Let’s Source a Deal: Part I
By Robert Befidi, Jr. and Mark R. Sinatra
The evolution of a deal is often unpredictable, but savvy buyers can improve
their odds of success by taking steps to ensure optimal deal sourcing.
This statement holds even truer for buyers in the lower-middle market
where the sources for deal flow are fragmented based on geography, industry
and size. For a buyer new to lower-middle market acquisitions, sourcing
quality deal flow can be a time-consuming and daunting task.
So, how do you create high-quality deal flow on a consistent basis? A
successful strategy involves both identifying the likely sources for deal
flow and executing an efficient process for targeting these sources. At
the highest level, deal flow can be segmented into two broad areas: mainstream
and proprietary. There are various trade-offs associated with each area,
which is why the optimal strategy for most buyers is to actively target
both groups.
Part one of this two-part series on deal sourcing examines the deal flow
created from mainstream sources and a process that buyers should implement
when working with intermediaries.
Mainstream deals are defined as transactions which are actively represented
by business intermediaries, such as brokers and investment banks. These
intermediaries often represent the sellers and reach out to buyers, who
specialize in the sectors, geographic markets, or deal size that they
target. Although many intermediaries are focused on larger deals, a significant
number of smaller firms are interested in doing business with buyers that
invest in lower-middle market companies. The landscape of intermediaries
in the lower-middle market is incredibly fragmented and includes: full-service,
middle-market investment banks, boutique advisory groups, and business
brokers, who typically work on smaller (<$5MM in EV) deals.
Buyers should be aware that the marketing process for business intermediaries
has grown so efficient that most deals they represent are highly competitive,
with the intensity of competition being further fueled by an increase
in the amount of committed acquisition capital available for deals in
the lower-middle market. Often, in these deals intermediaries will employ
a full-blown auction or controlled auction, which may result in a higher
than anticipated valuation for the target company. According to a study
by Dinan and Company, auction deals may result in an increase of 1.5x – 2.5x
EBITDA in the purchase price, versus proprietary (i.e. non-represented)
deals. In addition, information flow is controlled by the intermediary,
which in some cases may unintentionally limit the transparency of information
critical to the buyer in analyzing the deal.
Despite these challenges, there are a few advantages worth noting. Buyers
can greatly increase their overall deal flow by sourcing deals from intermediaries,
due to their sheer number. Moreover, deals sponsored by intermediaries
are often screened to ensure that the seller is truly motivated to sell.
This consideration, if overlooked, often exposes buyers to the risk of
engaging in time and resource consuming transactions where a seemingly
motivated seller was truly only interested in testing the waters and getting
a free valuation of their business. Lastly, the time to close a mainstream
deal may be quicker than a proprietary deal, where more time will be spent
upfront qualifying the seller and compiling the necessary financial information.
Identifying the right intermediaries is just one important step in creating
mainstream deal flow. Experienced buyers are adept at employing an efficient
process to source and evaluate sponsored deals. A framework used by Gordian
Capital is the DCP Approach™ (Discipline, Credibility and Persistence).
Discipline
In a seller’s market, a compelling, affordable deal is hard to find. Buyers
can often get frustrated with the magnitude of valuations and competition
and, thus may be tempted to stray from their true deal criteria focus
(industry, size, geography, etc.). Clearly, this lack of discipline presents
a risk for buyers, who will either close on a deal that they do not have
a true competitive advantage in or pursue a transaction only to pull out
later in the process. Buyers should have the discipline to consistently
apply their criteria to investment opportunities and resist the temptation
to make exceptions.
Credibility
The past few years have seen an increasing number of financial buyers
in the lower- middle market. This trend highlights the need for financial
buyers to clearly articulate their differentiating factors when they converse
with intermediaries. Simply saying that one is a $200 million fund based
in New York will not create a material difference in the minds of intermediaries.
It is important for buyers to speak about their expertise in a certain
industry or geography, or highlight advantages that they provide to owners.
For example, at Gordian Capital, we like to articulate our value proposition
by stating that we are one of the most flexible liquidity solutions in
the marketplace, both in terms of owner transition period and deal structure.
In addition to value proposition, intermediaries also want to ensure that
buyers are truly motivated to acquire and can easily finance an acquisition.
For committed funds, this does not pose a problem, but for fundless sponsors,
pledge funds, and the likes, this is worth addressing directly with the
intermediary.
Persistence
Because of the increase in the number of buyers in today’s market, it
is important for buyers to reach out to intermediaries on a regular basis,
especially to inform them of portfolio acquisitions and other material
updates. It is also critical for buyers to be thorough in contacting intermediaries.
It is easy to wait for intermediaries to initiate a call, but this is
risky, particularly for new funds.
By targeting the right intermediaries and implementing the DCP Approach™,
buyers can significantly increase the quality and quantity of the deal
flow they receive from mainstream sources. However, buyers should carefully
weigh the pros and cons of this strategy, especially when compared to
proprietary deal flow, which we will analyze in our next newsletter.
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