M&A Table of Experts: Is now the time to sell?
August 18, 2015
The Minneapolis/St. Paul Business Journal held a panel discussion recently, featuring five expert panelists to explore topics about the M&A market and landscape.
Panelists included Michael Mahoney, managing director at Bell Capital Finance; Charles Johnson, attorney and co-chair of business law section at Briggs and Morgan; Bruce Behm, president at Quazar Capital Corp.; Jeff Milkie, managing director of investment banking at Wipfli Corporate Finance Advisors; and Paul Plunkett, attorney at Larkin Hoffman and chairman of the M&A group. Ryan Miske, a partner at Faegre Baker Daniels, served as moderator.
Miske: Let's start with a general question. What are you seeing in the M&A market today?
Milkie: It's definitely a strong environment for sellers right now. One thing we're seeing is more and more sellers coming to market; however, some private equity is staying on the sidelines due to what they perceive as being too high of valuations. So, when we see that phenomena happen, that tends to lead us to believe that a plateau is starting to form. How long the plateau lasts or if the market could spike back up, that's hard to say, so we encourage prospective sellers to take advantage of today's conditions.
Miske: From a legal perspective, Chuck, what are you seeing in the deals you're working on?
Johnson: I echo Jeff's comment about it being a seller's market. You're seeing survival periods shortened and escrows reduced to levels they haven't been. Companies are confident, CEOs are doing well, and they're actively seeking strategic buys. I'm still seeing a lot of action by private equity firms. I think for a while the market was driven by tech companies and medical device companies. Now it's the less sexy and simpler companies. Mom-and-pop kind of companies are coming up more. These are unsolicited offers coming in, generating interest and culminating in an actual sale.
Miske: Mike, we'll turn to you. What's driving the market and values today?
Mahoney: Valuations continue to be driven by low interest rates and the abundance of capital at every level of the transaction's capital structure. There are more buyers than sellers. It is very competitive to place capital today regardless if you are talking about debt or equity. Senior and subordinated debt continue to be under pricing pressure, as well as aggressive structuring requests, including cash flow leverage expectations and amortization.
Miske: Based on what the other panelists have said, Bruce, it sounds like now is a great time to sell. Do you agree with that?
Behm: We always refer back to 2005 to 2007 as the glory days. All the private equity firms were looking for deals, and I promised if it ever happened again, I wouldn't waste the opportunity. And we're getting to those times right now. We have an extensive database and we're telling people now is the time to go to market. We're getting more people calling us and saying they've been approached by strategic buyers. It's a good time to sell now. We tell people to consult their tax and legal advisers and make sure they have things in place.
Miske: Jeff, you said we may be reaching a plateau. If you look into your crystal ball, how long do you think this strong M&A market will last?
Milkie: It's always hard to pinpoint market cycles. When we start to see a subset of private equity groups begin to shift to sellers rather than buyers, and more net sellers coming to market, it's a sign that things may start to normalize a bit soon. If you look back at the period that Bruce mentioned — the "glory days" — then the credit crisis hit unexpectedly and we had a hard stop in the M&A market. Today, minus any major negative economic event, it's safe to say you have another 12 to 24 months of attractive conditions for sellers. But it's difficult to predict after that. With our clients, we say don't try to time the market, but take advantage of attractive market windows if you are considering a sale in the near to intermediate term.
Miske: What types of businesses are in demand today?
Behm: I think what we're seeing is that manufacturing is in high demand. Other common themes we hear are not so much about an industry, as they are about businesses with recurring revenue. Everyone wants that stable business. We have people in ag world, service companies, construction companies, anything that has recurring revenue through a solid customer base. Mike, are you seeing that, too?
Mahoney: In the lower-middle market, we spend a lot of time with manufacturers and sub-$30 million companies, and the demand is being driven by the predictability. The business has a broader customer base, can sustain some of the bumpiness that buyers are anticipating. Long-standing companies with sustainable cash flow are always attractive.
Miske: Why would someone consider selling a successful company?
Plunkett: Without a doubt, the current good economy and low interest rates are driving much of the M&A activity today. But there are also a variety of unique circumstances or situations that affect family-owned businesses. One may be that they have been in business for 25 or more years, and it's time to cash out. Or the owner or owners are getting multiple offers, great offers, and they are ready for a new challenge, retirement or a second career. Unfortunate situations, such as adverse medical problems or divorces, for owners also create or require owners to explore exit strategies.
Miske: I've been hearing that baby boomers are delaying retirement, in large part because of the last recession. Is that really happening, and if so, what affect is that having on the M&A market?
Plunkett: I think it will come to fruition, but I haven't seen it yet.
Johnson: That could also be happening because this is their baby, they've had it for so long, and technology allows them to continue to manage from afar.
Plunkett: Another response is that people are on the whole living longer today. As a result, because the baby boomers are living longer and are generally healthier, they are willing to keep active in their businesses.
Behm: We had a call a few days ago from a 75-year-old man who wanted to look at a business that we're selling. I asked him if he'd maybe thought about kicking back a little and hanging it up, and he said, "No, I'm going to die in the saddle."
Miske: We've talked about what's enticing owners to come to market. How can an owner find out what their business is worth?
Behm: You can always pay for a valuation, but there are other ways. For example, you could contact several investment banking firms to get a general idea of the market value of your company. But if you need a professional valuation, you can get that. However, you have to be cautious about what the valuation is for. We do a lot of ESOP work, and right now the ESOP companies are being more conservative in their valuations. So, there might be a range of values.
Plunkett: Valuation is an art, not a science. And at the end of the day, a company is only worth what a buyer is willing to pay.
Miske: If an owner has decided they want to sell, what can they do to maximize value? Let's say they want to sell in two to three years.
Mahoney: If there are two companies that have very similar characteristics, when I think about enhancing the company's value, and when we review the transactions with our private equity partners, many of them are interested in whether there's growth around this business. Do they have projections that are supportable, do they have visibility, and is this company in enough of a niche to provide that next buyer with growth? Companies that receive that extra turn of value in the sale process are the ones that can articulate that they can grow. Another thing we're seeing more of is downside testing. Equity groups want to understand if the company has the wherewithal to weather a downturn.
Milkie: Growth is huge, that's very true. Other basic things include making sure you have your financials in order. Also, make sure you have a good management team, that's especially important if selling to private equity. If you've got a couple years and you're thinking about what to do to increase value, take a look at your management team. Determine how to fill the holes you might have. Maybe you need a good controller instead of a high-powered chief financial officer. Work with your advisers early in the process — your investment bankers, your CPAs, your attorneys — to determine what you need. And if you have a couple years, it's worth looking at your customer concentration and thinking about what you can do to diversify. If you can't diversify, try to get contracts into place with your customers and start to build a story about how you're embedded with certain customers. Think through those opportunities, and create a roadmap for the buyer. The more you can connect those dots for the buyer, the easier it is for the seller to prove its value.
Miske: Is the answer different if you have two or three years versus if you want to go to market now? You might not have time to build up the management team, but are there changes you can still make?
Milkie: That's a good question because occasionally we have sellers who come to us and say we want to sell tomorrow. They don't give themselves the runway sometimes needed to enhance value. Then we, as their advisers, have to think through what can we do to help. For example, can we identify holes in the management team and find a couple of candidates to offer up to the buyer? That can be effective in certain cases.
Plunkett: Jeff, I'm curious — since EBITA is king in the marketplace, companies start doing a lot of expense cutting just to drive that up even though long-term, it will hurt. What effect does that have on planning?
Milkie: We do see that occasionally, but it is relatively rare. We caution clients that if excessive expense cutting was conducted within the last year, you will have to justify that. We recommend if you go to market, the best scenario is to have a normalized business going forward. Don't overcut and don't overspend right before selling.
Mahoney: The buyers are so sophisticated now; they'll scrutinize line items and figure out historical trends and will recognize some of the gamesmanship. I'd say the less prepared the seller is, and the quicker the timeframe, it can impact value and slow the process down. Some might see opportunity in a management team that's not complete, but the cleaner the deal, the better. It's helpful if the seller is audited, and we're not getting a shoebox of tax returns. If the seller doesn't think about the sale process or prepare, it's very disruptive.
Johnson: To echo that, not only is the process longer, the risk of the deal unwinding and falling apart is exponentially higher. I've seen a lot of deals where everyone is energized, they think they have a meeting of the minds in terms of price, then they start digging into the financials and they find out there's a 20 percent gap that they can't overcome.
Behm: Going back to the original question, I think it really depends on the sophistication of the seller. We find that people who try to make too many changes, too many cost-saving measures, who might not get good advice, have difficulties. There's a fine line. You have to assume all buyers are sophisticated; if they're not when they start, by the time they get done, they will be.
Miske: Paul, from a legal perspective, if a year in advance you know a client intends to go to market, are there any actions you would advise that client to consider to get ready?
Plunkett: Jeff picked up on a lot of those strategies already and I would echo those, especially for building a team of advisers. Everyone's got an attorney and they specialize in different things. Some specialize in M&A transactions, but most out there don't do that. And you'd be surprised how many family-owned businesses just think their general lawyer that they've had for the last 25 years can handle this transaction. One thing I have noticed over the years is the sophistication and business acumen in buyers. Many owners think that once they have a signed LOI, they have their deal done. Not so. Over the last 10-plus years, with a sophisticated buyer, the LOI is just the starting point. Most particularly with the subsequent discussions and negotiations that take place over working capital. You think you have everything locked down and then you are forced to start negotiating add backs and adjustments for working capital. And without a doubt, those issues crater transactions. So, in addition to a good M&A attorney who can handle all of these unique situations, an owner should also think or consider about seeing or retaining an estate planning attorney, a financial planner and wealth experts to help them not only before the transaction, but, more importantly, afterwards.
Miske: Let's talk about timing. When is a good time for an owner or board of directors to begin considering a sale of their business?
Milkie: We always encourage owners to have a written liquidity plan in place. Whether they're going to sell in three months or five years, it's critical to have this to avoid costly mistakes. Talk to your wealth advisers about your cash needs and time horizon, talk to your investment banker about current market conditions and trends, and start putting together a strategy that can tie all this together. Then update this at least once or twice a year with your advisers so that you maximize value.
Miske: How early does an owner need to start thinking about an exit plan?
Behm: I think if you can plan a few years ahead and position the company properly you will get a higher valuation. On the other hand, if you're going to sell to private equity, build the management team. Get personal assets out of the company. Nobody wants your race car. Simple things like that are valuable. Sometimes there are big things, we still see real estate in businesses, and it always becomes a dispute. Pull your professionals together and discuss your goals. What's fun about this group right here today is that if a company walked in today, I bet we could create 20 percent more value just based on our experience and advice.
Miske: Does an owner need to hire an investment banker?
Behm: People do walk in and say, what do you do to earn your fee? My opinion is, every good investment banker will more than pay for themselves, based on creating value and getting a buyer to see that value.
Mahoney: When you think about an investment banker and the role they play, they act as a intermediary. A good investment banker will be active in preparing a sale, will create a market. If an owner is trying to create a market with multiple buyers, you cannot have enough time in the day to answer all of the due diligence aspects of the process. The investment banker is a shield where the sale is not impacting the operations of the business. From a lender's perspective, we always like to see professional representation.
Milkie: We typically have buyers say they're happy we're involved, even though they pay a higher price when we are. We professionalize the process, and we and the attorneys can have some of those difficult conversations with a buyer that a seller shouldn't necessarily have if they want to maintain a relationship with the buyer going forward.
Behm: I think investment bankers keep honest buyers honest. The buyer knows they'll need to pay a fair price.
Miske: Any thoughts about how you know if an investment banker is a good fit?
Milkie: Having a good rapport with your investment banker is critical — do you trust they will walk through walls for you and be your consigliere, like in the "Godfather" movies? Broad experience and the ability to be creative problem solvers is very important, too. Where were they trained? Can they run a disciplined process that creates competitive tension to drive value and deal terms? Can they handle difficult situations and keep the deal on track? Do they have the ability to manage multiple advisers and foresee potential issues? After a few meetings, most clients can get a strong sense of these things.
Behm: Experience is important, but I don't actually think it's the biggest consideration. Some depth is helpful, knowing you have a team, and frankly, I tell people make sure the personalities fit. Make sure you like that person because this gets to be a tense process. You get some people screaming and yelling, and everyone needs to walk away feeling good in the end. So, trust your gut. We're fortunate in this community that we have a lot of great investment banking firms, so it comes down to chemistry.
Miske: As a lender, investment banker, accountant or lawyer performing due diligence on a target on behalf of a buyer, what areas do you focus the most attention on? What areas do you view as the biggest risk?
Johnson: The buyer needs to test the financial models. The tax structure of the target company and the transaction needs to be reviewed. If there's real estate involved, you'll look at environmental issues. Sometimes there may be union involved so you have some labor issues to look at. All of these issues involve other professionals working with lawyers. When it gets to the pure legal work, it's more mundane; it's reviewing key customer contracts, supplier contracts, identifying if they're going to survive. There's permitting and litigation issues. But the big three that are most likely to turn a deal are tax, environmental and those financials.
Plunkett: Every deal or transaction comes with its own bag of tricks or surprises. Prospective sellers may have liens, lawsuits, judgments, employee or union problems, etc. A good M&A attorney can effectively handle or clean up these problems or issues and hopefully get the deal closed to the satisfaction of all of the parties.
Miske: Does a company need audited financial statements before the company goes to market?
Behm: We get that a lot, and the answer is not necessarily. Nowadays, if you have good numbers from a good accounting firm, that's usually enough. Also, quality of earnings are common today, so that's helpful.
Milkie: I agree. As long as they have good monthlies from a good CPA firm, it tends to be okay. It needs to tie throughout during the quality of earnings analysis though, so have your CPAs heavily involved.
Miske: From a lender's perspective, what should an owner expect during the due diligence process?
Mahoney: I think we've touched on some of them. The seller should expect there will be financial due diligence from a third party, quality of earnings most likely. They'll be testing what is a reliable cash flow number. There will be background checks, a review of the management team, review of contracts, industry analysis, customer analysis, and review of the company's systems and technology. Sellers should expect a very comprehensive due diligence process that will involve third parties and occupy company resources.
Miske: Representation and warranty insurance seems to be gaining wide acceptance for use in M&A deals. What are its pros and cons? Does it work for some deals and not others? Chuck, maybe you can start by explaining what representation and warranty insurance is.
Johnson: With rep and warranty insurance, the insurer is insuring the accuracy of the seller's representations and warranties in the purchase agreement. It can be useful for bridging the gap between buyer and seller. It's been around for 20 years, and we've been hearing a lot about it in the last five years. There are a lot of misconceptions about it: that it will complicate or slow the deal, that it's expensive, that there isn't clarity about how it works. However, I'm seeing rep and warranty insurance with more frequency and am beginning to think this is the new trend. The facts have to be conducive for it, though. There are different dynamics at play. The premiums are about 2 to 4 percent of the insurance coverage, and in the deals we've had, buyers or sellers were willing to pay that in order to have that kind of protection.
Miske: Switching to what can go wrong, for deals that fail to close after the letter of intent has been signed, and perhaps even after the purchase agreement has been signed, have you noticed any common causes as to why deals fall apart?
Johnson: I'd categorize them into two schools, one is diligence and the other is relationship. We've touched on it, but it's when the financials get tested. If the forecasts aren't realistic, that's often where a deal will fall apart. You might also see issues around taxes, environmental, maybe litigation, but those are all less frequent than pure finance. Maybe a key customer disappears. But even more than the diligence type of issues is the relationship between buyer and seller. During the course of negotiations, the parties find out they don't like each other. If the owner has to play a role going forward, and it's usually mutual, they walk away from the deal. After the purchase agreement is signed, it can be more complicated to terminate, but usually if the parties don't like each other they can find a way to kill the deal.
Behm: We play coach, confidant, therapist, and everyone seems to be feeling good, but something can surprise you. You can get to the very end, and someone comes back and says, "My kid wants to step into the business after all," or they find out they just can't leave, and it all blows up. You can do everything right, but you can't control the emotional side of deals. Every deal is different, and you have to go into each one with an eye toward what's unique and what you can add in terms of value.
See the full article on Minneapolis/St. Paul Business Journal website.