What is a Proprietary Deal?

In a recent conversation with a partner in a private equity firm, he mentioned that a recent deal had been a “proprietary deal.”  I had not heard the term before, so I asked what he meant.  When he told me, I was already familiar with the concept, just not the term.  I learned that proprietary deals have some or all of the following characteristics:

• The potential buyer engages a seller, suggesting that dealing with a single buyer will be more efficient, less expensive, less frustrating, and, if the buyer is the “right one,” will provide a better fit for the selling company and major owner(s) than some unknown other party that might surface if the deal were “shopped” in an auction.
• The seller likes the potential buyer, who is nice and attentive and seems interested in the seller on both personal and professional levels (and, of course, may be).
• The buyer is encouraged to negotiate with the single potential seller (who is quite experienced in making acquisitions) without the benefit of financial advisers.
• Some sellers do negotiate with a single potential buyer, and deals are struck.

This post examines the concept of proprietary deals primarily from the sellers’ viewpoint and suggests that, even if a seller deals with a single buyer, he or she is well-advised to get good financial  and deal advice.

Are Proprietary Deals “Fair, from a Financial Point of View” in Public Deals

I have had the opportunity to work with many sellers and buyers, many of whom were public entities, on many occasions over the last 30 years.  When our firm represents sellers, we (almost) always suggest that a form of an auction process be employed.  Price may not be everything in a particular deal, but it is best to negotiate the other deal issues with potential buyers who are already offering a reasonable, or even unreasonable, price.

Auctions are designed to get the highest available price in the market at a time when a company is in the market.  When investment bankers look at the financial fairness of deals in rendering ”fairness opinions” involving public companies, they must examine not only thepricing and terms of a negotiated deal, but also the process through which it was developed.  Based on their analyses, financial advisers develop fairness opinions which conclude that deals are “fair from a financial point of view.”

To be “fair, from a financial point of view,” the agreed upon price/terms must be evaluated in the context of the process through which they were developed.  If there is a single bidder for a company requiring a fairness opinion, the financial advisers must convince themselves that, in spite of the lack of active marketing (or an auction process), the financial advisers should determine (analytically or otherwise) that the price being offered is in the range of what I call “preemptive pricing.”

Preemptive pricing is normally associated with low-ball pricing to attempt to keep other competitors out of a market.  Preemptive pricing has a corollary meaning when talking about the acquisition of businesses.  A “preemptive” offer is one that should clearly be at least in the range of likely prices to be obtained in an active auction process.

In terms of fairness opinions, preemptive pricing in single-buyer deals is pricing in a range that the financial advisers believe, based on their analysis and experience, would likely have developed if an active marketing or auction process had been employed.  Investment bankers and financial advisers attempt to determine this range of pricing through analytical processes and through the application of market knowledge.

What About Private Deals?

Why do I talk about fairness opinions and fairness, from a financial point of view?  Because private company owners should think in terms of fairness (to themselves and to their fellow shareholders), as well, and consider the likely price and the expected process if they become involved in a proprietary deal.

The reality is that in proprietary deals, preemptive pricing is exactly what the buyers are attempting to avoid.  One “proprietary deal flow consultant” says the following to its private equity prospects [with comments]:

Proprietary deal flow is acquisition prospects for which you are the only bidder [no competition]. You know they will fit your strategy and criteria because you choose them yourself. You will be the only bidder because they are not actively seeking a buyer [and haven’t engaged a financial adviser]. However, they have sound reasons to consider a sale, reasons that have nothing to do with the expectation of an excessive price [i.e., the proprietary deal purchaser seeks a price well below “excessive”].

TASC believes proprietary deal flow produces significantly better results [for private equity buyers, meaning lower prices for sellers] than reacting opportunistically to companies offered for sale. Just because a company is seeking a buyer is no reason to assume it will meet your needs in seeking an acquisition. Even if it does, there is a high risk it will have found a buyer before you find it. If it hasn’t, the whole process of offering a company for sale is designed to create an auction [of course], to produce the highest possible price [yes, or to identify a range of attractive prices and terms for selection by the buyer]. The end result for you can be wasted time, hurried decisions, frustration or worse. Proprietary deal flow normally avoids all this.

One Writer’s Take on Proprietary Deals

John Warrillow, author of Built to Sell, warns sellers about proprietary deals, noting a number of likely results from not engaging in a fuller process with the benefit of appropriate financial and deal advice.  He notes:

Falling victim to the proprietary deal is easy. You get approached by a partner in a PE firm or a senior person from a big company in your industry you know and respect. They shower you with compliments about your business, invite you to a fancy lunch and then ask if you’d consider selling. Once you agree to a conversation, they convince you there is no need to involve an advisor to represent you – why pay the money, they’ll say, to some guy or gal who has done nothing to help you build your business – we’re friends after all.

But becoming the mark in a proprietary deal is much more expensive than having your wallet pick pocketed by a street crook. Here are five reasons to avoid being the target of a proprietary deal:

He then goes on to state the following (in bold), with a comment or two from me:

• You’ll get a lower price.  Have you ever been to an auction?  Have you ever been personally “involved” in an auction where you were an active bidder engaged in the process?  If so, you know that you paid a higher price for the item(s) than you would have otherwise paid in the absence of competing bidders.
• Due diligence becomes protracted.  Absent competition, the buyer is not in a rush, and will cause sellers to sign an exclusive agreement to preclude further shopping.  I heard an expression years ago that “Time wounds all deals.”  Protracted due diligence allows time for the sole buyer to find things that will hurt the deal, leading to Warrillow’s next point.
• Shrinkage.  If the buyer finds something that will cause them to want to lower the already agreed upon purchase price, there is little opportunity to counter on the part of the seller, and the buyer may demand a price reduction.
• Seller’s remorse.  The gist of Warrillow’s discussion is that absent some degree of considering other potential buyers, the seller in a proprietary deal may always look back and wonder whether he or she got a fair deal — remember my comments above about fairness opinions.
• Out of market terms.  So the buyer doesn’t tinker with the “agreed upon” price.  They may push for terms that have the effect of diminishing price, including unusually large escrows held for longer than normal times, thereby increasing the likelihood that something will go wrong and the purchase price will be diminished.

Although Warrillow doesn’t say it in his short post, the probability of one or more of these things happening in a proprietary deal is greatly enhanced if the seller does not have competent financial and deal advisers.  If a sole buyer advises you (or you client) that you don’t “need” to hire a financial adviser because that would only confuse their friendly negotiations with you, run, don’t walk, to hire one!  The presence of a competent adviser raises the prospects of future marketing and decreases the probability of a single buyer being able to take advantage of the process that they created.

Balancing the Scales and Putting the Wrapper on Proprietary Deals

If you are approached by a single prospective buyer who wants to deal exclusively with you (or your client), take a few minutes and enjoy the flattery.  Then rush out and find an experienced financial adviser to work with you.  Advisers charges will vary, but, depending on the size of a deal, will range from less than 1% of a transaction price to 3% to 5% for some deals (or even a 10% brokerage fee for very small businesses).

If these fees seem expensive, just know that buyers who seek proprietary deals are looking for price advantages that begin at 10% less than competitive pricing and rise from there.  Hiring an experienced financial adviser will balance the negotiating scales for you.

Your financial adviser, even in a proprietary deal, can simulate a competitive process and provide the very real threat of walking away and engaging in an auction process.  Sometimes, the “right buyer” comes to the table first.  They won’t leave if you hire a financial adviser.  After all, if they can succeed in keeping other buyers away, even if they have to pay a competitive price, their odds of completing the deal rise from very low (in an auction) to very high in your “assisted” proprietary deal with them.

Warrillow concluded his post with these comments:

At first blush, negotiating on your own with one buyer can look simpler. Life is short after all and you might argue it’s better to make a quick sale to a friendly buyer even if you leave a few bucks on the table. But the illusion of the easy deal can quickly turn into what amounts to a one-sided swindle.

Forewarned is forearmed.

Pent-up Demand for Deals

There are many reasons why the mergers & acquisitions markets should be heating up.  Let’s recount just a few of them in this post as we wait for what should be happening to begin to happen.

• According to PitchBook, there is a $425 billion “overhang” of private equity just waiting to be invested. Much of this equity was raised two or three years ago or more, and there is growing pressure for the private equity firms to invest the capital. For a chart illustrating this overhang, see here.
• However, there is another overhang in the private equity markets. PE firms have invested in more than 6,000 companies in the United States. Of these, some 4,000 are maturing investments in companies where the PE firms are under increasing pressure to sell in order to generate returns for their investors.
• Corporate coffers are over-flowing with cash, with more than $2.2 trillion in cash sitting on US companies’ balance sheets.
• Commercial and Industrial lending is on the upswing, primarily in banks with more than $1 billion in assets.  Smaller banks are seeing upward trends in lending, but primarily on the real estate side.  More bankers everywhere are beginning to think in terms of commercial lending.  If they got creative, perhaps they could facilitate some dividend recapitalizations and partial buyouts in successful closely held businesses that don’t want to sell in the entirety?

The Age of Aquarius?

The population of Baby Boomer business owners continues to age. I don’t have to cite a statistic for this. All I have to do is calculate the average age of business owners I meet and look at myself.  Many business owners are perhaps waiting for that elusive perfect time.

The absolute perfect time to sell a business is when the stock market is hot, when the economy is good, when industry conditions are favorable, when financing is readily available and cheap, when conditions at a company are on the upswing or perking along with good margins and growth,  when management is ready and has plans for what follows and ….  It reminds me of a song by the 5th Dimension, Age of Aquarius, which states, in part:

When the moon is in the Seventh House
And Jupiter aligns with Mars
Then peace will guide the planets
And love will steer the stars

This is the dawning of the Age of Aquarius
Age of Aquarius
Aquarius! Aquarius!

I’m not sure if the Age of Aquarius, or the perfect time to sell a business, will ever come. I wrote about this in February 2011.

A Perspective on the Baby Boomers

To touch on the Baby Boomers once again, many baby boomer business owners missed the surge in mergers & acquisitions activity that preceded the crash in 2008.  There was pent-up demand for selling businesses in 2008. Now that we are on the short side of 2012, that pent-up demand is causing unknown pressures for business owners, their families, and their employees, who are uncertain about the necessary transitions that await.  One M&A adviser tells the story this way:

What happened between 2008-2011?

The answer, from a business transition viewpoint, is very little. Businesses generally suffered a decline in revenue, profitability and cash flow, making them less valuable to buyers. It became very difficult to finance the purchase of a business as credit became tight and de-leveraging began to occur. Transactions were difficult to close. Sellers sought a return to the prices that were paid in 2005-7 which was not realistic given the reductions in value. Companies that performed well during the downturn achieved greater multiples of value as there was a shortage of supply of quality sellers.

Baby Boomer Transition Bubble just got kicked down the road?

In essence, the bubble is still there – it just got kicked down the road. Now, the backlog of sellers is bigger and the situation may become more urgent.  It is true that most business owners have adjusted their retirement expectations and it has been estimated that retirement ages have been pushed out about 3 years on average. Since very few businesses sold during the 2008-2011 timeframe, there is an enormous backlog of business owners who would sell given the right circumstances. Our best estimates are that between 1.2 million and 1.5 million business owners are in that backlog.

So What Should Business Owners be Doing?

Pent-up demand for business transactions is a fact of life.  We know from history that transactions tend to come in waves.  When will the long-awaited wave of transactions involving Baby Boomer business owners arrive?  I don’t know, but it almost has to come soon.  In terms of age, the leading edge of the Baby Boomers turns 67 this year.  The lagging edge turns 47.

Many of the Baby Boomer businesses are small firms with limited potential in the M&A markets.  However, much of successful, private corporate America is owned by and led by Boomers.  We won’t live forever.

I spoke with a business owner the other day.  He is 75 years old and still working.  His business needs to be transitioned to the next generation of owners (not his family).  And yet he waits.  The longer he waits, the less ability he will have to negotiate a favorable transition.  The situation is even more dire if he becomes disabled or dies and his family is left to handle the transition. This is, perhaps, an extreme situation, but it is not uncommon.

Owners should, as always, be running their businesses as if they were in the market to sell. I have said many times that a business that is ready for sale is, well, ready for sale.  It is also a whole lot more fun to work in than one that is not!

So business owners should be preparing themselves and their businesses for the next transactional wave.  Business advisers should be encouraging their clients to get ready, as well.

The tsunami is coming.  We may not see the Age of Aquarius, but we will see more deals in the foreseeable future.  Will you be ready?  Will your clients be ready?

If you need help with valuation or transaction issues, give me a call.