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FOCUS : Midyear review - Selling your business : The buyer may be in the office next door

July 31, 2006

By MICHAEL CARTER

Owners of closely held businesses often believe a sale to a strategic buyer in the industry (often a competitor) would provide maximum value. Because financial institutions are awash in relatively cheap capital, management may now be able to offer the selling shareholders as much value as a strategic buyer without going through the complex time-consuming process with all the risks.

 A management buyout (MBO) is a sale by the owners to senior management. Management typically forms a single purpose entity that makes the acquisition, and is usually financed by a mix of capital sources, including banks, mezzanine lenders, second lien lenders and equity investors.

The resurgence of mergers and acquisition activity in 2005 is reflective of increasing capital availability. Global M&A activity was up 37 percent in 2005, the best year since 2000. U.S. buyout activity was up 44 percent with the fourth quarter being the highest quarter on record. Buyout activity had an increasingly larger share of M&A, from 2 percent to 15 percent last year. These percentages are significantly higher for middle-market transactions.

Capital availability is a key driver of this M&A activity. In 2005, buyout and mezzanine funds raised $173 billion, versus $42 billion in 2004. This newly raised capital needs to be invested over the next few years. In addition to buyout and mezzanine capital, lenders are willing to lend up to four times cash flow under certain circumstances, thereby enabling buyout funds to pay more for an acquisition target, while not diluting their equity ownership. Capital is also coming from new sources; most notably hedge funds. The second lien loan market is now a $12 billion lending market with hedge funds as the primary player. Before 2002, this market was less than $1.5 billion for the prior five years.

While strategic buyers have historically paid relatively high valuations for mid-sized companies, most middle-market companies are not candidates, or choose not to pursue this path. Strategic buyers want “clean” companies, as opposed to companies that come with a “story.” Additionally, they prefer to acquire larger companies and perform an exhaustive due-diligence investigation that very few privately held companies can withstand. This process often leads to a reduction in purchase price.

Strategic buyers always insist upon extensive representations, warranties and indemnity obligations frequently secured by escrows or hold-backs.

One of the most sensitive issues for sellers is when the ideal strategic buyer is a competitor, requiring confidential information to be disclosed. The big risk is when a transaction does not close and the competitor has knowledge that irrespective of confidentiality agreements will inevitably be used in the future by the prospective buyer. 

Another significant risk is the consequences of pre-closing disclosure of the sale to employees, customers and vendors. Many transactions fall apart just before closing and when a transaction fails to close, these constituencies are no longer thinking long term but short term with respect to their relationship with the selling company.

The MBO can offer significant advantages to the selling owner:

• Corporate relationships maintained: Management will understand the owner’s concerns for the treatment of its customers, vendors and employees. 

• Enhanced confidentiality: There is much less likelihood of disclosure of the sale to competitors, employees and vendors.

• Less due diligence risk: To the extent management already knows the business, there is much less due diligence. Many deals fall apart or are re-priced during due diligence.

• Less risky transaction structure: Management will make the most of the representations and warranties to its financing sources instead of the owner; indemnities and escrows are often smaller.

• Higher confidence in management: This is especially important when sellers need to use seller notes to make the transaction happen. They truly know the buyer’s integrity, capabilities and motivations.

Management also benefits by owning a relatively significant portion of the purchasing entity, which would not typically occur in a sale to a strategic buyer. They know where to focus their efforts to build the company.

Michael Carter is a managing director of Carter Morse & Mathias, an investment banking firm based in Southport, Conn., specializing in raising capital, mergers and acquisitions, and valuations.