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Buying a U.S. company offers a quick and easy way for IT and IT enabled services (ITeS) firms to acquire a client base without having to undertake traditional sales and marketing efforts, efforts that can be expensive, time consuming and not always successful.
In the first part of the article last month, we had examined the advantages gained by both buyers and sellers. This month's update looks at The role of investment banks in managing deal steps followed by a description of each principal deal step.
Role of Investment Banks
Investment banks are contracted to provide deal management and advisement services. They are brought in regardless of whether the bank is providing financing. Financing is often not provided for first-time buyers, especially those from outside the U.S., largely because of difficulties associated with collateralization. However, after one U.S. acquisition, financing becomes much easier to obtain.
Advantages that investment banks provide are:
1. Investment banks can provide initial advising on strategies for making an acquisition and for targeting an acquisition so that there is a good fit between the buyer and seller. An investment bank’s knowledge of supply chains, markets, and industry structures can help target an acquisition to an optimal part of an industry or business sector, where a buyer will enjoy competitive advantages.
2. Having the acquisitions process managed by an investment bank enables buyers to enter the process from a position of power. This is reinforced by the use of research-driven investment banks that target a large number of acquisition candidates and then conduct simultaneous negotiations until the best three or four are offered buyout proposals.
3. Sellers respond more favorably and professionally to inquiries and approaches by investment banks, rather than direct inquiries from buyers themselves, especially buyers from outside the U.S.
4. The accessibility that investment banks have to company owners enables them to bring acquisition candidates to the table that have not formally placed their firms up for sale elsewhere. These firms are often better acquisition candidates and cheaper than those that have begun receiving competing offers from other sources.
5. Investment banks are experts at deal completion and at having deals completed quickly, efficiently, and cheaply (for buyers).
6. Investment banks that specialize in managing acquisitions on behalf of buyers become proficient in obtaining the best prices for buyers and in reducing transaction risks for buyers. This can be accomplished, in part, by negotiating earn-out (performance based) payments as a portion of the purchase price. This reduces up-front costs for buyers and provides incentives for sellers to ensure that the business meets or exceeds revenue or profit goals after the sale is concluded. With earn outs, for example, a four million dollar firm may be purchased for half that amount in cash.
7. Acquisitions involve more than successfully completing the mechanics of each stage of the deal process. In acquisitions of small and mid-market firms, there are psychological considerations that need to be anticipated and addressed. Sellers, in particular, have considerations stemming from the recognition that they are entering into the most important strategic transaction of their careers. Sellers often have unreasonable expectations, especially in regard to prices. Experienced investment bankers should be able to anticipate and proactively address sellers’ issues.
Buyers should expect to achieve significant financial savings and lowered risks by having an investment bank identify and approach acquisition candidates and then manage the deal process. These savings can exceed the costs of using an investment bank by a factor of three or more.
Except for domestic U.S. companies that make frequent acquisitions and have built up an in-house staff with investment banking expertise, it would be risky for a buyer to go out on their own and attempt to manage their own acquisitions process, just as it would be for business owners to eschew the use of lawyers in favor of representing themselves in high-stakes court cases.
Types of Investment Banks
There are two types of investment banks:
Niche banks: Niche banks work in defined industry sectors and often maintain close ties to a number of leading industry players, who they can call upon to quickly identify firms whose owners may consider entering into negotiations for a sale.
Generalists: Generalist investment banks operate in multiple business sectors. The most effective ones are research driven, using criteria developed with buyers to identify between 75 to 125 candidate firms. Bank staff will screen candidates to identify the most attractive ones, with whom detailed negotiations can be conducted simultaneously.
Niche banks have substantial expertise in narrow industry sectors. Niche firms are small, often with between five and twenty partners, most of whom have long-standing contacts with leading industry figures. Niche firms can be highly effective in industries where personal connections are paramount, such as outsourcing firms that specialize in government outsourcing contracts. Niche players can use their contacts to quickly identify a small number of companies that are ready to entertain buyout offers.
Generalist firms operate across multiple industries. By not concentrating on just one or two industry sectors, generalist firms can more energetically identify and pursue targets that best fulfill buyers' criteria and interests. Generalist firms are usually bigger than niche players, both in terms of the number of professionals and research staff that support them.
Bankers in generalist firms often have expertise in discrete industry sectors. Some became investment bankers after serving in management positions in industry sectors that are the focus of their M&A activities.
Generalist firms can be more ruthless in pursuing buyers' interests because their revenues are not dependent on repeat business (especially seller-representation business) from the same population targeted on behalf of a buyer. Generalists have a wider scope to identify and spearhead acquisitions that are most suitable for buyers, rather than follow the niche firm model that emphasizes outreach to firms with whom they have previously established contacts.
A buyer who initially intends to enter one industry sector may not be well suited to do so. Generalist investment banks are more likely than niche players to help buyers reformulate their strategies towards industry sectors that represent the best fit for buyers. Strategic advisement and positioning are critical for buyers from outside the U.S. who may not have a thorough working knowledge of the U.S. economy.
Transparency can distinguish niche investment banks from research-driven generalist ones. Transparency varies in terms of the manner and extent of reporting provided to buy-side clients. More significantly, it can be reflected in the size of the nets that research-driven generalist firms cast in searching for acquisition targets.
Deal Steps
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The process of making an acquisition is described below in eleven parts, called deal steps.
Step One: Strategy Development - Markets cannot be entered blindly. They need to be analyzed so that a buyer can target the market segment that is best for them. Sometimes this means going upstream and acquiring a firm that supplies inputs for potential clients in a targeted market segment.
A strategy project can help a buyer decide which business sector to target for an acquisition and the types of firms that will be considered attractive acquisition targets. |
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The results of a strategy project, if accepted by a buyer's management and principal owners, lowers the chance that a buyer will hesitate when a final decision is called for on whether to close an acquisition. Where an acquisition is to be accompanied by globalization of production and service operations, a buyer may not be deterred by finding that a business sector is characterized by low operating margins or low profit growth.
A strategy project begins with a meeting to define the scope and parameters of research to be conducted. Research staff at an investment bank may need about five weeks to complete a project of this type. Results are subsequently used to develop search criteria for acquisition candidates and, more significantly, for selecting a market segment and business sector. The strategy project's results may reinforce but not replace the subsequent criteria-development step in the acquisition process.
A typical strategy project can begin with the collection and analysis of data on three business sectors that are a priority for a buyer. A strategy project can be designed to produce these three types of research results:
1. How each of the three business sectors and their markets are defined, to include market and firm sizes, firm distributions, growth rates and trends;
2. The capabilities and potential synergies available to the buyer in each segment; and
3. Prior acquisitions in each segment and how valuations and deal structures evolved.
The third type of result above may indicate that a business sector has so few attractive targets that there are price premiums on acquisitions in that sector. There may be a finding that the ease of integrating an acquisition and transferring client or brand loyalty varies between business sectors, a finding that may be incorporated into the criteria development step.
A strategy project can cost $250,000 or more if conducted by a major investment bank with high overhead rates. Lesser known but more efficient investment banks can do the work for one tenth the cost.
Strategy projects do not normally include research and advisement on branding strategies. Acquisition advisors at investment banks often have good ideas about branding. However, because this is not their specialty it makes sense to utilize specialists in branding in Western markets.
Entering a market with a strong branding position can provide competitive advantages, even against established market leaders.
Entering a new market without properly putting together a branding strategy for that market can create handicaps that can permanently penalize a firm’s sales, recruiting and financing efforts.
Branding plays a major but frequently under-appreciated role in U.S. clients’ selection of vendors. Foreign-owned firms often face branding handicaps in the U.S., handicaps that may not appear to be significant to owners but can have long-term negative impacts on sales.
Step Two: Criteria Development The development of acquisition criteria represents the formal beginning of the acquisition process.
Criteria for identifying and screening targeted firms can include the following:
• Industry sector, industry position and industry role
• Financial condition and performance of preferred targets
• Type of work being conducted
• How well the work of a target firm could be conducted by offshore managers and staff
• Volumes and profit margins (before and after acquisition) on work that could be shifted
• The size and timing of investments that buyers are seeking to make
• Preferred locations of targets and their customers
• Types of customers and the stability of the customer base
Criteria can distinguish the type of company to be purchased. Some buyers will prefer privately held companies, whereas others may look for divisions or business units within larger firms. Other buyers will only be interested in publicly traded firms, which can be used to raise capital or to make additional acquisitions through stock trades. The corporate culture and management characteristics of potential targets will be a major consideration for some buyers, particularly those that intend to retain significant functions of the acquired firm in the U.S.
In calculating post-acquisition financial performance, the margins gained by cost differentials between onshore and offshore operations will be taken into account—and incorporated into the criteria to be used to search for acquisition candidates. Where the acquisition plus globalization (A+G) model is being applied to firms already engaged in outsourcing, price differences between existing offshore outsourcing arrangements such as the use of a call center in, for example, the Philippines at US$18 per production hour and the buyer's own facility can be included in calculations of post-acquisition financial performance.
Exceptions to explicitly costing out savings from the A+G model may be encountered where financing an acquisition is to be done in stages. For example, an investor group could raise their first round of capital to acquire a top-tier U.S. financial services firm. First round funding would be based on the performance and profitability of the firm as it currently operates in the U.S., and would only be enough to support that acquisition.
Once the acquisition is complete, a second round can be raised, possibly outside of the U.S., to build or buy offshore capacity to handle some or all of the work of the acquired firm. The multi-round approach is less complicated than going out for full funding at the onset, but in industries such as financial services it may hinge on a top performing U.S. firm being acquired. Top performing financial services firms are more expensive than mediocre ones but can ultimately provide better value and lower risk for buyers, particularly international buyers.
Step Three: Apply Criteria to Identify Candidate Firms
- Search criteria are applied by an investment bank's research staff to identify candidate firms. To identify candidates, searches can be conducted on public, proprietary and subscription databases. The process of developing and applying criteria normally takes six weeks.
The optimum number of initial candidates ranges from between 75 and 125. If less than 75 candidates initially pass the criteria, then the criteria are too restrictive. If more than 125 candidates make the list, then the criteria are too broad and need to be revised.
Step Four: Approach Targeted Firms - The investment bank prepares documents for approaching target firms. Documents describe the interested buyer, how the acquisition could work, and benefits that an acquisition could provide. Follow up documents can include financial statements of the buyer and exit options for sellers. These documents are intended to encourage targeted firms to consider being acquired.
The fact that an initial inquiry is made by an investment bank can encourage recipients to respond favorably. This can be particularly helpful if the buyer is a non-U.S. firm without widespread name recognition in the U.S. and if the target firm has not previously considered being acquired. Otherwise, the target firm may suspect that the buyer is conducting a fishing expedition to gather competitive information that can be used to compete against the target.
Once initial responses have been received, the investment bank can initiate negotiations with multiple target firms. Multiple simultaneous negotiations generate better information on market conditions and enable buyers to undertake negotiations from a position of strength. Initial contacts are usually made confidentially by the investment bank, typically in weeks seven through ten. The bank has non-disclosure agreements (NDAs) executed with interested parties and then screens candidate firms to assess their suitability. The bank's staff arranges for meetings and presentations.
In a research-driven acquisition process, NDAs can be executed with 20-25 prospects. This number is culled down to 7-10 firms to whom offers are made. Out of that batch, detailed negotiations may be conducted with three or four target firms. A single acquisition can be concluded at the end of the sixth month, although in some circumstances this process takes as long as one year.
Step Five: Initial Due Diligence - Weeks 11 through 14 are typically spent making conference calls and site visits. Initial due diligence activities are conducted during this phase. Information is collected on the finances, operations and market positions of target firms. The investment bank will introduce the buyer's decision makers to the most attractive target firms via conference calls, meetings and site visits.
Step Six: Letters of Intent - In weeks 15 through 19, letters of intent (LOIs) will commonly be sent to one or more target firms. Although the preparation of a LOI is typically the responsibility of the buyer (through the buyer’s legal counsel), the investment bank usually provides advice on all aspects of these documents.
LOIs formally indicate the interest of the buyer in undertaking negotiations for an acquisition. LOIs are not meant to be legally binding, except in regard to establishing confidentiality protections and barring the parties from recruiting each other's personnel. LOIs can clarify that each party is responsible for their own expenses.
The LOI will usually specify a period of exclusivity, during which the seller will only negotiate with the buyer and not with other suitors. Due diligence and negotiation activities require considerable effort and resources from both parties. If these efforts are to be expended, then the parties may wish to confirm that there is a reasonable chance that these efforts will not be wasted.
The LOI summarizes the intended price and principal terms that the buyer is likely to offer, thereby enabling the seller to determine whether a deal is likely to happen. The LOI provides an overview of the price the buyer is willing to pay, the assets it is seeking to purchase, the structure of the deal, and the process that the buyer proposes to undertake to complete the transaction. I like to keep these aspects of the LOI in mind once it has been accepted and detailed negotiations begin, because they can help forestall the seller from attempting to renegotiate what was already agreed upon in the LOI.
To prevent confusion about whether the LOI binds either party to conclude the acquisition process, the LOI can emphasize that the document does not create a binding contract regarding the terms of the acquisition. It can also describe how negotiations can be terminated and whether either party may incur any liabilities in the event that termination occurs outside the parameters allowed by the LOI. The LOI may allow the buyer to conduct simultaneous negotiations with other targets while establishing an exclusivity period for the seller.
If the seller accepts the LOI, then negotiations and further due diligence activities often proceed simultaneously. Exclusivity periods often extend for only two months, leading to intense due diligence activities as the buyer seeks to understand the true state of the seller's assets and liabilities. This understanding is used by the buyer for valuation purposes, to conduct price negotiations, and to determine how liabilities will be allocated between buyer and seller.
The LOI helps the parties concentrate on making a deal and encourages them to either reach an agreement or walk away within a reasonable period of time.
Step Seven: Negotiations and Additional Due Diligence - Once a LOI has been executed, negotiations and due diligence activities may be conducted simultaneously in weeks 20 through 26. Pre-LOI due diligence activities concentrate on finances. The post-LOI focus is usually on legal liabilities.
Step Eight: The Acquisition Agreement - An acquisition agreement represents a promise to transact a deal if certain terms and conditions are satisfied. Closing usually occurs later, when the agreement's conditions are met, additional contracts are executed, and consideration (payment) is exchanged to cause the deal to take effect.
An acquisition agreement may sometimes be called a purchase agreement or a merger agreement, although not all acquisitions result in merger—especially in international transactions. Depending on how a deal is structured, it may be known as a stock purchase agreement.
The agreement structures the deal, sets out the terms of an acquisition, and specifies the conditions that need to be fulfilled in order for the deal to close. It determines the purchase price and how payments are to be made. It contains the seller's representations and warranties about the condition of the business and its assets and liabilities. The buyer represents that it has the necessary authorizations and financial resources to complete the transaction.
It is usually best for a buyer to draft the acquisition agreement, rather than have to spend time revising and reforming an agreement prepared by the seller. Exceptions may be found when the seller is auctioning off their firm or the business unit to be sold, or where the managers of the unit or business to be sold are also the buyers. The latter instance is called a management buyout or MBO.
Step Nine: Signing - The signing of an acquisition agreement starts the clock for the parties to the deal to complete the promises specified in the agreement in order for closing to occur. These include preparation of audited financial statements, transference of deeds and leases, and possibly post-employment agreements for sellers’ managers, if these have not been taken care of beforehand.
Step Ten: Closing - Closings are scheduled events to be held when deal is actually to be transacted and consideration (payment) exchanged. They can be held at the same time as an agreement signing, although this is a rarity because closings usually require that audited financial statements be prepared after an agreement is signed.
Conditions for closing are set out in acquisition agreements, which specify the other documents that need to be in place for closings to occur. An audited financial statement is usually the most important document called for, because the final purchase price is often calculated on the basis of revenue data and other financial information contained in an audited financial statement. Additional documents needed for closing can include title insurance and real estate transfer instruments, lease transfers, and documents associated with any government approvals that may be required.
The buyer may seek non-compete and non-circumvention agreements from the principal owners of the entity being sold. These agreements are meant to prevent sellers from setting up or joining up with a competing enterprise and luring customers away from the business that is being sold. The standard period ranges from one to three years, with three years being the most common.
Step Eleven: Post Acquisition Transitions - The value of most outsourcing or service firms rests in their client base, not in their physical assets. The post acquisition transition period is risky for buyers because clients may switch to another supplier, thereby decreasing both the revenue and value of the enterprise that has been sold.
Risks are lowest for U.S. firms that are well managed before a sale and whose managers stay on to maintain client confidence after a sale is concluded. These types of firms carry a price premium or may not be open to entertaining sale offers, especially from non-U.S. firms and from parties that may not be well known to the sellers. Having an investment bank make the initial approach and then manage the deal process can be instrumental in both overcoming this initial reluctance and in obtaining a fair price.
The cheapest firms are those that are in need of immediate management intervention, which can be impossible for buyers from outside the U.S. to provide before a seller’s client base is dramatically eroded. The actual value received from buying a poorly performing U.S. company is usually less than the value for money received by buying a more stable enterprise.
However, if no suitable top performing firms are available in an industry sector or the buyer has a strong management team prepared to immediately stabilize a distressed business operation, then the acquisition of a distressed company could be considered as an opportunity to obtain assets at low cost. As the acquisition plus globalization (A+G) business model becomes more popular, the acquisition of poorly performing business operations is likely to become a more widespread strategy for aggressive firms from outside the U.S.
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The author, Anthony Mitchell, is the CEO of InternationalStaff.net , which manages call center and software outsourcing projects for U.S. clients.
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