By: Aritra Saha

Editor | Financial Markets  

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What exactly could you do with 1 trillion dollars? Well, to be precise, you could:

While many of these are not top priority for private equity firms around the world, with $1.45 trillion USD in “dry powder” – money ready to be invested – where this cash gets allocated will be a major focus as the global economy slowly reopens amidst the COVID-19 pandemic.

The numbers reinforce this statement: the Canadian Federation of Independent Business reports $117 billion CAD in added debt for small businesses directly due to the pandemic, while a mere 24% of companies have returned to normal revenue figures. Nearly 50% of small business owners have been forced into investing personal and retirement savings to fill the gaps that they have faced over the past half-year.

By this logic, private equity investment makes sense. SMEs obtain sorely needed capital that can help push their businesses past the issues that have arisen during the pandemic, while further gaining the network support of the partners at these funds.

Is Private Equity the Perfect Solution?

However, the current situation paints a different picture. In Canada, roughly 75% of all small business loans from the COVID-19 relief program are supposed to be repaid, leaving many firms in a fight to maintain solvency. That is only half the battle: pivoting from survival to success presents a whole other argument.

In this financial context, small businesses would be overloaded with debt obligations from any potential PE leveraged buyout, consequently increasing the likelihood of bankruptcy for the firm.

Fundamentally, PE firms seek to create and maximize value for their portfolio companies and investors alike. While improving the business model to make it sustainable in the long run is one such value creation method, there are various other ways of reaching the same goal (e.g., financial engineering), and not all of them involve significant business improvements.

The wrong approach to creating value can lead to operational losses for companies. In particular, buyouts have been found to lead to significant unemployment spurts as companies go from public to private; coupling this with record high unemployment rates  everywhere does not make for a good pairing.

Alternative Options Going Forward

Many of the problems being exposed across industries – financial fallibility, holes in business models  would not be resolved by throwing money at them.

That said, private investments will continue to be a key source of funding for small businesses. As a result, moving beyond the big picture LBO could present a solution for many of these ailing companies. Search funds, fundless sponsors, and search fund “accelerators” are strong alternatives available.

Search Funds: Private Equity, Except Now you Own the Company

PE firms and search funds look for similar types of companies: with solid business model, good cash flows, and room for growth and improvement. The principals at search funds are also backed by a series of investors who are ready to pool funds into a potential target firm. But that is roughly where the similarities end.

Search funds typically do not employ an LBO to finance the transaction. Rather, the primary funding source stems from whatever form of equity investors pour into the deal. The search fund’s financial model effectively bypasses the solvency issues facing many SMEs.

Following the search process, the fund’s principal(s) are ready to then take over the target’s business as the new company leader(s). This was the case for Josh LeBrun and Adrian Bartha as High Park Capital Partners principals in 2013, when they acquired and subsequently took over eComplianceManagement Solutions – a Canadian health safety software company – as the new CEOs. In contrast to the PE model, the two funding rounds to start and complete the deal enabled the two partners to spur the company forward.

The challenge that Bartha and LeBrun then tackled was one of operational guidance. The firm quickly shifted its direction towards SaaS products and US expansion,  propelling the strong growth eCompliance needed. The intense scrutiny that goes into the search process – paired with an entrepreneurial (and not financial) focus – means that a company’s fundamental operations are given a closer look, while other critical factors (e.g., organizational culture) are highlighted and managed appropriately.

Fundless Sponsors: Private Equity…Without the Equity

The fundless, or independent, sponsor model is the least straightforward of its peers: a prospective fund sponsor finds a target company with hopes to acquire them. The process is the same as in private equity, except that the invested funds are only realized after the fact rather than before the company is secured.

While concerns over the uncertainty of the quantity of financing naturally raises doubts over the effectiveness of this model, the fundless sponsor stands to benefit from this supposed point of weakness.

Through this approach, potential investors sign on to what they can view as a defined investment that suits their preferences. The added flexibility in the deal structure is the driving force for many to choose this model, with 66% of sponsors citing this as the primary factor.

The latter point is particularly important given the global pandemic: instead of being restricted to particular financing structures as in private equity, investors can grasp the bigger picture of how the virus will have affected these firms and structure the deal in a manner that accommodates for each company’s situation.

Operationally, fundless sponsors maintain the same general hands-off approach to day-to-day functions as most PE firms. Fundless sponsors certainly have an advantage with respect to their flexible financing structure.

Search Fund Accelerator: Private Equity + Search Fund + … Startup Accelerator?

The search fund “accelerator” (or SFA) takes everything we understand about search funds and effectively reverses it: various investors pool together, find a prospective entrepreneur, and pair them with a target acquisition to manage.

Drawing inspiration from startup accelerators, SFAs are designed to offset the major weakness within traditional search funds: a lack of mentorship and resources that has led to many principals to trudge down an unknown path. This is instead provided via the tutelage of the various investors that have joined together in a bid to increase the odds of success.

In this sense, the SFA takes the good bits from private equity (investor network/resources), search funds (dedicated entrepreneurs), and startup accelerators (guidance and comprehensive program) to deliver a young, but promising private capital model for small businesses to capitalize on.

So… is it really all that bad for PE firms?

Short answer: not yet.

All of the proposed alternatives have issues with them in one way or another.

Search fund results have generally yielded returns on both extremes, making this very risky in the eyes of the investor (a Stanford Graduate School of Business study has shown that the returns have begun to normalize, however, and are slated to continue this trend).

Their accelerator counterparts are still very new, and thus, it remains to be seen as to whether this approach can be sustainable in the long run.

Meanwhile, fundless sponsors rely on the existence of available capital in the market, which is not guaranteed.

Despite such shortcomings, these alternative private capital sources present structural changes to the status quo that can greatly benefit their target acquisitions.

The various presented financing structures are particularly crucial amidst the current pandemic and beyond, giving businesses a platform on which to grow without the worry of paying off their loans. Furthermore, each of these alternatives place a great impetus on supporting the fundamental business model, a change that will only help SMEs aiming for long run sustainability towards this goal.

Though many of these shortcomings are being noticed by PE funds, ultimately, most of these problems are systemic flaws that run beyond simply changing the scope of the investment. But systemic fixes take time to process and actualize, and for small businesses, the only resource scarcer than capital is time itself.