Small Businesses on Private Equity’s Radar?
A few days ago, I chatted with a founder in the medical field who turned down a private equity offer to acquire his business. Today, a founder of an automotive business reached out to me and shared that someone in private equity inquired about buying his firm. Neither of these founders had their companies up for sale. The private equity firms found them.
These two stories are anecdotal, but they align with what I’ve been hearing from other investors. Large pools of capital have been raised by private equity to buy relatively small, profitable businesses.
Small businesses represent a great investment opportunity. Their size, usually $10m in annual revenue or less, means there’s ample room to grow revenue if their market is big. Their operations may not be very efficient and may rely heavily on the owner, so technology and better processes can enable these businesses to grow while increasing profit margins. Last, because these businesses are small, valuations are low because there are (or were) fewer potential buyers (i.e., less competition).
Why a Founder Didn’t Sell to Private Equity
I chatted with an entrepreneur in the medical field who has built a business doing seven figures in annual revenue. He built the company from the ground up over the last decade and was recently approached by a private equity firm about acquiring his business.
He wasn’t looking to sell but decided to go through the process of having the private equity firm evaluate his business. In the end, the firm gave him a thorough analysis of his company and an offer to buy the entire company. He would have had to stay on, with a high salary, to continue running the company.
The founder did his own analysis and declined the offer. His business is generating a material annual free-cash flow. He concluded he’d rather own the business for the long haul than sell for a lump sum today because he’s built an asset that’s giving him an above-average return that probably will improve over time. He’d rather own a cash-flowing asset he controls with potential for increasing returns than take a lump sum and find other assets to invest in that will likely pay a lower return.
I enjoyed talking to this founder and hearing his thought process. I like the way he views his company as a cash-flowing asset and how he factored returns of his two options into his decision-making.
Takeaways from My Social Outing
Yesterday I was at a social gathering. The topic of markets and investing came up because a few of the people there make relatively small personal investments in their spare time. The gathering included people from various backgrounds, locations, and professions, so I was very curious to hear what everyone had to say. I observed three notable points:
- Negative sentiment – These people are interested in investing only in traditional cash-flowing businesses. This wasn’t surprising; I’ve heard the same from other investors and entrepreneurs. What stood out was the negative sentiment my friends had about start‑ups, technology companies, and to a lesser degree public equities. Their views applied to all start-ups and technology companies (excluding mega caps such as Google).
- Historical trends – They expect certain asset classes, including real estate, to continue to perform well even in the current interest-rate environment.
- Debt – They’re still embracing the use of debt to purchase physical assets.
Here are my thoughts on each point:
- Sentiment about start-ups and technology companies may have swung from too optimistic to too pessimistic.
- Understanding why a trend occurred in the first place is important. Then you can assess whether the same conditions still exist and gauge the probability of the trend continuing.
- Everyone must make the decision that’s appropriate for their personal situation when considering whether to assume debt.
I enjoy going to social events that include people from various backgrounds and perspectives. I get a lot out of conversations at these events. It’s a great opportunity for me to understand how different people think about things.
Distressed Amazon Aggregators
In the last few years, there’s been a push to acquire small retail brands that sell on marketplaces like Amazon. Fueled by the pandemic-induced surge in e-commerce growth, aggregators raised billions of dollars to acquire Amazon.
Aggregators remind me of private equity—but more focused. They build a scalable platform that allows acquired companies to benefit from economies of scale. They acquire a number of tiny retail brands and plug them into their platform. The idea is that these small brands can scale more rapidly as part of a platform. From what I’ve read, many acquisitions are teams of five or fewer people doing $1 to $5 million in annual revenue.
Many aggregators raised billions in debt to fund their acquisitions when interest rates were low in 2020 and 2021. Now, for a variety of reasons, they’re beginning to experience some pain. First, e-commerce growth rates in 2020 and 2021 have not held up. E-commerce is still growing, but at a rate much closer to historical averages because people are shopping in person again. This means that the growth projections of companies acquired in 2020 and 2021 aren’t being met, which in turn means that cash flow projections aren’t being met. Second, inflation has increased costs substantially. Costs for producing, packaging, and shipping physical goods are materially higher. High costs (absent offsetting price increases) translate into lower profit margins and cash flow. Third, interest rates have increased substantially since 2021. The debt service on some of these loans is an issue. When debt needs to be refinanced, it can be hard to demonstrate how you’ll repay the debt—especially when sales, margins, and cash flow aren’t meeting projections.
According to a Bloomberg article earlier this month, the Amazon aggregator industry is in trouble and may begin consolidating. Based on my e-commerce experience, I agree. But where there’s pain, there’s also opportunity. I can see sophisticated investors who are experienced in e‑commerce purchasing some of these assets at very distressed prices, turning operations around, and transforming these brands into assets that generate great returns.
Investor Entrepreneurs, Like Other Entrepreneurs, Need a Unique Insight
I’ve spent a good amount of time developing an understanding the journey of emerging investment managers. These are people who want to start a company that focuses on making money by investing capital. Many people think of emerging VC fund managers, but it can include anyone investing other people’s capital such as private equity and real estate fund managers. I think of these people as entrepreneurs who happen to be investors, or “investor entrepreneurs.” They want to invest as their profession, but not by working for someone else. They want to create their own investing company and work for themselves.
These investor entrepreneurs are no different from any other founder. The journey and struggle are the same; the details vary a bit because of the industry and business model.
Most great founders have a unique insight. They understand a problem well, seeing something about it that others have missed. This observation is their unique insight; it gives them an edge in developing a solution that creates real value for potential customers.
To be successful, investor entrepreneurs need the equivalent. They need to understand and see an investing opportunity that others don’t understand, have overlooked, or aren’t aware of. They need to understand how they can generate superior returns because of this insight. This unique insight is their investing edge, their investment thesis.
A founder with a clear, unique insight, a solution based on that insight, and the ability to execute has a higher probability of success and of raising capital from VC funds. An investor entrepreneur with a clear investment thesis, a strategy to generate superior returns based on that investment thesis, and the ability to execute that strategy has a higher probability of success and of raising capital to invest from limited partners.
The Twin Tailwinds That Drove 2021’s IPO Explosion
A friend saw my IPO post and asked a question: what was the driving force behind so many IPOs in 2021? In my opinion, two things happened simultaneously:
- Sales explosion – Many companies, especially tech companies, saw sales explode during 2020 and 2021 because of COVID-19. Years of projected growth were realized in months in some of the more extreme examples. In many (not all) cases, sales growth leads to higher free cash flow or profit. In others, companies accelerate their reinvestment into growth initiatives, driving even more sales growth but forgoing higher profits and free cash flow. When valuation multiples are applied to exploding sales, free cash flow, or profit (investors pick the appropriate metric based on the industry), you get an explosion in what the company is worth, too.
- Multiples explosion – Many companies are valued based on a multiple—for example, price to earnings. Investors love growth, and rightfully so. Sustained sales, free cash flow, or profit growth can lead to staggering results over a long period of time once compounding is factored in. This, as well as other factors like ZIRP, makes investors comfortable paying a higher valuation multiple for a growth company. When they pay a higher multiple, that means the multiple has grown or expanded.
Growth companies usually benefit from a single tailwind, sales growth, increasing company value. The multiples used to value them would fluctuate a bit, but not much. In 2020 and 2021, companies found themselves in a rare situation. Sales and multiples were exploding simultaneously. This wasn’t a tailwind. It was twin tailwinds on steroids. The result was an explosion in what companies were worth well beyond what we’d seen before. Valuations went to the stratosphere.
Let’s use an example to quantify the difference. Suppose that a $100 million annual revenue SaaS company is growing at 40% annually and valuations are determined by a sales multiple of ~10X trailing annual revenue. There’s no pandemic. Here’s what the company is worth a year later:
- $140 million annual revenue ($100M * 1.4) * 10 (sales multiple) = $1.4 billion valuation
Now let’s factor in the pandemic. The same $100 million annual revenue SaaS company grows 100% and multiples expand to 20x annual sales because of COVID tailwinds (they peaked at 29x in 2021 per the BVP Cloud Index):
- $200 million annual revenue ($100M * 2) * 20 (sales multiple) = $4 billion valuation
In the COVID scenario, revenue is ~43% higher, the multiple is 100% higher, and valuation, as a result, is 185% higher—valuation expanded 4.3 times more than revenue. The company’s value is $2.8 billion more than it would have been without the pandemic’s effects. This demonstrates the power of twin tailwinds.
Here’s the math:
- $140M revenue * 1.43 (43% more) = $200M revenue post COVID
- $1.4B valuation * 2.85 (185% more) = $4B valuation post COVID
- 185% (post COVID valuation growth) / 43% (post-COVID revenue growth) = 4.3x
Given this situation, many founders and investors opted to take their companies public while valuations benefited from the twin tailwinds. They were able to sell some or all of their companies’ shares at valuations that were abnormally high by historical standards.
IPOs: 2021 Was Gargantuan
An initial public offering (IPO) occurs when a private company is publicly listed on the stock exchange. It means the public can buy or sell shares (ownership) in a company. An IPO is a liquidity event favored by founders and venture capital firms because it gives them the liquidity of an auction-driven market that they don’t have when a company is private. Their ownership in a company can be easily sold or added to with a few clicks. And the funds from a sale are usually available instantly. That’s much more efficient than a private transaction.
I was curious about IPO historical activity. Here’s what I found for the number of IPOs annually:
- 2018: 255
- 2019: 232
- 2020: 480
- 2021: 1,035
- 2022: 181
The number of IPOs in 2021, in comparison with other years, was huge. That year didn’t just have the highest number of IPOs in the last five years (by a large margin), it saw the highest number of IPOs in in more than twenty-five years (I didn't find reliable data before this). And that includes the internet bubble of the late nineties.
This data was eye-opening—2021 was gargantuan. It was the best year in the last quarter century in terms of companies accessing liquidity via public markets.
Number of annual IPOs is a stat I’ll begin watching more closely.
Negative Sentiment Can Be Reversed
Negative sentiment about certain types of companies has caught my attention. Some of it feels extreme. When people say things like all companies in a particular sector should be avoided, that doesn’t make sense to me. With interest rates rising and funding for companies harder to come by, it’s reasonable to assume that companies will struggle and may even fail. But expecting all companies (in a sector or segment) to fail or not grow isn’t reasonable.
When sentiment is negative, that’s a sign that the market has negative expectations of a company’s future results. Said differently, negative sentiment is a prediction that the probability of a negative outcome is high.
Sometimes negative expectations don’t align with what’s happening within a company. It may have hit a rough patch, but its leaders have done things to get back on the right path. For example, they were focused exclusively on growth, which resulted in extreme negative profitability and a high burn rate. But now they’ve taken correction actions, examples of which could be focusing on more profitable customer segments or reducing headcount.
If the company continues to focus and take the right actions, eventually this will be reflected in their results. Then, market sentiment and expectations will become less negative (or even positive).
I’m curious to see how many companies will make this transition and prove the current market sentiment wrong.
Seasoned Investor Insights
I was exchanging thoughts with an investor friend about other seasoned investors. These are investors with many decades of experience. They’ve typically been through multiple cycles and navigated them successfully.
My friend said he doesn’t believe in reading about the thoughts of seasoned investors. He wants to know what action they’re taking and what their strategies are—not principles or concepts. Because they don’t share their current actions or strategies, he doesn’t read any of their writings; to him, they’re not interesting or insightful.
I disagree with my friend. I don’t think it’s realistic to expect an investor to share his strategies or real-time investments. Doing so would likely mean more capital being deployed into those investments, which would raise prices and reduce returns. Why would anyone want that?
I also think there’s value in understanding the frameworks other people use to inform their actions. How they view and think about the world may be different and worth considering, even if you disagree with it. Lastly, there’s something to be said for the wisdom accumulated during decades of success. It’s taken these people a long time to figure out some of their insights. Even if you don’t agree, it’s worth listening them—it might take you decades to reach the same conclusion on your own.
I may disagree with elder investors’ views, but I actively seek out material in which they share their insights because I have respect for the wisdom they’ve accumulated over their successful careers. The wisdom might not be valuable at the moment, but it could be priceless at some point.
Some companies are fortunate enough to have large cash positions. To figure out the true value (or, for public companies, market cap) of the underlying businesses, you must take the cash into consideration. Enterprise value is an approach to understanding a public company’s value. Here’s the simplified formula:
Enterprise value = market cap + total debt – cash
Let’s use an example. As of this writing, here are Zoom’s numbers:
Market cap = ~$19 billion
Debt = $0
Cash = $5.41 billion
*Note: I included cash, cash equivalents, and marketable securities (treasuries and bonds) in the cash figure.
Here’s the enterprise value of Zoom:
$19 billion (market cap) + $0 (debt) – $5.4 billion (cash) = $13.6 billion
This means the company itself is worth $13.6 billion.
Founders and investors talk about increasing the value of a company by executing. What they really mean is they want to increase the enterprise value of the company.