It can often be the case that sellers get a sense of the price their company will command at sale from friends of theirs who have sold similar businesses. But, according to Peter Leemputte, Principal at Wind Point Partners, when the math is laid out, that logic doesn't work if the buyer universe is expecting the same level of returns.
“Sometimes education is the medicine for that,” Leemputte said at last year’s Chicago Smart Business Dealmakers Conference. “Sometimes it's just time. And that's I think another reason why deal count has been down so much.”
He says the change in financing for just a four-month period saw rates skyrocket.
“You get term sheets, you put an offer in front of a seller, and then your financing is going up 4 percent over the course of two months when you're trying to get your diligence done,” he says.
That, he says, can even lead to conversations with LPs who are seeing their returns comparatively diminish, so it’s unsurprising that sellers’ mindset has yet to adjust.
To bridge the gap between expectations and reality, some buyers are using earnouts. Leemputte says they’re often a solution when there’s a valuation or expectation gap. But it’s just one tool.
“The solution is often structuring, whether it's earnouts, or seller notes or other things like that,” Leemputte says. “And sometimes for sponsors that can hold on to an asset for longer, they'll just hold on to it for longer if they want to avoid that complexity. A lot of the deals that are getting done right now, or the relative portion, is more leaning towards founder-owned businesses, family-owned businesses, carve outs from bigger corporates. And so they might not have the same timing flexibility that a sponsor could. And so for them to bridge that gap, an earnout or other types of structuring is really oftentimes the solution.”
Inflationary pricing has created a wrinkle in the earnout conversation. He says often early conversations in diligence during the management presentation or conversation with an owner is about how the company performed during the recession. The more time that’s passes since the event, the less focus there is on the impact to the business. But recent events have revived that line of inquiry.
“’What happened during COVID’ is just the new ‘How did you perform during the recession,’” he says. “And it's so recent. There's still so much noise and all these numbers that it just becomes the primary diligence for half the businesses you look at. I think the effect of that is just timing. It's just hard to unpack all the factors that play into it. And when cash is tighter, in this interest rate environment, the margin for error is just smaller for buyers. And so that plays itself out in elongated diligence processes as a result.”
Reps and warranty insurance has been used to expedite deals and make it simpler for sellers. But he says it can be a challenge to get paid for the expensive package that was negotiated. Because of that, he says buyers are more focused on bring airtight in negotiations, because nothing can be taken for granted. So, owners, he says, can benefit from operating at all times as if they have an active data room, and keep that mindset when it comes to how they're archiving things and running their business, because that can become material dollars for sellers.
With how long diligence takes and the challenges with financing, he says it requires his firm to be purposeful about how they spend their time.
“You need a reason to do it because everyone's looking for reasons to not do deals right now,” Leemputte says. “I think that three deals we've done, one was with executives that we had known for 10 years in the space, so that made that one easier. And the other two are family owned businesses that we had developed relationships with over several years, as well.”
