The deal process for a private equity firm can be very demanding and intense. In fact, the industry is becoming more competitive as the number of direct-investment firms increases in relation to the number of available investment opportunities. Not to mention the process takes a fairly long time – the median time to complete a transaction from the start is around seven to nine months.
Understanding how the deal process works as a private equity investor is essential for being prepared for a role as an associate. In this section, we cover the different stages of the deal process and the key aspects of each.
The first stage in the deal process is sourcing. Sourcing refers to how PE firms find deals that are worth pursuing. There are many different ways a firm does this, but the most common are through banks, brokers, cold calls, and relationships in general.
Deals sourced through investment banks are one of the most common. These are the deals that result from a bank approaching firms with an opportunity to buy a company they are advising. PE firms will look over the initial information the bank gives them, and decide if it sounds like something they want to research further. It is important to note that the firms that banks decide to approach with these opportunities can be heavily based on relationships. Sometimes firms can get access to some of the best deal opportunities because of their relationship with a bank, making this an important aspect of sourcing.
Sourcing deals through brokers takes a similar structure to sourcing through banks. Brokers will actively seek out companies that might be a good investment opportunity for the PE firm in hopes of getting a ‘finder’s fee’. These brokers will do the upfront research, and then bring the idea to the PE firm to evaluate. If the firm decides it wants to research the opportunity further, the broker will then help put them in contact with the company to discuss the potential of making a deal.
Deals can also be sourced through cold calls. A PE firm will come across a company it has no relationship with, but believes it to be a strong acquisition target. So in order to pursue the possibility of making a deal, the PE firm will simply cold call the CEO/owner to introduce themselves and express interest. Some PE firms do a lot of cold calling, while others don’t even try this method of sourcing.
If a PE firm has a close relationship with a key decision-maker at a company the firm is interested in buying, they can leverage that relationship to make a deal. This is considered to be the most desirable way for PE firms to win deals.
If a company was not actively in a sale process when the PE firm approached them (i.e. the deal was not sourced through a bank), this is called a proprietary deal. This is because the PE firm created the opportunity on its own in private, meaning it entered the deal process as the sole potential buyer with no other competition. Proprietary deals are harder and harder to find, as there is an increasingly large amount of competition among funds, and just about every good company is hiring professional help in the sale process.
Once a private equity firm has sourced a potential deal, there are typically three steps in the evaluation process: indication of interest (IOI), letter of intent (LOI), and purchase agreement.
Start: The Teaser
As we touched on before, if the opportunity is sourced through a bank-run process, the PE firm will first be approached by the bank with some information on the company. This information is distributed via marketing materials called a ‘teaser’. The teaser is typically a two-page document that usually keeps the name of the company confidential and will contain general attributes such as what the company does/offers, the industry it’s within, high-level historical financials, and a quick list of investment highlights. Essentially, it provides just enough information for a potential buyer to decide if it wants more information on the company.
If the opportunity looks interesting, the PE firm will sign a Non-Disclosure Agreement (NDA) in order to receive a more comprehensive document called Confidential Information Memorandum (CIM).
The Confidential Information Memorandum (CIM) is like a much longer version of a teaser. It is usually about 50 – 60 pages in length and it contains more detailed information about the company, the industry it operates in, investment highlights, and financial information. Basically, it contains just enough information so the PE firm can construct a decent preliminary valuation of the company. If the PE firm decides it is something it wants to pursue further, it will then submit an IOI to express interest in investing in the company and hopefully get brought into the process.
Indication of Interest (IOI)
This document is a formal letter expressing interest in purchasing the company, and gives preliminary thoughts on the important aspects of making a deal. These aspects include a price range, proposed transaction structure, due diligence tasks required, a timeframe to close, and more. This letter is non-binding, meaning there is no obligation to maintain the same terms further down the road. After the IOI is submitted, the seller will evaluate it and decide whether or not it wants to bring the PE firm into the next stage of the process, which is usually dependent on the seller’s expectations and competing IOIs.
As a whole, IOI’s are extremely helpful for both parties in the deal process. Specifically, it ensures a PE firm does not waste too much time and financial resources on the deal if their valuation range or other terms fail to meet the seller’s expectations, or if the offer simply can’t compete with others. On the other side, it also benefits the seller so that they are able to measure the general appetite for the company, compare perspective buyers’ views on valuation, and ultimately decide if they are a serious buyer.
Letter of Intent (LOI)
After a PE firm has submitted an IOI and is asked back into the next stage of the process, it will begin outlining specific diligence tasks it needs completed. These tasks are specific requests for information in order to gain a better understanding of the company, refine its operating models to be as detailed and accurate as possible, and ultimately decide if it would be a good investment. A large way these diligence requests are fulfilled is through the dataroom, which is a completely secure and confidential online ‘shared folder’, so-to-speak, that the company and the bank running the sale have complete control over. Once a buyer is brought into this stage of the process though, the bank will grant access to the potential buyer so it can access all the financials and data it needs. As time goes on, the potential buyer will have additional questions/requests, and the due diligence process continues on the seller’s side as they upload more to the dataroom for the buyer to access.
All of this information in the dataroom is being used by the PE firm to constantly refine its incredibly detailed operating model. This model will break the company’s sales down by each individual product, evaluate its net working capital cycle on a monthly or even weekly basis, breakout expenses into multiple line items, and so on. In addition, the PE firm will be constantly analyzing the effect of future debt repayments on the company’s projected cash flows to see what is feasible and what is not. As you can imagine, these models contain an unbelievably large amount of information, and that’s because the buyer does not want to leave any stone unturned as it evaluates the company. Not only that, but it wants to identify certain trends and areas for improvement in operating the company so it can form a strong, supported investment thesis.
Diligence requests are not just in the form of financial data though. PE firms will also make requests for meetings with the management team and company visits throughout this stage of the process. This allows the potential buyer to understand the kind of management team currently running the company and what their strategy has been thus far, as well as interact with other employees to get a feel for the overall operations of the business. Specifically, a potential buyer will almost always request a visit to a production facility (if applicable) to see how the company’s product is made and identify potential efficiencies and/or inefficiencies.
After a long process of being deep in the weeds of analysis, the PE firm will eventually decide if the investment makes sense and whether or not it wants to actually purchase the company. If it does, then it will prepare a letter of intent (LOI) in an attempt to reach a deal. An LOI is very similar to an IOI, except it comes months after the IOI and contains terms decided on after thousands of hours of research and analysis. I’m sure you can imagine why, at this point, the buyer does not plan on moving far from the terms in the LOI, if at all. The LOI does include some other additional details for the deal as well though, such as management compensation and employee retention, buyer financial source (how they would finance the deal), and fees. The document is also submitted at an exclusive stage in the process (few buyers remaining), and is expected to be submitted in good faith.
After the seller receives the final round of bids (LOIs) from the potential buyers remaining in the process, the company will make a decision on one and try to reach an agreement. Sometimes getting through this final stage can be the most difficult. The buyer and the seller will go back and forth on several different terms of the offer, each trying to come to an agreement that makes sense for both parties. Obviously, one of the most controversial topics is purchase price as the seller looks to obtain the highest amount possible, while the PE buyer attempts to get the lowest price possible to boost returns.
Once the two parties agree on a price, the purchase agreement is drafted. In addition to outlining the purchase price, this document will have a detailed list of definitions, post-closing purchase price adjustment terms, amount to be put in escrow, representations and warranties, indemnifications and basket clause. This takes the form of a legal document and is obviously binding.