Once perceived as a refuge from bidding wars, the middle market is increasingly receptive to the auction process. The dual challenge for middle-market private equity buyers is to generate deal opportunities outside of the auction framework, but also be able to effectively compete in auctions.
The middle market, defined here as companies with enterprise values between $50 million and $500 million, has traditionally been viewed as a segment offering opportunities for private equity buyers to purchase growing companies at reasonable prices, when compared to the multiples paid in larger deals. The assumption is that a buyer in the middle market has a greater likelihood of finding and negotiating a deal on a proprietary basis.
Sadly (from the buyer’s perspective), this is no longer the case. More and more, middle market companies are represented by investment bankers, who-with an eye on maximizing their client’s proceeds and their advisory fee-run sales through an auction process.
Middle Market Metrics
Our observation is that in recent years it has become increasingly difficult for buyers to find middle market deals outside of an auction. In Buyouts’ M&A transactions data, it discloses seller’s financial advisor. If an investment banker represents a company, then as a general proposition the sale is being run in a competitive process, and most likely in an auction. In the years 2000, 2001 and 2002, the percentage of sellers in the middle market that retained a financial advisor was 28.7%, 31% and 42.1%, respectively.
There are a number of factors contributing to increased demand for middle market companies, which gives those companies the leverage to insist on an auction process:
1. A lot of money needs to be put to work. And limited partners in private equity funds have a finite timeframe on their binding capital commitments.
2. Fewer large deals are getting done and the competition for those deals is fierce.
3. A sale is the logical exit. In general, the IPO window is closed to all but life sciences companies. Those companies that were seriously considering an IPO most likely have an investment banker on the scene, and that banker is steering them to a sale via auction.
4. Sellers are becoming increasingly sophisticated. A number of private equity firms have portfolio companies that they are positioning to sell, and they know, from bitter experience on the buy side, that the auction process tends to maximize value.
Reflecting this increased interest, private equity and investment banking firms are digging deeper into the middle market:
A number of top-tier private equity funds have focused on the middle market for years, but now big buyout firms are showing increased interest in this segment. Bear Stearns Merchant Banking, which traditionally invests in companies with enterprise values of $100 million to $1 billion, recently established a new unit, Bear Growth Capital Partners. The unit will invest in companies valued at $10 million to $100 million.
Additionally, while regional investment banking firms have long had middle market sell-side engagements as their bread and butter, they are now being joined by an increasing number of boutique firms that have spun out of the larger investment banks.
Getting Outside of the
Frustrated by the bidding wars, private equity firms are reexamining their deal origination process and investing substantial resources in sourcing proprietary deals. Strategies include:
1. Mining relationships. Often with the help of sophisticated contact management software, firms are becoming more systematic in identifying and pursuing leads from investment bankers and, more importantly, other deal participants, including lawyers, accountants and consultants.
2. Teaming up. A firm will partner with an executive who has achieved success, to exploit that executive’s industry knowledge and contacts in pursuit of a new deal (after confirming that a noncompete doesn’t stand in their way!).
3. Hiring salespeople. A firm will hire individuals whose sole job is to generate and manage deal flow.
4. Executing focused marketing campaigns. A firm’s investment staff identifies a certain industry as a strategic focus. Firm representatives attend trade shows, perform research and build contact lists in that sector. The firm’s associates and salespeople approach those on the targeted list, whether by letter, “cold call.”
Stuck in an Auction?
If, despite its best intentions, a private equity fund finds itself competing in an auction, the first step is to anticipate how the auction will likely proceed.
1. The investment banker, with input from management, drafts the confidential information memorandum (aka the “book”) describing the company, its industry and its financial performance.
2. The banker taps its contacts in the seller’s industry and the private equity community.
3. Interested parties receive the book (after signing a standard confidentiality agreement), and are invited to submit non-binding indications of interest.
4. Based on review of the book and independent research, bidders submit their indications of interest.
5. The investment banker and seller cull through the indications of interests, and narrow the field to those that are in the range of seller’s expectations.
The next stage involves the following:
1. Bidders review the contents of the data and attend presentations by seller’s management.
2. After diligence visits, bidders are provided seller’s draft form of purchase and sale agreement (P&S).
3. Bidders are asked to make definitive bids. The banker stresses that these proposals should contain the best and final price and terms, and that due diligence should be complete and financing arranged.
Mark-up or Memo? Bidders often consider whether to do a full mark-up of the P&S, as seller requests, or a memorandum summarizing their issues with the draft. They may choose the latter, in order to manage legal expenses in the event they don’t advance in the process, and in an effort to keep their options open on deal terms until due diligence is complete.
Price, Price and Price. Regardless of their form, do P&S comments most likely do not have a material impact on the bid since the seller’s overarching priority is maximizing transaction value.
The following are of secondary, and roughly equal, importance: Certainty and speed of closing; Deal structure and financing; and extent of bidder’s proposed changes to seller’s P&S.
Within the P&S comments, a seller will focus on the bidder’s response to its proposed indemnity package. If a bidder requires the following, such terms may impact seller’s view of its offer:
Significant escrows or holdbacks of the purchase price to secure indemnity claims
Multiple carve-outs to the limited survival period for standard representations and warranties and the cap on seller’s liability for indemnity.
If You Can’t Beat Em,
To compete in auctions, private equity buyers, instead of going it alone, may team up to make a bid (while keeping an eye out for antitrust issues). Although more prevalent in larger transactions, “club deals” are becoming increasingly common in the middle market. Even if its price isn’t the highest, a private equity consortium may be able to succeed in the auction, or preempt the auction altogether, by offering:
Flexible Financing. The group may offer a bridge loan in the event permanent debt financing isn’t in place at the time of closing.
Deep Pockets. A wider group of sponsors offers the assurance of multiple financing sources for additional investments in the acquired business, including add-on acquisitions.
Heavy Hitters. A consortium may offer broader and deeper industry expertise and financing contacts, at the Board level and otherwise.
If all else fails bid high, then back off. One potential strategy is to bid aggressively to win the auction, gain exclusivity, and then, after further due diligence, require price concessions to get the deal done. If a private equity firm makes a habit of this approach, it can get a bad name, though a seller may be guilty of enabling this behavior if it delays the release of bad news until the latter stages of the process.
Tricks Sellers Play
Keeping the Buyer Honest. To combat a winning bidder’s sense that he is in the driver’s seat, a seller may deliver news of the winning bid with words to the effect of: “We’re going with you even though you’re not the highest bidder because management really likes you” or “we prefer your financing structure,” etc. The goal is to create insecurity. The seller want you to think there is someone on the sidelines ready to pay full price if its process with seller goes sideways. Don’t back down.
You’ve Won. Now What? Middle market players typically proceed to a non-binding letter of intent (“LOI”) setting forth the transaction’s key terms. The LOI has an exclusivity provision, which bars the seller from talking to other bidders for a specified period of time. This assurance enables the winning bidder to commit the necessary resources to do the following:
Perform additional due diligence (accounting, legal, environmental, customer calls, management reference checks, etc.),review seller’s disclosure schedules, Arrange definitive financing; and fully negotiate the P&S.
Paul M. Mahoney is a partner in the Private Equity Practice Group of Edwards & Angell, LLP, a 300-attorney national law firm focusing on financial services, private equity and technology. Ragan L. Ferraro is an associate in the Corporate Practice Group.