Strategic Buyer vs. Financial Buyer
The Anatomy of a Deal Newsletter June 26, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
- “Strategic” buyers often look to acquire your business in order to expand their platforms or eliminate competition (subject to antitrust).
- Financial buyers, like PE funds and family offices, look to acquire your business to grow and sell after a period of time.
- The choice to sell to a “strategic” or “financial” buyer is rooted in the owner’s decisions related to price, risk, management continuity, hold periods, leverage, and post-closing operations.
We now return you to our regularly scheduled program…
This month, we take a look at some of the different types of buyers and how those differences may impact a transaction from the seller’s perspective.
You’ll often hear people throw out terms like “strategic buyer” and “financial buyer.” These names aren’t very descriptive: financial buyers still need to be strategic, and strategic buyers still have financial motivations. However, while the labels aren’t perfect, it is helpful to think about how different buyers think and act.
Broadly speaking, a strategic buyer is already engaged in an operating business in the same or an adjacent line of business. A strategic buyer is typically buying to expand its existing platform and/or to eliminate competition (subject to antitrust laws). Disney’s acquisition of 21st Century Fox last year was an example of an acquisition by a strategic buyer.
A financial buyer is a fund that raises money from investors, which it then deploys to buy businesses to grow and later sell. While financial buyers are not industry-agnostic, they tend to be more flexible about considering and acquiring businesses that may not be in their existing lines of business. When a financial buyer first starts, it isn’t engaged in any specific business at all until it acquires its first “platform” operation. Financial buyers come under a number of different names and variations, such as private equity funds and family offices.
And to make things even more interesting, there are many strategic acquirers who are owned by financial sponsors. For example, a financial buyer may have already acquired a platform business and is now adding on to that business through “bolt-on” acquisitions. These acquirers share some of the attributes of both financial and strategic acquirers.
Thanks for the academic exercise, but who really cares? Well, while no two acquirers are the same, we can sometimes draw conclusions about how an acquirer will act depending on how they’re classified. Here are some of the key differences that might have an impact on your transaction:
This one is a major generalization because there are certainly situations where the common wisdom turns out to be wrong, but in many cases, the right strategic buyer is willing to pay more than a typical financial buyer. Why? Because a strategic buyer has the ability to quickly capitalize on more synergies than a typical financial buyer.
That word “synergies” sometimes scares people, and to be sure, some of these synergies involve reducing headcount for duplicative roles. They don’t need two CFOs, for example. But these “synergies” also include the intrinsic benefit of possibly eliminating a competitor or gaining new customers to whom they can immediately sell their existing products or services.
In contrast, true financial buyers don’t have the ability to immediately reap these same benefits. In many cases (as discussed below), the financial buyer needs the existing team to stay intact after closing to continue running the business. And the purely financial buyer doesn’t benefit from the elimination of a competitor or the acquisition of new customers because it’s not already engaged in the business. Instead, the true financial buyer sets its price based on its super-secret model for projecting how it will be able to grow and ultimately exit the investment.
However, there are two important points about financial buyers that we should raise here. First, many financial buyers have some motivating factors that don’t apply to strategic buyers. For example, private equity funds generally take investment from outside limited partners. They have a set amount of time during which they are allowed to deploy the invested capital. As that time period becomes shorter, financial buyers may become more aggressive in pursuing deals because the alternative is to simply give the money back to their investors. That’s not a good look for the private equity group and makes it much less attractive for future investment.
Second, some financial buyers act more like strategic buyers if they already have portfolio companies in that space. Why? Because many of the synergies and other benefits discussed above will be available to them.
Some sellers prefer to deal with financial buyers because they’re less threatening. It’s scary to share all of your secrets with a competitor, not knowing whether the deal might go through. Even strong non-disclosure agreements may not be enough if your primary competitor now knows all of your secrets.
3. Rollover/Management Continuity
As mentioned above, most true financial buyers not only intend to keep the seller’s management team in place after closing, they need the team. Unlike the strategic buyer, the financial buyer is relying on the team’s knowledge of the business and ability to continue managing it post-closing. Because of that, sellers who prefer to sell and simply walk away may have more difficulty doing so with a pure financial buyer, at least in the near-term.
Moreover, financial buyers almost always expect the seller to rollover part of the sale proceeds into an investment in the buyer company. These rollover amounts can range anywhere from 5% to 20% of the sale proceeds, and sometimes more. Financial buyers view this as important for several reasons, including the desire to keep the seller engaged and aligned with the company’s interests post-closing and to test the seller’s faith in the business’s future prospects. If the seller won’t invest at this valuation, why would the buyer pay at that same valuation?
Strategic buyers are often much more amenable to dumping a bunch of cash on the seller at closing and then letting the seller ride off into the sunset.
Sellers have different preferences. On the one hand, some sellers like the idea of continuing with the business and participating in some of the benefit of the company’s success post-closing—knowing that they’ve already taken the majority of their chips off the table. In some cases, that “second bite at the apple” can be significant…sometimes even exceeding the initial purchase price the seller received for the majority ownership stake in the company. But in other cases, this investment could become worthless. Because of that risk and other personal or retirement goals, other sellers like the idea of just walking away.
4. Hold Periods
This is a concept that really only matters if the seller continues on after the closing in some fashion, whether as an employee, owner, or both. Strategic companies generally acquire the business with the intention to own and run it for the longer term—a “buy and hold” strategy. Of course, circumstances change, so nothing is forever. But few strategics enter a deal expecting to “flip” the business.
In contrast, almost all financial buyers are buying the business with the intention of building it up and selling it down the road. That’s their model.
However, even within the category of financial buyers, there can be wide variations in how long the buyer intends to hold the business. For some private equity funds, the hold period could be as short as 3-5 years. On the other hand, some family offices—which are funded by a wealthy family, rather than outside investors—will potentially hold the asset for much longer because they don’t have the same constraints and obligations to limited partners. But as conditions change, all financial buyers will look for the right time to sell.
Both strategic and financial buyers may use leverage as part of their strategy, but the financial buyer’s model is usually built on using significant leverage to fund the transaction, as well as future “bolt-on” acquisitions.
This again only really matters for sellers who remain involved with the business post-closing, but it presents both a risk and an opportunity. The risk is clear: the business must perform strongly post-closing in order to service the heavy debt load, and thus provide any return on the seller’s rollover investment. The opportunity? Using debt can help the company grow quickly post-closing and potentially lead to a better outcome for the seller upon exit of the rollover investment.
The amount of leverage required to close the deal may also lead to additional deal risks. If a buyer relies entirely on a heavy debt-load to complete the deal, your deal could get sunk if the banks don’t have the same confidence as the buyer or if there’s some major upheaval in the financial sector (ahem, like now).
In contrast, a buyer who has the ability to finance the deal without taking on new debt provides a degree of added certainty to the deal process. That’s why even some financial buyers will make clear that they can and will fund the entire deal…if they have to.
6. Post-Closing Operation
One thing is for certain: the business will change post-closing, regardless of whether the buyer is a strategic or financial buyer. However, there are a few typical differences in how each may impact post-closing operation.
For strategic acquirers, the potential for immediate or short-term changes in the team has been addressed above. The changes could be even more drastic, such as a relocation of the entire business to one of the buyer’s existing facilities or completely shedding the seller’s brand and product lines. Strategic acquirers may pursue other acquisition opportunities in the same space, but that’s not necessarily something that has to happen for the strategic to view the deal as a success.
For financial buyers, it’s very common to have additional acquisitions in the same space. For many of these acquirers, their core model is to build up the business quickly through “bolt-on” acquisitions that will help accelerate the growth curve—and therefore accelerate the exit.
Both strategic and financial buyers will have their own way of doing things. Even in the best of situations, this can cause consternation for the seller and the historical team that continues on after the closing. Some sellers adjust pretty well to someone else being in charge; many others do not. And sometimes these changes will feel very personal.
And it’s common to see big changes in budgets and priorities. Financial buyers as a whole get a bad rap as corporate raiders who buy the company, slash and burn, and then carelessly dump the smoldering remains. In reality, very few financial buyers operate this way today, but they will make changes after the closing in an effort to produce the best return on their investment. While strategics also make these types of changes, it may seem more dramatic with a financial buyer who has a shorter hold period. Even for sellers who have already cashed out entirely, these changes can feel like an insult or a hit to the legacy they tried to build.
In summary, there’s a lot to think about when considering a sale of your company. Obviously, most sellers want to get the best price and terms. But there are other important considerations that come into play depending upon the characteristics of the buyer sitting across the table. Ultimately, you won’t know whether a strategic or financial buyer is a better fit until you see what they’re each willing to offer. For that reason, sellers ideally will want to solicit interest from multiple strategic and financial buyers to get a good mix of potential acquirers. From there, sellers can better assess all of the benefits and pitfalls of doing a deal with each interested suitor.
Next Month: M+A Motivations
Read last month’s piece: I’m Still Standing. Now What?