Originally written for PROFIT Guide on January 25, 2016. http://www.profitguide.com/manage-grow/financing/private-equity-financing-metrics-98805

Private equity finance has been common practice in the US for several decades, but it only recently started to become popular in Canada. Over the past decade, US-based PE firms have been relentless in seeking promising Canadian companies to invest, acquiring iconic brands like Canada Goose and Cirque Du Soleil.

Despite these high-profile deals, owners of Canadian companies with sub-$50 million revenues remain largely mystified by how PE firms—whether U.S. or home grown—operate. According to Pitchbook, there were 1,956 PE firms in North America in 2014. Preqin reported in July 2015 that PE “dry powder” (the amount funds chasing valuable companies have at their disposal) has reached a record $1.3 trillion. Despite the staggering amount of money sitting idle, not all businesses seeking PE financing will end up receiving some. In reality, the ratio of companies seeking investments to those that actually gets funded is a paltry 2–3% for established PE firms.

If you’re considering soliciting or accepting an investment from a PE firm, it’s important to identify its investment criteria and philosophy. Most funds are managed by General Partners (GP), who invest the money of Limited Partners (LPs)—typically pension funds, insurance companies, endowments or ultra-high-net-worth investors with predefined investment criteria. With the exception of PE firms that either use their own funds or are directly owned by family offices, there is hardly any latitude on how the capital is invested.

It is therefore crucial to ensure the fund’s criteria fit with your goals and where you want to take the company moving forward. If you wish to hold the majority of your company’s shares and are not willing take a back seat as minority owner, a firm seeking majority and control position is not for you. Instead, look for a PE firm that is flexible and provides existing owner-managers autonomy to run their business. If your company’s profile does not meet the fund’s investment criteria, it is pointless to initiate a discussion. Continue to persevere in your search for the ideal firm.

Despite the slight variations in each firm’s investment criteria and financing structure, most PE firms look for similar characteristics in the businesses they invest in. Evaluation metrics fall into two categories: financial metrics and “soft” metrics.

Here’s what PE firms want to see from your company before they’ll make an investment.

Soft Metrics

Industry and above market growth potential

Some PE firms are generalists, while others are specialists focused on industries they know intimately. In due diligence, PE managers will try to understand your market share relative to the size of industry and whether your position is defensible. To determine growth prospects, they want to know if your company has the ability to expand to new geographic markets or disrupt the market by creating new and diverse demands that incumbents have failed to exploit. For example: Can your existing customer base generate meaningful organic growth, or are there adjacent markets you can explore? Are there potential for growth through alliances, partnerships and acquisitions either through the PE firm’s existing platform or other channels?

Funds are always looking for significant returns. If there are attractive industry trends that your business can take advantage of, PE firms are even more motivated to invest in your company. Those might include changing demographics, regional economic growth, transformation in consumer buying patterns, or technological and regulatory shifts. Recently, technology and healthcare have become heavily favoured industries.

Value Creation

PE firms want to know if there are synergies with other companies in their portfolio, including the potential to realize operational efficiencies or leverage distribution channels immediately upon investment.

Perhaps, your company can be an “add-on” to their existing portfolio or another company they are in the process of acquiring. The fund’s questions will include: Are there existing suppliers they can replace to optimize pricing? Can they cross-pollinate their customer base? Can they utilize each other’s assembly lines to increase production capacity and reduce downtimes? Are there R&D resources they can share? Are there potential cost reduction by integrating your company’s HR, Accounting and Finance with other companies?

The Management Team

No fund wants to invest in the right project in the hands of the wrong people. PE firms need to have absolute confidence in the management team’s ability to capitalize on value drivers. Most funds prefer management with significant experience and a successful track record, which allows them to grant operators the autonomy to make decisions. If they like the project or technology but lack confidence in management’s ability to extract, mine and create value, some backers will lend operational expertise and guide the company to a mutually desirable result. This might include helping formulate strategies, leveraging partners and alliances, or enhancing efficiencies through investment in advanced technologies.

Financial Metrics

Sustainable Cash Flow

Sustainable EBITDA (earnings before interest, taxes, depreciation and amortization) determines the enterprise value of your company and the price the buyer is willing to pay. Funds typically have a minimum EBITDA requirement of $3.5 million. A healthy EBITDA margin ranges from 10– 20%; anything beyond that is gravy.

To attract a fund, you need to have recurring cash flow, and adequate profit left each year after both the principal and interest on bank term debt used to purchase the company has been paid. The same cash flow metric applies when a private equity firm exits your company, known as a “liquidity event” in industry lingo. Any seasonal cash flow fluctuations need to be covered by a line of credit with the bank or another source of financing, to ensure short-term liquidity.

When considering investing in or buying a business, analysts run financial models and stress test them by nudging numeric variables up or down. To track your company’s performance, firms require weekly, monthly or quarterly financial reporting, which can be onerous if your company performs below expectations. Be warned: PE backers’ goal is maximizing profits and efficiency, so it’s common to see them trim the fat by getting rid of unnecessary expenses, low value activities, or low-margin, low revenue products.

Target IRR

The most important metric in evaluating a portfolio company’s performance is its Internal Rate of Return (IRR), a metric based on projected cash flow. It represents the net return to PE firm after all fees and interest are deducted.

The variables used to derive this rate differ from one company to another. Some firms have a minimum threshold of 20% annual IRR, but the usual range can vary from 15–30%, depending on the firm’s mandate.

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To obtain private equity financing, you need to understand how the firms that disperse it operate and what they look for in a potential investment. Seek the help of a financial advisor who can help you navigate these complexities. Ace their tests, and you’ll soon have the money to realize your company’s growth potential.

Alma Johns, MBA, is President of Bench Capital Advisory Inc., a corporate finance advisory firm focused on senior debt and alternative financing transactions for SMEs. She has two decades of experience in corporate and commercial banking from three financial institutions. She received her MBA from Schulich School of Business and has published articles on financing, succession planning, management buyouts and business valuation.