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The usual model
The usual private equity model for consolidations, which are strings of acquisitions, is to deploy as much equity as possible, as long as the last equity dollars deployed still earn an attractive IRR. At the margin that creates an incentive to deploy more equity, because it gets the firm closer to raising its next fund.
A fixed base of equity
The alternative picks one very specific number up front and holds to it. These companies are built on that base of equity and no more, often just 10 million to 25 million dollars deployed forever, and the goal is to own them for really long periods of time. Growth comes from a combination of acquisitions and organic growth.
Banyan Software
Banyan Software shows how far this can stretch. An investor funded its early days on his own while David Burkle designed a new way of perpetually buying vertical market software companies. With only $17 million of equity capital invested, Banyan grew into a holding company with dozens of software companies, and a recent recapitalization valued it well in excess of $1 billion.
Why do funds push to deploy more equity?
Funds commonly charge fees based on the capital they commit or invest, so a bigger pool of money means more fee income. A fully invested fund also gives the firm a record to point to when it raises the next one. Larger funds can write bigger checks for bigger deals. Fees of about 2 percent a year of committed capital have long been typical at private equity funds.
How does a holding company differ from a fund?
A fund is a partnership with a fixed life, and it must sell its investments and return the money to its investors. A holding company owns businesses through a corporation with no end date, so it can keep reinvesting its profits. Berkshire Hathaway, which owns dozens of businesses, is organized as a holding company rather than a fund.
How can a company grow without new equity?
Profitable businesses generate cash that can be used to buy other companies. A modest amount of borrowing can finance purchases of businesses whose own cash flow covers the interest. Software companies with recurring subscription revenue suit this approach because the cash arrives predictably. Predictable cash flow is what lenders look for when they finance acquisitions.
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