Reflections on 40 Years in Middle Market Mergers & Acquisitions – Part 1 of 3
By Russ Warren,
Life sneaks up on you when you’re not looking. It’s called experience.
When you reflect on how it was years ago, it is clear how much the world of middle market M&A has changed – for business owners and advisors. The art of the smaller deal as we know it is quite young.
No one should want to go back to ‘the good old days’.
The Way It Was – In 1976, the market for businesses with revenues between, say, $10 million and $100 million was inefficient and very thin. Such businesses were truly illiquid assets.
Pricing of a profitable, low-growth manufacturing business, for example, was likely to be less than net book value on the balance sheet. Terms usually included a large measure of seller financing as notes or an earn-out.
An owner had the rather stark choice of selling to someone with ‘no money’ and financing the transaction himself, or possibly being acquired by a competitor likely to erase the company’s identity.
Advisors facilitating a sale of a small business then were mostly lawyers, CPAs and business brokers. In the 1970s, several of the Big Eight accounting firms (now Final Four?) began to introduce clients who wanted to buy to clients who wanted to sell, but there was dynamic tension between the Independence principle and entrepreneurial investment banking practices, such as contingent fees and client advocacy.
Private Equity Is Born – In the 1970s, Nick Wallner, PhD, an entrepreneur who acquired a small business using a debt-based technique borrowed from the commercial real estate industry, published a thick soft cover tome with the catchy title How To Do A Leveraged Buyout or Acquisition. The Leveraged Buy Out, or LBO, was born and the world changed. I spoke on LBOs in London in 1980, and the audience was largely barristers and chartered accountants eager to understand the new transaction they had heard about – revamping the right hand side of the balance sheet from mostly equity to mostly debt. The hot topic earned our seminar a mention in The Financial Times.
The underlying theory is that Investment Risk (of the private equity firm) equals Business Risk (the stability of the operating company) plus Financing Risk (debt). The more consistent the operating company’s cash flows, the more debt the investment can handle, and vice versa.
With the low pricing parameters mentioned above and ample assets as collateral, a buyer needed very little equity (maybe 5% of the purchase price) to finance an acquisition. The operating plan after closing was simply to use the company’s cash flows to pay down debt, selling in five years in another LBO.
Soon entrepreneurial buyers began to seek suitable ‘boring’ businesses and, if needed, pass the hat to their friends, deal by deal, to provide the needed equity. Voila! The owner could receive cash at closing and the business remained independent.
Private equity was not a glamorous business in its early days. I remember meeting with the pioneer firm Kohlberg Kravis Roberts & Co. in its mid-town Manhattan offices, which were definitely underwhelming. They had raised a first fund of $31 million in 1977 to fund a number of smallish acquisitions. But soon, KKR left the middle market for loftier transactions, and in 2000 acquired RJR Nabisco, as chronicled in Barbarians at the Gate.
With competition, of course, valuation multiples for suitable businesses began to rise, and private equity firms had to hone a distinctive strategy to find a competitive edge. Many began to differentiate themselves. For example, Wingate partners sought ‘buy and fix’ situations, and other financiers began to work with experienced operating executives having deep operating experience in niche target markets. Riverside opened offices on four continents to help portfolio companies, and add foreign companies to their portfolio. The concept of bringing more to the table than money was born of necessity.
Another result of rising prices was the need to grow the business, organically or by add-on acquisitions, to achieve higher earnings and a possible multiple expansion, to hit target investor returns.
Private equity firms’ interest in diverse targets, and more financing options, meant that other types of businesses, like distribution, transportation and services, saw a wider range of financial suitors.
Recently, with interest rates on fixed income investments at historic lows and stock market multiples sometimes frothy, family offices have added direct acquisitions of private companies to their portfolio mix, to boost overall returns. Usually, they buy and hold a business, making them an attractive alternative in the eyes of many company owners concerned about a ‘quick flip’ by a private equity firm.
A Place For Mezzanine Financing – As richer acquisition multiples became commonplace, the need increased for nuanced financing structures to make acquirers’ financial return models work.
Banks’ willingness to lend senior debt (least costly financing) into a “highly leveraged transaction” (as defined by the Comptroller of the Currency, The Federal Reserve Bank and the FDIC) is limited by concerns of a recession, rising interest rates, a company’s track record and regulatory pressures.
Accordingly, in the 1980s insurance companies, savings and loan associations and eventually limited partnerships formed available pools of risk capital, such as subordinated notes and preferred stock, with characteristics straddling debt and equity. ‘Mezz’, as it is affectionately called, is midway between senior debt and equity in cost and rights.
Mezzanine lenders earn their returns as a combination of cash interest (fixed or floating with a base rate), PIK interest (accrued but not paid until repayment is due) and ownership rights (e.g. attached warrants).
The ESOP Evangelist – Louis Kelso, a visionary economist and merchant banker (Kelso & Company) who thought everyone should own a piece of the action, invented the Employee Stock Ownership Plan, a unique device for selling a company to all or most of its employees. Kelso created the ESOP in 1956 to enable the employees of Peninsula Newspapers, a closely held newspaper chain in the State of Washington, to buy out its retiring owners.
For years, Kelso worked with Senate Finance Committee Chairman Russell Long, to build into the 1974 ERISA legislation generous tax advantages for both the ESOP company and the owner who sold to an ESOP.
Sometimes misused (as in a failing steel company), the ESOP used as intended has created many millionaires on the factory floor and at steel desks. The tax carrot appeals to tax-adverse owners, and drives the use of this technique even today. I knew and presented a series of seminars with the impassioned Louis Kelso. It was a near-religious experience.
But Wait – There’s More – Reflections will continue in the next two issues of the EdgePoint Newsletter.
(Read: Part 2)
The Author’s Journey: It can be helpful when reading someone’s perspective to understand his or her professional experience. Here is mine.
With an engineering degree, a fresh MBA and a stint as Private in the U. S. Army (a reality check if there ever was one), I settled in at Ernst (before Young), auditing a rainbow of mostly mid-size companies and learning about businesses and industries from the inside out. In the mid-1970s, I joined the firm’s nascent merger and acquisition practice when the M&A market was robust and we were still figuring out where and how to play. Eventually, I led U. S. Merger and Acquisition Services for 10 years.
It was stimulating and educational, with client engagements from Hollywood, CA (for Sammy Davis Jr.) to Jamestown, NY (selling a Tier 1 supplier to Chrysler and Volvo). There was a lot of international travel. A capstone engagement (and digression) for me was an on-site study of how to improve venture capital access in Indonesia, Thailand, Malaysia, Pakistan and Sri Lanka, conducted for the Asian Development Bank, a large non-governmental organization. Results included funding for three start-up venture capital firms and the passage of recommended legislation by Thailand.
Months later, Ernst & Whinney moved its headquarters to New York, and I founded The TransAction Group, a boutique M&A firm serving middle market businesses. With a former Ernst colleague, we ran and grew the firm. We closed 75 transactions, nineteen of them cross-border. In 2008, we sold to EdgePoint, a dynamic young firm with shared values and the same mission: to bring top quality professional M&A services to owners of smaller businesses. I was happy to trade my former administrative duties for the role of Managing Director, developing business and serving clients.