How Do Private Equity Funds Decide When To Sell Portfolio Companies?

As a private equity fund focused on lower middle market manufacturing and distribution businesses, we are often asked about our eventual plans to sell portfolio companies. Private equity investors typically have a planned investment horizon (typically 5-7 years) during which they expect to hold, grow and exit a portfolio company. However, the exact timing of an exit depends on a variety of factors, some company-specific and some dependent on the broader economic landscape

1. Achievement of Growth Plans: Our goal heading into every acquisition is to double revenue through organic growth. Most companies we acquire, while excellent in engineering and quality, have not yet achieved their full potential due to a lack of market awareness and underinvestment in business development. Given the nature of our focus markets, new business development initiatives, specifically digital marketing programs, can take up to 18 months to gain traction. As we approach our topline growth goal, decisions on exit timing involve balancing the risks in the current business (customer, market, and macroeconomic) with the probability and potential value of near term growth opportunities.
2. Market Conditions: Broader market conditions also impact exit timing. A healthy economy often gives rise to higher valuations. Conversely, in a downturn, it may be necessary to hold onto investments for longer than planned to achieve an optimal return for investors. The financing environment, which is at least partially driven by lenders’ global economic outlook, also impacts exit timing. Most acquirers utilize some degree of financial leverage (debt) to buy businesses. Over the past year, that debt has become more expensive (as the Fed has raised interest rates) and banks have pulled back on how much debt they are willing to lend in lower middle market transactions. Accordingly, potential acquirers (especially private equity buyers) need to structure transactions with more equity, and therefore a higher cost of capital, than they would otherwise. This either tampers return expectations or, more likely, entry valuations.
3. Buyer Interest: Part of our internal due diligence process at acquisition is identifying potential acquirers for the business, including larger private equity funds and strategic buyers. Interested parties often reach out during our hold period for periodic updates on our portfolio companies. These conversations provide insight into how the broader buyer universe would perceive the portfolio company.
4. Value Creation Opportunity: We consider ourselves stewards of the businesses we acquire and hope to leave the company in a much better position than we found it in from both a financial and human capital perspective. If the company and its management team mature to the point where we determine the “levers” we traditionally pull to grow our portfolio companies will not result add significant value, we will explore bringing in an ownership group to help the company reach new heights.