Acquisition Criteria: What Every Private Equity Firm is Looking For

Private equity firms provide meaningful investment capital to growth-oriented businesses. Unlike venture capital firms, they do not invest primarily in start-ups. They focus on the leveraged buyout of companies with proven business models but which need a single round of investment and a strategic direction to get to the next level.

Businesses seeking expansion, change of investors, or even exit may benefit from private equity firms. Because they invest in companies to earn a return, they follow rigorous due diligence processes and stringent criteria for acquisition.

*Note for 2024: While the overall market was down, 2023 saw a more resilient middle market when compared to much larger ‘bulge bracket’ M&A deals. We anticipate a much stronger market for solid middle-market companies in 2024 from both Private Equity and strategic buyers.

If you’re a business owner who wants to sell in 2024, contact our sell-side Advisory team today. 

What Private Equity Firms Seek in M&A Investment Targets

Investment from private equity firms comes with conditions, clauses, and limitations. They want to ensure that they earn a good return on investment and easily divest after a few years. So, they may insist on a new business plan, members on the management board, etc.

Private equity firms thoroughly analyze the investment opportunity and research the business to understand the company’s market position, industry trends, financials, etc. Factors that help them determine if a company is a good investment target or not include:

1. Operation in a non-cyclical industry
2. A competitive business plan
3. Multiple drivers of growth
4. Repeatable revenue and reliable cash flows
5. Low capital expenditure
6. Favorable industry trends
7. Strong management team
8. Clear exit strategy
9. A seat on the management board
10. Operational discipline.

Operation in a non-cyclical industry

Because they intend to own companies for many years, private equity firms prefer companies that don’t operate in volatile markets and are easier to exit. A company requiring an economic rebound to be sold, such as a retail business catering to a specific holiday, does not interest them. They opt for companies that operate in non-cyclical industries.

A Competitive Business Plan

Private equity firms want to see an ambitious and realistic business plan before investing in a company. Good sales and profitability prospects are essential, and the target company’s facts and figures must support those forecasts.

Even more specifically, private equity firms want to see at least 20 to 25 percent annual profit, which may require the company to improve EBITDA, obtain economies of scale or synergies, and earn high margins.

Multiple Drivers of Growth

Private equity firms look for companies with multiple avenues of growth, including exploring new markets, new locations, sales strategies, customer acquisition strategies, etc. They assess the company’s growth potential by reviewing factors like customer base, past successes, and the size of current and potential markets.

Repeatable Revenue and Reliable Cash Flows

Companies must have steady and reliable cash flows to enable private equity investors to meet their interest payments. Because a company requires spending to grow, however, rapid growth does not promise an influx of capital, particularly when the cost of acquisition is high. Therefore, private equity firms keep track of operating costs, costs of increasing human capital, overheads, sales, assets, liabilities, and costs associated with upgrades of software, processes, etc.

Low Capital Expenditure

Unlike venture capital investors who expect to invest multiple rounds of investment, private equity firms avoid companies that require multiple rounds of investment or are capital-intensive. Such companies receive lower valuations from private equity firms, which see them as financially risky.

Private equity firms target established companies that they believe will thrive after one investment. This affords management flexibility regarding the allocation of business capital and the operation of the business. Such flexibility offers choices to issue dividends to shareholders, grow their core operations, invest in growth and acquisitions, etc.

Favorable Industry Trends

Private equity firms prefer companies that leverage trends and disrupt technology within their respective industries because these factors result in market growth and the potential for strong equity returns. They want target companies to have plans for innovation that will transform the industry by enhancing automation, introducing AI or other disruptive technology, and adapting to changing consumer behavior, changing demographics, increasing regulations, etc.

Strong Management Team

Private equity firms do not run the businesses they buy; they are investors, not operators. They provide strategic guidance and rely on existing management to execute their operational strategies. In rare cases, they may replace current management with their own team.

PE firms look for companies with a strong organizational structure and management team with a proven record of identifying key opportunities and mitigating risks because it’s easier (and less expensive) to retain existing management than bring in a new team.

Clear Exit Strategy

When private equity firms study a company, they dedicate 50 percent of their time to analyzing the investment and the rest on how they will divest after a few years, so they have a clear idea from the beginning. If they feel that a company could be difficult to exit after a few years, they’ll likely pass on that investment opportunity.

A Seat on the Management Board

To protect their interests, private equity firms insist on being included as decision-makers within the companies they own in whole or in part. This executive-level control makes them feel more secure about their investment because they can influence management regarding the approval of changes to the business plan if needed.

Operational Discipline

Private equity firms want to see a culture of operational discipline in their target companies. They look at management will and commitment, which is the first essential step of operational discipline within an organization. Target companies should have streamlined and effective systems and processes in place to ensure sustainable revenues and growth.

Summing Up:

Private equity firms invest in companies with the intention of creating value within a few years, after which they will sell their stake for the highest possible capital gain. Therefore, they seek businesses with clear growth potential and needing limited investment.

If your company is growing and market trends are positive, but you don’t have the fixed assets necessary to guarantee bank loans, consider selling a majority or minority stake to a private equity firm. By understanding what private equity firms are looking for, you can be in a better position to get a favorable deal.

If you’re a business owner considering a private equity sale this year, contact our sell-side Advisory team today.