Exits: A Question of Quality

Don’t be deceived by Facebook’s $1 billion (£629.8 million) purchase of Instagram, a company that is less than two years old and has yet to make a profit. In the real world, those companies looking to sell need to show a track record of reliable earnings and prove that there really is the potential for substantial growth.

Nigel Guy, Chairman of recruitment company The Cornhill Partnership, says: “The challenge for anybody buying a business until now has been the uncertainty of what levels of earnings you’re buying… The worst thing in the world, if you’re a buyer or seller, is to be involved in a transaction where halfway through you discover the numbers are going soft.”

A strong dose of realism is required. “There was a time when just turnover and EBITDA [earnings before income, tax, depreciation and amortisation] were enough to put a story together that got a reasonable valuation, but that’s clearly not the case anymore as it is so much more competitive now to get exits,” says Richard Adey, Chairman of JCC Lighting.

Within the boardroom, there has to be alignment on the timing of a sale and agreement about what an appropriate valuation could be. Paul Brennan, Chairman of hosting software company OnApp, says: “During any recessive cycle, buyers can say that your earnings aren’t growing at the rate that they were and they’ll bump down your valuation. So if you’re targeting an exit, you have to make sure everyone has a reasonable and rational view of what the exit value might be.”

Easier said than done, perhaps, but there is no shortage of potential buyers for UK businesses, especially on the international front. Peter Hemington, Head of M&A for professional services firm BDO, says: “We’ve seen lots of overseas interest on the buying side. The UK is perceived to be cheap and is getting attention from India and even the US.”

When it comes to valuations, Peter notes there is something of a “weird imbalance” in the market. He explains: “If a company is any good, it should get a healthy price. We have seen small businesses going for big multiples of EBITDA because, on the other side of the equation, there are massive amounts of unused private equity funds and corporate balance sheets stuffed with three or four years of uninvested cash. Deal volumes are low, but prices are relatively high and deals relatively straightforward to transact.”

Never the bride

For fair to middling companies, it continues to be hard to stir up interest. Chris Hurley, UK Portfolio Managing Director for private equity firm LDC, says: “Things are tough out there but high quality businesses with a competitive advantage are still attractive to PE and trade buyers alike. If you’re a ‘me too’ business and there is nothing distinct about you, then you are going to struggle to sell in today’s market.”

The challenge is to make a business stand out from the crowd. Chris, who recently worked on the £148 million sale of lingerie and swimwear specialist Eveden Group to Tokyo Stock Exchange-listed Wacoal Holdings Corporation, says the strategy was always about developing the business beyond the UK market.

LDC made its initial investment in Eveden back in 2006. Clearly market conditions changed dramatically and Chris reflects that after a period of de-gearing the business, a key decision was to make an acquisition in France in 2009 to drive on Eveden’s pan-European penetration. “It’s an extremely strong business and brand, notwithstanding it being consumer facing,” he says.

By contrast, Richard, who joined JCC Lighting last year, has deliberately opted to rein in the company’s expansion strategy: “We do sell internationally but I specifically closed some operations to concentrate on the UK market. You have to be really focused; at a certain stage in a business’ development strong international growth is a requirement but I don’t see that for us now as there is such an opportunity in the UK. The danger is that all you do is spread yourself too thinly.”

It’s an approach that demands both discipline and confidence. “You don’t carry legacy, you just kill it,” he says. “We have halved the number of products in our range as otherwise you end up managing your past as opposed to your future – and you have to clear your debt too and be really focused on it if it’s there.”

The fact is that executive and non-executive directors have to palpably work harder to achieve value as it is rare, outside of the tech sector at least, for buyers to purchase solely on the promise of future earnings. “What’s happened is that the middle-tier deals that were getting done at over-inflated prices no longer really happen,” says Chris. “Values have fallen because people can see there is nothing special about them.”

Simon Burke, Chairman of Bridgepoint-backed arts and craft retailer HobbyCraft, says that when it comes to PE firms, “the old notion of trying to achieve 30 per cent IRR [internal rate of return] and a three-year exit has gone out of the window”. He explains: “PE houses are now much more focused on the overall levels of return and are flexible in terms of timings. Investments have commonly got four, five-year or sometimes even longer horizons. Sensible PE houses are sensitive to creating the right moment in a company’s evolution to exit rather than looking at watches the whole time which, if I’m honest, is a much more intelligent strategy anyway and probably more likely to maximise value.”

Zero hour

Whether it is a trade sale, secondary buy-out or a flotation, there are genuine exit options for businesses at present. However, if the right results are to be achieved in these exacting market conditions, the CEO and chairman need to be working together and communicating openly as simmering tensions can fast become calamitous as a sale draws near.

It comes back to alignment. Paul says: “Some might be pushing for an exit and some resistant; there will be different personal views and all will be valid. If you are going to target an exit you need to know the primary shareholder’s mandate.”

This can create challenging situations, as the management team which has built up a business may not be right to take it to the next level for a sale. Simon comments: “It’s best to talk about the exit up front and get everybody on the same page from the start. That gives you a template for later on about what your objectives are. The biggest difficulties occur when people have wildly different expectations and you’re approaching the point of sale and things haven’t been resolved.”

Advisors have an important role to play too. Aleen Gulvanessian, a Partner at law firm Eversheds, says: “You need to be totally ready before the process begins, identify problems early and solve them before embarking on a sale; the cleaner your company appears, the smoother the sale process will be. Even if the buyer is prepared to take certain risks, you need to remove potential liabilities because it does affect the price. Don’t give buyers cause to get nervous.”

Although the latest incarnation of dotcom companies may be proving an exception to the rule, the difference today is that buyers generally want to see real revenue. “It’s much more about what channels you’ve established and what partners you have,” says Paul. “From the exiting party’s point of view, you have to do your homework. If your business neatly fits into the gap of a competitor’s portfolio, you need to be able to explain that with reference to accounts and really show why your company fills the gap in the marketplace or blocks off other competitors.”

The financials and story for growth have to be watertight. “It’s not just about trading,” says Simon. “It’s a question of where a business is pitched in the market, what opportunities it still has and how you can prove those opportunities.”

Please get in touch if you have any comments about the issues raised here.

I hope to see you soon.

Matthew

www.twitter.com/criticaleyeuk

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