Is a Search Fund the Right Partner for your…

By EdgePoint

Sellers today have many options when it comes to finding the right type of partner to acquire or invest capital in their company. The number of strategic buyers seeking acquisitions, traditional private equity funds, family offices, and independent financial sponsors have increased the possibilities available to an owner wishing to transition a middle market business. But a less well-known buyer type – Search Funds – might be the best fit for certain sellers and their employees.

Owner Situations Favoring a Search Fund:

• Owner wants to retire or cut back after the transaction
• No succession CEO in the company/family
• Required industry-specific knowledge can be quickly obtained
• Company has low business risk

Conceived in the 1980’s and becoming increasingly common over the past decade, a search fund is a unique investment vehicle through which a group of investors, often with business backgrounds, financially support an entrepreneur’s efforts to search for, acquire, manage, and grow a privately held company.

The individual (or principal) of a search fund will typically seek to identify and acquire a single company in which he or she will assume an active day-to-day leadership role as CEO or President, once the acquisition is completed. Some sellers might prefer selling to an individual willing to take over their company, rather than selling to a competitor who might adversely impact employees or company culture. Search funds, by their nature, can help in instances where a lack of management depth might deter buyers who require experienced day-to-day management teams in place.

Some common characteristics of search funds include:

• Most search funds have a longer-term outlook than private equity funds that have shorter term requirements to return capital to fund investors. Search fund principals often choose to refinance out their initial equity investors and then stay with the company as a sole owner.
• Search funds typically prefer to target businesses or industries which seem insulated from technological change, have straightforward business models, or operate in fragmented geographical or product markets.
• The purchase prices of the company acquired by a search fund is typically from one or two million to $25 million.
• Search fund principals may come from diverse professional backgrounds including operations, sales, investment banking/finance, private equity, or general management careers.
• In a search fund, investors typically invest money in two stages: (1) to fund the search (i.e. to pay the entrepreneur a modest salary and cover administrative and deal-related expenses over a two- or three-year period while he or she searches for an acquisition) and (2) to fund the acquisition of a given company.
• Investors who contribute the initial search capital (often five to 20 institutional or wealthy individuals) typically have the right, but not obligation, to invest pro-rata in the equity required to consummate the acquisition. So, the certainty of close may be lower and the process slower than with a private equity or strategic buyer which has its equity in hand and more deal experience.
• Search funds may not offer the highest price and best terms in an auction process unless the company fits the search fund profile.

While search funds can offer certain sellers a good option in the sale process, finding and selecting the best groups to consider – and ultimately transact with – requires guidance from an M&A advisor. There are roughly 300 to 400 search funds in the United States. In our experience, it’s the search fund principal’s professional background, search history, investor base, lender support, and character that will ultimately determine the outcome of a deal.

The M&A market remains strong for a wide range of sellers. But like with most important decisions and processes, having another option to consider is a good thing.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com

The Art of Client Service Today

By Russ Warren,
Managing Director

The servant leader is as old as the Bible. But how is the art of service practiced in the 21^st Century?

An investment bank is a specialized client service firm, advising owners of middle-market businesses on the most important projects of their professional career, harvesting the work of a lifetime, or multiple lifetimes. Consistent with the definition of the word service, we perform our work to benefit our clients and promote their interests. To thrive, we must consistently provide better service than competitors.

It’s About the Client – Core Values

Integrity. At the heart of a true service firm is a “Client First” culture. Nothing is as important as earning the reputation of consistently and decisively putting the best interests of the client first.

Service begins with checking egos at the door, listening to develop a thorough understanding of what a business owner wants to accomplish and answering questions and any concerns about the process. It includes offering a realistic threshold value and tailored ideas on advantageous financial structures, using a company-specific, forward-looking financial model with appropriate input assumptions. It means leading a client to think about the future “unfettered”—in other words, what could this business be with the right resources? What would the owner want to do after the closing?

Agreeing on the objectives of a transaction enables the bank’s client service team to conduct a process well proven to flush out more premium offers with better price and terms and ‘clear the market’. The client maintains control of key decisions, but the client service team does all the heavy lifting.

Exceptional service requires frequent, friendly and above all clear communications to keep everyone on the same page—the owner, other advisors, and employees brought onto the Transition Team.

Service excels when the client service team treats each engagement as a long-term advisory relationship rather than as a one-time transaction. In return, future referrals flow from such service.

Client Service – What’s New

The core principles of client service have changed little over the years. Nonetheless, if teamed with today’s evolving business practices and underlying enabling technologies, business owners can expect a gratifying 21^st Century Client Experiencewhen they decide to transition their business.

Expertise and Talent: Leading investment banks are specializing to better serve clients in selected industry segments within the middle market by creating dedicated Industry Service Teams led by a Managing Director with deep experience. Doing so enables us to tell the Company’s story effectively and to efficiently find the best prospective buyers—strategic, private equity, and family offices. Frequently interacting with these important industry players means they take our calls and listen to why we believe the idea is compelling. Examples of Industry Teams are: Industrials, Distribution, Business Services, Food and Consumer, Healthcare and Energy.

Leveraging the Computer: Tailored Resources: Electronic search capabilities and customized database platforms have enabled the creation of powerful in-house and subscription databases, search tools, and unique management systems to track prospective buyers’ interests and manage follow-up actions. Until this breakthrough, many prospective buyers of companies with less than $100 million in revenues were challenging to identify efficiently and contact.

One product of these custom resources is a prioritized Bespoke Buyers List, stating why each buyer is likely to be interested. The client can delete any sensitive prospects before calls begin. As a result, fewer calls can be made to better prospects, reducing the elapsed time to closing with less unproductive exposure of client information.

Another way the internet has changed the art of client service is in powerful research for the Confidential Information Memorandum. Years ago, it took a research librarian a week to locate specific information if it could be found at all. Today, a skilled Associate can find information on the company’s competitors and markets in an afternoon to support marketing claims and financial projections.

Long Reach: Today, many middle-market companies operate in a global market sector, which means they could attract strong buyer interest outside the United States. Cross-border transactions have an additional layer of complexity but can add value for some clients. Premium service includes the ability, resources, and experience to source and negotiate with foreign buyers using local support when needed. Therefore, investment banks have formed international alliances, such as the Alliance of International Corporate Advisors (AICA), which two times a year brings together similar member firms from the Americas, Europe, the Middle East, and Asia. Members assist each other by identifying local counter-parties and dealing with those parties in the local language as needed.

Communications and Expectations: Responsiveness and clear communications are cornerstones of exceptional service. The U. S. Postal Service doesn’t get much business related to M&A transactions anymore, because there are ‘instantaneous’ options. A client has the right to expect an appropriate, timely response to developments throughout the process using texts (“Got your message, we are on it, and will talk with you tomorrow morning…”); phone calls for when two-way interaction is most effective; and emails that lay out in writing for future reference important matters and conclusions. Of course, electronic transmission speeds scanned documents like draft purchase agreements on their way for review. However, meetings can also be important at key stages of the process, like management presentations or walk-through the most interesting Indications of Interest.

Technology has changed everyone’s expectations of appropriate response time. Years ago, many negotiations were conducted by mail, with plenty of time to think and respond carefully. While we would not want to go back to the ‘good old days’, there are times in a negotiation when it is best to heed the reminder of psychologist Victor Frankel— “Between stimulus and response, there is a space. In that space is our power to choose our response.”

The Opaque Value of Middle Market Investment Banking Services: Many business owners have more difficulty deciphering the economic return from purchasing a service than from buying a physical asset like a machine tool, or even in fully understanding what the service entails and why they need it.

Shedding Light: In 2016, finance professor Michael McDonald at Fairfield University conducted an independent study on “The Value of Middle Market Investment Bankers.” Casting a wide ‘blind’ net, the study obtained empirical data and commentary from 85 owners who sold their businesses for between $10 million and $250 million between 2011 and 2016. From written comments, “the majority of business owners felt that investment bankers added value in the sale transaction… with 84% of respondents citing the final sale price as being equal or higher than the initial sale price estimate provided by the investment banker.” Ranking the importance of the elements comprising the bankers’ service, the respondents revealed experience at odds with popular beliefs. They learned that there is a lot more to selling a business than finding the buyer:

• Managing the M&A strategy and process (Most important)
• Structuring and negotiating the transaction
• Adding credibility to the seller
• Enabling management to focus on running the company
• Educating and coaching the owner
• Preparing the company for sale
• Identifying and finding the buyer (Least important)

Creative Fee Structures: For better alignment with some clients, investment banks can offer ‘gain-sharing’ fee agreements in which a lower percentage is earned up to the midpoint in a pre-agreed value range and a higher incentive fee is applied to the premium for win-win results.

WIIFM – What’s in It for Me?

Benefits to the client of these recent improvements in the art of client service today coupled with the core principle of Client-First Service can mean exceptional results for a middle market business owner:

• Highly incentivized client service team
• More premium offers
• Higher Certainty of Close
• Faster process to Closing
• Market clearance – highest price, best terms at closing date

By the way, the acquisition market for middle-market businesses is very strong as we go to press.

© Copyrighted by EdgePoint. Russ Warren can be reached at 216-342-5859, by email at rwarren@edgepoint.com or on the web at www.edgepoint.com

Quality of Earnings

By Matt Keefe,
Managing Director

Preparing your business for sale requires you to act and think like a buyer

It is standard practice for a buyer to conduct extensive financial due diligence of an acquisition target and an increasingly standard part of a buyer’s accounting diligence is a Quality of Earnings (“Q of E”). A Q of E is a report prepared by a third-party accounting firm that confirms that the stated financial results are accurate and as represented. The report is not as exhaustive as an audit and places more focus on the income statement than the balance sheet. The Q of E can also identify potential risks, accounting irregularities, working capital issues and even cost-saving synergies. A quick (and non-scientific) polling of the bankers at EdgePoint suggests that a Q of E has been a part of every buyer’s due diligence process over the last three years: a group that includes large strategic buyers with expansive accounting and finance departments.

For a seller, the Q of E conducted by the buyer poses several risks. First, the report can identify errors on the underlying financial statements that were used by the buyer to establish a target’s valuation. This situation almost always leads to a reduction in value. Second, a Q of E can slow down the closing process considerably, especially if the seller is not prepared to handle the volume of requests that accompany a Q of E. Slowdowns are never good for sellers. Momentum is key to getting to a successful closing so getting bogged down during the early part of a buyer’s due diligence process does not bode well for a positive outcome.

To combat the eventual buyer Q of E, more and more sellers are engaging their own Q of E’s prior to launching a sell-side process. A seller conducting a Q of E prior to the launch of their sell-side process receives several benefits:

1. Creates credibility for the seller. All the information that will be ultimately requested will already be identified, reviewed and organized in a data room. Being able to respond quickly to buyer information requests drives credibility and trust.
2. Provides buyers with validation of the revenue and EBITDA. Hiring a third-party accounting firm to conduct a Q of E greatly reduces the ability of a buyer to “re-trade” during due diligence as the numbers presented during the process will “stand-up” to scrutiny. Moreover, the Q of E focuses on the “add-backs” and provides a third-party validation of the adjustments.
3. Conforms non-GAAP financial reporting to GAAP (as most lenders and buyers require).
4. Sheds insight into potential risks or issues prior to a sell-side launch. The opportunity to pro-actively modify accounting practices or minimize risks prior to launch can yield a significant valuation increase for a seller.
5. Consolidates all entities into a single financial presentation. Consolidation can be a timely exercise and being able to provide the buyers’ accountants with a road map reduces the closing period.
6. Provides the advisors working on a seller’s behalf the ability to negotiate from “firm ground.” With little concern about financial results shifting during diligence, advisors can push to get optimal terms at the LOI stage.

The cost of a Q of E depends on the scope of the assignment, the status of the company’s financial reporting and the number of entities being consolidated. Although a Q of E can be a material cost to sellers, the expense is almost always offset in savings gained by reducing the closing period (estimated 1-2 months). Furthermore, a proactive Q of E provides greater likelihood of a successful closing.

The sophistication of buyers, advisors and lenders in the lower middle market continues to drive innovation in due diligence and processes. Many of these innovations are techniques typically associated with larger transactions. Due to the growing sophistication of buyers, sellers require equal sophistication to prepare their businesses for a successful sale process. That is why we are seeing sell-side Q of E’s becoming almost standard in today’s M&A environment and a key component of a seller’s preparation for market.

© Copyrighted by EdgePoint. Matt Keefe can be reached at 216-342-5863, by email at mkeefe@edgepoint.com or on the web at www.edgepoint.com