Behind door No. 2

Many business owners operate under the misconception that the best time to sell their business is when the strategic buyers’ market is hot, or that the pool of potential acquirers is limited to competitors, industry consolidators or others up or down the supply chain.

But it is increasingly common for private equity firms (a.k.a. “financial sponsors”) to be active in M&A and be willing to pay premium prices for middle market companies. Indeed, with more than 900 domestic private equity funds that that have collectively raised more than $325 billion in the last decade, private equity firms are a real M&A force.

Understanding LBOs
A leveraged buyout (LBO) is a transaction in which a significant portion of the purchase price is funded with junior capital, including senior and subordinated “mezzanine” debt. It enables financial buyers to “leverage” returns on their equity investment and use the cash flows generated during the investment period to pay down debt and fund the company’s growth.

Private equity firms typically look to harvest their investment within three to seven years by selling the acquired company to another buyer, taking it public or releveraging the company and pocketing a large cash dividend.

Factors affecting private equity fund activity
Several factors contribute to the increased appetite of financial buyers and the notable spike of their recent activity. Most significant is the sheer volume of capital available, both equity and debt.

As credit markets have improved, more lenders have returned to the middle market and are under pressure to deploy capital. Second, high-yield bond activity has been on the upswing. In 2003, there was a dramatic increase in high-yield issuances as compared to the previous three years. Moreover, while 2003 was a good year for high-yield issuances, the volume of high-yield issuances in Q1 2004 nearly doubled from their level in Q1 2003.

Third, there is a disparity between the amount of private equity capital raised and private equity capital deployed over the past several years. While the level of fund-raising declined substantially over the past three years, much of the private equity capital raised between 2000 and 2002 has gone uninvested, and many of the investors in private equity funds are pressuring for more rapid deployment.

Several private equity funds are faced with the prospect of either spending the money or having to give it back to their investors.

Quasi-strategic buyers
An additional factor that has enabled financial buyers to compete and win auctions has been their ability to act as a pseudo-strategic buyer in certain situations.

With the recent downturn in the initial public offering market, private equity funds own an increasing percentage of U.S. businesses. If a private equity fund already owns a portfolio company that is similar to the business for sale, opportunities for cost-reduction synergies exist, which can further drive a private equity investor’s returns on invested capital (both for the company it already owns and the company it is seeking to acquire), and ultimately, justify a premium purchase price.

The partial sale — two bites at the apple
Most private equity funds will consider purchasing less than 100 percent of a business to allow existing owners to co-invest with them in the company. In fact, most prefer to partner with successful managers and will set aside additional equity capital to support a corporate growth and/or acquisition plan. In other words, private equity investors are often willing to purchase a partial yet controlling interest in a business, allowing the owners to diversify their holdings, “take chips off the table,” and yet remain motivated toward continued growth of the company and capitalize on such upside when the equity fund sells or recapitalizes the business in the future.

An investment banker will help familiarize the company owner with the private equity market and sale or partial sale to private equity funds as a logical alternative to the typical exit strategy of selling their businesses to strategic buyers.

David Sulaski ([email protected]) is the leader of Brown Gibbons Lang & Co.’s Private Equity group and a U.S. and cross-border new business development specialist. Reach him at (312) 658-1600.