Majoring in minorities

There are many positives about making minority investments in growing businesses. For starters, they tend to be less competitive transactions. Many minority deals are sourced independently, and are therefore not brokered by investment banks. This also means that the GP gets better access to the management team and the portfolio company pre-deal. Vendors are often looking for expertise as well as capital, and there’s often a ‘natural’ fit with a certain GP. As the buyers are not chosen on price alone, it’s easier for GPs to avoid overpaying for good assets.

“A good proportion of the deals that we do come from our own origination rather than from introductions from corporate financiers,” says Rob Southern, a director at UK firm Livingbridge, which predominantly makes minority investments. “We can have a much more creative conversation with an existing management team or a founder around the structure of the balance sheet because we’re not seeking to take majority ownership.”

What’s more, it’s no longer the case that majority investments outperform minority deals. Morgan Stanley Alternative Investment Partners analysed 215 deals – both majority and minority – involving funds in which it had a position, and found that for deals entered into between 2008 and 2013 there was no significant performance differential between majority and minority investments.

“The ones that say, ‘I only want a majority interest, if I don’t get a majority I’m not interested,’ I think they are missing out on good opportunities,” says Antoon Schneider, a partner at Boston Consulting Group and author of the April 2015 study Private-Equity Minority Investments: Can Less Be More?

“The data suggests that returns are at least as good in minority deals, so you’re just constraining yourself by saying, ‘I only do majority, I only do control.’”

However, it has to be said that minority investing isn’t suitable for every situation – or every investor. You need to approach the deal with a completely different mentality, says Southern.

“[The way] we look at it, we’re a responsible co-owner of this business, we need to be helping this management team make the right decisions about what it is that is the right thing for the business to create value, and we will seek to influence the agenda such that that occurs,” Southern says. “That influence is very often about our capability, our competence, our expertise, and that’s the right place for it to be, rather than our equity holdings.”

 DO BE CLEAR ON WHAT YOU BRING TO THE TABLE

“In a minority position, if you want to add value at the operating level, there’s a higher bar,” Warburg Pincus principal Peter Deming told delegates at PEI’s Operating Partners Forum Europe in April. “You have to prove well in advance that you can add value, that whatever you bring to the table can move the needle and is important for management, because you obviously can’t dictate those terms.”

Fellow panellist Southern agreed that once operating partners get through the door, they still need to prove their worth.

“We identify the interventions that are going to be no-brainer easy wins as soon as we possibly can, and that starts to build your influence,” Southern told forum delegates. “As a result of that influence you start to assert a power base that isn’t around control it’s around being the guys in the room that actually know how to grow this business in the best way.”

 DON’T DISREGARD MANAGEMENT’S VALUE

While investors should be clear on how they can add value to a portfolio company, it’s important to remember that founders and management teams are bringing a wealth of knowledge to the table too. Their opinions on the next move and the end goal should be heard respectfully.

“Recognise that the management team that has grown a business has typically got a very solid view about where the future lies, and that needs to be dealt with with respect,” Southern says.

Lewis Bantin, a partner in ECI Partners’ commercial team, the firm’s in-house operations team, agrees.

“They have a much better entrepreneurial sense of what’s relevant in the market, they’re much closer to the customers, they’re much closer to the product development,” Bantin says, adding that instead of stifling the business with bureaucracy, operating partners are “there to help harness and channel the energy that has created the business in the first place”.

 DO SPEND TIME BUILDING RELATIONSHIPS

It’s something we hear time and again: private equity is all about people. Never is this truer than in minority deals.

“A lot of the alarm bells that we would have would be around the behaviour of the people that we are going to be working with,” says Southern. “Are they behaving in a way that is consistent with delivering value within the business? Are they seeking to build a relationship with us? Are they being honest about good news and bad news?”

GPs should invest significant time during the due diligence phase to ascertain that all parties are aligned on where the business is going.

“In a minority deal it’s very important to make sure that you have alignment with the majority shareholder,” Schneider says. “Also, if you don’t have the right to replace management, it’s important that you are convinced the CEO will be the kind of person that wants your help and will take advice from you and really listen, somebody you believe you’ll have a constructive relationship with.”

 DON’T NEGLECT GETTING THE RIGHT TERMS IN PLACE

“The only thing around a minority that we’ll be careful on is that we have some legal controls to fall back on,” says ECI investor relations partner Jeremy Lytle.

What those legal rights look like will vary from deal to deal, but typically they will address issues such as board representation, the triggering of control rights in the case of underperformance, controls over compensation, bonuses and company expenditure, and exit timing.

But, as Southern points out, as necessary as these legal covers are, even in a majority situation if there comes a point where you’re asserting your equity right, then “things are already broken”.

“The fact of the matter is if you’re a majority investor and you’re turning up to the board meeting and going, ‘Well, I’m the major shareholder and I say this,’ that’s not going to build alignment between you and the management team. You’ll only be asserting your majority equity in a situation where things haven’t worked out, that there is misalignment.”

 DO PICK YOUR BATTLES

Whether a majority or minority investor, you will not always agree with management. There will be frictions. But these frictions can be creative, argues Southern, generating debate that could ultimately lead to the optimum outcome for the business.

“You need to be very clear about the times that you pick that you want to really intervene, especially in those situations where things aren’t quite working in the way that you want them to,” Southern told delegates at the forum.

This also goes back to recognising that sometimes founders and management teams really do know their own companies best.

“You debate and you put your best case forward, but ultimately we’ll let the management team run the business in the direction they feel they want to run it,” Deming told forum delegates. “Frankly we’re honest with ourselves, they’re in the business every single day operating, running it, and so they should have a pretty good view of which way to run it.”

 DON’T CHANGE YOUR VALUE-ADD STRATEGY

When ECI takes a minority stake in a business, the commercial team approaches its tasks in exactly the same way as it does when the firm acquires a majority interest.

“We’ll still run strategy sessions as a team and try to prioritise what the big issues are and help with those,” Bantin says. “We don’t treat it any differently, we don’t say, ‘We’re a minority and therefore we won’t contribute as much time and effort.’”

Schneider agrees that GPs should use their “normal toolkit”.

“Don’t start thinking, ‘It’s a minority, and therefore I’m not going to do my 100-day plan, I’m not going to do all the good things that I normally do operationally,’” he says. “You should pick companies that would be receptive to your normal way of adding value, and then go ahead and add that value.”

Southern adds: “Don’t let the whole minority thing get in the way of making the right decision.”

 DO THINK ABOUT THE EXIT ON THE WAY IN

At the Operating Partners Forum, Deming told delegates that exit timing can often be a point of disagreement.

“Exit timing always comes up,” Deming said. “Part of exit timing might be do you go public or do you hold on for longer and think about a sale to a strategic? Do you take it private? And sort of wrestling with those questions is something that we often debate a lot with our partners.”

Thinking about the exit on the way in, Schneider says, is even more important in minority deals than it is in majority transactions.

“In a minority deal, it’s even more important than usual to think about how you’re going to exit and what the alignment of interests will be at the time of exit,” Schneider says. “How will you get fair value if you want to sell but the other shareholders don’t?”

 DON’T ‘SETTLE’ FOR A MINORITY STAKE

If a GP is evaluating a business on the understanding that a majority stake is on offer and then the vendor suddenly switches to offering a minority stake, proceed with caution. There’s a danger that the prerequisites for a minority deal – such as minority rights and clear alignment of incentives – could be missing.

“Because it was envisaged to be a majority deal the GP normally would not have considered these issues carefully,” Schneider says.

It’s tough to turn your back when you’ve fallen in love with a portfolio company, but it’s often the wise choice.

“Sunk cost and time is exactly that,” Schneider says. “The fact that you spent a lot of time and effort and that it’s a really good company is all fine, but in the end if the prerequisites for a minority deal aren’t there then you should walk away.”