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How to Tell When Your Investment Banker is Lying |
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Written by Administrator
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Monday, 22 September 2008 |
Source: This article originally appeared in the Private Equity International special supplement "The U.S. Middle Market."
How can you tell when your investment banker is lying, asks the old joke. When his lips are moving, comes the punch line. But as the market for corporate control becomes increasingly competitive, making sure you and your investment banker are on the same page takes on an added sense of urgency: it is no longer a laughing matter. The following is a quick survey through several topics in relation to which agency risks can interfere with optimal deal execution.
Fee Structures
The Lie: "We like flatter fee structures, which are better for the client."
The typical M&A sellside fee is structured with a retainer fee, success fee, expenses, and, possibly, one or more progress payments. Of these four elements, the success fee is almost invariably by far the largest component, and the key to a successful fee package tends to be in negotiating the optimal success fee. For illustrative example only, in selling a company that we expect to be valued between $100 million and $120 million, we might seek a success fee equal to 1 percent of the value of the company up to $100 million plus 2 percent up to $120 million, plus 3 percent up to $130 million plus 5 percent thereafter.
I have been surprised to hear, in both competitive bidding contexts and at the various industry forums, the claim made by some investment banks that a steeply ascending percentage success fee such as the one outlined above is somehow less client-friendly than a "flatter" structure, such as a flat 1.5 percent. Nothing could be further from the truth.
Agency risks in sales is well-documented. In his provocative book Freakenomics, Steven Levitt points out that real estate agents tend to sell their own homes for better prices than they get for the homes of others. This is because the agent is not incented the same way to hold out for a better price when he is merely an agent as when he is a principal. An incremental $10,000 of purchase price means a lot to someone selling on his own account, but not that much to a real estate agent expecting only a 6% commission. When acting as an agent, the broker is simply likely to conclude that the certainty of a lesser value outweighs the small risk-adjusted benefit of seeking a higher one. Incentive Fees escalators go a long way towards solving this problem and insuring that your agent is incented to get you the best possible price.
Valuation
The Lie: "Your baby sure is beautiful."
Not all babies are beautiful, but all mothers think their babies are. In pitching for the right to sell businesses, sellside bankers are presented with a tremendous game theory dilemma, as they effectively bid with their competitors to put ever higher values on companies in their pitchbooks. Conventional wisdom holds that this is the sort of cheap parlor trick that might bamboozle one of those simpleton entrepreneurs (you know, the ignorant sort who grew a $200 million business from scratch) but not the sharp-eyed denizens of Park Avenue who staff the better precincts of private equity. Personal experience, though, indicates that even with experienced sellers, the high valuation "bid" almost always wins a sellside mandate.
This is, to some extent, understandable: the firm most enthusiastic about value should, all else being equal, make the best selling agent. In practice, though, some sellside bankers have simply gotten very good at playing the valuation game during pitches, and hope that a rising tide in the deal market will bail them out of any trouble or that, at bare minimum, memories will soften in the Port-induced haze of the closing dinner.
There is no simple cure for this problem, but sellers are well advised to weigh relevant experience, availability of senior-level attention, and familiarity with the likely buyers more heavily that a preliminary valuation number. They are also well advised that they have an instrument tailor-made to keep the banker honest about value: forcing the banker to set his incentive fee structure off of a base-line value, the seller can push the banker towards his "real" vision of value and away from pitchbook hyperbole.
Over-Auctioning
The Lie: "Broad auctions are always better--the more the merrier when it comes to buyers."
It is our belief that middle-market companies are somewhat over-auctioned. This might seem strange coming from bankers who are deservedly well known for running successful, extremely wide-reaching auctions. Nevertheless, we have observed a number of sellers opting to sell companies more broadly than perhaps they should.
The choice of type of sales process is made by a seller in consultation with his investment banker and generally involves selecting a particular point along a continuum which runs uninterruptedly from a negotiated sale to a single buyer, on the one hand, to a broad auction open to all comers (and perhaps advertised by SEC disclosure, press release and/or selected press leaks) on the other. There are many factors that should be weighed in deciding what process best fits a particular circumstance, including concentration of likely strategic buyers, size of the potential transaction, sensitivity of proprietary trade information, and disruption likely to be caused to the business from leakage of news of the sale to customers, suppliers, employees, or the public.
Again, agency risk often rears its ugly head here. Many selling bankers tend to bias their advice towards over-broad sales process. Potential motives (conscious or unconscious) are several, and may include a lack of confidence in the bankers' own ability to identify the most appropriate buyers or a desire to show more "sellside product" to private equity firms or other key clients and prospects. This takes on added import since the number of "ideas" shown to private equity firms is often used as a factor in the award of future banking business by those firms. It is important that a seller work together with his advisors to determine which process is best for the seller, not for his investment banker.
Stapled Financing
The Lie: "Stapled financing will always assist a process, and at any rate it sure can't hurt."
Stapled financing consists of financing packages arranged by a selling banker and available to all comers. There is a place for this in certain transactions, especially where the relevant corporate assets are difficult to value or finance, perhaps by virtue of their highly unusual nature or of a troubled history. We ourselves often arrange stapled financing packages in relation to sales processes that we run. However, we believe that as a general rule bankers have systematically over-used this technique to the detriment of their sellside clients.
First, a stapled finance package can send the wrong message to both strategic and financial buyers: strategic buyers can take away that the auction process is tailored to financial buyers, while financial buyers can take away that the auction is being run as the purest sort of IRR auction.
Second, a stapled process tends to allow the gossipy world of senior lending earlier access into the heart of a deal. I was recently disconcerted to have a senior lender I spoke to at a cocktail party blithely recite to me the precise values at which each and every participants in one of our active auctions was bidding.
Third, there is a time-honored cannon of construction which holds that inclusio unius est exclusio alterius (to include one thing means to exclude another). If a bank too often provides stapled financings on its deals, an added amount of scrutiny will be placed on those circumstances where stapled financing is not provided.
Fourth, stapled financing is sometimes seen by the market as little more than a cynical holdup. No bank I know (ok, almost no bank I know) would be so gauche as to actually say that use of a bank's staple would increase the odds of a buyer being invited into a second round or anointed the winner of an auction. This does not, however, prevent buyout firms from assuming that this is the implicit bargain.
In other words, while stapled financing is a legitimate weapon in a selling banker's arsenal, its unconsidered use, or overuse, is often a sign that the banker is thinking about his own bottom line rather than the interests of his client.
Investment bankers are, despite the almost superhuman ability to distinguish between fine cigars and single malt scotches, only human. With the best of intentions, they will sometimes have their behavior distorted by fundamental aspects of agency risks. Of course, working with a knowledgeable and reputable middle-market banker will mitigate these risks and ensure that the best result is achieved for the seller.
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