Episode 22: Investment Banking: Behind the Pinstripes
Episode Summary
When you talk about investment banks, many people think of large firms driving IPOs. But how do middle market companies use investment banks to support their growth and exit plans? On this episode we go “behind the pinstripes” to talk about types of investment banks, the role they play in the middle market, and how their role is different than business brokers and consultants.
Episode Transcript
Stephanie Chambliss Gaffin : 0:00
If you ask most people about investment banking, they probably know that it has something to do with finance, and maybe even that they work on raising capital and selling companies. But the common conception is largely driven by the activities of large firms. We all think about the IPOs that we hear about, but that's very different than the needs of the middle market. So this begs the question, how do middle market companies use investment banks to support their growth and eventually their exit plans? Today, we go behind the pinstripes to talk about the different types of investment banks, the role they play in the middle market, and how their role is different than either business brokers or consultants.
Welcome to Right in the Middle Market, a podcast about pragmatic perspectives on running, growing and selling your business. We talk about the challenges, decisions, and most importantly, the actions business owners can take to create long term value in their companies.
Welcome to Right in the Middle Market. I'm Stephanie Chambliss Gaffin, and here today with my co host, Mark Gaffin. On today's episode, we want to continue to build on the theme of working with advisors. And there's a special case of an advisor of working with an investment bank, that I think of everything that we've talked about. We've talked about consultants, we've talked about accountants, we've talked about attorneys, all of those, well, I think, hopefully, there's been a lot of good things to learn across these last few episodes. All of those are individuals that most people I think are relatively familiar with. Investment banks are a bit of a different story. People have seen them in the media, they are not usually portrayed in a nice way. But it is something that many business owners find when they get to a particular need, that this is an important advisor to them. So today, we want to dive into investment banks. What exactly is it that they do? Why would you use one? What are some of the different types, and to really just understand a little bit more about using an investment bank.
But before we do that, I wanted to give just a quick story. And if you'll indulge me being maybe a bit off topic, but as you all get to know us, and not only what we do, but why we do what we do. I was on one of the podcast Facebook groups that I'm on last night, and there was a question that was asked about a particular service, and it's one that I use and really like and so I along with a number of other people had chimed in saying, Yes, actually, this is a fantastic service. Matter of fact, the owner is often the one who's there on customer support, I've gotten to know him via chat, always incredibly helpful. I am not a techie person. And he has just been amazing and helping me through this. So I was more than happy to chime in. And, you know, share this experience to somebody who was contemplating using the same service. Little did I know that said business owner actually is also in this fairly large Facebook group. And last night, apparently, he stumbled on this thread and commented on it because I was not the only one who had chimed in talking about how incredible this company is and their customer support. And you could tell he was beyond touched and humbled that completely independent of him, he had raving fans, right, he had customers chiming in about how awesome it is to use his service. And I started thinking about it. And I was like, This is why we do what we do, not as podcasters. But when we are not here, we are running actually two companies, our consulting firm and our investment bank. And the reason that we do that is because we love helping middle market business owners. And I thought about that when I read this Facebook comment, he's not a client of ours again, I'm a customer of the service that he uses. But he's created a service that is really valuable to people. And you could tell from his comments, the pride that he takes and how much it meant to him to find out that people are using his service and they're loving it. So that's a little bit about why we do what we do.
And with that, Mark, let's dive into today's topic about investment banks. So maybe a good place to start. I'm going to punt to you here for this to start on this question. But what exactly does an investment bank do?
Mark Gaffin : 4:32
Well, I think it depends on the size, right? So if the big global ones that you're familiar with the Goldman Sachs, Morgan Stanley, some of the big ones from Wall Street have really a whole huge suite of services and they're going to go beyond what we call M&A advisory, they'll have restructuring, they'll have capital markets, they'll have sales and trading, equity research and the whole kitten caboodle and then you kind of have the next level down, which are probably some bigger, they're still big and they're still national, even global. And they can be firms that have very much the same amount of services, but they work with slightly smaller companies. Then we talk about investment banks, another size down which would be the middle market, which your boutique middle market banks as well. So those who tend to do more M&A advisory, which would be sell side, buy side, and capital raises, what they do.
Stephanie Chambliss Gaffin : 5:31
So, alright, so if I come back to the initial question, and that was a great preview of what we're going to get into in a minute. Which are, what are the different kinds of investment banks that so fundamentally for the middle market business owner, it sounds like the most relevant services to think about, I think I heard you say three things, right? Sell side, buy side, and capital raise.
Mark Gaffin : 5:51
Right. So people are gonna make their living in helping arrange a market trying to bringing a company that needs to sell, bringing them to market. And what they do is they maintain an ecosystem of people that are buying or would know, buyers, and then they manage that process. So that's kind of what they do, they're managing a process to get a company sold, which is, you know, you don't want to say building/ selling houses is not easy, not hard. But it's much, much more than that, because a house is a price and business is a value. So it's a very important process to find the right people, as we always say; right story, right people, right time. But that is in fact, what they do.
Stephanie Chambliss Gaffin : 6:35
So now let’s talk a little bit more about when we say a capital raise, what do we mean by a capital raise?
Mark Gaffin : 6:41
So capital is really all the different sources of money that come into the company to help support growth and ongoing operations. And that can be debt capital. And then we call this in seniority level, the highest would people be familiar with this as a line of credit in a commercial bank, right is a very plain vanilla example of that. And that's just to support ongoing operations, right. And then you'd have other kinds of term loans, which may be buying equipment, buying plants, growth. Those are more longer term loans, some of those come from banks, so you can actually have a capital raise, which really means going out and finding different banks. And we do that a lot of time in our consulting firm, because we maintain a lot of relationships with senior lenders, to help people find one or more commercial banks to come in and do something. And that kind of generically is called debt capital markets work. And then if you move further down, you can get to, you know, secondly, mezzanine lending, which is still debt, and then you can get down to bringing in Equity Partners into a company, from a minority standpoint to help fuel growth. Ultimately, that's the capital raise, then ultimately, if you actually bring enough capital, to actually sell the company now, you've actually kind of sold the company.
Stephanie Chambliss Gaffin : 8:03
Exactly. Now, the other one that we talked about is buy side, which I know is one that we don't see investment banks offering that service quite as much. Why is that?
Mark Gaffin : 8:14
So it's not that they don't want to and it's not that they couldn't, it's just at the end of the day, what happens is, it's kind of, I'll go back to using the house analogy because I think it's easy to think about, if I hired a broker to help me find a house, that could take a long time, and we could be all over the map and that broker needs to eat, right?
Stephanie Chambliss Gaffin : 8:36
Right we all we all know, the maybe it's been us, or you have the the realtor that you've worked with for months or even years, going to open house, after open house trying to find the perfect house.
Mark Gaffin : 8:49
Right. So it takes a long time. And so for them, they've got to maintain when you when you get paid and how the economics work for that. Everybody needs to get paid to do what they do. So the buy side is really more about sitting down and figuring out what is the strategy of the company, then how does the M&A strategy support that, and then it's actually building that, funnel of acquisitions and turning over a lot of rocks, if you will, to look for the right opportunity, and then chasing that opportunity. And it takes a while sometimes and there's ways to do it that are more economic for the client, and certainly more rewarding for the banks. The investment banks tend to focus on a defined process that's going to last, maybe six months, maybe eight months, to bring a company to market. And there is a definable into that process. And their economics are structured that way, right? So there's the retainer, and then most of their economics comes from what would be considered a success fee.
Stephanie Chambliss Gaffin : 9:55
Right. Part of that is about aligning the incentives, right? Because we want, you know, if I'm selling my company, if I'm the middle market business owner, and I'm selling my company, I want the investment bank to be incentivized to find the right buyer and to complete that transaction on my behalf. So I want most of their economics to come at the end of that transaction.
Mark Gaffin : 10:17
That's right. And you think you could, not that anyone who does, but you could perversely, if you were being paid a success fee on a buy side engagement, you come across the company, and it's kind of you know, you have to make sure that your moral compass is right. And you say, No, I'm going to say, don't do this deal. So we tend to structure those buy side engages on a hourly kind of retainer situation. So we tell them, Look, if it's not the right deal, we want you to walk away, it's the right thing to do, I don't want you to buy something that you're going to hate having six months later, it's not worth it for us.
Stephanie Chambliss Gaffin : 10:54
So the buy side, you may see, looking more like a consulting engagement, more than a traditional investment banking.
Mark Gaffin : 11:01
And again, it's not that the investment banks couldn't do it, there's certainly set up well to do that, from an economic standpoint, the way they're staffed, structured and the leverage model that they use behind the scenes.
Stephanie Chambliss Gaffin : 11:12
So let's go now to where I think you were starting and one of your first comments about talking about the different types. And again, there's no I know that there's a you know, often not bright lines between these but part of these, if I think about being a middle market business owner, and they said, Well, okay, so now I get it, I need an investment bank, but I don't think I really need to call Goldman Sachs, right? The answer is, if you're a middle market company, probably not, nothing against Goldman Sachs, but about matching what you need, and the services available from different kinds of investment banks. And we also talk about Business Brokers. So maybe let's go there for a minute. What is the difference between a business broker and an investment bank? And do you think about a difference between the smaller or sometimes called boutique investment banks, and the larger regional, or global investment banks?
Mark Gaffin : 12:05
Sure, so starting out with Business Brokers, there's thousands of them out there. And you know, they can be, some people will cast them somewhat disparagingly, and I'm not one of those people that do that, I think they serve a very good function, I think one of the challenges in dealing with the business broker, is there are so many of them, and there's not really a big hurdle to be one. So you could have somebody that's selling a house in the morning, selling commercial real estate in the afternoon, and then at night, they're putting companies on, on biz, buy, sell. Which is, you know, really filling out a sell sheet, and you're putting a company on the internet, or a bulletin board somewhere to be sold. Now, if I'm trying to sell my hair salon for $700,000, as an example, that's not bad, right? Because you're not going to look for an international search or national search of people that want that. It's probably going to be someone that's interested in my area in my, you know, local metro. So I'm trying to find somebody that's there. So if I go on an Internet, and find somebody that's looking for a hair salon in the northern parts of Chicago, that they could say, Ah, this is what I want to buy. And the due diligence is not as hard, right? It's pretty low. So the value add of the advisor here, the business broker is, it's there, and there's some guidance through the deal process, but it's significantly different as you get bigger and more complex in the deals.
Stephanie Chambliss Gaffin : 13:36
So just to recap, the business broker, it sounds like then is number one, working with smaller companies, typically, number two, a transaction that's going to be more straightforward. And obviously, that's a subjective, but something where there's, you know, it's relatively subjective. And the third thing is that it's probably going to be an operator to operator transaction.
Mark Gaffin : 13:58
Right, so that's a key point on the end, and people should be very careful about that. The boat broker should still be registered as a business broker. I, for example, have licenses that I had to go through FINRA, to get the financial institution, national regulatory association, but you have to take your series, you know, 63, or 79, and you're 82 to do different things. And there's a hurdle there to do that. And then you are bound by a lot of ethical background, all these kinds of things that you have to abide by. Business broker, you know, the Business Brokers writ large can be a little more wild west. So you have to find a reputable one and do your homework up there. But but the SEC has said, not too long ago, that they want everybody registered, right, which is going to be pretty problematic and what they came back and there's what's called the SEC No Action Letter and someone will run across that term if they're doing any kind of work. And it carves out certain very specific types of M&A transactions that can be done by a non licensed individual. And I would make, I'd want to make very, very sure, with my attorney, or my accountant, that the person I was engaging was that was legit to be doing under that no action letter should be easy to figure out. And if not, there can be there's a whole host of problems that can come by if you if you're working with somebody that's doing a deal they shouldn't be doing.
Stephanie Chambliss Gaffin : 15:32
So, I want to go next to talking about the investment bank and how that differs from the business broker. But first, let's take just a moment for a word from our sponsor. Right in the Middle Market is brought to you by SLS Capital Advisors. SLS Capital Advisors is a boutique financial advisory firm working directly with middle market leadership to tackle critical growth opportunities, including exits, mergers and acquisitions and access to capital. The principles of SLS Capital Advisors bring deep industry, financial and consulting experience to firms seeking tailored strategic opportunities, including capital for major growth initiatives and alternatives for those evaluating corporate transitions and exits. SLS Capital Advisors services include managing effective exits and sales processes involving sophisticated buyers such as strategic purchasers, financial buyers and operator to operator transactions, and raising capital to fund our clients growth, including debt and equity elements. They also assist companies and capturing growth opportunities through focused and effective organic growth and M&A programs and unlocking profit potential through business portfolio, rationalization and divestiture. SLS Capital Advisors, focused on delivering consultative executions for clients seeking strategic growth and capital. Find us at SLSCapitalAdvisors.com to learn more about how we can help you. Welcome back. I'm here with my co host Mark, and we are talking today about what exactly is an investment bank and when do you use one? So we were just talking about the specific use of Business Brokers, and being able to really provide a very valuable service to very small companies, and in particular, those that are looking to sell from what's called an operator to operator transaction. Now, let's shift to where does an investment bank differ from that? And if I'm a small business owner, how do I know if I should be looking for a business broker or an investment bank?
Mark Gaffin : 17:28
So let's stick with the middle market just for a second, because I think that's probably the most germane. Now you've got people that have gotten together that have skills in underwriting and putting companies up for sale. Right? So there's all that process that, you know, helping company, what am I going to market as, what will the valuation range be? And so that's a very different valuation than what you might get for a partner settlement or your heaven forbid, a divorce or something like that. We now want to have what is the likely purchase price of my company give me a range, how might that best be structured? And then going out and trying to find the right people, so what you're always telling us find the right people for the deal. And so are those private equity folks, or those family offices, are those still might be strategic buyers, and they and they still might be search funds or independent sponsors. So the the middle market investment banks, I think, are going to make a different point of differentiation by the types of people they can reach, as potential buyers and potential universe that they have out there. And then the process they manage, and what we need to do, I think with the smaller middle market deals, oftentimes, it's the first time this company's ever been sold. So it's still an owner operator, there's a good deal of work typically that needs to be done, to make sure that company is is ready to go and shine, it's best in a sale. And you want to make sure that the management team is on board and aligned with the process and how do we speak about the company in a way that's positive? We don't have to, you know, you're not hiding anything that's not gonna work, because due diligence, it will all come out.
Stephanie Chambliss Gaffin : 19:13
It's about, if you think about it, like dating, it's about, I'm probably not going to talk about my crazy uncle on a first date, right?
Mark Gaffin : 19:25
Yeah. But I mean, I would also say, you know, you think about the acquisition, there's probably going to be a rollover, there's going to be an EBITDA earn out, there's going to be some kind of deferred compensation. That part is the marriage. Because you are going to find out about all that stuff, who's squeezes the toothpaste from what end or flattens in the middle? You know, the next day, some will learn that early on. I think that's kind of I love it. That's, that's great. But no, that's so that's what a middle market company does. And so, ages ago, before the internet really took off, you had to have a certain scale, there had to be enough people because doing research and market research, if you think of putting what's called a book together to sell a company, doing all the analytics and the modeling was hard. But now, with technology like it is, we've seen a proliferation of middle market firms. And you can have two or three or four, really experienced individuals with deep resumes, deep experience. And all that ability to reach out to the investor universe can run a very efficient bank and a very credible bank. And then it's about can they tell my story as a client? Can they tell my story and manage that?
Stephanie Chambliss Gaffin : 20:36
So I think that's really helpful in thinking about this specific role of how investment banks can help middle market businesses and how they are different from a business broker. Again, I think both serve a very beneficial purpose, but very different purposes.
Mark Gaffin : 20:52
That's right. I think like any other thing, whether it's a law firm, or commercial bank, or any other thing, we as middle market, folks, we want to be with the right size- in the right pond, with the right fish. So if you're with a really super big anything, do you get lost in the shuffle. And if you're with somebody that's too small, that doesn't have the skills, am I going to get the service I need? So, I think it's really important. We help as consultants, help people select investment banks, it's that important. And we bring them say, this is their technical skills, this is what we think they can do. And then there's that all important fit, because there's a big process. And there's a lot of work to do together. And so there has to be some element of trust, that you are going to look at all my information and sell it in a compelling way. And give me the right advice as we go forward to have to structure the deal with a potential buyer. So that's I think, really important.
Stephanie Chambliss Gaffin : 21:49
Well, I think that brings up another interesting question, which is, so let's maybe take a step back from the perspective of the middle market business owner who hasn't decided for sure if they're going to sell or raise capital, and they're trying to decide if that's the right direction to go. Or maybe it's somebody who has been approached by a potential buyer, which we hear all the time, right? Somebody has, it might be a financial buyer, like a private equity firm, it might be a strategic that comes and proactively approaches an owner and says, look, we'd be interested in buying your company, are you willing to consider selling? So that person now all of a sudden says, Oh, my gosh, I have to make this big decision and may look for an advisor? Should they be looking for an investment bank or a consultant?
Mark Gaffin : 22:34
Well, it's, that's a great question. There's not a clear answer, right? I mean, I think, the benefit of having that opportunity. Look, so in the case that you brought up, it's someone's come in with an offer. And you're like, I don't want to get too far down the track, because then it's kind of hard to, you know, to engage this person start thinking about structure and pricing, because then it starts to solidify, we've been brought in on the investment banking side, and they're saying, I really liked this offer, I think this is the right one, but I want to get the very highest and best use. And so you could kind of come in and say, Look, you, Miss Bidder, you have an opportunity to pre up the process here, like doing your best now, or we have to start a process, it's the right thing to do for all shareholders and all those things concerned. And then what you're just trying to do, even if that's the best buyer, then that's who you want to go with, you often have a credible reason for them to do their very best because they don't want you to start a process. Conversely, you can also bring in on the consulting side to say, Gosh, I have gotten a couple of these calls now, is this the time? Is this going back to your right story, right time, right people? Is this the right time for me? So we've just recently talked to some folks about, let's double check that. What is the right timing for you? Is it time for full exit, it a time for a recap, really? If you're kind of open to the idea of other investors, maybe it's a minority recap that you could do right now. So I think then a consultant is a little more, this is the full view, my aperture is much wider, or some investment banks are like, I'm really good at helping with the process, I'm kind of predisposed to get you down that chute. It's not that it's unethical or anything like that, but it's like that's what I do. You know, so that's what the investment banker does. So that's probably what their bias would be. This is a good time to sell. And it is, you have a good company, which you probably do, but we would come in as a consultants and say, Well, if we did ABC, you probably would get actually another turn of EBITDA in the sale, right, in the valuation. There's a number of ways to increase the value drivers and identify and highlight the value drivers of the firm.
Stephanie Chambliss Gaffin : 24:56
Right. If I think about some of the things that coming in on a consulting side, right, a consultant could come in and can look to your point to say, look, this may be really interesting, but if you were to take six months, 12 months, you know, maybe 18 to 24 months, and make these changes in your operational and therefore financial performance, you could probably find a much more attractive offer. Or it may be a matter of being able to look and say, You know, I think of one client that we worked with who came in originally planning on doing a minority recap, to raise equity. And as we really got to know him and his company, what we identified was that, actually to meet his objectives, that was a much better instrument. It's that match funding concept of how do we make sure that the type of funding that you're thinking about is not just the one that happened to knock on your door, but to take just a beat? Right, take a take a pause, and really think about what are my long term objectives as owners, for the company, for you personally? How do we make sure that whatever you are thinking about doing right now from either a capital raise, or a sales perspective, is going to fit with those long term objectives?
Mark Gaffin : 26:12
No, I agree. And I think, as I hope we said, I hope I was clear on, I think that the business broker world is really important, I think the middle market investment me being one is really important. Consultants can serve a great, wider view of what some of the options are. And then the larger investment banks serve a terrific purpose as well. It behooves all of us to have a good market for companies to move to and fro. To me, it's about finding upfront the right fit. Like I said, we've been engaged in a number of times just to help people say, I do think it's the right time, and we've helped them come to that conclusion, we've helped them with their story. Now they go out and they we look at five or six investment banks and actually have them, you know, beauty pageant, bake off, whatever you want to call it, and then find the one that fits. The worst thing to do is be 60% into an engagement and find out you have a bad fit, or you don't have the right team, because it's with a firm, that's not giving you the right team, you know, not enough senior people or whatever. That's what the worst place you can possibly be. So we do anything we can to avoid that happening to anybody upfront.
Stephanie Chambliss Gaffin : 27:25
And I think for those who many people listening, this may be very familiar with what that process looks like to sell their company. If you're looking for more information. We actually did a three part series on that episodes, four, five, and six, walking through in some amount of detail what that process looks like. And stay tuned, we'll be doing a similar series on that from a capital raise perspective, which is similar but a little bit different. And so, two pragmatic tips before we close today, Mark, why don't you start.
Mark Gaffin : 27:57
I think the one is to figure out what you want to do, right? So I wouldn't let the phone calls drive my timing. They're coming in, because people doing it all the time, dialing for dollars, right? And someone may come in and come up with a very high number and lock you up with a no sell, which we can go into that terminology. But what it basically means is, I'm promising the moon, I'm going to come in and say I don't look at anybody else to sell, I got 90 days, and then they retreat down, that's a horrible position to be in. Use an advisor, they usually if you get a good advisor, they will make their fee up. That's why there still here. So to me, it's like you maintain control, finding the advisor that fits, has the skills, has the services that are what you need ahead of time. And again, that's that's one of the reasons we exist is to help people make that decision.
Stephanie Chambliss Gaffin : 28:50
Yeah, and I think mine very similar is really know what your exit strategy is. Because if you understand what your exit strategy is, when you want to exit, whether that's five months, five years, or 25 years from now, but understanding that horizon will help you think about what you want to be doing from an equity perspective, from a growth perspective, to make sure that you're making decisions today that will optimize the path for getting to that outcome on your desire timeframe. To your point Mark, to make sure that that's your desired timeframe, not the timeframe that's being driven by somebody else who happens to be calling or knocking on the door. And with that, I'm Stephanie Chambliss. Gaffin. And you've been listening to Right in the Middle Market, a podcast about running, growing and selling your middle market business. We'd love to hear your comments about today's episode or tell us what you want to hear about in the future. Send me a message on LinkedIn or drop me a line at podcast@gaffingroup.com and don't forget to subscribe to make sure that you don't miss any of our pragmatic tips on running your middle market business. Until next time, be well and be pragmatic.