What Buyers Are Willing to Pay: The gap between what financial and strategic buyers will shell out for healthy targets narrows.

As the economy continues to improve, prices in the m&a market are creeping upward. However, the key development on the pricing front is that financial buyers are close to erasing any pricing gap between what they and strategic buyers have been able to pay for acquisitions. Financial buyers are eager to put their hoards of unused money to work, targeting a wider range of deals, getting better deals from lenders, and accepting lower returns in order to get deals done. At the same time, many strategic acquirers are still holding back on making acquisitions. In fact, research indicates that m&a activity by strategic buyers has decreased over the past three years, while financial buyer deals have been holding at fairly steady levels. Sarbanes-Oxley requirements have led to heightened caution in mergers and acquisitions, as public companies fret about potential financial liability at companies they acquire. The few buyers that are venturing into the market are doing nothing to push the envelope. Eager to please investors and shareholders, they are stressing caution over boldness – thoroughly scrutinizing targets and not making the kinds of aggressively priced bets that were common in the frenzy m&a years of the late 1990s. Goodbye, frenzied bidding Long gone are the days of extravagant bidding. Too many companies got burned by overpaying for deals in which synergies proved to be elusive. Strategic buyers are much more disciplined these days, notes Tom Collins, a Managing Director at Capstone Partners. “The guys who said, Let’s just buy this firm and then figure out later where it fits in our company,’ lost their jobs.” Historically, it has often been the case that strategic buyers have been willing and able to pay more for companies because they tended to have more post-deal options than financial buyers did, including integrating product lines, gaining efficiencies from acquisitions, and enhancing revenues through cross-selling opportunities, among other initiatives. Since strategic buyers view a target in light of how the acquired company will enhance their existing operations, they generally have been willing to pay for readily realizable synergies – and often even for “speculative” synergies, especially if the target is being sold in an auction where rivals are eyeing the business as well. Strategic acquirers have also had an advantage in being able to use their stock as acquisition currency. Conversely, financial buyers generally buy exactly what the company has to offer – its expected future earnings. While financial buyers may see potential for boosting a target’s financial performance, they generally have been unwilling to pay for that “potential.” Unless private equity and LBO buyers are adding an acquired business to an existing platform – as more have been doing in recent years – they rarely have an opportunity to achieve significant synergies. But as the private equity arena has evolved over the last 10 years, many financial buyers have honed their investment strategies to specialize in specific sectors. As firms increasingly are choosing to create platforms in attractive niches – with the aim of combining a number of acquisitions to create a large company they can later take public or sell – they will have opportunities to realize synergies in their deals, and should be willing to pay for them. These “hybrid acquirers” are “still financial buyers at the end of the day,” says Andrew Petryk, a Managing Director and Principal at Brown Gibbons Lang & Co., “but they start thinking about their deals with a strategic bent to them. They think about synergies, consolidation, leveraging customer relationships, distribution, manufacturing facilities, and the like. When we’re working on the sell side and find a financial buyer with a substantial investment already in the industry, and we’re selling a potential add-on to that, we’ve been very successful in garnering a premium for the business.” Adam Max, Senior Principal at The Jordan Co., says that his firm considers itself to be a strategic buyer in a number of industries. “Where we already have a platform, the math for the deal is different. We are still looking to pay a reasonable multiple, but the EBITDA calculation changes because we are able to achieve all kinds of cost savings and sometimes revenue enhancements,” he says. In today’s m&a market, both financial and strategic acquirers are active. Both types of buyers are on pretty equal footing, as far as what each would be willing to pay is concerned, and in some situations financial buyers are the highest and most aggressive bidders – a result of the supply-and-demand imbalance between private equity and LBO buyers trying to put money to work and the availability of good targets. Both types of buyers remain risk-averse, with bidding being the most competitive for the healthiest companies. In Max’s view, both types of acquirers are so risk-averse in the current market that they will pay a premium for high-quality targets but will “significantly discount” what they will pay for “slightly damaged” businesses. Petryk agrees, adding, “Financial buyers are being very aggressive in going after healthy companies with $15 million plus in EBITDA and in getting the lending markets to support their purchase price with more aggressive lending multiples, which means they can leverage their returns.” The gap between what financial and strategic buyers have been willing to pay for acquisitions has narrowed in the past five or six years, notes Robert Reilly, a Managing Director at Willamette Management Associates. “Back in the late 90s, the spread was about 2.5 times cash flow. Today, that has narrowed to about one times cash flow, and in some deals, what each is willing to pay is the same,” adds Tom Collins, a Managing Director at Capstone Partners. “I think that the fact that the prices are collapsing on top of each other means that strategic buyers don’t want to take a lot of risk and only want to pay what a financial buyer would pay. They want to go to the bottom end of the value range,” says Christian Oberbeck, a Managing Director at Saratoga Partners. A number of factors are driving the trend toward more-equal buying power: Corporate buyers are skittish about doing deals Many companies are waiting for the economy to firm up and the deal flow to pick up before they will feel confident about re-entering the deals market. However, many private equity firms have large funding pools and are able to go after a wider range of deals. “Very few public strategic buyers want to do a dilutive deal, so they are capped out on the price they can offer by what the market is valuing their company at,” states Petryk. “Financial buyers can take a much longer view of the world since they don’t have quarterly earnings reports to worry about. They can utilize leverage and they can buy into stories’ that take a couple of years to mature, whereas a public company has to take a much harder look at that.” Glenn Gurtcheff, a Managing Director and Co-Head of Middle-Market M&A at Piper Jaffray, adds that as strategic buyers creep back into the market, “it’s for deals that are right down the middle of the fairway for them.” Depressed share prices make stock an undesirable acquisition currency Even public-company buyers that are dipping back into the market are finding that their deflated stock just doesn’t buy what it used to. During the bull market, stock was the acquisition currency of choice for strategic buyers but today, many sellers are reluctant to accept stock as payment. Cash is king, and financial buyers are used to paying with cash. Also, financial buyers typically can be more creative in their financing than strategic buyers can. “If a public strategic buyer’s stock is selling at a humongous multiple of earnings, it may feel like it has very cheap capital and can pay more than someone who’s paying real cash interest rates or feels he needs to have a high return on his money,” says John Castle, Chairman of Castle Harlan Inc. Today, that dynamic has clearly shifted. Highlighting some data on mode of payment in acquisitions, Mark Jennings, a Managing Partner at Generation Partners, notes that while all-stock and combination deals are at a 10-year low, all-cash deals are at a 10-year high. “That’s not necessarily a perfect indicator that strategic activity is down, but it’s certainly a pretty good indicator,” he says. Money needs to be put to work Financial buyers are furiously seeking opportunities for investing their money, spurred by the warnings by investors to “use it or lose it.” In their quest for deals, they increasingly have been willing to buy a business from another private equity firm, “club” with other buyers to participate in bigger deals, and foray into new markets. Not too long ago there had been a stigma to buying a company from a fellow financial buyer. It was thought that the “easy money” already had been made by the first financial buyer and that little value could be added to the business by a second private equity owner. That thinking has completely dissipated, dealmakers note. That practice is further evidence of the limited number of deal opportunities that are available, the amount of capital chasing deals, and the strong desire to put capital to work, they add. Financial buyers’ presence has grown rapidly in sectors such as technology in recent years. Traditionally, financial buyers have been reluctant to buy tech companies, and have preferred to stick to such tried-and-true sectors as manufacturing, retailing, and services. Again, the need to make investments is taking private equity and LBO buyers into new territories. Return expectations have headed downward More competition and higher prices means that the community of financial buyers is facing lower return expectations. In the 1980s, when the private equity business really became a business, firms expected returns of 30-plus percent, Castle says. “Now deals are being done as low as the high teens but very often in the low 20s. That appears to be especially true in the mega-fund area.” He adds, “Therefore, financial buyers are paying more, which means they are now paying closer to, or often in excess of, what strategic buyers are willing to pay.” Pricing metrics are converging Sources say that strategic buyers are more intently focusing on the kinds of financial metrics that private equity buyers have historically centered on. Gurtcheff notes that strategic buyers, while mainly concentrating on DCF analysis, are also looking at earnings accretion/dilution, shareholder value creation, and comparable company and comparable deal analyses and increasingly are buttressing those metrics with IRR calculations – the focal point for financial buyers. “Strategics can run an LBO model as well as anyone else. They have a pretty clear view of what the financing and mezzanine market look like and what the private equity guys would be willing to accept in terms of returns and can figure out what they think private equity guys would pay. If you don’t have other strategics bidding against you, why would you pay more than $1 more than what the financial buyers could pay?” Gurtcheff says. Eye of the beholder Many factors can give a certain type of buyer the edge in a given deals market, but in the end, most people find that the price a buyer is willing to pay really depends on what the deal means to the acquirer. Even financial buyers that have access to essentially the same capital markets and use the same pricing metrics do not all come up with the same dollar figure. Some dealmakers have more aggressive points of view about industries, companies, and prospects, and that’s what makes for good competition. Copyright 2003 Thomson Media Inc. 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