Monday, 20 August 2012

Winner’s Remorse: Does the M&A Process Lead Buyers to Overpay?

When managing a company divestiture, there comes a point when interested parties are requested to provide non-binding expressions of interest (this is the first indication of value based on reviewing the CIM and answering select questions, see: How Much Information (and when) Do I Share With Potential Buyers? ).  An expression of interest outlines a value range, structure and other criteria, on which potential buyers are prepared to move forward.  It is requested so as not to waste the seller’s time with potential offers that will not meet the needs of the seller.  When there are multiple expressions of interest for a company, they typically form a normal curve around the company’s notional value. 
Non strategic/financial buyers are typically at or below notional value (E1..E4) and strategic buyers are typically at or above the notional value (E4..E7).  The parties engaged to go forward in the process will be the ones above notional value (E6..E7) suggesting that they may be ready to pay a higher price than fair value, however, fair value is very much in the eye of the beholder.
A strategic buyer may pay more than the notional value for a business for reasons of competitive strategy (i.e. prevent your competitor from strengthening its footprint) or when the seller has certain assets that complement the buyer’s assets thereby allowing for the potential to create value through synergies. The value of a business is different to every potential buyer.  To a financial buyer (one that does not have the potential for synergies, but may nevertheless be able to bring special expertise to the table) a business may be worth the notional value which maybe six times EBITDA, generating a 17% non-levered ROI (maybe more  than 30% with 50% debt); but a strategic buyer could pay seven times EBITDA and expect to generate even more based on synergies.
So does the M&A process lead buyers to overpay?  Not necessarily; the process extracts the highest price for the seller by appealing to potential buyers that will benefit most from the purchase.  The buyer has to weigh the risks and benefits of the price they will pay versus not getting the business. Overpayment has been in the news lately with HP writing off $8 billion of goodwill from its $13 billion acquisition of EDS and Microsoft writing off $6.2 billion of goodwill in its Online Services Division where it houses the acquisition of aQuantive (which it acquired for  just over $6.3 billion).  The onus is on the buyer to correctly estimate the realisable cashflow from a purchase and then to execute on its plan.  Many things can go wrong in execution but the fact remains that if there is more than one buyer at the table it is highly likely that the winner will have paid more than notional value.
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, 12 August 2012

More Thoughts on Price Expectations

I noted recently that it is very difficult to predict exactly what a business’s selling price might be as a result of a well managed auction between two or more highly motivated strategic acquirers.  Outside of a competitive environment, a buyer will pay based on historical performance and not the incremental value they believe they can create.  Competitive tension is the situation M&A advisors seek to achieve and, personally, I have seen many competitive situations result in very good prices for sellers of mid-market private companies.
Because it is hard to predict what price might result, a discussion about price expectations should start with the notional value (the price a proper valuation will assign a business independent of what a particular strategic buyer might benefit from; see: What Will a Strategic Buyer Pay?) and then estimate the potential price increase based on the selling company’s attributes (i.e. complementary customers, products, brands, patents, etc.) and market attributes (no. of possible buyers, their financial strength, growth rate of the sector, etc.).  This typically results in an indicative range.
Discussing price expectations is a delicate dance between being realistic and optimistic, between the likely and the possible.  Some sellers want to hear a high number even if it is not likely achievable.  Others will worry that if you don’t pitch a higher sale price than the next advisor, you won’t fight for the best price on their behalf.  Sellers are often guided by publicly announced data points. Headlines where one market leader buys another for a tremendous amount (i.e. Facebook buys Instagram for $1 billion or HP buys 3PAR for 11 times revenues).  Such metrics don’t typically translate to smaller competitors yet, if you don’t account for the leading transactions in a business development presentation, you can be perceived as either not being in touch or not being the aggressive marketer the seller is looking for.  While I see the point, and I have lost mandates where other advisors led selling companies to believe they would achieve a higher sale price with them, I prefer to establish a reasonable expectation and over-deliver rather than over-promise and under-deliver.  The point I want to underscore here is that, regardless of whether one advisor promises to deliver a higher price than the other, if they both follow a thorough process and manage the auction as per the seller’s guidelines then both should end up pretty much at the same price.  Note, I say “as per the seller’s guidelines” because often the seller will guide the M&A advisor in the direction of a preferred buyer (and away from a potentially stronger but more hostile bid) for various reasons.  The point is, look to the material differentiators between advisors such as integrity, sector experience and international reach rather than promises of high prices.
I have talked before about aligning seller and advisor interest through compensation based on a successful transaction.  One mechanism that really awards over achievement is setting a base compensation rate up to an agreed level and then providing a substantially higher commission above that number.  For example, 3% up to $20M and 10% above that.  If the company sells for $24 million the seller would have generated $4M more than expected and the advisor would secure a healthy fee.  I am happy to subscribe to such models but the issue I have with them is that it is implicit in the arrangement that the advisor would not push for $24M otherwise.  The ideal situation is one where the seller has confidence in the advisor to do everything he can and the advisor in fact does everything he can.  If you are more cynical than that or need the additional assurance, then the extra incentive structure is something that can work for you.
Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap CorporateFinance in Toronto.