New attitude for business owners

In the prefinancial crisis days of 2005-2008, entrepreneurs and family business owners could more easily envision and focus upon longer-term organizational goals, including exit plans. Frequent acquisition inquiries from private equity funds even led some to approach the transfer of ownership with a singularly focused, "show me the money, here are the keys" attitude.

With business revenues now trending 15% to 20% lower, entrepreneurs/owners are firmly regrounded in short-term realities -- such as meeting payroll every other week. As the economy slowly recovers, the ability to focus on longer-term plans is returning, but this time around that focus is taking more of a partnership-oriented twist for both entrepreneurs/owners and PE funds.

This new breed of M&A partnership for future growth is aptly illustrated through a memorable exchange between boxer Rocky Balboa and his trainer Mickey Goldmill in the original "Rocky" film:

Mickey: "Your nose is broken."

Rocky: "How does it look?"

Mickey: "Ah, it's an improvement."

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Mickey's initiative to help Rocky move beyond "hits taken" in the past and focus on strengthening for his "next rounds" is also relevant to the new relationship dynamic between entrepreneurs and private equity funds.

As the M&A segment looks toward 2010 and beyond, owners must get their noses out of daily payroll issues and into navigation of a future that still holds opportunity, but requires a different plan. Concurrently, owners need PE funds to aid the fight by going the distance with investments, delivering on their promise to work with the management team and help it run the company.

As the business world leaves behind a financial engineering era and enters a period of emphasis on operational excellence, foresight and innovation, collective value creation by the PE fund and the family-owned business will prevail over value transfer from one entity to the other. Main Street and Wall Street will need to change the prism through which they see one another and work more closely together to realize desired returns for both buyer and seller.

"We see our operationally oriented investment thesis becoming increasingly attractive to sellers and have organized internally around family business owners' interest in a more integrated operational management partnership," said Robert Landis, partner, origination at Riverside Co.

As 2010 approaches, business owners are more receptive to a closer partnering with PE funds on the future of their organizations due to recent -- and ongoing -- seismic shifts in the competitive, consumer and regulatory landscapes.

The macro-economic global environment is hypercompetitive. There is no doubt that businesses are competing directly with low-cost and highly motivated labor from all continents and that any competitive advantage typically has a very short half-life. However, owners and funds that are truly integrated in management of the company can more effectively sustain and expand competitive advantages.

Consumer behavioral shifts continue to occur with rapid force. For example, any high-end retail organization is facing challenges to the basic premise of its business, and the housing industry is still recovering from McMansion fallout exposure. Owners who work closely with PE funds can gain greater flexibility to reposition their offerings in response to consumer shifts and have the financial wherewithal to buy time for consumer spending to return.

Nonbusiness-related variables to success (for example, regulations, taxes, mandates for healthcare, etc.) are likely to change drastically over the next couple of years. Much like consumer shifts, these potentially abrupt changes are more successfully weathered through the resources inherent to a closely integrated partnership.

Additionally, entrepreneurs are tired. Survivors of 2009's grueling battle for "sweat equity" are fatigued with limited succession plans in place. Still, the owners who are left standing recognize opportunity as competitors have been washed away and their own business operations have been strengthened through necessity. A strong PE partnership could be the missing ingredient to capitalizing on that opportunity.

For PE funds, actively pursuing closer partnerships with entrepreneurs/owners can help guide deal-sourcing activity amid increased pressure from limited partners to deploy capital. To a large extent, PE has been on the sidelines for two full years. In 2009, many supportive limited partners endorsed caution in deploying capital, but their stance in 2010 is likely to shift in favor of taking advantage of buying opportunities.

Closer partnerships with owners, and more complete integration with owners' operating skill sets, will effectively supplement funds' financial skill set to realize desired growth. Throughout the past decade, the primary core competency for generating returns at many PE firms was financial and capital structure acumen, but those days are over. Returns in the next decade are going to be created through an appropriate mixture of operational leadership, innovation, sales discipline and financial acumen -- a skill set mix that a PE fund on its own does not generally bring to the table.

Finally, closer partnerships between funds and owners are more palatable because of more unified transactional expectations; the "three stars" of seller's price, buyer's price and availability of financing are at last aligning.

Over the next two to three years, a key aspect of the new breed of M&A partnerships will be collective repositioning initiatives. As family businesses regroup from the challenges of the past two years and optimize operations for growth opportunities, PE funds and entrepreneurs/owners will also reposition the ways and structures of deal execution.

While the classic leveraged buyout will remain prevalent, key strategic shifts in dealmaking activity are likely to include minority investments, fundless sponsor sourcing, seller earnouts and seller notes, and PE fund vertical specialization.

PE funds will make more frequent minority investments into family businesses in situations where owners want to take some money off the table in order to provide security for their family and, with the right PE partner, to preserve an opportunity to take a second bite at the liquidity apple in five to seven years.

With unemployment at 10% and significant executive talent still on the street, the fundless sponsor model is poised to overcome its former negative connotation and mature with the leadership of more operationally and innovation-oriented talent within the sponsor. As fundless sponsors bring family business deals to PE funds, their enhanced value could bring more frequent execution for this deal structure.

PE funds will also continue to migrate toward specializing in particular industries or verticals in order to accumulate deeper operating expertise and gain closer access to the information and knowledge flow of the industries, with the ultimate objective to better understand firsthand the external realities that could potentially impact their investments.

"We believe we are entering a period where a deeper partnership will exist between the entrepreneur/family business owner and the private equity fund," said Phil Curatilo, principal and chief marketing officer at Key Principal Partners Corp. "Our differentiated model of taking a minority ownership position in a company, and working strategically and operationally with the owner/operator, will enable the owner to better attain both their business as well as personal objectives. This includes receiving the liquidity they need to ensure a comfortable retirement, the minimization of operational and execution risk, and retaining majority equity ownership in their business, which will allow for significant overall returns for the family business owner as well as our limited partners."

In the next 18 months, entrepreneurs will forge forward with a new appreciation and framework of risk, investment and partnership with the PE community. PE funds must recognize owners' new long-term battle plans and aid the fight through delivery on their promises of "value added" and "working with management" in order to realize outsized returns.

Thomas Bonney is founder and managing director of CMF Associates LLC.

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