Investments are exchanges with a price, and private equity buyouts are no exception. Since these transactions happen regularly in Canada, it's important to understand their mechanics to help business owners make informed decisions.
In this article, we will discuss the basics of private equity buyouts. If there's anything that we haven't discussed here, you can always consult a Lexpert-ranked private equity lawyer.
What are private equity buyouts?
Private equity buyouts involve acquiring a majority shareholding of a target company, typically 51 percent or more, and sometimes the entire company.
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Investors seek majority control to gain decision-making power and implement internal changes to improve the company.
After a holding period, the private equity firm aims to sell the company at a higher price. The goal is to increase the company's value through restructuring and strategic changes.
Buyouts are one of several private equity strategies firms can use when investing in or acquiring target companies. Other strategies include:
- venture capital: private equity firms raise money from investors (limited partners) and invest in early-stage companies with strong growth potential
- growth equity: private equity firms invest in established companies that need additional capital to expand geographically or grow their products and services
In return, the private equity firm receives an ownership stake in the company based on its investment.
Here's a video that shows private equity buyouts as a strategy in acquiring and selling businesses, and how it works compared to a hedge fund:
To learn more about private equity buyouts, consult the best private equity lawyers in Canada as ranked by Lexpert.
Characteristics of private equity buyouts
Although private equity buyouts do not follow a single rule, they typically follow a specific pattern. Understanding these characteristics can help business owners anticipate deal structures, timeline expectations, and what private equity funds or firms will do once they acquire their company.
Here are some common characteristics of private equity buyouts:
Majority or full control
The goal of buyouts is to have full (100 percent) or at least have a majority control (more than 50 percent) of a company. This allows investors to install their own management team, restructure operations, and implement their plans.
This characteristic is what makes private equity buyouts different from other investment strategies. For instance, buyouts typically involve 51 to 100 percent ownership. In contrast, growth equity investments usually mean private equity firms take only minority stakes (typically 20 to 40 percent) and let existing management remain in control.
Operational involvement
With majority or full control, the private equity firm becomes actively involved in the company's operations. This may include control or implementation of the following:
- cost-cutting measures
- streamline processes
- increase or decrease prices
- entering new markets
- launching new products
However, the existing management team is not always replaced after the deal closes. Depending on the private equity agreement, some members of the key management team are often retained to continue running the business. This approach is common because it reduces execution risk and retains institutional knowledge.
Target companies
Usually, target companies of buyouts are those that are underperforming or undervalued but have the potential to make more profits after internal changes. This is why buyouts rarely involve startups; mature businesses with unrealized potential are typical targets.
Debt plus equity
In terms of funding, private equity buyouts are typically financed by a combination of debt and equity.
This means the private equity firm does not pay the full price but borrows part of the amount, often from financial institutions. A common structure is a 1.5:1 debt-to-equity ratio.
Timeline for the sale
The private equity firm usually holds the company for around five to seven years (or more) before it sells it to another entity. This period is the goal for the company to be restructured, pay its debt, and grow in value.
Investors are typically committed for this period, ensuring alignment until the company is sold.
Leverage to increase value
Aside from improving operations, private equity firms use leverage to increase company value. Debt payments can increase equity value by reducing interest expenses and increasing cash flow for new owners.
How do private equity buyouts work?
In a private equity buyout, investors acquire a business, restructure it, and later sell it for a profit. In the perspective of the target company, understanding these steps is important so that they know what to expect when they're negotiating with a private equity firm.
Leveraged buyouts (LBOs)
One term that is closely related to private equity buyouts is LBOs, which is the primary way private equity firms acquire companies. In this case, the term "leveraged" refers to the use of debt in financing the buyout itself. Because the private equity firm does not pay the full price, it borrows funds from financial institutions. This borrowed money is the "leverage."
Private equity firms use leverage for two reasons:
- the firm can acquire majority or full control over the company, while investing less of their own capital
- leverage can increase returns on equity when the company is later sold.
In return, the assets and cash flows of the company will serve as collateral for this borrowed money, with the financial institution holding the collateral.
Watch this video, which explains LBOs as applied to a real-life example:
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Risks associated with LBOs
However, LBOs carry risks, as with any investment. After all, it's still an investment, and in the corporate world, all investments come with their own risks. As LBOs multiply the return for private equity firms, they also amplify the losses if the company doesn't do well.
Worse, debt payments still must be made even if the company's cash flow declines. These debt payments can also eat up a chunk of the company's cash that could've been used to improve its declining operations.
While debt can be useful in a buyout, it can also increase risk if the company underperforms.
Can lawyers help with private equity buyouts?
Lawyers play an important role in private equity buyouts, which involve complex legal structures and regulatory compliance. Both business owners and private equity investors should seek legal counsel from the beginning of a deal through closing and beyond.
Here are some ways that a private equity lawyer can help parties in a buyout:
- ensuring compliance with Canadian laws: whether it is Canada's laws governing corporations, antitrust, and taxation, private equity lawyers ensure that the capital structure complies with its rules
- conduct private equity due diligence: before closing the buyout deal, due diligence must first be thoroughly conducted, covering all aspects of the target company (e.g., industry, operations, financial, legal)
- negotiating and documenting debt arrangements: since buyouts largely involve debt, private equity lawyers are at the forefront in dealing with debt arrangements with the financial institutions
- defining management arrangements: if key management people are retained after the buyout, lawyers can carefully draft equity agreements that specifies how the old and new management people will work
Legal advice is important for both private equity firms and businesses involved in a buyout.
Private equity buyouts: Explained simply
While a private equity buyout can benefit both parties, the decision to pursue one should be made with legal advice. Private equity lawyers are there to guide owners and firm managers through deal structuring, tax implications, and negotiation strategy. Whether you're a business being acquired or acquiring others as an investor, legal guidance helps ensure you understand the deal and protect your interests."
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