Martin Salas

Convenient Union

Corporate Governance

Published in Newspaper El Espectador on 05/09/2018

The private equity funds have existed for several decades in the finance word in a variety of versions. In theory, their horizon to achieve a return on investment (usually between 4 and 7 years) is at odds with the vision of a family business, whose horizon extends indefinitely for several generations. However, for certain funds and family businesses, the investment strategy of Private Equity fits perfectly with the need for a family business’ suitable financial assistance.

What makes a couple, in principle an odd one, have the opportunity to meet and have a good relationship? As in real life, many circumstances of mutual benefit. It is then appropriate to identify the type of Private Equity that may have a better fit with family businesses as an investment partner. Of the variety of investment funds that exist in the financial spectrum, such as leveraged buyouts, mezzanine capital, venture capital or others, the most suitable is the ‘growth capital’.

This type of Private Equity specializes in investments, generally at minority stake, that are made in mature and successful companies that are in a transformative process of economic expansion – restructuring, opening of new markets or acquisitions – but that have used-up their traditional funding lines . Many of these companies in a country like Colombia and also in other countries in Latin America, are precisely the aforementioned family businesses.

It is known that, within the main characteristics of a family business, there are two that stand out consistently over time: first, they want to remain exclusively within the family, from generation to generation, as an untouchable legacy. The second characteristic is the unwillingness to contract debt to finance economic growth or capitalize on business opportunities. Both conditions can be relaxed over time.

A family business is usually reluctant to take on debt as a financing mechanism for its growth. Traditionally, the most common way to do this is through the capital increase, that is, contributions from shareholders – the family – to self-finance the projects. However, given that the expected return to contributed capital tends to be the most expensive and that the family’s resources are not infinite, the next step, which is often done reluctantly, is to contract debt.

Once external financing has taken place, the family business enjoys a certain period of prosperity and expansion. However, this circumstance does not limit new opportunities for growth. If that circumstance occurs again but when the company has still sizable obligations with the creditors, it is a good scenario for the business growth, although with a small cash flow. Therefore, a company is configured with real impossibility to finance that growth.

It is at that moment when family businesses decide to explore the possibility of seeking new partners and being open for external partners. In turn, these potential partners must meet certain requirements to be considered by the family. The most common of those requirements are: that they invest in a minority stake, so that the family does not feel that they run the risk of losing control of the company; and that they contribute to the partnership with something more than just money. Knowledge, best practices and cultural alignment.

At the same time, from the opposite shore, a Private Equity takes on a family business when, in addition to the good financial and commercial performance of it, there is a level of openness and commitment on the part of their owners to enter a process of transformation of their corporate governance And, without entering the private sphere, making sure there are no conflicts that may complicate the partnership in the future. If the family has not started its governance process by then, the potential partnership might be a good opportunity to start it.

When that match between Private Equity and a family company occurs, the right conditions are aligned for value creation. Among those benefits, the obvious one is that the capital contributed is the vehicle to keep the growth happening as this investment is an alternative channel of financing. Therefore, it is an additional element that sparks the economy: the investor creates value and in the end the company, the economy and society win. The Private Equity will receive the return benefit according to its expectations.

The investment is accompanied by a commitment to introduce changes to the management model and thus capitalize on the expected growth opportunity. The Private Equity fund will require one or perhaps more than one seat in the company’s board. That, depending on the level of sophistication of the family business. If that change represents an opportunity for a modern and formal corporate governance, it can also serve as an introduction to a more structured family governance process.

In this way, the corporate governance dimension is the first one that is benefited. Having external and independent board members is always considered as a good practice. Not because they are external and independent, that is obvious, but because they bring in to the meeting room new knowledge, experiences and improvements in the strategy, products and contacts in the industry, contributions which should be reflected in the management and results of the company.

The inclusion of new points of view, independent and always focused on defining a better strategy and business model, create a more favorable view on the part of the company’s stakeholders (banks, suppliers or customers). Up to here everyone wins. Then it must be validated that the horizon of the plan keeps that long-term vision, so that it transcends the established horizon of between four and seven years, which normally has a Private Equity before exiting the deal.

Another benefit associated with Private Equity investment is a greater focus on organizational efficiencies. The creation of value and, even more, the possibility for Private Equity to achieve its expectation of return, occurs with the fulfillment of two variables: revenue increase and optimization (read, reduction) of costs. To ensure both, the Private Equity must determine the suitability of the management team of the company, as well as its organizational structure and processes. The absence of it will become a requirement for the deal: renew/replace the ‘weak links’.

With the addition of the Private Equity firm in the management of the family business, the review of the CEO’s succession plan will be included in the agenda. This is one of the most critical issues that are discussed in the board during the partnership and even during the negotiations. This process will lead the family to define that succession plan at some point and, therefore, to accelerate their own process of family governance if they had not started it until then.

Finally, one aspect to consider in any business relationship is to anticipate what the terms of the separation will be. The agreement on the purchase of participation in the company is almost always accompanied by exit clauses, making it clear how Private Equity recovers its investment -exit strategy: IPO, sale to the family, sale to third parties-, while n important aspect for the family, such as staying with unwanted partners, would be eliminated or minimized upfront, so that it guarantees a friendly – or at least neutral – separation.

The encounter between successful family business and Private Equity is becoming increasingly common in Latin America, and Colombia is not the exception. It provides many benefits to both parties and boosts the market with a positive effect on the economy. The valuation of the company is enhanced by the intangibles -model of management, corporate governance- that is added to the financial results. On the other hand, Private Equity finds alternatives to accomplish its investment strategy and return search. Like any relationship, if it is to be successful, the formula is to give 100% and expect the business plans to be fulfilled.