In my former life as a financial analyst for a Fortune 250 company, a manager and long-time mentor of mine handed me an informative book entitled “Merchants of Debt” that gave an inside look into how private equity (“PE”) firms purchased businesses and operated them to support the continued investment in other businesses.  As dealership earnings have increased over the past few years, I have seen more offers from PE firms looking to capture some of these earnings as part of their investment portfolios. I am also reminded of that book’s focus on how PE firms rely on debt to purchase business assets and how that reliance significantly alters the terms that these firms are willing to accept in ways that may be significantly different from the terms accepted in dealership buy-sell transactions.

When compared to competing dealers looking to purchase dealerships, PE firms tend to make highly leveraged offers, with little of the firm’s cash being applied toward the purchase.  Additionally, the recent stretch of positive earnings among dealerships across the country has brought out more PE firms with less automotive retail experience.

With that in mind, here are a few important things to remember when entertaining private equity offers:

  1. Earnout Provisions – PE firms need consistent earnings to support the debt service they make for their purchase loans and to ensure that they will continue to receive preferential financing terms from their lenders on future deals. This is why PE firm offers include post-closing earnout provisions, where a significant portion of the purchase price is made after closing and is made contingent upon the buyer hitting certain annual earnings targets.  While the size of such post-closing payments can be reduced in negotiations, such reductions typically occur when the seller demonstrates a history (e.g., three to five years) of consistent earnings that justify stable cash-flow projections for the buyer’s pro-forma financials.  If this history cannot be provided, sellers accepting these earnout provisions should be ready to accept the risk of receiving only what they have been paid at closing – i.e., an amount that will be significantly less than the purchase price originally offered by the buyer.

  1. Buyer’s Automotive Experience – Does the principal investor at the PE firm have significant experience in automotive retailing? If not, they will need an experienced person, like a general manager, to run the store, to provide insight on the risks involved and understand what seller terms are reasonable for the buyer to accept.  Otherwise, many reasonable terms proposed by the seller can be seen by the buyer as too risky to accept because the buyer lacks the proper insight to understand how much, or how little, risk they are assuming by accepting the seller’s terms.

  1. Focus on Tangible Assets – Tangible assets are important to PE firms because their lenders will use these assets as collateral for financing purchases. However, the purchase price for a franchised dealership is mostly allocated to intangible assets that cannot be used as loan collateral, like goodwill and the blue-sky value of the store.  Of the hard assets that can be used as collateral, a significant amount of their value is derived from the seller’s vehicles and parts, which become collateral for the buyer’s floorplan financing lenders and trade creditors.  What is left as collateral for the purchase lenders is typically the used furniture, fixtures and equipment, all of which are not worth much relative to the blue sky, vehicles and parts being sold.  If the buyer does not realize his purchase lender can only secure its loan using a small fraction of the assets being sold, the parties should discuss this during the initial stages of any negotiations.

  1. Due Diligence – Unlike the short periods of due diligence that competing dealers may have before a purchase agreement is executed, the due diligence periods for PE firms buying franchised dealerships may be longer. This is often due to the lack of industry knowledge, but it can also be the result of a PE firm’s more stringent review of a dealership’s financial statements.  Sellers entertaining PE firm offers should have their accountants participate in early negotiations to help present a clear financial story to the buyer – i.e., to explain one-time revenues and expenses and to highlight expenses that may not apply to a prospective purchaser after closing (e.g., salaries and other expenses for family members employed by a dealership).

Mr. Timson is an experienced attorney focused on franchised automobile dealerships. He is a member of the Greater New York Auto Dealers Association and the National Association of Dealer Counsel.  He can be reached at ket@selawny.com or 631-777-2401.