Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions.
This month we focus on an institutional investment strategy that is often under-reported; acquisitions of a minority stake in a mature (i.e. not early-stage) company. Minority acquisitions are increasingly popular – we have outlined five reasons why, but also why it’s important to look carefully before you leap.
1. To avoid the crowds (but know your team)
If quality deal origination is one of the greatest challenges facing any private equity / institutional investor, are minority acquisitions the answer?
Potentially – as has been widely reported, the market for majority buy-outs is extremely crowded with high valuations being paid for businesses across many sectors. Many believe there is an untapped well of opportunities to acquire minority stakes, particularly in founder-owned businesses and SMEs. So why would the owners of such a business contemplate a minority sale? There are many reasons – owners may be sceptical of private equity, unwilling to cede control to a third party, keen to raise some funding, need some liquidity from their own shareholding, want to start succession planning, see benefits in having a professional investor with strategic value on board (e.g. to prepare for a subsequent sale or IPO), or a mixture of these factors.
However, it’s critical to be selective when picking a minority acquisition opportunity. A minority investor will not have day-to-day control of the company, so will need to be sure that the owners and management team share its vision for the company (including in terms of exit), and have working practices and standards that are compatible with the investor’s.
Personalities, relationship and ‘cultural fit’ are a key consideration when assessing a minority investment opportunity.
2. To get a foot in the door (but have a plan B too)
Of course, a minority acquisition may be an end in itself, but for many investors a minority investment’s added appeal is the prospect of obtaining limited financial exposure to a business and creeping further into the capital structure over time. The investor may also be dipping a toe in a new sector, business type or jurisdiction before making further investment. Alternatively it may use its shareholding and exposure to the management team to enhance its own expertise or as a stepping stone to an eventual buy-out.
From a legal perspective, these aims are typically achieved by a minority investor exercising pre-emption rights and rights of first refusal on a transfer of shares in the company. But if, at the critical time, the majority owners do not share the investor’s desire to exit or increase its stake, the investor needs to be able to either force its plans, or seek an exit on its own.
For these reasons, an investor should also push for an ability to require the company to initiate an exit process after a prescribed period (or on the occurrence of a material event, e.g. key person event or poor financial performance). The investor may also wield influence or control over any exit process, freely transfer its shares to a third party (although a lock-up period typically will apply to all shareholders) and perhaps even have a ‘put option’, entitling it to require the majority shareholders to buy its stake. These minority investor rights are typically included in a shareholders’ agreement or the target company’s constitutional documents. Their inclusion is a matter fof negotiation, and will depend on factors such as the size of the investor’s minority interest.
3. To go for growth (but pull your weight)
A company’s owners may prefer the sale of a minority stake when the business is still in its high growth phase, for example where they believe that the business can command a much greater purchase price in the medium term (so are unwilling to sell, yet), but still needs some institutional support in the short term.
A target company’s business growth plans are – in any investment – key in underpinning valuation, and therefore the decision to invest. But the robustness of those plans is arguably even more critical in the case of a minority acquisition, as the minority investor will not typically have the power to dictate or change direction, change the management team or enforce other operational tweaks.
In addition to undertaking thorough due diligence on the business growth plans, a minority investor can mitigate its risk by being actively involved in implementing those plans and supporting the management team in an advisory capacity or providing certain technical expertise. Aside from helping to steer the business in the right direction, active support increases the investor’s visibility of other day-to-day operational issues and relationships, allowing it to anticipate, and detect, emerging problems before they become material. It also helps build trust, which provides ‘soft’ compensation for reduced formal control rights, and helps to align interests.
4. To spread your risk (but still keep it under control)
In terms of aggregate risk profile across a whole portfolio, the relative benefit of making a large number of smaller investments is clear.
That said, the limited control rights held by a minority investor, and its dependence on trust and strong relationships, can make minority investments comparatively delicate on an individual basis.
We have already touched on some of the legal rights a minority investor might want to fight for (see section 2 above); in addition there are a number of ‘market standard’ protections that an investor should push for in order to maximise its influence.
These include board participation (board member or observer), veto rights over particularly material matters that might impact on an investor’s investment, which are often tied to the minority investor maintaining a minimum level of shareholding in the company, and information rights for ease of monitoring and early detection of problems.
5. Because you can (or can you?)
If a great investment opportunity appears, it can be tempting for an investor to pursue it even if it sits outside its usual “sweet spot”.
But there are some factors that might stand in the way of that opportunism. In particular, investors should check any applicable investment policy and relevant fund documentation / investor terms in case they restrict or prohibit minority investments. Such restrictions are common in the private equity industry, and many established private equity fund managers have launched bespoke funds whose sole focus is minority investment to capture those opportunities.
Leverage, or rather practical barriers to the use of leverage, can also be a limiting factor for some investors. Private equity investors typically rely on financial leverage to boost their returns. The absence of majority control over the target company (including limitations on the investor’s ability to exit or grant security over the assets of the target company) will be a natural brake on an investor’s capacity to borrow.
However, as fierce competition for quality assets continues to grow and appetite for minority acquisitions increases, it is likely that financial products will develop to fill this niche, and form part of this emerging sub-industry.
Is this brief too brief? Do you need any help with your next minority acquisition? Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
DEAL OF THE MONTH:
MJ Hudson’s M&A and Private Equity transactions team advised on the sale of a software group specialising in rights management and literary agency accounting to a large, Germany-based, multi-product software developer.
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