In Part I of this series, I discussed the "ins and outs" of the decision process sellers undertake when they consider hiring an investment banking firm to effectuate a sale of the company. Part I identified three common scenarios where bankers can offer high value on the sell-side. In this post, we'll take a deeper look at the banker interview process and explore some key questions (and the rationales behind them) that every seller should ask when considering engagement of an investment banking firm.
Not your father's LMM
The influx of talented deal professionals into the lower middle market ("LMM") over the last decade has radically changed this market segment. In the early going, most M&A advisory firms were generalists whose main expertise was in working on smaller transactions with privately held or small cap client companies. As the LMM has matured, it has segmented. The LMM has now evolved to the point where a banker must not only have "chops" in common LMM attributes (smaller transactions, knowledge of mezz players, closely-held companies, revenue volatility, customer concentration, thin capital, etc.), it must also have industry expertise. Moreover, as new industries rapidly emerge, evolve and undergo segmentation and sub-segmentation, clients increasingly are expecting financial advisors to have depth in sub-specialties, sectors and niches within industries. Nowadays, it is not uncommon to find many smaller, highly competent "boutique" M&A shops with these very deep and narrow sub-specialties.
With the plethora of choices available, it is possible now more than ever for sellers to find highly competent advisors to represent them in a sale process. However, in order to do so, sellers must be more diligent than ever before in their search. That process starts with knowing what questions to ask. If you are considering a sale of the company, here are some important questions you should ask bankers seeking to represent your business during the interview process:
Question 1. What percentage (by deal volume and dollar value) of your firm's work is in M&A? Corporate finance? Other?
Many middle market investment banking firms offer an array of different services – including merger and acquisition advice, corporate finance (e.g., capital raising), fairness opinions, valuation services, restructuring and/or turnaround advisory services. By asking this question, you will gain some general understanding of the relative importance of M&A to the firm's overall practice and the banker's expertise in M&A relative to other areas. Naturally, as a seller, you will want to select an advisor whose focus is M&A.
Question 2. How many M&A engagements have you led in the past 2 years?
Recent experience is generally more relevant than dated experience and many industries tend to move in 18-24 month cycles of activity. Moreover, transactions usually take at least 90-120 days from inception to closing. So a two year "look back" should provide a good barometer of the firm's familiarity with emerging deal trends. This question will also provide you with a sense of the banker's deal pipeline which you will want to know in order to determine the level of attention your transaction will receive and the capacity of the firm's top professionals. It's one thing for a banking firm to be highly sought after. However, if there are too many deals in the shop in the same stage of the process, you risk getting lost in the shuffle or getting the "B" players assigned to your deal.
Question 3. Of your firm's M&A engagements, what percentage is sell-side?
Most investment banking firms that do M&A will tell you that the vast majority of their engagements are sell-side mandates. However, there are firms out there who work with a select group of buyers in a narrow range of industries. As a seller, you should ask this question of the banker if only to filter out of your process any firm that does not have recent, relevant sell-side experience. Moreover, responses to this question (in combination with responses to the next question), should enable you to determine whether the banker has institutional relationships on the buy-side to which it is beholden and that could adversely impact the sale process for your company. One common example of this is when the banker receives a large share of its engagements from an institutional investor such as a private equity firm. In such cases, there can be a natural, if subconscious, tendency to show preferential treatment to that client in engagements that the banker has undertaken for other clients.
Question 4. What percentage of sell-side engagements is for Private Equity clients and what percentage is for Independent/Owner-Operated clients?
This is a very important question for a non-P/E-owned seller to ask. As I explained in the rationale for Question 3, many advisory firms have substantial, long-term relationships with private equity firms who will use the same investment banking firm (or group of firms) to sell their portfolio companies and also to identify acquisition targets for the firm and its portfolio of companies. This can present several issues for an independent owner/operator including, among others, how the transaction will be prioritized by the banker who has a significant institutional client sending it lots of deal flow? What resources and personnel will it allocate to the transaction? How much attention will senior bankers give to the deal? If questioned, the banker may tout its relationships with P/E firms as a benefit inuring to you, the seller. While this may be true if you will be considering bids from P/E firms, it may present more obstacles than benefits. Most importantly, as many LMM deal pros can attest, representing independently owned businesses that are run by families requires a unique mix of skills and experiences that is distinct from the skills required to represent institutional owners like P/E firms or large cap public companies.
Question 5. What has been the average transaction size (deal value) of your sell-side M&A engagements over the last two years? Minimum size? Maximum size?
Over the past few years the LMM has witnessed the entrance of banking firms that previously would not have considered doing transactions at values less than mid-nine figures (and yes, I mean to the left of the decimal point). As a seller, you want to understand the importance (as measured by indicative transaction value) of your deal relative to the banker's backlog of transactions. If it is too small, the banker might deprioritize your deal in favor of transactions that are larger and more lucrative to it. If it is too large relative to the firm's average transaction, the firm may lack the expertise and resources to get you to a successful closing. Ideally, the sale of your company should be of sufficient size and value that the banker is eager to obtain the engagement but not so large (or small) that it takes the banker out of its zone of competency.
Question 6. Of recent sell-side transactions (initiated in the last 2 years), what percentage have closed to date?
One of the biggest concerns a LMM seller must address is closing risk. The M&A process will take up an exhorbitant amount of management's time and attention for several months. The opportunity cost of a failed transaction in terms of attention and resources diverted from the operation of the business is considerable, to say nothing of the reputational damage. Sometimes deals break because the market turns in the middle of the process. Other times, deals break because they are mismanaged by the banker. Understandably, investment bankers prefer not to admit defeat. They are more apt to live by the adage "Old deals never die, they just close later"...and later...and ... you get the point. In the absence of external factors affecting the industry generally, if the banker is sitting on pipeline of deals that it hasn't closed within a two year time frame, it is a major red flag that you need to know about. This question is a way to elicit information on "close rate" that might not otherwise be apparent.
Question 7. What percentage of your closed transactions have closed at or above the initial valuation range?
When investment bankers come to pitch sellers, it is common for them to provide what is known as a pitchbook. Among other information, it contains a preliminary (or indicative) value based upon financial data provided by the selling company (usually under confidentiality agreement) and transaction data from the sale of other "comparable" companies. Bankers recognize that the pitchbook valuation has great significance because it establishes a baseline expectation in the seller's mind of what the company is worth. For this reason, most reputable banking firms will not submit a valuation unless they are highly confident that the final transaction price will meet or exceed that value. Conversely, investment bankers recognize that if the indicative value is too low relative to seller's expectations, they will be unlikely to win the engagement. So, reputational risk constrains them on the upside and competition constrains them on the downside. Either way, it is extremely important for a seller to be able to gauge the ability of the banker to deliver against the pitchbook valuation in the form of actual purchase price in closed transactions.
For company owners, no single event is as important as the sale of the enterprise. The transaction professionals and advisors you choose will have a very significant impact on the outcome of the transaction; none more so than the investment banker. By using these questions, you will be able to get better insight as to the best fit for your company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
