Many business owners operate under the misconception that the best time to sell a business is when the strategic buyers' market is hot. They believe the best sale (in terms of total consideration received) is to a strategic buyer, most often a local competitor, or a national or regional distributor that wants to get into their market. Given the current dynamics affecting the private equity market, this is often not the case. Today, private equity funds are more willing and able to pay premium prices for distribution companies than they have been at any time over the past three years.
As anecdotal evidence of the increased level of private equity fund activity, consider two recent distribution companies marketed for sale by Brown Gibbons Lang and Co. (BGL). Both were nearly identical in size, profitability, business models, quality of customer bases and quality of management teams. Company No. 1 went to market in early 2002. Company No. 2 went to market in early 2003. Twenty-nine private equity funds signed a confidentiality agreement and reviewed the offering memorandum for Company No. 1. Two private equity funds submitted a written offer that met or exceeded the owners' sale price expectations, versus five strategic buyers.
One year later, 91 private equity funds signed a confidentiality agreement and reviewed the offering memorandum for Company No. 2. Seven of those private equity funds outbid every strategic buyer by at least 20 percent. This is a trend I am seeing consistently across industries in today's market. While there are still exceptions, be it a distribution, manufacturing or service entity, more private equity funds are displaying a far greater ability and willingness to pay premium prices for leading middle-market companies.
Granted, strategic buyers often have some potential synergies available to them, including revenue enhancements such as ability to provide additional products and services to the combined customer base, and the ability to service additional customers through enhanced geographic coverage and/or sales and marketing capabilities.
Strategic buyers also have cost reduction opportunities such as enhanced purchasing power, closure of redundant branches, and the elimination of redundant personnel. Because of these potential synergies and the strategic buyer's apparent ability to pay premium price, in theory strategic buyers could offer the highest purchase price to a potential seller. But the strategic buyers' ability to pay a premium purchase price often conflicts with willingness to pay top dollar — even in today's recovering economy.
Several reasons may exist for a strategic buyer's unwillingness to pay premium price. These reasons might include managing quarterly earnings, bad experiences with unsuccessful acquisitions and integrations, or a belief that it can generate the same results through internal initiatives. This is why any business owner contemplating a possible business sale should understand today's private equity market.
How a leveraged buyout works
A leveraged buyout, or LBO, is an acquisition transaction in which a significant portion of the purchase price is funded with debt. This type of capital structure enables private equity sponsors (financial buyers) to “leverage” returns on their equity investment and to use the cash flows generated during the investment period to pay down debt and fund the continued growth of the company.
Private equity firms typically look to harvest their investment within three to seven years by selling the acquired company to another buyer, taking the company public, or re-leveraging the company and pocketing a large cash dividend.
In many cases, the leveraged acquisition capital structure will include several funding sources. Usually, the transaction will utilize a significant amount of senior debt because it's typically the cheapest form of acquisition capital.
Senior debt can be categorized in several ways, such as secured versus unsecured, or “asset-based” versus “cash flow.” Generally, asset-based loans are secured by the collateral value of the company's current and fixed assets. The total amount of secured debt that can be advanced is measured against the value of these underlying assets, whereas cash flow loans are predicated primarily on the company's projected cash flows and operating performance.
Many acquisitions also include “mezzanine” or subordinated debt, which is often closer to equity than debt in that it commonly incorporates equity-based options, such as warrants, with a lower-priority debt. Return expectations for mezzanine investors exceed those of senior lenders, but are lower than the return hurdles of equity investors.
Private equity groups are driving merger and acquisition activity
While much press has been dedicated to the recent acquisition activity of strategic buyers such as Sonepar and Hughes Supply, private equity funds are driving a significant volume of the current merger and acquisition activity. As illustrated in Figure 1, they have substantially increased the pace of their acquisitions since 2001.
Several factors are driving the private equity funds' increased appetites to acquire companies. The first relates to the improved credit markets, including terms and pricing, as well as leverage availability. Many traditional lending institutions are under increased pressure to deploy capital. In addition, there has been a recent increase in the number of nontraditional senior debt funds and more aggressive financing options provided by mezzanine funds. As a result, leverage ratios are improving. As leverage ratios improve, private equity funds are better able to leverage their equity investments to enhance their expected returns, thereby enabling the funds to offer higher purchase prices.
High-yield bond activity has further driven private equity funds' ability to leverage their equity contributions. In 2003, there was a dramatic increase in high-yield issuances as compared to the previous three years. Moreover, while 2003 was a good year for high-yield issuances, the volume of high-yield issuances in first-quarter 2004 nearly doubled from their level in first-quarter 2003.
The disparity between private equity capital raised and private equity capital deployed over the past several years is also driving private equity funds' willingness to offer premium prices for leading distribution companies.
The more than 900 domestic private equity funds collectively have raised more than $325 billion since 1994. Although the level of fund raising declined substantially over the past three years (see Figure 2), much of the private equity capital raised from 2000 to 2002 has not been invested. The investors in private equity funds are pressuring for more rapid deployment. Several private equity funds are faced with the prospect of either spending the money or having to give it back to their investors.
Valuation gaps are disappearing
All these factors have contributed to financial buyers closing, and in many cases eliminating, the valuation gap between themselves and strategic acquirers. The significant valuation gap that existed between strategic buyers and financial buyers from 1998 to 2001 has been virtually eliminated in many segments of today's market. For transactions with total enterprise values less than $100 million, financial buyers now more often pay equal or higher purchase prices and purchase price multiples than strategic buyers.
An additional factor enabling financial buyers to compete and win auctions has been their ability to act as a pseudo-strategic buyer in certain situations. With the recent downturn in the initial public offering market, private equity funds own an increasing percentage of U.S. businesses, and dozens of private equity funds own distribution companies. Not all may fit exactly with a particular distributor, but in the recent age where distributors are seeing their customer base shrink because of bankruptcies and the flight of manufacturing operations, distributor-buyers in general are seeking ways to capture a larger proportion of their existing customers' annual MRO and capital-project purchases. That's why they are seeking additional product lines and service capabilities to offer to these customer bases.
If a private equity fund already owns a portfolio company similar to a distributor-seller, opportunities for cost-reduction synergies exist, which can further drive a private equity investor's returns on invested capital (both for the company it already owns and the company it's seeking to acquire), and ultimately, justify a premium purchase price.
The partial sale
Most private equity funds will consider purchasing less than 100 percent of a distributor's business and let the existing owner and management team co-invest with them in the company. In fact, most prefer to partner with successful owners and managers and will set aside additional equity capital to support a corporate growth and/or acquisition plan.
In other words, private equity investors are often willing to purchase a controlling interest in a business, allowing the owners to take some chips off the table, but also support the company with future investment dollars. This allows the owner and managers to capitalize on the upside when the equity fund sells or recapitalizes the business in the future.
Partial sales are appropriate for business owners who are bullish on the future value of their businesses, but may, for any number of reasons, desire significant near-term liquidity. Such an option may be particularly attractive, given the uncertain timing/duration of the rebound in the economy and the fact that certain private equity funds have significant experience in the distribution industry and can help enhance a distributor's growth and financial performance.
Most buyout funds target at least a 25 percent compound annual rate of return on their equity investment; the owner/management team can expect to share in these equity returns.
Through a partial sale (or recapitalization), a seller can monetize a portion of their investment now and diversify their risk profile while maintaining an ownership stake in the business and retaining the opportunity to receive another, and potentially even higher, payoff down the road.
In addition to the monetary reasons outlined for considering selling to a private equity fund over strategic buyers, owners should also consider the risk profile of a sale or partial sale to a financial buyer versus a strategic buyer. Many owners are understandably nervous about sharing detailed information about their businesses with strategic buyers, which frequently are competitors.
Although this risk can be minimized through the execution of a confidentiality agreement, because private equity funds are professional buyers and sellers of businesses, and any breach of confidentiality by them could destroy their future in the buyout industry, they are particularly respectful of confidentiality. This is not to say that most strategic buyers do not exhibit the same degree of trustworthiness, but for private equity funds, their livelihood depends on it.
The author is director, Brown Gibbons Lang and Co. (BGL). BGL is an independent investment bank with offices in Cleveland and Chicago that serves middle market companies (enterprise values between $25 million and $500 million) and their owners throughout the United States and internationally. BGL's professionals are experts in mergers and acquisitions, debt and equity placements, and financial restructurings, and were named “2003 Deal Makers of the Year” by The Mergers and Acquisitions Advisor. BGL also publishes a Distribution Annual Review, which covers the dominant trends and factors affecting the distribution industry. For more information, please call the author at (216) 241-2800, or contact him via e-mail at [email protected].