Private equity funds are on the prowl

Back before he became the co-founder of a private equity firm, Jeffrey Kadlic found that he was encountering terrific small companies, but was precluded from investing in them because his firm only made larger investments. And back before he became the other co-founder of Evolution Capital Partners in Beachwood, Brendan Anderson found that he, as the owner and operator of small businesses, couldn't secure capital for what he, too, felt were terrific opportunities. “The more and more we looked at it, the more and more we were intrigued with the opportunity here,” Kadlic said of a market segment they believe was not getting a fair shake from institutional capital sources. Intrigue paved way to investment, and the two began investing in second-stage companies as Evolution Capital in October 2006. Since then, the firm, whose sweet spot is companies with $4 million to $10 million in annual revenue, has invested $65 million in a total of eight companies, four of which remain in the private equity firm's portfolio. Kadlic and Anderson recently discussed with Crain's the challenges people face when seeking growth capital. Interestingly, though they are investors, they say money is not the answer for businesses that seek to evolve. How does one know that his/her company is in need of — and ready for — second-stage capital? Brendan Anderson: Second-stage capital is for when you want to transform the business to something that is larger than yourself. Most of the time, there's capital needed to build out a team that's more experienced, that's truly going to step up and be held accountable, as well as investments in equipment, technology and additional locations. The huge investment is the people cost; you're going to need to hire that CFO, the COO and down the line. How is second-stage capital different than angel investments and other early capital? Jeffrey Kadlic: A business receiving second-stage capital is profitable, it's established and it has a proven market and model. So, you're eliminating venture risk, the risk inherent when you have an undeveloped business. How are the challenges involved in securing second-stage capital different today than they were a year ago? Similar? BA: I think it's always been extremely difficult to raise second-stage capital. There's hundreds and hundreds of venture firms that are looking for the very small companies. There are thousands of private equity funds that are out there to put some leverage on some bigger companies. But the pure second-stage players, it's always very, very difficult. Is its availability in any way cyclical/seasonal? JK: There is probably something to the cyclicality of it. Some second-stage entrepreneurs want a partner because it's the evolutionary process, if you will. Some want to stick it out. If banks are overextending themselves, they (the entrepreneur) will be able to secure some bank debt. In times of irrational exuberance, banks will get ahead of themselves and certain entrepreneurs will take as much capital as long as they can have control. It really kind of ebbs and flows with the credit market. Bank debt is fixed obligations. You have to start repaying it as soon as you get it. We provide permanent capital that fundamentally changes a balance sheet and allows for growth. What tend to be the responsibilities and requirements in attracting and securing second-stage money? BA: If an entrepreneur has a vision for growth and can explain it — how that growth is going to happen in almost a systematic form — then second-stage capital is available to them. Obviously, if they decide to go down that path, they've got a partner. When you have a partner, you have to chase that plan. It is radically different than doing what you want. You're no longer going to have your fingers in every aspect of the business. What are the biggest mistakes people make in seeking second-stage capital? JK: Many business owners truly struggle with transparency. They don't want to share all of the necessary information with their employees and stakeholders to allow them to make decisions independent of the owner. That's something that some folks never get over; they're just not ready to take that leap to a scalable business. If you want to grow, you're going to have to rely on other people to make decisions and execute on the plan. BA: The biggest mistake people seeking second-stage equity make is they believe money is the answer. Money sure helps, but money is not the answer. You'll never get where you're going unless you change how you're managing the business. This story originally appeared in Crain's Cleveland Business