Question

In 2006 and early 2007, investment banks representing firms for sale saw financial buyers bidding more than strategic buyers. Why is this unusual and why was it happening?

Answer 1

Financial buyers will carefully scrutinize the financial statements of the company. Most are looking for a well-managed company with a history of consistent earnings, and preferably, earnings growth. The transactions of financial buyers are often leveraged. It is common to see financial buyers use as much as 80% or more debt to finance an acquisition. By using high leverage, the financial buyer is effectively partnering with someone who is willing to accept a level of return (a lending rate, perhaps augmented by “kickers” to augment returns) that is generally lower than that required by financial buyers.

Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may include vertical expansion (toward the customer or supplier), horizontal expansion (into new geographic markets or product lines), eliminating competition, or enhancing some of its own key weaknesses (technology, marketing, distribution, research and development, etc.).

Strategic buyers are often willing and able to pay more for a company than financial buyers. There are two main reasons for this. First, strategic buyers may be able to realize synergistic benefits almost immediately due to economies of scale that may exist through the combined purchasing power of the new entity and the elimination of duplicate functions. The better the fit (i.e., the more realizable the synergies are), the more they will want the business and the greater the premium they will pay. Second, strategic buyers are generally larger companies with better access to capital. They often have another currency available to them in the form of stock. Strategic buyers often offer stock, cash, or a combination of the two in payment of the purchase price.

In short, the strategic buyer is buying the company in light of how it will enhance their existing operations. They are often willing to pay for readily realizable synergies, and many times will pay for speculative synergies, particularly if the target company is being marketed to other competitors (through some type of “auction”). Strategic buyers are much less likely to retain all of the current personnel.

Whether a strategic buyer or a financial buyer is right for a specific company depends largely on the seller’s goals in selling the business. Listed below are different scenarios discussing the seller’s goal and the type of buyer most appropriate.

The Seller Wants the Highest Price Possible. If the only goal in the sale is achieving the highest price possible, regardless of what happens to the plant or employees, the open auction process is the best way to drive the price upward. And obviously, with highest price being the only goal, the strategic buyers will most likely be the best fit. That is not to say that financial buyers should not be considered in the process.

The Seller Wants a High Price, but Has Other Concerns. If the seller’s goal is a high price (not to be confused with “highest” price), but the seller wants to protect employees, a strategic buyer is still probably the most appropriate.

From 2004 through 2007, Goldman Sachs was an active participant in the mortgage market, particularly in the area of securitization. On multiple occasions, it helped lenders like Long Beach Mortgage Company, Fremont Loan & Investment, and New Century Mortgage, securitize billions of dollars in poor quality, high risk mortgages and sold them to investors. In doing so, Goldman Sachs provided these lenders with additional liquidity to make even more bad loans, many of whichwere included in risky securities.Two examples illustrate Goldman Sachs’ role in the securitization process.

The example involves Washington Mutual (“WaMu”) and its subprime lender Long Beach. An exhibit from the Subcommittee’s first hearing shows that WaMu, Long Beach, andGoldman Sachs collaborated on at least $14 billion in loan sales and securitizations,2 even though Long Beach originated some of the worst performing subprime mortgages in the country. In 2003, WaMu halted all Long Beach securitizations and sent a legal team for three months to clean up the company’s problems, before allowing securitizations to resume in 2004. In 2005, Long Beach saw a surge of early payment defaults on its loans and had to repurchase over $875 million of nonperforming loans from investors, as well as book a $107 million loss.

Internal audits of Long Beach and examinations by the Office of Thrift Supervision repeatedly identified lax lending standards, poor controls over loan officers ignoring credit requirements,and loans subject to fraud, appraisal problems, and errors. Long Beach securitizations had among the worst credit losses in the industry from 1999-2003, and in 2005 and 2006 Long Beach securities were among the worst performing in the market.

Nevertheless, in May 2006 Goldman Sachs acted as co-lead underwriter with WaMu tosecuritize about $532 million in subprime second lien, fixed rate mortgages originated by Long Beach. Long Beach Mortgage Loan Trust 2006-A (“LBMLT 2006-A”) issued about $495million in RMBS securities backed by the Long Beach high risk mortgages. The top three tranches, representing 66 percent of the principal loan balance, received AAA ratings from S&P,even though the pool contained high risk, subprime second lien mortgages—loans for which there was little prospect of recovering collateral in the event of a housing downturn—issued by one of the nation’s worst mortgage lenders. In this instance, Goldman Sachs was able, with thehelp of the ratings agencies, to turn two-thirds of that extremely risky debt into AAA-ratedsecurities. Goldman Sachs then sold the Long Beach securities to investors.In less than a year, the Long Beach loans started to becomedelinquent. By May 2007,the cumulative net loss on the underlying mortgage pool jumped to over 12 percent, wiping out a significant amount of the deal’s loss protection and causing S&P to downgrade 6 out of 7 of the mezzanine tranches of the securitization. The Long Beach securities plummeted in value. Goldman Sachs owned some of the mezzanine securities, but had also placed a bet against themby purchasing a credit default swap that paid off if the securities incurred loss. One Goldman employee, upon learning of the Long Beach losses, wrote in an email to management: “badnews… [the loss] wipes out the m6s and makes a wipeout of the m5 imminent… costs us about 2.5[million dollars] good news… we own 10[million dollars] protection at the m6… we make$5[million].” Ultimately, in this transaction, Goldman Sachs profited from the decline of thevery security it had earlier sold to clients. By May 2008—only two years later—even the AAA securities in LBMLT 2006-A had been downgraded to default status. By March 2010, the securities recorded a cumulative net loss of over 66 percent.

This brief discussion is in no way intended to try to address all of the circumstances that may need to be considered in the prospective sale of a business. If you are a business owner who is considering the sale of your business please contact us at Mercer Capital to confidentially discuss your specific situation.

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