Monday, September 15, 2014

Private Equity (PE) Is From Mars - Corporate Strategic Buyers (CSB) Are From Venus

I have previously touched on the differences in Valuation and Capital Structure between PE and CSB. The differences go beyond these two factors and distort M&A averages. They reflect the differing incentives and objectives of the two groups of acquirers.
CSB have permanent capital and take a longer term strategic acquisition viewpoint. PE is transactional orientated with an intermediate investment horizon of 5-7 years. This reflects the temporary nature of their capital - 10 years per fund with a 5 year investment period. This distinction is critical. As Warren Buffett likes to say there are no called strikes in CSB M&A - you can wait for your pitch. In PE, the clock is ticking - there are called strikes. This difference raises the risk of forced errors for PE. I am not suggesting CSA does not error. Rather, I am suggesting PE errors have a different basis from CSB.

Some of style differences are as follows:

1)     Valuation:
a)     CSB use a WACC based DCF and perpetuity based terminal value.
b)     PE uses a cost of equity bases RETURNS TO EQUITY model with a 5 year exit multiple usually tied to the purchase price multiple.

2)     Debt Capacity
a)     CSB employ a permanent capital structure with an investment grade focus that is company determined. Additionally, they use simple funding instruments - straight debt and common equity.
b)     PE uses temporary capital structure focused on maximizing debt capacity. This means their capital structures are non investment and market not company determined. Also, they use complex structures with multiple debt layers.

3)     Value Added
a)     CSB value added is synergy related.
b)     PE value comes from financial engineering and exit multiple expansion.

4)     Affordability Constraint
a)     CSB EPS dilution from any required equity issuance serves as the main constraint. Typically prefer a dilution earn back of 2-4 years.
b)     PE maximum debt capacity and the IRR on the required equity (usually 35% of the price) serve as the main constraints.

5)     Holding Period
a)     CSB infinite
b)     PE 5 - 7 years with an outside limit equal to the fund’s life-usually 10years.

6)     Integration Risk Concerns
a)     CSB high as the acquisition is usually merged into the acquirer’s existing operations.
b)     PE low the target is usually treated on a standalone basis.

7)     Search Process
a)     CSB strategic focus
b)     PE opportunistic

8)     Incentives/Performance Evaluation
a)     CSB corporate level
b)     PE at the transaction and find level

Understanding the differences between PE and CSB allows a better understanding of their styles and allows improved recommendations.


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