Intermediation in private equity refers to a middleman that facilitates a deal (business brokers, investment bankers, corporate advisers, strategic consultants, etc). I talked briefly about intermediation in my post about deal origination, but here I’m going to expand on what I believe are the pros and cons.
Personally, I much prefer to work on proprietary deals because you have the chance to build a rapport with the owners and work on a more personal level. The processes created by investment banks typically (not always) take the subjectivity out of the deal, which is the foundation of most private equity deals. With that said, the higher prices typically achieved with intermediated deals suits private equity firms when they want to exit investments. So, it’s really a case of “can’t live with them, can’t live without them”.
- The potential investee is usually qualified: that is, the private equity firm knows that the business is interested in a sale or investment. This negates much of the extensive legwork required to sell the idea of private equity and to get a commitment. There is still the risk that the owner can pull the pin at any time, but it is less of a risk in an investment bank deal.
- The investment bank can smooth negotiations: when a private equity firm tries to convince a business owner that equity claw backs are typical and that their business is only worth 3 times earnings, it doesn’t hold the same credibility as it does from an independent party. That’s not to say that intermediators are independent, but they’re arguably more independent than the private equity firm is. So, the intermediator may help by prepping the owner beforehand.
- Many deals are only available through investment banks: this is especially true with larger buyout deals where business owners (or directors in the case of public companies) are obligated to run a process and shop the deal around. Similarly, if a business owner enlists the services of an intermediator, they tie themselves to that agreement for a lengthy period, which essentially thwarts the efforts of private equity firms looking for proactive deals.
- Interests are often unaligned: deal-related fees often incentivize an investment bank. If this is on the top-line payment price, then the incentive is for the intermediator to secure a higher price. If it is on the cash payment/injection, this will shift incentives away from expansion deals towards full sale deals (it will also create disincentives towards earn-outs and the like).
- Shopping the deal takes place: in investment banker deals, the private equity firm is only one of many parties in contact with the deal. The first problem with this is, a trade buyer can create the illusion of a better deal with a higher top-line valuation (remember, often they are the more natural buyer due to synergies). The second problem is, it creates an auction for the business and private equity firms rarely care to be the highest bidder.
- It becomes difficult to learn about the business: this is a by-product of misaligned interests, but it warrants special note because it can be terribly frustrating. Investment banks often prefer to create bargaining chips and burning platforms in order to inflate their advisory fee. This usually works against a private equity firm attempting to understand the motivations and thoughts of the business owners.
Contrary to common belief, investment bankers have feelings too. In fact, bankers think of us (private equiteers) the same way we think of them; as cold, callous, calculating financiers. Sure, we act like close comrades in tête-à-tête, but deep down we boil each others’ blood. You see, investment bankers hamper our dealmaking efforts. They may think we wouldn’t have access to deals without them, but we actually think we’d have a more direct path to deals if they disappeared. We’d understand vendor needs to a greater extent, be able to negotiate more effectively and not have the usual problems dealing with middlemen. So, it’s a little love/hate as you can see.
But, this is a dangerous view. Investment bankers undoubtedly have influence over markets and their clients (who just happen to be our potential investees). And even leaving the investment banker value-add debate to one side, it’s impossible to make a case that states investment banks have no influence over our deals. They are hired as stewards, have pride in this implied stewardship and don’t exactly have a lack of access to private equity firms (or other potential buyers).
So what’s my point? Well, we only hurt ourselves by disrespecting investment bankers. I’m not talking about the kind of disrespect that gets in a banker’s face; I’m talking about the disrespect we try to obfuscate but secretly hope isn’t too obfuscated. The disrespect that says you’re middleman pond scum and we’re the kings that control the money. The disrespect that they feel when we beguile their efforts to manage the transaction with them at its epicenter. However, apart from being pretentious and pugnacious, this disrespect just doesn’t help our cause (and I’m sure Dale Carnegie would agree).
I’ve (secretly) found it pays high dividends to empathize with an investment banker’s soulless benevolent endeavors and to treat them as equals. They provide additional deal flow, intel on the market, hints to handling vendors, notes on competing offers, honesty around expectations and suggestions on deal structuring. But remember that they’re generally quite perceptive, so any egregious attempt to appear best pals will just make the situation worse. You need to find some genuine empathy, which may just be the difference between a great deal and no deal at all. Plus, you never know, your new-found banker friends may even provide good company over a cold ale on a hot summer’s day.