The five-year investment period set forth in the limited partnership agreements of many private equity firms have now elapsed, and these firms (“sellers”) are now in harvest mode with respect to the portfolio companies remaining in their funds. Achieving attractive return on investment multiples is their highest priority because, among other things, their ability to raise a new fund is significantly dependent upon past performance on a realized basis. As a result, investment banks are being hired to sell these portfolio companies and to create private auctions in order to do so on the theory that such a process will foster competition so as to achieve the highest purchase price and best terms possible.
The process is straightforward. A private placement document (PPM) is created, as is a data room. The market of potential buyers is analyzed (strategic versus financial, or some combination thereof), selective potential buyers are contacted and, for those who express interest, confidentiality agreements are drafted, negotiated and executed.
Those expressing interest in pursuing a transaction after review of the PPM (“buyers”) are then typically requested by the banker to provide a written “indication of interest” setting forth:
- A non-binding indication of the enterprise value (or range) that the proposed buyers would pay in cash for 100 percent of the outstanding stock of the target, assuming a debt-free, cash-free balance sheet, and what assumptions are being relied upon in arriving at such number (typically a multiple of EBITDA)
- How the proposed buyers intend to finance the subject transaction, including the specific names and interest levels of any third-party financing
- The proposed buyers’ views on continuing employment roles for existing management and any “skin in the game” rollover requirements of equity owners who propose to remain as management
- The rationale for the buyers’ interest and initial due diligence issues that the buyers would like to address should they have the opportunity to meet with management
- A proposed timeline, including an estimated time to close following the execution of a letter of intent
- The names of external advisors the buyers plan to engage
- The nature of the buyers’ approval process necessary to sign a definitive agreement
The indication of interest will usually trigger a dialogue with those potential buyers considered “live ones,” whose nonbinding submissions are within the sellers’ minimum price range expectations, whose financing is deemed credible and whose proposed arrangements with management are deemed acceptable. Such persons are then invited to visit the data room and to have initial meetings with management.
The next step is typically a request from the banker for the remaining eligible buyers to submit proposed, non-binding letters of intent (except for the exclusivity, confidentiality and related clauses). Concurrently, the eligible buyers will often be provided with a draft purchase agreement, which is frequently very seller-favorable, with a request to have the buyers’ counsel review it and advise whether they can live with its provisions. Sometimes the banker includes a term sheet in columnar form which lists key points—for example, purchase price, dollar amount of baskets and caps, escrow amount and duration, definition of knowledge and of fundamental representations and warranties, duration and geography of restrictive covenants and similar items. This format then requests the buyers to mark up their purchase agreement and set forth their position in the applicable column of the term sheet opposite the stated position of the sellers.
The sellers are looking for the bidders to offer the highest price possible, and for buyers that are willing to live with their one-sided terms and conditions. This process creates a dilemma for the buyers. They want to win the bid because they like the target company but do not like the terms set forth in the term sheet or the draft purchase agreement. What will the other bidders do? How many are there? How high a price will they offer and what terms are they willing to live with?
What happens frequently is that buyers will hedge their position, telling the sellers much of what they want to hear (sprinkled with various caveats and “subject to’s”). Then, after they have obtained the exclusive right to negotiate a definitive agreement, they will instruct their counsel to substantially rewrite the purchase agreement the way they wanted it in the first place.
So, what have the sellers accomplished? In trying to squeeze the maximum from the buyers, they spent time and money drafting a very one-sided agreement, which the buyers then spent time and money on redrafting what could have been done from inception. Did it result in a higher purchase price and more favorable terms?
Sometimes. In resisting any price reduction proposed by buyers, the sellers will argue that the buyers agreed to the initial terms (including purchase price) in the letter of intent, notwithstanding the non-binding nature thereof. The buyers will often counter that their quality of earnings report had not been completed at that time and that their proposal was subject to those aforementioned caveats and the completion of due diligence, which is ongoing.
Many potential buyers simply refuse to participate in any auction process because the cost in time and money weighed against the odds of being chosen are not very favorable. Some buyers try to avoid this process by making a preemptive bid with which they are comfortable, by offering a purchase price that they have reason to believe will be acceptable to the sellers upon condition that the auction process be suspended during the exclusivity period.
Did the buyers learn from the banker what range of purchase prices and terms will make them the successful bidder? Remember that the banker was engaged and is being paid by the sellers and its success fee is typically based on a percentage of the purchase price, so the interests of the buyers and that of the banker are not aligned. Are the buyers being used as stalking horses to increase a purchase price bid from another buyer? These and others are questions all buyers consider before making a preemptive bid.
Depending upon the sellers’ timetable, a preemptive bid may be most advantageous to them. Once they decide to sell, they surely want to conclude the process as quickly as possible. The price offered, meant as a preemptive bid, would normally be within their acceptable price range, although perhaps not the highest bid possible. A single bid is more efficient and less disruptive to the management team and company employees, and lessens the chance of the proposed sale becoming public knowledge to the advantage of company competitors.
Is “a bird in the hand worth two in the bush”? From the sellers’ perspective, they can keep the preemptive buyers’ feet to the fire by the implied threat of resuming the auction process upon the expiration of the exclusivity period. From the buyers’ perspective, one objective will be to whittle down the purchase price upon completion of the diligence process by identifying the weaknesses of the target, increasing the escrow amount and duration, and broadening the representations, warranties, covenants and indemnities. Let the bargaining begin.