A new study from boutique investment bank Harris Williams should alarm corporate development groups. The survey of 500 middle-market executives discovered a 38 percent jump this year from last in the number of respondents who named private equity firms as their preferred acquirer. Even more worrying for strategic buyers is the risk of losing bite out of a growing M&A pie: a whopping 95 percent of companies surveyed are open to striking a deal over the next three years, up from about 81 percent last year.
What explains the shift to private equity buyers? After all, it’s strategics who can lure sellers with sector expertise and promises of synergy. We posed that very question to Masco Corporation’s Eli Slack, a corporate buyer, and ButcherJoseph banker David Lake, to gain some much-needed answers.
What we concluded is that private equity firms are gaining an edge by leveraging their own core strengths of relationship building, financial discipline and diligence. The good news for strategics is such strengths can be replicated. But it may require a shift in thinking.
A structured approach to relationship building and business development is one early advantage private equity firms leverage to boost deal flow, meet sellers and communicate their vision. David, an intermediary, crystallizes the issue: “In any given week we’ll have three or four private equity firms in our office giving us their 30 minutes about what they want to see and just keeping the relationship warm. I can’t say the same for strategics.”
Private equity firms know that regular, frequent communication touchpoints are necessary to cultivate relationships, even ones that may not pay dividends until years later. It’s a practice competitive strategics now pursue equally well, often by leveraging sophisticated investment and relationship management platforms such as Navatar Corporate Development. Eli, for instance, uses Navatar to schedule touchpoints with preferred bankers at least once a quarter. Potential sellers too should be engaged early and often. Even if a sale is not imminent, you want to be on their call list when the time comes. Private equity firms are becoming naturals at this, but do not have a monopoly on the practice.
After enduring long slogs on the fundraising trail, private equity buyers must exercise restraint when bidding for assets – their survivability rests on generating a high IRR for limited partners. Strategics, meanwhile, don’t have this issue. Capital is usually pulled from the balance sheet, or shares can be offered in consideration. The end result, though, can be a lack of financial discipline. Strategics are thus winning deals they shouldn’t necessarily want, depleting cash flow for future, smarter opportunities.
One way to avoid this outcome is being aware of what Eli calls “deal fever” – a condition in which overly-optimistic corporate development teams use ill-measured synergy potential to justify aggressive bidding. One cure is designating a team member a contrarian role during valuations, but more fundamentally strategics should adopt the same financial discipline exhibited by buyout shops. Question valuation assumptions, enter negotiations with pre-agreed guidelines on forecasting future financial performance and constrain return projections.
Diligence is a third area we identified as potentially troublesome for strategics. It’s true that corporate buyers have an intimate sense of a target company’s industry, easing due diligence requirements at the outset. But that existing industry knowledge can be harmful if it results in false assumptions being made about a seller’s business. David describes this misplaced sense of confidence as “imposing your philosophy” on the target, something sellers find irksome. Erik added that corporate teams should “assume zero knowledge” of the target’s market and business model, especially when entering unfamiliar territory or new industry sub-segments. Private equity firms are good at this, and neutralize the initial due diligence disadvantage by drawing on a network of consultants, industry advisors and sector-specific research reports to quickly learn and assess a target’s financials and business strategy. Strategics adopting what Eli calls a “data-driven approach”, one similar to the research heavy and facts-based due diligence model pursued by private equity teams, reduce the chances of losing a competitive deal.
What ultimately determines which type of buyer sellers pursue comes down to a number of factors. Price, of course, continues to be the primary driver. But private equity firms have managed to diminish a historical M&A advantage enjoyed by corporate buyers through a mix of strategies that are replicable. See below for what those strategies are in detail, and how they can help strategics avoid losing deals to private equity rivals: