Table of Contents
Introduction
Private equity (PE) firms have emerged as key players in the M&A space to the extent we can say that the two share a symbiotic relationship.
A Harvard study implies that PE has driven one-third of all M&A transactions.
It basically translates to PE firms acquiring a stake in private companies to generate additional profits in these companies and then re-selling their business to gain returns on their investment and profit.
What is private equity and what does it consist of
Private equity investments are investments that acquire an equity interest in a privately held company. It is the Stock capital held by a private company that is not offered to the general public.
Private equity funds are a type of investment funds, as they are used to invest in companies which are not listed on the stock exchange, i.e. the public cannot buy and sell shares in these companies. The PE investors acquire shares and invest in these private companies.
Private equity is “an investment fund, which invests in and restructures private companies.” These funds entail an element of ownership of shares or assets, i.e. equity.It is also categorised as a class of assets (equity securities) that govern the financial management and operation of private companies.
The PE industry is made up of institutional investors and PE firms. They have the capacity to deploy large amounts of capital for a long duration. They pool resources together from multiple investors and these resources are then invested in organisations that are in need of restructuring and improvement.
Why do private companies allow PE
Once the PE funds are invested in the company, the PE firm runs the company as it has acquired ownership through this investment.
They then use their expertise to boost the value and profitability of the acquired private company. Thus, private equity investment is a way to revive a sick company’s business post-investment through a new management and business strategy.
The firm enhances the efficiency of operations, cuts down costs and adopts structural changes that are necessary for growing business.
What is in it for the PE firm
After driving the success of the target company, the PE investors get back returns on their investment by re-selling the company or business and they distribute their profits in a predetermined ratio.
Thus, it is a win-win as the company’s financial prospects improve and become more valuable, and the investors gain good returns on their investment.
Role of private equity firms in M&A transactions
1) Injecting capital-
Private equity firms provide necessary funds and capital reserves necessary to drive M&A transactions. They know where to make specific investments and deploy capital and resources to reap maximum profits.
2) Expertise-
PE professionals possess peculiar knowledge about industries, so they can add value to these companies. The firms specialise in particular industries and sectors and can thus help revive them.
In addition to industry knowledge, they also have an understanding of market research dynamics and thus know which strategies to apply to make the most of the market and consumers.
3) Restructuring the operational aspect-
The firms identify areas that need restructuring, and carry out internal changes that help to boost the efficiency and productivity of the company. They enhance the production, distribution, sale, and other aspects of business in a way that transforms the company’s business and reaches greater heights.
4) Guidance and leadership-
The experienced professionals are capable of providing the necessary guidance and insights to the company’s management, and this can help breathe new life into the company.
5) Financial expertise-
PE professionals know the way through finance and they manage the capital and resources in a way that reaps the maximum benefits. They know the right strategies to allocate and utilise resources efficiently to grow the financial graph.
6) Exit Strategy-
PE firms plan timely and successful exit strategies such as IPOs to realise significant returns.
7) Cultural Compatibility-
PE firms make sure the acquiring company and the acquired company share a fairly compatible corporate culture so that there is smooth integration and transition with a spirit of cooperation. Even otherwise, they have the expertise to manage the cultures of the companies effectively.
Kinds of private equity
1) Venture capital- Venture capitalists are the ones who invest in startups at the early stages. They assess the future potential of the start up, and invest amounts accordingly. Thus, it is done for entities who are new and just getting started in the market.
2) Mezzanine financing- This is an investment that is made into the debts of an organisation. If the invested debt is not disposed of on time, then the investors acquire an equity interest. The debt is converted into equity, and the rate of interest on such a debt investment is high.
3) Growth capital- This investment is made in entities and organisations that are well established and looking to expand their operations into newer places and markets. Thus, it is done in mature organisations that are looking to diversify their markets and their products or looking for greater funds for further acquisitions.
4) Real estate PE- As the name suggests, this investment focuses on investing in real estate properties. There are three types-
a) Core– This investment is made in properties that can provide an assured amount of cash flow.
b) Core plus– This investment is done in properties that require some improvements, and therefore, there is some element of risk.
c) Value added– The invested properties require a good number of improvements, and so the risk associated is high.
How do PE firms raise money
They raise money from a number of sources such as-
- Limited Partners (LPs) such as insurance firms
- endowments
- wealthy persons
- retirement funds
- pension funds
Forbes 2024 trends in private equity and M&A
Despite political issues and conflicts, there has been considerable growth in M&A activity.
There is a slight decrease in ‘mega’ deals.
The lower middle market experienced the most action, with M&A transactions, joint ventures and the purchase of minority shareholdings increasing there.
Private equity firms are driving the M&A game.
The lower middle market is seeing an increase in the number of ‘serial’ acquisitions, as they provide for simpler valuation and a smoother management and post-integration transition. This is because companies in the lower middle market are smaller in size and less complex. So, there are fewer hassles in valuation and post-deal integration.
Such recurring acquisitions bring greater expertise, as they refine the skills and procedures of each acquisition, which acts as a building block. The process gets more and more efficient with each deal, generating a high long-term value.
According to PwC, there has already started a bounce back of M&A in the energy, technology and pharma sector. Real estate has recovered. But sectors like Banking and healthcare remain slow because of the impact of market conditions.
M&A activity is expected to remain sustained in the next few months in the middle market, largely supported by private equity firms.
Bain and Company conducted a study in 2020 which revealed that the technology sector received the most investment from private equity, which led to expanding its share in the market. Thus, PE are the key dealmakers in the technology sector.
The major reason PE firms engage in M&A is to expand their investment options and to diversify their holdings.
When these firms invest in different sectors and different geographies, they reduce their risk and increase their returns, as such deals give them access to new markets, technologies and consumer bases, broadening the scope of growth.
How does strategic M&A work
Acquisition strategy–
Strategic players make strategic acquisitions by identifying companies that complement their industry or business. Thus, they create a company portfolio that has collaborative and harmonious businesses.
They make targeted and cohesive acquisitions that can produce synergistic benefits.
Eg- Blackstone Group’s acquisition of Hilton Worldwide (2007)–
Hilton was a leading luxury and full-service hostel and hospitality company. Blackstone Group was an investment firm that focused on real estate, private equity and asset management.
Blackstone had significant experience in the hotel and real estate sector, and so it was able to manage the multitude of Hilton’s hotels and real estate.
Blackstone effectively managed Hilton’s hotel operations, improved customer service, cut costs and expanded its business because of its experience in hotels and asset management. It launched new hotels in Asia and Middle East, complementing the growth aspirations of Hilton and boosting profitability with its asset and financial management.
When Blackstone went public, it was one of the largest hotel IPOs, and Blackstone continued to have a significant stake as a major benefactor after the IPO.
Comparing strategic M&A with PE-backed M&A
Strategic M&A and its PE counterpart have very different approaches and strategies. From identifying targets to valuation methods, PE has evolved and developed a strong financial discipline and expertise, which may give it an edge over strategic M&A.
Let us compare various aspects of Strategic and PE-backed M&A one by one-
1) Source of funding–
Strategic M&A-
a) Profits of the company– Strategic M&As rely upon the profits generated from current operational activities, so they do not have to rely on additional borrowing.This incurs no liabilities on the company and indicates sound financial health.
In addition, this does not dilute ownership in any manner.
b) Cash reserves– The company can also leverage its cash liquidity to raise funds. Having sufficient internal cash flow means the company would not be vulnerable to the need of external debt assistance. Again, this does not affect the pattern of ownership in the company.
However, it can deplete cash reserves, thereby affecting the volume of capital available for future operations and investments.
c)Banks loans– Companies can raise long-term loans from banks which are tailored specially for M&A. Loans can have lower interest rates compared to high-yield debt and the interest is usually tax-deductible.
However, they need to be secured by way of collaterals, such as the assets of the company against whom the loans are secured.
d) Making partnerships such as joint ventures– In partnerships and JVs, both parties are jointly responsible to provide capital. Such an arrangement creates a dual obligation and sharing, and such sharing can better facilitate raising of funds.
Burden of financing gets allocated to various partners or strategic allies, but on the downside, may lead to conflicts among partners over the sharing of revenues and control.
e) Issuing corporate bonds– Companies can issue Corporate bonds i.e. securities issued to raise capital.
They can be issued in the form of a senior or subordinated debt, depending on the requirement and terms.
Corporate bonds help to raise capital without immediately affecting the current operations and affairs of the company.
They can be issued according to the size of the acquisition and the term of repayment is usually long.
However, their issuance incurs additional costs and may also impact credit ratings.
f) High yield bonds – Aka Junk Bonds, they are usually issued by companies with lower credit ratings, but have the potential to generate high rewards and capital.
g) Royalty financing– This method involves issuing a percentage of the revenues that will be earned in the future. Companies can utilise royalties begotten from existing products or issue a certain proportion of the future revenues.
h) Asset-based financing – This involves pledging assets such as company property, inventory, and receivables. They act as a collateral and provide capital depending on the value of the assets.
Thus, they serve as a quick source of raising funds, but may have an impact on the operations of the company, along with posing a risk of high interest rates.
i) Divestitures– This involves selling off the non-core assets of the company, i.e., assets that are not essential, as a means to raise immediate capital.
Sometimes, such sales can also lead to loss of valuable assets. They can sometimes disrupt the operations and affairs of the company.
j) Development financing– Government and development banks can issue loans for acquisitions that can play a role in economic development. Such mergers and acquisitions which complement the economic and growth aspirations of the government, can receive finances.
Since the aim is the greater good of the economy, such funds come with lower rates of interest and the terms are also usually favourable.
But the process for applying and obtaining such funds can be cumbersome, entailing a number of terms and conditions.
Private equity-backed M&A-
a) Private equity investment– This involves issuing shares which are not traded on the stock exchange for the purpose of raising capital. Investors purchase or subscribe to shares and thus acquire ownership.
This kind of investment brings with it ownership and expertise, but on the other hand this change usually means dilution in the earlier pattern of ownership and influence.
b) Leveraged buyouts – These are acquisitions that are made through debt financing. A public company may be bought out and delisted.
Such buyouts can lead to magnified returns after improving the financial prospects of the acquired company.
However, It creates a debt liability on the company which incurs high rates of interest on the debts borrowed.
c) Equity co-investments– Co-investors are other investors who join hands with the lead private equity firm. The main lead is the PE firm, but it will have co-partners such as institutional investors, other private equity firms, offices or limited partners who participate in the investment.
Since there are multiple sources of funds available from the co-investors, it reduces the burden of extracting equity solely from the lead PE firm.
However, the co-investors in return can demand a share in the profits and a control in the management.
d) Convertible securities– Upon certain conditions, these securities can be converted into equity. Thus, investors invest and help raise capital with the option to convert their securities into equity in future.
Therefore, it implies a possible dilution in ownership in the future.
The structuring of such deals can be complex.
e) Seller financing– It involves leveraging the Seller’s capital or finances to fulfil investment goals. Thus, it is like a loan mechanism, given by the seller to the PE firm to fulfil its capital needs. Thus, it is useful where the acquirer may not have sufficient funds.
However, the seller’s interests may override the interests of the company.
The rates of interest may be high and the seller may exert some influence.
Strategic acquirers have more means to raise funds compared to PE acquirers. This might make it seem like the former has an advantage, but this instils a sense of financial discipline on the PE firms, who may not win the highest bid, but can catch up to valuable deals faster.
2) Identifying targets-
Strategic M&A-
Strategic players have a greater understanding of their industry and therefore identify potential targets that align well with their objectives.
Thus, Strategic players look for companies and firms within their industry that bring in synergies.
But this knowledge is meaningful only when they brace themself to the risk of diversification, otherwise the number of targets can go down.
For Eg- When Apple acquired Beats Electronics in 2014 after studying the latter’s technological Audio system, which integrated well into Apple’s ecosystem.
Another example is Microsoft’s acquisition of LinkedIn in 2016-
Microsoft analysed how Linkedin, a professional networking software based platform could be used to integrate with its own professional tools like Microsoft 365 and Dynamics 365. Thus, it leveraged the technology of another platform that not only boosted its own productivity, but also fetched high returns post-acquisition.
Lack of Diversification– Strategic investors hesitate to invest in industries or services that do not complement their core competencies. Thus, their pool of potential targets gets restricted, and they miss out on opportunities in unrelated industries.
For instance, a food delivery company like Zomato might acquire another similar e-service food delivery company like Swiggy, and may miss out on investing in other tech sectors which might help it to develop and innovate its supply chain logistics.
However, diversification also brings with it an element of risk.
For example, when General Electronics (GE), whose core industries were power generation and industry equipment, diversified its domain by entering into the financial services, it faced significant challenges as these services did not align with its core competencies. The complexities grew and GE was forced to divest many of its financial services assets and focus again on its core operations.
Private equity-backed M&A–
PE firms have the expertise to conduct in-depth financial analysis. They are aided by a professional network of bankers, lawyers and finance professionals who guide them in identifying potential targets as smoothly as the strategic players. The network not only assists in sourcing the deals but also in structuring and executing them.
For example- Kohlberg Kravis Roberts and Co. used its wide network of investment bankers, consultants and advisors to get hold of valuable deal targets. After a rigorous analysis, they acquired First Data, a technology payments solution provider.
Diversification across Sectors–
PE firms are not restricted to one or a few sectors. Their network of multiple professionals helps them to pursue opportunities in multiple industries and sectors.
For Example- Carlyle Group, a reputed PE firm, has invested in a number of unrelated sectors such as healthcare, energy, technology, consumer products and financial services.
Thus, Strategic players have an understanding of their domain and often do not venture into other sectors, as they may encounter integration and other challenges.
But PE firms, through their vast network and expertise, can identify and work well even in unrelated sectors, thus diversifying their investment portfolio.
3) Antitrust regulations–
Strategic M&A–
Strategic players, since they look for similar targets within their domain, tend to attract antitrust regulations under the regulatory authorities because they can pose a significant threat to the other competitors as they become a direct player in the market post the acquisition.
For Example, when a large Technology company seeks to acquire another technology company, the authorities will scrutinise the impact it has on competition and market share. They will impose significant restrictions like divestitures if its dominance is found to hurt competition in any way.
PE-backed M&A–
PE firms are usually not viewed as direct competitors or threats, but merely as investors. Therefore, they are not subject to as many tight regulations under antitrust laws as strategic players.
For Example, when Carlyle Group extended into the technology sector, it was not looked at as a key competitor to other technology companies, as PE firms do not have a similar market share and do not focus on competing and dominating the market, but on diversifying and earning returns.
4) Due diligence–
Strategic M&A–
The process of Due Diligence might be similar and streamlined for strategic players, as they look to acquire similar targets in their quest to achieve synergy.
They have specific knowledge of their industry and therefore they may be well accustomed to the process of due diligence for targets within their industry. The process can be smooth and less time consuming for them.
If they do wish to venture into other domains, the strategic players might lack experience and network to execute the diligence and may have a hard time conducting due diligence of an unrelated industry.
Private equity-backed M&A–
Since these firms venture into a number of different industries, each process of due diligence will require unique knowledge pertaining to the target company’s industry.
Therefore, they require a comprehensive network of diligence professionals who possess specific knowledge of the industries the firms wish to enter.
Therefore, it may take longer for the firm to familiarise itself with the working of different industries.
The Target Company can assist in preparing documents tailored to its industry, as it has a better understanding of the same.
For Example, when a PE firm seeks to invest in a niche industry like a chemical industry, it will need a team of professionals who will study the inner technicalities of the chemical industry such as chemical safety standards, its regulatory landscape, licences and permits pertaining to chemicals, etc.
The target company can help bridge this information gap by providing the necessary inputs to the diligence process to speed it up, else it can be time-consuming for a firm that is new to the industry.
5) Valuation-
Strategic M&A–
While undertaking valuation, the strategic players will conduct a Discounted Cash Flow (DCF) analysis, to identify synergies that extract the maximum value.
The DCF analysis determines the value of a company by predicting the cash flows of the company in the future, and then adjusting them in the present. In this way, it analyses the present worth of the company by assessing its expected financial value in the future.
The strategic player can use the estimates of the DCF model to help identify and validate certain synergies.
For example, HealthPro, a healthcare company, is seeking to acquire MedTech, a company that manufactures innovative medical technology devices.
While preparing the DCF model, HealthPro forecasts MedTech’s future cash flows, such as the cost of production and operation, capital expenditure incurred, and profits earned. These estimates are then discounted back to the present to determine MedTech’s worth today.
Synergies–
By integrating MedTech’s operations and products into HealthPro’s ecosystem, they can bring down the operation and manufacturing costs.
HealthPro can use its established marketing channels to boost the sales of MedTech’s products, thus expanding its market share.
The DCF Model considers these expected synergies while determining the valuation of the acquisition.
Large strategic players may display inflated estimates in the DCF analysis to win approval for the transaction.
In a bidding context, they may use aggressive tactics to outbid other bidders in an attempt to win the contest. Such a victory will not reward a high Internal Rate of Return (IRR), rather it will lead to losses.
Private equity-backed M&A–
These firms usually base their valuation on Leveraged Buyouts aka LBOs.
In LBOs, the financing is obtained through external loans from banks and creditors.
So, the PE firm needs to estimate the amount that it needs to borrow for acquisition, which will depend on the value of the target company.
The firm will use multiples, such as the price-to-earnings ratio, to determine the company’s value.
It will make forecasts of the target’s future cash flows, estimate how much money will be earned by the target in the future and determine the value of the company.
Based on this, the Company will decide the amount of debt to be borrowed, and they must also consider the Acquirer’s ability to pay back such debt.
Validating the company’s cash flows is important, as the PE will borrow debts based on these cash flow projections.
Estimates of future profits after the acquisition are also considered, as it is hoped that the integration will improve the operations and financial prospects. They need to make sure the future profits are enough to enable the firm to pay back the debt.
As a lot of borrowing is involved, the Acquirer cannot afford to go wrong with the future cash flow estimates or the future profit estimates. Moreover, these values have a direct bearing on the valuation of the acquisition.
In situations of bidding, the PE firms may be at a disadvantage as the bidding is conditional upon the bank approving the loan for acquisition, and other bidders may not face this issue.
Although arranging the loan may be tricky, it is worthwhile as the firm makes the investment not through its own capital but from borrowings, and if the acquisition reaps the benefits as forecasted in the future cash flows, then the PE will have high internal rates of return (IRR) without depleting its own cash reserves or capital.
Macroeconomic conditions such as economic recession, higher cost of borrowing, tightened credit markets, regulatory changes, stock market volatility may, however, affect debt financing and PE’s ability to leverage funds.
6) Negotiation and execution-
Strategic players tend to have experience as they negotiate and execute similar deals repeatedly within the industry.
As the process is newer and more demanding for PE firms, especially with the involvement of debt, they need more financial discipline and diligence.
7) Value creation post-execution-
Most strategic acquisitions seek to integrate the acquired company fully after the transaction to make use of the synergies they expect.
However, according to data, between 70-90% of all M&A deals fail to achieve these synergies, as accommodating the eco-systems of both companies becomes difficult.
A Harvard Business Review Article published in 2014 titled “The Big Lie of Strategic Mergers” highlighted the integration challenges post-mergers-
a) Cultural Clash- The different Corporate cultures of the companies lead to employees remaining dissatisfied and productivity of the merged company going down.
b) Operational disruptions- Merging different systems, people, and processes can disrupt the flow of operations, and it may take time to get them back on track, sometimes failing to do so altogether.
c) Too much emphasis on synergies- Companies prioritise realising the benefits of the expected synergies, such as reducing costs and improving revenue, and transition activities take a back seat.
d) Poor Management and Leadership issues- A good leadership is required to manage and execute the transition process, otherwise it could lead to unclear roles and consequent conflicts.
Case law-
Akorn, Inc vs Fresenius Kabi AG (2018)
Fresenius, a German Healthcare Company, agreed to acquire Akorn, a U.S. pharma company. They signed an agreement, but soon Akorn faced severe financial and operational issues, including regulatory hassles.
Fresenius sought to terminate the merger agreement, quoting a Material Adverse Effect (MAE) due to significant downfall in Akorn’s business.
Akorn challenged the termination of the merger agreement, arguing that the MAE was not valid.
The Delaware Chancery Court found that the issues at Akorn post-signing of the Agreement did constitute a valid MAE, and Fresenius was allowed to walk away from the deal.
Private equity-backed M&A–
The Target acquired by a PE firm, in most cases, will operate as an independent business, without requiring a blend of two cultures or systems.
Moreover, they are burdened with debt and therefore are under pressure to manage their cash flows carefully.
Therefore, they undergo regular financial and performance assessments.
They might have to carry structural changes, undergo cost cuttings, even sell off non-core assets to gain greater returns.
In addition, the company can issue performance-based incentives to enhance performance, such as bonuses, Restricted Stock Units (RSUs), other forms of equity ownership, milestone-based- rewards, a share in the profits etc. to boost productivity and meet targets.
The pressure of repayment weighs high and they have to adhere to greater regulation and discipline in business.
This discipline, along with incentive measures, puts private equity on a higher peg in terms of value creation post-acquisition.
For example-
Acquisition of Dunkin’ Donuts by Roark Capital Group (2020)–
Post Acquisition, Dunkin’ Donuts continued to operate as a standalone business in its own brand, and retained its operational autonomy, without merging into other brands of Roark Capital.
As it was a debt transaction, Dunkin; Donuts focused on optimising its supply chains and introduced new products to attract more customers to improve profitability.
The employees were awarded bonuses upon achieving specific targets such as reduced costs.
8) Long term goal–
Strategic M&S–
A strategic buyer’s goal after the transaction is to hold onto the business for a long time because they merge or acquire businesses to integrate them into their system of operations. As a result, they focus on the company’s long-term aspirations, such as upgrading technology or spreading out into different markets and places, etc.
PE-backed M&A-
On the other hand, PE firms work on the principle of “Purchase, optimise and exit.”
They will exit the investment after 3-6 years, usually through IPOs.
Since they have a limited time to improve the business, they follow the required practices and orderliness that are required for a business to excel.
On the downside, as investors are not much concerned about the long-term performance of the company, they tend to have a myopic vision, i.e. they remain short-sighted on the long-term aspirations of the company.
Thus, they mostly focus on getting immediate or short-term gains.
The company’s long-term aspirations tend to be overlooked.
Case laws- preference shareholders
In re Trados Inc. Shareholder Litigation (2013)
SDL acquired Trados, a software company in 2013. Trados was financially vulnerable and had received several stages of funding from venture firms (similar to private equity.) They had preferred stock, which meant that during the liquidation process at the event of a sale, they would be entitled to receive a fixed pay out first.
Consequently, at the time of liquidation, the preferred shareholders, including the private equity shareholders, received their liquidation preferences, and the common shareholders got nothing.
Common shareholders alleged that many Directors were connected to the firms and had breached their fiduciary duty by approving a provision that upheld the interest of preferred shareholders over common shareholders.
The Delaware Chancery Court ruled that while Directors were obliged to honour their fiduciary duties towards all shareholders, they are not strictly required to maximise the value of the common shareholders if circumstances of the company so require.
However, in this situation, the directors had not fairly and sufficiently considered the circumstances and interests of common shareholders, and thus the court applied the principle of “entire fairness”.
It held that the sale was not entirely fair to the shareholders.
The case emphasised the duty of directors to be considerate of the interests of all shareholders, and not just the preferred ones.
Conclusion
Both kinds of mergers and acquisitions bring their own share of pros and cons, for instance, strategic players possess industry-specific expertise and benefit from the synergies they gain from related businesses. They focus on the long-term aspirations of the acquired business, but merging it within itself can be challenging. For instance, the Vodafone and Idea merger VI witnessed many post-integration and operational challenges and could not reap the desired benefits. Then, there are mergers like Cisco and Mittal Steel, which are great examples of strategic mergers.
On the other hand, a PE firm with its team of multiple professionals possesses varied expertise and adheres to greater focus and regulation to optimise value from the deal, as the acquisition is only for a few years. The targets can operate through their own brand and thus can retain their identity. But the due diligence process can be challenging upon venturing into different industries. The risk of debt is high in cases of Leveraged Buyouts and if the company does not produce the desired results, repayment of that debt would be the biggest challenge. The company’s long-term aspirations don’t hold much regard.
Strategic players have intimate knowledge of their industry, and can thus maximise value by consolidating the products and services of a compatible target with its own, upgrading technology and mastering their operations. Whereas for PE firms, investment and M&A are the only arenas in which they operate, a diverse ecosystem of other professionals is crucial to keep them at the top.
