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Why auctions are becoming more prevalent in middle-market private equity deals05/08/2004. Source: Edwards & Angell . Paul Mahoney and Ragan Ferraro 
 Once perceived as a refuge from bidding wars, the middle-market is increasingly receptive to the auction process. The dual challenge for middle-market private equity buyers is to generate deal opportunities outside of the auction framework, and when they do participate in auctions, to compete effectively, according to Paul Mahoney and Ragan Ferraro of Edwards & Angell.
The middle-market, defined here as companies with enterprise values between $50m
and $500m, traditionally has been viewed as a segment offering opportunities for
private equity buyers to purchase growing companies at reasonable prices, when
compared to the price multiples paid in larger deals. The assumption is that a
buyer in the middle-market has a greater likelihood of finding and negotiating
a deal on a proprietary basis.
This is no longer the case. More and more, middle-market companies are represented
by investment bankers, who—with an eye on maximizing their client's proceeds
(and their advisory fee)—run sales through an auction process.
In recent years, it has become increasingly difficult for buyers to find deals
outside of an auction. This assertion is supported by published data. In its
lists of announced middle-market M&A transactions, Buyouts discloses the
seller's financial adviser. If an investment banker represents a company, then
as a general proposition that sale is being run in a competitive process, and
most likely in an auction. In the years 2000, 2001 and 2002, the percentage
of sellers in the middle market that retained a financial adviser was 28.7 per
cent, 31 per cent and 42.1 per cent, respectively.
The Impetus For Auctions
There are a number of factors contributing to an increased demand for middle-market
companies, which gives those companies the leverage to insist on an auction
process:
1. A lot of money needs to be put to work and limited partners in private equity
funds have a finite timeframe on their binding capital commitments. Fewer large
deals are getting done and the competition for those deals is fierce.
2. A sale is the logical exit. Although the IPO market has improved, it is
not the likely exit scenario for the vast majority of companies. Those companies
that had been seriously considering an IPO most likely have an investment banker
on the scene, and that banker is steering them to a sale via auction.
3. Sellers are becoming increasingly sophisticated. A number of private equity
firms have portfolio companies that they are positioning to sell, and they know,
from bitter experience on the buy side, that the auction process tends to maximize
value.
A number of top-tier private equity funds have focused on the middle-market
for years, but big buyout firms are showing increased interest in this segment.
Further, regional investment banking firms having long had middle-market sell-side
engagements as their bread and butter are being joined by an increasing number
of boutique firms that have spun out of the larger investment banks.
Auction Process
If, despite its best intentions, a private equity fund finds itself competing
in an auction, the first step is to anticipate how the auction will likely proceed.
Generally, the auction process begins when the investment banker, with input
from management, drafts the confidential information memorandum (the "book")
describing the company, its industry and its financial performance.
The banker taps its contacts in the seller's industry and the private equity
community. Interested parties receive the book (after signing a standard confidentiality
agreement) and are invited to submit non-binding indications of interest. Based
on review of the book and their independent research, bidders submit their indications
of interest. The investment banker and seller cull through the indications of
interests, and narrow the field to those in the range of the seller's expectations.
Bidders review the contents of the data room and attend presentations by the
seller's management. After diligence visits, bidders are provided the seller's
draft form of the purchase and sale agreement (P&S). Bidders are asked to
make definitive bids. The banker stresses that these proposals should contain
the best and final price and terms, and that due diligence should be complete
and financing arranged.
Bidders often consider whether to do a full mark-up of the P&S, as the
seller requests, or a memorandum summarizing their issues with the draft. They
may choose the latter, in order to manage legal expenses in the event they don't
advance in the process and in an effort to keep their options open on deal terms
until due diligence is complete.
Regardless of their form, P&S comments most likely do not have a material
impact on the bid, since the seller's overarching priority is maximizing transaction
value.
Winning The Bid
To compete in auctions, private equity buyers may team up to make a bid (while
keeping an eye out for antitrust issues), instead of going it alone. Although
more prevalent in larger transactions, "club deals" are becoming increasingly
common in the middle-market. Even if its price isn't the highest, a private
equity consortium may be able to succeed in the auction, or pre-empt the auction
altogether, through:
1. Flexible Financing. The group may offer a bridge loan in
the event permanent debt financing isn't in place at the time of closing.
2. Deep Pockets. A wider group of sponsors offers the assurance
of multiple financing sources for additional investments in the acquired business,
including add-on acquisitions.
3. Heavy Hitters. A consortium may offer broader and deeper
industry expertise and financing contacts at the board level and otherwise.
To combat a winning bidder's sense that it is in the driver's seat, a seller's
investment banker may deliver news of the winning bid with words to the effect
of: "We're going with you even though you're not the highest bidder, because
management really likes you." Or maybe, "we prefer your financing
structure." The goal is to create insecurity. The seller wants you to think
that there is someone on the sidelines ready to pay full price if your process
with the seller goes sideways. Don't back down.
This article first appeared in Fleet Capital publication, CapitalEyes.
As a result of the merger of FleetBoston (the parent company of Fleet Capital) and Bank of America late 2004, Fleet Capital is now Bank of America Business Capital. Bank of America Business Capital, one of the world’s leading asset-based lenders, finances the needs of mid and large-sized businesses in the U.S, Canada and Europe. We provide asset-based loans from $10 million to $1 billion for working capital, acquisitions, turnarounds, recapitalization, DIP financing and more. For more information, please visit http://www.bofabusinesscapital.com
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