3.1 Finding and evaluating deals

A buyout firm looks at many more companies than it ever buys. Most are rejected after a quick look, some after weeks of work, and a few go all the way to closing. How a firm finds and tests deals has a big effect on the price it pays and the mistakes it avoids, and so on the returns its investors eventually receive.

You don't need to run a deal to benefit from knowing the process. Operations staff fund and book the investment, investor relations teams and LP-side analysts are asked how a manager sources and approves deals, and service providers are involved at several stages. This lesson follows a fictional buyout firm, Ashcombe Capital, as it buys Northfield Components, a mid-sized maker of industrial parts, through Ashcombe Capital Fund I. The steps and timelines are illustrative and vary a lot from deal to deal.

The deal process at a glance

This is the same journey a lender follows in PC101 4.3 (The deal lifecycle), seen from the buyer's side. The buyer and its lenders run their processes side by side, because the buyer usually needs the debt agreed before it can make a firm offer.

Sourcing: proprietary deals and auctions

Deal sourcing is how a firm finds companies to buy. There are two broad routes.

A proprietary deal is one the firm finds and negotiates largely on its own, with little or no competition. It might come from years of building a relationship with a founder, from an industry contact, or from an operating partner (an experienced executive who works with the firm). With fewer rival bidders, the firm may pay a more reasonable price and have more time to do its homework.

An auction is a sale process in which several buyers compete. For larger companies, the seller commonly hires an investment bank (the sell-side adviser) to run it. A typical auction runs in rounds:

1. The bank sends a short summary to many possible buyers. Those interested sign a non-disclosure agreement (NDA) and receive an information memorandum describing the business.
2. Buyers submit indicative bids: non-binding price ranges.
3. A shortlist gets access to a data room (an online store of company documents), meetings with management and time to do diligence.
4. The remaining bidders submit final bids, usually with a marked-up sale contract and evidence of their financing.

Auctions tend to push prices up, which is good for the seller. The buyer's challenge is to win without overpaying.

In our example, Northfield's family owners hire a bank to sell the company. Ashcombe has known Northfield's chief executive for several years, which helps it understand the business quickly and make a credible bid.

Screening

Screening is a fast filter. In a few days, the deal team asks questions such as:

• Does the company fit the fund's strategy, size range and sectors, as set out in its fund documents?
• Is the business stable enough to carry debt? (Lesson 3.2 explains why this matters.)
• Is there a clear plan to make it more valuable over the holding period? (See lesson 3.3.)
• At a likely price, could the deal earn the return the fund is aiming for?
• Are there obvious red flags, such as one customer providing most of the revenue?

Most opportunities stop here. Those that pass may get an early write-up to the investment committee, which at many firms gives a first approval before the firm spends serious money on advisers.

Due diligence

Due diligence is the detailed investigation of a company before buying it. The deal team leads it, but much of the specialist work is done by outside advisers whose fees can be large, so firms go deep only on deals they think they can win. The main workstreams are:

EBITDA (earnings before interest, taxes, depreciation and amortization) is a rough measure of a company's cash profit. The quality of earnings report matters so much because both the purchase price and the amount of debt are set as multiples of EBITDA. If Northfield's true EBITDA were $2m lower than reported, a buyer paying 10 times EBITDA would overpay by $20m.

There may also be IT, environmental, insurance and pensions reviews. Lenders run their own analysis alongside, often relying partly on the buyer's reports.

The deal team pulls everything together in an investment memo: the case for the deal, the price, how it will be financed, the plan for creating value, the main risks and the expected returns.

From investment committee to closing

The investment committee (IC) is the group of senior partners who decide whether the fund invests. It reviews the memo, challenges the assumptions and approves or rejects the deal. Approval often comes with conditions, such as a maximum price.

What comes next depends on the process.

• In a proprietary deal, the buyer typically signs a letter of intent (LOI): a mostly non-binding document setting out the proposed price and main terms. It commonly includes a period of exclusivity, during which the seller agrees not to negotiate with anyone else, so the buyer can finish diligence.
• In an auction, the buyer submits a binding final bid, and the seller picks a winner.

Either way, the two sides sign a sale and purchase agreement (SPA), the binding contract for the sale. Signing commits both sides. Closing, when the money is paid and ownership passes, can come the same day or weeks or months later, once conditions are met. Common conditions include competition (antitrust) and other regulatory approvals and third-party consents.

Closing is where the operations teams take over. The lender funds its loan. The fund's finance team issues a capital call to its investors for the equity (lesson 2.2), and the money flows through a carefully checked funds flow statement showing who pays whom. The fund then records Northfield as a portfolio company. From first contact to closing is often a few months, and can be much longer for complex deals.

Key terms

• Deal sourcing: finding companies that might be bought.
• Proprietary deal: a deal negotiated largely with one buyer, with little or no competition.
• Auction: a sale process, often run by an investment bank, in which several buyers bid.
• Due diligence: the detailed investigation of a company before buying it.
• Quality of earnings (QoE) report: an accountant's report that tests and adjusts a company's reported EBITDA.
• Investment committee (IC): the senior group that approves or rejects investments.
• Letter of intent (LOI): a mostly non-binding document setting out proposed deal terms, often with exclusivity.
• Exclusivity: a period in which the seller agrees not to negotiate with other buyers.
• Sale and purchase agreement (SPA): the binding contract for buying the company.
• Signing and closing: signing commits both sides to the deal; closing is when money is paid and ownership passes.

Key takeaways

• Deals are found through proprietary relationships or auctions; auctions, often run by an investment bank, usually mean more competition and higher prices.
• Screening removes most opportunities quickly, before expensive diligence begins.
• Due diligence covers commercial, financial, legal, tax and management questions, and the QoE report underpins both price and debt.
• The investment committee gives formal approval; an LOI with exclusivity or a binding auction bid leads to signing.
• Signing and closing can be separated by conditions such as regulatory approvals; at closing the lender funds and the fund calls capital from its investors.