The longlist as a filter. Why the highest price is often paid by a buyer the seller did not have on the list

In one of the sale processes we ran at Capital One Advisers, the highest price was paid by an investor that was not on the list prepared by the seller. We added it ourselves, but only to list B, the second priority tier. It did not respond in the first round. On the Tuesday after the first bid session, we went back to it on our own initiative. In the end, it bought the company for a price 35 percent higher than the next offer.

The first version of the list that I proposed to the team was wrong. This investor did not fit the obvious profile of a buyer from the industry and was therefore placed in the second tier. Only during a second analysis, when we looked at its recent investments and the gaps in its product range, did we see that the company for sale filled a specific position for it. On its own, it could not have built that position in less than three years. Without that second analysis, we would have left it on list B with no further contact, and it would not have reached the second round.

I have changed the details so that neither the company nor the parties can be identified.

Most owners picture selling a company as a search for the right buyer. In practice, a sale means screening buyers out, and who gets through each successive sieve is decided by work done six weeks before the first anonymous description of the company goes out. The buyer that pays the most rarely responds first. Funds and companies that buy regularly respond fastest, because acquisitions are their daily work. A large corporate group needs weeks before the anonymous description of the company makes its way through its business development department and lawyers to the person who can sign a confidentiality agreement. The speed of response therefore says something about the buyer’s organization, and the price says how much the buyer needs the company.

How the process runs and where the filters are

Buyers on the list first receive a short, anonymous description of the company, called a teaser. Those that are interested sign a confidentiality agreement and receive an information memorandum. On that basis, they submit indicative offers, which the seller compares at the first bid session. In the first round, buyers know only the figures set out in the memorandum. Those selected move on to the second round. There they meet the management board and get access to a virtual data room with the company’s contracts and financial documents. At the end of the second round, one buyer signs a letter of intent and gets exclusivity, which I wrote about separately.

Two types of buyers usually compete for a company. A strategic investor runs a similar business and folds the acquired company into its own. A financial investor, most often a private equity fund, buys the company in order to grow it and sell it after a few years.

At the start of this road, the seller can set three filters: the list of buyers, the memorandum and the first-round questionnaire. Each of them can be designed deliberately or left to chance.

The first filter: the list of buyers

A longlist is a preliminary list of entities that could buy the company. Most of the lists I am given to assess look similar. Eighty names in alphabetical order, each with a short note, “potential strategic investor” or “potential financial investor.” Such a list does not say whom to talk to first or why any of these entities would pay more than the others.

A good list has tiers, and the tiers set the order of the conversations. Large foreign groups, which decide more slowly, receive the description of the company earlier so that they can meet the same offer deadline as the funds. Direct competitors recognize the company from the anonymous description faster than anyone else and are keen to enter the process only to learn about its customers and prices. The owner approves every name before first contact and can strike out a competitor to whom he does not want to show any data. The remaining competitors are shown data later and to a lesser extent.

Buyers are searched for in two passes. The first covers competitors and companies in the same industry, that is, names the owner knows. These buyers often pay the least, because they already have the same product and the same customers. The second pass covers companies from adjacent links in the chain. These are companies that sell a different product to the same customers, foreign groups that, after their first acquisition in Poland, lack one element of their offering, or fund portfolio companies that are building a group in an adjacent niche. The owner usually does not have such buyers on his list, because until the day of the transaction they do not compete with him at all.

At Capital One Advisers, we assess each potential buyer against four criteria. We assess the fifth, the person who will lead the transaction on the buyer’s side, separately.

The first criterion is the ability to pay and to close the transaction. We check whether the buyer has the money this quarter for an acquisition of this size and when it last bought a company in this sector. We also check how many other processes it is running in parallel. Financial statements filed with the KRS (the Polish National Court Register) will show a Polish buyer’s debt and cash as of a few months earlier. They will not show the available funds of a foreign group or a fund. Information about those has to be gathered from announcements of transactions over the last eighteen months and from conversations with people who finance or advise on transactions in this sector. In the case of a fund, it is also necessary to check whether it can still buy new companies.

The second criterion most often decides the price and is most often overlooked. It is the strategic rationale, that is, the answer to the question of what this particular buyer will do with the company that it cannot do without it. A buyer that cannot describe its rationale in one sentence will pay the market price. A buyer for which the transaction closes a specific gap will pay more, because building the same thing on its own would cost it more and take longer. That was the case with the four offers for the same company that I described in a separate article: the highest came from the buyer that, without this company, would have spent four years building the same thing.

In the process described here, the buyer’s rationale was narrow and specific. It concerned one position in the product range that neither the buyer nor its competitors had. Building it alone would have taken three years, with no certainty of success. The buyer was therefore paying for three years it did not have to lose.

The third criterion is the way the buyer integrates acquired companies into its organization. Experienced buyers have a repeatable pattern here. Some leave the acquired company its brand and independence and combine only financial reporting. Others move everything under their own brand within twelve months. Still others keep the existing management for two years through an incentive plan and then replace it with their own people. An owner who wants to leave right after the transaction should not sell to a buyer that makes part of the price depend on results over the following two years, that is, on an earn-out, and requires the owner to keep running the company. An owner who wants to keep growing the company within a larger group should not sell to a buyer that eliminates acquired brands within a year. The mismatch usually comes to light six months after closing, although it could have been seen on day one.

The fourth criterion is the risk of a culture clash. Advisers most often do not assess it, because it is hard to quantify and awkward to discuss. A company in which the owner decides on spending over lunch loses momentum within a quarter if it is bought by a fund in which every expense above PLN 1 million is approved by a committee. A team used to talking to the founder starts to leave within a year once a layer of regional corporate managers appears above it. This risk can be assessed before signing the letter of intent. Three conversations with managers or former owners of companies this buyer acquired earlier are enough. They take one Thursday afternoon and concern only the few buyers that have reached the second round.

The fifth criterion concerns the person who will take the transaction through the investment committee, the body that approves acquisitions at the buyer, and through its supervisory board. Without such a person, the transaction will not close, however perfect the numbers look. I wrote separately about the four signals by which such a sponsor can be assessed from outside. In the process described here, the buyer’s sponsor called us on a Friday evening with a specific question about one item in the EBITDA bridge. The EBITDA bridge is a set of adjustments that lead from the result in the financial statements to the result from which the price is calculated. That one call convinced us that there was someone on the other side who would steer the transaction through their organization.

If an owner is thinking about selling within eighteen months, it is worth starting work on the list now. Six weeks of this work, done alongside running the business, in practice spread over three to four calendar months. Anyone who starts two months before the planned start of the process will not finish it in time. A list drawn up early also shows what the best buyers may pay more for. The remaining months make it possible to prepare evidence for this in numbers, for example by reporting separately the margin of a product line that a future buyer would want to develop. The timing of the start is the first decision that affects the price, and one of the few that the seller makes alone.

The second filter: the information memorandum

The information memorandum is the document in which the company presents itself to buyers after they sign a confidentiality agreement. Most of the memoranda I read at owners’ request resemble brochures. They list the company’s strengths but leave out the investment thesis and the comparison with competitors. Such a memorandum screens out no one. That is why the first round usually produces four similar offers and no premium.

A memorandum that is meant to work as a filter sets out a clear thesis. It shows in numbers where additional revenue and profit will come from in the first twenty-four months after the transaction. They may come from expansion abroad, a new product line, acquisitions of smaller companies in the industry or access to customers the company will not win on its own. It also describes what the buyer has to contribute for this to happen.

The same memorandum, however, goes to buyers of different types. A good memorandum therefore describes several sources of value and the evidence for each of them. The conversation with each buyer leads it to the source that concerns it specifically. A strategic investor either recognizes itself in such a document or sees that the transaction is for someone else, and both outcomes are good for the seller. A fund checks whether it has a team in its portfolio that will deliver this value. A buyer prepared to pay more than the market average has to find in the memorandum a thesis to which it can tie its own rationale. Without such a thesis, it has nothing to defend before its investment committee.

The third filter: the first-round questionnaire

The questionnaire is a few questions that the buyer answers in writing together with its indicative offer. It is usually part of the instructions that buyers receive with the memorandum and that describe what the offer must contain. In sale processes for mid-sized companies, it is rarely used. Drafting the questions takes an hour, and the difference is visible at once in the quality of the second round. Each question screens out a different group of buyers whose participation in the process takes up management’s time and does not raise the price. A good questionnaire has six to eight questions in three groups.

The first group concerns the strategic rationale. The buyer writes why the company is worth more to it than the price it is offering and which earlier acquisitions it compares it with. It also identifies the synergies it expects and their sources. The answers show whether its rationale will survive a discussion with its own investment committee, or whether the buyer is only exploring the market and will not submit an offer.

The second group concerns authority and financing. The buyer states who is running the transaction on its side, up to what amount that person can decide alone and who will sign the letter of intent. It writes where the money comes from: approved equity, a loan the bank has provisionally confirmed, a fund’s uninvested capital or a structure that still has to be built. These questions separate buyers that have secured financing from those that will be looking for it during due diligence.

The third group concerns the process. The buyer describes the timetable of its decisions up to the signing of the letter of intent and the expected scope and duration of due diligence. It writes how it sees the company twelve and twenty-four months after closing: who runs it, what will be merged into its organization and what will remain independent. It also states what place this transaction holds among its current priorities and whether it has a team that can keep to the proposed timetable.

A buyer that answers specifically, with dates and figures, is the one worth meeting in the second round. In the process described here, the investor that paid the most completed the questionnaire in three hours and sent it back the same day. Another buyer sent its answers back only after two weeks, skipped the question about the source of financing and in the end did not submit an offer.

Answers such as “we will consider it,” “we will assess this during the process” or “it depends on the terms of the transaction” mean that the buyer’s interest is not yet backed by an internal decision to spend money. A refusal to answer means the same.

Without a questionnaire, the second round fills up with industry companies that have no decision-making authority and with funds that are only gathering market information. Each of them requires three meetings and two sets of additional data. Only after two weeks does it turn out that it never intended to submit an offer. The seller’s management loses this time, which it should be spending on buyers that have money and authority.

What the filters will not fix

A well-built list has its limits. In some sectors, there are only a few buyers that can pay a premium, and everyone knows them. Work on the list then changes little. A questionnaire can also put off a large corporation that does not answer in writing before a first meeting. The same questions then have to be asked in conversation, which costs time and produces answers that are harder to compare. Finally, an overly strict filter can screen out buyers whose presence keeps competition going to the end of the process, even though they themselves will not pay the highest price. Without that competition, the highest offer can easily fall.

The bottom line

Based on processes from the last five years, I estimate the difference between the price from a well-designed process and the price the market sets on its own with minimal information at usually 10 to 20 percent of the transaction value. In the process described here, the winning offer was 35 percent higher than the next one. That is a different measure, but it shows how much one buyer with the right rationale can be worth. At Capital One Advisers, we build the list in tiers and return to it after the first bid session. I wrote about what happens later, during due diligence after the letter of intent is signed, in my article on the EBITDA bridge.

One question remains open: how wide should the list be? A wide list increases the chance that it will include a buyer no one considered obvious. It also increases the risk that news of the sale will reach competitors, customers and employees too early. A narrow list protects confidentiality and management’s time, but it easily misses buyers like the one at the start of this article. Where to draw the line depends on how much the company will lose if information about the sale gets out beyond the circle of buyers.

Service: M&A advisory on a company sale