MacFadyen: Crossing the Valuation Gap
May 21, 2009
The enduring question that continues to ring out from deal circles is how to close the valuation gap. It’s a query that probably belongs on Buddha’s list of unanswerables.
While no remedy exists that completely solves this problem, buyers are increasingly coming up with solutions that at least allow them to avoid the dreaded earnout clause.
Deal pros will always point to seller paper and minority stake deals as potential solutions. In a recent conversation, one growth equity investor came up with an alternative that a few years ago might have been considered unthinkable to any other red-blooded deal pro.
The source noted that his firm has recently been using "highly structured" securities that provide downside protection when valuation discrepencies occur.
“We will give the sellers the valuation that they want, but we will be first in line for the money coming out,” he said. The source further identified that in a typical situation, they might go pari passu with the sellers after hitting an initial return hurdle, be it two or two-and-a-half times invested capital. Then, after achieving a four or four-and-a-half times return, the buyer allows the sellers to corral the remainder of the profits for themselves. “If they manage to do what they claim and turn the company into a $500 million behemoth, then we’ll let them recoup the lion’s share of the upside beyond what we modeled,” he described.
Of course, this structure effectively caps the firm's profits. Apologies to Leon Black or Steve Feinberg if they just spit their coffee all over their keyboards. I have to imagine that capping profits, to some in the buyout world, could be classified as the male capris of deal structures -- it may be trendy to some, but it's certainly not for everyone.
At the same time, in this environment, who can argue against a four times return on equity? And if it bridges the valuation gap, who really cares if it’s a covered bridge, so long as it gets you to the other side?
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