Sunday, January 15, 2012

All’s Fair...

In the heat of battle, strategy and tactics collapse to one very simple principle: win.

No answer.


The sea rumbled ominously in the distance; the tide lapped and murmured at the two men’s feet.

“You’re late again, aren’t you? Is that your strategy? As far as I’m concerned, it’s a cowardly ploy. It’s two hours past the appointed time. I was here at eight, just as I promised. I’ve been waiting.”

Musashi did not reply.

“You did this at Ichijōji, and before that at the Rengeōin. Your method seems to be to throw your opponent off by deliberately making him wait. That trick will get you nowhere with Ganryū. Now prepare your spirit and come forward bravely, so future generations won’t laugh at you. Come ahead and fight, Musashi!” The end of his scabbard rose high behind him as he drew the great Drying Pole. With his left hand, he slid the scabbard off and threw it in the water.

Waiting just long enough for a wave to strike the reef and retreat, Musashi suddenly said in a quiet voice, “You’ve lost, Kojirō.”

“What?” Ganryū was shaken to the core.

“The fight’s been fought. I say you’ve been defeated.”

“What are you talking about?”

“If you were going to win, you wouldn’t throw your scabbard away. You’ve cast away your future, your life.”

“Words! Nonsense!”

“Too bad, Kojirō. Ready to fall? Do you want to get it over with fast?”

“Come... come forward, you bastard!”

“H-o-o-o!” Musashi’s cry and the sound of the water rose to a crescendo together.

— Eiji Yoshikawa, Musashi1

* * *

Ex-banker and would-be gadfly to the investment banking industry William Cohan posted a very silly opinion piece over at The Washington Post last Friday. In it, he cites his experience as an M&A advisor helping clients sell their companies to explain that he found private equity firm Bain Capital particularly prone to using “bait and switch” negotiating tactics. Mr. Cohan explains:

In my experience, Bain Capital did all that it could to game the system by consistently offering the highest prices during the early rounds of bidding — only to try to low-ball the price after it had weeded out competitors.

Once it had passed through the intermediate competitive bidding rounds and earned exclusive negotiating rights with the company, Bain’s due diligence professionals

would suddenly begin finding all sorts of warts, bruises and faults with the company being sold. Soon enough, that near-final Bain bid — the one that got the firm into its exclusive negotiating position — would begin to fall, often significantly.

Now, I cannot say whether Bain Capital was (or still is) particularly prone to using bait and switch tactics in sell-side auctions. I can say, pace Mr. Cohan’s few counterexamples, that they are definitely not alone in doing so, nor is any private equity firm averse to using such tactics when they calculate it is to their net advantage. Mr. Cohan’s description of the bidding process in a sell-side auction is highly simplified, but basically accurate. Where he goes seriously off the rails, however, is in trying to cast doubt on Mitt Romney’s character and appropriateness for public office based on his own highly anecdotal experience with Bain Capital:

This win-at-any-cost approach makes me wonder how a President Romney would negotiate with Congress, or with China, or with anyone else — and what a promise, pledge or endorsement from him would actually mean.

Would a President Romney, along with a Republican Congress, cut taxes for the wealthy even more than he has pledged to do? Would he not try to balance the federal budget, even though he has said he would? Would he protect defense spending, as he has indicated he would?

I have no idea how Romney might behave in office. I do believe, however, that when he was running Bain Capital, his word was not his bond.

This reeks of a staggeringly naive and simplistic view of finance and politics. Does Mr. Cohan expect us to disqualify Mr. Romney from office because he ran a firm which fielded clever, tenacious negotiators who fought their corner hard? Does he really believe that sharp-elbowed negotiating tactics are unknown and/or frowned upon in the halls of Congress or the state ministries in Beijing? Does he think the American people want a morally squeamish milquetoast conceding their interests at home and abroad because he doesn’t want to get his hands dirty? Does he believe there is anyone in this country under the age of 18 who truly thinks that politicians either do or should honor their promises no matter the consequences or whose interests they injure? Citizens of a complex society expect and demand their elected officials to combine firm principles, moral and ethical flexibility, and tactically astute pragmatism to achieve the goals they have been elected for. That’s why it’s called politics. Anyone who thinks otherwise is a bloody fool.

And attempting to tar Mr. Romney with the brush of his junior partners’ supposedly naughty behavior decades ago—even though Mr. Cohan admits that he never dealt with Romney directly—is transparently tendentious and disingenuous. This does not jibe with Mr. Cohan’s own stated principles of honor and character.

For, speaking as a banker who dislikes private equity firms (and other potential buyers) who bait and switch processes just as much as Mr. Cohan does, let me make this perfectly clear: by doing so, Bain Capital did nothing wrong.

* * *

Selling companies or divisions of companies is one of the cleanest, least-conflicted, and most valuable services investment banks provide.2 It is also one of the most varied and complex processes we conduct. While the end result of most sale processes is the same—money passes from the hands of one party in exchange for the ownership stake of another—the actual sale process for every property is for all intents and purposes unique. The overall structure of a typical sales process is fairly straightforward:

  1. Seller hires sell-side advisor
  2. Advisor works with seller to select sale strategy, identify potential buyers, compile information on business, conduct due diligence, and create marketing materials
  3. Advisor contacts potential buyers for interest in property, signs confidentiality and standstill agreements, and gives buyers preliminary information
  4. Buyers submit initial bids (“indications of interest”) with summary preliminary offer terms
  5. Seller and advisor select buyers to pass into next round
  6. Seller management present further information to selected buyers and buyers begin documentary, legal, and business due diligence
  7. Buyers submit formal offer letters
  8. Seller and advisor pick one or more buyers for further negotiation (which may involved extending exclusive negotiating privileges to one buyer)
  9. Buyer(s) conduct confirmatory due diligence and negotiate legal purchase agreement and other deal documents
  10. Buyer and seller agree final terms
  11. Transaction closes
Although it is not always true, most sale processes nowadays are what Mr. Cohan calls “auctions,” in which the advisor approaches a very broad range of potential buyers, usually both private equity firms and corporate (or “strategic”) buyers. There are two purposes for that: 1) broad participation tends to ensure the highest level of competition among buyers, which tends to produce the highest price and best terms for the seller; and 2) auctions are good for properties which may be unique, poorly understood by the market, and/or for which the “best” buyers are unknown. In the latter case, the broad-based, shotgun approach to the market tends to flush out hidden or unexpected high bidders much more efficiently.

Now, as you might expect from sophisticated financial buyers who have a fiduciary duty to maximize returns on invested funds to their limited partners (and who have their own financial interests in mind, too), private equity firms hate auctions. They much prefer to find a fat, unsophisticated seller without professional representation whom they can wheedle and cajole into negotiating exclusively on terms advantageous to the buyer. Fortunately for Yours Truly and my fellow financial parasites intermediaries, most companies nowadays have heard enough about mergers and acquisitions to realize they are much better served getting professional help, and we professional help are more than happy to persuade them they will get a much better price for their baby by selling it at auction.

As a bidder in an auction, of course, your best strategy is to bid high enough to get into the next round. Unlike my skeleton outline above, though, there can be multiple bidding rounds in a company sale process, so bidders have little incentive to lowball their bids unless they are truly indifferent to winning. On the other hand, the deeper you get into a sale process, the more time, opportunity cost, and direct due diligence expenses (e.g., accountants, lawyers, consultants, etc.) each bidder expends, so buyers will tend to drop out rather than bid on companies they don’t think they can win. The sell-side advisor’s job is to maintain as much competitive tension as possible among the bidders for as long as possible. Ideally, the advisor can run a process where the seller has multiple bidders competing to the very last moment without exclusivity. Such processes are a banker’s dream, for the prices and terms realized for the seller make us look like heros. Plus, it’s a blast to beat up private equity professionals and their lawyers all in the name of client service.

But sooner or later, the usual sale process gets to the stage where the seller grants the buyer exclusive rights to negotiate a final deal. At that point, the negotiating leverage which the seller has enjoyed drops dramatically, and the buyer has every opportunity and incentive to begin whittling away at the price it promised, using new facts discovered in due diligence, weakening industry fundamentals, unfavorable market conditions, or even sunspot activity as an excuse. This is where the sell-side advisor earns his or her fee. He must argue the facts (“No, the complete economic collapse of the Eurozone will have no effect whatsoever on the sales volumes of Acme European Imports, Inc.”), emotions (“My client is beginning to think you’re a real dick.”), tactics (“We have three other buyers chomping at the bit in the wings, and their offers were all higher than the new lower offer you are proposing.”), and anything else he can to weaken the buyer’s attack. Because, you know, at the end of the day the entire process is a negotiation.

Furthermore, private equity firms (and corporate buyers, too) do not have a completely free hand to work bait and switch tactics. The most important restraint is reputation, which Mr. Cohan himself mentioned and demonstrated in his article. Firms which commonly bid high then almost always claw back value during exclusivity periods get widely known for doing that among bankers. The Street can be a very small place. Repeat offenders get put in the penalty box, don’t get shown deals (like Mr. Cohan did), get used as stalking horses to boost the offer prices of preferred bidders, and generally get fucked with by bankers who find them annoying. It is important not to overstate the restraint which reputation imposes on private equity firms, however, because they also tend to be the biggest fee payers in the M&A market, and investment banks (especially those with big leveraged finance operations which private equity uses to fund their purchases) are careful not to shut them out or fuck them over completely. Another restraint is the relationship which private equity buyers need to build with the management of the firm they are buying. Most private equity firms do not want to replace incumbent management—at least right away—after buying a company, so they need to maintain friendly, productive relations with them. If the management is the owner/seller, baiting and switching can really poison a potential future working relationship, if not scupper it completely.

* * *

Bain Capital may indeed have been more inclined to retrade offers during exclusivity periods than many of its competitors, but this may have been due to the legacy and practices inculcated in its ranks by the eponymous consulting firm which spawned it. Bain is notorious for approaching private equity investing with armies of (ex-Bain) consultants, who pore over the books, records, and operations of subject companies looking for areas to improve, like consultants do. Bain may simply have found more flaws and blemishes in their potential purchases than other, less manpower-intensive PE buyers. If they learned to expect that outcome, they may have settled on a strategy to bid higher than others in early rounds because they wanted a chance to win a few deals.

At the end of the day, however, it is important to keep in mind that selling a company is always and everywhere a negotiation: There is no “true,” “honorable,” or “correct” value for a business.3 The tactics, process, and outcome all depend upon the relative negotiating leverage of the parties involved, and it should be no surprise to anyone that the stronger party will win out most of the time. A clever and resourceful sell-side advisor can try to maximize the leverage of a seller with a weak hand, but at the end of the day even genius rainmakers can’t make it rain in the Sahara in August June.4 What is not at stake, however, is an archaic view of “honor and character” that requires a bidder to pay more than it ought to (or, what is the same thing, what it can get away with) simply because some prissy investment banker can’t bring himself to get down in the mud and wrestle for his client.

That’s what they pay us the big bucks for, Bill, not for swanning about in Saville Row suits at The Four Seasons. You should remember that.

More on dirty hands, politics, and negotiation:
In the Nation’s Service (December 29, 2011)
You Realithe, Of Courth, Thith Meanth War (May 3, 2009)
More of a Kickin’ Sitcheyation (May 11, 2009)

1 Eiji Yoshikawa, Musashi. Tokyo: Kodansha International, 1995; pp. 967–968. Spoiler: Musashi kills Kojirō. With a sword he carved from a wooden oar. Pretty badass.
2 Which is not to say it is as clean as the driven snow. See nuance, above.
3 If you remember nothing else of this screed, remember this. Tattoo it on your forehead, backwards, so you can remind yourself of it in the mirror every morning.
4 Update January 16, 2012: A clever and observant critic writes to inform me that, mirabile dictu, August is actually the wettest month in the Sahara, and June is usually the driest. I might claim simple ignorance, which serves me well often, but skeptics among you might suspect my original phrase was a dastardly investment banker ploy to take credit for the rather common as the miraculous: “Well, Mr. Client, you know it almost never rains in the Sahara in August, but through my heroic efforts we were actually able to summon this tremendous monsoon for your benefit. Now, can we talk about fees?”

© 2012 The Epicurean Dealmaker. All rights reserved.