If there was a Wild West in Private Equity (PE), it would be the Lower Middle Market (LMM) — the ecosystem of companies with revenues between $5 million and $50 million. The LMM offers lucrative opportunities but comes with unique risks that can derail even the most promising deals. For investment professionals, navigating this space requires a deep understanding of agency risk, an often-overlooked challenge stemming from the reliance on underqualified intermediaries and inexperienced sellers.
Companies at this end of the market can vary greatly in terms of management quality, company infrastructure, and economic viability (post change of control). In addition, this end of the market is severely under advised, meaning that services given by the business brokers operating in this market are not as sophisticated as larger PE markets.
Sellers often have little corporate or finance experience. Rather, they are technical and operating experts who often have built their businesses from scratch — without the help of institutional capital. A sale transaction is often a business owner’s first foray into the world of mergers & acquisitions (M&A). These business owners are selling their life’s work.
The LMM Business Broker Profile
Business brokers — the intermediaries in the lower middle market — are often not sophisticated M&A experts like investment bankers or attorneys. Yet, they have little trouble convincing sellers that they are. Brokers know enough about the M&A process to sound sophisticated to sellers. Given that brokers are usually the first point of contact with business owners considering M&A in this market, they quickly gain trust. This new trust, or acquiescence, quickly turns into an “advisory” relationship with a lengthy non-circumvention period with the broker squarely in the middle.
At first blush, this arrangement does not raise any red flags. The broker helps the seller market the business — there is nothing wrong with that. The problem and the risk stems from the fact that the marketing relationship often turns into a de-facto financial advisory and/or legal advisory relationship. This is because often a seller isn’t sure if he or she wants to sell. Sellers are reluctant to spend money on appropriate advisors before they are certain of the viability of a sale. Brokers often step in to fill this void and are generally happy to negotiate letters of intent (LOI) on behalf of sellers and opine on deal terms.
This is where significant agency risk[1] comes into play. There are three sub-categories of agency risk that LMM sellers and buyers should be aware of and attempt to mitigate:
Anchoring: Brokers will sometimes anchor sellers to terms that are not market. Unlike investment banks that can see hundreds of deals a year, some brokers may work on five or fewer transactions a year. Worse, some or all these transactions may not close. However, this may not stop a broker from providing an opinion on what they believe are market terms for a particular part of the deal. We’ve had a broker anchor a seller to an interest rate that, when pressed, the broker admitted that they got from a term sheet on a transaction that did not close. Anchoring to terms that are non-market erodes trust by worsening what are already tight and emotional negotiations. Because brokers are good at convincing sellers that they are M&A experts, sellers might believe buyers are not being fair or forthcoming when a term comes in that is not in line with the anchor.
Bad advice: Bad advice is an error of omission. It happens when a broker misses something that an attorney or a financial advisor would catch. This typically has to do with the details. For example, a broker often will help a seller negotiate an LOI while the buyer will have an attorney perform this task. You can imagine the mismatch. Once the LOI is signed and the seller finally engages an attorney, the attorney will look at the signed LOI and point out areas in which the seller is at a disadvantage. Situations like this can lead to bad optics — the seller will again think the buyer is trying to take advantage — leading to re-trading and wasted money. These circumstances erode trust by worsening what are already tight and emotional negotiations between a buyer and a seller.
Telephone: Some brokers like to remain in the middle of the conversation, insisting that they are involved in calls or meetings, and some sellers give their brokers permission to negotiate on their behalf. The agency risk here is the potential for brokers to take liberties with negotiations. For example, a broker may neglect to vet an idea with the seller before offering it up as a term or a compromise. A broker can misinterpret or misrepresent a term from the buy-side to a seller, particularly if an agreed-upon term would make the broker look bad. We’ve had both situations happen and either can lead to frustration, re-trading, and eroded trust.
Agency risk is a real problem and can make it significantly harder, if not impossible, to get a deal done. Knowing this, there are a few ways to control and partially mitigate agency risk:
Speak candidly with the broker about anchoring. Brokers are incentivized to get deals done. If they are made aware of the anchoring impact that their words can have on sellers, it could make a difference. We had a good outcome regarding an anchoring situation where the broker acknowledged that he likely said too much, and it was a lesson learned. Mitigating this situation by having a conversation with the broker about anchoring to different deals or their own opinions can build trust and save a lot of pain later.
Advise the seller to obtain advisory services. To us, a seller with counsel indicates a level of seriousness regarding the sale process. If a seller does not have legal counsel or financial advisory lined up pre-LOI, advise them to do so. It is important to note that, while the LOI is not legally binding, it does typically include a “good faith” clause, meaning that the parties must act in good faith to close the transaction in line with the terms in the LOI.
Only negotiate with the principal seller. By only negotiating with the seller directly, you can be sure that communication isn’t lost in translation. That said, some sellers are very busy managing the business and rely on the agent, usually the broker, to manage the sale process. In this case, it is important to ensure that deal terms are negotiated in writing, with the seller copied. We ask the seller to confirm the details of terms negotiated with the broker.
While these steps will not eliminate agency risk, they provide a good pathway for smoother negotiations and closings.
[1] Agency Risk is generally defined as a conflict of interest problem where the agent does not act in the best interests of their principal
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