As a business broker who specializes in smaller transactions (total transaction size between $2,000,000 and $20,000,000), I often see companies at or below the smaller end of our range that are having trouble attracting crowd interest. of private capital. Typically, a private equity group wants to invest in companies for at least $5,000,000 and borrow a substantial portion of the purchase price. Even PEGs with lots of money to invest want to take advantage of the deal.

So why would a PEG who would happily do a $5MM deal with half a loan from a bank not be interested in doing a $2.5MM deal? They clearly have the money to do the deal and there is more room to grow the smaller company. Also, the leveraged company is less risky.

To understand the motivations of PEGs, you need to look at it from their perspective. Let’s say a hypothetical PEG has three employees who are paid $200,000 a year, each of whom will review offers and oversee the companies they buy, and $400,000 a year in overhead for rent, travel, receptionists, etc. . The total amount needed to operate the PEG may be $1,000,000 per year.

Let’s assume our PEG can comfortably oversee 5 companies at a time while looking for new acquisitions and exiting mature investments. If they buy 5 companies for $2.5 million in the first year, they will have invested 12.5 million. Most of the profits from those companies will either be absorbed into the PEG operating cost or reinvested in the operating companies to grow them, so if they double the value of those companies over 5 years, they will have generated a return of 14.8% . That is not an acceptable rate of return given the risks of Private Equity. Investors in a PEG understand that they are taking high risks in illiquid investments and demand returns commensurate with that risk.

On the other hand, if our PEG buys $25 million worth of companies, but borrows $12.5 million and doubles the value of each company over a 5-year period, its return on equity more than doubles to 32%, much better performance. (12.5MM X 1.32^5 = 50MM) Of course, businesses will have the added interest expense and principal payment as they draw down the loan, but larger businesses should generate enough cash to cover with you increase that expense.

So, to produce a reasonable rate of return, the PEG wants to buy larger companies and use leverage to increase their returns.

There are exceptions to this generalization. Some PEGs specialize in turnaround situations, where they buy companies that are in trouble. These businesses can be less expensive and more difficult to leverage because banks will not lend against cash flow when there is no cash flow. Most PEGs will look at smaller deals as add-ons to an existing platform company, especially if the company allows them to expand their product offerings or geographic coverage. Finally, PEGs sometimes buy several smaller companies and merge them into one rundown. This allows them to cut costs across companies, achieve economies of scale and end up with a stronger company with a lower EBITDA multiple.