Surviving M&A Auction Rigors

The auction process continues to play an important role in the private equity industry. Mergers & Acquisitions recently assembled a group of professionals to discuss the ins and outs of the auction process and some best practices. An excerpted version of the discussion follows. Fugazy: We’re always hearing private equity firms say that they don’t participate in the auction process, but we know that’s not really true. What’s really happening? Jrolf: Why is the word “auction” such a pejorative term, and what is it that private equity firms are trying to say when they say we don’t participate in auctions? Almost any company with an EBITDA of a million dollars or more is going to get a professional resource to help them sell the company. And that professional resource almost always is going to bring in competing bids. We expect that, but for us it’s important that we get an opportunity where there are some factors, in addition to price, that will be considered. You also want to know that it’s going to be a process where you’ll have ample time to complete your due diligence, and that you have some assurance that you’ve won the deal before you start spending a huge amount of time and money on due diligence. If you get those opportunities, it doesn’t matter if they’re showing the deal to more than one buyer. There are auctions where none of that happens. Serena di Lapigio: The vast majority of companies go to auction because price dictates everything, which is understandable. The investment banks have done a great job for the sellers. But there’s a negative connotation to the auction process, because there’s a lack of access to management. When we buy into a middle-market enterprise one of the most important things is being able to assess the quality of management and the operation, which you don’t get in an auction process. Stephenson: One of the problems with the auction process is that a lot of firms have seen successes that M&A advisers have had with broad auctions, and, therefore, the tendency is for everyone to go right into an auction for every property, and that’s just not appropriate. The perversion of the auction process is that you don’t get to meet the managers until the end, and that’s backwards. You actually should try to meet them up front when there are issues involved that need judgments. Jones: Yes, but let’s not forget about the benefits of an auction. Most of our companies are sold in some type of orchestrated process. Fugazy: How do you convince a seller that you’ll be able to get top dollar for the business without a broad auction process? As for the private equity folks around the table, when you’re ready to sell, would you accept a process that doesn’t use a broad auction? Jones: You do want the best price, but you give a lot of deference to management. Also, private equity investors know that whether it’s a limited auction or a broad auction, there’s so much efficiency in the market that you’re going to pay a fair price. The aversion to participating in the broad auction is that the likelihood that you’ll win is slimmer. If you’re one of 100 people looking at a business, it’s pretty tough to think you’re going to come out on top. If you’re one of a couple, maybe you can create an angle and maybe it’s worth spending the time on. Stephenson: Earlier this year CIT commissioned a polling company to ask private equity firms, “What do you want from middle-market advisers?” Something like 90% of the respondents said they do not like to participate in auctions and they do not like to buy businesses in auctions. But then 80% to 90% said that when they’re going to sell businesses, they prefer an auction process. How to sell a company depends on the complexity of the situation. If there are big social issues, like family members who want to continue to participate in the business or are very concerned about the social dynamics of the new owner, those issues can sometimes prevail and will cause us to really be very choosey about who we market the business to. Like it or not, every private equity firm has a different personality. If the selling company simply wants to maximize value, we have to look at the economics of the business and whether that lends itself to a broad book job process. Sometimes it does. But if it doesn’t, we’ll explain to our client that the issues involved don’t lend themselves to a cold information memorandum sent through the mail; it really requires a person-to-person dialogue to get that business sold. Serena di Lapigio: If I’m the recipient of a book and I know it’s a broad auction, even if it’s a very nice business with nice growth in a nice market, I still may not take it that seriously because I know that my chances of winning are so slim. I just don’t put the effort into it. That’s where I see the weak link in the auction arena. Stephenson: I absolutely respect that, but there are so many people who make that complaint and then submit a bid anyway. Sullivan: Aren’t we talking about the basic laws of supply and demand? I’m not in the private equity business, so I’m treading on thin ice here. Hauser: Hallowed ground. Sullivan: Not very far from it. You raise a fund, you’ve got a certain period of time over which to spend the money in the fund, and auctions have to be a primary source of potential investment opportunities for you. So everybody can talk about not participating in auctions, but it seems that auctions are the best source of deal flow, given the limited nature of the investment period. Fugazy: What types of companies lend themselves to a broad auction? Stephenson: If it’s a business with information that’s readily available, it lends itself to a broad auction. A public company certainly lends itself to an auction. With the publicly available information, people can do evaluation methodologies quite easily. As you move away from that, private companies with a lot of readily available information, easily understood products, markets, customer bases, and a good clean history of performance are going to be companies where people can simply do the math. When you start to tear away from that, you need more. Maybe the company has a problematic history or there’s been uneven performance in the past. The industry, product, or market sector is undergoing change and there’s a great deal of uncertainty. That’s when you really need to sit down at the table and meet people. Just simply looking at a book that was produced is not the right way to place your bets. Jrolf: If what you’re looking for is some type of a partnership, either between a management team and the private equity firm or the shareholders and the private equity firm, they need to spend time with those people. The front-end human interaction really has to be increased to have a successful outcome. Hauser: I wonder how many auctions lead to the highest price? Jones: The corollary that I hear from a lot of investment bankers is that we, as private equity groups, would be amazed at how many times they recommend that a seller not necessarily sign up with the person with the highest bid. Investment bankers have long memories and so do databases, and they know the equity groups that will close. If purchase price is number one on the list, then certainty of closing in an expedited fashion is certainly number two. Stephenson: A major complaint is that you’re asking private equity firms to make a bet and to commit time and resources based on imperfect information that you’re almost certain will change during the process. That’s probably one of the fundamental problems in the auction process. If somehow we could ensure that the parade of uglies is brought out right at the front, and that perfect information and knowledge are given to the buyers, you probably would have more willing participants. Then you could place your bets and take risks with a little more certainty. Hauser: Even if you get past the uglies and you want to buy it and you put a price on the table that you think is fair, others are just putting a price on the table to get to the next round. Then you’re not invited to the next round. So from the adviser’s point of view, do you want honesty or do you want baloney? A lot of us don’t want to play that game. We’ll be honest, and we don’t like to lose and we’re going to see it through to close, but we’re not going to put a bid in just to get to the next round. Jones: That’s a frustrating thing because I hear about deals closing at the price we initially bid up front. Our attitude has always been that the race is long and the world is too small to intentionally take a strategy of re-trading a deal on the front end. People find out about that. Sullivan: You put your best foot forward trying to indicate what a company is worth and you don’t make the cut. Then the deal closes within a million bucks of what you were willing to pay. Is there a way to keep in touch with the team running that auction or is the mindset that you’ve put your best foot forward and you have other things to do? Jones: You do have to stay in touch. Has it closed? If not, come back to me. Stephenson: As the seller’s agent you must have a bit of skepticism and you have to protect yourself. So when you get a call from a private equity firm saying that they’re going to bow out because the price has gotten too rich for them but if the deal crumbles then give them a call, that could mean a couple of things One is they’re testing you and trying to see whether you have anything else. Two, there’s always the fear that you’re going to be on your knees, because now they know that your deal has crumbled and they have all of the leverage in the bargaining position. That’s a call I usually don’t like to get because I can’t be on top of that one. There are probably a lot of honorable people who will stand behind the bid, but I’ve had more instances where we’ve gone back to that second-choice bidder and they’ve said, “Okay, let’s take a look at everything again.” Jones: They’re holding the two aces. Fugazy: What does the broad auction, with so much activity going on, do to the information flow that needs to go on during the process? Sullivan: The growth of virtual data rooms has been somewhere between aggressive and spectacular over the last three years. It makes the information more broadly available, more easily and more quickly. Maybe it’s bad in that it potentially speeds up auctions and tightens up the time frame for due diligence review, but it does help the process because it’s giving everyone more time. The analogue to the virtual data room is a physical data room. We all know that physical data rooms can be in Las Cruces, N. Mex., or Spokane, Wash. In the world of limited time and resources, reading this stuff at your desk or printing it out and taking it home are a heck of a lot easier than going to any of those places. Jrolf: We just recently closed the acquisition of a small private company. At the end of it all, the CFO said, “Somebody ought to invent a way to put all of this due diligence information in an electronic file so people can access it without my having to photocopy it.” Sullivan: What a revolutionary idea. Hauser: It makes the process easier, but it also makes the process more complicated. It leads to more questions from a buyer because we dig into it. Unless you have management there to tell you what the data means, it sometimes leads to more problems and more questions. Jrolf: As a buyer, you want to spend time with managers to get to know them. Jones: Right. The online data room is great but it can’t substitute for management interaction. Sullivan: On the sell side, it provides a great amount of additional information. We can tell the investment bankers who is spending the most time in the data room, who seems interested, and who’s not doing the work. Stephenson: We certainly track who has spent time in the data room but we’re also mindful of the fact that sometimes people have an administrative assistant in the office open the data, and you just don’t know who is looking at it. Some people play fairly. They say that their lawyers were checking this document for so many hours or that their accountants were checking that document, so we can tell what they’re looking for. That’s extraordinarily helpful. Some have just one person go and open all of the documents, so you just don’t know. But we only use virtual data rooms now. Serena di Lapigio: One day an investment banker called me and asked why we hadn’t accessed the data room. We were seriously interested in the business, and the reason we hadn’t gone into the data room was because we were trying to sort out another issue with the business. We were talking with our own adviser and trying to figure out whether it made sense or not before we started plowing through reams of paper. Hauser: Keeping track of who has been in the data room can be a game. In the old days, before a buyer would look at the documents, the seller would have a secretary smudge it with peanut butter and jelly so it looked like someone else was there before. Jones: Looking at a data room is a sterile reference point. It’s more important to say that you’re willing to close the deal quickly, that you’re willing to bridge the transaction, that you don’t have a financing contingency, that you don’t have a due diligence contingency, that you’re talking with the investment banker and the management team, that you’re discussing post-deal economics with management, and that you’re communicating a real desire to buy. Reinebach: Jim, have you guys figured out how to put peanut butter and jelly online? Sullivan: We haven’t figured that out yet but we have figured out how to prevent documents from getting ripped off. In the peanut butter and jelly and coffee stain program, documents sort of just mysteriously disappeared over time. I’m not here to suggest that this is the end all and the be all. It may just be one piece of data or something that should be used in the entire scheme of things. Most important is that the data available from a virtual data room can be used by investment banks to give their clients better advice at the end of the day. Stephenson: Everything sends signals. How many hits you get in the data room alone is not going to tip the scale. But if you haven’t called us, if you haven’t asked for additional information, if you haven’t accessed the data room, we’re just going to assume that you’re not interested. Fugazy: As a buyer, what recommendations would you give to an investment banker to improve the process? Jones: When you introduce the marked-up asset purchase or stock purchase agreement, if prepared by an investment banker, you’re asked to agree to it too far in advance of when your due diligence will be completed. I think you’re setting yourself up for adjustments later, because you just don’t know. There are too many issues. You’re getting into all of the specificity of caps and baskets and expiration of reps and warranties before you know enough about the business. I don’t think it’s fair to the buyer. Jrolf: You would like the banker to give you the respect of allowing you to sign the deal up. I would also say that bankers should be careful when they present first-round or second-round bids to not just present the bidders and their pricing. There are many more elements to the offer than price. We’ve sold six companies in recent months with different bankers, and there are some bankers who have an automatic table that they print out. It’s just price. Jones: When we’re selling a company, we hire the investment banker. Part of why you’re hiring him is to help you evaluate the quality of the bids and tell you things like, “We don’t think this guy will close or this one has a reputation of re-trading.” Serena di Lapigio: If the bankers have done their homework and know you, I think that instead of always going in the direction of a broad or semi-broad auction, it would save a lot of time, effort, and money to accept more preemptive situations. Stephenson: In some circumstances that’s a terrific idea. The problem, from our perspective, is that you shift the balance of the negotiating power. When I get to decide who gets to be part of the dance or not, I hold all of the cards. When I give you that preemption, you have the power and you can reject the deal later for a due diligence issue or something else. What we might do in the future is have the information memorandum ready for market then turn to you and ask, “Will you do the deal at this price? You’ve got two weeks to complete your due diligence and give us your red line of the definitive agreement. If anything goes wrong, this is going to the market.” I just don’t want to give up all of that leverage. Fugazy: When you’re selling a company will you give an investment bank the job in the hopes of looking at one of their deals? Hauser: As a seller, I want a banker who knows that industry very well and as a buyer, if I can ask that banker questions about the industry and he knows the answers, it makes my process a lot easier. Jones: We’ve hired five different investment bankers for the last five companies we’ve sold, so there’s a concerted effort on our part to spread the business around. But do we hire an investment banker because we think we’re going to get a leg up on the next deal? No, because they have a fiduciary responsibility to their future client, but you do hope that you will be more likely to be on their short list for the deal. We consider industry expertise as a data point. Probably more important is our sense of the investment bankers as deal people. When it gets into the minutia of what makes or breaks a deal, how you play those bluffs and play the poker, that’s really important. There are folks in the market who are better at that than others. Hauser: What we’re seeing now that I’ve never seen before is that investment bankers are coming to us after we’ve owned a business for a year or two and saying that they’d like to get know the company and the management team. They say they know that we won’t be selling it for two or three years, but they’d just like to get to know us and get to know the management. We’ll remember that two years later. Jones: That just shows how competitive it is for investment bankers. Stephenson: From my perspective, you have to know your clients. You’re showing them ideas, you’re financing their projects, or you’re offering to finance their projects. You’re involving them in auctions and you know their kids’ birthdays. But investment bankers win business by their ability to deliver well on deals. That means knowing an industry and the buyers. You can’t just Google the Yellow Pages and pull up some names. Fugazy: What is one of the most important things you try to remember when entering into an auction situation? Jones: Private equity groups need to remember that we’re selling ourselves just as much as we’re evaluating a company. Hauser: I know a fellow, and every six months for the last seven or eight years he and I have gone to the same deli for lunch. I’m trying to convince him to sell his business. He’s now in his late ’80s. I’ve given him a trust and estates attorney, I’ve given him an accountant, and I’ve helped him do his taxes. And still, you know what the odds of winning are? Fugazy: When you take this guy out every six months, you’re probably giving him the idea that his business is a good one and that he should shop it around. Maybe you’re opening yourself up to more competition. Hauser: Absolutely, so the odds of him selling in a one-on-one negotiated deal are very low. But you try, and once in a while it works. Participants: Mark Hauser, Managing Director, FdG Associates Ottavio Serena di Lapigio, Managing Director, Lincolnshire Management Mark Jrolf, General Partner, Heritage Partners Randall Stephenson, Managing Director, Head of Middle Market Mergers & Acqusistions, CIT Mark Jones, Partner, River Associates James Sullivan, National Director, Merrill Corp. Danielle Fugazy, Contributing Editor, Mergers & Acquisitions Adam Reinebach, Publisher, Mergers & Acquisitions (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com