I always look forward to going to a good steak house, but as soon as you are there you are faced with the dilemma of just how much of the cow you want to have. Do you go for the 150g option which leaves room for desert, the 250g which fills you up but there is still room for fries, or do you go all out with a bigger portion that ultimately leaves you feeling uncomfortable but looked tempting when you were hungry?
And if I’m already struggling trying to decide what’s the best portion size for me, how do private equity houses decide on what size stake they are going to take in an investment company? The proportion of a PE/VC’s stake will have an impact on the mind-set and incentives of all parties, and their hunger (pun intended) to grow the company.
How much is too much?
The headlines typically cover larger deals with one of the big players scoping a majority/”meaningful” stake. But this is a far cry from how the majority of the market actually operates: 73% of investments made by PE houses are actually minority investments.
These minority investors are there because they believe in the management team, they like the strategy but still want to have some oversight – which all seems sensible to me. The board position they take lets them keep their hand on the tiller to stop companies going off-strategy, but not to control. After all, if they believe in the management team, should they really need to micro manage?
In this situation, management will still feel in control (even if the shareholders’ agreement imposes certain constraints), and is hugely incentivised to push for growth. Ultimately, this may mean they are better aligned with the PE house through their own majority position in the equity upside.
In other situations, a majority stake for the investor might make more sense. It gives the PE voting control alongside its rights under the shareholders’ agreement.
And in circumstances where the PE investor wants to be more involved – perhaps because it has real sector experience and depth of knowledge, maybe there are hard decisions are to be enacted, or where it can leverage its network – the PE house is bringing quite a lot to the table.
The more they’re bringing, and the more capital they’re bringing, the more it might make sense for them to take a majority stake.
Having said which, sometimes big cheques are there just because the opportunity arises – an existing investor is retiring, the sale is from an existing PE investor with a large stake, a PE is involved in further financing rounds, to name a few.
So which is better? I could do the typical woolly “each case is unique” spiel, and to a great extent that’s true and a lot of majority stake investments thrive for all the right reasons.
However, empirical evidence supports that minority investments outperform majority stake investments, on average. A cynic could say it’s because there are more of them and it’s a numbers game, but perhaps it’s because of the fundamental driver of a minority investment – we like your management team and we have great taste.