The Anatomy of a Private Equity Transaction

By Generational Equity


As loyal readers of this publication know, I keep my eyes open for interesting real world deal stories to share with you folks so you can see that many of the research findings we discuss in these articles are not “ivory tower” fluff pieces but are actually borne out and proven in the real world.

So I was intrigued by an article published recently by Inc. on its website, Entitled “Inside the Sale of an Inc. 5000 Company” and written by Jeremy Quittner (who does a really good job of getting detailed information on this investment), the piece highlights three key concepts that we have been discussing for years:

  1. Partners running these lower middle-market firms have tremendous vision and insight.
  2. Private equity firms who operate in the lower middle-market do so to help GROW their acquisitions, not tear them apart.
  3. There are equity firms that focus on making very small acquisitions.

And actually the article's title is a bit misleading. As you will see, the acquired company was actually probably much too small to be even in the Inc. 5000, at least when it was first acquired.

The nuts and the bolts of the acquisition are these: Evolution Capital Partners, founded by Brendan Anderson and Jeff Kadlic in Cleveland, was launched in 2006 and created solely with the idea of investing in lower middle-market companies, turning them around, and selling them at a 20-30% ROI (return on investment). They started with only $75 million in committed capital, primarily from wealthy entrepreneurs located in Cleveland who shared their same vision for acquisition targets.

In 2009, after acquiring three companies and investing most of the initial committed capital in the fund, they stumbled upon an interesting investment opportunity and acquired Accurate Group, a mortgage-servicing firm in Charlotte, North Carolina. Accurate owned “a powerful suite of mortgage-servicing software capable of managing thousands upon thousands of real estate transactions. Kadlic and Anderson had a hunch that the software could be upgraded and marketed to banks nationwide.”

Private Equity Leaders Look to the Future

What strikes me was this description of the condition of the target (Accurate Group) at the time Evolution Partners looked at it. Reporter Quittner paints this picture:

“Brendan Anderson and Jeff Kadlic opened the door to the storage room and stopped short. This was not what they were expecting to see.

A large blue plastic tarp was suspended like a tent from the ceiling. The tarp protected a set of blinking computer servers from water that trickled through the cracked ceiling whenever it rained. A small portable fan whirred away and oscillated, cooling the machines.

Anderson and Kadlic looked at each other. This was what they were going to spend millions to acquire?”

Can you imagine planning to acquire a company whose entire business was based on software and servers that were covered from the elements by a blue tarp? So we start with the first point above to say that these two guys had the ability to see possibilities in Accurate. This is how Quittner describes their vision:

“Accurate seemed ripe to grow, but it was stuck in neutral: Revenue hovered at about $6 million, and its owner, Paul O'Connor, wanted to leave the business and spend more time on his 50-foot yacht. Doman [a business associate of Anderson and Kadlic’s] proposed that he and Evolution team up to buy the company, which he would then manage.”

Now, let’s take a step back in time and remember where the lending/housing/mortgage business was in 2009: heading into a deep, deep foreclosure hole. But Anderson and Kadlic had a long-term vision for the business and realized that with some attention, hard work, and managerial oversight, there was potential.

So the first lesson of this story for entrepreneurs is that there are investors out there who are willing to see potential; however, you need to make sure you can educate them about it. Although the article does not mention how O’Connor (the original owner) was able to get the two fellows past the blue tarps, somehow he was able to sell them on the potential. You will need to be able to do the same when you approach the market.

Growth is the Key Strategy

The second lesson is this: Unlike what you hear in the business media about mega equity firms, those that focus on companies in the lower middle-market (those valued, let’s say, below $25 million) do so to help them grow. These firms don’t make investments using extreme leverage, hammering the balance sheet with extraordinary amounts of debt, nor do they do so to break the company up and sell its assets individually. I mean, in this case, how much can you get for a blue tarp, the real world “firewall” that Accurate used to protect its servers?

Here is the description of Accurate’s growth trajectory:

“During the first 12 months, long-overdue investment vacuumed up most of the company's cash flow. But by Year Two, the investments began paying off. By 2011, with new customers such as Royal Bank of Scotland and KeyBank, cash flow jumped to nearly $3 million, and the company landed at No. 1,153 on the Inc. 5000. By the end of 2012, it was No. 936 on the list, and Doman forecast EBITDA would close in on $7 million or even more.”

OK, so I stand corrected, the company did reach the Inc. 5000 list. But it only did so because the two founders of Evolution Capital Partners teamed up with Paul Doman, a 20-year veteran in the banking and mortage service industry.

Although the article doesn’t focus on this, I would bet that the turnaround in the business, post-acquisition, entailed the three of them implementing basic financial, managerial, and marketing controls that helped the company achieve growth that under its original founder was neither probable nor possible. And this is vital to how private equity firms in this niche operate: They have to grow their investments, not tear them apart, because that is the only way to eventually provide an ROI to their limited partners.

Size vs. Potential – Which Wins?

Which brings us to the last point in the list above: Lower middle-market equity firms are more interested in the opportunity and the potential than the size. Here is how the author of the Inc. article described the situation:

“Anderson and Kadlic took a hard look at Accurate's EBITDA–earnings before interest, taxes, depreciation, and amortization–the amount of cash generated by the company. This is a key metric in most private equity deals. Anderson and Kadlic usually seek cash flow of $500,000 to $2 million–which, as a rule, provides them enough cash to reinvest in the business without having to take on debt. Accurate had EBITDA of only $350,000,but with a profit margin of about 10 percent, the pair bet that sales growth could make up the shortfall.”

Consider for a moment that their normal lower threshold is around $500K … Accurate was far BELOW that threshold, which probably made it easier to invest what was left in the original fund, but also, I am sure, caused some concern on the part of their LPs, especially since even a 30% ROI on $350K would not yield all that much cash.

But Anderson and Kadlic had a plan, worked the plan, acquired the company (again, consider the condition of the mortgage industry at that time), and through their hard work and dedication, grew the company to $7 million in EBITDA in 2012 and sold it at the end of that year to a larger equity firm – a true success story in action.

Points to Ponder

Now, naturally, not every lower middle-market company starting with blue tarps protecting servers ends up with such an amazing turnaround. In most cases, you will be better off preparing your company for sale far in advance (which means actually patching the roof and getting rid of the blue tarp) if you want to attract equity firms.

This was a very rare case where the two founders of Evolution Capital Partners teamed up with a knowledgeable industry expert to get beyond the condition of the company and see the future. Most professional buyers won’t, even in the lower middle-market. However, by taking some well planned, value-building steps, you can significantly improve your position in the market relative to other investment opportunities.

The history of the M&A industry is replete with stories like this where folks took a chance on a lower middle-market company and turned it into a profit. Generational Equity has helped a number of clients do the same, i.e., find a buyer willing to make an investment and reap a profit. Keep in mind that in this case the original owner was cashed out. In many cases, the owner stays on board and participates in a “second bite of the apple” when the larger entity is sold or taken public.

If this story intrigues you, if you own a company and have reached the point where you want to spend more time on your 50-foot yacht (or even your 12-foot sloop) or if you want to stay with the company but just need capital and professional guidance to help it grow, I suggest that you attend a Generational Equity exit planning workshop. These are designed to help business owners discover how to remove the blue tarp (figuratively speaking) and position their companies to be ready for buyer attention.

Special thanks to the founders of Evolution Capital Partners for sharing the details of this transaction with us and to Jeremy Quittner for writing such an excellent, insightful piece.