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Agency Risk in the Lower Middle Market: A Guide for PE Professionals

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If there was a Wild West in Personal Fairness (PE), it will be the Decrease Center Market (LMM) — the ecosystem of firms with revenues between $5 million and $50 million. The LMM presents profitable alternatives however comes with distinctive dangers that may derail even probably the most promising offers. For funding professionals, navigating this area requires a deep understanding of company danger, an often-overlooked problem stemming from the reliance on underqualified intermediaries and inexperienced sellers.

Corporations at this finish of the market can differ drastically by way of administration high quality, firm infrastructure, and financial viability (publish change of management). As well as, this finish of the market is severely beneath suggested, which means that providers given by the enterprise brokers working on this market should not as refined as bigger PE markets.

Sellers typically have little company or finance expertise. Somewhat, they’re technical and working specialists who typically have constructed their companies from scratch — with out the assistance of institutional capital. A sale transaction is usually a enterprise proprietor’s first foray into the world of mergers & acquisitions (M&A). These enterprise homeowners are promoting their life’s work.

The LMM Enterprise Dealer Profile

Enterprise brokers — the intermediaries within the decrease center market — are sometimes not refined M&A specialists like funding bankers or attorneys. But, they’ve little hassle convincing sellers that they’re. Brokers know sufficient concerning the M&A course of to sound refined to sellers. Provided that brokers are often the primary level of contact with enterprise homeowners contemplating M&A on this market, they shortly achieve belief. This new belief, or acquiescence, shortly turns into an “advisory” relationship with a prolonged non-circumvention interval with the dealer squarely within the center.

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At first blush, this association doesn’t increase any pink flags. The dealer helps the vendor market the enterprise — there’s nothing unsuitable with that. The issue and the chance stems from the truth that the advertising relationship typically turns right into a de-facto monetary advisory and/or authorized advisory relationship. It is because typically a vendor isn’t certain if she or he needs to promote. Sellers are reluctant to spend cash on acceptable advisors earlier than they’re sure of the viability of a sale. Brokers typically step in to fill this void and are usually glad to barter letters of intent (LOI) on behalf of sellers and opine on deal phrases.

That is the place important company danger[1] comes into play. There are three sub-categories of company danger that LMM sellers and consumers ought to pay attention to and try to mitigate:

  • Anchoring: Brokers will typically anchor sellers to phrases that aren’t market. In contrast to funding banks that may see tons of of offers a 12 months, some brokers may fit on 5 or fewer transactions a 12 months. Worse, some or all these transactions could not shut. Nevertheless, this may increasingly not cease a dealer from offering an opinion on what they imagine are market phrases for a specific a part of the deal. We’ve had a dealer anchor a vendor to an rate of interest that, when pressed, the dealer admitted that they obtained from a time period sheet on a transaction that didn’t shut. Anchoring to phrases which might be non-market erodes belief by worsening what are already tight and emotional negotiations. As a result of brokers are good at convincing sellers that they’re M&A specialists, sellers would possibly imagine consumers should not being honest or forthcoming when a time period is available in that’s not in step with the anchor.
  • Unhealthy recommendation: Unhealthy recommendation is an error of omission. It occurs when a dealer misses one thing that an legal professional or a monetary advisor would catch. This usually has to do with the main points. For instance, a dealer typically will assist a vendor negotiate an LOI whereas the client may have an legal professional carry out this process. You may think about the mismatch. As soon as the LOI is signed and the vendor lastly engages an legal professional, the legal professional will take a look at the signed LOI and level out areas wherein the vendor is at an obstacle. Conditions like this will result in unhealthy optics — the vendor will once more suppose the client is making an attempt to take benefit — resulting in re-trading and wasted cash. These circumstances erode belief by worsening what are already tight and emotional negotiations between a purchaser and a vendor.
  • Phone: Some brokers like to stay in the course of the dialog, insisting that they’re concerned in calls or conferences, and a few sellers give their brokers permission to barter on their behalf. The company danger right here is the potential for brokers to take liberties with negotiations. For instance, a dealer could neglect to vet an thought with the vendor earlier than providing it up as a time period or a compromise. A dealer can misread or misrepresent a time period from the buy-side to a vendor, notably if an agreed-upon time period would make the dealer look unhealthy. We’ve had each conditions occur and both can result in frustration, re-trading, and eroded belief.

Company danger is an actual downside and may make it considerably tougher, if not unimaginable, to get a deal performed. Figuring out this, there are just a few methods to manage and partially mitigate company danger:

  • Communicate candidly with the dealer about anchoring. Brokers are incentivized to get offers performed. If they’re made conscious of the anchoring affect that their phrases can have on sellers, it might make a distinction. We had a great consequence relating to an anchoring scenario the place the dealer acknowledged that he doubtless stated an excessive amount of, and it was a lesson realized. Mitigating this case by having a dialog with the dealer about anchoring to completely different offers or their very own opinions can construct belief and save a variety of ache later.
  • Advise the vendor to acquire advisory providers. To us, a vendor with counsel signifies a degree of seriousness relating to the sale course of. If a vendor doesn’t have authorized counsel or monetary advisory lined up pre-LOI, advise them to take action. You will need to notice that, whereas the LOI will not be legally binding, it does usually embrace a “good religion” clause, which means that the events should act in good religion to shut the transaction in step with the phrases within the LOI.
  • Solely negotiate with the principal vendor. By solely negotiating with the vendor straight, you’ll be able to make sure that communication isn’t misplaced in translation. That stated, some sellers are very busy managing the enterprise and depend on the agent, often the dealer, to handle the sale course of. On this case, you will need to make sure that deal phrases are negotiated in writing, with the vendor copied. We ask the vendor to verify the main points of phrases negotiated with the dealer.

Whereas these steps won’t get rid of company danger, they supply a great pathway for smoother negotiations and closings. 


[1] Company Threat is usually outlined as a battle of curiosity downside the place the agent doesn’t act in the perfect pursuits of their principal

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.

Picture credit score: ©Getty Photos / Ascent / PKS Media Inc.


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