Strategic and Financial Buyers: Why They Pay Differently

A strategic buyer already runs a business in the same industry, so it can stop paying twice for things the two businesses each carry once. A financial buyer has no such operation and prices the business as it stands. At Year 7 Q2 in one invented sale that difference put Rs 2,03,00,00,000 against a highest financial bid of Rs 1,75,00,00,000, a gap of Rs 28,00,00,000, being 16.0 per cent of the lower bid.

A point that sounds obvious turns out not to be. A business does not have a price the way a kilogram of rice has a price. A business has a number that two particular parties agree on, on one particular day, and that number follows from what each of them will be holding once the paperwork is signed. Two bidders can read the identical set of accounts, agree on every figure in them, agree on how the business is trading and where it is going, and still write down two different numbers at the foot of their offer. Neither of them is wrong. The arithmetic that produces a bid is not run on the seller's books at all, but on the buyer's.

Sahyadri Diagnostics Private Limited, an invented company, was holding 1 of Nilgiri Growth Partners Fund II, a closed-end fund managed by Nilgiri Alternatives Advisors Private Limited, and that holding is the worked case throughout. The fund bought its position for Rs 55,00,00,000 at Year 1 Q3 and put in a further Rs 15,00,00,000 at Year 4 Q1, a total cost of Rs 70,00,00,000. At Year 7 Q2 it sold, and what follows begins at the moment the offers were on the table.

What is a strategic buyer, and what is a financial buyer?

The whole distinction is one question: does the bidder already run an operating business in this industry, or not? A strategic buyerA buyer that already runs a business in the same industry as the one it is buying. does. A financial buyerA buyer with no operation in the industry, buying the business to hold it as an investment. does not. The single question is the entire definition, and nearly everything else follows from it.

Resist the four things people usually put in the definition instead. The distinction is not about size: a small industry operator is still a strategic buyer and a very large fund is still a financial one. The distinction is not about where the money comes from: both may borrow, and both may write a cheque from cash they already hold. The distinction is not about how long the buyer intends to hold: a fund may hold for a decade and an operator may sell the business on in three years. And the distinction is not about being nice or being ruthless. Kindness and ruthlessness circulate in conversation and explain nothing. The only difference that generates any arithmetic is what the bidder already has on the day it bids.

Out of finance for a moment: two people want to buy the tea stall at the end of a lane. The first already runs the tea stall at the other end and has a boy who buys milk in bulk every morning, a gas connection with a spare cylinder, and a cousin who does both stalls' accounts on Sunday. The second is a schoolteacher with savings who has never sold a cup of tea. Both will look at the same register of daily takings. Only one of them can look at that register and know, honestly and specifically, that the milk bill is going to fall the day the stall changes hands. She will be buying for two stalls instead of one. The knowledge is not sentiment but a number, and a number can be put into a bid.

Why does the buyer's own set of books decide the ceiling?

Because a buyer is not really buying a business. The buyer is buying the difference between what its own accounts look like today and what they will look like once the business is inside them. The two pictures are the only thing a bidder can actually compare, and the second picture is different for every bidder in the room. The seller's accounts are the same document for everyone; the picture that document produces once it is added to a bidder's own accounts is not.

The buyer's own books are why the highest number in a competitive sale is so often not the number a valuation exercise would have produced. A valuation asks the worth of the business. A bid asks what it is worth to me, given everything I already have. The two questions have different answers, and the second answer is the one that gets written on the offer letter.

Look at the picture below and count the finance functions. Before completion the strategic bidder has one and Sahyadri Diagnostics has one. Two people or two teams are doing the same job in two buildings. After completion the combined business still has two, and it needs one. The surplus is not a saving that somebody has to be clever to find. The surplus is arithmetic that exists the moment the two sets of books are added together, and it is visible to the bidder before it has met anybody at the company. The financial bidder runs the same exercise honestly and finds nothing. There is nothing on its side of the addition.

What can a buyer in the same industry remove that a fund cannot?

The general name for it is duplicated costCost that two businesses each carry separately and one combined business would carry once., and the test is blunt: after completion, is this rupee being spent twice on the same job? If yes, one of the two can stop. If no, nothing has changed and there is nothing to bid with.

In the invented sale worked here the winning bidder wrote down a figure of Rs 4,20,00,000 a year. The bidder stated the figure, and nobody verified it. A figure like that usually holds something unglamorous and specific. Two payroll systems where one will run both. Two audit fees where one entity would pay one. Two warehouse rentals in the same city. Two sales managers driving to the same three hospitals on alternate Tuesdays. A rate on consumables that improves once the order is placed for both businesses at once. None of it is a forecast about the market and none of it depends on the business growing: it is money the combined thing simply stops sending out of the door.

Here is the discipline that separates a real figure from a hopeful one. Ask what specifically stops, who was doing it, and what they were paid. A figure that survives that question can be tested by anybody. A figure that dissolves into words about scale and reach cannot be tested by anybody, and usually nobody tried.

The uncomfortable part is the part sellers skate past. Duplicated cost is very often a person. The finance function that stops being run twice is somebody who came to work for years, and the decision to bid a premium built on that saving is a decision about people, taken by a bidder, before the seller has even chosen who to negotiate with. The arithmetic is not bloodless, and setting out exactly how it works is the only way to read a bid honestly.

How does Rs 4,20,00,000 a year become a number on a bid?

A saving is an annual thing and a bid is a single payment today, so something has to convert one into the other. The converter is a capitalisation multipleThe number of years of a recurring saving a buyer is willing to pay for up front.: the number of years of the saving the buyer is willing to hand over now in order to receive it every year afterwards. The annual figure multiplied by the multiple is the most the saving can add to a bid.

One point about where the multiple comes from matters more than the arithmetic. The invented record does not state the multiple. The record states two things: an expected saving of Rs 4,20,00,000 a year, and that the saving was worth about Rs 29,00,00,000 on the multiple the bidder was paying. The second divided by the first is 6.90 times, a figure implied by those two numbers rather than observed in any market. Every figure derived from that saving is carried at 6.90 times and is therefore only as exact as the rounded Rs 29,00,00,000 it came from. Carried to more places the division is 6.9048, and at 6.9048 the same Rs 4,20,00,000 supports exactly Rs 29,00,00,000 rather than Rs 28,98,00,000, a difference of Rs 2,00,000 on a bid of over two hundred crore rupees. The multiple is stated as 6.90 and used as 6.90 throughout, a rounded input named as one rather than left to pretend it is exact.

With that stated, the rule of the picture below is a single line. The bid ceilingThe highest number a particular bidder's own arithmetic will support, above which it is paying to lose. for the bidder in this industry is Rs 1,75,00,00,000, being what a bidder with nothing to remove was willing to pay, plus 6.90 times whatever it can stop spending each year. The line passes through the origin, and that is the whole teaching of the shape: a bidder in the same industry that finds nothing to remove has an arithmetic identical to a fund's, and the ceiling collapses onto the other bid exactly.

What did the two bids on Sahyadri Diagnostics actually say?

At Year 7 Q2 the fund had two kinds of bidder in front of it. The highest offer from a fund with no operation in this industry was Rs 1,75,00,00,000. The offer from a buyer already running its own operation in the same industry was Rs 2,03,00,00,000, and that is the one that completed. The gap between them is Rs 28,00,00,000, and the very first thing to do with a gap is say what it is a percentage of.

Rs 28,00,00,000 on the lower bid of Rs 1,75,00,00,000 is 16.0 per cent exactly. The identical Rs 28,00,00,000 on the higher bid of Rs 2,03,00,00,000 is 13.8 per cent. Both sentences are true, both describe the same rupee amount, and they differ by more than two percentage points. A note that says the winning bid was fifteen per cent higher has quietly chosen a denominator without naming it. The convention here is stated every time: premiumThe amount by which one bid exceeds another for the same asset on the same day. as a percentage means the gap over the lower bid, so the figure is 16.0 per cent unless the sentence says otherwise.

A bid without a reason under it is just an assertion, so put the arithmetic beside the number. The stated reason was Rs 4,20,00,000 a year of duplicated cost. At the implied 6.90 times that is Rs 28,98,00,000 of premium the reason can carry. Added to the Rs 1,75,00,00,000 that a bidder with nothing to remove was willing to pay, the ceiling those two figures support is Rs 2,03,98,00,000. The bidder paid Rs 2,03,00,00,000. The bidder stopped Rs 98,00,000 short of the highest number its own stated reason would have justified, and stopping short is the difference between bidding hard and bidding past the point where the transaction stops being worth doing.

One caution against taking that Rs 98,00,000 too seriously. The headroom is a residue of a rounded input. Carried at 6.9048 rather than 6.90 the ceiling would be exactly Rs 2,04,00,00,000 and the headroom would be Rs 1,00,00,000 instead. Both readings say the same thing: the bidder came within about half of one per cent of its own ceiling. Neither reading supports a sentence about what the bidder was thinking.

Who ended up with the value the buyer expected to create?

Almost all of it went to the seller, and that is not an accident of this transaction. A process with more than one bidder in it does exactly that.

Follow the rupees. The bidder expected to create Rs 28,98,00,000 of value by removing a cost it would otherwise pay twice. To win, it had to beat Rs 1,75,00,00,000, and it paid Rs 2,03,00,00,000. The bidder therefore handed Rs 28,00,00,000 of the Rs 28,98,00,000 across the table before it started, and kept Rs 98,00,000. The seller captured 96.6 per cent of a saving that exists only inside the buyer's business and that the seller will never see, will never help deliver, and had no way to produce on its own.

The split inverts the way people usually talk about a strategic premium, and is worth pausing on. The premium is not a reward the buyer collects. The premium is the price of admission the buyer pays for the right to try to collect it. If the saving arrives in full and on time, the buyer is Rs 98,00,000 better off than the next bidder would have been. If the saving turns out to be Rs 3,50,00,000 a year rather than Rs 4,20,00,000, the buyer has paid Rs 28,00,00,000 for something worth Rs 24,15,00,000 at the same multiple, and it has overpaid by Rs 3,85,00,000 against its own case. The seller keeps the money either way.

There is a household version of this that lands immediately. Two people are bidding at an auction for a second-hand scooter. One of them already has a spare set of tyres in the garage that fit it exactly, so the scooter is worth about two thousand rupees more to her than to anybody else. She wins by bidding two thousand rupees more. The tyres were her advantage, and she has just handed the whole of that advantage to the seller in order to be the one who gets to use them. Winning a competitive process and capturing the value brought to it are two different things, and the second one is much harder.

How much cost had to come out to carry the whole premium?

Run the division the other way and the answer is uncomfortably precise. The premium actually paid was Rs 28,00,00,000. At 6.90 times, the annual saving needed to carry the whole of it is Rs 28,00,00,000 divided by 6.90. The division gives Rs 4,05,79,710, or about Rs 4,05,80,000 a year. The bidder expected Rs 4,20,00,000. The entire Rs 28,00,00,000 premium rested on a margin of about Rs 14,20,000 a year of duplicated cost, roughly three and a half per cent of the saving the bidder had written down.

Say what that means without dressing it up. If the combined business finds Rs 4,05,80,000 a year instead of Rs 4,20,00,000, the bidder has paid the exact worth of the saving and gained nothing at all from being in the same industry. If it finds Rs 4,00,00,000, it has paid Rs 28,00,00,000 for something worth Rs 27,60,00,000 and is Rs 40,00,000 behind. And if it finds nothing, it has paid Rs 28,00,00,000 for a business that was worth Rs 1,75,00,00,000 to the next bidder in the room.

The ladder below is the same arithmetic laid out as rows. The slope is obvious. The two highlighted rows are the point: they sit almost on top of each other, and the difference between paying a fair price for a saving and capturing something from it is a bar length barely visible. The ladder is not an argument that premiums are foolish. The argument is that a premium is a thin claim which has to be checked, and that the checking takes one division.

Why does a fund sometimes bid higher than an industry buyer?

Because the arithmetic here never said that a saving is the only thing that can raise a ceiling. The arithmetic said that a saving is what a bidder in the same industry can have and a fund cannot. Everything else that lifts a ceiling is available to either of them, and sometimes only the fund has it.

Consider what a fund can be pricing that an industry buyer is not. The fund may be reading the future earnings of the business more optimistically, a judgement and not a saving. The fund may be planning to buy three more businesses like this one and run them as a group, pricing a saving that is not there yet but that its own plan creates. The fund may hold a lower requirement for what the money must earn, and a lower requirement lowers the discount it applies to the same expected cash. The fund may simply want this transaction badly, for reasons of its own that no sheet records. A ceiling is the sum of everything a bidder believes it will hold after completion, and a removable duplicated cost is one line in that sum rather than the whole of it.

The other direction surprises people more, so run it too. An industry buyer can bid low for reasons that have nothing to do with the business. The buyer may already be carrying an integration it has not finished. Its board may not move quickly enough to approve. The buyer may be unwilling to show a competitor its own numbers during diligence. Or the buyer may have looked at the same duplicated cost and concluded that removing it would take four years and cost more than it saves in the first two. All of those produce a lower number from the bidder that supposedly always pays more.

Does a buyer in the same industry always pay more?

The honest version of the sentence is longer and it is the one worth memorising. A buyer already running an operation in the same industry can sometimes reach a higher ceiling than a fund by removing cost that is currently being paid twice, and the size of the premium it can support is that saving multiplied by the number of years of it the buyer is willing to pay for today. Every clause in that sentence is doing work, and the word sometimes is doing the most.

What does a seller run differently for each of the two?

Two things, and neither is about being friendlier to one of them. The first is what gets released and when. The second is the seller's handling of the risk that the transaction never completes.

Think about a shopkeeper who is thinking of selling her shop. A stranger from another city asks to see the takings for three years, and that is uncomfortable but survivable. The shopkeeper across the road asks the same question, and it is a different question entirely. If the sale falls through, the shopkeeper across the road still knows exactly which of her customers buy on credit and what margin she takes on rice. Information given to a bidder who walks away is not returned, and a bidder in the same industry is the only one who can use it.

So the seller runs two release orders at once. Both bidders see the same short opening document with no customer names in it, and both see the audited numbers early. A bidder cannot form a price without them. After that the orders diverge. The bidder from the same industry gets the accounts, gives a non-binding offerA written price and structure that does not yet oblige the buyer to complete., and only sees named customers and pricing once confidentiality has been tightened and exclusivityA period in which the seller agrees to negotiate with one bidder and nobody else. has been granted. The bidder with no operation in the industry can see the customer list early with far less consequence. A fund holding no competing business cannot go and call those customers on Monday.

The second difference is what the seller asks for in the reasoning. A stated saving is a thing the seller can and should probe. A premium built on a saving that has not been thought through will be reopened during diligence, and a bid that gets reopened is worth less than a lower bid that does not. Asking a bidder to name what it will stop paying for is not rudeness. The question is the seller finding out, before it grants exclusivity, whether the number in the offer has anything holding it up.

How much of the profit on this holding does the gap explain?

A small part of it, and saying so precisely is more useful than a picture that covers the rest. The fund paid Rs 70,00,00,000 in total for holding 1 and received Rs 2,03,00,00,000 at Year 7 Q2, so the profit was Rs 1,33,00,00,000. The Rs 28,00,00,000 gap between the two bids is the only slice of that profit this record attributes to a stated cause, and the remaining Rs 1,05,00,00,000 has no stated cause at all.

There is a real and well established way of splitting a private return into what the business earned, what the multiple did and what borrowing did, and it is covered separately by people whose subject it is. The record here supplies no inputs for that split, and three invented components that happen to add to Rs 1,05,00,00,000 would look exactly like three measured ones. A gap left visible teaches more than a complete diagram that was made up.

What can actually be done with a stated premium?

Most readers will meet a premium in somebody else's memo rather than in a transaction of their own. Four kinds of reader meet the same sentence and each has a different next move.

Notice that three of those four moves are the same move in different clothes. Name the saving, name who was doing the work, and divide the premium by it: a premium that cannot survive one division and one question was never a number, it was a mood. On the transaction worked here that division gives about Rs 4,05,80,000 a year against a stated Rs 4,20,00,000, a claim that is tight but at least testable.