By Jordan Stolper (with plenty of help from Mo Lam)
The first deal is the hardest.
This is a common refrain in the independent sponsors/search fund community. In our experience, it’s true. In this post, I’ll discuss how our first deal, the acquisition of Peterson’s, came about, and the many challenges we faced on the path to close. (For context, I’d recommend reading the preceding post.)
We first took a look at Peterson’s in July, 2017. Nelnet, the company’s owner, announced the acquisition of Great Lakes Education Loan Services and was looking to sell Peterson’s as it was considered non-core to its loan servicing business. The Great Lakes acquisition was transformative and Nelnet wanted to focus its attention there.
We were excited by the deal for a number of reasons. I was familiar with the company’s brand and products; as a high school student, I’d used Peterson’s college guide to help with the college application process. We saw a business that had suffered from de-investment for a number of years, and so we could envision a path to growth by executing the much celebrated “digital transformation” strategy. In this case, that would mean digitizing Peterson’s library of content and making it easy for consumers to buy it. We also saw a business that had a number of meaningful contracts - thereby providing ample cashflow for investment into higher growth channels. A review of the company’s staffing plan revealed that it was perhaps top-heavy relative to its size.
In sum, we saw opportunities for both growth and cost savings - meaning multiple paths to a good investor return.
So we made an offer. And it was rejected, almost immediately.
Why?
This is a good moment to walk in a seller’s shoes. It will help explain why, as a fundless sponsor, doing deals (especially the first one) can be difficult. While we were not privy to the conversations that took place within Nelnet, we have a pretty good idea of how things went down. Mo and I had both done M&A before (he more than me).
Likely Reason #1: The purchase price was lower than the competing offer. This is life in the big leagues. The other buyer may have been a strategic or PE firm with deeper pockets. It happens all the time, but it’s seldom the only (or even the main) reason an offer like ours is refused.
Likely Reasons #2 - #99: The seller doesn’t believe that we can get the deal done. With time the single scarcest resource, the seller doesn’t want to mess around with a buyer where there is transaction risk. What is transaction risk? It’s the risk in any deal process that one party cannot make it to the finish line. Usually, the concern is that they do not have the money to do the deal. Therefore, an offer from a firm with a track record of successful transactions trumps an offer from an unproven buyer. Even if the purchase price is lower, most corporate sellers prefer surety of close over a slightly higher purchase price. In 2017, Nelnet’s revenue was $1.2B and about to get bigger. Peterson’s revenue, while meaningful for us, is relatively small potatoes for its parent. For searchers like us, this is where life gets exceedingly difficult. One way or another you need to convince a seller that you are not totally full of shit. That your “firm” is not simply a shell entity with a pretty website and a heart-rending mission statement. That you can pull the equity and debt capital together within the agreed-upon time frame. That your investors are not going to throw up all over the management fees and carry. That your lender isn’t going to back out because underwriting got cold feet. That your due diligence process is refined enough that when the inevitable hiccup surfaces you don’t freak out and walk.
In short, because these deals are complex, precarious, and just plain hard, they want confidence that in three months they won’t be back in market with a broken process and dashed expectations of a clean carve out.
Lucky for us, this is exactly what happened. The buyer Nelnet moved forward with back in July ended up walking away from the deal. We don’t know the exact reasons why. But in October 2017, the company came back to us and asked if we were interested in re-engaging.
We were.
So we put together a revised LOI and boarded flights to Denver. We sat down with the management team and a member of the corporate development team for a day and a half of due diligence. We went through each of the business lines, talk about the various risks to the business, and, broadly speaking, let the management team sell us on the opportunity. There was a lot to like about the business. It had - and has - a terrific brand, excellent content assets, a number of longstanding commercial relationships to deliver a strong base of recurring revenue. There was also a lot to be concerned about. The company was almost entirely distributed, with the then GM running it from his home in upstate New York. Its technology infrastructure was dated. There were meaningful risks to some of the existing business lines.
None of it was a showstopper. All of the problems we identified in the business were correctable and, in a sense, would be our value add. After all, Mo and I are operators. We are comfortable getting our hands dirty.
One of the many things we learned in this transaction was how to triage the issues that emerge according to their potential impact to the overall business, and by extension, the deal’s return profile. And to make sure that these material issues are addressed at the beginning of the transaction (before we’ve invested a lot of time) rather than at the finish line. A good example of this is working capital adjustments. It comes up in every deal, large or small, and can become a major irritant to both parties. For this reason, we’ve learned to address it early on in any M&A process. More on this in subsequent posts.
Negotiations with Nelnet continued.
After some further discussions to address some of the issues uncovered in DD, we revised our LOI yet again. I won’t get into the purchase price and the nitty-gritty of the negotiations, but suffice it to say that we asked for additional concessions by the seller. They agreed - but only if we could close by December 31, 2017.
Nelnet asked to see proof of funds. We, of course, did not have the capital raised at this point. We went to one of our likely equity investors and asked them to write a letter, on company letterhead, stating that they were supportive of the transaction. It helped immensely that the investor runs a $10B asset management firm. Nelnet ended up calling the investor to verify their commitment to the deal. As discussed above, they were looking to reduce transaction risk. It was less about the purchase price (though that certainly mattered) than about our ability to pull the deal off.
One way or the other, we convinced Nelnet that we could close the deal on the agreed-upon time frame. At this point, we were now in early November - so roughly 60 days from close.
Holy moly.
Here’s the to-do list at this point:
Perform further DD (technical, sales, financial)
Write CIM (aka PPM) for distribution to potential investors
Raise equity capital
Raise mezzanine debt
Raise debt capital (term + revolver)
Draft APA (asset purchase agreement)
Draft operating agreement
Draft multiple LLC agreements
Draft the subscription agreement for equity
Negotiate agreement for mezzanine debt and bridge financing
Draft the management agreement between the acquisition vehicle and our management company
Close the deal
Fly to Denver to take over the business.
The long pole in the tent here was of course the equity capital. Without these commitments in place, there would be no deal. In the end, we needed someone to come in as a lead investor - taking at least 50% of the equity in the deal. This lead investor would ostensibly negotiate the terms of the subscription agreement, the operating agreement, and the management agreement. Part of this is also negotiating the carry, management fee, and any go-forward compensation for me and Mo. Put simply, a lead investor needs to have the cash but also should be reasonably sophisticated in understanding the structure of private equity transactions and how sponsors are compensated. Often, the minority investors will want to know who the lead investor is and will take comfort (or not) in knowing that the lead is reputable. Because all of our minority investors are “friends and family” there was trust in us that largely superseded concerns about the lead.
So how about that equity capital?
We met with the aforementioned family office in NYC. They liked the deal, and almost immediately presented us with a term sheet. The terms were decent, and we stepped away to think about the offer.
Around the same time, Mo headed out for a long-planned family vacation. While away, he re-connected with a fellow alum from Harvard Business School. They got to talking about the Peterson’s deal. Much to our surprise, Mo’s classmate stepped forward and offered to lead the investment on his own. After a series of late-night conversations and friendly negotiations, we had found our lead equity investor.
On the debt side, we had made progress with a handful of small banks but it was clear that our deadline was incompatible with the speed at which the banks could underwrite the loan. So we decided to lock in a mezzanine debt financing and take a bridge loan from some of our equity investors in order to ensure close. We would end up getting bank debt a few months after close and pay down the bridge debt at that time.
The weeks that followed are a blur. We managed to get through the to-do list. Though not without making plenty of mistakes along the way. For example:
The lawyers we hired to paper the debt ended up going MIA for a period of time leading up to the transaction;
We paid a heavy price for debt financing because of our shorten close;
We paid for transition services because we didn’t have enough time to stand up health benefits and payroll for a newly constituted entity.
In the end, most of these were rookie mistakes that we now know how to avoid. Their ultimate impact on the deal was negligible. Like all things, experience teaches you how to separate out the stuff that really matters from everything else. We were also very lucky in some cases that none of these missteps ended up hurting the company. Nelnet was easy to work with after they were comfortable with our ability to close. Our investors trusted us. I’ve come to conclude there is a certain amount of breakage that comes along with every deal and, so long as the fundamentals of the transaction are intact, this is just a cost of doing business.
We worked through Thanksgiving, Christmas and really straight up until close on December 29, 2017.
On the day of close, I remember waking up at around 4 AM, taking a Lyft to the office I was renting, and setting to work. The close would happen electronically. Documents were flying around; we were signing stuff without always fully knowing what we were signing; we were calling lawyers to get capital released; we were getting urgent texts from the seller wondering when the funds would arrive. It was an insanely stressful, exhausting day.
And then it was over. I went home by mid-afternoon and collapsed in exhaustion. We’d close the deal. Nearly 6 months after our initial offer.
On January 1, 2018, Mo and I met up at Denver International Airport.
The next day we would walk into Peterson’s as its owners.
