By Patrick Powell , Managing Director
Lexington Office, Corporate Finance Associates
Over the past 3 years we have seen a marked change in the level of mid-market acquisition activity in North America. Looking backwards, the reasons are fairly obvious.
One of the largest pools of potential buyers for middle market companies are private equity groups (PEGs). Their job is to purchase good, solid companies with potential for growth and ultimately make money for their investors. If you own a business and are considering selling, a private equity buyer is one important option for you to consider. It is, therefore, helpful to know how private equity thinks. What are they buying? How much are they willing to pay and is there really a “formula” for pricing a business? How does a private equity firm discover businesses for sale? How long does it take to sell a business to a private equity firm? What are typical stumbling blocks? What is the process? What should you expect? Recently we listened to private equity professionals answer these questions and we are sharing the answers with you.
At our recent Winter Conference in Scottsdale, Arizona, a select group of private equity firms participated in a discussion on the state of the middle market M&A industry, both from a current prospective and looking forward to 2011 and beyond. Although each participant had a slightly different point of reference, there were definite commonalities that bode well for middle market companies.
What are private equity companies investing in today? By and large, participants found this question easier to answer based on what they avoid… cyclical industries, fads, risky customer concentrations and sub-par management teams. Most firms admitted being “generalists” and if a potential company had the qualities they look for in an acquisition, they would consider it regardless of the industry. What makes a business investment worthy? PEGs seek to acquire industry leaders… businesses who are first in class. “While we target companies that fall within a certain size range (EBITDA's $1.5 - $7.0 million), our primary consideration is to invest in those companies who are leaders in their respective industry, market or trade area. These companies generally set the pace leaving the competition to follow their lead,” said Craig Sanford of Westshore Capital Partners. Quality management teams with breadth and depth, strong financials and solid, sustainable cash flow were other common criteria that PEGs consider a must.
What are PEGs willing to pay for solid, first in class businesses? Prices are usually set as a multiple of EBITDA (earnings before interest, tax, depreciation and amortization), and the answer to this question was fairly broad. Current multiples ranged from 4 on the low side to 8 plus at the extreme. Is there a formula for pricing a business? No, not really. Each business is evaluated based on both qualitative and quantitative factors. The general rule is the higher quality the business, the higher the multiple and the larger the business, the higher the multiple. Will the size premiums we see in the larger transactions trickle down to the middle market? To some degree, yes. Chris Reap of True North Companies, LLC states, “The premium in part is being driven by a lot of available capital and too few deals. I see significant competition in the lower middle market, and we have seen a number of deals that have traded at higher multiples than in the past. We've seen an upward shift of the overall multiple bracket you normally associate with a middle market transaction, especially for quality deals.”
During the peak of the middle market M&A boom, sellers expected certain multiples when bringing their businesses to market. As the economy weakened and multiples declined, sellers were reluctant to accept the new market prices. We asked the panelists if they believed seller's expectations were more realistic in 2011. Most answered that this was still a work in progress. They felt that sellers were slow to forget the multiples of 2006 and 2007, but now in many cases a “reality check” has kicked in.
So, where do private equity firms find the businesses they acquire? In 80-90% of all cases, an M&A intermediary introduces the business for consideration. PEGs usually look at between 40 to 50 business summaries per month. If they like what they see, they proceed to examining the confidential information. The next step in the process is to arrange a site visit for those companies that are of increasing interest. A typical PEG may visit between 2 to 6 companies per month. And, how many transactions will a private equity group enter into during a typical year… and that again depends on the market. During 2010, the range was between none and 5-6. If they decided that the business fits well into their portfolio, they will sign a letter of intent to purchase and due diligence would come next. The bottom line is that PEGs only invest in companies that make sense in terms of earnings, cash flow and appreciation. They have a blueprint for investing and if a company doesn't fit into their “plan”, they pass.
During the recent economic downturn one stumbling block to a completed middle market transaction was financing. We asked private equity if credit conditions were improving and sourcing deal financing was becoming less of a complication. “Financing is not a problem right now,” states Gretchen Perkins of Huron Capital Partners. “Banks' appetites for putting new dollars to work has returned.” Both national and regional banks are now active in the market. Private equity firms are also doing “one-stop” financing by providing both equity and mezzanine (term debt) financing for the transaction.
How long does it take to sell a business to a PEG? Again, answers were in a range between 3 months on the fast side and to up to six months for more complex transactions. One thing all PEGs mentioned was that during the due diligence phase, NOBODY likes a deal killer. Paul Wolf of Century Park Capital Partners comments, “Once an LOI has been signed, mentally… the deal is done… absent any strange things that are uncovered during due diligence.” Transparency is the key.
Since the industrial revolution, private equity has been an important source of capital for business expansion and growth. We see this capital source becoming increasingly important in light of the sheer volume of companies that will hit the market as the baby-boom generation looks to retire. So, when private equity talks, we listen and then we let you know what they want. If you can work to make your company attractive to a PEG buyer, you also position yourself well for other types of investors like strategic buyers and ESOPs.
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