The recent Private Equity Roundup in Scottsdale, Ariz. brought together investment professionals from buyout firms, hedge funds and acquisition finance companies. And virtually every one of them concurred that we are in the midst of a seller’s market.
For one thing, there is a glut of debt liquidity in the market. Banks and finance companies are eager to lend money at leverage multiples that are high by historic standards. Leverage standards in middle-market transactions are actually higher than they were at the previous high-water mark in 1998. There also are more sources of financing as specialty finance companies have proliferated.
Moreover, there continues to be a significant “capital overhang” measured in hundreds of billions of dollars consisting of unfunded private equity commitments that need to be invested before they expire. This creates enormous institutional pressure on private equity firms to put money to work. The last shoe to drop is the strategic buyer’s return to the marketplace. Based on metrics delivered at the conference, levels of strategic buyer acquisition activity enjoyed a significant uptick in 2004, and the expectation is that this trend will continue and accelerate during 2005.
Before accepting a final bid, however, a prudent seller should carefully consider how the differing financial and strategic motivations of corporate buyers and private equity funds affect their approach to transactions.
“As a financial buyer, with fiduciary responsibilities to our investors, we are concerned about our projected return-on-investment over a five year period,” says Thomas W. Janes, managing director of private equity firm Lincolnshire Management. “Strategic buyers, although concerned about investment returns, are generally focused on long term strategic and competitive goals.”
Ability to leverage an acquisition with external financing is a key factor for most financial buyers. Earning fluctuations affecting targets make it difficult for financial buyers to arrange debt financing for a proposed acquisition. Quarter to quarter changes in financial results have a significant affect on the availability and cost of debt financing. The absence of stable earnings not only makes the deal less attractive, but often causes financial buyers to seek price concessions or to restructure the transaction to obtain downside protection through holdbacks, earnouts and similar deferred payment provisions.
Private equity firms often spend substantial time analyzing historical financial results and creating complex financial models. Even if earnings growth is low, as long as it is relatively stable, financial buyers can typically use leverage to create a reasonable return. Conversely, if the business cannot be leveraged due to significant variations in earnings or inaccurate or incomplete financial information, most financial buyers will pass on the opportunity.
Established corporate buyers can finance acquisitions on the basis of their own historical performance. When large strategic buyers are purchasing smaller fold-in businesses, bank syndicates and capital markets are generally not as concerned with the target’s historical performance or projections. Even in situations involving mergers of relative equals, acquirers with a baseline of solid historical financial performance can often convince lenders to look beyond the target’s spotty earnings as long as there are reasonable assurances that integration of the new business can proceed effectively.
Lamar Advertising Company, one of the largest outdoor advertising companies in the United States, has acquired hundreds of out-of-home media companies over the past 10 years. Kevin Reilly, president and CEO of Lamar, points out that the vast majority of these acquisitions were either financed with cash on hand, or with drawings under Lamar’s existing credit facilities. For most of these transactions, the consent of the bank group was not required. Even in the context of very significant acquisitions financed through the capital markets, Wall Street took comfort from Lamar’s profile in the industry and historical success making strategic acquisitions.
“Although strategic buyers may have industry knowledge and the ability to self-finance an acquisition; deal expertise and rapid decision making can provide private equity firms with a distinct advantage,” Janes explains. “Private equity firms on average close a deal every quarter,” he says. “Very few corporations acquire more than a single business once every few years.” When difficult issues arise, internal corporate bureaucracies and political hurdles can stop a strategic deal dead in its tracks.
With both strategic and financial buyers in the market, it is important that sellers consider the different exit strategies favored by strategic and financial buyers. If there is little potential for a future sale or public offering, most financial buyers will be unwilling to proceed. Strategic buyers, however, are rarely concerned with their ability to sell the acquired business. Rather, the decision to proceed with a strategic acquisition usually depends upon the perceived competitive and economic synergies that can be achieved from combined operations and larger size.
The role of selling owners/managers in the future enterprise is also important to consider. Retaining senior management is often a priority for private equity firms. For some, the willingness of the target management team to roll over a portion of their equity may be a condition precedent to closing the deal. Conversely, corporate buyers often have strong management teams in place and are generally more willing to permit owners and managers to “cut and run”, subject to negotiated indemnities and non-compete arrangements.
Factors unrelated to financial results or management capabilities sometimes push sellers towards the financial buyer. Regulatory issues can have a big impact. Antitrust concerns lead the list but concentration and regulatory compliance problems may also arise under other federal and state laws in industries as diverse as banking, communications, liquor and healthcare. To the extent that acquisitions structured by financial buyers do not build on established platforms, such transactions are less apt to be delayed or affected by federal and state regulation. Strategic combinations are more apt to present antitrust, concentration, labor, political and other issues that can result in substantial delays or lead corporate buyers to demand price concessions or even walk away all together.
While the return of the strategic buyer is opening new doors to sellers, there is considerable risk to the seller’s business when a strategic deal is negotiated but never consummated. If a financial buyer elects not to proceed, the proprietary information obtained during the process is generally of limited or no use to such buyer. As Janes points out, “The cost to a seller of a busted deal with a financial buyer is time; with a strategic buyer, the genie’ is out of the bottle and difficult, if not impossible, to put back in.”
In the process of weighing the risks and advantages of proceeding with a potential strategic or financial acquirer, sellers these days may be faced with a new animal-the hybrid buyer: a strategic platform business backed by a private equity fund. The partnership between a private equity fund and a strategic buyer offers the advantage of the deal expertise and entrepreneurial approach of a private equity fund together with an existing platform, industry knowledge and potentially greater access to capital markets. In theory, from a seller’s perspective, this should improve the likelihood that the transaction will be consummated. Having two buyer constituencies with different motivations, however, can complicate an acquisition at a minimum, and potentially cause it to be derailed.
Given new options presented by the return of the strategic buyer, sellers should resist the temptation to react too quickly in favor of the highest offer. The ultimate decision must be based on a combination of factors, including not only price, but also timing concerns, financing and capital markets risks, regulatory issues and the costs to the seller of a busted deal. Sellers should also be cognizant that this strong seller’s market may be a short-lived phenomenon. The historic leverage ratios and debt levels achieved during the last 12 months may well give rise to significant deterioration of corporate credit quality which will cause financers to pull in their horns and make debt less available to financial buyers to fund acquisitions.
George Ticknor and David L. Ruediger are partners at Palmer & Dodge LLP and are members of the firm’s Private Equity and Venture Capital Practice Group.