Why private equity groups prefer to buy larger companies and use leverage

As a corporate broker specializing in smaller deals (total sizes between $2,000,000 and $20,000,000), I often see companies at or below the smaller end of our range that are struggling to attract interest from private equity groups . Generally, a private equity group wants to invest at least $5,000,000 in companies and borrow a significant 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 that would be happy to close a $5 million deal with half a loan from a bank not be interested in closing a $2.5 million deal? Obviously they have the money to close the deal and there is more room to grow the smaller company. In addition, the unleveraged venture is less risky.

To understand PEGs’ motivations, you need to look at them from their perspective. Let’s say a hypothetical PEG has three employees, each paying $200,000 a year to handle business and oversee the businesses they buy, and $400,000 a year in overhead for rent, travel, receptionists, etc. The total amount , needed to operate the PEG can be $1,000,000 per year.

Let’s assume that our PEG can comfortably oversee 5 companies at the same time while looking for new acquisitions and divesting mature investments. If you buy 5 companies for $2.5 million in the first year, you have $12.5 million invested. Most of the profits from these companies are absorbed into the PEG’s operating expenses or reinvested in the operating companies to grow them. So if they double the value of these companies over 5 years, they’ve made a 14.8% return. Given the risks of private equity, that’s not an acceptable return. Investors in a PEG understand that they are taking significant risks in illiquid investments and demand a return commensurate with that risk.

On the other hand, if our PEG buys $25 million in companies but borrows $12.5 million and doubles the value of each company over a 5-year period, their return on equity doubles to 32%, a far better return. (12.5M x 1.32^5 = 50M) Of course, the companies will have the additional interest expense and principal repayments when they repay the loan, but the larger companies should generate enough cash to more than cover these costs .

In order to generate a reasonable 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 struggling companies. These companies can be lower cost and more difficult to leverage because banks won’t lend against cash flow when there is no cash flow. Most PEGs view smaller deals as add-ons to an existing platform company, especially if the company allows them to expand their product offering or geographic coverage. Finally, PEGs sometimes buy multiple smaller companies and merge them in a roll-up. This allows them to reduce expenses in the companies, achieve economies of scale and end up with a stronger company with a lower multiple of EBITDA.