As the US economy enters its tenth year of expansion and M&A markets remain at a cyclical peak in terms of deal volumes and valuations, we are witnessing an interesting phenomenon in the lower end of the mid-market (i.e <$250mm EV). Late in transaction processes, buyers appear to be “walking away” at an alarming rate. How can such fiscally competitive auction environments sow such a high percentage of broken deals? Based on anecdotal evidence from private equity professionals, other investment bankers, deal lawyers and our own experience, I believe the following to be the key drivers of this memorable dichotomy.
First, most sellers speak to a myriad of prospective investment bankers prior to engaging one to manage a sale process. Bankers know valuation is a key consideration in the selection process and therefore make largely rosy assumptions (with limited data) about the business, its prospects, and buyer appetite. After hearing such consistent feedback from the “professionals”, the seller is rightfully left with lofty valuation expectations from the outset.
Am I suggesting the standard process employed by investment bankers to sell mid-market companies that has changed little over the past two decades is perhaps flawed? In a word, yes.
Once hired, and in an effort to meet the newly-minted client’s valuation expectations, the banker aggressively identifies and quantifies potential “add-backs’ and “pro-forma adjustments” meant to “normalize” the company’s historical earnings performance to what the buyer can expect going forward; and pushes management to put forth an aggressive budget for the current year and five-year forecast.
Armed with a white wash of historical financial performance, a robust budget for the current year, and a completely unachievable forecast, the banker now casts his net far and wide for prospective buyers. Processes can often include hundreds of buyers at first as the banker works to find a handful of parties that are buying what he’s selling. While these auction processes as originally envisaged were meant to create a market for the asset and allow that market to determine the price, all too often the banker is providing price guidance to drive the market to the top end of the range he pitched to the client. And, unfortunately, buyers are all too often opting to express interest in such a valuation without really having true conviction around the opportunity at that price point (but willing to be convinced…).
Now, you have a group of buyers working hard (and working the management team hard) to provide facts, figures, analyses, market studies, and diligence findings that justify their decision to carry forward in the process as the banker continues to bombard them with implications and/or outright assertions that other buyers are behaving more aggressively and this opportunity might easily be lost. Many transactions start to falter at this point, as the Company generally is underperforming relative to its aggressive budget and many of the diligence findings present a less optimistic view than what was provided in the offering materials. More often than not, those with the most vivid imaginations, or with funds desperately in need of deployment, or ideally, both, jump through the necessary hoops to “win’ the deal.
By this point, most other buyers in the process have limped away licking their wounds and wondering why this is the profession they have chosen for themselves. The banker reluctantly gives the prevailing party a short period of exclusivity to finalize negotiations and check off any remaining diligence items too sensitive to have broached previously. This seems to be when the the wheels start to come off.
The buyer at this point feels completely “stretched,” questioning if he “won” the deal or is simply overpaying. They begin to take a much harder look at the company’s current performance and budget for the remainder of the year. They often take very pessimistic, even draconian, views towards seemingly innocuous findings or events. Imagine a balloon filled with too much air that can pop simply by brushing against an otherwise harmless object. In short, they are experiencing “buyer’s remorse” even prior to closing the deal. This buyer psychology often leads to efforts to re-price the deal prior to close or even to simply walk away from the deal entirely to save face.
So, am I suggesting the standard process employed by investment bankers to sell mid-market companies that has changed little over the past two decades is perhaps flawed? In a word, yes. Everyone involved in the process seems to be pushing too hard. Many buyers are involving themselves in sale processes for all of the wrong reasons. Buyers are treated like cattle heading to the slaughterhouse, and unfortunately, it is the sellers that end up on the losing end, having subjected their organizations to a grueling process and exposing confidential information that could hypothetically fall into the wrong hands, without achieving the outcome the bankers promised.
This is why we at Livingstone believe in a more artisanal approach to deal making. We aim to provide prospective clients with a realistic assessment of both the marketplace and the company-specific attributes that could dampen investor interest. We seek to educate prospective buyers on the opportunity – the good, the bad and the ugly – so they can arrive at their own initial valuation conclusions, with no price guidance. We look to engage buyers that have a strategic rationale for owning the target, as they are most likely to overcome the variety of negative issues that invariably arise during a diligence process. We believe that a sale process that promotes full disclosure, transparency, open and honest dialogue is the surest way to optimize the outcome.