With debt financing for larger transactions never a given, private equity funds are finding more deal opportunities through partnerships with strategic buyers. While such pairings can facilitate deals that may otherwise be impossible, they also present an array of challenges for both the financial and strategic buyer. Nonetheless, there are a growing number of success stories and many commentators believe this trend will only increase as lending remains tight and buyers look for creative deal structures.
Financial and strategic buyers each possess distinct advantages in M&A transactions. Private equity funds have access to large pools of committed capital and are great at sourcing and closing complex transactions, while strategic buyers can often provide synergies, industry expertise and a cash-rich balance sheet. Harnessing these strengths through a joint venture can be very effective, and this approach has been taken in a number of transactions that could not have otherwise been financed during the financial crisis. Below are examples of strategic-financial partnerships from recent years, including several deals occurring before the credit crunch. All of these deals were struck by larger funds in the upper echelons of the M&A market. However, the model could easily take hold in the middle market.
Table: Recent Private Equity-Strategic Partnerships
Financial and strategic buyers are accustomed to competing for deal flow. During the buyout boom of 2005-2007, financial buyers had many distinct advantages, including the availability of cheap financing and the ability to lure target management teams with large equity stakes and assurances of continued employment. For strategic buyers, synergies are expected to drive higher valuations, but competition with financial buyers during the buyout boom was still difficult. Now the tables may be turning. Strategic buyers that have successfully trimmed costs during the downturn are now sitting on large cash reserves. To meet Wall Street’s expectations for continued earnings growth in an environment where organic growth has become more difficult, increased M&A activity by strategic buyers is a logical next step. If the debt markets turn tight again, financial buyers could face stiff competition from strategic buyers for transactions. Faced with this competition, some private equity funds may look to the joint venture model to increase deal flow and gain a competitive advantage. However, the financial-strategic joint venture is not without its challenges, and it may only be suitable for certain transactions or industries.
Pros and Cons
There are a number of distinct advantages to the joint venture model for both the strategic and financial buyer. With the explosive growth of private equity over the past decade, the M&A market has become a crowded space. As a result, deal sourcing can be a time consuming and humbling exercise. The joint venture model could provide a new source of deal flow while capitalizing on the unique strengths that each financial and strategic buyer brings to the table.
A joint venture approach can also provide enhanced flexibility for both partners. The strategic buyer typically seeks earnings growth by integrating the target into its existing operations, thus achieving valuable synergies. However, the integration process can be very unpredictable and negative synergies can often outweigh the positive ones. By partnering with a fund, the strategic buyer can retain the flexibility to either redeem the fund if positive synergies materialize (through buy-sell or similar mechanisms) or exit along with the fund through an IPO or other sale process. In essence, the strategic buyer can wear both a financial and strategic hat, and then decide which hat fits best after operating the business.
For the fund, the ability to sell its interest to its strategic partner would give the equity sponsor an additional liquidity option than would otherwise exist in a solo investment. The fund could also benefit from the industry expertise, cash reserves and management resources of the strategic buyer.
The primary difficulty in a financial-strategic joint venture may arise from divergent liquidity goals. Typically, strategic buyers seek long-term earnings growth and operational synergies, while funds will seek an earlier (and certain) exit. The path to liquidity in a joint venture can get complicated if the partners cannot agree on the timing and nature of the liquidity event. Buy-sell or appraisal mechanisms provide some certainty of exit, but valuation of a private company interest (particularly a minority interest) is inherently difficult and can become very contentious for the partners. An IPO is often the preferred exit in these transactions, and a typical joint venture agreement would contain provisions that would permit either partner to initiate a public offering process.
Another thorny issue is the extent to which the target can be integrated with the strategic partner, and the difficulty of subsequently detaching the target for an exit transaction. A joint venture of this nature could make less sense without synergies, but to realize those synergies, it becomes difficult to operate the business on a stand-alone basis. These issues can be addressed contractually through governance provisions and veto rights over certain major decisions, but this is clearly an area where the partners’ interests may diverge. However, if the synergies become too valuable, the strategic partner can negotiate a buyout arrangement with the fund (or exercise buy-sell or similar liquidity mechanisms).
There are a number of other challenges that arise from any joint venture relationship, including governance issues, funding additional capital calls, corporate opportunity issues and transfer restrictions. These issues exist in any joint venture relationship, and there are many established legal strategies to address these issues. Agreements used in club deals during the buyout boom could also be useful models. However, those deals involved like-minded buyers, while the financial-strategic joint venture has greater potential for culture clash. Closing an M&A transaction is a complex process even for one lead buyer, so the joint venture relationship could add additional execution risk to an otherwise fragile process.
There may also be increased regulatory risk for joint ventures of this nature. Just as the large club deals began to draw scrutiny from antitrust regulators during the buyout boom, a financial/strategic joint venture could face similar regulatory hurdles. This risk could be enhanced by the involvement of a strategic partner with competitive operations.
Despite the many advantages to be gained from partnerships between strategic buyers and private equity funds, such transactions may be unlikely to succeed unless the buyers’ goals and investment horizons are closely aligned.
Joint ventures could be used to facilitate a roll-up or similar acquisition strategy in a particular industry, as seen in
Although these joint ventures have been embraced by larger funds accustomed to club deals, could this model thrive in the middle market? The model probably makes less sense for smaller transactions where debt financing is more available and the deal size does not justify the added complexity and expense. However, if the goal is a roll-up strategy in a particular industry, the benefits of these joint ventures would still prevail even for smaller transactions. Also, with financing scarce for larger transactions, larger funds are likely to be chasing smaller deals, with the ability to finance these transactions entirely with equity from the fund. Faced with this additional competition, mid-market funds may need to venture outside their comfort zone in order to find and close deals. At bare minimum, a joint venture strategy could be a valuable relationship building exercise for both financial and strategic buyers.
The common thread among private equity funds and many strategic buyers is the need to deploy capital, and by most measures there seems to be a historically large amount of capital to deploy. With increased competition for M&A transactions, buyers may need to find creative strategies for sourcing and closing deals, and a strategic-private equity joint venture might just be the answer.