In 280 BC, King Pyrrhus of Epirus defeated the Romans in battle at great cost to his armies. His experiences gave rise to the saying “pyrrhic victory” - a regrettable triumph. Today’s private equity environment, characterized by high multiples and an oversupply of capital, has increased the risk of regrettable triumphs for investors. For decades, the top private equity firms have had access to “proprietary deals,” or those that don’t go to market. Unfortunately for LPs, those deals are becoming increasingly uncommon as more capital floods the space. It may be possible to find firms with truly differentiated deal flow, but, in the lower middle market especially, it is critical to identify firms who can bring a unique edge to competitive processes. There are two primary ways to create this edge and avoid pyrrhic victories: 1) find markets that are simply less competitive, and 2) offer better terms. We suggest asking a few simple questions to GPs as you evaluate investing alongside them.
What is your niche and how competitive is it?
Revenues between $50 and $500M, a market leading product or service, a stable history of growth, a stellar management team, and recurring cash flows… all investment criteria quite familiar to sponsors in the middle market. Companies meeting these criteria have a long list of suitors and will typically sell at hefty valuations. Sponsors should be assessing how their in-house expertise positions them to target less conventional opportunities. Firms with strong legal, financial or turnaround capabilities may look a bit closer at bankruptcies. At Ilion, our passion for small businesses leads our firm to pursue smaller deals than most firms would consider. Others might look into orphaned carveouts, highly regulated industries or cross-border transactions. The point: the best sponsors have a niche and own it.
What do you bring to a buyer that others don’t?
Many deals are still competitive regardless of the strategy, but there is almost always more on the table than money. In many cases, sellers have spent decades building their businesses, creating institutions of which they are rightfully proud. These sellers are focused on their legacies, employees, customers, and communities. Beyond the purchase price, sellers are looking for a buyer they can trust to meet their non-monetary objectives. Speed to close may be critical for a corporation looking to finish a carve-out by the end of the year or for a family business undergoing health or relationship issues. Founders usually look for a buyer who they are sure will steward their business through further decades of success. Sponsors must understand each seller’s unique motivations to make a deal and ensure communications, process, and terms address their needs.
Much has changed since Pyrrhus fought the Romans, but, unfortunately, the trap of regrettable triumphs remains. In this competitive market, true victories will accrue to investors who marry discipline and creativity and, as in any market, engage all counterparties with honesty and respect. “Buy low and sell high” is always hard in competitive markets, but a select number of managers are still able to do it. Asking these questions will help investors to identify those sponsors ahead of time.
What does this mean for sellers?
It is easy to think of selling your company as a win/lose proposition -- if an investor gets a good deal, doesn't that mean you got a bad deal? Fortunately, this way of thinking does not stand up to scrutiny. In every case the group buying your company knows that they need to provide a fair offer if they are going to have a shot at closing the deal. For sellers, the critical point is to decide ahead of time what are the most important criteria and to run the process with those criteria in mind. Price will be an important element, but plenty of owners have sold to the highest bidder only to see their company buckle under the weight of the debt used to acquire it. Just as investors must identify the groups that will bring a competitive edge to sourcing and closing deals, you should look to work with only those firms whose values and niche align with yours.
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