What do entrepreneurs looking for private capital investment need to know in today’s economic climate? Procopio Mergers & Acquisitions and Strategic Joint Ventures co-leader Jason Femrite dove into that topic in a Q&A with Craig Dupper, Managing Partner of Elan Growth Partners LLC. They discussed the current private equity landscape, tailored growth strategies, and working capital optimization, while providing advice to company leaders looking to engage with a private equity investor.

Jason Femrite (JF): Can you provide an overview of the current landscape of private equity, particularly in light of recent economic conditions and political volatility?

Craig Dupper (CD): There are two primary economic factors influencing lower middle-market private equity, and they are closely related: (1) inflation, and (2) interest rates. Inflation was created by the government injecting too much liquidity into the system. Higher rates are the result of the Fed’s attempt to tame inflation.

Overlay these two elements with the demise of several community banks and you get a more challenging lending environment. All of our investments include some element of leverage, or debt, so that impacts deal-making, both on the buy and sell sides.  Entrance multiples are lower and exits are not as aggressively priced.

For existing portfolio company management, inflation has made margin maintenance a challenge, necessitating price increases in order to recover ever increasing raw material, labor, insurance, and other costs.

It seems that in the last several months, business owners are coming around to this new higher cost reality. In recent discussions with potential investment targets, there appears to be an acceptance that lower sale multiples are the reasonable result of the broader economic conditions. 

JF: Are there particular industries you’re watching more closely right now?

CD: We focus on partnering in certain high-growth industry sectors, including Consumer/Food/Pet, Engineered Products (precision manufacturers), B2B Services, and Niche Software, typically service intensive technology businesses with revenue recurrence that can be commercialized. We take the term “partnering” very seriously, and it manifests itself in our investment structures where seller, or “partner” retained equity averages 40-49%. Ours is typically the first institutional capital to be invested in the business and our target companies are often founder or family owned.

JF: How can companies receiving investments continue to grow in value? Are there specific operational improvements or efficiencies you prioritize?

CD: Entrepreneurs often welcome investment from operationally oriented private equity firms. We seek to help good companies become better companies through operational enhancements that promote visibility, accountability, and repeatability, all of which support growth and scale.

We always evaluate and often augment the existing management team, ensuring first that the finance and accounting function is adequately led. Without reliable information, managerial decision-making is strained. Part of upgrading the finance function may include ERP system upgrades in addition to people.

Then it’s important to take a comprehensive look at the revenue and expense sides of the business. On the revenue side, we’ll often enhance sales team and process, support new product introduction(s), and evaluate synergistic add-on opportunities. On the expense side of the ledger, we’ll evaluate all elements of COGS and SG&A to ensure optimal, highest yielding spend.

As former investment bankers, we’re naturally transaction-oriented. That said, our investment thesis relies on fundamental business building as opposed to financial engineering.

JF: What’s an appropriate approach to ensure capital optimization within portfolio companies in the current economic climate?

CD: Optimizing working capital is a challenge for many companies in this ever-shifting economic landscape. When a business relies on certain components in its production process and component lead times expand from six weeks to six months or often even longer, it’s important to have components on hand in inventory—contradicting the just-in-time framework. For example, during the COVID period, some businesses saw spikes in demand, leading managers to go long on inventory or ramp up capital investment to service those temporary spikes.

Elan strives to inculcate data-driven decision making at each of our partner companies to account for often volatile economic conditions. This includes continually forecasting capital requirements for growth, analyzing risks and evaluating financing options. To supplement working capital at each of our invested companies, we establish asset-based lines of credit or revolvers that help expand balance sheet capacity for additional inventory, offering longer terms to large enterprise customers, and to support other unforeseen issues that may require liquidity. We track days sales outstanding, days payable outstanding, days inventory on hand, cash conversion cycle and overall working capital turnover. With Elan’s data driven approach and scalable financing, we help our partners optimize working capital to achieve rapid growth, while avoiding obsolescence and oversupply.

JF: Are there any consolidation trends you’re observing within specific industries or sectors? How would private equity investors position themselves to take advantage of consolidation opportunities?

CD: As I noted before, the primary support for any investment thesis must be organic growth potential. Elan steers clear of pure roll-up strategies.  That said, we regularly evaluate and on occasion execute synergistic add-ons. Part of our underwriting includes an analysis of potential exit opportunities. In this context, we look at industry consolidation, with a drive to invest in industries with a few large consolidators that could provide multiple avenues for strategic exit.

JF: There can be a lot of variety in the structure of private equity investments. Do you have a typical combination of debt vs. equity, warrants, etc.?

CD: Our partner equity structures include a larger than typical seller, or partner, rollover, averaging 40%+. We are conservative with leverage, limiting third-party debt to less than 3.0x regardless of cycle-driven debt availability. To bridge valuation gaps, we will often include back-end equity participation tied to objective performance metrics.

JF: This has all been very helpful, Craig. Thank you for sharing these insights. For a final question, I’m wondering what advice you would give to company leaders when in discussion with interested private equity investors?

CD: I’ve enjoyed this conversation, Jason. Here are my thoughts. While they’re easiest to measure, valuation and cash at closing are but two factors a business owner should be evaluating when considering a private equity partner. Additional key considerations are structural alignment, firm experience, access to functional and industry-specific expertise, and chemistry with the team. Given the large partner roll in Elan’s investments, we often liken the relationship to a marriage with planned objectives and an ultimate separation once we’ve accomplished what we set out to do together. Most people take a wholistic approach when looking for a spouse, and they should apply some of this orientation in their search for a private equity partner.