As the race for strategic mergers and acquisitions (M&A) continues, competition will only get stiffer between the various groups of acquirers competing to buy cash-flow companies. There are different types of investor groups on the hunt for acquisitions and the source of capital affects deal structure, investment horizons and strategic direction. In this article, we discuss acquisitions led by managers, private equity, special purpose acquisition companies (SPACs) and strategic companies.

Tutorial: Mergers And Acquisitions 101

Management-Led Buyouts
Management-led buyouts (MBOs) are acquisitions completed by a group of senior executives and former high-level operators who bring significant operational and strategic expertise. Their salaries may have been restricted by salary "bands" and ranges by their former company employers, enticing them to search for greener pastures. Successfully purchasing and running a company often provides much higher compensation, partly due to their contributed equity in deals.

Often, these former executives partner with a financier in order to help fund a transaction. Such equity partners generally control most of the outstanding shares. The new management group may earn a salary in growing the company; most importantly, they have strong incentives to increase the value of their locked-in equity. (To learn more, read How The Big Boys Buy.)

Accumulation plays have become the standard for value enhancement. This is a "defragmentation strategy," which involves the acquisition of many small companies in the same, or similar, industry. Combining them into a single larger entity increases equity value for shareholders, as larger companies achieve higher valuation multiples than smaller ones. MBOs have flexible investment horizons and depend on the preferences of the manager/shareholder and those of the financing partner. The investment horizon can be as short as two or three years, or the group may own the company for 20 years or more. There are typically many managers involved in the initial phase, so the financing partner or the other shareholders can purchase the shares for the investor wishing to liquidate his portion of the equity. (For related reading, see Institutional Investors And Fundamentals: What's The Link?)

In most cases, these types of operators bring the highest level of expertise within a particular industry. MBOs are led by managers who have successfully run businesses, and because they are often required by the equity partner to contribute a meaningful percentage of their net worth, these managers have strong incentives to make the business succeed. As a means of further inducement, many financing partners enact agreements that allow these managers to earn more equity and/or cash bonuses, if the company achieves certain performance benchmarks. (For further reading, check out Evaluating Executive Compensation.)

Private Equity
The second group of investors looking to acquire companies is private equity. These acquirers have pools of capital raised from high net worth individuals, private equity fund of funds (financiers who only invest in other private equity firms), university endowments, and government and corporate pensions.

While various compensation structures pay these wealth managers to earn rates of return for investors, private equity firms typically earn a management fee of 2% of committed capital per year, as well as carried interest of 20% of profits. Attractively, the latter is taxed at the current capital gains tax rate of 15%, as opposed to the much higher ordinary income tax rates.

Private equity managers face strong incentives to earn high rates of returns, by increasing the value of portfolio assets. In terms of talent, they seek the best and brightest, and when they successfully defragment an industry and create a platform company, the exit strategy often calls for a sale to an acquiring public company that can pay higher multiples. Later rounds of fundraising often yield much higher amounts of committed capital for managers with strong track records, allowing them to increase their individual compensation, due to the increased amounts of committed capital. (For more on this topic see, Private Equity Opens Up For The Little Investor.)

Such firms normally have an investment horizon of five to seven years; the successful divestiture of a portfolio company allows its investors to realize returns. Due to stiff competition from other funds, these firms often partner with "executive affiliates," former senior industry operators and executives who help source good companies, as well as run them successfully.

Special Purpose Acquisition Companies
SPACs allow common investors to access the buyout marketplace. SPACs sell their shares in lower dollar denominations and are public shell companies, often created by investment banks for the purpose of merging with a private company. In effect, these are vehicles for taking private companies public, but on a shorter and less costly time horizon than a traditional initial public offering (IPO).

SPACs are garnering popularity as a means for public shareholders to acquire companies. Financial institutions create these public shell companies in order to generate fees, as SPACs normally reserve 10 to 15% of the capital generated for various fees and accounting and legal expenses associated with a merger. These vehicles also provide ready sources of money to fund acquisitions for senior executives who would like to run a public company. Additionally, these managers receive a hefty equity stake in the public company. Investors who fund these vehicles are, in effect, betting that the managers will be able to successfully acquire a business within 12 to 18 months, and successfully run it. These shell companies are especially aggressive when it comes to acquisitions; if they are unable to successfully acquire the business, investors lose a percentage of their committed capital. Finally, these acquisition companies can pay higher multiples when acquiring a private company due to the public nature of the source of capital.

Strategic companies join the buyout frenzy when they see operating synergies, opportunities to gain market share, and other complementary strategic overlap in a target company. Private equity has helped to consolidate industries and build platform companies and has created mini competitors for the largest public strategics. When investment banks take private companies for sale in a full auction environment, strategic acquirers often pay the highest multiples due to their massive acquisition war chests.

Smaller private companies offer ready inclusion into the acquiring company, as professionalized systems in finance, human resources, procurement, legal and operations are directly carbon copied into the acquired company. Many managers and other employees at the acquired company are often let go en masse post transaction, because of the more professionalized parent organization.

Perhaps the quintessential example of a strategic acquirer is General Electric, especially under the stewardship of legendary CEO Jack Welch. Under his leadership, G.E. acquired 993 companies from a highly diverse set of industries. Due to the conglomerate nature of the public strategics, smaller strategic companies attempt to fend off hostile takeovers by including poison pill provisions in their corporate charters, which destroy value for the acquiring investors.

The Bottom Line
There are many players in the buyout landscape and they can come in many different forms. It is important to understand the structure of these key players, because their influence on the markets will remain great and will likely only increase into the future. (For more information on this topic, see Mergers And Acquisitions: Understanding Takeovers.)

Related Articles
  1. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  2. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  3. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  4. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  5. Markets

    The Biggest Private Equity Firms In India

    Learn about the leading private equity firms operating in India and which companies and industries are attracting foreign investment dollars.
  6. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  7. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  8. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  9. Financial Advisors

    Are Alternatives Right for Your Portfolio?

    Alternative investments are increasingly making their way into retail investors' portfolios. Are they a good fit?
  10. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  1. Do hedge funds invest in private companies?

    Hedge funds normally do not invest in private companies because of liquidity concerns. Capital funding for private companies ... Read Full Answer >>
  2. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
  3. Can mutual funds invest in private equity?

    Mutual funds can invest in private equity indirectly by buying shares of publicly listed private equity companies, such as ... Read Full Answer >>
  4. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  5. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>
  6. How does investment banking differ from commercial banking?

    Investment banking and commercial banking are two primary segments of the banking industry. Investment banks facilitate the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center