Originally published in Blakes Bulletin on Business Law, February 2007
The Canadian merger and acquisition market has seen a significant increase in the use of "controlled auctions" by sellers in the past several years. So much so, sellers and managers now ask themselves whether a negotiated sale with a single prospective buyer, without an auction, ever yields the highest price or best transaction terms for the seller (or shareholders) – much like homeowners who in recent years in some markets have second-guessed whether they received top dollar for their home without a frenetic "multiple offer" sale. These articles explore the growing phenomenon of controlled auctions in Canadian M&A transactions and the pros and cons of participating in auctions for both buyers and sellers.
In a nutshell, controlled auctions involve a seller, usually with the assistance of financial and legal advisors, preparing a "confidential information memorandum" or "book" describing the business for sale. Potential buyers are identified and contacted and sign confidentiality agreements with the seller or an advisor running the auction before they review the book. At this stage, the bidders may or may not be granted access to additional due diligence materials, often in an electronic data room. Buyers are then asked to submit non-binding expressions of interest from which the seller narrows the field to a shorter list of potential buyers. Short list bidders are provided access to more detailed due diligence information and an opportunity to meet with the target’s management team. Bidders then submit an offer, frequently in a form prescribed by the seller, which may also include comments on definitive transaction documents. This second stage may be repeated to further narrow down the short list or clarify offers. The seller will then identify one bidder, or possibly more than one, and enter into (frequently exclusive) negotiations, with the hope of signing a binding agreement. There are various permutations to this classic auction formula, but a common theme is that the seller maintains strict control of the process and flexibility to negotiate with one or more bidders (or none) and accept any (or no) offer, regardless of price or terms.
Why More Auctions?
A number of factors have come together to create a positive climate for controlled auctions:
Sellers’ Market.Most importantly, the low cost of capital and the growth of private capital pools such as private equity funds, hedge funds and large pension funds, together with the scarcity of good businesses for sale, have created a sellers’ market. Auctions allow sellers to showcase their businesses to all kinds of buyers – strategic and financial – and allow buyers to bid up the purchase price based on each buyer’s particular circumstances (strategic fit, life cycle of a fund, relative cost of capital, access to customers or management, etc.).
Sophistication of Sellers.While family-owned businesses and entrepreneurial start-ups may have been sold primarily to known competitors or similar strategic buyers in the past, such sellers are now aware of the broader market for their businesses, including the range of financial buyers. Private equity buyers continue their work of developing so-called "proprietary" deal flow by fostering relationships with owners and managers in relevant industries with the prospect of pre-empting the auction process, but owners and managers are now well versed in the auction game. Private equity funds and other financial buyers are in turn sellers at auction, frequently to other financial buyers.
Sophistication of Buyers.Financial buyers are exploring a broader range of potential acquisitions and assembling "platforms" of various related or complementary businesses in an effort to streamline costs or realize other synergies. Domestic and international private equity funds have discovered the buying opportunities in the Canadian "mid-market", particularly for "tuck-in" transactions where a target business fits nicely with an existing platform. Financial buyers, and to some extent strategic ones, actively market their platforms and declare their interest in specific industries, thereby making it easier for sellers, or their advisors, to identify bidders. In our experience, once foreign buyers, financial or strategic, acquire their first business in Canada and gain a critical mass of knowledge and experience in this market, they are keen to make further acquisitions, and controlled auctions have facilitated this expansion.
Sophistication of Intermediaries.Investment bankers, consultants and other intermediaries are increasingly aware of the M&A opportunities involving mid-sized Canadian companies and have developed contacts and capabilities in this segment of the market. Once only the realm for public company engagements and large private enterprises, investment bankers and other financial intermediaries accept sale engagements, run auctions and beat the bushes globally for potential buyers of all kinds of businesses. As legal counsel, we are increasingly engaged by clients internationally in connection with their interest in Canadian businesses being sold at auction.
Technology.The use of electronic data rooms has allowed sellers and their advisors to provide a virtually limitless number of potential buyers with access to relevant financial, operational and legal information in an efficient manner. Further, sellers can leverage this technology to gain a better understanding of the materials that are relevant to particular buyers and to gauge the interest of buyers by monitoring their access to and use of the data site. Technology has also helped sellers identify and access potential buyers globally.
Exit Options.The appeal of the classic IPO exit transaction has waned somewhat due to the increasing rigour and cost of public company compliance and the recent government announced tax changes for income trusts. As a result, more sellers, including financial owners, see a private auction sale as the best avenue for liquidity of their investment.
Liquidity and Control.While private companies have generally been viewed as the antithesis of a liquid investment, with the growth of financial players in private M&A, many owners, particularly large pension funds or other capital pools, view large positions in public companies as being relatively illiquid due to the inability to sell the position without impacting the share price. With the growth of controlled auctions, these financial players are attracted to the relative liquidity of private companies which also afford opportunities for "home run" investments.
In short, all of the participants in Canadian private M&A transactions have learned how to participate in controlled auctions and are conditioned to expect businesses to be purchased and sold at auction. It is not uncommon for private equity funds or pension funds to receive and review literally hundreds of "books" annually in the hopes of ultimately concluding only a few acquisitions and strategic buyers are regularly approached with buying opportunities.
Participating in Auctions – The Seller’s Perspective
As noted above, sellers presume that a controlled auction will yield the highest price and best contract terms due to the leverage that can be imposed on all bidders. This competitive process also provides support for the seller’s board of directors (or a fund manager) when determining that a proposed transaction represents the best available transaction. Auctions also allow a seller to maintain control over the sale process, including timing, staged disclosure and the setting of critical terms and conditions of sale. However, there are various factors that need to be considered by a seller before it chooses to initiate an auction, including the following:
Up Front Time and Expense.Preparing for an auction costs money and always takes more time than a seller expects. A seller first needs to develop its objectives for the transaction and get organizational buy-in, including key managers. Key personnel need to be focused and motivated and understand what their role in the transaction, and the ongoing business, will be. Sellers need to anticipate and manage potential conflicts or biases. Advisors should be selected and involved at an early stage to assist through this planning and will be closely involved in the preparation of the book, collection and organization of data room materials, and drafting of material agreements.
Ongoing Time and Expense.Once the auction has been launched, the seller, management and relevant personnel will be involved in evaluating bidders’ expressions of interest or bids, due diligence questions, management presentations and negotiation sessions while still running the business. This process will typically stretch out over several months and will likely involve challenges managing personnel, customers and suppliers.
Confidentiality.Due to the nature of the process, sellers will face challenges protecting the confidentiality of sensitive business information contained in the book, the data site or management presentations.
Potential Chilling Effect on Buyers.In some cases, prospective buyers will be deterred by an auction since they may feel they have lost any opportunity to exert their own leverage or engineer a unique transaction. Some strategic and financial players are on record stating that they do not participate in auctions, but in the current market this would be unusual. Some potential bidders may simply not have the financial or human capital to participate in every auction and will need to target their resources.
Failed Auctions.One of the greatest risks in conducting a controlled auction is that a failure by the seller to conclude a transaction will likely make it more difficult for the seller to exit the business in the short to medium term. While this may not be unusual if the reason for failure is the unattractiveness of the target business itself, a failure in the auction process or negotiations may force the seller to keep the business off the market for some period of time. It is also not uncommon for businesses being auctioned off to deal with operational challenges that may threaten the sale process itself.
Participating in Auctions – The Buyer’s Perspective
From a buyer’s perspective, it is easy to identify a number of disadvantages to acquiring a business through auction, including lack of leverage or control over the process and competitive pressures to outbid all suitors. There is also considerable time spent and expense incurred in evaluating numerous businesses while only occasionally winning the bidding process. However, there may be some advantages for buyers in the proliferation of controlled auctions:
Standardization of Process.Common procedures have been developed through many auctions, and intermediaries and advisors, such that buyers know what to expect from a well-managed auction. Buyers can review books, quickly understand data site contents, draft expressions of interest, ask questions of management and navigate key provisions of purchase and sale agreements. In our experience, sellers are more proactively addressing challenges in their disclosure of the target business, and this helps buyers evaluate the opportunity.
Access to Information and Markets.Potential buyers, both financial and strategic, are increasingly approached with opportunities in distant markets as a result of technology, the buyer’s own contacts and marketing efforts, and the role of intermediaries. Whether successful or not, participating bidders gain access to broader markets and accumulate market data and trends that will influence future transactions. Bidders will develop relationships with, and have access to, other market participants, skilled managers and others who can generate future opportunities.
What Goes Around Comes Around.Most bidders will end up on the selling side of an auction at some point.
Here to Stay
Like it or not, controlled auctions are here to stay. Even when the cost of capital cycle turns and available pools become more scarce, it is hard to see how sellers will forsake the benefits of the auction process and rush to conclude M&A transactions with individual buyers without testing the broader market. There will always be scope for proactive buyers who can differentiate themselves from the pack and appeal to sellers, either through their vision for the future growth of the business, their speed of execution and successful track record, or their success in developing close contacts in relevant sectors, but this proprietary deal flow will remain the exception rather than the norm. A properly developed and executed auction strategy by sellers, and even buyers, will yield optimal results.
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