Key Takeaways
1. Understand the Private Equity Game
Private equity in the context of this book refers to firms or funds that use private money to purchase companies.
A different game. The private equity industry is rapidly expanding, operating with a unique set of rules and players compared to traditional business. These firms aggregate capital from limited partners—primarily pension funds, wealthy families, and individuals—to acquire, expand, and strengthen businesses. This private nature means no readily available liquidity, with capital committed for the fund's typical ten-year life span.
Capital calls and distributions. Limited partners don't invest all their money upfront; instead, they commit capital and respond to "capital calls" as the fund identifies investment opportunities. When a portfolio company is sold or refinanced, the fund returns capital to its limited partners through distributions. This cycle of buying platforms in early years and selling them in later years defines the fund's life.
Diverse fund types. Private equity firms employ various strategies, including buyout funds (acquiring controlling stakes in mature businesses), venture capital funds (minority stakes in early-stage companies), and funds of funds (investing in other PE funds). Larger firms often manage multiple funds across different industry verticals, while smaller firms typically focus on one or two active funds at a time.
2. Measure Success Like a Pro
IRR is important, but you can’t spend it. It’s not cash!
Key performance metrics. For both business owners considering a sale and executives joining a PE-backed company, understanding how private equity funds are measured is crucial. Funds are ranked by vintage year into quartiles (top 25%, etc.) using three primary metrics, allowing limited partners to evaluate historical performance and potential future success.
Internal Rate of Return (IRR). This is the most important ranking, representing the net return earned by limited partners over a specific period, expressed as a percentage. IRR is time-dependent, factoring in all cash flows (capital calls, fees, distributions) and a discount rate. A good IRR is typically in the mid-teens (14-15% net), while over 20% is considered great, reflecting the premium required for illiquid investments.
Multiple on Invested Capital (MOIC) and Distributions to Paid in Capital (DPI). MOIC is the cash return, calculated as return divided by invested capital, but it doesn't account for the hold period. DPI measures the ratio of money distributed against the total paid into the fund, showcasing the velocity of returns. While IRR is paramount, all three metrics provide a comprehensive view of a fund's performance and are essential for informed decision-making.
3. Know Your Players and Pick Your Team
The partner or managing director has the most tenure—typically fifteen to twenty years or more of experience.
Hierarchical structure. Private equity firms operate with a distinct hierarchy, from junior analysts to senior partners, each with specific roles. Understanding these players is key to navigating the PE world, whether you're selling your business or joining a portfolio company.
Senior and mid-level leadership. Partners or managing directors are the "deal guys" with extensive experience, making key decisions, often serving as board chairmen, and directly interfacing with the CEO. Principals or vice presidents, with 10-15 years of experience, manage the investment day-to-day, working closely with the CFO and reporting to partners.
Junior staff and external advisors. Analysts and associates, typically recent graduates, perform extensive research and financial modeling, working long hours to support senior staff. Beyond internal teams, PE firms leverage a network of "old gomer" advisors—experienced professionals who provide industry expertise—and rely heavily on investment bankers, who act as independent "Realtors" to facilitate company sales and acquisitions.
4. Beyond Price: Evaluate Your PE Partner
Oftentimes, the business owner looks at price and picks the highest bid. If your goal is to sell and retire, this may be the right call to make.
Price isn't everything. While the sale price is a major factor, it shouldn't be the sole determinant when choosing a private equity partner. For entrepreneurs looking to stay involved or executives joining a PE-backed company, factors like firm culture, management style, and long-term alignment are equally important for future success and potential subsequent paydays.
Hands-on vs. hands-off. Private equity firms vary widely in their operational involvement, from highly "hands-on" (weekly calls, detailed to-do lists) to "hands-off" (monthly financial reviews, quarterly board meetings). Your personal operating style and preference for autonomy should align with the firm's approach. High performance often leads to greater autonomy, as firms focus their attention on underperforming assets.
Critical questions for evaluation. When engaging with a PE firm, ask insightful questions about their historical fund performance (IRR, MOIC, quartile rankings), investment model for your company, and willingness to allow rollover investments. Also, inquire about their governance philosophy, typical rhythm with management, and senior leadership changes. Always request references from current and former CEOs to get a balanced perspective on working with the firm.
5. Align Incentives for Generational Wealth
The best way to do this is to create an equity structure that management participates in.
Equity for alignment. Private equity firms prioritize aligning their interests with management teams to ensure everyone works towards the same goal: increasing company value. This is typically achieved through management's participation in the company's equity structure, often through rollover investments or incentive stock.
The ABC Waterfall. This common structure involves three classes of stock:
- Class A: Preferred stock, where the PE firm and management invest equity, sometimes with a preferred yield (e.g., 7-10%).
- Class B: A profit interest unit (e.g., 10% of profit) issued to management, paid after Class A equity and preferred yield are returned.
- Class C: Further incentive (e.g., 25% of profit) for management, triggered when the fund hits a specific MOIC threshold (e.g., 2.5-3.0x).
This structure ensures management benefits significantly from successful exits.
Other structures and considerations. Less common is the "accelerated method," where management must invest cash for disproportionately higher returns. Be aware of potential "management fees" charged by the PE firm to the company, which can reduce cash flow and management's equity value. Dilution protection, which maintains management's ownership percentage during additional equity raises, is a beneficial provision to seek.
6. Hit the Ground Running: The Early Days
Time is not your friend when it comes to IRR.
New boss, new pace. Upon acquisition, the company gains a new boss: the Board of Directors (or Managers). This board, typically comprising PE firm members, independent advisors, and the CEO, provides strategic guidance and oversight. Engaging them as thought partners is crucial, as their sophistication in financial and operational matters can be invaluable.
Need for speed and execution. Private equity operates at a fast pace due to the time-dependent nature of IRR. Management must hit the ground running, translating the pre-sale "hockey stick" growth projections into a concrete strategic plan with measurable initiatives and assigned owners. Establishing early credibility by hitting numbers is vital, as it often leads to greater autonomy from the PE firm.
Talent assessment and adaptation. The increased pace and growth trajectory demand a critical assessment of the existing leadership team. Be prepared to make swift personnel changes if key players cannot adapt to the new speed and scale. Simultaneously, foster a culture that embraces change and continuous improvement, engaging the board early when economic conditions or plans shift to ensure collective buy-in and adaptation.
7. Master EBITDA: The New Scorecard
EBITDA is the level playing field on which all companies are valued by private equity.
The universal valuation metric. In the private equity world, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the primary metric for valuing companies. Unlike public companies valued by price-to-earnings ratios, PE-backed private companies are valued at an EBITDA multiple, which varies by industry.
Operating for EBITDA. Traditional private company owners often focus on minimizing taxable income, but PE-backed companies inherently reduce tax burdens through interest payments on acquisition debt. The focus shifts to how expenses impact EBITDA: operating expenses (opex) reduce it, while capital expenses (capex) do not. Strategic decisions, like buying vehicles outright instead of leasing, can shift expenses below the EBITDA line, increasing the reported figure.
Adjusted and pro forma EBITDA. Beyond raw EBITDA, firms use "adjusted EBITDA" to account for one-time, non-recurrent expenditures, and "pro forma EBITDA" to reflect changes post-acquisition (e.g., removing owner's personal costs, adding fair market rent). Understanding these nuances and how they influence the company's valuation multiple is critical for management, as every dollar of EBITDA increase can translate to a significant boost in shareholder value.
8. Drive Growth with Strategic Levers
Virtually every company owned by private equity focuses on three levers of growth that can be used to increase shareholder value: organic growth, margin expansion, and merger and acquisition.
Three pillars of value creation. Private equity firms employ a multi-pronged approach to accelerate growth and maximize shareholder value within their typical 3-7 year hold period. These three interconnected levers—organic growth, margin expansion, and buy and build (mergers and acquisitions)—are strategically deployed to achieve aggressive financial targets.
Maximizing shareholder value. Each lever contributes uniquely to increasing the company's EBITDA, which directly translates into higher enterprise value upon sale. For instance, every new dollar of EBITDA generated through these strategies can be multiplied by the industry's valuation multiple (e.g., 10x), creating substantial shareholder value.
Integrated approach. While each strategy can be pursued independently, their combined application often yields the most significant and rapid growth. A successful PE-backed company will continuously evaluate and implement initiatives across all three areas, ensuring sustained momentum and optimal returns for both the fund and management's equity investments.
9. Organic Growth: Innovate and Expand
The goal is to increase revenue from current customers or finding new customers, but the company will essentially do the same thing it did before the private equity firm purchased it.
Internal revenue generation. Organic growth focuses on increasing revenue through internal efforts, without relying on acquisitions. This involves two main components: adjusting pricing and increasing the volume of products or services sold. Companies should regularly review and test price elasticity, as even small increases can significantly boost revenue.
Sales and marketing transformation. Accelerating organic growth often requires a complete overhaul of sales and marketing strategies. This includes leveraging modern CRM software, optimizing sales processes (balancing "hunters" for new business with "farmers" for existing accounts), and tiering products/services to appeal to a wider customer base, from value-conscious to premium buyers.
Rebranding and "blue ocean" strategies. Rebranding can inject new energy into a company, refreshing its image and marketing message. More profoundly, seeking "blue ocean" opportunities—untapped adjacent markets with little competition—can unlock massive growth potential. This involves pivoting from existing customer bases to serve new, mission-critical needs, as seen in the example of a refrigeration company expanding into assisted care facilities.
10. Margin Expansion: Optimize for Efficiency
Margin expansion is simply becoming more efficient at servicing the revenue you already have by working on process efficiency.
Efficiency drives profit. Margin expansion is the second key lever for growth, focusing on increasing profitability without necessarily boosting sales or customer count. This is achieved by becoming more efficient in delivering existing products or services, directly translating to higher EBITDA and shareholder value.
Technology as a catalyst. Investing in technology is a powerful way to drive productivity and expand margins. Automating manual processes, optimizing logistics with algorithms (like the laundry company's route optimization), and streamlining operations can drastically reduce costs and improve efficiency. These technological upgrades often yield significant returns by lowering the cost of servicing existing revenue.
Challenge the status quo. A critical aspect of margin expansion is relentlessly questioning existing processes and conventions. Complacency in mature companies often leads to inefficiencies that go unnoticed. By conducting thorough internal assessments, seeking employee input, and asking "Why do we do it this way?", companies can uncover outdated practices (like the complex keying system) and implement modern, more efficient solutions, leading to substantial productivity gains and increased EBITDA.
11. Buy and Build: Accelerate Value Creation
The most popular way that private equity likes to grow a company is to use the “buy and build” strategy.
Rapid scaling through M&A. The "buy and build" strategy is a cornerstone of private equity, offering the fastest path to growth and crucial for optimizing IRR. It involves acquiring other businesses to create a larger platform company, leveraging additional debt (Other People's Money, or OPM) to fund these acquisitions efficiently.
Strategic acquisitions and synergies. Companies are acquired for various reasons: filling strategic needs (e.g., buying a parts company for a medical device repair firm), building density in existing markets, or expanding into new geographies. A key benefit is "synergies"—positive gains from merging operations (e.g., combining departments, bulk purchasing discounts)—which lenders credit upfront, allowing for more debt financing and creating significant shareholder value without additional equity investment.
Expertise and integration. Executing a buy-and-build strategy requires a unique skill set, which private equity firms bring to the table through their deal teams and networks of specialized legal, financial, and diligence partners. Successful integration of acquired companies is paramount, necessitating a detailed "integration playbook" to manage everything from employee benefits and technology systems to customer overlaps and contract harmonization, ensuring smooth transitions and maximized value.
12. Leverage Consultants for Speed and Expertise
As a leader, as a CEO, I recognize that there is a time and a place to bring in consultants.
Strategic use of external expertise. Private equity firms frequently utilize consultants, and for good reason. Consultants' fees, while substantial, are often treated as one-time "add-backs" to EBITDA, making them financially attractive. More importantly, they bring invaluable best practices and fresh, objective perspectives that internal teams, focused on day-to-day operations, might miss.
Surge capacity and specialized knowledge. Consultants provide crucial "surge capacity," enabling companies to tackle large-scale projects with speed and efficiency without disrupting ongoing operations. For example, a sales redesign project can be completed in months by a specialized consulting group, delivering new compensation plans, job descriptions, and management playbooks, far faster than an internal team could manage.
Diverse applications. Consultants are deployed at various stages, from pre-acquisition due diligence to post-close strategic implementation. They assist with complex integrations, market analysis, process optimization, and even international expansion, offering expertise in areas like legal compliance or large-scale change management. Their ability to accelerate initiatives and impart specialized knowledge makes them a valuable asset in the fast-paced PE environment.
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