Why You Need to Understand the Differences Between Strategic Buyers and Private Equity Buyers

We frequently get asked by entrepreneurs who are looking to sell their companies whether they should sell to a strategic buyer or a financial sponsor. This question often leads to confusion about what the terms “strategic buyer” and “financial buyer” mean and what a transaction with each might look like.

The purpose of this article will be to:

• Describe the various types of financial sponsors and strategic acquirers;
• Discuss the rationale for acquisitions made by each of those parties;
• Describe what typical acquisitions by these parties look like; and
• Discuss how a seller should determine which type of transaction they should pursue.

Types of Financial Sponsors

A highly evolved financial system has evolved in the United States that provides capital to companies across a wide spectrum of circumstances. Accordingly, the phrase “financial sponsor” is too generic and doesn’t properly describe the diversity of those markets. Financial Sponsors tend to differentiate themselves across five basic criteria:

• Stage: There are capital pools available to invest at every stage of the growth cycle, from venture capital to early and late-stage growth equity to financings or acquisitions of mature companies. Generally, the returns sought by financial sponsors increase the earlier in the investment’s life cycle.
• Place in Capital Structure: Financial capital pools exist to fund at every level of the capital structure, from senior debt and subordinated debt to mezzanine or hybrid securities to equity, both minority, majority, or complete buy-out.
• Industry: Financial sponsors, especially larger financial sponsors, have increasingly established expertise in specific industries, which they can bring to bear on investments through developing strategy, adding to management, or providing access to other industry clients and resources.
• Growth Characteristics of Client: Private equity shops usually have a preference for the growth characteristics they seek in investments, with general categories of growth vs. value. Within growth, firms differentiate between hyper-growth (usually early-stage growth equity) and mature companies with above average growth characteristics. Value investors range from funds looking to invest in mature companies in attractive industries to funds that will perform minor or major restructurings, with some firms specializing in companies already in bankruptcy to those rapidly approaching insolvency.
• Size: Financial sponsors typically have raised an outside fund and are looking to deploy capital based on the amount of capital raised and available to them, and will size investments accordingly. Most funds have diversity caps, limiting the amount of the fund they can allocate to any one company (usually 15%), and are looking to diversify their fund among 8 to 15 investments. This would mean that a $100 million fund would deploy no more than $15 million to any one company and would make typical equity investments of $6 million to $12 million.

In the middle-market buyout world, there are three types of financial sponsors that a seller will typically encounter:

Funded Sponsor: This is a group that has raised a formal fund from institutional investors with the mandate to buy companies, improve their operations, and then sell them. A typical fund has a ten-year life, with the goal of deploying capital in the first five years and then harvesting the investments before the fund’s life is over. Funded sponsors typically model their investments over a five-year “hold period” and target returns of 18%-25% on invested capital, depending on the nature of their investments. This functionally means they are looking to triple their equity investment over the life of their five-year investment. Most of these funds are “2 and 20” funds, meaning the fund managers charge a 2% annual fee on the funds they have invested, which they typically use to pay staff salaries and fund expenses, and then they receive 20% of the capital gains on their investments. This would mean that if a fund turned $100 million of equity capital into $300 million at the end of its fund, it would be entitled to 20% of the $200 million gain, or $40 million, to split among its partners as “carried interest.”

Unfunded Sponsor: An unfunded sponsor makes investments in the same manner as a funded sponsor, but instead of having a formal committed fund to draw from, typically it has a group of three to five outside investors who have informally committed to back transactions on a case-by-case basis.  Unfunded sponsors are typically first-time investors who do not yet have the formal track record to raise an outside fund, but have enough credibility with some institutional investors who will assist them until they reach the funded stage. Unfunded sponsors tend to do lower-middle-market transactions and need another layer of approval (from their partners) before making investments. This slightly raises the risk profile for a seller as both financing sources need to approve the deal rather than just one level.  Unfunded sponsors typically have investment timing similar to that of their funded sponsor brethren (i.e., a five-year hold horizon).  Additionally, their compensation structures are more flexible, though they try to use the “2 and 20” model when investors allow.

Family Offices: The third major type of financial buyer is the family office. Family offices are typically created by wealthy individuals who have a large pool of capital to invest and choose to invest it directly rather than through intermediaries such as fund-of-funds sponsors. Family offices are typically differentiated from sponsors in the following ways:

• More Flexibility as to the Nature of Investments. Family offices are not limited to equity investments and can be more flexible in creating unique securities for specific situations.
• No Hold Period Requirement: Family offices don’t have to return capital to their investors on a specific timeline and can technically hold investments forever.
• Orientation Towards Capital Preservation: Most family offices are more focused on not losing money rather than on making huge returns on investments. Accordingly, they tend to invest in value rather than growth companies and to use lower leverage than sponsors.

Types of Strategic Buyers

Strategic buyers are companies that are already operating in a market. They come in two general varieties:

• Stand-alone Businesses: These are independent business entities, either publicly traded or privately held.
• Portfolio Companies of Financial Sponsors: These are entities with a financial sponsor as their owner, but seeking to scale.

There is little practical difference between the acquisition rationales of stand-alone strategics and sponsor-backed portfolio companies. The key distinction is that financial sponsors tend to define “strategic” more broadly when pursuing add-on acquisitions for a platform company. Build-up strategies—assembling a series of acquisitions in a given industry to create scale—are particularly common in private equity, and sponsors are often less selective about “perfect fit” targets as they execute that roll-up.

As suggested by their name, strategic buyers typically acquire another company for strategic reasons, aiming to improve the operations of a current entity. In evaluating acquisitions, most strategic buyers make a “buy vs. build” decision. Essentially, this means they attempt to determine whether it would be cheaper, easier, and faster to achieve a strategic goal by making internal investments vs. acquiring an outside entity.

In general, the most frequent strategic rationales for an acquisition are as follows:

• Fill a Hole in the Product or Service Offering: The most common acquisition rationale for strategic buyers is to fill gaps in their current product or service offerings. This frequently happens in industries where customers are buying a suite of products and/or services, and the acquirer is missing an essential element of that suite, which is putting them at a competitive disadvantage in the market.
• Build Scale in an Existing Product or Service Offering: Often called “bolt-on” acquisitions, companies acquire a company with a complementary product or service offering, knowing it can be sold through their existing sales force. Because the acquirer already has the infrastructure to sell the acquired product or service, it can often eliminate the acquired company’s sales force and back-office functions, creating synergies and improving the acquired entity’s financial performance. This is the primary strategy of companies pursuing industry-build-up transactions.
• Add a Product or Service Offering in an Adjacent Market: Strategic acquirers will often acquire companies that can fill a niche into which they are looking to expand, identifying it as a growth opportunity. In this situation, they are looking for cross-selling opportunities to expand their top line rather than for cost-cutting synergies.
• Eliminate a Competitor: Sometimes, companies acquire a competitor to remove them from the market. This is probably the least common rationale for acquisitions and is generally used only by larger companies in rapidly evolving technical markets.

Who Will Pay More?

In general, strategic buyers should be able to pay more for an acquisition than a financial sponsor. This is because strategic buyers often achieve synergies when integrating an acquired company. These can be revenue synergies, where they can expand their existing sales by cross-selling each other’s products and services to clients. Additionally, there may be cost synergies from eliminating duplicative functions across the acquiring and acquired companies. These can be such things as duplicative salespeople, duplicative back-office operations (you typically don’t need two accounting departments or CEOs, for instance), or situations where you can run two separate departments as one with fewer employees than they could be run individually.

However, this is not always the case. The amount a strategic buyer can pay for a business often depends on the target’s strategic importance to its business. In my experience, strategic acquirers put potential acquisitions into one of four buckets:

• This is something we “have to own.” It is vital to our market position, and we can’t build it ourselves. Alternatively, this would be devastating to our market position if our competitor bought it.
• This is something we would “like to own.” It is not vitally important, but it would be a very nice addition to our current business and improve our position in the market.
• This is something we would “like to own at the right price.” It could be helpful to our overall business. However, we may be able to build it ourselves, and we should only buy if the price is lower than the cost of doing it ourselves.
• This is something that would be “nice to own if we can get a bargain.” This might be helpful to our business, but the price needs to be highly attractive for us to make the acquisition.

Generally, strategic buyers pay more when targets fall into category one and category two. If the target falls into category three or four, financial sponsors are often quite competitive with strategic buyers.

What Do Transactions Look Like?

Strategic Acquirers
In general, in the middle market, strategic acquirers are looking to acquire 100% of a target and integrate its operations into their own. This means they will often be looking to eliminate redundant costs and current management. There are times when the acquirer seeks to retain the acquisition as an independent division of its business and keep management in place. This typically happens when the target represents a new business in an adjacent market and needs management expertise to run it.

In circumstances where management is deemed duplicative, acquirers will still seek a transition period from the former CEO to ease integration and ensure customer relationships are properly transferred. This period typically can last anywhere from three months to a year.

In circumstances where the management stays on, difficulties often arise because the former entrepreneurial manager finds themselves uncomfortable working in a corporate environment and reporting to a boss. Care should go into negotiating how that relationship will work going forward and the reporting structure required by the acquirer.

Financial Sponsors

Financial sponsor transactions are not monolithic but generally fall into four categories:

Majority Buyout 

The preferred private equity deal is one in which the sponsor purchases a majority interest in the company, finances the transaction with a combination of debt and equity, and the current owners retain a minority equity position in the business and continue to run it. This allows the seller to “take some chips off the table,” diversifying their financial holdings while still running their business and maintaining an ownership position that will allow them “a second bite at the apple.”

In the typical middle market majority buyout transaction, the PE shop will own 80% of the levered company post transaction (though this can range from 60-80%, depending on the desires of the seller) and will attempt to have somewhere between 50% and 70% of the purchase price be funded with debt and the rest with equity.  To put numbers to this, if the transaction size was $50 million and it was half funded with debt and the PE shop ended up with 80% ownership, the company would have $25 million of debt and $25 million of equity, $20 million of which would be provided by the sponsor and $5 million would be roll-over equity from the seller.  The seller would receive $45 million in proceeds and own 20% of the leveraged company post-transaction. If the PE shop met its investment goals and tripled the value of its equity, the second bite at the apple would also triple to $15 million once the company was sold, usually three to five years post-transaction.

Complete Buyout

A limited number of private equity shops will complete buyouts of businesses that are very similar in structure to strategic transactions. Generally, private equity complete buyouts are priced at 20-25% discounts to majority buyout transactions, reflecting the additional risk to the buyer and the hassle of identifying and hiring a new CEO and management team. Short transition periods are still required, but there is no rollover equity requirement, and management can walk away after the transition.  Most private equity firms won’t do these types of transactions, but a minority group believe the risk/reward of complete buyouts make them worthwhile.

50/50 Transactions

A limited number of private equity sponsors (around 10) specialize in a specific type of transaction, in which they essentially form a joint venture with the current owner. The general structure of these transactions is typically as follows:

• Ownership is split 51% to the current owner, 49% to the sponsor
• The board is split evenly between the two parties
• The sponsor has special rights in a number of specific areas, mainly: 1) the ability to approve budgets; 2) the right to replace management if it materially misses plan; 3) control over the timing of exit, after a pre-agreed period (typically five years)
• Leverage is employed, but typically at lower levels than a standard buyout (30-50% of the capital structure)

The result is that an owner can take some chips off the table (though less than in a majority buy-out) while still maintaining control of their business (with the exceptions listed above).

Minority Equity

The final private equity structure involves the sponsor making a minority equity investment in the company. This typically takes the form of growth equity and is generally available only to high-growth companies that need capital to support their growth plans. These investments are typically made in certain industries, most notably technology, health care, and food and beverage.

Growth equity investments are typically made by funds that specialize in their industry, and those firms also provide support to their investments in areas such as building management teams, infrastructure improvements, sales and marketing support, and customer introductions.

Generally, a company needs to be growing its top line by more than 25% a year to be considered for a growth equity investment, and it isn’t unusual for top-line growth of 100%+ annually in some sectors.

Who is the Right Buyer for Your Company?

This really depends on your objectives. Generally, the factors that go into this decision consist of the following:

• What is the valuation?
• How much longer are you looking to work?
• What will happen to employees post-transaction?
• Is there a child or long-time employee whom you wish to have a continuing role in the business post-transaction?

If total proceeds are the sole criterion for your sale, a strategic buyer is likely your best alternative as a transaction partner. That said, not all potential acquisitions will fall into the categories of “have to own” or “nice to own” for strategic acquirers, especially for middle-market and lower-middle-market targets. Strategic acquirors may still have the advantage of potential cost synergies, but the farther you fall down the priority list from “nice to have” to “nice to have at a price,” the smaller the advantage of the strategic acquiror over its financial sponsor rivals.

If criteria other than price play a major role in your decision process, the financial sponsor community is often better able to flexibly structure transactions to better meet your needs as a seller. There may be a discount in valuation that accompanies that flexibility, but oftentimes, the ability to still run the company and have a second bite at the apple can outweigh the high upfront valuation.

The key to this decision is that it does not need to be made up-front. M&A processes can be designed so that all potential parties described above are contacted simultaneously to gather more information about what each potential transaction might look like, so a seller is better able to assess which decision factors are more important based on real feedback from buyers and actual acquisition proposals. Our general advice to sellers is not to limit the process too early. Contact all potential acquirers that make sense and get meaningful feedback before deciding who is the right buyer.