With the current bull market over a decade old and bond yields near historic lows, many investors are looking for the silver bullet that will provide them their desired rate of return over the next decade. Many have turned to private investments in search of returns exceeding those of publicly traded securities. As of January 2019, Preqin estimated that there is over $2 trillion of capital committed to private investments that has not yet been deployed[1]. Cornerstone, where appropriate, has invested in this space on behalf of our clients for over two decades; however, this Independent Insights is focused not on the investors in private equity but on the entrepreneurs who own the companies often targeted by private equity funds.

At Cornerstone, we manage a robust private client business consisting primarily of entrepreneurs. For those of you who are entrepreneurs or know one, you understand that they are constantly in transition. Whether it is expanding the business, looking at intergenerational transfer of ownership, or an outright sale of the business, the landscape is forever changing. Entrepreneurs tend to work in their businesses more than on their businesses. They understand what makes their companies successful but sometimes fail to make sure that more mundane aspects such as buy-sell agreements are up to date. 

How do the prior two paragraphs tie together? For one, there is a lot of money looking for a place to be invested, and secondly, that pot of money includes trillions aimed towards buying companies that are privately held. The chart below utilizes information from Bain & Company[2].  Imagine that in 2003 you made your last visit to your business advisor. At the time, you had a company that made $5 mm annually in EBITDA (earnings before interest, taxes, depreciation and amortization), which is a metric commonly used to value a company. In 2003, the private equity market would have paid you 7.3x those earnings for your company, or a total of $37 mm. From 2003 until 2019, the economy grew by about 86%, so let’s assume your company’s earnings grew by that amount. That would have added another $31 mm to its value, but instead of the market paying 7.3x for your now $9.3 mm of EBITDA, private equity firms were offering, on average, 10.9x those earning. You now have a company worth over $101 mm!



A business that grew like this would have to be considered a success story, right? Not necessarily. Remember, in this example, you last updated your business documents in 2003. That means you likely planned and financed a buy-sell agreement[3]  that is more than $60 mm short of what is necessary to pay market value. What happens if a 50% owner of the business passes away? It appears there is a financing gap. Again, in this case, the entrepreneur worked in the business more than on the business; that success, alongside a lack of planning and funding, may force the remaining shareholders to take unwanted calls from private equity firms since the current owners cannot afford to purchase the shares of their deceased partner. 

On a related note, we would suggest you revisit your business plan with your advisors even if you have no interest in selling or have not had the type of increased valuation described above. The recent tax law changes allow for intergenerational gifting in amounts not previously afforded. These gifting changes are not permanent and could be overturned as soon as next year’s election.

As always, we thank you for taking the time to read this Independent Insights and wish you a healthy and happy fall!
 

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[1] https://www.preqin.com/insights/blogs/alternatives-in-2019-private-capital-dry-powder-reaches-2tn/25289
[2] Bain & Company Global Private Equity Report 2019
[3] An agreement between shareholders/partners dictating the method and value for purchasing one another’s shares.
 

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