The Private Equity Phenomenon and the Fall of the IPO: An Interview with Bob Woosley

After beginning his professional service career at Price Waterhouse, Bob became the first professional employee of Frazier & Deeter, a nationally ranked CPA and advisory firm, shortly after the company was founded in 1981. In 1985, Bob became a partner and over the next 18 years he served the firm as head of the Audit and Strategic Consulting services departments. In 2000 Bob founded iLumen, Inc., the CPA profession’s leading business intelligence and analytical platform that today is used by leading CPA firms and financial institutions across the country. Bob served as CEO of iLumen through 2010 and is currently an active board member and advisor to the company. In 2011, Bob returned to Frazier & Deeter where he served as the leader of the firm’s entrepreneurial consulting practice and directs the firm’s strategic growth initiatives on both a national and local level. He is now the firm’s national practice leader in private equity.

Key Takeaways:

  • The private equity market in the Southeast has accelerated in recent years, with a lot of money chasing a limited number of quality deals.
  • A good deal of private equity firms are eager to invest in traditional, family-owned manufacturing and distribution companies.
  • Attention is shifting toward growth equity, which is more about making a minority investment in a company and betting on the existing management team.
  • The technology industry is driven more by revenue than the traditional Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)-based valuation model.
  • The Southeast is a great place to do business because of its business-friendly environment and growing entrepreneurial infrastructure.

We’re looking to get an idea about middle market activity of private companies in the South. Overall, what middle market activity are you seeing in the Southeast?

We’ve seen a significant increase in mergers and acquisitions (M&A) activity in the Southeast over the past decade—it’s far more robust than in previous years.

For one, the initial public offering (IPO) market is slower than it has been in recent years, so companies are exiting through M&A instead. And many companies simply have more wealth to spend. When the recession hit, corporations stopped investing in research and development (R&D) and started accumulating cash on their balance sheets. Now, in a relatively healthy economy, they’re using that cash to purchase companies that have been innovating, as a kind of outsourced research and development strategy.

A lot of this M&A activity also comes from the rise of private equity. Ten or 12 years ago, most of the activity was driven by strategic acquisitions of corporations buying other companies. Now, private equity firms are driving M&A activity as much as strategic buyers. This private equity phenomenon has really accelerated over the past decade and it doesn’t look like it’s slowing down.

Why has private equity accelerated?

It goes back to the recession and companies hoarding cash. These companies were very successful at raising money pre-recession and with the way the agreements are structured, they’re carrying interest on that money unless they put it to work. There’s a financial incentive to get that money off the sidelines and working. There are only so many deals to be made out there, however, so there’s a lot of competition for these mid-market companies.

In what industries is M&A activity particularly strong right now in the South, and why?

Most private equity firms we work with fall into one of two buckets. In one, we have traditional, family-owned manufacturing and distribution companies. There are plenty of firms chasing those deals looking to infuse capital into these companies, bring in a new management team, increase valuations and then exit for a higher value.

In the other bucket, there’s technology, and there’s a lot of activity in the technology industry in the Southeast. For example, in Atlanta, data security is big. Healthcare technology is another hot sector right now. There’s also a lot of interest in software as a service (SaaS) and we’ve seen a shift away from licensing software toward subscription-based platforms. Investors like that recurring revenue model and that’s true across all industries. Valuations in the technology industry are driven by revenue growth more than EBITDA, and SaaS-based companies fit this recurring revenue model, making them appealing to investors and propelling M&A activity.

Can you elaborate on how valuations have evolved in the past decade? Why is this?

Traditionally, when valuing a company you consider how much a business is making and then apply a risk-adjusted return, which is expressed through EBITDA. In my experience, most of the discussions on valuations 10 years ago centered around that type of financial metric.

In the technology industry, it’s a little different. Valuations are no longer about how much the company is making, but rather on how much recurring revenue that business has coming in.

With the subscription-based SaaS model, it’s much easier to forecast what’s going to happen next. Once SaaS-based companies hit an inflection point, they can become extremely profitable as they grow. This is very appealing to private equity firms because investors can see how the company will scale and how financially attractive the opportunity is and will be down the road. The business community is becoming more and more receptive to cloud-based business solutions each day, and that’s why this sector is becoming more vibrant in our region.

How available is capital in the Southeast? Is it becoming more available or less available?

From my perspective, access to capital in this region isn’t easy for middle market companies, but it is improving. The discussion is shifting away from private equity and controlled transactions – where the company is purchased, the value is increased and then it is sold – toward growth equity. The growth equity market, funded with venture capital, is more about making a minority investment in the company, betting on the management team and hoping it will make the money back later.

But now a void has developed – a gap in early stage investment – when companies are beyond the support of angel investors but not mature enough to attract a traditional venture capital firm. Primarily, we’re seeing this void because the risk profile for venture capital firms has changed, and they now want to see companies that are more established and have successfully operated for many years before making an investment. This goes back to the IPO markets and the surge of companies going public in the dot-com days. The IPO markets have slowed tremendously, and exit profiles have changed. Investors can’t hit a quick IPO home run, so they have to make more intelligent choices and take a different look at early stage investments. Middle market companies really have to stand out to catch the attention of investors.

You founded a tech startup in Atlanta several years ago and raised a lot of capital for it. Tell us how the environment has changed since then. What challenges still exist today?

Early stage companies must get enough traction in the marketplace to validate their product and value proposition, and that traction comes from customers. However, many times they need capital to build the product or service in order to gain those customers. It’s a classic catch-22.

Good entrepreneurs will find early-adopting customers to believe in them and pilot their product. Once they can demonstrate demand, capital is easier to come by. Validation is now being done by the marketplace. When investors see large companies interested in these early stage companies and adopting its products or services, it serves as a proxy for the entire market and takes a lot of the risk out of it.

Looking ahead, where does the opportunity lie to improve middle market activity in the South? How could local and state governments, incubators, angel investors or other stakeholders play a role?

The Southeast is an unbelievable place to do business for mid-market companies in almost any sector. A lot of corporations have been relocating their headquarters in the region and we’ve seen several key segments of the economy moving to the Southeast. There’s a very vibrant entrepreneurial ecosystem in the region, and the technology sector is only going to become more viable as universities and incubators establish a solid infrastructure.

To that end, it’s organizations like colleges and accelerators, along with local and federal government, that have the ability to make the Southeast an even better place to start, grow and sell a company. Groups like Launch Tennessee are doing an incredible job driving innovation and spurring job creation through entrepreneurial activities. And we’re seeing state governments across the South continue to place priority on tax incentives. Tennessee and South Carolina both have statewide initiatives that have enhanced their business-friendly climates.

On the federal level, crowdfunding will be something to keep an eye one. New rules in the Jumpstart Our Business Startups (JOBS) Act, which will soon allow individuals to invest in crowdfunding transactions, could be a new way for companies to source capital. It’s just too early to know how viable this option will be.

Brought to you by the team at FourBridges.

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