Yes, we are in a sellers’ market, and we have been in one for quite some time-about two years if you want to put a number on it. But to simply say that those on the sell-side of any given transaction are in a more advantageous position than they had once been would be an oversimplification. There are degrees of just how good things are for those on the sell side-degrees that can be measured, in part, by the power and influence that investment bankers yield over today’s private equity processes.
The manner in which the market has evolved over the past 24 months clearly indicates that today’s sell-side financial advisors have worked up significantly more muscle than they had when the market first took off. One blaring observation that supports this is the fact that a vast majority of general partners today accept the auction process as a natural part of the private equity landscape. Within that, investment bankers have the power to filter which firms are made aware of particular deals, and, to a degree, are able to set tighter deadlines for said bidders to conduct their due diligence.
But perhaps one of the biggest signs of the sell-side’s growing influence is the increased use of stapled financing in today’s auctions. Stapled financing is when a sell-side investment bank-while putting together its book and conducting due diligence-seeks out a lender, secures a pre-arranged debt package for the company and, in affect, “staples” the lender’s commitment letter to the memorandum, thus making the same financing setup, and the same debt multiple, available to all competing bidders. In cases when larger, universal investment banks are putting together a staple, many choose to tap their own financing arm to provide the debt.
“Stapled financing often, but not always, makes sense,” says Justin Abelow, a director at Houlihan Lokey Howard & Zukin. “It’s a cost-benefit analysis that a seller needs to conduct because while a stapled financing can sometimes provide real benefit, it also might have with it real costs.”
At first it was almost exclusively the large, universal banks that deployed stapled financing on assignments for businesses earning between $40 million and $50 million of EBITDA and up. But lately, some private equity pros and investment bankers have observed stapled financing in middle market deals for companies that earn between $20 million and $25 million of EBITDA.
“What I can tell you definitively is that today, a lot more of the deals we see show up with a stapled financing, where 10 years ago you didn’t have it at all” says Justin Wender, a managing director at New York private equity firm Castle Harlan.
Indeed, market pros agree that stapled financing’s most visible roots are imbedded in 2001 and 2002, a time when the financing markets experienced a major hiccup, and when private equity buyers found it difficult, if not nearly impossible, to secure debt. At the time, intermediaries took to stapled financing as a means to facilitate transactions and to make a statement to the marketplace that companies could still be levered at “reasonable levels,” says Giles Tucker, a managing director at Harris Williams & Co.
Today, however, even though the debt markets are a world away from those dismal years, the staples remain, a factor that some say can heavily influence today’s private equity processes in a number of ways-price being paramount among them. For even though potential buyers are not required to use the stapled financing offered, the simple fact that it exists is enough to influence the ultimate value of a transaction.
“Having a staple in place when you go to market, in some cases, provides a floor from a pricing perspective, and if it is a financial sponsor-driven transaction, it does send a message to the marketplace about the debt levels that can be obtained for that company,” says Tucker.
Often, setting a debt-multiple floor, in itself, can be the key driver for intermediaries to set up a stapled deal, leaving the ultimate identity of the lending party and the terms of the debt to take a back seat. “It’s rare that financial buyers ever use the lending that we’ve gift wrapped,” says Jack Helms, a managing partner at Goldsmith, Agio, Helms & Lynner. “They use our due diligence work and the lenders that we worked with to lever their relationships, to meet the same terms and win… And when the smoke clears, they end up using their [own lender] with underwriting terms that are the same as the ones that the lenders we lined up were proposing.”
To this, some buy-side pros are of the opinion that, when it comes to deals with stapled financing, the emphasis is placed too heavily on the equity commitment that a firm is willing to lay on top of the debt, and that financial creativity is stifled.
“That’s what the bankers would like-for everybody just to compete over their equity,” Wender says.
“I would be shocked if an intermediary could put together a better financing package than we could. But it would be interesting to see what they have to offer,” says Aldus Chapin, a principal at Milestone Capital.
Needless to say, problems can arise on the sell-side, too. Perhaps the most serious error that can be made by an investment banker is setting the floor too high. “I’ve seen processes where the stapled financing has been so damn high that I think it’s had a perverse result and it actually suppressed bidding,” says one investment banker speaking on condition of anonymity. “Not too long ago there was a situation where the [financial] sponsors thought the business was worth about 7x to 7.5x [EBITDA], and the stapled financing was at around 7x to 7.5x [EBITDA]. It didn’t take too much goading to get them to walk straight for the door.”
A Time To Staple
On the sell-side, investment bankers cite a number of circumstances in which stapled financing is beneficial to both the sell-side and the buy-side of auction processes. For example, if it is perceived by the intermediaries that financing the company could prove difficult-perhaps because the company is in a thorny industry (such as the automotive aftermarket sector) or due to surface blemishes on the company’s performance record-then some investment banks will set up a staple to build confidence for both the seller and the buyer.
Similarly, investment bankers say they often find prearranged debt packages beneficial when they are selling unique or niche-oriented companies that, though they might be high-quality businesses, are out of the mainstream.
Another area where staples can be helpful is when a company that’s coming to market already has a devoted, incumbent lender. “If the incumbent wants to stay in, and can provide a staple, oftentimes that upfront commitment will have a little more meaning to it because they know the company-they’ve obviously been a lender to it for a long period of time. And because of that, I think sellers can have greater comfort that that lender will deliver at the end of the day.”
But again, sell-side agents note some serious potential downfalls to stapled transitions and the need to choose wisely when to employ them. “[Using stapled financing can be a little disruptive if you have a very, very sensitive and confidential transaction,” says Helms. “There are times when shopping the same financing to multiple potential buyers can work to break down your confidentiality.” To this, David Santoni, a managing director at Goldsmith Agio adds, “We don’t like to give any hints as to what the ultimate price of the deal is going to be, but when you get down to one [financing] proposal that you’re attaching to your memorandum, it does let out some hint.”
With that in mind, the investment banker who spoke on condition of anonymity believes that sell-side advisors should take an apprehensive approach to employing stapled financing in “plain vanilla” processes, saying it may inadvertently give the impression to the financial sponsors that they are “pure and simple involved in an IRR auction”-that everyone is going to effectively have access to everyone else’s bids, that there will be very little opportunity for them to differentiate themselves by means of preferred relationships with financial providers and financial creativity.
“You’re taking away the incremental ability of sponsors to differentiate themselves and you’re forcing them into a situation where the bidding process in essence sounds like, Okay, who will do this for a 20% IRR? Do I hear 19%? 19%? How about 18 percent?’ And that’s a tough situation to be in,” the investment banker said.
So while intermediaries enjoy the increased certainty of close, the increased speed of close, and the floor on valuation that stapled financing can provide, the aforementioned risks can potentially outweigh the benefits. As such, investment banks such as Harris Williams and Goldsmith Agio both say that only about 10% of their transactions come with stapled financing.
As a safer, less intrusive alternative to the staple, intermediaries have increasingly been employing what some refer to as “paperclipped financing,” which, like stapled financing, entails running parallel auctions, one for the buyers and one for the lenders. The difference is that no single lender is chosen to make a commitment and no hard floor is set regarding debt multiples. Instead, the investment banker uses the information provided by the lenders to get preliminary data on what the likely financing will look like and, once the auction is under way, those lenders’ packages are made available to the potential buyers.
Admittedly, says the anonymous investment banker, these tactics are more aggressive than those used in traditional processes of yesteryear, but in today’s cutthroat M&A marketplace, it is becoming a common practice.
“There isn’t a middle-market bank out there now that isn’t out talking to lenders while they’re running a process and getting, not full commitments, but letters of interest,” says Goldsmith Agio’s Santoni. “It’s just another way of making sure you can shepherd the process through-it’s good banking and it’s good for your clients.”