M&A ROUNDTABLE Pockets of Opportunity

Financing is harder than ever to come by, the sour economy is dimming prospects for once-worthy target companies, and many prospective acquisition candidates are moving to the market sidelines rather than accepting prevailing bid prices. A bad mix for LEO sponsors! Yet, they continue to look for the special situations and structures that will put their investors’ money to work.

M&A: This has been a very slow time for M&A in general and corporate buyers are holding back. Does this create any opportunities for you to buy companies that might have been priorities for strategic buyers, and what private equity techniques, such as pricing or recaps, could you use for an edge in these situations?

TAYLOR: I think that there are opportunities in this current environment. One technique is to do a partial recapitalization, where we acquire 50% or less of a company, thereby leaving the entrepreneur with significant upside potential. The value proposition of a partial recap to an entrepreneur is a lot better today than it was in the late ’90s. Back then, strategic buyers were offering to pay eight to 10 times cash flow, and almost every time the entrepreneur would take the cash on the table and sell 100% of the business.

But because valuation multiples are lower today, we are finding that owners/entrepreneurs are more interested in the partial recap approach, which lets them sell 50% or less of their company, diversify their net worth, and continue to build and operate the business. In our view, the pendulum is swinging back, and that is beneficial to the private equity firms.

TENBROEK: Wind Point is primarily a middle-market buyout investor, managing about $600 million in our active funds. Our strategy is to back strong executives and find businesses to buy for them. The recap sometimes works for us, but usually in a case in which we can bring another manager into the equation. Often our formula works with spin-offs of businesses or underperforming businesses.

What we’ve found is that even in the tough times, if the business is off strategy or a team isn’t quite cutting it, the corporate owner is still willing to sell. The prices have come down, which creates an opportunity for us on the exit three or four years from now. Financing has come down, too, so relative to several years ago we are putting in more equity to get deals done.

From the sellers’ perspective, they are getting less for their businesses today. But, if they are still willing to sell, the market has created opportunities for us because we do not have to compete with strategic buyers, and prices are down. We are still having good success at getting deals completed.

SCHAYE: At Chestnut Hill, we are somewhat different because we are originators for quite a few private equity firms. In terms of the marketplace, the playing field has been leveled for everybody in terms of pricing, and for corporate and strategic buyers, their currency has been devalued as their stock prices are down. As a result, that has created an opportunity for private equity firms.

They can get more into the debt market than a strategic buyer and provide a lot of strength on that side. So executing the leveraged recap and allowing the business owner to stay in and get two bites of the apple is becoming more advantageous. We’ve seen more of that happening now as opposed to taking the money and running.

TSUSAKA: At Brera we are seeing the beginnings of more structured transactions. I would say that more than 50% of the prospects we are looking at are highly complex in structure. For example, we are working with a large strategic buyer who has a subsidiary that it currently does not want to invest capital in. At the same time, it is not looking to divest it. The subsidiary has the opportunity to make an industry-redefining acquisition but is not being provided the capital by its parent.. As a result, the company has sought us out as a capital partner.

We are talking about governance issues and potential exits that cover everything from the company having a call option on our equity stake to our being able to put our interest back to it. We also are looking at potentially selling the entire company to some third party at a later stage or selling our interest through an IPO.

JONES: Berkshire Partners is a middle-market buyout firm, and we just closed our sixth fund with over $1.5 billion. We look to invest in growth-oriented companies, with management staying intact. We are typically looking for strong managers to partner with.

My colleagues here have talked about the current environment, including a decrease in some of the competitive elements. Although financial buyers may be more competitive relative to what some strategic buyers are paying, multiples have come down across the board. A lot of people look at that as good news. But we are also seeing that the number of properties has dropped off and the quality of what is available is probably deteriorating.

We are also seeing some corporations that, having decided to get out of a business, have become more rational with respect to price expectations because of the environment right now. They are willing, for strategic reasons, to divest anyway. Making a deal in this environment can lead to more complex structuring at times. For example, the seller may want to keep a minority interest so it can have some insurance on the future upside.

M&A: What about the downturn in the IPO market? Are you getting opportunities from people -who basically are looking for some kind of liquidity that they hoped to get from an IPO?

SCHAYE: In the second quarter of 2000, there were 98 IPOs and in the second quarter of this year there were 26 IPOs. That’s an incredible drop-off. The exit strategy for the middle-market company used to be “I can do an IPO.” Well, unless your name is Martha Stewart or the Worldwide Wrestling Federation, that exit isn’t available anymore. So a lot of people have said, “If I can’t do an IPO, this is an opportunity for the private equity community.”

There is more money in private equity than ever before. The number that has been bantered around is about $454 billion. It is incredible. This year alone, I think about $154 billion in private equity was raised. So you have all of that demand for product from the private equity community, and IPOs have shut down. Those are the factors that tell you there is opportunity for private equity firms to do buyouts.

“One of the trends that we have seen is a concentration on organic growth as opposed to growth by acquisition.”

JONES: Paul’s point is that there is clearly a much tighter window, if there is a window at all, for companies to go public. Whether that shuts down an exit alternative or eliminates the ability for a company to raise capital, it does redirect some demand to private equity. Berkshire looks to both buyouts and growth capital investments, so there are different ways that can play out for us. In general, we are seeing more opportunities from companies that had considered going public, or that already are public, but can’t raise capital.

TAYLOR: Advent focuses on well-managed companies with good growth prospects. So the downturn in the IPO market, coupled with lower valuations, makes this environment quite attractive to us. Most fast-growing businesses need to raise capital, and when the IPO market is shut down, that clearly creates opportunities for private equity firms. In our experience, great management teams want to accelerate their growth even if they are in a down economic cycle. In fact, some of the best management teams we have backed have made savvy acquisitions, or launched aggressive growth initiatives, during down cycles.

For example, we see outsourced business services companies that are investing in systems, acquiring competitors, and needing working capital. Depending on the needs of the company, we can do a straight growth equity investment, a low leveraged recap, or a buyout. So an environment like this works out pretty well for us.

SCHAYE: There used to be what I would refer to as the IPO deal de jour. At this point in time there is no IPO deal de jour. If you look at the deals that have been done this year, no segment is dominating the IPO industry. Someone in the telecom industry used to look at IPOs and say, “That is my avenue of exit,” and the market would zero in on multiple offerings from that industry. There is no light at the end of that tunnel for any one industry that suggests that the IPO is a common exit. It is not out there anymore.

TENBROEK: On the investing side, especially for industries that were once in favor and are now out of favor, there are now opportunities. A number of companies had thought they would access the public markets and can’t now.

Telecom, for example, has become a bad word, with a number of struggling companies out there. But there are also some good gems that never went public or are already public but can’t raise additional growth capital. A number of them are now circling around the private equity community, often looking for a sizable piece of private equity.

We don’t chase hot IPO markets. When an industry gets hot for IPOs, the whole industry typically becomes overheated and too expensive for us to play in. Even with a strategic purchase, the prices go up and the entire industry becomes out of reach. In a number of formerly hot markets, valuations for all companies have become normalized, and this has created opportunities for us.

M&A: How important is organic growth to the companies that you acquire of consider? Do you really have any quantitative criteria about growth? In what particular measurements do you want growth to take place as far as creating value is concerned?

TSUSAKA: We are comfortable looking at both slow-growth companies or fast-growth companies. The key for us as investors is to make sure that we value a company taking into consideration its growth rate and set up the capital structure that is consistent with what the company is trying to do in the long term.

In terms of measures, we don’t look at one thing. We look at, among other things, revenues, EBIT-DA, free cash flow, and return on capital. We have to look at all of the aspects of the business because they are all interrelated. You can certainly buy revenue and you can certainly buy market share, but at what cost? You need to understand at what cost you are generating revenue growth. Ultimately, it has to be a very balanced equation. The key is to capitalize the company in a manner that is right for it and not to over-leverage it to the extent that it may experience swings in business performance.

JONES: Those are good comments in terms of balancing the risk/reward, the growth, the capital structure, and all of the related elements. Berkshire tends to look a little bit more for growth because our predicting precisely what a company is going to do has proven over time to be more difficult than we would like to admit. So we try to make sure that there is a credible case for growth in the business so that we can grow our way out of troubles or misses from a projection standpoint. That is particularly important when you are looking forward and are not sure if you can count on the same kind of multiple expansion opportunities as we’ve all benefited from in this business over the last decade.

We tend to look at all of the different metrics. But a fundamental belief that the business we are investing in has some way to gain share or enter new markets is important so we can have confidence that the company will grow its way to increased value.

SCHAYE: One of the trends that we have seen that amplifies what you are saying is a concentration on organic growth as opposed to growth by acquisition. A lot of people thought they could generate growth just by buying more companies and doing a consolidation.

So a lot of people stuck their toes into consolidation as opposed to growing their businesses by a good solid management team with blocking and tackling and going back to the basics. Now they are going back to the basics and looking at good, strong base operations that can drive the business.

TENBROEK: That’s a good point. If you look back and pick your dozen private equity home runs, more often than not they are in industries that have good tailwinds and solid growth that allow you to build the business over five or 10 years to large values.

One qualifier that I always put on growth, though, and we as an industry are terrible at it, is that you need to be sure that in due diligence you are focusing on the industry that your company addresses. People often cite sector or industry growth rates when they should be focusing on specific products, services, or competitors. You have to be focused on the relevant customer base that is going to buy your company’s product or potentially would buy its product. It is amazing that growth niches can be found in what some people would consider “stagnant” industries.

JONES: You know that the industry definition is a little off when you are looking at a $50 million company that claims to dominant in a multi-billion dollar industry.

TAYLOR: At Advent we are looking for businesses in markets that are growing 5% to 15% organically. We want to see management teams that have demonstrated over a span of several years the ability to grow twice as fast as the market because they execute better, or because they have technology advantages or more efficient business models.

SCHAYE: I have seen a sort of fundamental shift. Five or six years ago everybody was saying they would combine companies, seek out cost savings, and not look at the top-line revenues so much. The earnings would come because they were going to squeeze it tighter. Now they are looking to get a good management team behind a good business.

TAYLOR: We have found over the years that certain businesses are easier to grow than others and, thus, we have really focused on how scalable the business is and how much operating leverage it has. If a business is scalable and has operating leverage, along with organic growth, you have the potential for rapid earnings growth. Attractive business models are important to us.

M&A: A lot of firms, like high-tech or new economy companies, used to be kind of out of bounds for private equity investment, but many have become more mainstream as the technology has been made obsolete or more commonplace. Are you looking at any of these companies and, if so, what are some of the sectors you are considering?

TSUSAKA: We have always focused on industries where we have expertise. That includes financial services, where we are very much focused on asset management and insurance and financial processing. We are also focused on outsourcing because we are big believers that companies will continue to look at their cost structures and outsource functions that are not core to their operations. As far as technology investments are concerned, we address that through our portfolio companies and avoid making direct, stand-alone technology bets.

In insurance, for example, we have spent several million dollars trying to build a new type of insurance adjuster exchange in a very fragmented industry. The space that our company plays in is a $30 billion-a-year market, of which 10% is outsourced. And 90% of that outsourced business is done by mom-and- pops. So our vision for creating an exchange is to take control of the fragmentation, institute standards, and run a lot of the business through the exchange.

SCHAYE: We have been focusing on what I would refer to as “dot.rust.” We look at those things that may support the infrastructure of technology as opposed to hard technology. It might be the person who is servicing the equipment in the switching center, such as outsourced technicians.

It goes back to the type of multiples that private equity firms want to pay. The high-tech arena is too risky in certain respects for the mature firms. This is not venture capital. The private equity firms are going back to the basics.

TAYLOR: We are already starting to see spinout opportunities from the large telecom and tech companies that have balance sheet problems. In all likelihood, they will spin out the under-performers first. So if you are going to consider these types of investments, you have to make sure that all of the good engineers haven’t left. In all likelihood, most of these spinout opportunities will be of companies that were acquired within the last few years.

Two years ago you couldn’t touch a spinout from a large tech or telecom company because it would either go the IPO route or be sold at such a high valuation that you couldn’t finance it. So going forward, spinouts should be an opportunity, but the challenge will be how to structure the deal. The revenue outlook for these tech spinouts will most likely be flat to negative for the next 12 to 18 months.

JONES: The challenge is to have a more specific understanding of the dynamics in these markets. For a while the telecom industry basically had free money available. Now this radical idea of actually having a profit model has come back into favor.

Berkshire has spent a fair amount of time hunting for opportunities in telecom. We have looked for infrastructure-related deals that have some cash flow Ñ thus we are staying away from the earlier-stage deals for the most part. We are working on something right now at a pretty advanced stage which meets our criteria. It’s a spinout from a parent company that can’t continue to focus in a certain region of the world right now.

TENBROEK: It is unfortunate that the public markets tend to ruin a lot of good industries. There is a period while the dust settles after the bloom comes off the rose in which you have companies that went public prematurely. They were good stand-alone companies, but their capital structures or expected growth rates are out of whack with what can actually be achieved.

Telecom is a good example. You have a number of companies that have pretty solid business models but they raised way too much debt and set expectations way too high. Unfortunately, we are going through a period of sobering up where there are going to be a lot of bankruptcies and rejuggling of capital structures, and, at the same time, a lot of equity owners are adjusting to the fact that their equity is worth a fraction of what they thought it was worth. It may be a while before deal activity picks up again.

Some companies that have pain are looking to spin off assets, and we have already seen a number of good spinouts. Often, they are divisions or companies that were bought just a few years earlier for five or 10 times more than what you are going to pay for them now.

M&A: A lot of companies across the economic spectrum are not doing well in this economy. Are you looking at some of these under-performers even though they may take more work and capital than most private equity targets?

SCHAYE: Some of the companies that we have been talking to and some of our clients are prepared to do that. But there still has to be some sort of attribute to make it attractive. If it has a good market share and some other worthwhile asset, and it’s not just in a bad market, someone may get in there and do the heavy lifting.

But if it is an across-the-board problem and the management is trying to revitalize it, that is not a place to go. However, if everybody else is doing well in the industry and you just have a dog of a company, there are people out there that will try to turn it around.

TSUSAKA: We are very much prepared to work on those. We know exactly the type of things that we like and we know where a lot of handholding is needed.

We like those situations because we are organized in such a fashion to really do only one or two deals a year and concentrate our portfolio. We are not looking to diversify our portfolio by any means. What that means is that you have to stick to the industries in which you have expertise and where you can bring direct, hands- on expertise.

TENBROEK: This is one of the areas where our strategy of bringing in a top-caliber CEO does play out pretty well. Everyone has good examples of strong industries where mediocre management can do a good job of building a company. When the industry is down and times are tough is when good management shines and mediocre management starts to struggle. When you are bringing in an outside management team, often you can create a lot of value by finding an underperformer.

We don’t like turnaround situations. That is not what we do. But if we can find an underperformer and bring in a team that can really take advantage of the situation, there is tremendous value that can be created.

You do have to be patient with this strategy Ñ plan on a four-to-six- year window to really create value and double or triple your EBIT-DA. We feel that the next four years are going to be great years for investing because the values are down. This is a good time to put money to work.

TSUSAKA: The key is that you have to differentiate yourself. There is a difference between an underperforming company and a distressed company. There is a reason why a company is distressed, and distressed investing is a very specialized field requiring a certain skill set.

TAYLOR: We spend a lot of time on our portfolio companies. When you look at growth businesses that will double in size, you run into operational challenges as well. During rapid growth you need to reinvent operational processes, invest in systems and strengthen management teams. So whether you are investing in an undermanaged business or a well-managed fast growing business, you must spend a lot of time with your portfolio companies.

At Advent, we are sector-focused. Our sectors include business services, financial services, specialty retail, and technology. We have been seeing a lot of good companies in the business services and financial services areas; both of these sectors are doing pretty well. In specialty retail and in tech – both sectors that are currently somewhat out of favor – we think it is an attractive time to invest. During the late ’90s we kept asking, “When is the economy going to slow down?” It is hard to go into a retailing deal when you are buying off of peak earnings. Right now, you have the benefit of entering the specialty retail sector near the bottom of the economic cycle, which is better than starting off at the top. So we are spending significant time in this sector as well.

Technology is similar. The outlook for technology sales and earnings for the next 12 to 18 months is not great, but we are willing to look at profitable technology companies with strong long-term fundamentals, even if the near-term growth prospects are weak.

JONES: I guess we all have to deal with distressed companies to the degree that we have any kind of existing portfolio. Berkshire has looked for basically good companies that may have a bad balance sheet. If you know of a financial sponsor that is worn out with a decent but underperforming company or a sponsor that wants to find somebody else to bring in some new capital and some new blood, let us know and we’ll look at that.

M&A: There was a big burst of going-private deals last year Ñ companies that aren’t bad performers but can’t get a decent stock price. How do you feel about them? Do they involve any special problems or opportunities?

TSUSAKA: There are a lot of public companies that ought to be private companies. The problem is that stock prices have fallen from their highs and it is hard for boards and CEOs to accept the fact that their stock is trading at 20 cents on the dollar from its highs and to do a transaction that is valued lower than what they perceive the value to be.

But the reality is that if they thought long and hard about it, they would realize they are better served as a private company. We will probably begin to see more private deals next year if the economy continues to move sideways and the stock market does the same.

JONES: It has been an interesting change. In 2000 we privatized U.S. Can. At the time, the slower-growth companies were looking at the crazy multiples being offered to the more growth-oriented companies. There was some jealously. Now there is another dynamic where everybody is trading at lower values.

But I think you still have this waiting it out attitude because of expectations on what values should be. It takes some time for people to readjust, and the financing markets won’t help right now. It is generally a tougher process to buy a company in a public environment. It is not for the faint-hearted.

M&A: Generally speaking, what is the lending climate right now? Is there any correlation with the Fed’s bringing down interest rates? Are there any special rules or criteria that are being applied as far as multiples or covenants are concerned?

SCHAYE: I can sum up the lending market in two words: It stinks! The leverage hasn’t been this tight in probably the last eight years. And because of the consolidation of banking, they only go after so many people these days. It is very, very difficult. There is tighter leverage, capital calls are being built into deals, and mezzanine financing is ever so hard to get. Again, there are fewer players in the business so there are fewer and fewer deals you can lock onto. It is just that much harder to get deals done.

TENBROEK: Multiples are down to a point where you’ve reached the asset-based loan to cash flow loan crossover. In a lot of cases, it is easier to get an asset-based loan, and the banks are more comfortable giving them. So we are seeing more asset-based loans and in companies that aren’t even particularly asset-intensive.

There are pluses and minuses to asset-based loans. Of course you have a gap that you have to fill somehow, with sub-debt or another form of capital. The market has responded with a senior preferred equity strip, typically targeting returns in the 25% range.

M&A: Do you consider that part of the mezzanine strip?

TENBROEK: No, this is not a debt instrument, otherwise senior lenders tend to factor it into the total debt cap, which has come down. Mezzanine debt is still the standard sub-debt with a 12% to 14% current coupon, tax deductible interest, and so forth. The senior preferred equity strip is an accruing piece of the structure, typically with a 12% to 16% accruing dividend and a bigger piece of equity than sub-debt. It’s typically offered by insurance companies, though some non-control equity investors are getting into the area as well.

SCHAYE: It doesn’t come cheap.

TSUSAKA: I think the big U.S. money center banks were pretending to be in the business for the past six months. On occasion you would see a large deal get done as well as relationship-driven deals. But the truth be told, it doesn’t matter where interest rates are; the liquidity we have enjoyed in the past several years is not there. Until we get the liquidity back into the system there will be repercussions in the stock market as well. There is just not a lot of money flowing. There is a lot of con- traction at this point.

JONES: Because of consolidation among financial institutions, you have fewer doors to knock on. There are fewer banks, and to make matters worse, they want to hold less exposure.

So there is a lot more thinking required in terms of how you will get a deal done, particularly the smaller, middle-market deal where you don’t have the loan size that it takes to really attract some of the more structured fund buyers. It is tough. You can see that fact statistically through the way the total leverage multiples have been coming down over the last year to under four times total debt-to-EBIT-DA on average.

TSUSAKA: The math doesn’t work. You can only get 3.9 times total debt and you bought the company at seven times and put in a whole lot in terms of equity. So this company had better be growing at 20% with strong EBITDA margins.

TAYLOR: In the middle market there are not a lot of players to whom you can syndicate your loans. So to get a deal syndicated, you must support the lead bank’s efforts a lot more than you did in the past. I think that as long as we have a weak economy, the banks are going to be tight. M&A: In this particular environment, haw important is the mezzanine?

SCHAYE: It is still a necessary component. You can only put so much equity in and still get the returns you need. Though it is high-cost, it is a force that has to be dealt with. You have to use mezzanine or you are just not going to get the returns.

TSUSAKA: I don’t find the mezzanine to be scarce. I think the common factor is that it is expensive. It is there, but it comes at a cost.

TAYLOR: We tend not to utilize maximum leverage in our transactions because we are focused on growing the business. Many of our deals require only equity and senior debt.

If you buy 30% to 70% of a company in a recap, most of the time you don’t need the mezzanine strip. It is expensive capital today.

TENBROEK: People thought this was supposed to be the golden age of mezzanine. They thought that the growing gap that was created between purchase price and senior debt would be filled with mezzanine. The reality is that the total debt covenant has been coming down as well.

So there is not a widening slot in there for mezzanine. It is still staying fairly small, in the 1.25 times to 1.5 times EBIT-DA range. The slowing down of the deal flow is really hitting the mezzanine players harder than I think they expected. A number of mezzanine players got few deals done last year.

M&A: What in general are the average or median levels of pricing and how has this changed over the last year?

JONES: Over the last two plus years, there has been a decline from peak purchase price multiples of 7.5 to 8 eight times EBIT-DA to six or less times EBIT-DA. It is interesting that we did see a lag between the decline in lending multiples and the impact on purchase prices. For a little while, as banks got more concerned about their loan portfolios, equity was filling the gap; optimism continued to drive the equity side. But now, a higher level of concern and conservatism has moved all the way down the balance sheet.

How do I sell my business?

By NOELLE KNOX, AP Business Writer NEW YORK (AP) PrivateEquityCentral.net / HedgeFund.net / Alternative Universe

“If your business isn’t a hot Internet company, you’ll probably have a hard time selling it through a public stock offering. You might have more luck selling to another company or a private equity fund in the current market”, said Paul Schaye, a partner at Chestnut Hill Partners, a merger acquisition specialist in New York. Ideally, you should start planning years in advance for the sale of your company. This will give you time to adjust your accounting practices to show a three- to five-year track record of maximum profitability.

That may be a big switch for many entrepreneurs who operate their companies to minimize their tax liability. That practice might save on taxes, but it usually minimizes the value of a business as well.

“You need to run your company like a public company,” Schaye said. “That means getting your uncle or spouse off the payroll and any other personal expenses.”

You may decide not to sell the entire business, and instead sell only a stake in the company. But whatever you decide, be prepared to justify your reason.

“After the buyer asks, ‘How much?’ the next question is ‘Why is the seller selling?’”, Schaye said.

Once you start the process, the final contract may still be a year away. So, be patient, financially flexible, and keep your equipment and inventory in good working order.

Once you’ve decided to sell, the next step is to hire professional advisers. These experts not only can help reduce your emotional turmoil, but also steer you through the process.

For small businesses, such as a laundromat or dry cleaning store, you will probably want to hire a business broker. For a mid-size company, with sales of $150 million, a merger and acquisition specialist is probably what you need; a good specialist will have a proprietary data base of potential buyers for most companies.

An experienced intermediary can provide a number of time-and-money saving services, including pricing the company, setting the financial terms and conditions, preparing a marketing presentation, screening potential buyers and assisting in negotiations.

In addition, “You have to have a fantastic (corporate finance) lawyer and you have to have a fantastic chief financial officer that can work with that attorney, because there are a lot of decisions you have to make as a seller,” said Dick Blaudow, president, chief executive and chairman of Advanced Technology Services Inc., which provides industrial services, including electrical repairs and computer services.

Blaudow sold 60 percent of his Peoria, Ill.-business to a venture capital group in 1998. Looking back, he said, “I would have done an awful lot more research on the people I sold to.”

“I found out later that my vision did not really match their vision and we found ourselves bumping heads along the way.”

Since the buyer will try to purchase your company at the lowest price, you have to watch every word in every draft of the sales contract.

One final tip: be prepared for the separation anxiety.

“It is an emotional nightmare for most entrepreneurs or founders,” Blaudow said. “One day, I would be eager to get the deal done. The next day I was ready to walk away.”

Apollo moves past CalPERS woes

The private equity firm portrays itself as a victim in the public pension fund scandal.

March 26, 2011|By Stuart Pfeifer and Nathaniel Popper, Los Angeles Times

The firm is led by Leon Black, a former protégé of Michael Milken at high-risk securities operation Drexel Burnham Lambert Group Inc. When Drexel went under in 1990, Black and a few colleagues founded Apollo.

Black, the son of a rabbi-turned-food-industry tycoon, is an avid art collector and sits on the boards of the Metropolitan Museum of Art and the Museum of Modern Art. His net worth was recently estimated at $3.5 billion by Forbes magazine.

“They stick up for the investors,” said Paul Schaye, the founder of Chestnut Hill Partners, a private equity advisory firm. “They want to get transactions done, and sometimes that involves sharp elbows.”

The financial crisis hit the firm hard, causing it to delay earlier efforts at a public offering of stock. But last year Apollo’s portfolio grew 26% and generated a profit of $94.6 million.

The upcoming public offering could raise as much as $417 million, which the firm wants to use to expand its operations. The deal is structured to keep decision making power firmly in the hands of Black and his partners.

Apollo does not appear to have been particularly fazed by the CalPERS investigation. In its regulatory filings, the company said it expects that the probe “will not have a material adverse effect on its financial statements.”

“Apollo believes that it has handled its use of placement agents in an appropriate manner,” the filing said.

The CalPERS report, the culmination of a 17-month investigation by a Washington law firm, focused blame on Villalobos, former CalPERS Chief Executive Federico Buenrostro Jr. and others at the pension fund.

Last week’s report said Villalobos had turned Buenrostro into “a puppet,” promising him a lucrative job, lavishing him with gifts and securing a valuable advocate for Apollo and other Villalobos clients inside CalPERS.

Apollo portrayed itself as a victim in a court filing in Nevada, where Villalobos has filed for bankruptcy. The company submitted a claim against Villalobos, saying he violated state and federal law by lavishing CalPERS staff with gifts, causing Apollo “reputational harm.”

Apollo spokesman Charles Zehren declined to comment.

Franchise firm looks for brains. Tripod founder searches for smart ideas in untapped markets

By Greg Farrell

If Tip O’Neill coined the phrase “All politics is local,” Bo Peabody has a rejoinder for the new economy: All venture capital investing is local, too. And to Peabody, that insight translates into a business opportunity.

Peabody claims that in 1999, 77% of all venture funding went into areas occupied by only 17% of the USA’s population. By and large, companies clustered in areas like Silicon Valley, Silicon Alley and the college campuses around Boston got the bulk of the funding because they were closest to the big VC firms.

Peabody, an Internet boy wonder who started Tripod as a student at Williams College and sold it to Lycos for $58 million, is launching a company to fill what he sees as an open niche. The company, Village Ventures, is designed to operate on a franchise basis. Think of it as McVenture Capital.

The idea makes sense to Paul Schaye, managing director of Chestnut Hill Partners, an investment advisory firm in New York.

“It’s brain-banking,” he says. “They’re trying to go where not everybody is and be the big fish in a little pond.”

“We want to redefine the demographics of business in the US.,” says Peabody, 29. “It’s fulfilling the promise of the Internet.” Peabody and Matt Harris, a fellow Williams alumnus, have raised $80 million from a pool of investors including Bain Capital, Highland Capital and Sandler Capital Management. The game plan is to launch a family of small-bore, early-stage venture funds of approximately $10 million each in markets like Portland, Maine, that have intellectual capital but little access to big VC players.

The model is Berkshires Capital Investors, a $5 million fund backed by Williams College, located in rural Massachusetts, and managed until March by Harris.

“We started doing Internet deals in 1997,” Harris says. “We had no competition, and a value proposition to entrepreneurs and employees that made sense. Half a million dollars up here can last 18 months.”

While venture capitalists are always on the prowl for the next great investment, the field has exploded in recent years. The National Venture Capital Association says the top 100 VC firms raised $12.4 billion in the first quarter of 2000, almost double a year earlier.

But the massive amounts of money flowing into venture funds have made it impractical for the biggest firms to look at every proposal that comes their way.

Competition in Silicon Valley for the best new ideas remains fierce, but Peabody’s betting that the second tier markets he’s targeting will be noncompetitive.

At least that was his experience with Tripod. He had to scrounge for his first institutional investors.

When he and Harris saw the demand in the marketplace for Berkshires Capital, they decided to place a larger bet on the concept.

“There’s not room for five funds in Portland, but there’s certainly room for one, and maybe two,” Peabody says. “We think that because of supply-and-demand economics, compared to Silicon valley or Boston, we’ll have better operating margins than CMGI. Venture capital investing is a very local hands-on business. It’s not writing a check and showing up for meetings every quarter.”

NY Firms Shop for Bargains to Grow

By Elaine Pofeldt

Starpoint Solutions weathered a sales slump recently, but that hasn’t stopped Chief Executive Jeff Najarian from pulling the trigger on growth plans for his full-service staffing firm. The Manhattan company is ready to close two deals to purchase small staffing outfits in other cities, in addition to doing some hiring

“It’s a good time to pick off these companies,” Mr. Najarian says. “I believe I’m getting in at a great price right now, because the market isn’t that great from a valuation standpoint.”

In a relationship-driven field, he believes, making acquisitions is smarter than trying to build offices in new markets from the ground up.

Starpoint, which is No. 179 on this year’s Crain’s list of the region’s largest privately held companies, expects about $70 million in sales for 2009. It’s not the only private firm ready to snap up other businesses. Bethpage, L.I.-based mattress company Sleepy’s (No. 39 on this year’s list) recently acquired the assets of Dial-A-Mattress Operating Corp. (No. 180 last year) after the Queens company filed for bankruptcy protection.

“There’s a buy-and-build trend going on,” says Paul L. Schaye, a managing director at private equity firm Chestnut Hill Partners.

Companies with strong balance sheets often see buying other firms as a cost-effective way to expand capacity, he observes: “You get a whole infrastructure and the business surrounding it.”

Businesses in health care, financial services, professional services, transportation, manufacturing, distribution and information technology are especially popular acquisition targets nationally for middle-market firms, says Thomas D. Farrell, executive vice president of Generational Equity, an advisory firm that represents sellers in M&A transactions.

“IT has been very hot,” he says, noting that Generational Equity considers the New York region one of the strongest markets in the country for IT. “We can’t find these businesses fast enough to sell.”

Of course, given the dreary state of the economy and the credit markets, M&A isn’t going full speed ahead just now. Many potential buyers are only at the “thinking about it” stage. But that represents a dramatic change from the recent past.

“Buyers were not doing anything for about 12 to 18 months,” says Michael Goodman, managing director of Pharus Advisors, a boutique investment bank. “Then around two to three months ago, CEOs and boards figured out the world isn’t coming to an end.”

Burning up the phone lines

Now, Mr. Goodman reports, his phones are “ringing off the hook” as private equity firms and middle-market companies look for deals.

“If you’re flat this year and still making a reasonable profit,” he says, “it’s a great time to figure out what adjacent spaces or complementary firms are out there that can expand your capabilities—and go buy them.”

Given the current difficulties of extracting loans or capital from banks or lenders, it doesn’t hurt that sellers are increasingly willing to partner with buyers in structuring deals.

One option, suggests Pete Rozsa, senior managing director of investment banking firm HT Capital Advisors, is to arrange the purchase so that the seller receives part of the payment at a future date.

Mr. Rozsa points out that sellers have a big incentive to help make deals happen sooner rather than later: If they don’t close transactions by the end of 2010, when the reduced capital-gains tax rate is expected to expire, higher taxes could cut into the proceeds of a sale.

With or without a helping hand from the target company, not every would-be buyer can get in on the action. Since lenders aren’t rushing to finance these deals, the cash-poor are left on the sidelines. “You need to have capital,” Mr. Rozsa says.

While Starpoint Solutions did structure its two deals so that the sellers will receive part of their payments in the future, it paid for the rest with cash, Mr. Najarian says.

Even middle-market firms with ample cash reserves may find that it’s hard to pull off some acquisitions because the targets are, essentially, underwater.

“A lot of companies that want to take advantage of cheap assets are finding that the market value is less than what the [target company’s] stakeholders have invested in this asset,” says Michael Epstein, managing partner with CRG Partners, a financial advisory and turnaround firm. Sometimes, potential sellers are concluding that it would be better to wait until valuations improve, he says.

Adding talent another option

For some middle-market businesses, it makes more sense to add talent—an abundant commodity right now—than to bet on acquisitions. Mr. Schaye of Chestnut Hill says many companies are looking to bring on consultants in 2010, a relatively low-cost way to add manpower. Other enterprises have started hiring additional employees.

“The companies we finance are really taking advantage of the downturn to bring in higher-quality people than they had access to a couple of years ago,” says Charles Garoklanian, senior vice president of PNC, which runs asset-based lender PNCBusiness Credit.

But it’s a good bet that more prospective buyers will enter the market, fearing that competition will heat up and bargains won’t last, says Robert Brown, managing director at investment bank Lincoln International.

“This window,” he says, “could go away in 12 months.”

Emerging markets drawing big capital

Already at a record, private equity fundraising expected to climb.

By Thao Hua

Emerging markets private equity is on a roll.

The level of private equity fund-raising targeting emerging markets is at record levels with further growth expected to be sustained over the long run, according to consultants, managers and pension fund executives.

In 2007, private equity fundraising dedicated to emerging markets nearly doubled to a record $59 billion globally compared with $33 billion the previous year, according to data from the Emerging Markets Private Equity Association, Washington. The industry organization represents 195 managers in 74 countries with $700 billion in total assets under management.

Despite the credit crunch, which is causing acquisitions in the U.S. and other established markets to dry up, private equity capital continues to be deployed at a healthy pace in emerging markets, managers said. In general, M&A transactions in emerging market economies depend less on leverage, they said.

Furthermore, asset managers and pension fund executives bracing for an economic slowdown in the U.S. and Western Europe might be looking toward less mature markets in Europe and Asia to diversify their sources of returns, said Christopher Rowlands, managing partner of Asia for 3i Group PLC based in Singapore. In April, 3i raised $1.2 billion for an India infrastructure private equity fund. The amount was 20% above the target.

“Emerging markets is our principal strategic objective for a number of reasons — portfolio diversification and excellent growth prospects being among them,” Mr. Rowlands said. “The fundamentals look strong, notwithstanding current market turbulence.”

Recent volatility in emerging markets might actually help private equity managers by pushing companies to seek private equity funding and potentially lowering valuations, managers said. In addition, emerging market economies have also largely escaped the subprime crisis and resulting credit problems, leaving local financial institutions in a better position to finance small to medium-size deals.

As a consequence, private equity managers who have been building their presence in emerging markets over the past several years might find that they’re now in a better position to weather the global economic downturn, consultants said.

“Private equity’s job is that it has to invest; it has to put that money to work,” said Paul Schaye, managing director of New York-based Chestnut Hill Partners LLC, which helps private equity firms find investments. “If that means finding opportunities in the less mature markets, then that’s what has to be done.”

However, consultants also warned that a lengthy credit crisis inevitably will damage returns for private equity managers globally, including those operating in emerging markets.

“I think strategic investors are still moving forward and looking on a case-by-case basis in regions that are less likely to be affected by the (credit) crisis … emerging markets are viewed as being more insulated,” said Eric Johnson, managing director at Cambridge Associates LLC, Boston. “But if we have a prolonged crisis, that’s not good for exit (strategies), which will hurt returns and eventually make fundraising more difficult.”

Bigger funds

Most funds raised in 2007 occurred during the second half of the year, according to EMPEA.

Fund sizes reached record levels in 2007. TPG Asia V, a pan-Asia fund, raised $4.2 billion, while the KKR Asian Fund LP raised $4 billion. There were 19 funds that raised $1 billion or more compared with four in 2006. Average fund size increased to $426 million in 2007 compared with $272 million in 2006.

“Based on preliminary figures … we don’t expect a slowdown” in the first half of 2008, said Jennifer Choi, director of research for EMPEA.

The total raised for emerging markets funds still is only a fraction of the $324 billion raised for U.S. funds in 2007, according to data from London-based Private Equity Intelligence Ltd.

At 3i, Asia accounted for 10% of the firm’s €11.7 billion ($18 billion) total assets under management as of Sept. 30. That’s quintuple the proportion of assets invested in Asia three years ago. Overall, 16% of the group’s total investments in 2007 were in emerging markets compared with “next to nothing” three years ago, Mr. Rowlands added.

RREEF Alternative Investments, the global alternative investment subsidiary of parent company Deutsche Bank AG, Frankfurt, plans to invest $1 billion in India within the next three years, mostly in real estate and infrastructure private equity. Earlier this year, RREEF bought an undisclosed stake in Golden Gate Properties Ltd., an unlisted developer in India. Emerging markets private equity investments have been dominated by certain sectors, such as infrastructure and real estate.

“Private equity’s role in the development of (emerging markets) property and infrastructure is, in some ways, more relevant today than it was six to 12 months ago,” said Kurt Roeloffs, Singapore-based chief executive officer of RREEF Asia Pacific, which doubled assets under management to about $15 billion at the end of 2007 compared with two years earlier.

“Asia has become a key investment destination for (private equity) investors all over the world,” Mr. Roeloffs said. “They do believe in the diversification benefits. Overall return opportunities are greater and growth prospects are greater.”

The $248.2 billion California Public Employees’ Retirement System, Sacramento, has an estimated $2 billion committed to emerging markets private equity. “These are rapidly growing economies that offer us enhanced diversification with maturing private equity markets,” Clark McKinley, spokesman for the fund, said in an e-mail response to questions. “We anticipate higher risk but also greater potential returns.”

Danish interest

The 440 billion Danish kroner ($91 billion) ATP pension plan, Hilleroed, Denmark, also is among those expanding into emerging markets private equity. Susanne Forsingdal, partner at ATP Private Equity Partners, which manages the fund’s €6 billion ($9 billion) private equity portfolio, said the move will likely be made later this year or early next year. Ms. Forsingdal declined to detail how much will be committed or in what region.

“We’re looking at India, South Africa and Australia, which from a private equity standpoint is considered an emerging market,” Ms. Forsingdal said. Last fall, ATP made its first emerging market private equity investment in Mid Europa Fund III LP, an opportunistic fund targeting Eastern Europe. She declined to specify the amount.

Besides normal emerging market risks — political, regulatory, cultural, managerial and currency factors — investors also must contend with the lack of long-term track records, Ms. Forsingdal added.

Another concern with emerging markets private equity is whether the record levels of capital raised can be deployed efficiently.

“We haven’t seen many big buyout transactions,” said Richard Frank, CEO of Darby Overseas Investments Ltd., Washington, which has $2.2 billion in emerging markets private equity assets under management at the year-end 2007. “As much larger pools of capital become available, the big question is what will be the pace of big transactions. At the moment, they’re (transactions) still proving difficult to do.”

The Carlyle Group, Washington, launched its Middle East operations in 2006 and has yet to make a single investment, even though it expects to raise about $750 million.

“We make investments when they make sense,” said Christopher W. Ullman, spokesman for Carlyle. “When I joined in 2001, the real estate team went through a year and half without making an investment. Then in the following two years, (the team) deployed all the capital. Things ebb and flow.”

Mirror, Mirror on The Wall

By Marc Raybin, Editor in Chief

PrivateEquityCentral.net / HedgeFund.net / Alternative Universe

With the book quickly closing on 2006, a year that will certainly go down in history as the time of the mega-deal and mega-fund, it is only natural to turn the page to next year. Considering the amount of money pouring into private equity, a long-term asset class, chances are business will be pretty good for the near future. The question, however, is at what price?

Paul Schaye, a managing director of Chestnut Hill Partners, predicts private equity will continue to prosper at the expense of hedge funds.

If you look at what hedge funds have become, it is the Wild, Wild West, says Schaye. It does not have the same kind of discipline that you have when you look at private equity.

Schaye speculates a shakeout will hit the hedge fund market at some point relatively soon. Should that happen, he believes investors in alternatives will move their money toward private equity and away from hedge funds, with the implication being the former is more stable than the latter. Schaye likens the current state of hedge funds to the atmosphere of what private equity was 20 years ago. If he is correct, that means what is bad for hedge funds could be good for private equity.

As far as specific sectors are concerned, Schaye believes healthcare and financial services will continue to flourish next year. He thinks investment will gravitate to these industries, taking away from money that would usually be allocated for classic manufacturing. Schaye points toward the margins in healthcare and financial services as being much greater than the margins found in manufacturing.

Whoever thought Ford Motor would be leveraging their assets, asks Schaye. They have never done that in their 104-year history.

Schaye is not alone in this belief. John Sinnenberg, a managing partner at Key Principal Partners, echoes these sentiments, saying healthcare works in a long-term, secular, trend. KPP does not invest in financial services, due to the firms connection with banking company KeyCorp.

When it comes to looking at the automotive industry, Sinnenberg disagrees with Schaye, saying there will ultimately be money to be made in that space.

The question is how far down have things gone, says Sinnenberg. There are going to be firms out there supplying the OEM and [that begs] the question of whether it is this round of financing or the next round [that will be profitable].

Sinnenberg also points toward the possible benefits an economic slowdown for restructurings. Firms that specialize in this sort of transaction could find themselves in the middle of a windfall if the market loses steam in 2007. Sinnenberg predicts a number of companies will need to refinance in light of slowing economy combined with the amount of leverage taken against the company. These businesses need a reasonable amount of growth in order to make the leverage work and if the growth is not there, odds are the companies will have to redo their deals.

You will end up with companies that are defaulting and probably investors who are not prepared to work through those issues, explains Sinnenberg.

Both Schaye and Sinnenberg are in agreement about the future of the building sector in the United States. Schaye acknowledges the space has taken a hit recently and thinks the trend will continue. He says it is not so much private equity investing in real estate that could be in trouble, but rather, the related industries that are at risk. Building materials and distribution are two areas that he noted specifically. Sinnenberg says the multiples that are being asked for by potential sellers in construction would seem attractive at their face value, but considering the downward trend that he suspects will continue into the New Year, the numbers do not add up. In fact, he thinks the sector will not reach rock bottom until after next year. Sinnenberg anticipates a gradual decline through all of 2007.

Predicting the future is always a tricky proposition and seeing that neither Schaye nor Sinnenberg has a time machine, we will have to cut them some slack if their prognostications do not come out exactly as they say.

Considering the amount of capital flooding the asset class and the need to get deals done, perhaps next year at this time private equity investors will be putting their money in fortune telling.

You never know.

Tax bill could slash Blackstone earnings

From Times Wire Services, June 16, 2007

Blackstone Group on Friday warned potential investors in its initial public offering that a tax bill before Congress could reduce its earnings substantially in coming years.

The tax measure, which would tax publicly traded private equity firms as corporations rather than partnerships, was introduced late Thursday by the Democratic and Republican leaders of the Senate Finance Committee.

Some form of the bill is widely expected to be adopted.

The sudden emergence of the legislation raised the question of whether Blackstone would go ahead with its IPO, which had been expected to take place the week of June 25. The New York-based private equity giant declined to comment. But by amending its Securities and Exchange Commission filings regarding the IPO to discuss the bill, the firm gave the appearance that it intended to proceed with the offering.

Under current law, by organizing as a partnership Blackstone would be able to avoid a 35% corporate tax rate on most of its income. Shareholders would pay taxes as low as 15% on their share of the firm’s income.

As the bill is written, a five-year grace period before taxes rise would apply only to Blackstone and Fortress Investment Group, which went public this year. Fortress shares fell $1.64, or 6.5%, on Friday to $23.47 in reaction to the proposal.

Other firms filing to go public after June 14 would face the new tax provisions immediately.

The tax implications may extend to firms that sell stakes on private markets, including Goldman Sachs Group Inc.‘s GSTruE exchange, on which Los Angeles-based Oaktree Capital Management sold shares May 22.

Oaktree shares traded Friday at $43.75, down from $47.25 on Monday, when they were last quoted. They started trading at $50, according to Bloomberg News. Representatives of Oaktree and Goldman Sachs couldn’t be reached for comment.

Blackstone hopes to raise $3.87 billion to $4.14 billion by selling a 12.3% stake in the IPO, valuing the whole company at $32 billion.

The Chinese government separately has agreed to invest $3 billion in the firm.

Paul Schaye, managing director of Chestnut Hill Partners, predicted that Blackstone would go ahead with the offering despite the tax bill. “I’d be really surprised if this puts the brakes on,” he said.

But for other private equity firms considering going public, “This changes the landscape,” Schaye said.

Viewpoint: Is your client’s would-be deal for real?

By Paul Schaye – 5 April 2007

Some of your clients own family businesses. In many cases it is the primary source of their wealth, and the principal focus of their lives. That makes selling a family business a high-stakes proposition. In addition to the possibility of a significant liquidity event, it can also be an emotionally charged, psychically draining process. So when called on to advise family-business owners on selling, it is handy to have in mind ways to help them evaluate potential buyers.

A matter of process

What does the prospective buyer plan to do with the business? Do they care how much of your client’s emotional capital is invested in the company? Will longtime employees — some perhaps the owner’s relatives — be treated with respect or pink-slipped as soon as the deal is done? And can the would-be buyer actually close the deal or will he leave the owner hanging?

Most family businesses leave the family. Less than a third of them reach a second generation, according to the trade journal Family Business Review. Only 12% are still viable into a third generation. A mere 3% survive into the fourth generation. Many of these businesses are owned by entrepreneurs born shortly after World War II who are ready to retire but do not have next-generation family members who are willing or able to take over.

The good news is that there is plenty of money chasing after businesses. The issue is not the “green” available but whose green the family-business owner should take.

Fortunately, when selling the family business becomes a consideration, there is a logical way to work through the process — and remember that selling is a process, not a single event.

Encourage a family meeting

All the key stakeholders should be on the same page. Before they consider a buyer, have them get together and determine the main reason for selling.

Is it because many of the stakeholders are getting close to retiring?
Is ill health among key owners causing a disruption to the business?
Are there changes in the marketplace that family members are unable or unwilling to keep up with?
Does the family need cash to fund pursue a totally new business venture?

The possible sale of a family business can be viewed in very different ways by family members. Some may see it as a way to move forward; others may view it — no matter how potentially remunerative — as a failure. Selling a family business should be done for reasons that everyone can buy into.

If, for example, a family-owned company that makes toys in the U.S. comes to realize that to remain competitive it has to start manufacturing overseas, it might in fact be time to consider selling it. The question would be: does this family’s business leadership know enough about the dynamics of international production to make it happen?

The family should set out agreed-on priorities to guide negotiations with potential buyers. This should cover questions like:

How important is it for the company’s legacy to continue?
Are they interested in a total buyout?
What about a partial buyout?
Would a minority investor solve the problem of cashing out part of their equity and still allow them to run and grow the business?
Should the family sell part of the business outright — perhaps a portion of the enterprise they are less interested in running — and retain the rest?
What is not negotiable with regard to keeping personnel, maintaining relationships with vendors and ties to the community?

The family should also choose the right person to negotiate. The best lead negotiator may not be the founder or even another family member. It could be a CFO brought in from the outside. Bottom line, the negotiator should be the person best qualified to speak on behalf of all stakeholders.

The family’s goal in planning is to convert subjective family sentiment into an objective course of action.

Buyer background check

Knowing whether a buyer is for real takes due diligence. Family-business owners need to take time to research potential suitors. A member of the family can check the buyers’ references, but it’s wiser to bring in outside professionals.

Advise the family to speak with their attorney about a confidentiality agreement that they want buyers and others involved in a possible transaction to sign. If employees, customers and vendors get wind too soon of the family’s intention to sell, it can wreck the process. And, as the saying goes, you can’t unscramble a broken egg.

An M&A specialist can handle the logistics of evaluating the buyers. Have the family consider not only the past transactions the specialist helped bring about, but ask how the specialist’s valuation of the companies compared with the final sale price of the businesses.

Ask the buyer for a snapshot of deals from at least the past three years and request at least five references that reflect the type of transaction that might take place with their business. When checking these references, there are questions to keep in mind to help the family determine the potential buyer’s legitimacy.

Was there anything they promised beforehand that the buyer reneged on after the transaction?
If they continued doing business with the buyer after the transaction, how comfortable was the working relationship?
How smoothly did the buyer handle the transition with various stakeholders including employees (especially retained family members), customers and suppliers?
If you had to do it all over again, would they work with this buyer?

One of the most effective background check techniques is to conduct a reverse site visit. It’s assumed the buyer will want to inspect the business facilities. However, request that family members be able to visit the buyer’s offices and schedule meetings with as many key people as possible. In particular, connect with the people who will sign the final documents.

Advise the business owner to watch for extremes in demeanor: too much optimism or too much pessimism.

The overly pessimistic buyer is likely to mention things like future market conditions, the age of the business’s infrastructure and perhaps the need for post-transaction retraining of current staff — all to justify a lower offer than what the owner believes the business is worth. The buyer may even use research and documentation to back up all these claims. However, it’s like arguing a case in court: each side can draw opposite conclusions from the same evidence. It’s the responsibility of the business owner to consider the buyer’s research and to do some of their own.

There can also be a downside with an overly optimistic buyer. The buyer may be timing the purchase to another transaction and so try to rush it along. That might not be all bad, but if it doesn’t match the family’s timeline for the sale it can create problems. The buyer may also become overly optimistic about the valuation. That could be a ploy to distract the family from other critical negotiation points such as retaining family members as employees after the sale.

Because every business has a culture of its own, it may also be advisable to conduct a “personality” evaluation on potential buyers. This can be done by getting answers to a checklist of questions such as:

What is the buyer’s communication style? Do they dialog or dictate?
Does the buyer desire to understand the business’ history and its current position in the marketplace or do they see it as just another financial statement?
What is their understanding of transactions with family owned businesses?
Have they grasped the motivation and goals of the company?
Have they internalized the owner’s concerns with post-transaction issues in dealing with staff, customers and suppliers?
Do they volunteer to share their entire track record, even some negative experiences?
If the business is a major factor in the local economy and community involvement, do they show a sincere interest in continuing that tradition?

The last question can be important to some family-owned businesses. Often they see their communities as stakeholders. After all, without the community’s support — as a patron, a source of labor or both — some businesses simply would not exist.

Like it’s your own

Taking the step to sell a family business is a big one. After the transaction takes place, the family business owner may have little interaction with the buyer and perhaps little or no control over the business. As an advisor to the family, be as diligent and careful throughout the sale process as you would be if you were selling your own business.

The transaction you help to create will have strong emotions tied to it and the consequences of a negative experience could be far reaching. On the other hand, a positive experience can help make the relationship between you and your client last for many years to come. –FWR

http://www.familywealthreport.com

Diligence Process Strong, But Could Be Better

Publication Date: Monday, May 14, 2007

Paul Schaye, managing director at boutique advisor Chestnut Hill Partners, represented a buyer in a deal for a maker of vinyl coating for fabric. Everything went smoothly – until the due diligence process uncovered the company’s plant sat on a toxic waste site.

“The first question we asked was ‘are there any environmental issues’ and they said ‘nope’,” Schaye said. “Then when you get into due diligence and you say ‘whoa, what is this?’”

That’s how the diligence process should work. But in the flurry of activity, is due diligence suffering? A recent survey says the hot M&A market might be causing some to take short cuts with respect to due diligence. Other dealmakers say the process is still strong, but it is being done at a faster pace and in less depth than in years past.

The survey, commissioned by accounting firm J.H. Cohn, said one-third of respondents believed current due diligence processes are inadequate. About three-quarters of respondents said the flood of private equity money has compromised the quality of due diligence.

Moreover, weak due diligence is the main reason many mergers fail to create value, two-thirds of respondents said.

The respondents say there’s no problem with the main issues in due diligence – verifying the accuracy of financial statements, sales forecasts and valuation. The problems are with less tangible issues such as assessing management or the intellectual property a target may have. Other problems surround how to value a company’s inventory or equipment up front and not just rely on post-closing purchase price adjustments.

Many say the due diligence process is more robust than ever, thanks to the advent of things like electronic data rooms for reviewing confidential documents and the use of the Internet to dig up more data than was once easily available.

“Back in 1999, I would have agreed that people have thrown due diligence out the window,” said Jeff Rosenkranz, managing director at Piper Jaffray. “Despite how hot the market is, we really haven’t seen a degradation of diligence.”

But the diligence process may still be lacking in some areas. Rosenkranz says it is becoming more common for junior members of a private equity firm or third-party consultants to carry out diligence work rather than the senior members. The lack of experience or deep insight into a business may make it harder to foresee potential problems.

“Those two are probably not the best equipped to figure out the strategic drivers of a business,” Rosenkranz said. “There has been much less time spent between senior management at the buyer and the seller to discuss how to drive the business.”

As a result, management, organizational structure and long-term strategy get short shrift in the diligence process, Rosenkranz says.

“There’s more box checking going on than anything,” Rosenkranz said. “People may be missing the forest for the trees.”

Peter Taft, a partner at private equity firm Morgenthaler Partners, says diligence can be done more easily thanks to electronic data rooms.

“Not long ago, you were huddled in a conference room pawing through documents in boxes with a lawyer standing over you making sure you did not steal anything,” Taft said.

But if it’s easier, it also means the work has to be done faster. Closing periods for deals have shrunk from an average of 75 days a couple years ago to 60 days on average today, meaning there is less time to carry out the same amount of diligence work. Taft says it’s not only due to the seller’s market, but also to a strategic move on the sell-side to keep the buyers from digging too deeply.

“You might not have the time to do the diligence you once did,” Taft said.

Brad Gevurtz, managing director at D.A. Davidson & Co, agrees that due diligence may not be as rigorous with the competitive market among buyers. Diligence still hits the main points, but it has to be done much more quickly.

Buyers, as well, have to accept fewer deal protections such as smaller indemnity caps and no escrow in order to keep up with the speed of deals.

But buyers are not rolling over completely. He has seen deals where a buyer uses the exclusivity period after submitting a bid to do an even more extensive review of the business. In some cases, the bidder will come back with a lower bid after the second round of diligence.

But he doubts that buyers, particularly private equity buyers, have skimped on assessing management.

“If a financial buyer does not feel confident in management, they will always pass,” Gevurtz said. “A private equity firm that would not take a serious look at management, I would doubt their viability.”

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