Agency Risk in the Lower Middle Market: A Guide for PE Professionals

If there was a Wild West in Personal Fairness (PE), it might be the Decrease Center Market (LMM) — the ecosystem of firms with revenues between $5 million and $50 million. The LMM gives profitable alternatives however comes with distinctive dangers that may derail even essentially the most promising offers. For funding professionals, navigating this house requires a deep understanding of company danger, an often-overlooked problem stemming from the reliance on underqualified intermediaries and inexperienced sellers.

Firms at this finish of the market can differ significantly when it comes to administration high quality, firm infrastructure, and financial viability (publish change of management). As well as, this finish of the market is severely below suggested, which means that providers given by the enterprise brokers working on this market aren’t as subtle as bigger PE markets.

Sellers typically have little company or finance expertise. Slightly, they’re technical and working specialists who typically have constructed their companies from scratch — with out the assistance of institutional capital. A sale transaction is commonly a enterprise proprietor’s first foray into the world of mergers & acquisitions (M&A). These enterprise house owners are promoting their life’s work.

The LMM Enterprise Dealer Profile

Enterprise brokers — the intermediaries within the decrease center market — are sometimes not subtle M&A specialists like funding bankers or attorneys. But, they’ve little bother convincing sellers that they’re. Brokers know sufficient in regards to the M&A course of to sound subtle to sellers. Provided that brokers are normally the primary level of contact with enterprise house owners contemplating M&A on this market, they rapidly acquire belief. This new belief, or acquiescence, rapidly turns into an “advisory” relationship with a prolonged non-circumvention interval with the dealer squarely within the center.

At first blush, this association doesn’t elevate any crimson flags. The dealer helps the vendor market the enterprise — there’s nothing flawed with that. The issue and the danger stems from the truth that the advertising and marketing relationship typically turns right into a de-facto monetary advisory and/or authorized advisory relationship. It’s because typically a vendor isn’t positive if she or he needs to promote. Sellers are reluctant to spend cash on acceptable advisors earlier than they’re sure of the viability of a sale. Brokers typically step in to fill this void and are usually pleased to barter letters of intent (LOI) on behalf of sellers and opine on deal phrases.

That is the place important company danger^[1] comes into play. There are three sub-categories of company danger that LMM sellers and consumers ought to concentrate on and try to mitigate:

• Anchoring: Brokers will generally anchor sellers to phrases that aren’t market. In contrast to funding banks that may see a whole bunch of offers a yr, some brokers may go on 5 or fewer transactions a yr. Worse, some or all these transactions might not shut. Nonetheless, this will likely not cease a dealer from offering an opinion on what they consider are market phrases for a selected a part of the deal. We’ve had a dealer anchor a vendor to an rate of interest that, when pressed, the dealer admitted that they acquired from a time period sheet on a transaction that didn’t shut. Anchoring to phrases which can be non-market erodes belief by worsening what are already tight and emotional negotiations. As a result of brokers are good at convincing sellers that they’re M&A specialists, sellers may consider consumers aren’t being honest or forthcoming when a time period is available in that isn’t in keeping with the anchor.

• Unhealthy recommendation: Unhealthy recommendation is an error of omission. It occurs when a dealer misses one thing that an lawyer or a monetary advisor would catch. This usually has to do with the main points. For instance, a dealer typically will assist a vendor negotiate an LOI whereas the client can have an lawyer carry out this job. You may think about the mismatch. As soon as the LOI is signed and the vendor lastly engages an lawyer, the lawyer will have a look at the signed LOI and level out areas wherein the vendor is at an obstacle. Conditions like this could result in unhealthy optics — the vendor will once more assume the client is attempting to take benefit — resulting in re-trading and wasted cash. These circumstances erode belief by worsening what are already tight and emotional negotiations between a purchaser and a vendor.

• Phone: Some brokers like to stay in the midst of the dialog, insisting that they’re concerned in calls or conferences, and a few sellers give their brokers permission to barter on their behalf. The company danger right here is the potential for brokers to take liberties with negotiations. For instance, a dealer might neglect to vet an concept with the vendor earlier than providing it up as a time period or a compromise. A dealer can misread or misrepresent a time period from the buy-side to a vendor, notably if an agreed-upon time period would make the dealer look unhealthy. We’ve had each conditions occur and both can result in frustration, re-trading, and eroded belief.

Company danger is an actual drawback and might make it considerably tougher, if not inconceivable, to get a deal completed. Understanding this, there are just a few methods to manage and partially mitigate company danger:

• Converse candidly with the dealer about anchoring. Brokers are incentivized to get offers completed. If they’re made conscious of the anchoring affect that their phrases can have on sellers, it might make a distinction. We had a superb final result concerning an anchoring scenario the place the dealer acknowledged that he possible mentioned an excessive amount of, and it was a lesson realized. Mitigating this case by having a dialog with the dealer about anchoring to totally different offers or their very own opinions can construct belief and save quite a lot of ache later.

• Advise the vendor to acquire advisory providers. To us, a vendor with counsel signifies a degree of seriousness concerning the sale course of. If a vendor doesn’t have authorized counsel or monetary advisory lined up pre-LOI, advise them to take action. You will need to observe that, whereas the LOI isn’t legally binding, it does usually embody a “good religion” clause, which means that the events should act in good religion to shut the transaction in keeping with the phrases within the LOI.

• Solely negotiate with the principal vendor. By solely negotiating with the vendor immediately, you possibly can ensure that communication isn’t misplaced in translation. That mentioned, some sellers are very busy managing the enterprise and depend on the agent, normally the dealer, to handle the sale course of. On this case, it is very important be certain that deal phrases are negotiated in writing, with the vendor copied. We ask the vendor to substantiate the main points of phrases negotiated with the dealer.

Whereas these steps won’t eradicate company danger, they supply a superb pathway for smoother negotiations and closings. 

^[1] Company Danger is mostly outlined as a battle of curiosity drawback the place the agent doesn’t act in one of the best pursuits of their principal

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

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