Private Equity Bidding Wars: When Capital-rich Funds Compete, Intangibles Win the DealPublished: April 26, 2007 in Knowledge@Wharton
With so much money pouring into private equity funds, competitors for deals are able to match one another easily when it comes to price. Clearly, valuation remains the most important part of any transaction, but in today's capital-soaked private equity environment, bidders must also come up with other, less tangible ways to set themselves apart. According to private equity experts, timing, sound strategy, operational expertise and a track record of successful deals are the new currency in a market where money is no object.
"Capital is now a commodity, so sellers are looking for anything else that the bidder is going to add," says Robert Chalfin, a Wharton management lecturer and president of The Chalfin Group, a Metuchen, N.J., advisory firm specializing in closely held companies. "Price is not the only determinant, especially if the sellers are keeping some equity."
Chalfin, author of the book, Selling Your IT Business: Valuation, Finding the Right Buyer, and Negotiating the Deal, says even business owners who are selling out completely are concerned about picking new owners who will maintain the reputation of the company that they may have built from the ground up, or at least nurtured for a time. "They are going to look at the buyers' operational history to see if they will keep the business running and continue to service the customers. The sellers frequently care about that."
For companies eager to sell out completely, or parcel off 100% of a division, price is about all that matters, insists Kevin Landry, CEO of TA Associates, a private equity firm in Boston. Yet he argues that a deal based solely on price is not likely to generate the kinds of returns investors expect from private equity. Returns are driven by a private equity firm's ability to restructure a company and work with management to unlock new value, he says. "If a deal is 100% about price, why would you want to be in it?"
Three Elements of a Deal
Bob Frost, a managing director at Piper Jaffray who specializes in advising clients in middle-market mergers and acquisition transactions, says bidders compete on three elements of every deal: value, timing and certainty.
"Value is value, and people have become very aggressive [about it], particularly for high quality assets," he says. "As for timing and certainty, that's probably where firms can differentiate themselves at the margin. We certainly are seeing an environment where you can differentiate yourself in the auction process by putting yourself in a position to move very quickly and create a timeline for the seller that fundamentally gets them to a close more quickly."
To do that, he says, companies need to pull together enough resources to front-load much of the due diligence process. To the seller, that translates into greater certainty. "Sellers are focused on making sure they move forward with parties that they are highly confindent will close the deal," says Frost.
He adds that industry expertise and specific experience in the sector, or related sectors, along with a private equity firm's track record, also can lead to raising a seller's comfort level with an individual bidder. "In an auction environment, often it's the case that sellers are looking at values that are comparable, and they're really trying to pick a partner based on their understanding of the business and their understanding of the risks."
Luke Duster, director of new business development at Harris Williams & Co., an advisory firm specializing in middle-market mergers and acquisitions, estimates that about 5% of any deal is determined by intangibles beyond price. To set themselves apart from the pack, private equity firms need to act fast from the start and identify a convincing strategy that will stand out among the many bidders' proposals, says Duster. "It's important for the group to find its angle quickly and communicate that to the banker and the potential seller soon -- and often -- to stay ahead of everybody else."
Financial sponsors also need to emphasize their "brand," he continues. That means highlighting their track record and showing they have added value to other companies. They also need to make clear who exactly will be involved in the deal and describe their working styles, as well as outline what in-house resources they can bring to the firm going forward.
Prepping, Wining and Dining
The next crucial step in the auction process comes during the management presentation. Duster says that in today's super-competitive market, many private equity firms have spread themselves thin chasing down too many prospects. Some private equity firms may sit in on 35 to 40 presentations a year. Too often, he says, companies send junior analysts who have not had enough time to research the company and are clearly distracted.
"It's hard to prepare, especially if you're checking your BlackBerry during a meeting," he says. "The first impression is key. You need to come prepared to listen to the company's story and come prepared with your own story. You have to really woo management."
Duster says too many private equity teams do not take advantage of bonding opportunities, such as asking management out to dinner the night before the presentation. "Groups that don't take these opportunities end up having a sterile relationship with the management team. ... Learning who they really are plays a very important role in management's decisions."
Landry of TA Associates notes that while there is room for relationships in a deal, there's not a lot of room. "You've still got to be competitive on price," he emphasizes. "They may say, 'We really like you,' but what they really like is the check."
Private equity firms often bring full teams of up to 10 people, including lawyers and accountants, to presentations. "Some companies like you to bring in a huge team to show how sincere you are," says Landry. TA usually limits its company visits to three. "We tend to bring a smaller, focused team and save the lawyers and accountants for later."
During the due diligence period, private equity suitors can also impress managers by seeking the right information in a courteous manner, even under tight deadlines, says Duster. "You have to balance demands on the management team and the time allocation. People who are able to balance that well build good rapport, and people who lose sight of that develop a reputation for being a difficult partner. If they're too demanding and focused on the wrong areas of diligence and create mountains of work around the wrong items, it shows they are missing the mark."
In addition to record prices, the competition for private equity deals is altering the terms for deals in favor of sellers, says William Parish, Jr., a partner in the Houston office of the law firm King & Spalding. He recently represented a buyer who agreed to acquire a firm with no financing contingency. "Basically, we took all the closing risk," says Parish. "That's unusual. A couple of years ago, we were not seeing that."
In addition to disappearing financing contingencies, Parish pointed to other trends in deal terms that are moving in favor of sellers:
- Reverse break-up fees: Sellers are now able to demand penalties for buyers who fail to complete the transactions. For example, he notes, Bain Capital and Thomas H. Lee Partners agreed to include a $500 million break-up fee in their deal to acquire Clear Channel Communications.
- Assumption of industry risk in material adverse change conditions: In 80% of private equity deals announced in 2005 and 2006, the buyer assumed industry risk in material adverse change closing conditions, according to King & Spalding.
- Limited indemnification: Buyers are agreeing to shorter indemnification periods, from up to three years to a year or less. Escrow amounts are now a smaller percentage of the purchase price, and some buyers are taking on representation and warranty insurance to avoid the escrow support requirement completely.
Even strategic buyers are stepping up the competition with favorable terms. Traditionally, financial buyers had an advantage over buyers already working in the industry because they did not face anti-trust review. Now strategic buyers are agreeing to so-called "Hell or High Water Clauses" that guarantee they will make divestitures or take on other remedies to complete the deal.
Buyers are also eager to sweeten the deal for sellers in terms of compensation. "Management compensation is an area in which both financial and strategic buyers can get creative. Many private equity firms find this a good way to differentiate themselves," says Duster. Compensation packages are structured on the needs of the management team and whether they want to continue to be equity partners or are hoping to sell out completely, he notes.
Frost says compensation is closely evaluated by sellers, but is not a critical factor in differentiating among buyers. "I think most private equity firms understand they need to create an attractive incentive structure for management and, for the most part, people are doing that."
A Role for Investment Banks
To help sellers choose among their many potential private equity acquirers, investment bankers are growing increasingly active in the middle market. "The market has become more sophisticated in terms of the amount of capital going into private equity firms, but also the number of intermediaries out there now," says Frost. "The market has become very efficient."
Brian Conway, who heads the Boston technology group for TA Associates, says there has been a consolidation among investment banks in which larger firms have acquired smaller specialty boutiques. Now, individual bankers are spinning out new specialty firms that lack services such as trading and underwriting that exist at the large investment banking houses, but they offer a sharp focus on advisory services. "As a result, there are very few good companies that go unbanked," says Conway. "I think there's a right bank for every company. You might find Goldman Sachs selling a middle market business, or you might find a middle market firm doing it."
Conway adds that when TA is on the other side of the equation selling companies in its own portfolio, it looks for the best individual banker with strong experience in the industry and deep relationships.
According to Landry, the rising population of investment bankers poses problems for private equity firms and drives up fees. "They're on all sides. They're running the auctions. They're doing the debt financing and getting fees and sometimes they're competing with you for deals." In addition, he is dubious of investment banks that also have their own captive private equity wing. "You've got to wonder, if they're bringing you the deal, why didn't they take it?"
As prices soar ever higher, Wharton's Chalfin says sellers who are retaining equity need to be especially concerned about how private equity firms will deliver outsized results for their investors, particularly when they are heavily leveraged.
"I think everyone is concerned about the large amounts of money private equity firms are paying," he says. Sellers sometimes find themselves having to think about whether the buyer can really afford to pay what they are offering. "Sellers are now asking, 'Are they competent stewards? Are they overpaying?'"