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<p>Elias Kurta is an external doctoral candidate at WHU — Otto Beisheim School of Management and a Consultant at The Boston Consulting Group (BCG). He mainly focuses on private equity investments in (former) family firms. </p>

Elias Kurta

<p>Prof. Dr. Nadine Kammerlander is chairholder of family business and co-director at the Institute of Family Business and Mittelstand at WHU — Otto Beisheim School of Management. In teaching, research, and practice transfer, she focuses on innovation, leadership, and governance in family businesses and family offices.</p><p></p>

Prof. Dr.

Prof. Dr. Nadine Kammerlander

<h5>1. Introduction</h5><p>Family firms are the dominant form of business and one of the primary drivers of the global economy.1 However, family firms face various challenges like the need to gain a competitive advantage and foster growth, limited access to resources and capabilities, or complicated succession processes to safeguard the continuity of the firm.2 From the perspective of private equity investors, family firms represent an interesting investment opportunity. On the one side, family firms offer a significant potential deal pool due to their prevalence.3 On the other side, family firms are often suffering from scarce resources, lack of capabilities, and nepotism, hence providing private equity investors the opportunity to increase enterprise value by increasing professionalization, improving efficiency, and reducing agency costs by implementing stricter governance systems.4</p><p>Private equity investments have increased significantly from EUR 46 billion in 2010 to EUR 104 billion in 2019 in European countries and dropped only slightly to EUR 86 billion in 2020 due to the global COVID-19 pandemic, revealing the importance of private equity investments. Around two-thirds of the target firms were SMEs, and many were family firms.5 Despite this importance, academic research emphasizes conflict potential between private equity investors and family firms. For example, while family firms often pursue non-financial goals,6 private equity investors primarily pursue financial motives.7 In addition, whereas family firms are commonly long-term oriented, private equity investors are mainly short-term oriented and focus on predetermined investment horizons.8 As a result of the many potential disagreements, it may be concluded that private equity investors may shy away from investing in family firms.9 However, the abovementioned numbers present a somewhat different picture, showing that private equity investors frequently invest in family firms.10 Hence, to date, we do not know what specific factors of the private equity investor influence the decision to acquire a family firm. Understanding the conditions, characteristics, and typical strategies of the private equity investor resulting in an acquisition of a family firm is essential and the basis for further necessary research in this area, such as the success versus failure of family firm takeovers and the valuation of family firms by private equity investors. Furthermore, the collaboration of family firms on the one side, and private equity investors on the other side, might have a very promising future.11 Hence, we ask the following question: What are the drivers or inhibitors of a private equity investor’s acquisition of a family firm?</p><p>Based on a quantitative survey of 142 investment professionals in the German-speaking area, we show that family firms are very attractive to private equity investors pursuing a buy-and-build strategy or strategically focusing on operational improvements. Moreover, we also show that family firms are less suitable for private equity investors with many portfolio firms that may have less available time and resources per portfolio firm.</p><h5>2. Key drivers and inhibitors</h5><h6>2.1 Buy-and-build strategies</h6><p>Buy-and-build strategies are characterized by an initial investment of the private equity investor in a so-called platform firm and subsequent add-on acquisitions.12 The platform firm usually has outstanding characteristics like a high reputation or technological leadership in a (niche) market.13 Furthermore, on average, the subsequent add-ons are smaller than the platform firm and provide a specific value-add due to certain tangible or intangible assets (for example, new technology, new markets). In most cases, private equity investors pursue a horizontal acquisition strategy, in which platform firms and add-ons operate in the same industry. As a result, private equity investors may consolidate fragmented industries and markets.14 Hence, the share of deals, including add-on acquisitions, increased from 20% in 2000 to 53% in 2012. While in 2000, the average number of add-on acquisitions per deal was 1.3, it was 2.7 in 2012.15 Furthermore, the Boston Consulting Group (BCG) found in a practitioner-oriented study that, particularly in transactions in case of buying directly from the family owners or founders-team, buy-and-build strategies are employed – 43% versus 32% transactions between private equity investors.</p><p>The significant increase in buy-and-build strategies is backed by academic research and industry reports, highlighting their advantages. Analyses show that those acquisition activities during the holding period of a portfolio firm significantly increase the deal return for the private equity investor. Furthermore, add-on acquisitions lead to abnormal margins and multiple improvements during the holding period because larger firms have easier access to capital, knowledge, and labor.16 Lastly, the platform firm and the add-ons may realize synergies and increase overall efficiency, resulting in higher transaction multiples.17</p><p>Family firms often struggle with proper resource management due to the permanent trade-off between financial and non-financial goals.18 As a result, family firms often face several significant limitations. First, family firms often lack highly skilled managers and employees. Second, family firms have only limited financial capital. Consequently, family firms have limited available resources and, therefore, often develop a niche business model to leverage the scarcely available resources most efficiently. Add-ons may strengthen the resource basis by providing additional tangible and intangible resources and assets, encouraging and fostering family firms to expand, grow, and internationalize. Hence, family firms are a highly promising firm type for private equity investors who are pursuing a buy-and-build strategy due to their niche focus and the opportunity for private equity investors to develop a niche leader into a global leader by strategic add-on acquisitions.</p><h6>2.2 Operational improvements</h6><p>Whereas until the late 1980s, most private equity investors mainly created value through financial and governance engineering, in recent years, operational improvements have become more and more relevant in the value creation process of private equity investors.19 Nowadays, most private equity investors leverage their industry knowledge to identify attractive targets and develop and implement value creation plans in portfolio firms.20 Such programs may include cost-cutting measures, productivity improvements (for example, in purchasing, supply chain, and production processes), repositioning actions (for example, customer orientation, internationalization), as well as management changes.21</p><p>Academic research from both the United States and Europe confirms significantly increasing operating performance after the takeover by private equity investors. Kaplan (1989) shows for U.S. deals in the 1980s that the ratio of operating income to sales increased by 10% to 20% (absolutely and relative to industry) after a takeover by a private equity investor.22 In addition, the ratio of cash flow to sales increased by 40%. The operational improvements were reflected in significant increases in enterprise value. Furthermore, several researchers show similar results for Europe.23</p><p>There are many reasons why private equity investors may increase the operational efficiency of their portfolio firms. First, private equity investors’ high leverage in transactions mitigates agency problems between management and shareholders.24 The additional debt obligations foster management to maximize cash flows and cut inefficient investments to repay debt obligations. This phenomenon is also called the control function of debt. Second, private equity investors are active investors who provide additional financing and may offer expertise and strategic resources to the acquired firms. In addition, private equity investors often implement an external, highly professional leadership team that implements and drives a dedicated value creation plan, increasing operational efficiency.25</p><p>Family firms are appropriate for private equity investors to foster operational improvements for two reasons. First, family firms have challenges in gaining a proper level of resources, such as financial resources and managerial resources, in particular highly qualified employees and managers.26 As a result, family firms often struggle with poor operational processes and offer significant improvement potential.27 Private equity investors provide financial and non-financial resources and, thereby, may support family firms in overcoming the abovementioned limitations regarding their operations. In most cases, private equity investors take an active role in the advisory boards of their portfolio firms and provide managerial as well as strategic advice, which further helps optimize the operations of the family firm. Second, the first (financial) investor (i.e., the first owner following the family owner) will try to implement all the easily realizable measures with the most significant value creation potential. Hence all low-hanging operational fruits will be reaped in the case of buying from a private equity investor. In the case of buying directly from the family owners, those low-hanging fruits will still be ready to reap, hence providing significant operational improvement potential. Therefore, buying firms from families is particularly interesting to private equity investors that aim to improve operations.</p><h6>2.3 Number of portfolio firms</h6><p>Private equity investors actively monitor and manage their portfolio firms. Therefore, a private equity investor’s available time and resources limit the number of portfolio firms the investor can effectively handle.28 Private equity investors may help family firms to overcome their abovementioned challenges, such as succession, conflicts among shareholders, and limited growth opportunities due to a lack of financial and managerial resources, by providing financial funding and managerial expertise to their portfolio firms.29 Private equity investors offer an opportunity for family firms to professionalize, develop further, and grow. By providing financial support and managerial knowledge, investors typically become actively involved in managing their portfolio firms.30</p><p>As mentioned above, family firms are highly interesting to private equity investors because they provide significant improvement potential. However, family firm takeovers are more complex than takeovers of other firms due to family dynamics and the importance of non-financial goals.31 Hence, the private equity investor’s active (and often time-consuming) management is required to turn an investment in a (former) family firm into a successful transaction. Therefore, resources are needed on the private equity investor’s side. However, the private equity investor’s number of experts and managerial resources are limited, so investments are not infinitely scalable. Moreover, the quantity and quality of managerial advice per portfolio firm decrease with an increasing number of portfolio firms held by the private equity investor because of a lack of time and resources.32 Therefore, family firms are less suitable for private equity investors with little resources and capabilities per portfolio firm.</p><h5>3. Methodology</h5><p>We conducted a quantitative survey to analyze how a planned buy-and-build strategy, a strategic focus on operational improvements, and the number of portfolio firms of private equity investors drive or inhibit acquisitions of family firms. Specifically, we asked survey participants (investment professionals) to imagine the situation of acquiring a hypothetical target firm in the global power tools market. Comparable to previous vignette studies, we included only a little information about the target firm and requested an indication of the propensity to acquire: 1) a family firm, 2) a carve-out of a multinational conglomerate, and 3) a secondary buyout. Comparable to previous studies, we used hypothetical case vignettes to reduce potential random noise. Furthermore, we collected personal and firm information from an adjacent questionnaire. After sanitizing and cleansing, we collected 142 responses from investment professionals in the German-speaking area. The regression results confirm the hypothesizing presented above.</p><h5>4. Discussion</h5><p>Family firms represent a vast deal pool for private equity investors.33 Private equity investors can support family firms to overcome resource-related challenges (for example, lack of financial resources and managerial capabilities, nepotism, and succession problems), thereby increasing the enterprise value. However, family firms are often considered ‘difficult’ to work with.34 Our study analyzes which determinants drive the propensity of private equity investors to acquire a family firm. To do so, we analyze the potential effects of a buy-and-build strategy, strategic focus on operational improvements, and the number of portfolio firms on the propensity to acquire. In essence, we find that a buy-and-build strategy and a strategic focus on operational improvements positively affect the propensity to acquire. Furthermore, we reveal that the number of portfolio firms has a negative effect on the propensity to acquire.</p><h5>5. Concluding Remarks</h5><p>The results of our study enhance the knowledge about the drivers of a private equity investor resulting in the acquisition of a family firm. Notably, private equity investors pursuing a buy-and-build strategy tend to acquire a family firm because of their limited resources and the resulting focus on niches to leverage their limited resources. Hence, in particular, in such cases, strategic add-on acquisitions and buy-and-build strategies may help to overcome resource shortcomings. Furthermore, we unveil that private equity investors with a strategic focus on operational improvements, as well as private equity investors with a fewer number of portfolio firms rather, tend to acquire a family firm because private equity investors see significant improvement potential in family firms but need sufficient experts and capacity to lift all potential areas for improvement successfully.</p><blockquote>1 See Anderson/Reeb: Founding-family ownership and firm performance –
evidence from the S&amp;P 500. The Journal of Finance, 58, no. 3, 2003, 1301–28.
2 See Howorth/Westhead/Wright: Buyouts, information asymmetry, and the
family management dyad. Journal of Business Venturing, 19, no. 4, 2004, 509-534.
3 See Chrisman/Chua/Steier: An introduction to theories of family business.
Journal of Business Venturing, 18, no. 4, 2003, 441–448.
4 See Jensen: The modern industrial revolution, exit, and the failure
of internal control systems. The Journal of Finance, 48, no. 3, 1993, 831-880.
5 See Kranitz/Irwin-Brown/Giuroiu: Investing in Europe – private equity activity 2020.
Invest Europe, 2021.
6 See Berrone/Cruz/Gómez-Mejía: Socioemotional wealth in family firms.
Family Business Review, 25, no. 3, 2012, 258–279.
7 See Dawson: Private equity investment decisions in family firms – the role of human
resources and agency costs. Journal of Business Venturing, 26, no. 2, 2009, 189–199.
8 See Sirmon/Hitt: Managing resources – linking unique resources, management, and wealth creation in family firms. Entrepreneurship Theory and Practice, 27, no. 4, 2003, 339–358.
9 See Ahlers/Hack/Kellermanns: Stepping into the buyers’ shoes – looking at the value of family firms through the eyes of private equity investors. Journal of Family Business Strategy, 5, no. 4, 2014, 384–396.
10 See Kranitz/Irwin-Brown/Giuroiu: Investing in Europe – private equity activity 2020.
Invest Europe, 2021.
11 See Schickinger/Leitterstorf/Kammerlander: Private equity and family firms – a systematic review and categorization of the field. Journal of Family Business Strategy, 9, no. 4, 2018, 268–92.
12 See Brigl/Jansen/Schwetzler/Hammer/Hinrichs/Schmundt: The power of buy and build – how private equity firms fuel next-level value creation. Boston Consulting Group, 2016.
13 See Brueller/Carmeli/Drori: How do different types of mergers and acquisitions facilitate strategic agility? California Management Review, 56, no. 3, 2014, 39–57.
14 See Brown/Keith/Dittmar/Servaes: Corporate governance, incentives, and industry
consolidations. The Review of Financial Studies, 18, no. 1, 2004, 241–270.
15 See Brigl/Jansen/Schwetzler/Hammer/Hinrichs/Schmundt: The power of buy and build – how private equity firms fuel next-level value creation. Boston Consulting Group, 2016.
16 See Acharya/Gottschalg/Hahn/Kehoe: Corporate governance and value creation –
evidence from private equity. Review of Financial Studies, 26, no. 2, 2013, 368–402.
17 See Brueller/Carmeli/Drori: How do different types of mergers and acquisitions facilitate strategic agility? California Management Review, 56, no. 3, 2014, 39–57.
18 See Chrisman/Chua/Steier: An introduction to theories of family business.
Journal of Business Venturing, 18, no. 4, 2003, 441–48.
19 See Kaplan/Strömberg: Leveraged buyouts and private equity.
Journal of Economic Perspective, 23, no. 1, 2009, 121–146.
20 See Kaplan/Strömberg: Leveraged buyouts and private equity.
Journal of Economic Perspective, 23, no. 1, 2009, 121–146.
21 See Acharya/Gottschalg/Hahn/Kehoe: Corporate governance and value creation –
evidence from private equity. Review of Financial Studies, 26, no. 2, 2013, 368–402.
22 See Kaplan: The effects of management buyouts on operating performance and value. Journal of Financial Economics, 24, no. 2, 1989, 217–254.
23 See Bergström/Grubb/Jonsson: The operating impact of buyouts in Sweden –
a study of value creation. The Journal of Private Equity, 11, no. 1, 2007, 564–590.
24 See Jensen: Agency costs of free cash flow, corporate finance, and takeovers.
The American Economic Review, 76, no. 2, 1986, 323–329.
25 See Salerno: Does the private equity financing improve performance in family SMEs? Journal of Family Business Management, 9, no. 1, 2019, 110–124.
26 See Sirmon/Hitt: Managing resources – linking unique resources, management,
and wealth creation in family firms. Entrepreneurship Theory and Practice, 27, no. 4,
2003, 339–358.
27 See Faghfouri/Kraiczy/Hack/Kellermanns: Ready for a crisis? How supervisory boards affect the formalized crisis procedures of small and medium-sized family firms in Germany. Review of Managerial Science, 9, no. 2, 2014, 317–338.
28 See Jääskeläinen/Maula/Seppä: Allocation of attention to portfolio companies and the
performance of venture capital firms. Entrepreneurship Theory and Practice, 30, no. 2, 2006, 185–206.
29 See Achleitner/Schraml/Tappeiner: Private equity minority investments in large family firms – what influences the attitude of family firm owners, 2008.
30 See Bernile/Cumming/Lyandres: The size of venture capital and private equity
fund portfolios. Journal of Corporate Finance, 13, no. 4, 2007, 564–590.
31 See Berrone/Cruz/Gómez-Mejía: Socioemotional wealth in family firms.
Family Business Review, 25, no. 3, 2012, 258–279.
32 See Bernile/Cumming/Lyandres: The size of venture capital and private
equity fund portfolios. Journal of Corporate Finance, 13, no. 4, 2007, 564–590.
33 See Chrisman/Chua/Steier: An introduction to theories of family business.
Journal of Business Venturing, 18, no. 4, 2003, 441–48.
34 See Kellermanns, F. W. E., Kimberly A. 2004. Feuding families: When conflict does
a family firm good. Entrepreneurship Theory and Practice, 28(3): 209–228.</blockquote>

Are family businesses the better acquisition targets - the authors explore this question and examine, how investments by private equity investors in family businesses have developed in recent years.

Are family firms the preferred acquisition targets?

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