means that private equity firms would view such businesses as having real opportunities for growth.

It is important to be aware that companies with operational, business or management issues should not think that this rules them out of private equity opportunities.. Private equity firms often have specialists to help management make transitions in these areas. For instance at LDC we have the Value Enhancement Group, staffed by ex-management consultants and former senior corporate managers who really understand companies from a business rather than an investment perspective and specialise in helping growing companies address such issues.

Finally, SMEs should not be put off by an assumption that they are too small nor a limited understanding what private equity is and can do for both an individual and a business. Private equity firms exist to help companies grow and prosper — whatever their size — and their profits are closely correlated to the profit outlook of their portfolio companies. At its best an SME’s relationship with a private equity firm should underpin its funding, provide additional expertise, support acquisitions when required and, above all, enhance its growth and commercial success.

Understanding the principles behind private equity investment is a great starting point for any business.