Keeping Control

Other private equity groups, Cavanagh says, serve as mezzanine debt lenders. Mezzanine debt—a middle layer of debt between equity and senior debt (which has the highest claim on the assets of the company, should it be liquidated)—includes interest on debt and warrants that convert into equity ownership. When a private equity firm acts as a mezzanine lender, it makes part of its return when the company pays interest on the loan. It makes the rest of its return when the company buys back—or when it exercises—its equity option. Mezzanine debt is typically structured with a scheduled balloon payment of principal that’s funded by company resources, a sale, or a refinance.

A private equity or venture capital group might also create a payment in kind (PIK) investment. In a PIK, the investor typically receives preferred stock with a fixed interest rate. The business owner doesn’t pay the interest in cash; instead, the interest converts into additional stock, which is paid off when the company is sold. The investor may also negotiate the right to demand payment if the company fails to meet certain financial tests or isn’t sold within a set period of time. “They can force the company owner to buy back their interest at a price formula agreed upon in advance,” says Matthew Knopf, a partner at Dorsey & Whitney.

Those arrangements, however, are departures from the most common private equity model in which a private equity firm invests in a company and gets actively involved in the way it’s run. The investors plan to improve the firm through injections of capital, partnerships with other firms, or adjustments to the firm’s operations. Then, within five to seven years, the private equity group sells its interest and returns the profit to its investors.

Structured this way, a private equity investment can offer a business many benefits. The first and most important, of course, is the money. A private equity deal can allow a firm to fund new research and development, stores, distribution, and hiring, all of which could fuel growth that would be all but impossible without that investment.

However, majority owners must feel comfortable with the other things these investors bring to the company. A private equity group can serve as a mentor to the company’s majority owner. It might introduce the company to new consultants and employees, or offer relationships with other companies it owns. “There’s a forced management-consulting approach that gets layered on top of the money,” Kampe says. “For some, that’s a burden. They just want to run their business; they don’t want the other stuff. For others, this is great—now they have guidance and a sounding board. They’re not alone anymore.”