Editor’s Note: In July, the Buyouts’ staff sat down with Hiter Harris and Christopher Williams, the founders of Harris Williams & Co. The following is an excerpted version of our conversation. This is the second part of a two-part series, with the first installment running in Buyouts Aug. 9 issue.
Buyouts: What do you look for, specifically, in a private equity buyer?
Williams: People are always surprised to hear that 50% of the time, we favor a buyer that wasn’t the highest bidder. Other factors play into the decision: certainty of closing the transaction, how well the firm fits with management, the firm’s timing to close, and whether they’ve done what they said they were going to do during the sale process. The importance of these intangibles is often very underestimated by board members and other advisors not intimately involved in the process but who put forth recommendations.
Harris: In the case of public companies, they are far more restricted and must view value as the key driver of a transaction. Obviously, that is a consideration of private companies, too, but so many other things also come into play.
Buyouts: Are there groups that you will not deal with because they have fallen short of your expectations?
Williams: In general, private equity buyers recognize that if you don’t do what you say you will do, it’s going to catch up to you. We have pretty long memories. It’s not often that we won’t work with a firm, but it happens. It’s a more relevant issue when you get to the stage of preliminary bids. Of the firms that have put forth preliminary indications of interest, which do you bring in for a meeting? A firm’s preliminary valuation can vary a lot from its final bid, so you try to judge who has thrown a high number in and doesn’t really mean it, versus who has a sincere and keen interest. We track all that information in our database.
Buyouts: What common mistakes do private equity groups make? Is there anything specific that keeps happening over and over?
Williams: Yes. [One common mistake is] underestimating the qualitative factors that can drive a decision. Have they done what they were asked to do? How much work have they done to truly understand the business? Understanding the messages their actions send is critical. Little things like taking the time to have dinner with the management team the night before a presentation, being well organized and well represented when they come in for a visit, not having to cut the meeting short to catch a flight, not checking their Blackberries and running out of the meeting for calls-that kind of behavior leaves an impression.
Buyouts: Do you see any changes in seller compensation? Are more buyers looking to add non-cash components to deals?
Williams: Very few of our deals have a non-cash component to them. That’s been very consistent over the last decade. Maybe in 2001, you took a little more non-cash payment because the market was so weak and it was a way to bridge the value gap. I don’t know how many deals in the last two years have had a non-cash piece, but it’s got to be very few, like five percent. I’m sure it’s different for other advisors, but it’s a minor factor in what we do.
Buyouts: Are there any sectors that private equity firms seem to be more interested in these days?
Williams: There’s a lot of interest in health care, and if you were to look at the top 200 private equity portfolios, it seems like more and more often, the traditional, middle-market players are touching the health care world. We are also seeing a lot of business-process outsourcing-everything is about outsourcing now, and there are some interesting models out there. We are also seeing a lot of transactions in consumer product companies.
Buyouts: Will the uncertainty regarding the presidential election have any influence on the LBO market?
Harris: Uncertainty drives a lot of things and whatever is uncertain is always the topic of conversation. People talk about the dynamics of the economy or the market when there’s a major event and how it will affect us in the short term. The election is a near-term event that everyone talks about, but its actual effect will not be that significant. Of far greater importance is the perception that we’re in a strong market and we don’t know how long it’s going to last, and so sellers want to take advantage of it. And there is some interconnectivity between the economy and the presidency, but I don’t think people are that focused on it. Absent an extraordinary event, we believe this market will continue to show strength.
Buyouts: Other than overpaying, are there other risks you see being taken by private equity firms?
Williams: Hindsight is always 20/20. It’s tough to sit here and say that the private equity groups that are winning bigger deals because they are paying up are going to look back and say that it wasn’t smart business – because you just don’t know.
Their greatest risk is not sticking to their sphere of expertise. We believe this was a lesson learned by many during the tech and telecom bubble, when many private equity groups who thought they could be successful VCs were burned terribly.
Harris: Keep in mind, you may be paying a high price, but getting real quality. Some of the highest returns that people have achieved in companies they bought from us were those for which they paid a premium and they knew it. But these were companies with great growth, and they became home-run deals for the buyers. There are some firms that made big bets in cyclical industries three years ago when some people were saying, Why go into this industry when the economy isn’t very strong?’ And they went into it anyway, and it has worked out unbelievably well. Hindsight will always be 20/20.
Buyouts: What are private equity IRR expectations these days?
Williams: When we first got into the business in 1987, people were looking at 35% to 38% IRRs, but IRRs have steadily been forced down. As this asset class has been validated, and more capital has flowed in, it too became more efficient and competitive. It’s not uncommon at all to see groups model equity returns in the low 20s and mezzanine returns in the 13% to 15% range. Three years ago, mezzanine returns were 18% or 19%, but three years ago I don’t think people considered 7% returns from public market investments so great either, but now they are.
Harris: From an LP standpoint, this asset class has changed. Ten years ago, the number of private equity groups with funds was much different than today, and so was their sophistication. So, do you require the huge returns in a market that is now more liquid? Probably not.
Buyouts: How long does the whole deal-making process take, on average?
Williams: It can take anywhere from five to eight months, but the average is six months. People will tell you it’s a lot faster, but from start to finish it really takes that long.
Harris: You have to figure on seven or eight weeks just to get ready, before anyone else even knows that the company’s for sale. Then you start calling buyers, and you’re actually out in the market for two to four months.
Williams: The interesting thing about timing is how the schedule is managed today versus four years ago. Potential buyers used to have a 45-day exclusivity period to do a lot of their work. Today, sellers are so concerned about getting re-traded, or about having someone drop out, that buyers are given a very short exclusivity period, if any.