More than 35 different companies are rapidly consolidating the veterinary industry, where most of these corporate groups are owned by Private Equity (PE) firms. Who are these PE firms and how do they operate? When a consolidator offers to buy your practice, they offer ownership or equity in their company. That ownership is an illiquid investment in the group that will own your practice: Is that a good investment? What are the risks? We’ve compiled the basics for you below.
A Brief History & Rebranding
“Private Equity” rose to prominence in the 2012 presidential election with the publicizing of Mitt Romney’s leadership at Bain Capital. Private Equity is the “rebranded” name for what were originally known as Leverage Buyout (LBO) firms in the 1980s. LBOs essentially bought up companies using significant amounts of debt. You may have heard of some of these PE firms and their takeovers before. For example, KKR buying out RJR Nabisco, Blackstone purchasing Hilton, and Apollo and TPG Capital acquiring Harrah’s.
In the 1980s and 1990s, the PE industry was known for “financial engineering.” Simply put, they bought businesses using lots of debt, made the operations more efficient, eliminated ‘bloat’, and sold the businesses or took them public three to seven years later. Financial engineering worked for 10 to 15 years, but more and more firms entered the business and strategies needed to evolve with the PE industry becoming more competitive.
By the late 1990s and early 2000s, the industry rebranded from LBO firms to private equity, implying a shift from pure financial strategies to an attempt to help grow and build businesses. Over the past twenty-some years, the PE world has grown exponentially – there are now thousands of firms pursuing different investment strategies and even more PE-backed companies in the U.S.
Today, PE is an enormous part of the national and international economy. The amount of money (or capital) invested in these firms is astounding: They control trillions of dollars in their investment funds and have $1.45 trillion of ‘dry powder’, or money to invest.
Private Equity vs. Venture Capital
You may have heard of the term “Venture Capital” (or VC) used interchangeably with private equity. However, the two terms are distinctly different regarding their investment strategies. A venture capital firm invests in start-up and early-stage businesses. Typically, these startups are pre-profit (and sometimes even pre-revenue). The VC firms that take the most risk invest in entrepreneurs with exciting business plans, many of which haven’t even launched the business to paying customers yet. At the same time, there are ‘later stage’ VC firms that invest in businesses that have launched their products and have some revenue, but aren’t quite profitable yet.
The key for any VC firm is that the strategy assumes failure. VC firms invest in 10 to 15 companies in a fund with the assumption that 3 to 7 of those companies may go bankrupt and fail. Simultaneously, they also hope that 2 to 4 of those companies will be hugely successful and generate sufficient returns to make up for those that went bankrupt. For VC firms, their MO is finding the ‘grand slams’ of companies since the successful ones will return 50 or 100x the original investment. When VC firms do well, they do really well: the original investors in Google, Facebook, Uber, and other technology giants are just some examples. On the opposite end of the spectrum, the infamous Theranos corporation or Pets.com during the dot-com bubble are instances of hugely public VC failures.
Private equity is different because the risk profile of their investments is different. PE invests in businesses that generate millions in revenue and usually turn at least $3 million in profit. The profits from these companies allow PE firms to borrow money to help finance the acquisitions (as the original name “Leverage Buyout” implies). While PE funds are seeking strong returns on their deals, they’re also mitigating the downside risk. Where complete write-offs are common in the VC world, PE firms are different: Write-offs rarely happen since the business was already generating meaningful profits. A PE fund that returns 2.5x its money is generally a successful firm, and the standard deviation of the returns is much lower than that of VC funds.
Who Provides Capital to PE Firms?
Private equity and venture capital tap the same sources of money. They both approach large ‘institutions’ that (a) have significant capital to invest, and (b) are seeking to diversify their returns from the traditional stock and bond market. PE and VC funds are known as alternative investments that also include Hedge Funds, Real Estate Funds, and other investment vehicles. So, who are these large ‘institutions’? They could be any of the following:
- Endowments: Colleges, universities, non-profit groups, and other organizations that have large amounts of money to invest. Today, they’ll normally invest a percentage of this money in PE and VC funds to provide long-term returns.
- Public Pension Funds: Teachers’ pension funds, state employee pension funds, and many other pools of retirement funds need to generate returns. A portion of these funds are usually invested in PE and VC funds.
- Insurance Companies: These companies have enormous pools of capital that need to be held as ‘reserves’ against potential losses. Some of those funds are not needed for many years and can therefore be invested in longer-term, illiquid assets like PE or VC.
- Sovereign Wealth Funds: These are countries that have enormous pools of capital that they invest. For example, large oil-producing countries like Saudi Arabia and Dubai have been frequent investors in PE and VC funds.
- Wealthy Individuals: High net-worth individuals can and do invest in PE and VC funds.
The investors in a PE fund are typically called “LPs” or “Limited Partners” since they have a ‘limited’ level of decision making and control. The PE firm is the manager of the funds and makes the investment decisions, while the LPs perform due diligence on the firm and then let the firm make investment decisions.
What is a ‘Family Office’?
You may have also heard the term “Family Office” thrown around, but it’s different from a PE and VC firm in that it does not raise capital from LPs. Instead, a family office is essentially one rich person’s family money or the pooling of a handful of rich people’s money. Why are family offices attractive? They’re longer-term investors. PE Funds want to be in and out of an investment within 3 to 7 years, while a family office can have a longer horizon (up to 10 years or more). A family office does NOT need to get money back to its investors like a PE firm does. Limited Partners like endowments, public pension funds, etc., all have limitations on how long they can leave money invested.
Types of PE Firms
With many PE firms in the market today, they’re segmented by fund size, investment strategies, and industries in which they invest. While some PE Funds have $300 million to invest, others, such as KKR, Blackstone, and Carlyle, have more than $15 billion in their largest funds. A firm typically makes anywhere from 10 to 15 investments in each fund, so a firm with $300 million of capital will generally place $25 to 30 million into each investment. In thinking about PE firm size:
- Lower Middle Market: These are firms that invest into businesses with $2 to 10 million in EBITDA or profits. The equity investment is typically $10 to 50 million with a certain amount of debt also being used for any investment.
- Middle Market: These are firms that invest into businesses with $20 to 75 million in profits. They make equity investments of $50 million to $300 million and use debt to help finance transactions.
- Large Firms: These firms look at businesses with $75 million to $500 million in profits, and write equity checks of $300 million to $2 billion. Again, debt is a key part of these larger transactions.
In addition to fund size and the size of firms they look for, many funds have different investment strategies:
- Growth Equity: This is a common term that refers to firms focused on outsized revenue growth for their investments (they tend to invest in veterinary). Usually, they do not use as much debt as more traditional buyouts so that there’s money to invest in growth initiatives. Growth equity firms will pay higher prices for businesses with better growth trajectories.
- Distressed Funds: There are several groups that look for large businesses experiencing financial trouble. These firms believe they have the operational expertise to help turn around a poorly performing company.
- Traditional PE Funds: They try to buy slower-growing businesses at lower purchase price multiples. Their strategy is to increase profit margins or slightly accelerate revenue growth to achieve good returns.
Firms have clear investment strategies that are sometimes industry specific, and sometimes include broader mandates. For example, most firms investing in veterinary services are investing in healthcare services, ‘retail’ (consumer-facing) healthcare, or even the technology side of the industry. A firm will have two to four industry groups where it invests. Developing industry expertise among their principals allows the firm to make smarter investment decisions.
We’ve observed some traditional PE firms that invest in “startup” veterinary consolidators. While this may seem more of a venture capital investment, the stability and clear path to growth and profits makes starting veterinary companies attractive to select PE firms. Some of the notable consolidators that recently started ‘from scratch’ by PE firms include AmeriVet by Imperial Capital in 2017 and Companion [Animal Health] started by Cortec in 2019.
How do PE firms work?
Most PE firms have the same business model, where starting the firm itself and raising initial capital is the most challenging. Given the plethora of choices for LPs today, you need to be a proven PE executive in order to raise a new fund. A healthy track record is essential to raising an initial fund—the results of each fund from there on out will help to ensure more future funds are raised.
A PE firm makes money in multiple ways. The first is through management fees, or about two percent of the fund. For instance, on a $500 million fund the firm will take $10 million annually in management fees. Sometimes that number is lower if the capital isn’t invested. The other important fee for a PE firm is their “carried interest”. PE firms typically receive a 20 percent ‘carried interest’, or they receive 20 percent of the profits. As the industry has gotten more competitive, the 20% carried interest can have hurdle rates of return for the investors before this fee starts accumulating to the PE Firm. The bottom line is that PE firms make a management fee and then get a share of the profits (carried interest).
Of course, the firms then take their capital and find businesses to invest in. In the 1990s and early 2000s, PE firms would approach companies directly to develop relationships and invest. In today’s competitive market, most businesses that are selling to PE firms use an investment banker to navigate the process as the presence of a formal process helps drive higher pricing.
The PE firm typically owns a majority stake in the company with management owning a minority stake. The company’s board includes two to three PE firm representatives, an independent board member with industry experience, the CEO of the business, and maybe one other management team member. The board meets quarterly, sets the strategic direction of the business, and approves all major decisions. The PE firm does not run the day-to-day business (the company has a C-suite to do that!), but there’s significant oversight from the PE firm with its role on the board. Many veterinary consolidators are managed in this manner where the board approves the proposals to buy individual practices.
Senior partners at a PE Firm generally sit on three to five boards of businesses where they led the initial investment. They’re always looking for new investment opportunities too. The PE firm usually has a strategic focus on each investment, leaving the management team to run the business day-to-day. On the other hand, PE firms mainly measure key metrics, goals, and objectives.
The goal is to sell their companies in three to seven years at 2 to 5x the amount of money initially invested. The ‘exit’ is something that is always on the horizon as the companies achieve certain growth milestones.
If you intend to sell your practice to a consolidator, it can be useful to understand the dynamics behind the investment firm that likely owns the consolidator. Most veterinary consolidators are owned by PE firms, with a few owned by family offices. Private equity is an ever-expanding part of our economy: PE firms help to instill discipline and analytical decision-making in companies for above-market returns.