Private Equity Viewpoint: Going Once, Going Twice . . .

Today’s economic climate has created a seller’s market in the sale of businesses. Low interest rates have contributed to a relatively low cost of capital for acquisitions, and capital allocations to the private equity asset class have generated a large pool of equity dollars looking for investments. There are often many potential buyers competing for the same business. As a result, more companies are being sold through the auction process.

How can a private equity firm effectively compete on the buy side in today’s environment? It is difficult for a private equity firm to avoid auctions entirely. Avoiding auctions means foregoing a significant number of potential investments. While the auction process can be challenging, a private equity firm that follows a rigorous discipline in its approach to auctions will be in a better position to not only survive the auction process, but to succeed as well. Here are some guiding principles for dealing with auctions:

• Pick auctions selectively. In the current environment, a private equity firm cannot expect to make an opportunistic purchase of a good business; the acquisitions market is too efficient. As a result, it only makes sense for a firm to participate in auctions for businesses in which it is keenly interested and willing to pay a full purchase price. Saying no to unattractive auctions will free up resources for more profitable endeavors.
• Be cautious when competing against the synergistic buyer. It is axiomatic that a financial buyer with a portfolio company in the same line of business as the business being auctioned can pay a higher purchase price because it can afford to give up some of the synergistic cost-savings to the seller. If a private equity firm is fortunate enough to have a portfolio company with a complementary business, it will have an advantage in the auction. On the other hand, if the private equity firm knows that an auction competitor has a complementary business, and the private equity firm does not, it may not make sense for the private equity firm to participate in the auction.
• Participate fully or not at all. Some private equity firms participate in auctions even though they are interested in the business being sold only at an opportunistic price. Early in the process, there is little downside to this strategy. It costs relatively little to read a confidential information memorandum and submit a non-binding indication of interest. However, later in the process, the costs increase materially, both in terms of time and out-of-pocket expenses. Due diligence also becomes a major issue – how can a potential buyer perform satisfactory due diligence without engaging outside accountants and lawyers? While there is always the possibility of submitting a final bid that does not include a fully marked-up contract, has no financing arranged and is subject to due diligence, this kind of bid is almost guaranteed not to succeed. The downside of participating fully in an auction is the cost of losing – lost time and meaningful out-of-pocket expenses. However, this is the price of competing in today’s acquisition market. Moreover, there is a collateral benefit to making an early decision on whether or not to participate fully – it is a good management discipline.
• Stick around. While bidders drop out of auctions for a variety of reasons, a private equity firm should not drop out solely because it thinks it will not win. There have been numerous auctions in which the high bidder ultimately dropped out, sometimes late in the process. As a result, a bidder who has participated fully, completed due diligence and submitted a fully financed bid may well turn out to be the only viable bidder at the end of the auction.
• Ask candid and direct questions. A private equity firm that is considering getting involved with an auction often can obtain useful information just by asking the right questions. For example, "Is ABC fund or their portfolio company XYZ participating in this auction? We do not have a platform like XYZ so we have no synergies to share. ABC and XYZ are the logical buyers here. We are going to drop out of the process unless you tell us they are not in. We cannot afford to waste time on an auction in which we are guaranteed to be outbid."
• Do not renegotiate. Some private equity firms make it a practice to bid high and then attempt to negotiate down the price once they are awarded the deal and engaged in negotiations. Sellers may be particularly vulnerable to this practice when the auction process does not require bidders to complete due diligence and submit a fully marked-up acquisition agreement. However, this is a risky strategy in today’s competitive environment. First, most sellers and investment bankers are savvy enough to turn quickly to bidder number two if they sense that a price renegotiation is coming. Second, no private equity firm can afford to have a reputation as a bidder that can be expected to bid high and then attempt to negotiate down.
• Recognize the importance of contract terms. Sellers and investment bankers now dwell on contract terms, including the size of the escrow, the cap on seller’s indemnification obligations, the scope of the indemnification obligations and the survival period of the representations and warranties. The trend is toward deals that mimic the public markets – representations and warranties that do not survive the closing or that survive for a relatively short period of time and no post-closing recourse or very limited post-closing recourse against the seller. These terms put a premium on good due diligence because there may not be adequate post-closing recourse to satisfy a problem that is missed during due diligence.
• Maintain a good relationship with financing sources. The strength of a bidder’s financing is a key aspect of its offer. If a bidder cannot submit solid financing commitments, its bid will be severely hampered. Moreover, investment banks running auctions are focused on the conditions to funding and have begun to push bidders and their financing sources to limit or eliminate conditions that only a few years ago were considered entirely standard. If a private equity firm works in advance with its financing sources to limit or eliminate conditions to funding — and thereby increases the probability of closing — it can enhance its bid in a manner that will help distinguish it from the bids of other potential buyers.
• Do not forget management. A private equity firm should have a strategy for dealing with the selling company’s management. There have been situations in which a winning bidder’s deal fell apart because the bidder and management were unable to conclude an agreement. If the buying firm needs the company’s existing management, it should not assume that management will fall into line and join the deal no matter what terms are offered. The firm should be prepared to "sell" management on the deal and explain why manage other companies in the seller’s portfolio can be useful references for the firm if the relationship with these managers is good.

Conclusion. Adopting and following a rigorous, disciplined approach to auctions can help a private equity firm survive the auction process. However, it also pays to remember that each auction has its own peculiar circumstances. While it is advisable to have a general "firm" approach to all auctions as a starting point, it also makes sense for a private equity firm to retain the ability to be nimble and flexible in the right circumstances. Being in a position to move quickly, especially at the late stage of an auction, can help a private equity firm secure the deal.