June 13, 2017
When it comes to selling off businesses, competition among buyers remains fierce. With a greater number of private equity (PE) and cash-rich corporate business development groups bidding for the same assets, prices continue to rise. Furthermore, depending on the nature of the transaction, corporate buyers often have greater synergies with target organizations–due to such factors as consolidation opportunities or product adjacencies — which allows them to pay a greater premium and crowd out private equity. This requires financial investors to think more creatively.
Operationally focused financial investors have allies in activist shareholders, who have never been more prominent in their efforts to derive value from their public investments. Activist investors are pressuring corporate boards to reexamine portfolios–to strengthen and grow those businesses with the greatest promise and divest those that are either underperforming or are poorly aligned with the company’s overall strategy. Herein lies a significant opportunity for operationally financial investors.
An alternative to engaging in a bidding war for divested assets is entering into a joint venture or equity partnership. We are seeing an uptick in these nontraditional funding approaches, and they generally take two forms. In the first scenario, the PE firm buys a business but allows the seller to retain an equity stake and stay involved in running it and participate in future upside–a strategy known as a staged divestiture or acquisition. In the second situation, the PE firm teams up with a different corporate partner to buy a standalone business. In some ways, these arrangements present the best of both worlds – the corporate partner can bring certain synergies and industry knowledge, while the PE firm can offer deep financial pockets, functional expertise (for example, the ability to streamline back office operations), and a longer-term focus in the absence of pressure to meet quarterly earnings targets.
Nevertheless, these deals are not without challenges, primarily arising from the differing objectives and approaches of PE firms versus corporates. The challenges we see most often relate to establishing the investments, duration of the investment, and exit of the investment. When a PE firm is injecting capital through equity and/or debt, it often wants control, and this leads to deconsolidation of the entity for the corporate partner. As a result, the corporate partner may have concerns about both the assets and the people it has contributed to the joint venture—since it no longer controls them–as well as potential reputational risk.
Another significant issue in establishing the joint venture is the cost of services that continue to be provided by the corporate organization. These costs, which were previously shared across the entire enterprise, may now be deemed too expensive by the PE firm, which may prefer to build such services as IT, HR, and accounting itself, using a more streamlined approach. This can improve the joint venture’s profitability, but it can also strand large costs at the corporate parent if the joint venture does not use its shared services, because the company can no longer allocate costs across as large a base.
With respect to the partnership’s duration, the PE firm receives capital from outside parties and ultimately may have to return capital—generally within six to 10 years. As a result, the PE firm has to consider how to return not only a profit but also the original investment. Depending on the industry, this can be a barrier for the corporate partner, as it may want a longer-term joint venture. This is one reason why carefully planning the exit from the partnership is so critical. Both parties need to agree on the best exit strategy — whether this will be through a repurchase mechanism by the parent, a sale to a third party (another corporate or PE firm), or a public offering.
Although there are challenges to overcome, we’re finding that PE/corporate partnerships can generate significant value by leveraging the strengths of both parties–industry expertise and synergies on the corporate side and financial resources, functional know-how, and economies of scale on the PE side. In fact, with foresight and proper planning, these types of arrangements may well provide a solution that even an activist investor can love.
For more information contact:
Howard Friedman, PwC Deals Partner
Scott Cohen, PwC Deals Director