By-Lined Article
Valuation and Structure
By Duane Morris Private Equity Connections
Summer 2012
Duane Morris Private Equity Connections
Strategic buyers can and often do pay more for an asset than a financial sponsor. Yet these buyers can be harder to pin down. There is as much psychology as financial analysis involved in coming up with the right deal, no matter who is buying.
How do strategic buyers price a deal? That depends on how badly they want it, says UPS's Chang. "Is this a 'nice to have'? Or is this a 'must have'?" he asks. What signifies a "must have" is if one of your largest customers says, "If you don't have this capability in this market, then I'm going to have to let one of your competitors in the door," notes Chang. That creates a need for doing a deal that goes beyond just the standalone metrics of the company; it is to retain your current customers, he said.
Fortunately for UPS, most of the deals Chang does are in the "nice-to-have" category. But if it's a "must have," then "we'll pay what the seller needs to get the business into our hands," he added.
Valuation: A Three-Way Street
Because most other bidders will not know the rationale for a strategic buyer, their participation—and pricing—can be hard to predict. Investment banks with a sell-side mandate will try to come up with a potential valuation. SunTrust's Bomar says, "You have to balance. If a sponsor is involved, we would run a leveraged buyout analysis. If strategics are involved, we'd want to understand the willingness to pay. I think in the ideal world, you want to have both involved."
"I think in the ideal world, you want to have both [sponsors and strategics] involved." Stirling Bomar, SunTrust Robinson Humphrey
Easily said, but less easily done, Bomar acknowledges. If the investment bankers with the sell mandate think there are one or two logical strategic buyers, then they circle them, but the offers do not always materialize. It makes sense to gain a broader perspective for his clients right out of the gate in the auction process, says Bomar, "because in this environment, sponsors can be very competitive, given the cost of capital and the fact that there's a lot of cash on the sidelines."
Yet that provides only so much extra energy to the bidding process. The reason, Bomar explains, is because you also need to bring in an expanded set of strategic buyers—usually competitors to the seller—alongside financial sponsors, a strategy which entails additional complications. "This can be challenging to sellers, who are wary of competitors trying to uncover private information. A lot of times sellers will request that we redact certain information from certain buyers," says Bomar.
"It's tricky in how you manage that, because you want to bring the most logical buyer to them—and the ones that have the ability to pay," he explains. "You just need to work with management to shape the type of process that makes sense for them." This can be particularly important because financial sponsors want all the information they can obtain to understand the inner dynamics of the seller's business—information that strategics usually take for granted.
Chang looks for consistent historical earnings and ignores ecstatic "hockey-stick" forecasts of future growth. "We have to apply valuation methodologies, not play a guessing game." Ronald Chang, UPS
Sellers Tend to Look at the World from Their Company's Perspective, Not from the View of the Market
Reaching a valuation agreement can be challenging when dealing with owners who are neophytes in the dealmaking world. Many owners are unaware of what their company would be worth to a buyer. "We have come across a surprising number of deals where we spend the bulk of our time trying to get owners to understand conventional valuation methods," says UPS's Chang. He looks for consistent historical earnings and ignores ecstatic "hockey-stick" forecasts of future growth. "We have to apply valuation methodologies, not play a guessing game."
Both strategics and sponsors face the same unrealistic expectations from sellers who think their companies are still worth what they were at the market peak. Chang finds that many of these smaller businesses are on the block because the markets have not recovered from the recession; their owners are looking to "monetize" valuation levels that no longer exist. In the service industry, large firms such as UPS become problematic for smaller companies, particularly in a down market. "As we grow, we creep into the space of the medium- to small-sized companies, and they find it increasingly difficult to compete because we're offering similar levels of service as they would offer," says Chang.
"[W]e obviously would like to avoid paying for synergies, particularly if we’re creating them." Steve Voorhees, RockTenn
Conventional wisdom says that in these cases, strategics typically have an advantage against financial sponsors because of their industry focus. They understand and can deal with certain risks that might arise because they know the industry and can also pay more because they can make more money off the synergies.
However, synergies can be akin to a poker game, says RockTenn's Voorhees. He says that strategics have to figure out those synergies and what they are worth. "Then, we obviously would like to avoid paying for synergies, particularly if we're creating them," Voorhees said. Netting it all out, synergies can give strategics an edge in valuing a deal.
Private equity firms can invest considerable time pursuing a target without much to show for it if it all comes down to price. "[A]t the end of the day, [the sellers are] looking for the highest valuation; in some cases, that's us, but in others, it isn't." Robert Bryant, Roark Capital
"Price is one element, but it's not the whole game." Joseph Ibrahim, The Riverside Company
Operationally, the Deck May be Stacked for Strategics, but the Best Hand Wins
Competing against strategic bidders creates challenges for financial sponsors that go beyond ability to pay. "As the valuation multiples creep up, the financing and leverage have to increase correspondingly," says Roark Capital's Bryant. "We might find ourselves in a situation where the sellers want 10 times for their business, but they're leverage-averse; and when you do the math, that doesn't really work." That sort of divergence can put an end to honest negotiation. "We want to grow the business, so we want to have the balance-sheet flexibility to be able to execute initiatives," Bryant explains. "At the same time, we need to be competitive in an auction process."
Private equity firms can invest considerable time pursuing a target without much to show for it if it all comes down to price. "In some opportunities, we fostered a relationship with the seller over a number of years and price didn't appear to be the most important factor," explains Bryant. "We're looking for a partner. Then, at the end of the day, they're looking for the highest valuation; in some cases that's us, but in others, it isn't."
Where price is not the only factor, financial sponsors can offer some enticing incentives. In a recent bidding process involving Riverside, Ibrahim says his firm "developed an acquisition plan for the management team and opened doors throughout the process, whether we closed the deal or not. The GPs sweetened the offer with an ambitious schedule to close, did not add any financing contingencies and did not change any deal terms," he said. Riverside prevailed over strategic investors even though his firm was not offering the highest valuation. "Price is one element," says Ibrahim, "but it's not the whole game."
The Duane Morris View
Stephen DiBonaventura: In some deals, possibly the majority of those in the middle market, the transaction's tax implications can generate a material component of overall deal value. Prepared sellers have already contemplated the major issues and brought their lawyers, accountants and other advisors into the dialogue early in the process to address the optimal tax structure, as well as wealth-planning strategies.
