Exclusivity. This is the moment in a transaction where you have picked the one buyer you want to close with after receiving Indications of Interest from (hopefully) several buyers. The exclusivity part of the Letter of Intent is usually binding and prohibits a seller from talking about (writing, texting, etc.) a transaction with any other party. Does this sound restrictive? It should. The entire sell-side transaction strategy up to this point has been to communicate with multiple parties in order to maximize value, but now we are signing away that right. Why?
Exclusivity for the buyer means that they have a proprietary path to a transaction close. It also marks the point where they begin to spend a lot of time and money. Buyers don't generally want to make this kind of investment if the seller is going to continue to negotiate with other parties. This trade off of exclusivity is generally good for the seller as well because once a buyer starts spending a lot of money, they are more likely to close -- and quickly.
Higher Valuations Mean the Stakes of Exclusivity Have Changed
In the last 4 years, we have been in a period of unprecedentedly high valuations -- meaning buyers are lowering their return on investment thresholds. Due to an increased number of Private Equity (PE) groups with record amounts of capital to invest, competition over transactions has increased, resulting in lower ROI thresholds in order to be the "winner." A study by Harvard professor, Josh Lerner, State Street, and Bain, for example, found a meaningful drop of six percentage points between the 10-year annualized return in 1999 and the comparable return in 2019. Additionally, PE firms have three times as much capital under management compared to 10 years ago, and they are desperate to put that money to work buying companies.
Lower ROI thresholds and higher valuations mean that buyers are engaging in due diligence on a business like never before. In the days of lower valuations/higher ROIs, an item uncovered in diligence wasn't necessarily the "deal breaker" because there was a little "cushion" in the valuation. Today, deals are priced at "perfect" in the bidding process because they have to be in order for a buyer to win and move onto an LOI and exclusivity.
Lastly, add to this mix an environment like the second half of 2021, where deal volume was also at unprecedented levels. This means that buyers, in addition to paying top prices, were very, very busy.
The Problem with Pricing at "Perfect"
This environment has created two consequences:
- Pricing a transaction at the very top of the acceptable return range means there is little room for a misstep in diligence. Buyers are taking longer for diligence and it has become increasing complex. A Quality of Earnings report -- once only needed for the largest transactions -- has almost become standard in the middle market (sellers, think about this as you plan your exit).
- In addition, buyers have no problem asking for a reduction in price when they find something in diligence or simply walking away. This used to be characterized as the old "bait and switch" or a "re-trade," but many buyers have become completely unapologetic in this approach.
Exclusivity, High Valuations, and Flaky Buyers
What does this all mean for middle market sellers?
It used to be that when you signed an LOI and granted exclusivity to a buyer, you were pretty darn sure that a deal was getting done with that particular party. Sellers were giving away their ability to negotiate with multiple parties in return for certainty around getting the deal done.
In a world where buyers are paying top dollar, are super busy, and have less and less of a problem asking for a price reduction, or walking away -- you might ask yourself, "why do I give away the right to negotiate with multiple parties?"
Exclusivity has not gone the way of the buggy whip or the VCR, but it does need to be proactively managed. The granting of exclusivity now needs to have some additional bells and whistles in the form of a timeline with checkpoints, where a seller can terminate the arrangement, if for example, a purchase agreement is not produced or IT diligence isn't done by a certain date. In addition, an exclusivity provision should also include language that allows for a seller to terminate if terms change materially from those agreed upon in the LOI.
This isn't exactly a great answer because remember, the buyers spend money and time on a transaction once they have exclusivity. A timeline approach might cause them to limit their time/money exposure until different hurdles are reached -- meaning that your diligence could take longer. The ability to terminate exclusivity if the terms change sounds great, but a seller then has to be prepared to go to Plan B (hopefully another great buyer). Although while walking away is a very effective negotiating tool, it can be difficult to do in practice, especially late in a transaction.
This is a time in mergers and acquisitions where sellers need to be prepared for some trade-offs and bumps in the road. On the positive side, valuations are incredibly high, there are buyers eager to look at transactions, and there is more and more money chasing good assets. On the negative side, buyers are becoming more serious about diligence and are prepared to adjust transaction terms as they find things they don't like. I always suggest that sellers not go out and spend the money from a business sale until the deal is actually done, and that is true now more than ever. Steel yourselves sellers -- it's going to be a wild ride.