Smoothing the I-Bank Deal Flow Cycle
One of the challenges of managing a mid-market M&A firm is coping with the sporadic, binary nature of the payoff for your efforts. In an industry where the compensation for a deal is often a large lump sum or nothing at all, it’s critical to manage both the company’s internal cash flow and the work-flow roller coaster for the firm’s team.
Below, I discuss various ways investment banks may smooth their cash flow cycle.
The Roller Coaster
Investment bankers work simultaneously on three fronts:
- Deal flow origination
- Transaction execution
- Internal organization
A typical investment banker’s focus swings like a pendulum between deal origination and deal execution, sometimes at the expense of the internal organization.
Here’s how it plays out in practice…
A banker realizes he or she is in a deal flow lull and feels the pressure to put more opportunities in the pipeline. Consequently, the banker focuses heavily on marketing to potential new clients. Surprisingly, marketing leads to new clients, perhaps several. Because M&A transactions are time consuming and require tremendous focus and attention to detail, the banker must now allocate the vast majority of time to deal execution. With this single-minded, concentrated effort, the banker begins to neglect three things: sleep, internal organization and marketing – in that order.
When deals close (or die), the banker realizes the deal pipeline is once again anemic and the pendulum swings back to a focused effort on marketing to gain new clients again. Consequently, bankers are either doing deals or marketing, but rarely both at the same time. This produces a vicious work-flow cycle and lumpy, unpredictable cash flow from success fees that can be difficult to manage and may exert an emotional toll.
Epidemic to the Whole Industry
Middle market bankers might think this cycle is confined only to smaller shops. Bulge bracket firms surely find a balance between origination and execution, right? Not really.
When I worked at Bear Stearns (back when that was still a firm), we encountered the same cycle. At the largest firms, deal teams function fairly autonomously and behave like smaller, non-competitive, industry-specific groups within the larger bank. Consequently, each industry group experiences the same swings between origination and execution as seen at the smaller banks. As a whole, the larger corporate entity has a smoother revenue cycle because the various industry groups are often not in sync. But for each industry group within the larger bank, it feels much like working at a smaller firm. And, because year-end bonuses are highly correlated to the performance of your specific group, you really do feel the cyclical effects. It’s just the nature of the industry.
That said, there are things bankers can do from a business model and process perspective to smooth the revenue cycle, which I discuss next.
Smoothing Cash Flow
Below, I have outlined some methods investment banks may use to mitigate their volatile cash flow.
Retainers & Upfront Fees
Surprisingly, many investment banks accept new clients without an upfront retainer. More unexpectedly is that most sell-side clients willingly pay an upfront fee if you simply make it part of your engagement agreement with one stipulation – that the retainer is creditable to the final transaction fee.
If the potential client fully intends to sell the company, the retainer is not viewed an extra fee, just an advance of the success fee to cover some initial expenses. Think of it as a consulting fee. In the process of selling the business, the banker provides ample strategic advice on positioning and strategy. A consultant would charge for this. A banker should too.
If the seller thinks of himself/herself as a seller, the upfront fee is palatable. If the seller views the upfront fee as an additional expense, he/she may not fully intend to sell. Losing a potential client for this reason might actually save you a lot of time. In this way, retainers not only help smooth cash flow, but also help pre-qualify clients and reveal their intent.
Consulting isn’t as lucrative as transaction work. However, consulting provides a steady income that allows bankers to smooth their revenue stream and it’s a great way to position the firm as the preferred transaction advisor when the client is ready. Two key points here:
- Be careful about accepting full-time, long-term consulting assignments. You might end up only consulting and not doing transactions.
- Structure the nature of your consulting, and the clients you intentionally target, to lead to eventual deal flow.
Hire a business development executive
I know, “Business Development” is just the new way of saying “Marketing & Sales”. For many transaction-based executives, this may look like another operating expense… another mouth to feed. That said, a good business development executive can do wonders for a bank’s deal flow activity. They continue to bring in leads at a steady pace while the banker actively works on live deals. This can help smooth the sinusoidal nature of the business.
Only engage great businesses
You can expend a tremendous amount of time trying to sell a mediocre business… and it may not be in the best interest of your firm. Why? Chances are, you, as the banker, will feel like it was a herculean effort to get the company sold, while the company owner may not be completely pleased with the outcome if the end valuation was low relative to expectations (expectations defined as “the highest multiple the seller has heard on the golf course”).
In the seller’s mind, the reason why the company did not get top dollar isn’t because the business had (pick any two):
- declining revenue
- a customer concentration
- poor financial records
- a spotty management team
- a potential legal liability
No, the valuation was low because you, the banker, didn’t do your job well… or so he tells his golf buddies.
This is why accepting engagements from poor-to-fair businesses is often not a good practice. It can consume all your time and adversely affect your firm’s reputation.
Start a valuation services division
Valuation service firms are not glamorous businesses. They can be lower margin and, frankly, a grind… but a valuation division:
- Generates its own (more stable) cash flow, smoothing it for the firm as a whole
- Allows the banker to offload the initial valuation work for potential new client pitches to this department
- Brings in potential new clients through these relationships.
One caveat – there is a significant cultural difference between a valuation firm and an investment bank that you will need to actively manage.
Do larger deals
I’ll admit, this recommendation doesn’t necessarily smooth the cash flow spikes, but it does bring in larger success fees for approximately the same amount of effort.
Most investment bankers will tell you that larger deals (in the mid-market) are a bit easier than smaller deals. This is partly because the client is often more sophisticated and requires less hand-holding through the transaction process. The financials are cleaner. The organization may be more professionally run. But the M&A process itself is nearly identical for a small deal and a larger deal. So, you might as well do larger deals, all things being equal.
Outsource some analyst work
Outsourced analyst services can help alleviate some of the workload of deal origination and execution while not committing to a long-term increase in fixed costs for the firm. It’s worth investigating and trying for a season as proof-of-concept.
Use your lunches
I saved the easiest for last… a proven way to meet more business owners, improve your network and consistently prime your deal flow pipeline is to offer to take business owners to lunch. You need to eat anyway, so you might as well use that lunch time to meet with businesses within a 20-minute radius of your office.
Have other ideas? Drop us a comment below.