• 113 01/12/2021

    In this post we will cover the M&A auction process from the buyside perspective by detailing a "standard" process for a private equity group. In any process the objective should be to win by the smallest margin possible. Every participant knows this in theory, but the gamesmanship and strategy involved in an M&A auction can make it difficult in practice (as the first video below will demonstrate). But before we dive into the strategy, let's first outline the process.

    The process is initiated by the investment banker. Per the image below, the investment banker will deliver a teaser to a list of all parties they believe might be interested in the opportunity. At this stage very little information is shared. If the teaser describes an investment opportunity that is even remotely interesting, the private equity firm is likely to execute the confidentiality agreement required to review more information.

    Once this document has been executed, the private equity firm will receive a confidential information memorandum. This document provides substantially greater detail, and if the contents confirm the private equity firm's interest, the next step is to start working towards the submission of an indication of interest (or first round bid if there is to be more than one bid). The image that follows organizes the timeline by the documents that are exchanged.

    M&A Auction Process

    In this process all potential buyers will be constantly evaluated by the investment banker and seller as they attempt to identify the most suitable buyer. All participants should keep this in mind at all times because this process can be stressful. Maintaining a cool, level-headed approach under any kind of emotional duress will reflect positively and it will potentially provide an advantage in the process.

    Unlike the purchase of public securities, acquiring an interest in a privately-held business is highly time consuming. Information is made available only to parties that demonstrate interest, and demonstrating interest requires due diligence. The more work that goes into any process, the greater the bias becomes to win the deal. A talented investment banker can and will use this to their advantage. This can be difficult to understand without an example, so we have included an anecdote describing precisely how this works in the video that follows.

     

    Being aware of the gamesmanship involved does not necessarily answer how best to engage in the process to avoid overbidding (to the degree possible). The ultimate objective in an auction is to work towards an understanding of what it takes to win the process. In an effort to uncover valuation in the current market, private equity firms will take the steps outlined in the video available below.

     

    The final video in this series addresses how private equity firms use the limited amount of information provided to bid. It also addresses how a private equity firm should respond if they arrive at the conclusion that the information provided is misleading.

     

    If the private equity firm's bid is accepted, they will be invited to submit a letter of intent (LOI). This is where scale starts to play more of a role in what is expected, largely because this entire timeline gets pulled forward as scale increases. In the lower-middle-market and core-middle-market of private equity much (definitions included below) due diligence will remain after the LOI has been submitted. On larger transactions there will generally be two rounds of bids before an LOI is submitted, with confirmatory due diligence taking place after the second bid. In the upper middle market and megafund category submitting the letter of intent is viewed as the end of due diligence. At this stage, the expectation is that all third-party work is complete, lenders are lined up and the investment committee has approved the transaction. In either case, and regardless of scale, executing the letter of intent brings the auction to a close. Then it is up to the private equity firm to close the transaction.

    Middle Market Private Equity

     

    This content is a highly summarized version of a more comprehensive lesson available as part of the Private Equity Training curriculum. Please click on the image below to learn more. 
     

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  • 112 12/31/2020

    In this post we are including a personal budget template and a "watch-me-build-it" tutorial video that explains how the template works. Please see the video below for more detail.

    This is an exercise I have worked through every year since I was 25 years old. At the time my father told me that as it relates to financial performance, he believed data tracked generally tended to improve over time. He was a lifetime investor (and absolute nerd :) that focused most of his career on private equity. In his opinion, the scrutiny applied to personal finances should mirror the scrutiny applied to a new investment. 

    So early in my career he encouraged me to create a balance sheet to track personal assets on a quarterly basis. It felt like a silly exercise because I only had a checking account and a savings account at the time, and building a spreadsheet with just two entries felt dumb. Fortunately, I recognized that he was much smarter than I was, so I went along with it.

    What I started to notice, however, was that the quarterly practice started to change my behavior. I wanted to show an increase in each quarter, which required a thorough understanding of my expenses. So I developed the personal budget template associated with this post to better understand where my cash was going. Awareness encouraged a more frugal mindset, and my savings as a % of my earnings started to increase.

    The change was simple. Instead of looking at cash as a resource to support my lifestyle, I started thinking about keeping the value of that cash on my balance sheet. If I received a large bonus, for example, I would weigh an increase in rent against the decision to purchase a condominium. The condominium, purchased at an attractive price, would cause my balance sheet to grow over time whereas an increase in rent would cause my balance sheet to shrink in each subsequent period (all other variables held constant). 

    This practice also gave me the confidence I required to leave my full-time position in private equity to pursue building ASimpleModel.com in 2020. And it is in that vein that I wanted to share this post. If you are contemplating a change in 2021, make it an informed decision. This template can be used to evaluate what is possible, or to simply identify potential savings should you want to improve your financial cushion.

    All the best in 2021!


    Post Script: Should you want to develop the Excel skill set demonstrated during the "formatting blitz" portion of the video, please visit the Excel for Models course.   

     

 



  • 111 12/23/2020

    Seasonality can have a drastic impact on the amount of working capital required to run a business, which is why it is frequently cited as one of the primary revenue-related challenges in negotiating the working capital adjustment in a private equity transaction (aka “the working capital peg”). To help give this concept some teeth, in this post we will use visuals to explore how seasonality impacts the liquidity required to maintain a business. 

    To emphasize this point, imagine that you have an opportunity to buy one of two businesses. In this hypothetical scenario, both companies generate $10 million of profit selling 1 million pool floats per year at a price of $30 dollars each. Financially, everything about these two businesses is identical apart from monthly sales volumes and the liquidity required to support these volumes. In other words, the primary discrepancy relates to seasonality.

    High Seasonality Example

    In the first example we will assume that the busines is located in Texas, and that all of the company’s customers are also located in Texas. Texas is notoriously hot during the summer months, so it would be practical to assume that the company’s sales ramp in anticipation of the heat and that sales peak sometime in summer (please see chart). 

    Working Capital High Seasonality

    The management team of this company, being fully aware of the company’s revenue cycle, significantly increases inventory purchases early in the year. By June of each year this company has all the inventory it will require for the summer season. During these summer months, sales increase, inventory is sold off and the company generates cash. 

    The challenge is that such a ramp in working capital requires cash to accommodate both inventory purchases in advance of sales and the delay of cash receipts from accounts receivable. In the image that follows the chart has been updated to include cash.

    Working Capital High Seasonality

    From the chart above it is obvious that the company made a profit selling pool floats because it has substantially more cash after the selling season, but what you will also notice is that the company nearly ran out of cash attempting to fund the growth of inventory and accounts receivable. Had sales spiked more abruptly, the $15 million cash balance that the company started the season with would have been insufficient. It is a little counterintuitive, but strong growth can bankrupt a company with positive net working capital.

    Low Seasonality Example 

    If you were to take the exact same annual sales but reduce the seasonality, the outcome is wildly different. It is in fact quite obvious from the chart that the amount of cash on the balance sheet is no longer necessary. In this new scenario, with the exact same number of units sold at precisely the same profit as before, cash does not drop below $11 million (please see chart). 

    Working Capital Low Seasonality

    To reiterate, in both scenarios the company makes $10 million of profit selling 1 million pool floats at an average price of $30 dollars each. But this “low seasonality” business, which clearly operates in a fantastic geography where people buy pool floats year-round, requires substantially less liquidity to achieve the same economic result. In fact, the highly seasonal business requires more than 3 times the amount of liquidity to make the same amount of profit!

    The best way I have found to communicate the value of this discrepancy to an entrepreneur or CEO is to ask them to imagine that they own the business in its entirety (some of them already do); and then explain that if they can find a way to reduce seasonality the difference in liquidity can be transferred from the company’s balance sheet to the owner’s bank account. 

    For more information on the working capital peg in a private equity transaction please see the course titled "Working Capital Adjustment Process" (Subscriber Content).

    Related Video: Introduction to the Working Capital Adjustment 

     

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Models are:
 
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

 

 


*Answers a, b, c, d, e, f and g are all correct.