30 May Strategies for Private Equity Sponsor and Independent Buyer Alliances
Private equity sponsors acquire companies with an eye toward selling them. The formula is simple: buy a company, grow it (e.g., through vertical or market extension or mergers and acquisitions) and sell it at a profit. Strategic buyers, by contrast, are usually already located in the target company’s industry–or at least in an allied industry–at the time of a purchase. While strategic buyers also rely on acquisitions to grow, their goals are different. If private equity sponsors are interested in rapid growth and the payoff at the other end of the process, strategic buyers are more concerned with integrating the acquired entity to help gain dominance within a specific sector. Given the vastly different business goals of private equity sponsors and strategic buyers, why are they increasingly teaming up on transactions?
The primary reason that private equity sponsors are increasingly looking to partner with strategic buyers first and foremost reflects private equity sponsors’ own limitations. Most obviously, private equity sponsors typically need the assets of the target company as collateral to move forward with a purchase (e.g., they seek companies with cash on hand to service the debt that will be incurred through the acquisition). This is not the case for strategic buyers. Strategics can frequently fund acquisitions with available cash. In this way, strategics can more easily carry out acquisitions without incurring debt. This in turn can inject speed into the process and speed has been shown to be a critical component in the success of mergers. This means that strategics also hold other advantages over private equity sponsors. For example, they can more easily acquire businesses carrying debt, and they also do not face the high management fees of most private equity sponsors engaging in purchases.
For all the above reasons, compared to private equity sponsors, strategics have the advantage of being able to acquire a broader range of companies and to generally do so at a lower cost of capital. Understood in this context, the growing trend of private equity sponsors teaming up with strategics begins to make more sense, despite their seemingly opposing short and long-term goals. Still, this does not fully explain the surge in private equity sponsor and strategic buyer partnerships, which are also happening for more specific reasons and increasingly being instigated on both sides.
First, there are a growing number of private equity sponsors teaming up with strategics who already have a foothold in a foreign country; in this case, the alliance enables a sponsor to build a new company from the ground up outside the United States. Second, a growing number of strategics are turning to private equity sponsors too (e.g., to sell a stake, usually a minority interest, in an existing business). In this case, however, strategics maintain control of the company. Finally, there are growing reports of strategics selling stakes in existing joint ventures to private sponsors. The result is that the private equity sponsor then finds itself teamed up with the remaining strategic.
With private equity/strategic alliances on the rise, investors and analysts are watching carefully. After all, these alliances open up great opportunities for both private equity sponsors and strategic buyers but they also raise new questions, challenges and risks. Among other key steps, when navigating the complex terrain of a private equity sponsor/strategic buyer alliances, one should take the following factors into consideration.
Develop a joint business plan: While both entities will no doubt be committed to making money from their shared venture, agreeing on a business plan may be more difficult. For example, since private equity sponsors are thinking short-term, they may be less risk adverse than the strategic buyer with whom they have chosen to partner. After all, the strategic likely has a long-term stake in the industry in question. Developing a business plan that works for both parties is thereby critical.
Anticipate other points of discord: Business plans will not be the only potential point of discord between the two entities that have teamed up. Identify other potential points of disagreement (e.g., strategies for capital contributions) from the onset and where necessary, agree to disagree.
Establish rules of governance: Where the private equity sponsor is a minority shareholder, there may be additional discord over veto rights (e.g., in relation to the hiring and firing of senior executives, changes to the strategic plan etc.). Establishing clear rules of governance from the onset of the partnership is critical; in short, both parties need to know where they stand (namely, who holds veto rights and under what circumstances).
Acknowledge differences: The two parties will never fully be on same team, and the post-merger integration strategy needs to reflect this reality. Indeed, private equity sponsors teaming up with strategics may be better understood as a temporary cohabitation rather than a marriage—it’s for now and convenient but not for life, and there is no need to pretend otherwise.
Develop an exit strategy: At the end of the day, private sponsors and strategics have different goals. Private equity sponsors enter with the intent to exit and strategics typically do not. For this reason, it’s critical for the private equity sponsor to have an exit strategic in place upfront with the terms of the exit clearly established. Like writing up a prenuptial agreement, establishing an exit strategy upfront will save a great deal of time, energy and money down the line and reduce exit-induced conflicts.