Private equity buying takes center stage
Demand rises for platform and add-on acquisitions
As we approach the midway point of the first quarter of 2010, merger and acquisition transaction activity continues to gain momentum. That momentum is characterized by several factors. First, we are witnessing wider strategic buyer participation and interest in 2010 versus 2009. Second, debt to fund acquisitions is becoming more readily available from a wider group of lenders under more attractive terms. Third, the number of private equity (PE) firms actively seeking platform acquisitions and add-on acquisitions is increasing dramatically.
The combination of more attractive debt financing in concert with an increasingly active PE environment presents great opportunity and challenges for sellers of government contracting businesses. Recognizing the increasing influence of PE buyers in sales processes requires sellers and their advisers to focus more than ever on preparation before entering the market.
PE firms, often referred to as financial buyers, are composed of professional finance executives who have a wealth of experience in evaluating businesses. Although financial buyers can be outstanding choices for sellers of government contracting businesses, they present unique challenges when compared to the strategic buyer alternative. Those differences fall into three crucial areas: deal structure, financing and due diligence.
Contractors are accustomed to hearing about strategic buyers paying all cash, net of an indemnity escrow held for any future indemnity claims. By contrast, many financial buyer transactions have more complex structures designed to look and feel more like a partnering transaction. Such deal structures often ask key shareholders of the seller to roll over a portion of their selling proceeds into the equity of a new company being formed by the financial buyer to purchase the seller. Sellers have to evaluate the participation in the rollover equity that often consists of both common stock and preferred stock. The great advantage of this structure is the opportunity of the seller to get a second bite at the apple when the financial buyer exits years later.
With respect to financing, financial buyers achieve their returns by leveraging their investment. Thus such transactions often involve a significant level of debt financing. In transactions for sellers with less than $25 million in earnings before interest taxes depreciation and amortization, total leverage multiples of EBITDA have recently extended to 4 to 4.5 times EBITDA. Combined with new equity infusions from the financial buyer in addition to rollover equity and seller financing, total enterprise value to EBITDA multiples can be competitive with those offered by strategic buyers.
The due diligence process with financial buyers tends to be more challenging and complex when compared to strategic buyers, as the entire deal structure is highly dependent upon a third party — the banks — and its own due diligence that is separate and distinct from that of the buyer. Financial buyers also typically employ a whole host of advisers in the due diligence process, ranging from industry strategy consultants and accountants to law firms and human resources consultants, among others. Sellers who are ill prepared for such an intense due diligence process risk losing the leverage of the competitive marketing process and, in some instances, can place the entire deal at risk. Thus preparation is the key to maximizing value and the likelihood of closing.
The high level of interest from the financial buyer community plays an increasingly important role in the health of the government contracting industry. More interested, capable buyers translate into better pricing, more options and higher levels of liquidity for shareholders of government contractors. That, in turn, serves to attract the best shareholders, managers and employees to the government contracting industry.