November 30, 2017
So far, 2017 has consistently seen record highs in the US capital markets. This strong performance has been supported by several positive economic indicators, including high corporate earnings growth, slowly fading macro tensions and decreasing market volatility, with VIX close to near multi-year lows. These trends have resulted in an environment ripe for M&A activity.
Prime opportunities for private equity
Within this environment, private equity (PE) firms have been very successful in their fund raising activity. High-yield primary issuances continued at a strong pace in October, as $23 billion was priced across 39 deals. Credit spreads in the debt markets continue to narrow and decline (0.79% for a 5-year A-rated bond to 1.54% for a 10-year BBB-rated bond). This has made debt capital even more accessible and increased the appetite in high-yield debt, which is a common source of financing in PE-backed deals. All of this has resulted in more than half a trillion dollars of dry powder – money that has been raised but not yet deployed or invested – for PE firms.¹
Competition makes M&A difficult for PE firms
While this is an excellent market for M&A deals, it’s not that easy to bring one about due to high price tags, reduced return on equity and intense competition from corporate buyers. These buyers are flush with cash, have access to the same robust debt and equity capital markets, and can outbid on price due to potential synergies with the target.
As a result, we are seeing a shift in PE M&A activity from platform acquisitions (buying an entirely new business) to add-on acquisitions (existing portfolio company expanding its business through acquisitions).
Joint ventures are a good alternative
In an add-on acquisition, PE firms can be more competitive because they may also realize the benefit of synergies with the target. However, these add-on acquisitions increasingly require paying with greater synergies on expanding multiples. As sellers become more sophisticated, PE firms must become more creative. This is where joint ventures and other non-controlling structures can come into play.
Bridging the valuation gap
Gaps in valuation happen when a seller and buyer can’t agree on the value of a company. This often occurs from growth rates of the business, recurring revenue or value of the assets. An M&A deal might fall through due to a valuation gap, but a joint venture can be used to bridge that gap by giving the seller a minority interest.
Three tips to bridge the value gap
For PE firms considering a joint venture, we look to three areas:
● Keep the founders engaged: By offering a minority stake to company founders through a joint venture, PE firms can keep them more engaged and align the founder’s objectives with the PE firm’s goals around capturing value in the future. This also helps align the seller’s expectations at sale with a longer-term goal. It’s also possible to leverage the unique talents of a founder to discover new business opportunities after a sale.
● Look for synergies: In many cases, a corporate partner contributes a business which may provide the opportunity to achieve synergies with a particular target, while the PE firms often bring expertise with capturing those synergies. In a joint venture, the focus is generally on growth and capturing synergies through a roll-up of competing businesses, which means that both partners are critical to efficiently capture synergies and create value.
● Negotiate exits up front: In our experience, it is critical to have clear exit mechanisms built in up front, so both parties understand the ultimate objective. The more specificity around exit, the less likely that the partners will have a future disagreement and a drawn-out exit process. There are a number of standard exit mechanisms to consider. The most common structure involves providing one or both of the partners with Puts and Calls over the equity of the business. The pricing of these Puts and Calls, as well as who has the right to exercise over what time period, varies depending on the objectives of each partner. Negotiating the exit mechanisms is where the most time will likely be spent up front, and in many cases where the upfront value gap will be bridged.
As PE firms continue to deploy capital in a rich money supply environment, dealmakers will likely have to be creative to find a better path to capital and to ensure the desired return on investment. For more in-depth information, check out our recent paper, Joint ventures and strategic alliances: Examining the keys to success.
¹ Source: Bloomberg and S&P LCD