The reality of developed economies is that a high proportion of the businesses in the growth space are private equity (PE) backed. Whilst this is one of the most substantial segments in the Tech ecosystem, it is one that is very often miss understood by CFOs and finance professionals. This occurs as many finance professionals spend a significant part of their early career in audit, or perhaps in industry, where they are insulated from the sharp-end through layers of management. The CFO at the top might be conscious of navigating the business to an investor plan, but this focus may not be as apparent a few steps down in the organisation.
Those with experience in Venture Capital get used to a wholly different set of behaviours, investors demanding hyper-growth and prepared to take risks. In fact Venture investors are hedged against a negative outcome with your business, and when the CFO has all their eggs in one basket the venture approach towards risk-taking can be an understandable frustration.
The key characteristic with those businesses that attract private equity is that they are relatively predictable businesses. Those funds nearly always seek to acquire a controlling majority in the shareholding of the business, leaving the Exec Team, and the CFO among them, with an equity holding and a ‘sweet equity’ structure to incentivise an aligned outcome in the end.
Within the PE space there are also differing segments, for example small-cap or mid-cap. Private Equity is not all about the KKRs of this world, that seem to occupy so many of the headlines in the Financial Times. These small and mid-cap funds target businesses that have similar criteria to a venture investment, as they might still be small to medium enterprises seeing steep revenue growth. However CFOs need to keep in mind that this sort of business going into PE ownership is subject to a completely different set of rules relating to expected outcomes.
A typical approach for a new PE investment is to establish a plan by which the business would, over a 3 to 7 year period, be attractive to a new acquirer at a much higher valuation. That could be a strategic acquirer, an IPO onto the public markets or even an exit to another PE fund that focuses on businesses with a market cap one notch up the ladder.
The expectation of reasonable predictability is key. The fund is buying into the business at a valuation that means the PE is not expecting a failure rate within their Portfolio. This is not VC, where two in three might fall by the wayside even after a substantial Series A raise. For the CFO this is actually a huge plus, those who sit around the board table with you are actually aligned with your outcome.
But what does this mean for the CFO in terms of delivering on expectations? It means a good deal of intensity, high expectations and having to invest a lot of time and effort in expectation management. Any CFO new to this space will have to get into the weeds, understand every lever in the business and run the trading meeting. It’s that trading meeting that offers up the chance to be offering the Board updates on a business that tracks broadly to plan.
One story that I have heard in the tech ecosystem that illustrates the importance of the CFO role in PE-backed is worth putting down here. It’s not uncommon for a business in this space to track behind plan on revenue growth for 6 or 9 months, and ordinarily it would be assumed that the sales and marketing function is underperforming and due a shake-up. In fact, a lot of finance leaders would be surprised to hear the person the PE fund sacked in month 9 was the CFO. They’re looking at that person as the chief-in-charge-of-making-the-business-predictable, if plans are proposed that are bolstered by unfounded aspects of the growth engine, that is a shortcoming in the CFO. For those that succeed in this important commercial and strategic role the results can be lucrative.
As finance leaders shape their skills with this breed of investor, they get into a routine of hyper-detailed board meetings and managing upwards on information flow so any negatives are never first aired in the board meeting itself. It also becomes essential to build a team beneath you.
These businesses usually have more complicated legal structures and include debt in the mix, so managing bank covenants is essential. The finance team needs to be one that can step up to many of the aspects supporting the business generally. After all, the next exit may be just 3 to 5 years away, and when that comes along the CFO is likely to find it all consuming. The finance team becomes an essential foundation at that point, allowing the CFO to step away from the day-to-day and to focus on delivering the exit outcome.
In many respects these PE roles are for finance leaders that reflect the skill set of CFOs in listed businesses. These PE-backed companies can be wildly successful and it’s not unheard of for those leading them to line up three successful exits over a decade. However it does require a person with a well refined set of financial skills who is prepared to provide overall commercial governance to guide outcomes towards a pre agreed plan.
