Strategic buyer or financial investor? - 7 factors

Intro

In an M&A transaction - buying or selling a company , a financial investor (such as private equity) proceeds differently from a strategic buyer in many important respects. Understanding these differences is crucial for advising both sellers and buyers.

When faced with the sale of your business, it is important for the entrepreneur to be clear about the following aspects:

• The possible advantages and disadvantages of each type of buyer.
• Understand what to expect depending on the type of buyer.
• How to decide between competing offers.

Let's look at the 10 key factors that impact the outcome of the transaction according to the type of investor (strategic vs. financial):

Evaluation of the business

The financial investor sees the acquisition as an investment and the strategic investor as a part of his long-term business plan:

• A well-crafted financial investor considers an acquisition like an investment. He intends to invest up to a certain amount of money in the acquisition of the target company and expects that this investment will generate a satisfactory return within a certain period of time. In order to ensure that he gets a return on his investment, the financial buyer must start by examining the financial records of the company he intends to buy. The buyer is interested in the consistency of the historical financial statements and the predictability of future financial statements.

• Essentially, a strategic buyer is interested in how the acquired company aligns with its long-term business plans.. There may be different reasons for acquiring a new company, such as vertical integration (targeting customers or suppliers), horizontal expansion (exploring new markets or product lines), getting rid of competitors or helping to eliminate or overcome weaknesses in the acquired company's market.

The origin or main cause of the differences between these two types of investors stems from the fact that a strategic buyer is better placed to obtain synergistic benefits.

Key management team: Continuity and linkage

The founder's willingness or interest to stay in management after the transaction is a key aspect in understanding which type of investor is of most interest:

• A well-crafted strategic buyer acquires the target company in order to integrate it into the buyer's existing business. Employees, including senior management, may be retained depending on the needs of the integrated business after completion, but often there is no need for the founders or the sellers to continue to provide their services. This approach allows sellers to a strategic buyer to completely sever ties with the company they have sold.

• Since private equity typically does not have its own team to take over the day-to-day operations of an acquired company, they often specifically require the existing senior management and the sellers or founders to commit to continue to run the company or at least to remain involved for a period of time after the acquisition.

Sellers may want to continue to participate after the closing because:

• They want to participate in the share value growth that can be realised when the financial investor exits the investment (3-5 years).
• They want to step back or monetise part or all of their investment, but are not yet ready to abandon the company completely.
• The purchase price includes a variable payment depending on future developments and they want to ensure that they maximise the earning power of this price increase.

In short, if the entrepreneur is thinking more about his well-deserved retirement, a strategic partner will allow for less downstream linkage and may pay a better price at the time of the transaction. On the other hand, if the entrepreneur wants to lead the growth of his sector, maximising long-term value and capitalising part of his current value, a private equity fund may be more appropriate.

Leverage

In general, the main difference is that the strategic partner tends to use its own resources and the financial investor tends to finance part of the purchase price with debt:

• Depending on the size of the acquisition, many strategic buyers use a combination of cash and existing lines of credit to finance the purchase price of a transaction. This increases the likelihood that funds will be available when needed and that the transaction will be completed in a timely manner.
• In contrast, a financial investor finances the purchase price of a transaction using cash from equity investors and a relevant weight of external financial debt.

Price

It is not possible to conclude whether one type of buyer has an inherent advantage over the other, except where macroeconomic conditions substantially restrict the availability of debt financing and adversely affect the ability of firms to leverage.

• When valuing a target company, sophisticated strategic buyers will focus on identifying which synergies will have the greatest value impact. Their knowledge of the industry and its trends will help validate the DCF model's projections. In terms of financing, they are unlikely to have the leverage of private equity firms.

• The private equity firm performs its valuation leveraged buy-out (LBO) model, which will further emphasise the use of multiples. The key features of the LBO model will be forecasts of the target's cash flows and future ability to repay debt. It will also include expected improvements in the target's operations.

In summary, while strategy buyers have the advantage over PEs in improving the valuation of the target because of the ability to generate synergies, PE buyers have the advantage of leverage.

Flexibility of the structure of the operation

The strategic investor offers very little flexibility with regard to the price structure because his objective is to acquire 100% ownership of the company on completion.

In contrast, the financial investor can offer significant flexibility in both the type and timing of the consideration paid and the percentage of shares purchased.

Negotiation and execution of the transaction

The repeated experience of a financial investor (private equity, family office, etc.) in structuring and negotiating gives them an advantage, although the need to raise external finance can make the process more complex. On the other hand, the structure of private equity firms makes them more disciplined in negotiating aspects of value creation, while their flexibility and speed make them better able to execute and close the transaction.

Not all strategic buyers have adopted a growth strategy of acquisitions and are used to the transaction process. Many do not make acquisitions on a regular basis.

This may mean that:

• Its internal processes are more bureaucratic
• Responses to requests and negotiations are slower.
• The buyer takes longer to be ready to complete the transaction.

Conversely, the strategic investor may be less demanding in DD by facilitating discussions with the seller.

Confidentiality of information

When talking to a potential buyer of the company, it is often more comfortable to talk to a financial investor than to a strategic partner who may be a competitor. There is no confidence in sharing company secrets or confidential information when there is no assurance that the deal will go through. Despite written confidentiality agreements, these are sometimes not sufficient if the main competitor now knows all the company's own secrets.