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Financial Buyer

Step-by-Step Guide to Understanding Financial Buyers in M&A

Last Updated February 20, 2024

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Financial Buyer

What are the Characteristics of Financial Buyers in M&A?

Financial buyers are investors such as private equity firms that purchase companies primarily as investments to achieve a specific monetary return.

The most common type of buyer in an M&A transaction is a financial sponsor, e.g. a private equity firm (PE), which refer to investors that specialize in leveraged buyouts (LBOs).

Financial buyers, such as private equity firms or family offices, are investing on behalf of their fund’s limited partners (LPs), which provides the firm’s general partners (GPs) with the capital to deploy and generate positive returns.

Leveraged buyouts (LBOs) are transactions in which a significant portion of the purchase price is funded using debt – most often a 60% debt to 40% equity split.

Given the risk associated with LBOs, where a significant debt burden is placed on the acquired company, i.e. the portfolio company, PE firms must spend extensive time performing diligence on the company and its ability to handle the potential debt load.

Specifically, the portfolio company must meet periodic interest payments and repay the debt principal at maturity, or else the company would be in technical default.

If the company were to default, the PE firm will likely incur a significant loss in returns from the investment, which not only hurts the fund’s current returns but also its ability to raise capital for future funds due to the damage inflicted on the firm’s reputation.

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Strategic vs. Financial Buyer: What is the Difference?

The other acquirer type is a strategic buyer, or a company seeking to purchase a controlling stake in another company.

Strategic buyers are corporations acquiring companies that operate in overlapping markets, whereas financial buyers are firms that view the acquisition as an investment.

In contrast to a financial buyer, a strategic buyer – or “strategic” for short – is acquiring the target company for the opportunities to realize synergies post-deal.

Most often, a strategic buyer operates in the same or an adjacent market to the target, creating the potential for the combined entity to benefit from revenue or cost synergies, i.e. the incremental revenue or cost savings from the combination of the two companies.

Strategic buyers can afford to offer higher purchase price premiums because of their ability to benefit from synergies, such as generating more revenue from greater reach in terms of end markets or product capabilities, as well as cost-cutting measures like consolidating overlapping business functions and eliminating operating inefficiencies.

Since strategic buyers have historically paid higher purchase prices than financial buyers and perform diligence more quickly, sellers tend to prefer exiting (i.e. selling) to strategics.

Besides the higher purchase prices, another key difference is the objective of the purchase.

On the date of purchase, the strategic buyer seeks to create long-term value from the acquisition (and the acquisition target becomes part of the larger company).

Private Equity Firms: LBO Investment Horizon and Risks

Financial buyers only acquire a company (LBO) if the potential returns meet its minimum investment threshold.

Specifically, for private equity firms, the internal rate of return (IRR) on the investment is a critical metric – and moreover, the IRR is highly sensitive to the duration of the holding period. As such, financial buyers typically only seek to own a portfolio company for about five to eight years.

The traditional business model of the private equity industry is to exit an investment after around a five to eight-year time horizon.

Therefore, private equity firms proceed with an LBO only if their target return is anticipated to be met under the expected holding period.

While strategic buyers typically have unique value-creation tactics that they could implement, private equity firms are limited in terms of the number of levers they can pull compared to strategics.

Private Equity Industry: Add-On Acquisitions (Buy and Build Strategy)

The strategy of add-on acquisitions – often called the “buy-and-build” strategy – has become increasingly common among financial buyers and the private equity industry.

The trend of add-ons has led to a reduced gap in the purchase premiums paid between strategic and financial buyers, enabling PE firms to be more competitive in auction processes.

In an add-on acquisition, an existing portfolio company (i.e. the “platform”) purchases a smaller-sized target to benefit from synergies.

The platform is essentially playing the role of a strategic buyer that can also benefit from potential synergies, but the notable difference is that a financial buyer owns the platform itself.

Nonetheless, the acquisition premiums paid by financial buyers must still be reasonable, based on the intended strategy for integrating the target company into the long-term business plans of the combined entity.

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