M&A Without Buying the Company

By Mike Myatt, Chief Strategy Officer, N2growth

Most people tend to look at acquisitions from a rather myopic and traditional M&A perspective: making a strategic or synergistic purchase of an operating entity on an accretive basis. However restricting your view of acquisitions to operating companies is like playing a football game with only one play in your playbook. The truth is that acquisitions aren’t just about buying companies, they’re about value creation. In the text that follows I’ll share 8 ways to acquire value without having to also buy the brain damage that comes along with purchasing the entire enterprise.  

Understand the Play
With the right perspective, combined with knowing where to look, acquisitions can be extremely profitable while not being all that complicated.  There’s an old saying that “one man’s garbage is another man’s treasure” and nowhere is this more applicable than in the world of acquisitions. Here’s the thing – the best acquisitions are made when the buyer sees value where the seller doesn’t. If your value-added acquisition targets can be found in things the seller has little interest in, there is a spectacular acquisition in the making. Want to see a transaction come together quickly? Allow someone to monetize on something they either view as an asset of little value, or better yet, something they view as a liability.

Acquiring Value Not Companies
I want you to think about acquisitions from this perspective – anything that has been well engineered or properly developed has also been heavily invested in. This often creates both tangible & intangible worth, even if someone else doesn’t currently recognize it or benefit from it. The simple truth is that it’s often much easier to acquire an asset than create one from scratch. This can occur because you’re leveraging the investments of time, money and efforts made by someone else who now doesn’t value them in the same fashion they once did. By stripping the target out as a stand alone asset you acquire the leverage of sunk investments which will often include significant good will, mindshare, marketshare and any number of other benefits in a much less complicated transaction. 

While the text above discusses acquisition from the buy-side perspective, the logic should not be lost upon potential sell-side players. Those companies that have developed assets that they no longer value, or companies who are maintain unwanted liabilities should look into a valuation and consider a possible divestiture of said assets and liabilities that don’t fit into the company’s operating strategy going forward (where it makes economic sense to do so).

The following list contains eight representative examples of acquisitions that can be made without having to purchase the entire enterprise: 

  1. Talent: It is not at all uncommon for a company to undervalue, under compensate, or otherwise take its people for granted. An “at risk” employee for the current employer is an opportunity for the prospective employer. Even when a company highly values its talent there is no assurance that said talent feels the same way about its employer. The right talent acquisition can have a rather substantial and immediate impact on things like revenue, culture, positioning, brand, etc. Smart employers are always on the lookout for great talent. They also go to great lengths to guard against the unnecessary loss of their own talent. There is also a great opportunity for adding talent leverage via outsourcing, crowdsourcing, and other contract opportunities that provide cost savings and scale.
  2. Intellectual Property: Whether it be formal IP such as patents, trademarks, copyrights, etc., or informal efforts produced via someone else’s R&D or innovation efforts, companies often start projects that they don’t finish. This can create an opportunity for the astute buyer. I have personally witnessed companies who have hundreds of pieces of intellectual property just sitting around collecting dust. I have also observed numerous transactions over the years that have been good for both buyer and seller. This occurred in instances where the seller was able to monetize on theoretical value, and the buyer was able to convert the acquired IP into real value.  
  3. Cash Flow: Many companies are in need of generating cash and simply cannot afford to wait for payments over time, and are therefore willing to sell contracts, notes, deeds, loans, leases, etc. In today’s market you can buy anything from a single note to an entire portfolio of debt (both performing and non-performing) at deep discounts. While this is not a market that everyone should dive into, there is substantial opportunity for exceptional returns for the right buyer.   
  4. Markets: Whether you purchase distribution, licensing, or other contractual rights, you can enter into market segments, verticals, or geographies via intelligent acquisitions. Often times these acquisitions can provide you some form of exclusivity or other form of competitive advantage.
  5. Customers: Some of the most interesting acquisitions I’ve been a part of have resulted in the purchase of customer contracts. A contract is a commodity that has both tangible and intangible value (for the right buyer). Contracts can often times be purchased, assigned or otherwise transferred. All companies have contracts they don’t value at the level they once did. Many companies face changes in circumstances that make it difficult for them to continue to fulfill on their contractual obligations. Other companies are in need of cash and are willing to sell certain contracts as a financing vehicle. In other circumstances, you’ll find business that you can fulfill better, faster, and more cost effectively than the current provider creating an opportunity for arbitrage or even subcontracting.
  6. Equipment: An unwanted piece of equipment owned by someone else can result in allowing you to enter a new market, increase your production capacity, or provide you the ability to win business from a potential customer whom you could not previously serve. Whether you purchase equipment directly from the owner, via auction, from a bank, receiver, trustee or other custodian, you can add significant value to your business through the intelligent purchase of equipment.
  7. Brands: Real brands have real value…in fact recent studies confirm what many of us have known for quite some time, which is that brand equity can become one of the largest assets on a companies balance sheet and ultimately lead to increased valuations. That said, many companies have made substantial investments into brands that no longer fit into their operating strategy, or that for other reasons they no longer value to the extent they once did. It’s much easier to enter a market, or expand marketshare by acquiring a brand than creating one from scratch. Just because the current brand owner doesn’t value their brand equity, doesn’t mean that you shouldn’t.
  8. Real Estate:  While there are certainly exceptions to every rule, we are in the midst of the worst global real estate market in recent history. Valuations are down worldwide, so if you’re looking to expand manufacturing or distribution facilities now is the right time to acquire real estate. If you want to expand sales operations, but don’t want to acquire a building, fantastic sub-lease opportunities are available in virtually every market at deep discounts. Many companies are upside-down in their real estate holdings and are looking for someone to stop the bleeding for them. Likewise, the special assets and real estate owned groups within banks and financial institutions have a dearth of property that they are trying to liquidate. It is not uncommon to be able to purchase a property for less than the face value of the current debt owed.  

Bottom line – you don’t have to buy an entire operating entity to incorporate an acquistions plan into your overarching business strategy. While the value of a component may not be as great as the overall value of the entity, this doesn’t mean that a component still doesn’t have significant value.


Capital vs. Influence

By Mike Myatt, Chief Strategy Officer, N2growth 

I have watched entrepreneurs and executives initially trivialize the value of influence in a capital transaction, only to regret it down the road. Savvy CEOs simply aren’t in a rush to close the deal and secure the funding if it means sacrificing knowledge, experience or influence. Impulsivity has a huge cost when it comes to capital formation. I have long held that the influence a capital partner brings to the table is significantly more valuable than their funding in the grand scheme of things. Since I’ve authored other posts on valuation, capital structure, negotiations, M&A, employment agreements, etc., in today’s post I’m going to focus on what you want out of an investment partner post closing. Hint: it’s not about the money. 

You did everything your were supposed to do; you developed a product, validated proof of concept, protected your intellectual property, did your due diligence on the investment community, put your offering memorandum together, banked a ton of frequent flyer miles on your road show, painstakingly negotiated valuation, closed the current round of financing, and gave up a few board seats. But now that the beauty contest is over, and you have a very real, and often demanding investment partner kibitzing from the cheap seats, what post-closing value are they really adding?

From my perspective I’d advise clients to give a bit on valuation, or live with more rigid financial engineering to acquire influence (gain access to markets, knowledge, intelligence, connections or superior business savvy). Let me take this thinking one step further…I simply wouldn’t recommend clients accept capital from investors who can’t wield influence on their behalf, and add significant non-financial value to their business model.

While most venture capital and private equity firms will tout the non-financial value adds they bring to the table pre-closing, the reality is that most of them simply don’t deliver post-closing. In fact, many investors simply don’t carry much clout, or add very little value once the deal is closed. What a sad commentary on the state of equity markets, since it’s the best way for an investor to manage the risk surrounding their investment. Astute investors mitigate risks and help to insure operational success by adding value to the business model, and by filling gaps that may exist in any of the areas I mentioned in the opening sentence of the preceding paragraph.

I recently keynoted at a leadership summit held by a venture capital firm, who in a brilliant move, brought together all their portfolio CEOs for two days of collaboration about what is, and is not working in this economy. I had assumed that this firm did this regularly, only to later find out that this was the inaugural event. I probed further to ask if they considered holding similar events for the CFOs, CIOs, CSOs, CTOs, CMOs, etc. of their portfolio companies. The answer was interesting: “wow, we hadn’t thought about that.” Following are just a few representative non-financial questions that I recommend my clients ask of potential investors:

  • What can you do for my company besides invest in it?
  • How many professional advisers and consultants do you have on retainer, or on staff that I can leverage for my firm?
  • Will I have unfettered access to other CXOs within your portfolio companies? 
  • What can you bring to the table that will expand my distribution, add velocity to my sales, increase my brand equity, open new markets, etc.?

The bottom line is this; I view one of the primary obligations of venture capital and private equity firms to be to drive collaboration and innovation across their portfolio companies. That being said, they also need to be actively engaged in catalyzing high impact sales, marketing, and business development activities with strategic and tactical partners outside the portfolio. The moral of this story is don’t get so hung-up on valuation that you fail to get the in the trenches expertise your company will need in future.


Growth by Partnering

By Mike Myatt, Chief Strategy Officer, N2growth

Growth By PartneringIf corporate growth is what you seek, but you lack the patience to endure the slow pace of organic growth, and don’t have the capital necessary to finance an acquisition binge, then you might want to consider the many benefits associated with partnering.  While the concept of creating a strategic partnership is familiar to many, the reality is that few companies take advantage of them. Let me offer the initial disclaimer that the subject of today’s post is a complex area that would require much more in depth coverage to do it justice. That said, in the text that follows I’ll provide an overview of the many reasons why partnering should be included as a key component of your corporate growth strategy…

Growth by acquisition in most cases constitutes a complex, capital intensive, and time consuming process. Furthermore the brain damage associated with an acquisition is just beginning when the deal closes. It is the difficulties associated with post acquisition integration that many companies often fail to consider. The merging of cultures, employees, technology, process etc., can cause what appears on paper to be the perfect acquisition to fall far short of expectations. Even in the case of an accretive acquisition, it can take far longer to reap the benefits than is often reflected in the initial projections.

Organic Growth
The predominant business risk associated with a reliance on pure organic growth is lost opportunity costs tied to a decrease in velocity of achieving business objectives. In most cases, organic growth simply means slow growth. Many executives and entrepreneurs let their concerns about the certainty of execution, or loss of control associated with transferring responsibility to a third party keep them from pursuing strategies that accelerate growth. This type of antiquated thinking puts companies at a severe competitive disadvantage. Moreover, these concerns should not be an issue with the proper selection, operating structure, and management of a partner.

Joint Ventures, strategic alliances, corporate partnering, licensing, royalty, revenue sharing, distribution agreements, and numerous other collaborative business arrangements provide an exceptional opportunity to catalyze growth. These types of ventures can rapidly meet corporate needs for key resources, generate more customers, attract capital, acquire needed expertise, expand product lines, open new markets, secure new facilities, access new distribution channels, increase production capacity, and offer a whole host of other additional benefits. The reality is that few organizations have everything they need, and the basic principle behind partnering is, no matter what the need, there is another entity somewhere that can fulfill any unmet need.

The obvious advantages to partnering as contrasted with either organic growth or growth by acquisition is the low financial and operational barriers to entry, combined with very rapid deployment capabilities. The need for speed is critical to evaluate when considering partnering as on option. Corporate partnering is very commonplace in industries experiencing rapid technology change. There is often a strong correlation between the rate and scope of change within a particular industry, and the amount of partnering that occurs within said industry.

Partnering is an extremely fluid and flexible business model. There is no preferred methodology to structure and organization as each relationship should be engineered based upon its own unique requirements. Sometimes corporate partners form a new jointly owned entity, while in other instances one partner may purchase an equity interest in the other partner. However by far the most common method of structuring and governing partnering relationships is by written contract. The presence of a governing document allows both parties to address such issues as non-competition and non-circumvention, use of brand guidelines, intellectual property considerations, performance requirements, indemnifications, and winding-up provisions among others.

As fond of partnering as I tend to be, it is certainly not without risk. Care needs to be given to the underlying motivations and business logic behind the implementation of partnering as a strategy to begin with. You must be careful not to create or strengthen a future competitor, or to become dependent upon a partner for mission critical initiatives. Businesses looking to co-venture need to exercise extreme diligence when selecting a partner as said partner will become an extension of your brand.

Despite the risks, or the form of partnering utilized, the business model has proven itself to be one of the preferred growth strategies of choice for companies desiring to maintain a competitive advantage.


My Philosophy on Valuations

By Mike Myatt, Chief Strategy Officer, N2growth

You better get this right...While my philosophy on valuations hasn’t changed in years, my feeling as to their importance has. Valuations are always a dicey proposition, but even more so given today’s business climate. I can’t think of a time in recent history where having third party validation for your valuation metrics has been more critical. Over the years I have particpated in the M&A process from virtually every angle possible. I have been a principal of a company being acquired, as well as a principal of a company conducting acquisitions. I have also served as an executive working on both acquisitions and dispositions teams, and as a professional advisor representing both the buy-side and the sell-side. Having sat on all sides of the acquisition table it has been my experience that regardless of approach, style, timing, culture, synergy, supply/demand drivers, or any other catalyzing factor, the transaction will eventually boil down to valuation metrics.

When I’m on the buy-side of the table I’m obviously looking to drive down valuations to make accretive purchases that provide a solid return on investment. Conversely, when I’m on the sell-side of the table I attempt to secure the highest valuation possible in order to maximize my return on equity. It is easy to see and to understand the divergent interests in play between buyer and seller. Thus when both the buy-side and sell-side parties are in alignment on valuation metrics and philosophy the transaction in play will have a certainty of execution that does not exist when there is either a philosophical gap or a large pricing delta between the bid and the ask. Regardless of which side of the table you sit on, the best way to close a gap in valuation is not by continuing to hammer on the financial metrics in a vacuum, but to rather use non-financial metrics to justify movement in valuation pricing.

While I have always placed a strong emphasis on valuation, I perhaps place an even greater emphasis on the quality of the employees, the client base, the product and service mix, the reputation of the business within the market place, the character of management and the integrity of the management process, current trends and future forecasts of the competitive landscape, brand equity, mind share, etc. Acquiring a large revenue stream that is also a poorly run organization simply results in a much “larger” headache. Simply put, building critical mass is not the same thing as building an excellent organization.

Unless you’re considering an acquisition based upon nothing more than intellectual property value or to exploit break-up value, strong consideration must be given to the recognition that there must be an excellent cultural and organizational “fit” in order for any acquisition to succeed. By “fit”, I simply mean a similar set of values and practices regarding the actual running of an ongoing business: business ethics, work styles, work ethic, a vision for the future, perpetuation objectives, leadership styles, and so on. It is the valuation of the non-financial metrics described in the last two paragraphs that should be the major influencing factors in your decisioning behind the justification of the final valuation.

Now that we’ve discussed the major influencing factors behind how to negotiate movement in valuation I want to give you an overview of what I believe is the “right” way to arrive at the “right” number to begin with. There is an abundance of available data on common industry rules of thumb concerning “multiples” that can be used to estimate the value of a business. However, while multiples may be useful in providing an immediate ballpark of a business’s value, they do not substitute for a more comprehensive valuation approach. Multiples are shortcuts to value based upon the simplification of more in-depth valuation methodologies.

The use of multiples as the primary valuation methodology is equivalent to the business plan that is written on the back of a napkin.  This is primarily true because no understanding of the data underlying the multiples has been performed, and thus neither the data integrity nor comparability with the subject business can be evaluated. Valuation multiples provide a rough guideline for the price of the average business in a particular industry, but often without due consideration given to the unique attributes of an individual business (geographic location(s), current competitive landscape, current economic environment, etc.).

I have always believed in providing open, honest, fair and full disclosure of how I value an organization. In order to insure that both buyer and seller model a transaction that is fair to all parties, and economically viable going forward, I developed a blended valuation approach that takes into account a variety of valuation methods that is weighted to the unique circumstances of a the particular business and the market timing of the transaction. I have successfully used this algorithmic valuation methodology to establish a fair price for a business. The following inputs are a representative sampling of some of the factors that we weight in our calculations:

  1. Pre-tax Cost of Debt (PD) is the Company’s marginal cost of borrowing long-term funds.
  2. After-tax Cost of Debt (AD) is the cost to the company of borrowing money after factoring in the benefits of the deductibility of interest.
  3. Risk-free Rate of Return (RF) is the return an investor would require at the present time to invest in a long-term security with essentially no risk. The closest indicator to a risk-free long-term investment is a 30-year U.S. Treasury bond.
  4. Equity Risk Premium (EP) is the historical premium that investors have required to invest in stocks over the returns that were available on risk-free treasury bonds at the time.
  5. Integration Analysis (IA) is the estimation of both hard and soft costs projected for post integration activity as well as any projected cost savings due to enhanced leverage or economies of scale attributed to operating activities.
  6. Beta (B) represents the volatility of an individual stock (as a result of the risk of the underlying business) relative to the volatility of the overall stock market. A beta of greater than 1.0 means the stock is more volatile than the market in general; less than 1.0 connotes a stock that fluctuates less than the overall market.
  7. Small-Company Premium (SCP) is the incremental return historically required by investors in small stocks over the return required to invest in the market overall, after considering the impact of beta.
  8. Company-Specific Premium (CSP) is the incremental return required on early stage companies and those with extraordinary risk characteristics over the premium required on equity securities in general.
  9. Growth (G) is the estimated growth in the cash flows that can be sustained in perpetuity. It is important to understand that this number must be small, i.e., 0% to 3%, because of the underlying assumption that this growth occurs forever. As an example, many companies claim that they can grow at a rate of 10% per year indefinitely. However, if a company with revenues of $25 million today grew at 10% annually for 40 years, it would have revenues of over $1 billion. Very few companies with current revenues of $25 million will ever become $1 billion companies.
  10. Capital Structure (CS) is the percentage of debt and equity that the company should operate with over time given the norms within its industry. This may differ from the existing capital structure of the company.
  11. The Weighted Average Cost of Capital (WACC) is a function of the capital structure in that it is the after-tax cost of debt times the percentage of equity in the capital structure.

At the end of the day it is a combination of financial and non-financial metrics that will determine the valuation (let’s not forget timing and positioning). Post valuation, and post acquisition, it is the solid operating skills and cohesiveness of management (or lack thereof) that will determine eventual success or failure of the acquisition.

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My advice: transactional motivations aside, have your business valued frequently (formally or informally) as a strategic planning tool. Few things will give you better indication as to the success of your business model than seeing how valuation is impacted.

Term Sheet Generator

By Mike Myatt, Chief Strategy Officer, N2growth

Only the good term sheets get signed...Term Sheets are a foundational element in justifying your valuation logic. Over the years I’ve had the opportunity to view some absolutely brilliant term sheets, and regrettably, I’ve also reviewed more than my fair share of laughable terms sheets. Guy Kawasaki turned me on to this term sheet generator tool provided by the law firm of Wilson, Sonsini, Goodrich & Rosati. While certainly not perfect, it produces something far better than most term sheets I see. However if you use the output of this tool as a baseline for further refinement and customization, you’ll have a term sheet rooted in logic and substance that can also tell your story in a uniquely branded fashion. If the term sheet generator doesn’t work for you, forget about suing as the use of the tool comes with a plethora of indemnifications and disclaimers…after all, it is produced by a law firm.

Blogging for M&A

By Mike Myatt, Chief Strategy Officer, N2growth

Blogging for M&AI think it’s fair to say that Blogging for M&A has arrived when two banks merging spawns a blog. I saw a tweet (code for twitter post) from Dan Schawbel about the new Wells Fargo – Wachovia Blog which is dedicated to topics directly related to the Wells Fargo / Wachovia merger, and I simply couldn’t resist the opportunity to applaud the efforts of Wells Fargo on this initiative. This is the first blog that I’ve seen focused on a merger, and I think it sets a brilliant example of a creative way to transactionally leverage the use of the blogosphere. In today’s post I’ll share my thoughts about blogging for M&A…

While many mergers and acquisitions don’t live up to the hype generated pre-closing, it is the post closing issues dealing with the integration of culture, business process, systems etc. that actually causes many M&A transactions to fail.  Put simply, unless you’re considering an acquisition based upon nothing more than intellectual property value or to exploit break-up value, strong consideration must be given to the recognition that there must be an excellent cultural and organizational “fit” in order for any acquisition to succeed. By “fit” I mean a similar set of values and practices regarding the actual running of an ongoing business: business ethics, work styles, work ethic, a vision for the future, perpetuation objectives, leadership styles, and so on.

I’ve often mused that any idiot can put together a deal, but it takes real leadership to keep the deal together over the long haul. The preceeding paragraph constitutes the soft-side of the M&A business that takes place once the investment bankers have left the table. When the transaction team passes the baton to the operating team is when the real work starts. So what does a blog have to do with this? Think about it…what I’m really talking about here is communication and expectation alignment. What better medium could there possibly be to facilitate this type of interaction than a well conceived blogging platform?

Bottom line…as a CEO Coach my hat’s off to Wells Fargo CEO John Stumpf for not only creating a tool to align expectations and disseminate important information to all stakeholders, but also for authoring the initial post on the blog. Job well done John…

The Next Collapse…

By Mike Myatt, Chief Strategy Officer, N2growth

The Next CollapseIt seems as if the more layers of the onion we peel back on the chaos in the capital markets the worse the news seems to be. I have long been a believer in the axiom “where there’s smoke, there’s fire,” and trust me when I tell you that the fire is far from being under control, much less extinguished. You see while most of the attention in the mainstream media has been focused on the debacle in the real estate and public markets, the next wave of failure is about to rear its ugly head. In today’s post I’ll share what I believe is the next segment of financial collapse set to rock the investment world…

Riddle me this…What conclusion should you draw from the simultaneous occurrence of a bear market, a recession, the virtual collapse of the investment banking industry as we know it, massive government bailouts, and the capital and credit crisis? The answer: Big trouble in the Private Equity markets.  News Flash…private investments are inexorably linked to public markets, and we’re on the brink of watching private equity firms suffer the same fate of their public counterparts. The problem is this…many private equity firms have yet to write down their investments and are still carrying them at book value, which can mean only one thing…they are significantly overvalued.

Think about it…private equity markets were perhaps even more frothy than the public markets the past few years. Massive amounts of deals were being done at very aggressive valuations that just won’t hold-up in today’s economy. Try this analysis on for size…take a random sampling of PE deals closed in 2005 and 2006 and look at their original valuations. Then revalue those some companies by marking them to current market conditions. The big sucking sound that follows is  the painful realization of equity erosion. Does this sound familiar?

The real shame is that the same short-term greed mongering that affected the public markets is about to rear it’s head on the private side of the table. Remember that PE investments are high risk investments, yet the big players in this market are institutional investors who simply got greedy and took on more risk than they should have. Again, does this sound familiar? It only gets worse…not only has the door been slammed on the public exit for many PE investments changing the landscape dramatically, but PE investors are likely going to be hit with big capital calls that can’t or won’t be met. This simply means a sell-off of PE investments at deep discounts is impending.

Even if you can’t connect the dots based upon recent adjustments in valuations in the real estate and public markets, just roll back the clock and revisit the evisceration of the paper wealth that occurred during the dot.com era when the bubble burst on frivolous valuations at that time. The moral of the story is this…don’t be at all surprised when the bottom falls out of the private equity markets…

Deal Transparency

By Mike Myatt, Chief Strategy Officer, N2growth

The Power of AuctionsIf deal transparency isn’t at the forefront of your M&A strategy, you might want to stop and do a bit of thinking. In some ways the world of corporate M&A is much the same as it was 20 years ago, and in other ways the events of the last few weeks have changed the landscape dramatically. The Bailout, the current capital and credit crunch, and the outcome of recent litigation have taken and already inefficient market and made it even more so. In today’s post I’ll share my observations as to what might be the single biggest trend that will influence how transactions will be closed in today’s changing marketplace…deal transparency.

Over the years I have participated in the M&A process from virtually every angle possible. I have been a principal of a company being acquired, as well as a principal of a company conducting acquisitions. I have also served as an executive working on both acquisitions and dispositions teams, and as a professional advisor representing both the buy-side and the sell-side. I’ve been around long enough to remember the days when proprietary transactions (deals that didn’t get shopped) were the norm. However with recent events, exclusive transactions will be all but dead unless you’re very comfortable painting a bulls-eye on your chest.

In a recent decision in Delaware, the court found independent directors of a target company personally liable for what the court called a breech of fiduciary obligations by holding a “passive” sale. If officers and directors on the sell-side cannot entertain exclusive deals without incurring personal risk, guess what…they won’t do it. Combine this with what will most certainly be an environment of increased regulatory oversight, and enhanced investor scrutiny, and you’ll quickly arrive at the same conclusion that I have…Most deals will have to become very transparent in order for the sell-side to be comfortable in moving forward.  

Moving forward it is my opinion that virtually all deals will get shopped (advantage sell-side). The environment today simply reflects a bias toward auctions when looking to sell or finance your firm. The spoils simply go to the highest bidder on a price basis, or the highest bidder on a value add basis, but in either case (preferably a combination of the two) it usually boils to the most aggressive bid winning the transaction. As an advisor who often represents the sell-side, I am particularly fond of this proliferating trend.

This frenzied world of deal auctions is a function of supply and demand, but as I mentioned above, it is also a function of fiduciary obligation in maximizing shareholder value. In fact, “Go-Shop” provisions are included in most of today’s agreements with potential suitors. “Stand-Still” provisions are becoming a thing of the past as they set-up the seller for third party allegations that the seller failed to fulfill their fiduciary responsibilities by agreeing to sell the company at a “low-ball’ price, and/or by signing off on measures designed to dissuade competing bidders. The offset for buyers to induce them into agreeing to a go-shop provision is the inclusion of a provision to pay a break-up fee should the seller unwind the deal due to a better competing offer.

Let me point out that savvy sellers know the difference between cattle-calls or shot-gunning a deal vs. inviting a small group of the right buyers to the table in a controlled bid process. The fastest way to taint your deal in the market is to not be discerning or discriminating in selecting who should be invited to participate in your transaction. Sellers that fail to recognize the subtlety of what I’m describing in this paragraph will soon find themselves receiving a very costly education from the buy-side when few if any suitors express an interest in your deal.

As I mentioned above, pricing is only part of the deal. Since I discussed non-financial value adds in a previous post entitled “Capital vs. Influence” I won’t go into a deep discussion here other than to state that sophisticated sellers look for more than just price when selecting their buyer.

The most critical factor in running your transaction is the selection of the right sell-side advisor. Your advisor should be able to guide you in defining your benchmark valuation metrics, understanding your negotiating leverage points, helping you prepare your offering documents, advising you on which buyers to solicit, how to manage the deal auction, and ultimately how to close the deal with the right partner at the right price.

Bottom line…The auction environment, properly managed by the right advisor can be your best friend by proving transparency and maximizing valuation. Conversely, attempting to auction your company for sale with the wrong advisor will end-up in massive amounts of unnecessary brain damage being incurred, and an increased risk profile. Good Luck and Good Selling….

Due Diligence – Not Optional…

By Mike Myatt, Chief Strategy Officer, N2growth

It pays to do your homeworkAs much as you wish it might be so, due diligence is really not an optional consideration. Have you ever made a decision based upon what you thought was a thorough understanding of all pertinent information only to find out after the fact that you didn’t know as much as you thought you did? It’s not much fun to find yourself on the wrong side of the information gap…Incorrect data, omissions, information that is biased or skewed, misrepresentations, misunderstandings, or any number of other scenarios that lead to the creation of information gaps can be very costly in today’s business environment. In today’s post I’ll discuss the critical nature due diligence…

Quality information enables good decisioning. While at face value this would appear to be a rational statement, the problem lies in the fact that it is also a relative statement…Over the years I’ve witnessed business people that make critical decisions based on nothing more than gut feel or instinct. I’ve observed others that rely on the use of detailed internal checklists and/or processes to validate their assessments, and I’ve known others who won’t make a critical decision unless they hire third party professionals to conduct due diligence on their behalf. Regardless of your method (or lack thereof) managing information and decisioning risk has never been more important than it is today.

With the constant pressure to compress transaction timeframes in an effort to remain competitive, many firms are actually doing less due diligence on larger transactions involving more potential risk…While this may sound ridiculous, the sad truth is that it is a scenario which is all too common. Hedge funds, venture capital and private equity firms, asset managers, investment banks, or corporations involved in anything from early stage investments to real estate transactions to mergers and acquisitions have intense pressure to get deals closed quickly in a market that has never been more complex to navigate. 

While you by no means should ignore due diligence, you also cannot allow yourself to fall prey to being paralyzed by analysis paralysis. To balance the main topic of this post with the transactional realities present in today’s market you should also read a previous post entitled “Timing Is Everything.”  

Let’s put aside the obvious reason for thorough due diligence (making a good deal), firms that don’t have rock solid due diligence capabilities may find themselves in arbitration, litigation or under the scrutiny of regulators as a result of poor decisions. Public companies dealing with Sarbanes-Oxley should be terrified of not crossing every “t” and dotting every “i”…

Bottom line…No amount of due diligence can protect you against flawed decisions or a bad deal, but if a thorough due diligence effort can manage or transfer risk in the majority of situations it is well worth the time, effort and cost to do it properly. If you short cut the process you’ll likely find yourself being held accountable for that decision someday…

Public vs. Private

By Mike Myatt, Chief Strategy Officer, N2growth

Public vs. Private Public vs. Private finance…The question is, which option is better, and why? Entrepreneurs, investors, and advisors have very strong opinions as to whether you’re better-off with private equity or an IPO when seeking to finance, sell, or otherwise seek investment capital for your company. In today’s post I’ll share some recently released information which may help you make the right decision…

If you are successful in your entrepreneurial endeavors, you will someday likely find yourself at a crossroads where you attempt to cut through the ambiguity of public sentiment and conflicting opinions and find the answer to the age-old finance debate of public vs. private equity. The good news is that the results of a recent study by Ernst & Young concluded that businesses who received capital from investment firms substantially outperformed those who companies who received capital from the public markets.

The E&Y report which derived its conclusions from studying the trackrecord of the global buyout industry’s 100 largest exits last year found that the enterprise value of companies funded by private equity was twice that of publicly-held companies. Moreover, the report found that the EBITDA of companies who received private equity investments increased by more than 30% over that of their public company counterparts. Another meaningful difference between companies who received private equity was that the primary driver of value creation came via organic growth initiatives, whereas the public companies most often had an acquisition based model as there primary value creation driver.

In a previous post entitled “Capital vs. Influence” I made the case for seeking value added investment partners. The E&Y report seems to support my conclusions. The simple truth is that private equity investors stay engaged post funding, and add ongoing value to the enterprise. Contrast this with the IPO process which is a long, costly, and heavily regulated endeavor where the value add of your investment banking relationship laregly disappears once your offering has hit the market.

Let me pose one final queston…when determing the future of your company do you really want to hand it over to the regulatory and compliance ridden world of public finance, where your destiny is largely placed in the hands of analysts who assess whether your short-term performance is in alignment with Street expectations? From my perspective I would choose to seek capital from a world that focuses on the creation of long-term value through an engaged and proactive process that adds value beyond just the original investment.

Secondary Markets 101

By Mike Myatt, Chief Strategy Officer, N2growth

With the meltdown in credit markets over the past several weeks I thought it may be insightful to look beyond the typical cries of mutual greed on the part of lenders and borrowers alike to some of the lesser known underpinnings associated with this debacle. I’m not disputing for a second that many lenders have pushed the razor’s edge with aggressive, perhaps even in some cases predatory lending, and that many borrowers were (and still are) all too willing to accept potentially disastrous loan terms in an attempt to create a short-cut in the wealth building process. However my suspicion is that most of you reading this post don’t have clear visibility to the fact that there is a third head to the greed monster which I’ll reveal in today’s post…

The sad reality is that mercenary investors and rating agencies (their co-conspirators) will always be willing to make a market and arbitrage the greed factor exhibited by lenders and borrowers. As I mentioned above, it is really only the lender and borrower sides of the three headed greed monster that make it into the mainstream media, and as such constitute the public veneer on what is actually a much deeper trough of gluttony. Those reading this post not familiar with capital markets need to be aware of the behind the scenes conflict of interests and greed mongering that takes place in the form of the roles played by investors and rating agencies in order to have the third head revealed and possess a full picture of what caused this most recent meltdown.

The three primary global rating agencies are Standard and Poors, Moody’s and Fitch Ratings. These three rating agencies and a hand full of lesser known agencies (A.M. Best, Baycorp, Dominion, UK Data, etc.) assign credit ratings for issuers of debt obligations which allow them to be placed into securitized pools and sold into secondary markets transferring the balance sheet risk from the original lender to the institution purchasing the structured credit product in the form of an asset backed security.

In order to further explain and expand on the above paragraph let’s start with a bit of history…If we roll back the clock we can easily point to a time when loans were underwritten by the institution that was going administer and service the debt for the life of the loan, which means that all risk associated with loan performance was born 100% by the institution that originated the debt. You see all lenders were once upon a time portfolio lenders holding all credit obligations on their own balance sheet. This meant that lenders tended to be more conservative in their underwriting guidelines because it was them, and only them, that stood to suffer in the event of a default.

Okay, so you may be asking what do investors and credit agencies have to do risky loans? The answer is virtually everything. In today’s era of modern lending which came on the scenes in the late 1970’s and early 1980’s, and whose proliferation has only gained momentum since then lending practices have shifted focus from portfolio lending to off-balance sheet loans, the main profit center in lending has shifted from the retail side of the table to the wholesale side. In today’s market loans are rarely structured to be held on balance sheet by lenders. As opposed to the old-school lending practices described above, most lenders now sell a majority of their debt to third party investors. By creating a secondary market for lenders to sell into, they are able to improve liquidity, increase loan production, and transfer risk. It all sounds quite reasonable on the surface doesn’t it?

The problem in my opinion begins when lenders begin to underwrite to a different standard (aided by the rating agencies) with the sole intention of moving their loans off balance sheet. You see when lenders sell their loans into secondary markets they are transferring default risk by selling the future value income stream for net present value fees. When this process of transferring risk to investors in exchange for a fee occurs, lenders are really no longer lenders, but in fact become little more than brokers as they have no long-term qualitative incentive inherent in their lending practice. When a chief credit officer becomes a chief investment officer the emphasis is clearly on making markets not quality underwriting. 

The bottom line is that loans don’t stand on their own merit today. Rather they are propped-up by a broad array of financially engineered synthetic derivatives and credit enhancement techniques which should never substitute for sound underwriting. Artificial market making run amuck for fee generation does have the impact of boosting short-term revenue and profit. This is all well and good until the tires come off due to poor underwriting standards. The plot has only thickened of late as the Federal Reserve seems to have expanded its domain from fiscal oversight to financing private M&A transactions, and underwriting and making markets in the purchase of the very asset backed securities that started this problem to begin with…

If there is a bright side to this debacle it is that this most recent shake-up is really nothing new as we experienced something similar during the last credit downturn…does anyone remember the Resolution Trust Corp? As memories have faded, financial engineering has evolved, and the role of rating agencies has not been properly governed, the problem we experienced in the 1980’s has just remanifested itself on a grander scale and on a global stage. A major difference between underwriting debt for a securitized mortgage pool and underwriting a loan to be held in the lender’s own portfolio is that, in the former case, the emphasis is on cash flow whereas in the latter case the emphasis is more on value. The reason for this is that the capital markets require above all certainty of cash flow to service securitized debt. The failure to pay debt service on time will immediately impact the value of the securities in the secondary market, causing loss to investors selling prior to maturity (i.e. the recent collapse of Bear Stearns). By contrast, traditional balance sheet lenders normally do not continually adjust the values of their portfolio loans but rely on their initial underwriting to assure the loan will be repaid either by the borrower or through a foreclosure.

From the retail borrower’s perspective, along with securitized lending comes a total lack of accountability in mortgage servicing. Because the originating lender no longer services the loan post-closing, borrowers are now forced to navigate a complex world of master servicers, sub servicers, and special servicers when they have an issue with their loan. Borrower’s facing a challenge often cannot even determine who it is that they should contact about their loan. Making matters only worse is the fact that many of these agencies won’t even speak to a borrower unless the loan is in default.  

So what’s the answer? It all begins with regulating the rating agencies. I’m clearly not against the many intended benefits that secondary markets afford which have been described above, but I vehemently oppose the manner in which these markets are governed. I made earlier mention of rating agencies being co-conspirators with lenders, and until the rating agencies become something more than a codefied self-regualtion scheme then problems will continue to exist. A great first step in this process was the Rating Reform Act of 2006 signed into law by President Bush, however the operative phrase here is “first step”.

Until the rating agencies set underwriting guidelines based upon managing default risk and prevention of predatory lending, as opposed to participating in a pay to play environment bent on maximizing value, we are going to continue to run into problems. Moreover don’t think that this problem only exists in the sub-prime lending market. We are quite likely to see further proliferation of the credit crisis as these same problems spill over into traditional mortgage, commercial mortgage, and business lending arenas. Our capital markets are very fluid and very sophisticated, but they are nontheless very scary as a result of flawed logic, a lack of accountability, and a system that places profit incentive above sound risk management. Get prepared for the meltdown ahead…

Mid-Market Capital Opportunity

By Mike Myatt, Chief Strategy Officer, N2growth

Today’s post will focus on the analysis of mid-market capital providers, which I believe provide the most significant opportunity for companies seeking funding in today’s tight credit markets. If on one end of the spectrum you’ve recently been given the cold shoulder by a bulge bracket lender, or at the other end of the spectrum been rebuffed by a smaller financial player, you’re not alone. In the text that follows I’ll lead you to the pot of gold at the end of the rainbow…the mid-market capital providers.

The tightening of lending and investment guidelines all but have the smallest and largest capital providers sitting on the sidelines engaging on only the most coveted opportunities. In today’s market small banks are hesitant to even come close to brushing up against loan-to-one restrictions, or maximum legal lending limits. At the same time, bulge bracket players (the largest 10 investment banks – Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, and UBS) are largely still licking their wounds. With only the rarest of exceptions both ends of the capital markets are closed for new business.

This presents a veritable land grab scenario for the mid-market players who are not bashful about exploiting the opportunity afforded them by the absence of their smaller and larger competitors. The simple reality is that it is much easier to get a $50MM or $100MM deal done than it is to swim upstream with a $5BB dollar transaction or to swim downstream with a $5MM dollar play. In addition to mid-market firms being well capitalized, they are also stealing talent from the larger I-banks who have recently made tremendous cut-backs in staff. It is my opinion that what your seeing in the capital markets represents the perfect storm for companies whose capital needs sink up with mid-market underwriting guidelines.

Regardless of what level of the capital stack your looking to fund, focus your efforts on the mid-market investment banks, regional banks, private equity firms, hedge funds, and foreign banks. Who knows…maybe you can even attract a bulge bracket player who is slumming and wouldn’t ordinarily otherwise consider a smaller play but for current market conditions. Happy hunting…

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