If there have been a Wild West in private equity (PE), it might be the Lower Middle Market (LMM) – the ecosystem of corporations with revenues between $5 million and $50 million. The LMM offers lucrative opportunities but presents unique risks that may derail even probably the most promising deals. For investment professionals, navigating this space requires a deep understanding of agency risk, an often-overlooked challenge that arises from reliance on underqualified intermediaries and inexperienced salespeople.
Companies at this end of the market can vary widely by way of management quality, corporate infrastructure and economic profitability (post-change of control). Additionally, this a part of the market is severely underserved, meaning that the services provided by corporate brokers operating on this market will not be as sophisticated as larger PE markets.
Salespeople often have little business or financial experience. Rather, they’re technical and operational experts who’ve often built their corporations from the bottom up – without the assistance of institutional capital. A sales transaction is commonly a business owner’s first foray into the world of mergers and acquisitions (M&A). These entrepreneurs are selling their life’s work.
The LMM Business Broker profile
Corporate brokers – the intermediaries within the lower middle class – are sometimes not experienced M&A experts like investment bankers or lawyers. Nevertheless, it’s hardly difficult for them to persuade the sellers of this. Brokers know enough concerning the M&A process to seem sophisticated to sellers. Since brokers are typically the primary point of contact for entrepreneurs considering M&A transactions on this market, they quickly gain trust. This recent trust or toleration quickly evolves right into a “consultative” relationship with an extended period of no-go around, with the broker right in the center.
At first glance, this agreement doesn’t raise any red flags. The agent helps the vendor market the business – there may be nothing fallacious with that. The problem and risk arise from the indisputable fact that the marketing relationship often becomes a de facto financial advisory and/or legal advisory relationship. This is because a seller is commonly unsure if she or he desires to sell. Sellers are reluctant to spend money on appropriate advisors until they’re sure of the viability of a sale. Brokers often step in to fill this gap and are generally completely happy to barter letters of intent (LOI) on behalf of sellers and comment on terms and conditions.
There is a major agency risk here[1] comes into play. There are three subcategories of agency risk that LMM sellers and buyers should pay attention to and seek to mitigate:
- Anchoring: Sometimes brokers force sellers to comply with conditions that will not be in step with the market. Unlike investment banks, which may process tons of of transactions per yr, some brokers may process five or fewer transactions per yr. Worse, some or all of those transactions may not complete. However, this will not prevent a broker from giving an opinion on what he considers to be fair market terms for a specific a part of the deal. We had an agent who locked a seller into an rate of interest, and when asked, the agent admitted that he got it from a term sheet for an unfinished transaction. Being tied to conditions that will not be in step with the market undermines trust by making already tight and emotional negotiations worse. Since brokers are good at convincing sellers that they’re M&A experts, sellers may consider that buyers will not be being fair or accommodating if a condition is received that doesn’t match the anchor.
- Bad advice: Bad advice is an error of omission. It happens when a broker misses something that a lawyer or financial advisor would notice. This typically has to do with the main points. For example, a broker often helps a seller negotiate an LOI, while the customer leaves this task to an attorney. You can imagine the disproportion. Once the letter of intent is signed and the vendor ultimately hires an attorney, the attorney will have a look at the signed letter of intent and indicate areas where the vendor is at an obstacle. Situations like these can create bad optics – the vendor will in turn think the customer is attempting to make the most – resulting in re-trading and wasted money. These circumstances undermine trust by worsening the already close and emotional negotiations between buyer and seller.
- Phone: Some agents prefer to stay in the midst of the conversation and demand that they be involved in calls or meetings, and a few sellers give their agents permission to barter on their behalf. The agency risk here is that brokers may take liberties during negotiations. For example, an agent fails to debate an idea with the vendor before offering it as a condition or compromise. An agent may misinterpret or misrepresent a buyer’s term to a seller, particularly if an agreed term would make the agent look bad. We have experienced each situations, and each can result in frustration, turnover, and lack of trust.
Agency risk is an actual problem and might make closing a deal significantly harder, if not not possible. With this in mind, there are several ways to manage and partially mitigate regulatory risk:
- Speak openly with the agent about anchoring. Brokers are incentivized to shut deals. Making them aware of the anchoring effect their words can have on salespeople could make a difference. We had final result in an anchor situation where the agent acknowledged he had probably said an excessive amount of, and that was a lesson learned. Defusing this case by having a conversation with the agent about commitment to varied deals or his or her own opinion can construct trust and prevent lots of hassle later.
- Advise the vendor to hunt advisory services. For us, a seller with legal representation implies that the sales process is taken seriously. If a seller doesn’t seek legal or financial advice prior to the LOI, advise them to accomplish that. It is significant to notice that while the LOI is just not legally binding, it typically accommodates a “good faith” clause, meaning that the parties must act in good faith to finish the transaction in accordance with the terms of the LOI .
- Negotiate only with the predominant seller. By only negotiating directly with the vendor, you’ll be able to be assured that communication won’t be lost in translation. However, some sellers are very busy managing the deal and depend on the agent, often the broker, to administer the sales process. In this case, it will be significant to be sure that the terms and conditions are negotiated in writing and that the vendor receives a duplicate of them. We ask the vendor to verify the main points of the conditions negotiated with the agent.
Although these steps don’t eliminate agency risk, they supply path to smoother negotiations and closings.
[1] Agency risk is mostly defined as a conflict of interest problem through which the agent doesn’t act in the perfect interests of its principal
