Friday, 23 September 2011

What Will a Financial Buyer Pay?

Now that we have examined the logic that drives a strategic buyer, what logic drives a financial buyer? 
First of all, what is a financial buyer?  A financial buyer is one who is buying strictly for a financial return.  Financial buyers include individual investors, who have either saved up or cashed out, and institutional funds such as Venture Capital Funds, for early stage high growth opportunities, and private equity funds, which come in many varieties (including Leveraged Buyout, Growth Capital, Distressed and Mezzanine Funds).  There are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as BlackRock, Onex and Kohlberg, Kravis Roberts.
How does a financial buyer compete in a world with well capitalised strategic buyers?  Two ways: leverage and portfolio tuck-in acquisitions.
If cheap credit is readily available (i.e. leverage) then financial buyers can be very competitive.  Here is an example.  Company A, a stable profitable company, generates $10M of EBITDA per annum and a financial buyer is prepared to pay the notional value, let’s say it is 5 times EBITDA or $50M.  In this case, assuming no growth, the financial buyer will expect an ongoing stream of EBITDA of $10M or a 20% return on capital per year. 
Let’s say a strategic buyer is willing to pay 6 times EBITDA or $60M.... how does the financial buyer compete?  In a word... leverage.   By using 50% debt and 50% equity, the financial buyer can pay $65M and generate a similar risk-adjusted return on capital deployed.  Here is how it works.  The financial buyer secures $32.5M in debt financing (at 3.25 times EBITDA this will likely include subordinated term debt (“sub-debt”) as well as secured bank operating and capital loans) at a combined rate of 8% per annum.  Now the company earns $7.4M after debt interest payments and the net capital (equity) used is only $32.5M, so the return on equity is now 22.8%, on a risk-adjusted basis close to the 20% originally targeted (one could argue that a higher risk adjusted return is required but the point is made.  More about the risk-return equation later).  How did this come about?  Secured debt is a cheaper (and tax deductable) form of capital than equity and, therefore adding debt to a capital structure – while it increases the risk - concentrates the return on equity and can improve equity value.
Another way a financial buyer can compete with a strategic buyer is to look for tuck-in acquisitions.  Financial buyers typically look for opportunities where they can make additional acquisitions in the space to grow the company to a meaningful market position and enhance value by building a larger, stronger competitor.  The financial buyer’s first acquisition in a sector will be for a target financial return but with the foresight that subsequent acquisitions will build incremental value.  In this case, a financial buyer becomes a strategic buyer.  I said earlier that financial buyers buy strictly for a financial return but in many cases financial buyers envision growth strategies that make them quasi strategic buyers.
So who will pay more?  A strategic buyer or a financial buyer?  I can think of examples where both financial buyers and strategic buyers have paid seemingly exorbitant sums for companies (for example Goldman Sachs buying into Facebook at a $50 billion valuation (over 30 times run-rate revenues) and HP buying 3PAR for 11 times revenues) but if I were to look at the average transaction, I would say strategic buyer. 

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Monday, 19 September 2011

What Will a Strategic Buyer Pay?

Now that we have identified reasons for paying a premium; what is a premium? By definition, it is higher than the average price.  But if the market will ultimately determine the price, where do you start?
You start with the notional value.  A notional value determination is one in absence of an open market transaction, in other words, intrinsic or stand-alone value.  The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e. with a distribution network or sales force, etc.)  The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a Discounted Cashflow Analysis (DCF) and/or a public company market trading and acquisition comparable analysis (I will provide more details regarding valuation analysis in a later post).
The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings.  Earnings may be generated by levered or unlevered assets.  Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.
A premium is the amount a buyer will pay, over and above the notional value, however, how the purchaser is being valued is a factor in this equation.  Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings.  An example is acquiring technology; whether it is a patent that doesn’t generate any direct revenues or whether it is a company that is losing money presently but is expected to be very profitable in the future.  In cases like this it may make sense to accept short-term dilution to earnings (i.e. an investment in future earnings) from an acquisition.
The norm is that an acquisition is accretive to the purchaser’s earnings.  An example of an accretive acquisition is best illustrated with an example of a publicly traded company (Company A).  Say Company A trades at 12 times EBITDA of $10M (i.e. an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M).  The go forward enterprise now generates $11 million (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M. 
While the example is simplistic, the concept that I want to highlight is, what if the notional value is $5M? 
Perhaps during a divestiture process there would have been several expressions of interest at $5M but the winning bidder had to pay more.  Company A could have paid $10M (10 times EBITDA – as it trades at 12 times EBITDA) and it would still have been accretive.  How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.
So what will a strategic buyer pay?  They will pay somewhere between the notional value and the value to the buyer.  Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Sunday, 4 September 2011

Attracting Foreign Buyers: The Benefits of M&A International

Mid-market, private company M&A’s challenges are different from public company M&A.  Typically, public companies are larger and have more resources at their disposal, including a corporate development department.  Corporate development (not to be confused with business development) focuses exclusively on strategic relationships and M&A.  They have the experience and resources to efficiently complete acquisitions.
In the private company market, most companies do not have corporate development departments.  You typically approach and discus an M&A opportunity directly with the CEO or CFO.  If acquisitions are not of interest, or possible around the time you approach them you typically will not get the time of day from them.
In mid-market M&A it is important to have relationships with many entities to be able to get that connection and get your opportunity considered.  But, what if you envision your potential buyer to be in a foreign country?  Speaking from Canada, we have many leading specialised mid-sized technology companies that have emerged here and for them to realise full value in a strategic auction process they must access international buyers.  The USA has always been the primary hunting ground for well capitalised buyers but today we see international interest in specialised technology from Germany, the UK, as well as India and China.
That is why Veracap is a longstanding member of M&A International.  Founded in 1985, M&A International Inc. (“MAI” see offers the resources of over 600 professionals in 47 M&A advisory and investment banking firms operating in 41 countries. MAI members advise primarily middle-market companies on acquisitions, divestitures, fundraising and fairness opinions, closing over 1,400 transactions totaling more than US$85 billion in transaction value in the past five years.
As I check our intranet site, I see that MAI members are working on over 450 live transactions today…. over 50 in technology alone.  50 technology deals around the world…, that means that my colleagues may have reached out to over 2,000 technology companies in the last six months.  That means that right now members of MAI have relationships with, and are engaging corporate development personnel at RIM in Canada, Google in the USA, Sony in Japan, China Mobile in China, HTC in Taiwan, Infosys in India, Samsung in Korea, Siemens in Germany, Philips in the Netherlands, BT in the UK, etc.
So what is the point?  In mid-market, private M&A reach is important.  In large public M&A, the banking relationship are so established that if Facebook wants to buy Badoo (a social media site popular in Latin America) it is not hard to initiate the conversation, but in private M&A if “ABC Co”, an excellent company but not a household name by any means, wants to be considered by “Giant Tech Co.” in a foreign country, then MAI relationships will get it done … and get it done quickly.  An invaluable component as mid-market transactions are increasingly completed on an international scale.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Finding a Buyer: It is Rarely the One You Expect

When presenting your M&A advisory credentials to a prospective client, the part that typically has the most impact is illustrating that, either you already know the perfect buyer, or that you can find the perfect buyer for your prospect (i.e. you have done deals in the space which implies that you know the buyers in the space).  Some M&A shops taut the fact that they have a database of many (for example, more than 5,000) active buyers.  My experience is that the highly anticipated buyer is rarely the actual buyer.
One reason for this is that the private M&A market is a highly illiquid market.  What does this mean?  It means that when you decide to sell your business, you initiate a process, and that process will approach many qualified buyers during a fairly short timeframe.  During this timeframe the highly anticipated buyer may:

·        be engaged in other acquisitions
·        be engaged in a financing
·        be engaged in a strategic review where acquisitions are put on hold
·        be on an extended business trip/holiday
·        not be interested or able to acquire
·        be engaged in being acquired themselves; or maybe
·        your business is no longer a strategic priority for them

There are many reasons why the highly anticipated buyer may not be interested or able to pursue an acquisition when you approach them.  Once you have started the process you can’t wait for the company that you thought would be your next buyer to be ready.  You have to make the best of the universe you are addressing to bring to the table a number of capable and interested purchasers.
The other reason why the highly anticipated buyer is rarely the actual buyer is that it is sometimes impossible to predict the rationale for the buyer’s interest.  One type of buyer that can be a very good buyer is called a “platform buyer”.  A platform buyer will be interested in the business for one of three reasons, its customers, its personnel, or its technology.  As an example, we were engaged to sell a pattern recognition company in the field of product quality control.  This technology would scan a production line and “kick-out” products that did not meet certain criteria.  In this case, the ultimate buyer was the US defense department, who paid a strong premium and who then used the technology for facial recognition for national security purposes.  Who would have predicted that? ... but having approached large technology companies that we also defense contractors ultimately led to this outcome.
Getting back to my first point...having done deals in the space or knowing more than 5,000 active buyers is of course a plus but other factors that are important are getting the right team on the file, making sure they have the time to spend on it and it is a priority for them.  What foremost an M&A advisor needs to do in any and all cases is run a thorough and diligent process.  As I have noted before, you might start by sending 200 teasers, then 20 CIMs, get 5 EOIs, have 3 management presentations and then go exclusive with one.  This experience is not unlike any other sales or business development funnel and as anyone in these fields knows, success comes from a thorough diligent and tenacious approach.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.