Mergers and acquisitions (M&A) can appear dauntingly complex with the various transaction structures and numerous participants involved in the process. Adding to the confusion, industry players are often coined by multiple, synonymous names. It’s no wonder many outside Wall Street view the M&A industry as a Byzantine Empire of financial wizardry.
Setting aside the various transaction types and associated financial engineering for now, this article provides a structured outline of the roles played by the various M&A participants. In any given transaction, M&A participants may be categorized as the Seller, the Buyer, the Adviser or the Financier. The role of each is outlined below.
While the number of shareholders in a particular company may vary from a single person to thousands, for the purposes of this article, the number of shareholders is not significant. Collectively, the shareholders are referred to as the Seller.
Generally speaking, the buyer universe is divided into three camps: Financial Buyers, Strategic Buyers and Public Investors. Financial buyers are those firms whose business model is to buy, to develop, and subsequently to sell businesses. Financial buyers acquire operating companies for their fund’s portfolio by making direct equity investments into these companies in exchange for a percentage ownership. By doing this, the financial buyers expect to profit from both the cash flow that the operating company generates and the capital gains realized upon exit (upon selling the company). Financial buyers therefore acquire and grow businesses in anticipation of implementing a future exit strategy. The exit provides the financial buyer liquidity (converting their equity back to cash) to either re-invest in a new company or to distribute as proceeds to the firm’s limited partners (the entities that contributed capital to the financial buyer’s fund).
Financial buyers’ investment preferences usually fall within a certain investing bandwidth coinciding with the phases of corporate growth – from startup to maturity. Consequently, different financial buyers are more prominent at different stages of a company’s life cycle. As a result, financial buyers are often categorized by the maturity and size of companies in which they typically prefer to invest. Although there is some overlap across each of the categories, the following are recognized industry naming conventions of three distinct types of financial buyers:
* Angel Investors: Angel investors are typically high net worth individuals who back an entrepreneur during a company’s startup phase. Angel investors hope to back a good entrepreneur with a good idea. Together with venture capital firms, angel investors provide the earliest stage of investment to a company as it is newly founded.
* Venture Capital Firms: Venture Capital firms (VCs) generally invest in companies from a pool of money (a fund). Like angel investors, venture capital firms tend to invest in the early phases of a company’s life-cycle. However, because VCs often have sufficient funds to make much larger investments than a high net worth individual, as a group, venture capital firms often invest in growth companies a bit later in stage compared to angel investors.
* Private Equity Firms: Private equity firms (sometimes called financial sponsors, buyout firms or investment companies) almost always operate from an invested pool of money contributed from a variety of sources including wealthy individuals, pension funds, trusts, endowments and fund-of-funds. While there are always exceptions, private equity investors typically invest in companies that have matured beyond the proof-of-concept phase, where the company possesses a definable market position, a solid revenue base, sustainable cash flow, and some competitive advantage, yet retains plenty of opportunity for further growth and expansion.
It should be noted that while the majority of private equity firms closing deals in the market place operate from a pool of committed capital, there are also unfunded sponsors, who essentially operate as opportunity scouts. Once they find a business that they would like to purchase, they then seek to raise the required capital. Relative to a private equity buyer with a fund of committed capital, an unfunded sponsor is disadvantaged in that the seller may perceive him or her to be a higher risk candidate to actually close the transaction, given the lack of committed capital. On the flip side, an unfunded sponsor is under lower pressure to make acquisitions because he or she does not have an idle pool of capital waiting on an investment opportunity.
Strategic buyers (also called industry buyers or corporate acquirers) are companies that are primarily geared toward operating within a given market or industry. Strategic buyers typically acquire companies for the synergies resulting from the combination of the two businesses. Synergies may include revenue growth opportunities, cost reductions, balance sheet enhancements or simply size in the marketplace. As such, strategic buyers look to make acquisitions with an integration strategy in mind rather than an exit strategy (as in the case of a financial buyer).
Because of the opportunity to benefit from potential synergies, it is generally thought that strategic buyers should be able to justify a higher price for a target company compared to a financial buyer for the same company. However, in certain instances, financial buyers may look and behave like strategic/industry buyers if they hold complementary operating companies in their portfolios. This is why searching the business profiles of the portfolio companies owned by private equity firms is key to finding those targeted financial buyers that may act like a strategic buyer.
Different from the financial buyer and the strategic buyer, the seller may instead elect to sell the company to public investors by floating some or all of the company’s shares on the securities market through an initial public offering (IPO). If the selling company is already publicly-traded, it may also elect to issue new, additional shares to the investing public through a secondary offering (also called a follow-on offering). Publicly-traded companies are usually more mature and established, with sufficient historical operating performance to better gauge the performance of the company. While a public offering may offer attractive valuations for the seller, the process is also quite expensive and comes with the burden of tight regulatory constraints for the company going forward.
The Advisers to an M&A transaction usually consist of the M&A Adviser and the professional service providers. Analogous to a real estate agent in the function they perform, M&A advisers are the link between the Buyer and the Seller and are usually the catalyst that keep a transaction moving forward. M&A advisers are referred to by various names, segregated by the size of the transaction that they typically handle. Although there are no generally accepted thresholds within the industry to clearly delineate where one type of firm ends and the other begins, as a general guidelines for the purposes of our M&A Advisory Firm data module:
* Investment bankers serve clients whose enterprise values are consistently above $50 million (on the low end and often in the billions).
* Middle market investment bankers (also called intermediaries) normally work on deals with enterprise values between $5 million and $75 million.
* Business brokers are those firms that consistently work on transactions with an enterprise value less than $5 million.
Other professional services typically involved in an M&A transaction include transaction attorneys, accountants and valuation service providers. The transaction attorneys’ involvement in a deal varies by firm and by transaction. However, at a minimum, the transaction attorneys have the primary responsibility to draft the contract and may also be involved in the negotiations. The accountants serve to provide financial and tax advice to the principals (the buyer and the seller) in a transaction. Frequently in an M&A deal, an independent valuation of the company is needed or required. This is performed by a valuation service provider, whose goal is to assign a third-party, fair market value to the company. Private Equity Info also provides subscribers with a data module of valuation service providers.
Senior lenders provide senior debt to companies. In an M&A transaction, the buyer, in addition to the equity investment, looks to lending institutions (typically commercial banks) to provide some senior debt to fund the purchase.
Senior debt within an M&A transaction is analogous to the first mortgage on your house. In the event of a default, the senior lender is the first in line to get paid from any liquidation value from the underlying asset, in this case the purchased company’s assets.
Unlike angel investors, VC’s and private equity groups who normally make pure equity investments in companies, mezzanine lenders provide subordinated debt to a company, often with a potential for equity participation through convertible debt. Mezzanine debt may also be sought to finance a company’s growth or working capital needs. However, in an M&A transaction, mezzanine firms frequently team with strategic and financial buyers to bridge the gap between equity and debt. Mezzanine loans are analogous to the second mortgage on your house.
Because mezzanine lenders are behind senior lenders in the hierarchy of bankruptcy proceedings upon default, mezzanine investors look to invest in companies with solid historical cash flows, which enable the company to service the required interest payments on the debt.
A number of large institutions offer mezzanine lending for M&A transactions of various sizes. However, small business investment companies (SBICs), government-sponsored entities, also provide mezzanine debt strictly to smaller M&A transactions.
Merchant banks are simply investment banks that are willing to invest some of the firm’s capital as an equity investment into a transaction in which they are also the adviser. Some argue that the merchant banking business model has inherent conflicts of interest – in the case where a merchant bank is advising the seller (and hence should be trying to get the highest valuation for its client company) and also acting as a buyer (and hence trying to get the lowest valuation). The counter argument, provided by the merchant banks, is that the firm believes in the deal and the client company’s future prospects to the extent that they are willing to invest their own capital to support the transaction. In most cases, merchant banks make small, minority investments.
Lastly, it is typical in M&A transactions for the seller to also be a financier. If the collective equity and debt provided by the buyer do not equate to the desired purchase price, the seller may be asked to carry a seller note to bridge this funding gap. This is analogous to owner financing when selling your house.