Choosing the Right Deal

Issues to Consider Before Selling or Merging
By Doug Mitman and Trent Myers
Grace Matthews, Inc.

With the recent melt-down in the tech sector, many formerly high flying venture capital funds have lost their allure, and a lot of institutional money that formerly went into VC funds has been reallocated to private equity or management buyout (MBO) funds.

A recent article in Forbes reported that currently there are about 500 buyout firms with over $100 billion in cash in North America. Over the next year, a lot of this money will go into taking public companies private, especially now that stock market valuations have declined to their lowest levels in years. Though these deals will get most of the press, there will be plenty of funds left to go into what traditionally has been the cornerstone of buyout firms: that is, funding purchases of a privately held businesses by a seasoned manager or management team.

In a “typical” MBO, a private equity firm partners with the management team and puts up most of equity cash required to buy the company. For this, the equity firm will get the majority of the ownership interest; management gets a minority position in return for their future “sweat equity” and a small, but material, cash equity contribution. The balance of cash for the deal comes from various types of debt, including senior term debt, subordinated debt, a revolving line of credit and other instruments. The structure of deal — the specific amounts and types of securities involved — can be quite complex, and exceptionally creative financing schemes are becoming more commonplace everyday.

Because of the different types of securities involved, MBOs are more difficult than “straight-up” acquisitions. Usually, multiple negotiations are proceeding at the same time as the management team, the equity and subordinated debt firms, the sellers, and commercial lenders balance their interests against one another. The challenge is to negotiate and structure a deal that works for everyone.
What makes a company an attractive candidate for a management buy-out? What do equity firms look for when they are considering an investment? What can a management team do to maximize its chances for success? There are no simple answers to these questions, but here is a run-down of some general considerations equity firms take into account in considering a deal.
Cash is King: Using leverage to maximize the equity firm’s return on investment is standard procedure in MBOs, so the first thing an equity firm wants to know is whether the target firm has sufficient free cash flow (free cash flow = operating cash flow less capital expenditures required to sustain operations) to service the debt that will be required to do the deal. And the steadier and more predictable a firm’s cash flows are, the better the terms will be from the senior lenders and, by extension, from the subordinated debt and equity firms.

Quality Management: Another critical hurdle is the quality of the management team. If the management team doesn’t have a history of successfully running and growing a business, it stands little chance of finding an equity partner to do the deal. MBO investors aren’t just looking for the highest possible return on their money; they’re looking for the highest possible return while managing their risk. While there are many business risks that are beyond their control, choosing the “right” management team is one risk over which they have absolute control. Unless the equity firm has a high level of confidence in the management team, there will be no deal — it’s that simple. “Bet on the jockey, not the horse” is an often repeated mantra in the MBO trade, and with good reason.
“Right” Deal at the “Right” Price: If a management team buys at a fair price, finds the right financing partners and structures the deal to reflect the business’s risk profile and cash flows, they stand a good chance of success. Buying well increases returns and reduces risk; buying poorly may mean a lot of effort for mediocre — or even non-existent — returns.

Finding the right financing partners is equally important. It’s a good idea to shop for terms, and not just with commercial lenders. If an experienced management team with a good business plan is shopping a deal that involves a stable, profitable company of reasonable size that can be bought at an attractive multiple of EBITDA, it pays to shop for equity partners as well. And management should not just shop for equity partners based on deal terms - the “right” equity partner which brings industry experience and/or a management philosophy that is consistent with the management team’s can be more important than maintaining a few percentage points of management ownership.

If there is any advice we have for managers who are thinking of doing a buyout, it is to work with advisors who have successfully completed MBOs in the past. Doing a deal is not like running a business, and just because you have been successful in one area doesn’t mean you will be successful in the other. It also helps to be well connected in the financing community. Assembling the right deal team -- lawyers, tax accountants, and investment bankers - often makes the difference between successfully completing a deal or never even getting to the starting line.

By Doug Mitman, principal, and Trent Myers, vice president, at Grace Matthews Inc., a Milwaukee-based investment banking firm. For more information go to www.gracematthews.com or call Doug at (414) 278-1120. Copyright - 2001 Profits Joumal Inc.