Navigating deals in the mid-market sector
by Neil du Toit
Deal values in the South African market are declining year-on-year, mainly as a result of the country's declining competitiveness in the global market.
A number of factors have contributed to this, including political instability and high sovereign debt levels, which have decreased the ability of government to fund projects, and contributed to the recent credit
DealMakers - 2019 Annual
Niel du Toit
downgrades by major rating agencies. The result is a shift in the deal landscape from mega M&A and project finance deals (where more stable and predictable economies are preferred) to deals in the mid-market sector, approximating deal enterprise values from R50m up to R500m.
As deals shift to the mid-market sector, many advisers and service providers will be required to adapt their approach and business model to accommodate the changing landscape, if they have not done so already. The following observations are typically evident when navigating deals in the mid-market sector:
Unlisted private companies
Many mid-market deals are concluded in the unlisted sector. Most private equity firms typically look for businesses of scale, with interest much higher for targets with earnings before interest, tax, depreciation and amortisation (EBITDA) in excess of R50m, and intense competition for targets with EBITDA approaching R100m and above. The consequence is a smaller pool of prospective private equity acquirers for smaller businesses. Deals in this space are typically not publicised, resulting in limited public information regarding comparable transaction multiples. Advisers are therefore required to be more creative in their approach to sourcing a universe of prospective acquirers and comparable transaction multiples by, inter alia, engaging with industry experts and trade associations, and attending industry-focused trade exhibitions.
The statutory requirements for companies in the mid-market sector are far less onerous for unlisted entities than for listed entities, and are affected by, inter alia, the Companies Act public sector score. A listed entity is required to appoint a JSE-accredited audit firm, comply with listings requirements and regularly report its figures according to a stringent timetable. In contrast, mid-market firms in many instances are only required to report financial figures to taxation authorities and/or finance providers. Advisers and service providers therefore need to invest additional time and effort to ensure that the underlying information and compliance processes are credible and robust, and that client expectations and timelines are appropriately managed in order to avoid unexpected surprises at critical phases of the deal process.
Most deals in the mid-market sector are concluded with owner-managed entities, wherein the shareholders and owners are often the same party. This creates a different dynamic when compared to a company in which the majority of shareholders are distinct from those charged with management and governance.
To begin with, where owners are desirous of disposing of the entirety or a significant portion of their shareholding, there is a risk of the loss of business-critical skills and knowledge. These businesses are often characterised by “key man” dependency and a lack of succession planning. Transactors are thus required to ensure that sufficient management skills and knowledge are retained and protected, post-transaction, through transaction mechanisms, restraint of trade agreements and earn-out clauses – at least until a sufficient handover has been completed and enough time has passed for sensitive information to be redundant.
Owner-managers are also typically emotionally attached to their businesses: the experience of disposing of a business may be comparable to disposing of one’s childhood home. Often, this emotional attachment can result in unrealistic pricing expectations, a more difficult negotiation process, “cold feet” and other challenging dynamics throughout the transaction process.
Moreover, in an owner-managed enterprise, governance and management structures may have remained unchanged for some time. This – along with lower governance requirements due to the less stringent statutory requirements, and sometimes, autocratic management styles – often results in potential pitfalls and deficiencies remaining undetected or unaddressed until the due diligence investigations of a potential transaction. This can be avoided through sufficient pre-deal investigation, management interviews and industry expert consultations prior to officiating an engagement.
A shortage of expertise
Large organisations typically have in-house M&A and deal-making expertise, ensuring that deals are executed smoothly. However, in mid-market organisations, this expertise is often lacking. In many instances, sellers execute transactions without the necessary advice and services being provided, resulting in unrealistic pricing expectations, and challenges during the transaction.
Furthermore, burdens are typically placed on existing staff members, in addition to their usual responsibilies. This can result in timelines being extended, deal fatigue and sometimes even failed transactions. It is therefore imperative that all parties obtain sufficient external advice to ensure a seamless execution.
Typically, the transaction sizes in mid-market deals are vastly lower than with the mega-deals. Advisers are thus expected to perform services at significantly lower rates and, oftentimes, at risk, while in many cases there may be more work involved in order to determine sustainable and/or normalised levels of earnings. Transactors are required to right-size their offering to ensure that all parties are accommodated, and also that advisers are incentivised to ensure seamless execution of the transactions.
In conclusion, advisors and transactors executing transactions in the mid-market sector need to plan assignments carefully, taking into account the legal, statutory, psychological and fee-related challenges that require a bespoke approach.
Du Toit is an Associate Director, BDO Corporate Finance.