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Playing to Win-Win

The Case for Constructive Capital in Today’s Fevered Deal Market

Dave Novak discusses the benefits of a partnership approach to deal-making.  Originally published on Agenda by the World Economic Forum

Thursday, January 16, 2020

Many years from now, if archeologists were to discover newspaper headlines covering today’s torrid deal environment, they might mistake it for a horse race. Company A has the pole position; Company B is in the lead; Company C may be gaining ground. Then, at the end of the race, there is just one winner and many losers.

This is, in fact, how many deal-makers view it. We win the deal. Everyone else loses. This win/lose way of thinking is deeply embedded in the transactional culture of finance, particularly in the private equity sector, where there is enormous pressure to deploy the capital entrusted to managers by endowments, foundations, and pension fund investors.

But paying the highest price is never the best indicator of the future success of the business. In other words, whether a buyer has “won” the deal does little to ensure that it will ultimately deliver the expected returns to investors, or for that matter to a broad range of people with a stake in the company’s long-term success, from customers and suppliers to employees and the communities in which these enterprises operate.

The incentive structures that stem from this highly compressed and opportunistic system of deal-making produce several structural challenges. Sellers are incentivized to view M&A as a means to offload businesses in need of restoration, rather than shoulder the burden themselves. Often, they limit and carefully curate information made available to buyers; if there is a negative surprise down the road, they will be long gone. Buyers, on the other hand, gravitate toward cleaner or simpler businesses where incomplete information poses less risk. These processes do little to engender trust.  As a result, companies that face the biggest challenges and the most complexity – often the assets that are starved for attention and could benefit the most from a new ownership structure – are difficult to transact in.

Many business owners build their enterprises to a certain level of success, only to recognize that they need additional strategic and operational support, plus capital, to achieve the next level of profitable growth. These companies face a broad range of challenges, from talent and platform expansion issues to capital access and innovation hurdles, which, in many cases, represent tremendous value-creation opportunities if the right resources can be brought to bear.  A system that doesn’t incentivize investment in solutions to these challenges will struggle to maximize value regardless of ownership.

But it doesn’t need to be this way. Consider the following approach instead: pursue deals not as a zero-sum game but as opportunities to align the most knowledgeable and invested people around a shared vision for the company. Fundamentally, the success of the business and all its key stakeholders is tied to the buyer’s ability to grow the size of the pie, often despite headwinds and hurdles, such as succession issues, technological disruption, and slowing market growth. What if transactions were structured to maximize this outcome? Sellers retain a significant interest in the business. They are transparent about the challenges in the business through the due diligence process. They select a buyer based on their view of the new owner’s ability to increase the value of the business, not just the favorability of how that value is allocated. They contribute meaningfully to the post-transaction, long-term value-creation effort. In other words, when the transaction is successful, everybody wins.

Of course, this does not preclude both buyer and seller from having the responsibility to win a deal, drive profit, or optimize financial value. At CD&R, 60% of capital deployed over the past decade has been invested in ‘partnership’ transactions, where the firm acted as a co-owner alongside the seller. And we believe alignment advantages between buyer and seller bring a slew of benefits:

  • First, diligence is more transparent and collaborative. After all, both buyer and seller are going to own and be accountable for the business together.
  • Second, buyer and seller working with this approach allows more time to confirm that skillset, experience and networks are complementary and add value to an investment thesis or growth plan.
  • Third, lower leverage levels create a favorable risk profile. When sellers roll significant equity by sharing in the terms, less leverage is often required to get these deals done; and
  • Fourth, a rigorous due diligence process means that a buyer is more likely to pay a fair and often confidently higher price or a bid that works for both sides, often more than would be possible during a short auction process.

These partnership transactions demonstrate the favorable dynamic that can occur when a seller—be it corporate, family, or founder—cares who the buyer is. It starts with trust, trust supported by transparency, credibility, and integrity. For 2020 and beyond, more market uncertainty means collaborative deal-making approaches should be advantaged when business owners seek help from proven partners they trust.