Andrew Greta's Business Development Blog

A recent article in The Economist did a post mortem on the 10-largest leveraged buyouts (or LBOs) of the year and found many were in trouble almost from the start. Lenders and companies both pushed the very limits to the point where businesses now walk a razor thin line where the tiniest misstep or earnings hiccup could plunge them into default.

To understand why deals like the giant TXU transaction (done by a consortium of brand name investors like Goldman Sachs and KKR), or Blackstone’s buyout of Hilton Hotels could now face the danger of bankruptcy, you first have to dissect the typical LBO to understand its anatomy.

A leveraged buyout is simply a method of financing the purchase of a company or asset using a significant portion of debt financing which is typically serviced by the operating cash flows of the business itself. A classic real-world example of an LBO occurs when a landlord purchases a rental property as an investment. The investor puts up a portion of the purchase price as equity in the form of a down payment, and the bank lends the rest. If the deal is done at the right price, the monthly lease income from the tenant more than covers the investor’s after-tax interest, principal, and maintenance costs with maybe a tickle of cash flow left over for cushion.

But that hardly sounds like a great way to get rich. Real estate (and other hard-asset businesses like heavy equipment, and utilities) generally grow with the overall economy at or around the gross domestic product (or GDP). Why would I look at an investment in a staid old asset growing at a steady but boring 3-5%, when I could sink my cash into the stock market or next high-growth VC-funded biotech company and perhaps make much more?

The secret is in the “L” part of LBO – or leverage. By using the bank’s money as a fulcrum, I can dramatically increase the power of my equity stake and reap huge gains (or losses) on my investment. To see how, remember that leveraged financing is typically in the form of a loan from bond buyers who are guaranteed a stated interest rate no matter how the company performs. As long as I pay my interest, the bondholders don’t get any upside (or face any downside) based on company performance.

So, if I buy my $1mm rental property (or oil rig, or fleet of leased railcars), with say 10% equity that means I ante up $100,000 and the bank (or bondholders) front the rest. If the investment rises in value just 10%, I’ve doubled my money (and this is ignoring any pay-down of debt you might choose to fund out of operating cash flows). The more leverage (i.e. debt) I can pile on, the more I stand to make on my equity investment so I have an incentive to push the limits – and banks are only too happy to lend in booming times awash with liquidity.

Unfortunately, if those initial cash flow projections aren’t right, the property bought at too high of a price, or if market conditions later impact asset values or revenue streams, the bondholders can be left holding the bag. This is what seems to be brewing for companies like TXU as their cash flow now looks insufficient to make their interest payments.

But, at the end of the day, the companies may still not be out of business. Most bondholders don’t have any experience actually running the companies they loan to (witness GE Capital’s ill-fated takeover of Montgomery Ward after a bond default as a classic example). So, when push comes to shove, most are likely to restructure the loans and give the company a chance at survival. And even in the event of an outright liquidation, hard assets tend to retain some value so it’s unlikely the lenders will suffer 100% losses.

While often overlooked in the glamorous world of growth investing, LBO specialists (often termed private equity), can quietly continue to do extremely profitable deals of 20% ROEs or greater based on fundamental cash-flows, and hard assets by focusing on areas and industries others might consider boring. But just like any deal, they aren’t foolproof money makers if over-enthusiastic bidders pay too much or are too optimistic in their assumptions.

Labels: Structuring

posted by Andrew Greta  # 9:46 AM 0 Comments Links to this post

Once corporate strategy identifies a new industry or market with attractive fundamentals for the business, M&A jocks often mount up the I-Banker safari wagon, lock & load the elephant gun, and roll off into the Serengeti in a cloud of dust to bag the next big acquisition. While M&A is often the cornerstone of a good business development function, outright acquisitions aren’t always the best path into new markets.

Building (through a new product development process or Greenfield business startup) should always be considered as an option even if discarded or reserved as a fallback position to any eventual 3^rd party negotiation – even if it doesn’t result in a commemorative Lucite paperweight for the trophy case. In addition, skillful partnership creation is becoming increasingly more important in our rapidly globalizing economy as certain jurisdictions place limitations on foreign ownership and investment. Narrow-minded deal junkies with only a hammer in their corporate development toolkits run the risk of seeing every opportunity as a nail instead of taking a more nuanced approach to targeting value.

Listed below is a menu of entry options along with typical pros and cons to consider before blasting off on the next game hunt.

A well-rounded business development function has skills in each area and can fit the right tool to the job. And while BD bread-and-butter is executing acquisitions and JVs, we’ll consider each entry path in greater detail on future posts.

Labels: Strategy, Target ID

posted by Andrew Greta  # 3:13 PM 0 Comments Links to this post

According to Reuters, merger activity in the United States dropped 29 percent in the second quarter as financial deals driven by leveraged private equity shops dried up from lack of lender liquidity. Meanwhile, strategic investors are seeing opportunities to snap up cheap assets, bidding for stalwart consumer staples like Anheuser-Busch Cos Inc (BUD) and Wm. Wrigley Jr Co (WWY).

But what’s this distinction between financial and strategic acquisitions? Aren’t all deals just deals and shouldn’t they all be driven by financial returns at the end of the day? After all, we don’t want to be like the misguided company president I once heard describe an acquisition that, “isn’t expected to make any money… it’s strategic”. Yes. Good deals create real economic value for the participants, but the distinction is often how that value is realized.

In the most general terms, financial investors tend to be hands-off money. They invest in opportunities at an arms-length and expect to reap their gains in a future sale, or recapitalization of their holding. Any Joe on the street who buys stock online through his internet broker is the epitome of a financial investor, as are Wall Street firms and other investment funds.

Financial Deals

Strategic investors, on the other hand, are more like the Monster Garage mechanics of the financial world. Their interest is in buying up businesses, properties, assets, and technologies they can integrate and use to build something better. Typically these are operating companies pursuing corporate and business development activities on their own behalf.

Strategic Deals

This is clearly a gross simplification and deals can involve complex hybrid approaches (e.g. it’s not uncommon for a private equity LBO shop to take an active role in a company’s operational turnaround after an acquisition) but it provides a general framework to understanding where deals touted in the press fit in terms of rationale.

We’ll cover each of these deal types in greater depth on future posts.

Labels: Business Development Basics, Strategy

posted by Andrew Greta  # 11:04 AM 0 Comments Links to this post

“The theory is simple,” he used to relate during deal review meetings as a precursor to any new or “visionary” business proposal. “Regardless of how unique you think your business is, certain core fundamentals remain. If you can’t map out your high-level business model showing inputs, outputs, customers, suppliers, value creation, and strategic barriers on a cocktail napkin for your airplane seatmate at 30,000 feet, you haven’t thought through your pitch.”

“The secret,” he said as he walked us through the process, “is to start with the customer and follow the money. Don’t get hung up on the minutia. Capture the core of your business model that explains the most material 80% of what you do and save the peripheral nitpicking for later follow up.”

1. Customers: A concise summary of who pays you and for what. Capture the main customer group (or groups if they’re big enough to be material). Are they paying directly for discrete goods and services, or is it a subscription-based flat-fee model? What are they getting from you in return? Try to boil this down to a per-unit measure which can roughly equate to average revenue-per-customer.
2. Suppliers: What are the inputs needed to create your product or service? Common big block categories include compensation and benefits for employees (which can be the vast majority of cost for a service business or other high-tech company), assets (like machinery, vehicles, facilities, or computer servers), and raw materials (especially in manufacturing organizations). Are these fixed costs (does your rent bill come due every month regardless of whether you sell a single item) or variable (incurred only when you produce a product or service)?
3. Value Add: What role in the business process is your company playing to add real economic value? Common answers can be assembling raw materials into finished goods (manufacturing), getting physical stuff efficiently through a supply chain (distribution), providing skills and information to help customers make or save money (services).
4. Margin: Once the customer pays you (revenue) and you pay your suppliers (costs), what’s left over is your operating margin. Focus on your core business for the moment and figure this on a cash-basis ignoring additional outflows like interest, taxes, and dividends.
5. Strategic Barriers: Finally, it’s time to explain what keeps you competitive in the marketplace and allows you to reap the margins you enjoy? Is it an advantage in scale that allows you to produce at the lowest cost? Is it high quality and better service? Or is it some sort of barrier to entry like exclusive access to scarce resources or ownership of a key patent. Answering these questions carefully will help you identify the sustainability of your business while pinpointing key threats.

After looking at his seatmate’s business model, my former CEO quickly realized that the would-be entrepreneur was competing on price alone in a commoditized industry. He had negative margins funded by investors (as a customer subsidy) with no barriers to entry. He predicted that once the VC money burned up, prices would increase by necessity and customers would switch to other substitutes. A few month’s later he was proven right – which shows the power of cutting through pulpy marketing spin and buzz to hit hard bone of business fundamentals when evaluating any new opportunity.

I believe all businesses can be modeled at a high level with this approach. But if there are readers who think they’ve got a really unique stumper that’s so out-of-the-box that it can’t possibly conform, let me know here and we’ll see if we can model it out in future posts.

Labels: Pitches, Strategy

posted by Andrew Greta  # 12:04 PM 1 Comments Links to this post

A solid deal process is roadmap for executing good transactions quickly and effectively while providing the framework needed to eliminate bad deals affirmatively. While some may feel that following any kind of process is cumbersome and takes the creativity out of deal making, the opposite is true. A good deal process provides structure and tollgates that can help move deals along faster and keep teams focused to eliminate red herring distractions. It also frees up the deal team to spend meaningful mental energy on the *real* sources of creativity and business development value – problem solving, overcoming obstacles, making strategic connections that others don’t see, and designing elegant structures to reach value-creating solutions.

The process starts out with strategy and planning. Some BD departments run the strategic plan itself or participate in this work. Other times it’s a hand-down from a visionary leader, output from a consultant, or the product of an annual corporate-wide strategic process. Whatever the origins, new “inorganic” growth paths (i.e. opportunities outside of the current core business) quickly break down into a Buy, Build, or Partner decision. Typically Build paths fall outside of the BD mandate and are taken up by the new product introduction process (NPI) with the appropriate departments contributing to the effort.

Buy and Partner decisions are the bread and butter of business development. From here, it’s up to the orchestrators of the deal team to marshal resources through the key stages. A typical proactive process includes the following steps:

Target Identification: Teams canvass the landscape of potential acquisition or partnership candidates, assessing size, strategic fit, and opportunity to do deals. Targets are prioritized based on a variety of factors which vary with the circumstances and rationale of each deal.

Originate: The target is approached and engaged in initial discussions. Typically non-disclosure agreements are executed at this time to enable greater information sharing.

Value: Once initial business and financial information is collected, a preliminary model is developed informing the internal team on viable bidding ranges, economic inputs, and business risks. Typically, a letter of intent (LOI) is issued at this tollgate indicating a preliminary range and deal structure with certain carve-outs or contingencies for items not fully assessed on a preliminary basis.

Due Diligence: If the LOI is accepted, it’s time to dig into the records, financials, operations, and assets of the target in depth to confirm assumptions and uncover deal-impacting issues. Due diligence can range from simple paper contract reviews when buying a portfolio of loans for example, to full site visits, environmental audits, systems reviews, and personnel assessments for large operating businesses.

Structure: Once due diligence is complete, revisions are made to the offer and – assuming no deal-killing items are discovered – a structure and terms are proposed.

Negotiation: Parties negotiate the final terms of the deal. Typically, the LOI terms would be codified into legal-eze, and any open items addressed. Contingencies like anti-trust reviews and shareholder approvals are identified and documents are signed.

Close: Assuming contingencies are met, pre-identified purchase-price adjustments may be made, funds change hands, and the seller “hands over the keys”.

Each step in the process requires different skills, competencies, and information. From what I’ve seen, it would be possible to devote an entire book or career to fully capturing and mastering the complexity of each step. We won’t attempt to boil the ocean here, but future posts will cover and discuss the individual steps in greater detail.

Labels: Business Development Basics

posted by Andrew Greta  # 10:02 AM 0 Comments Links to this post