To the investment advisor managing a client’s portfolio, the world of mergers and acquisitions may appear to exist in another galaxy, far far away. Beyond assessing the impact of headline-grabbing M&As on your client’s investments, you may see little need to understand the mechanics of an acquisition, much less expect to have a close encounter with one. But if your client owns a business, nothing could hit closer to home.
Should the client decide to sell, that enormous illiquid asset could suddenly be converted into a sea of cash crying out for allocation. It is perhaps the most momentous financial event you or your client is ever likely to face, of far greater magnitude even than an inheritance. Fail to prepare and you could lose your client at precisely the moment the relationship becomes exponentially more valuable.
Even in a down market, the volume of deals is staggering, and the astute advisor will prepare for the eventuality of a sale by understanding:
- the market
- the factors influencing valuation
- the proper role for the investment advisor
- the sale process
By acting on that knowledge early in the sale process or, preferably, being among the first to suggest a sale, especially where most of the client’s net worth is tied up in the business, the proactive advisor can not only make sure that the windfall investment opportunity isn’t lost to a competitor but also see to it that the client is being well served before, during, and after the sale.
Understanding the Market
The challenge for you is not simply to look for the most propitious time to sell and suggest it to your client, but to understand both the market and your client’s needs.
Such a sale is more than a remote possibility. There are about 10,500 deals annually in the United States. The overwhelming majority, some 80%, take place in the middle market–companies valued at $500 million or less. While these deals may fall far below the radar of the media, this is a big business in aggregate: Those deals are worth approximately $1.2 trillion annually.
The acquisition market is closer to home in another way as well. About 85% of middle-market deals involve U.S. companies making strategic acquisitions (see sidebar on page 87).
That market is cyclical. At the peak of the cycle, middle-market companies can sell for as much as seven to nine times their cash flow, versus five to six times their cash flow at the bottom of the market. Currently, we stand at the beginning of a down cycle, with a decline of 5% in terms of deal count from 2006, a trend likely to continue for the next three to four years.
Although valuations will inevitably be lower, on average, during a down cycle than an up cycle, that doesn’t necessarily mean that your client shouldn’t sell. On the contrary, companies that buck the cycle by continuing to grow can command a premium during this part of the cycle in an M&A process. Moreover, your client may be at a time of life when he or she is ready to sell, no matter the state of the overall market.
Factors Affecting Valuation
In addition to where the market stands in the cycle, a number of other general factors will affect the valuation of your client’s business. For one, the state of the economy, particularly its prospects for growth, inevitably figures in. Further, the amount of money in the hands of buyers can also drive the market up or down. Today, for example, private equity firms are awash with cash, with close to $250 billion in unleveraged equity capital that has been raised over the past three years. In fact, at no time in history have private equity firms had so much fresh capital that needs to find a home. Unlike strategic buyers, private equity buyers have a finite period of time in which to deploy funds–typically within five years of raising the funds–or they have to return the capital to their investors.
How an industry is perceived–not how it has actually performed, but how it’s viewed in the marketplace–can also make some businesses more attractive than others. For example, companies in the media and entertainment industry, despite weak and variable financial performance, often yield a premium price. In some industries such as technology, oil and gas, and agriculture and food, sale prices are actually trending upward.
By far the most decisive factors that affect the valuation of a particular company are internal. Prospective buyers will look closely at the company’s growth rate and at its profitability, from gross margins to cash flow margins to free-cash-flow margins, and compare those margins to industry averages to see if the company is underperforming or outperforming its industry peers. They will also closely evaluate the company’s proprietary services or products, including its patents, trademarks, brands, and all of the other barriers to entry by potential competitors. The higher the barriers your client has created, the higher the value of the company.
The quality of the company’s management is of paramount importance. In a competitive world where the playing field has been leveled by technology, globalization, and labor and supply arbitrage strategies, one of the few remaining differentiators among companies of all sizes is the quality of their management. Financial buyers like private equity firms almost always want the owner and key managers to stay on after the sale. These buyers realize that nobody knows the business better and depend on them to deliver the returns on invested capital promised to the private equity group’s investors.
Usually, of course, the seller is also the CEO of the company. Whether she is ready to cash out or is willing to continue to lead the company can certainly affect the valuation in situations where the buyer wants to retain key executives. Again, understanding and managing the psychology of the seller is critical for a smooth selling process in which all sides understand each other clearly.
The Role of the Investment Advisor
The selling process may be set in motion in a number of ways. Your client may have been considering selling and decides to test the waters. Perhaps a buyer has approached your client to discuss the possibility of a deal. Or with your understanding of the market and the life-stage of your client, you bring up the possibility of a sale yourself. In any case, the owner discusses it with his family and decides that it’s a go. This is the decisive moment for you: the point at which, by adroitly assuming your proper role in the process, you can secure the client’s post-sale investment business.
Simply put, your primary role is to advise your client in how to assemble the M&A dream team–an investment banker, lawyers, and an accountant–and by doing so greatly diminish the likelihood that the team will recommend someone other than you to invest the proceeds from the sale. For most middle-market deals, even relatively small ones, the services of these professionals are absolutely essential. You should interview and screen candidates for these roles and help guide your client to the right choice.
The investment banker is the coach and quarterback of the team. Middle-market deal experience is an indispensable qualification for this leading role in the entire sale process. In interviewing a candidate for the role, you should not only probe for experience but also ask for a preliminary estimate of what the banker thinks the business might bring on the market, understanding, however, that in a truly competitive process the market is the ultimate barometer of value, not an investment banker’s pre-engagement valuation. In a down market, where valuations are lower and the room for error is smaller, it’s doubly important to have a highly experienced investment banker. For example, in a down market the price elasticity can be significant: a 5% shrinkage in demand can trigger as much as a 20% decline in price. In such a climate you want an investment banker who can make sure your client gets the most out of the deal and, on the other hand, can help manage the client’s expectations.
A highly specialized and experienced “deal” lawyer is also a critical component of the team. These transactions are highly technical and cannot be left to amateurs. It’s certainly not like selling a house or arranging estates and trusts, and you will need a lawyer who specializes in the area. Their fees may be higher than those of a generalist or those of your client’s personal or company lawyer, but in the long run they will save your client money. Inexperienced lawyers often insist on the wrong things, may make time-consuming mistakes, and in the event that they are unreasonably obstructionist, may cause a deal to blow up. In addition to the deal lawyer, an equally important member of the legal team is a trusts and estates (T&E) lawyer who specializes in high-net-worth, pre-sale tax planning and asset protection (see sidebar).
Choosing the accountant often involves no choice at all. Your client likely has on the payroll an accountant or an auditor who thoroughly knows the business. The accountant’s role in the sale process is to compile the due diligence data that the buyer will need in order to evaluate the business and make a fully informed offer. Your client’s current accountant is likely in the best position to assemble that data efficiently and comprehensively. If, for some reason the current accountant isn’t suitable, you should seek an outside accountant from a mid-to-large regional firm, which is well suited for middle-market transactions and, most importantly, well-equipped to handle entrepreneurs and closely held businesses. In interviewing candidates, the key consideration will be their experience with such deals. What outside accountants may lack in first-hand knowledge of your client’s business, they should be able to make up in experience and expertise in deals of this kind.
Once you have assisted in assembling the team, you have essentially completed your role in the sale process. During the sale period you should be working on preliminary post-sale investment planning, as well as tax-optimization tactics. Perhaps the most valuable contribution you make at this stage, however, is to help keep the client focused on what should be his number one priority during the sale process: running the business to the best of his ability. The seller will certainly have some sale-related work to do, but the worst mistake he could make would be to spend his time selling, rather than running, the company. It was his business acumen that attracted interest in the first place, and the buyer certainly doesn’t want him to take his eye off the ball during the six- to nine-month period typically required to consummate a sale.
The Sale Process
Responsibility for the sale process lies with the team, and it’s helpful for you to understand it as your client goes through it. Throughout the process, the investment banker’s team interacts closely with the seller, the management team, the seller’s accounting and legal professionals, and a host of potential buyers. Assuming that the investment banker has the requisite experience, expertise, and market savvy to conduct this highly technical and complex process, it should typically unfold in highly structured stages, as follows:
Preparatory. During this stage, the investment banker conducts the initial meetings with the accountant and lawyers on the team, interviews management, and undertakes financial, operational, and industry analysis in order to arrive at a valuation of your client’s business. From this work there should emerge a marketing strategy, some price parameters, an outline of the Offering Memorandum, and the early identification of any red flags that might adversely affect the sale, such as potential environmental liabilities, technological obsolescence, management deficiencies, capacity constraints that would require large sums of capital expenditures, and others.
Developing the Offering Memo. Working from the initial outline, the team develops the Offering Memo, a legal document that provides a narrative of the company’s industry and a lengthy description of the company and its operations, including products, markets, growth strategy, and historical and projected financials. The team also prepares a detailed financial pro forma and gathers backup data to support the claims made in the Memo and the pro forma.
Compiling the Buyers’ List. The investment banker conducts additional industry analysis and combs through its network of contacts and proprietary databases to arrive at a list of potential buyers, including strategic and financial investors who might be interested in the business.
Legal. At the same time, the team creates a legal dossier containing the corporate charter, shareholder agreements, necessary consents from other shareholders in the client’s business, a confidentiality agreement, and other legal documents.
Marketing. The investment banker contacts potential buyers and distributes confidentiality agreements and the Offering Memo to those who express interest. Management presentations and facility tours are then conducted with the bidders who emerge. From these bidders, a “finalist” and a “runner-up” are selected. Negotiation of major terms with the finalist begins, while the runner-up is held in reserve as an alternate, should the finalist not work out.
Transacting. This is the end game. The parties negotiate a definitive purchase agreement, due diligence is completed, the financing and other deal documentation is locked down, and the deal is closed. With the stroke of a pen, your client’s valuable, illiquid asset has been transformed into a sizeable liquid asset.
Let the Fun Begin
When the deal is done, the investment advisor once again steps to the fore. Having played an exemplary role in assembling a top-notch sale team and in discreetly letting them do their work while you remained close to your client, you will have strongly cemented your relationship with your client. You can then continue to do what you have always done best: help the client grow his money. But one thing will likely have changed dramatically: the way you think about the relevance of mergers and acquisitions.
Nimi Natan is a co-founder and managing director of Aquetong Capital Advisors (www.aquetongcap.com), headquartered outside Philadelphia. Combining the traditional functions of investment banking and strategy consulting, the firm provides strategic advice and transactional services to middle-market companies in the manufacturing, distribution, service, and technology segments of the economy. He can be reached at email@example.com. Erik Rudolph is a partner and managing director with Aquetong Capital Advisors. Using his legal and financial knowledge, he has worked on numerous assignments involving the formation, sale, and recapitalization of privately held businesses in a variety of industries. He can be reached at firstname.lastname@example.org.