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How to Manage a Private Equity Sale Process: "The Market for Lemons"

Twenty years ago a fresh faced economics undergraduate read a book called An Economic Theorist's Book of Tales by Professor George Akerlof. In it was a paper called The Market for Lemons that talked about the problems of selling things where the seller knows the quality of the thing, but the buyer doesn't. Akerlof concluded that the market might fail to work irrespective of the price in these circumstances. Akerlof won a Nobel Prize; the undergraduate was John Gilligan, now a corporate financier.

Part of a corporate financier's job involves preparing, marketing and selling companies. Corporate assets are, by their nature, complex and can conceal many risks to the unwary buyer. Of course the vendor knows, or perhaps should know, what these risks are, whereas the purchaser generally does not. It is much like Akerlof's "Market for Lemons" - one side knows more than the other. A good corporate financier's job is to make an efficient market in the asset and get a deal done. The worst outcome is the one Akerlof got his Nobel Prize for spotting and explaining; You can't sell it at any price.

There are basically two tactics, and many variations on those tactics, when selling a business:

Either;

Decide what you think a good price is and find someone who'll pay it,

Or;

Find everyone you think might buy it, and ask them their price.

The latter is, of course, the almost ubiquitous auction process adopted in the majority of situations. The upside of a controlled auction is that you maximise the chance of finding the buyer prepared to pay the best price; the downside is that everybody in the industry knows the business is for sale, and when competitors know the business is for sale they invariably start to use this to gain a competitive edge. You can draft confidentiality agreements from now until the Devil skates to work, but experience suggests that widely run processes leak. If the business doesn't sell, it can be catastrophic for trading relationships and destroy the value created by years of prudent management.

The second decision is what to say to potential purchasers in the Information Memorandum ("IM")? All of the professionals in the M&A industry are generally both buy-side and sell-side participants. We all create and receive information packs about corporate assets all the time. It is therefore somewhat surprising how many Information Memoranda contain aspirational, rather than realistic, descriptions of the business and its prospects. "Hockey Stick" projections abound, businesses projected to grow so rapidly that they start to fall foul of the monopolies legislation by year three. New products that capture the Zeitgeist despite having failed to gain any customers during the accounting periods headed "Actual". One certainty in any sale process is that falling behind budget during the process flows straight to value. If the shortfall is material, the evaporation of confidence may leave the business un-saleable. The frustration to vendors is that the converse is rarely true. The only way you usually get more value from being ahead of budget is usually via the closing net asset or cash adjustment. Rarely can you get bidders to offer a multiple of the excess more without reopening an auction process with all the attendant risks.

A poor IM is generic, describes everything as "leading" ("the world/UK's leading widget manufacturer/service company") or other such hyperbole and contains a brain dump of information about the business leaving the acquirer to wade through and find what is important for himself, if he has time and can be bothered.

A good Information Memorandum:

• Is, if possible, tailored to the specific purchaser who receives it;
• Has a coherent narrative that explains the true value drivers of the business from the perspective of the purchaser in terms that are familiar to the intended recipient;
• Relegates un-necessary data to clearly headed appendices, preferably, as one colleague always insists, in a separate data appendix document that can be referred to side by side with the IM text;
• Is readable. The authors of IMs should be continually reminded that nobody (normal!) ever bought an Information Memorandum as fun bedtime reading. The author's style is important. Long sentences of meaningless jargon are less use than short sentences that contain useful facts. Sections written by different people that are not in the same style or tone, will grate with the reader, and;
• Goes through rigorous quality controls to make sure it not only stacks up as a narrative, but that it adds up as a set of data. Adjusted P&L accounts imply adjusted balance sheets if it is all to reconcile.

Selling a business is about selling and validating this narrative. The vendor and his advisers tell the story of the business sewing together the history and future. Often the best way of honing the narrative is to spend a disproportionate amount of time and effort writing the executive summary before producing the main body of the document. The body of the document then becomes the expanded articulation of the Executive Summary and the appendices the detailed supporting data. As the saying goes "Tell them what you are going to tell them. Tell them. Tell them what you told them". The purchaser reads, understands and likes the way the story fits into his view of the world. That's why they bid.

The tactics of bidding in a typical multipart auction are generally straightforward. Bid as high as you can, there's no point not being in round 2. This sets the tone for all that follows. The process is one where the adviser tries to defend the highest bid and the purchaser tries to find reasons to reduce it. A tug of war ensues that is won by the party with the strongest character.

The brave have occasionally applied Game Theory, the intellectual offspring of another Nobel Laureate, John Nash, to the auction process to address these short-comings. One could, for example, tell purchasers that the highest bid would be excluded to encourage realistic bidding, or alternatively tell all second round bidders what the highest first round bid was. In practice however the process almost always involves a straightforward auction followed up by conversations with bidders to gauge the seriousness, or otherwise, of the bid.

So, whatever process is run, the putative purchaser offers a value and if acceptable, proceeds to check the coherence of the story that underpins that valuation via due diligence. If it doesn't stand up, the price goes south.

There are again basically two extreme ways (and a continuum in between) of running the validation/due diligence process:

Either;

Let the purchaser have full access and do as much DD as they like and tell them to rely on their advisers for comfort,

or;

Strictly limit the access to the business but be prepared to answer any reasonable questions asked and give meaningful warranties that the answers were truthful.

The decision regarding which risk is acceptable depends largely upon the assessment of the vendor and his advisers regarding the probability of completing a deal. If you are highly confident that the business will be sold it's most logical to give freer access to the purchaser. If you aren't sure or anticipate a price chip, you would want to restrict access and run more than one party in parallel. If you think the purchaser is just on a fishing trip you will want to see meaningful cash invested in the deal process, either as a deposit (difficult to negotiate but not impossible) or in (say) a considered and reasonable mark up of a draft SPA in conjunction with appropriate advisers before going to the next stage.

Having found a process that allots the risk of things that people should or do know about, the question always remains as to who should take the risk of things that nobody knows, or should know about.

Some years ago I advised on the acquisition of a nuclear energy business that had built many facilities that dealt with nuclear reprocessing but were no longer in the construction and engineering market. The question was; 'Who takes the risk of a particular piece of equipment failing to do what it was supposed to be doing?' The lawyers argued for hours but we all became bogged down in an apparently insoluble impasse. We asked one of the management of the business, a world expert on the modelling and assessment of engineering risk, if he could figure out what the cost of the plant failing in this particular way would be and if there was a solution from an engineering perspective that might get us past the point. At about 3am he came back and gave us the following memorable advice: "The probability of [the event that you are discussing] occurring is approximately 1 x 10-19. To put that in context for the lawyers, that's around 1000 times less likely than the sun not rising tomorrow." My client decided to accept the risk (if the vendor conceded on some unrelated and unresolved issue!) and we completed the transaction the following morning. The lesson? When allotting risk, it helps if someone in the room really deeply understands what they are talking about. It's not enough to identify risks, you need to quantify them if your negotiating position is to achieve an optimal outcome.

About once a year, you get the dream client, a business that is of a higher quality than the market suspects with a strong, acquisitive, strategic buyer out there. A tactic we've used to great success in these circumstances is to play down the business in the IM, finding a tone that's upbeat but including projections that are conservative. The strategic purchaser, assumes that you are overselling the business ("All IMs are over optimistic"), and will bid on the assumption that the price will fall in due diligence. When they find things to be as you said, it's very difficult for them to cut the price without a good reason and, because it's a strategic purchaser, they can't risk the fall out of an unjustified price chip losing the deal. On more than one occasion in the past I have told the purchaser the "reserve" price of a business that was strategically important to him - often directly, sometimes by implication. On more than one occasion the code name was the clue - Project Hawaii (Project Hawaii = £50m, as in "Hawaii Five O") has been used a couple of times: we told the purchasers it was a word association game. Indeed a former partner of mine and I once spent an evening thinking up code names for every price from £1m to £100m. A personal favourite was the range implied by Project Enid Blyton: As every English School child of a certain age would know, this denotes a range between (famous)£5m and (secret)£7m!

Where there are only financial bidders, the risk of spurious over-bidding escalates rapidly. It may not be popular to say it, but it is a universal truth that not every Private Equity investor is upper quartile and not every Private Equity firm intends to pay what it bids in an auction. The risk of spurious bids increases further where there are no valuable commercial relationships at stake between purchaser and vendor or vendor's advisers. Again at the risk of being unpopular, overseas PE entrants to the UK market have a generally lamentable record for over-bidding and pulling out after limited due diligence. Equally some of them have recognised that they need to buy a market position and outbid the UK's traditional market participants with every intention of completing on that price.

Having received bids, whittled them down to one or two, how do you get the deal over the line? I often tell clients that it's either like the beard scene in the market chase in Monty Python's "The Life of Brian" - "You've got to haggle", even if you don't want to - or like a marriage ceremony - you can't just wander up to the alter and say "I do", you've got to go through the whole ceremony including the "I do" bit. Deals have to go through a process and each one has its own tempo set by, amongst other things, the skill and judgement of the project manager. US buyers, for example, have a totally different approach to warranties and indemnities to UK buyers. Those operating in the US corporate environment are acutely sensitive to the risks of litigation. UK and European players are much less concerned about the possibility of suing/being sued and much more interested in using the threat to force disclosure to minimise acquisition risk. This alters the tempo of the deal process. The experienced adviser is constantly looking down the track and anticipating the foibles of both his adversary and his own client. The analogy we use is drawn from another passion: motor racing; It's not how fast you go into a corner that matters, its how much speed you carry out. "The last of the late breakers" may look spectacular, but in reality it's never the quickest way round a track. You need to be smooth and anticipate the road ahead to get things done as quickly as possible. Knowing when, and with whom, to intervene and when to leave things to resolve themselves is all about judgement and experience.

So how do you sell a business?

Tell a coherent, credible story that seamlessly takes the business from the past into the future. Pitch the business appropriately for the intended purchasers. Beware the disingenuous over-bidder; they are often the worst of all time wasters. Agree a process to allow the purchaser to get comfortable with the risks of the business. Look well ahead as well as at the road in front of you and know when it's best to do nothing. And, remember Akerlof's Nobel Prize and "The Market for Lemons": Where information is asymmetric, if you don't know what you are doing, there is a very real risk that an asset won't sell, whatever the price.

John Gilligan is a corporate finance partner at PKF accountants and business advisers and a Special Lecturer at The University of Nottingham Business School. He began his career at 3i in 1988 and spent 10 years with Deloitte, latterly as a corporate finance partner. He has also been a non-exec on the board of a number of private companies and was a member of the ICAEW Corporate Finance Training Faculty.

For further information on PKF visit http://www.pkf.co.uk