Strategic Buyer vs Financial Buyer: What Each One Is Solving

A strategic buyer already runs a business and is pricing what the target adds to its own group. A financial buyer is working out what return its own capital earns over a holding period. For one invented company the strategic indication is Rs 27,40,00,00,000 and the financial buyer's entry is Rs 24,48,00,00,000, and a different test produced each.

Everything else follows from one fact that is easy to miss. Neither of these two buyers is estimating the value of the business. Each is solving a constrained problem of its own and then reporting the answer as a price. The strategic buyer's constraint is the effect of the combination on its own reported earnings and its own balance sheet. The financial buyer's constraint is a return over a defined hold, given a funding package that somebody will actually provide. Both constraints produce a ceiling on a price, and a ceiling that falls out of a constraint is a different object from a valuation, even though it arrives written on the same piece of paper with a rupee sign in front of it.

The company underneath both of them is Sankalp Industrial Systems Limited, invented, a listed maker of industrial valves and precision castings with Year 0 earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 2,88,00,00,000 and 20,00,00,000 shares in issue.

What is the difference, once the labels are set aside?

Consider a street corner. Two people want to buy the sweet shop on it. The first already runs three sweet shops two streets away, buys sugar and ghee by the tonne, and has one accountant doing the books for all of them. The second has no shop at all. She has money she has promised to give back to the people who lent it to her, with a return on top, within about five years, and she is looking for a business she can buy with a loan and sell on.

Asked to price the shop, the two give different numbers, and neither number actually answers the question put to them. The first will only ever hold the shop added to the three she already runs, and that is the shop she prices. The second gives the most she can pay and still hand back what she promised. Both have answered a question about themselves, and the shop was only one input.

The distinction is entirely that one, and it holds all the way up to a company with a balance sheet under it. A strategic buyer is measured on how the target changes something it already has. A financial buyer is measured on what its own money earns between going in and coming out. So the definition worth carrying is not the one about a company on one side and a fund on the other. The definition is this: a strategic buyer is solving for a combined result, and a financial buyer is solving for a return on a stake it intends to sell.

Two invented buyers carry the comparison from here. Mahasagar Industrial Group Limited, invented, is a listed manufacturer in the same segment, with 50,00,00,000 shares at Rs 200.00, a market capitalisation of Rs 1,00,00,00,00,000, profit after tax of Rs 5,00,00,00,000 and therefore earnings per share of Rs 10.00 on a price to earnings of 20.00 times. Sthira Capital Partners, invented, is a financial buyer with no operations of its own at all.

What is the strategic buyer actually testing?

Mahasagar Industrial Group Limited puts an indicative offerA price a buyer puts forward while it is still free to walk away from that price. of Rs 115.00 a share on the table for the whole of Sankalp Industrial Systems Limited. Five lines take that offer price up to an enterprise value, and the record already fixes every one of them.

Why each of those five lines belongs where it does is covered separately, and the walk is quoted here rather than argued. The test Mahasagar then runs against the figure at the bottom of that column is what matters here.

The test is not whether the price represents good value. The test is the effect of the deal on the acquirer's own earnings per share. Sankalp's Year 0 profit attributable to its owners is Rs 1,38,00,00,000, being earnings before interest and tax (EBIT) of Rs 2,40,00,00,000 less interest of Rs 48,00,00,000, taxed at the company's own assumed effective rate of 25.0 per cent, less the Rs 6,00,00,000 belonging to the outside holders of Sankalp Coatings Private Limited, invented. Sankalp's earnings come to Rs 6.90 a share, so Rs 115.00 a share is 16.67 times what the target earns.

Run the two funding versions and the answer changes sign. Paid entirely in Mahasagar shares issued at Rs 200.00, the deal needs 11,50,00,000 new shares, taking the count to 61,50,00,000 against combined profit of Rs 6,38,00,00,000, so earnings per share becomes Rs 10.3740 and the deal is 3.74 per cent accretive. Paid entirely in cash borrowed at 8.50 per cent, the after-tax interest bill takes combined profit to Rs 4,91,37,50,000 over an unchanged 50,00,00,000 shares, giving Rs 9.8275 and 1.73 per cent of dilution. Add the Rs 45,00,00,000 a year of pre-tax cost savings the buyer underwrites, worth Rs 33,75,00,000 after tax, and the cash version turns into 5.03 per cent of accretion. The four accretion figures are derived step by step under the accretion and dilution calculation, and only their shape matters to the comparison here.

Every one of those four figures is a statement about Mahasagar, not about Sankalp. The target's earnings never moved. The acquirer's share count, the acquirer's interest bill and the acquirer's own multiple are what moved. So the strategic buyer's constraint reads: pay up to the point where the combined earnings per share still clears whatever the buyer's board has decided it must clear. On this company, with no savings and an all-share consideration, the deal clears as long as the price to earnings paid stays under the acquirer's own 20.00 times. Mahasagar is paying 16.67 times, so the deal clears.

What is the financial buyer actually testing?

Sthira Capital Partners comes at the same company from the other end. The sponsor starts with the rate it has to earn, works backwards through a funding package, and arrives at the most it can pay. Entry is at 8.50 times Year 0 EBITDA, and that puts the whole business at Rs 24,48,00,00,000. After settling the existing gross debt, buying out the minority in Sankalp Coatings Private Limited, and paying financing feesWhat arranging the borrowing costs, paid once at the start, buying nothing that operates. of Rs 32,00,00,000 and advisory fees of Rs 20,00,00,000, total uses come to Rs 27,20,00,00,000, funded with Rs 13,00,00,00,000 of borrowing, Rs 1,20,00,00,000 of the target's own cash, Rs 1,00,00,00,000 from selling the non-operating assets, and Rs 12,00,00,00,000 of its own equity. How that ladder is assembled rung by rung, and why its share column does not settle on a tidy hundred once each rung is cut to two decimals, is laid out in full under the buyout structure; what the comparison needs here is only the shape of the package.

Hold the structure still and the ceiling becomes pure arithmetic. Year 5 EBITDA in the sponsor's case is Rs 4,32,00,00,000, and a sale on that same 8.50 times values the whole business at Rs 36,72,00,00,000 by then. Net borrowing outstanding at that point stands at Rs 7,91,85,00,000, and the equity left over is Rs 28,80,15,00,000. Set that beside the Rs 12,00,00,00,000 the sponsor wrote a cheque for on day one: the stake has multiplied 2.40 times, and spread across five years that works out at 19.14 per cent a year.

Now run it the other way. Ask what the sponsor could have paid and still earned exactly 20.00 per cent, and the answer is a ceiling rather than a value. Discount that Rs 28,80,15,00,000 of exit equity across the whole hold at a required 20.00 per cent, and what stands behind it on day one is Rs 11,57,47,00,000, rounded to the nearest lakh. Now notice what sits between a sponsor cheque and an enterprise value: the borrowing of Rs 13,00,00,00,000 raised against the target, less the Rs 52,00,00,000 of fees it costs to raise and to advise on. The borrowing less those fees comes to Rs 12,48,00,00,000, and not one rupee of it is negotiated with the seller, so the figure holds still whatever the entry price turns out to be. Stack the Rs 12,48,00,00,000 on top of the Rs 11,57,47,00,000 and the entry enterprise value comes to Rs 24,05,47,00,000, or 8.3523 times, printed as 8.35 times. The Rs 24,05,47,00,000 and the exactly 20.00 per cent belong to 8.3523; at a flat 8.35 the sponsor writes a slightly smaller cheque and earns 20.01 per cent instead.

So this buyer paid 8.50 times against a ceiling of 8.3523 times, and the return lands at 19.14 per cent rather than 20.00 for that reason. The gap between the ceiling and the price paid is the useful part. A sponsor's number is not an opinion about a company, rounded off to a price. The number is the output of a division, and the inputs to that division are the exit assumption, the debt available, the hold length and the rate required. The debt schedule and the return build are worked at length under the buyout structure. Only the kind of number that comes out matters for the comparison.

How does each one pay for it?

Funding is the other structural difference between the two, and where the money is raised settles how much either buyer stands to lose. Mahasagar funds from its own resources. Mahasagar either issues its own shares and dilutes its existing holders, or it raises borrowing against its own Rs 1,00,00,00,00,000 of market capitalisation and its own cash generation. Either way the obligation sits with the acquirer, is serviced by the whole combined group afterwards, and every lender to it has recourseWhether a lender may chase anything beyond the assets pledged to it if the borrower stops paying. to everything Mahasagar owned before the deal as well as everything it has just bought.

Sthira does the opposite. The Rs 13,00,00,00,000 is placed on Sankalp itself: a senior term loan of Rs 9,00,00,00,000 at 9.50 per cent, amortisingA loan whose balance is worn down in instalments across its life instead of falling due in one lump at the end. against every spare rupee the business throws off, and subordinated notesBorrowing that waits behind another lender in the queue whenever cash is short. of Rs 4,00,00,00,000 at 13.00 per cent that sit untouched until the end. Both are secured on the target and both are served out of the target's own cash flows. Nothing beyond the sponsor's own Rs 12,00,00,00,000 was ever pledged, and the Rs 12,00,00,00,000 it put in is the whole of what it can lose. A business valued at Rs 24,48,00,00,000 now has Rs 13,00,00,00,000 of borrowing sitting in front of the shareholder, so on day one that stake is worth Rs 11,48,00,00,000. Hold that against the Rs 12,00,00,00,000 the sponsor actually handed over and a shortfall of Rs 52,00,00,000 appears immediately. The shortfall is the fee bill, and the fee bill bought no machine, no customer and no rupee of EBITDA, so the return has to make it back before it makes anything.

Line the two structures up against each other and the entry leverage tells the story: Rs 13,00,00,00,000 of debt against Rs 2,88,00,00,000 of EBITDA is 4.51 times, sitting on a company that carried Rs 6,00,00,00,000 before anybody arrived. The sponsor's equity is 44.12 per cent of total sources and the borrowing is 47.79 per cent. The household version is a mortgage: the bank lends against the flat, the flat secures the loan, and the buyer's exposure ends at the deposit. The strategic buyer, by contrast, is the neighbour who buys the flat next door by borrowing against the one he already lives in.

Why can a financial buyer pay more than a valuation model says?

Here is the result that unsettles people the first time they meet it. Value Sankalp on its own forecast, discounted at its own 12.00 per cent cost of capital with year-end discounting, and the whole business comes out at Rs 21,28,13,79,094. Set against Year 0 EBITDA that is 7.39 times. The sponsor's entry is Rs 24,48,00,00,000. The entry stands Rs 3,19,86,20,906 above the model, being Rs 319.86 crore, for the same business on the same day. The obvious explanation is that the sponsor is more optimistic. The obvious explanation is wrong, and it is wrong in a way that can be checked line by line.

Set the sponsor's operating case beside the standalone forecast row by row, and only two rows differ. Neither of them sits above EBITDA.

Each of the two differences carries a stated reason, and neither reason is a claim about trading. A third valve line waits until after the sponsor has gone, and that flattens the spending row. The sponsor also works the cash conversion cycleThe stretch of time between paying a supplier and collecting from whoever buys what that supplier made possible. harder, and that shrinks the working capital row. Not one rupee of revenue and not one point of margin moves in either.

The rest of the lift is leverage and the tax deduction. Borrowing of Rs 13,00,00,00,000 carries part of the price; the interest on it comes off taxable profit at the 25.0 per cent rate this company already applies; and the loan is then worn down using cash that the standalone model had put in its forecast anyway. No line of the business had to be re-imagined for any of that to work. So the honest sentence is: a financial buyer buys the same cash flows through a different funding structure and a deferred spending profile, so it can clear a standalone valuation without believing anything different about the business. A household reaches the same place from the other side. Two people bid for the same flat. One pays cash, one takes a loan and can set the interest against something. The second can bid higher on identical expectations about the flat.

Two buyers, one company, two prices: what constrained each?

Both prices are now on the table for Sankalp Industrial Systems Limited. The strategic indication is Rs 27,40,00,00,000, being 9.51 times. The financial buyer's entry is Rs 24,48,00,00,000, being 8.50 times. The difference is Rs 2,92,00,00,000, or 1.01 turns on Year 0 EBITDA of Rs 2,88,00,00,000. The temptation at this point is to say the strategic buyer values the business more highly. The two numbers actually show two different tests, each satisfied, and the tests share no inputs at all.

Read the middle row across and the point lands. The strategic buyer's constraint contains its own trading multiple, the mix of cash and shares, and the savings it is prepared to underwrite. The financial buyer's constraint contains the debt package, the exit assumption, the hold length and the rate. Not one input appears on both sides. Two buyers arrived at prices a turn apart on the same company. Neither test can see the other's inputs, so neither number is evidence about the other.

The sponsor's price also carries its own premium arithmetic. Run the five lines of the bridge in reverse and its Rs 24,48,00,00,000 leaves Rs 20,08,00,00,000 for the shareholders, or Rs 100.40 a share. The sponsor's Rs 100.40 lands 11.56 per cent above the unaffected share priceWhat a share changed hands at before any word of a possible transaction reached the market. of Rs 90.00, where the strategic buyer's Rs 115.00 lands a good deal higher again. Whether either gap is what a change of control costs, and why a premium measured on a share price is a different number from one measured on enterprise value, is covered separately.

Where does the buyout entry sit among the values this company carries?

Sankalp has been valued four ways on the same day. All four answers are enterprise values, and all four rest on Year 0 EBITDA of Rs 2,88,00,00,000. Sharing one base is what lets the four stand in a single column with nothing adjusted in between. Doing that puts the buyout entry in an interesting position: above what the market pays for a small stake in similar businesses, and below what buyers have actually paid to take control of them.

The two placements have two different reasons, and neither of them is a view about the business. The entry sits above the trading comparables because a peer medianThe middle multiple in a set of similar listed businesses, which prices a small stake changing hands rather than a whole company. prices a small holding changing hands on an ordinary day. A structure that funds Rs 13,00,00,00,000 of the price with deductible borrowing can support more than that. The entry sits below the precedent median because a required return is a hard cap: once the exit assumption and the debt package are fixed, there is a price above which the arithmetic simply stops working. A buyer with its own operating reasons for wanting the business has no equivalent cap in the same place, and the strategic indication of Rs 27,40,00,00,000 sits above every one of these four for that reason.

The traded enterprise value of Sankalp is Rs 22,40,00,00,000, and the only thing anybody may honestly say about it is that it sits inside the range. Sitting inside a range is not evidence that the company is cheap, expensive or worth buying at any of these numbers, and it is no evidence that either buyer's price was the right one.

What happens to the business afterwards under each?

The aftermath is where invention creeps in most easily, so it is worth being blunt about what the record actually settles. On the sponsor's side the answer is the pair of rows already tabled higher up: spending on plant flattened to Rs 90,00,00,000 a year while a third valve line waits, and the annual working capital draw cut back to Rs 12,00,00,000. Trading itself goes untouched, so nothing in the upper half of the account shifts by a rupee.

Under the strategic buyer, one thing is settled: Rs 45,00,00,000 a year of pre-tax cost savings in procurement and a shared service centreOne team handling the same back office work for several units instead of every unit staffing its own., phased in fully by Year 2. The savings are worth Rs 33,75,00,000 after tax, and that figure turns the cash version of the deal from 1.73 per cent of dilution into 5.03 per cent of accretion.

Everything else people habitually say about what each type of buyer does afterwards is not settled by the record. Notice the shape of what is settled, though. The shape is the teaching. The sponsor's two changes are both below EBITDA: they are about how much cash the business consumes, not about how much it makes. The strategic buyer's one change is a cost line that only exists because two organisations are being run as one. A financial buyer's case is built out of the target's own arithmetic; a strategic buyer's case is built out of the overlap between two businesses. The sponsor's case can therefore be checked against the target's own history, and the acquirer's cannot.

What does the one financial buyer in the transaction record actually establish?

The set of five completed transactions is assembled in full under the transaction record. One row of it matters for the comparison. Deal 1, Marudhar Valve Industries Limited, invented, went for Rs 12,40,00,00,000 at 8.6 times. Marudhar was bought by a financial buyer, for the whole of the equity, with no savings underwritten and none claimed. The Marudhar row holds both the lowest multiple of the five and the sole financial buyer among them, and the two together amount to a single observation and nothing more.

The other four transactions in that set were struck by strategic buyers, at 9.1, 9.5, 9.9 and 11.4 times, a median of 9.70 and a mean of 9.98. Line the pair up and the inference practically writes itself: 8.6 against 9.70, so financial buyers pay less. The inference does not follow, and the reason it does not follow is worth being precise about rather than waving at.

Deal 1 is not only the transaction with a financial buyer. Deal 1 is also the second smallest of the five by size, struck at its own moment, on its own business, with its own seller and its own reasons for selling. With a single data point there is nothing to average and nothing to hold constant. Any one of those other differences could account for the multiple exactly as well as the buyer type could, and no arithmetic performed on one row can settle which. The picture below plots the five by size and by multiple for that reason: with both axes in view, the confusion between the two explanations is visible rather than argued.

So why keep the distinction at all?

If the labels do not predict who pays more, a reasonable person asks what they are for. The answer is that they identify which question a price on the table has already answered, and therefore which inputs would have to move for that price to move. Knowing which inputs would move a price is considerably more useful than a ranking.

Suppose an indication arrives at Rs 24,48,00,00,000 and is known to have come from a financial buyer. A division with a rate in the denominator produced that price, so the sensible next questions are about the debt package and the hold, not about whether the buyer likes the business. Suppose instead an indication arrives at Rs 27,40,00,00,000 from a strategic buyer. A test against the acquirer's own earnings produced that price, so the sensible next questions are about the acquirer's own trading multiple, the consideration mix, and how firm the underwritten savings really are. Knowing which constraint produced a number reveals what would change it, and that is worth far more than a rule about which category pays more.

How does somebody actually use this on a live file?

Three groups reach for the distinction and each uses it differently, and that spread is a fair test of whether it is worth anything.

An analyst covering a listed company that becomes the subject of an approach uses it to read the price. If the approach is from a listed operator in the same segment, the analyst asks what the acquirer's own multiple is and how the consideration is being paid. Both sit inside the buyer's test and decide how far it can go. If the approach is from a financial buyer, the analyst asks how much borrowing the package carries and over what period the buyer expects to be in. In both cases the analyst is reverse engineering a constraint, not second guessing a valuation.

A lender being asked to fund one of them uses it to work out what it is lending against. Lending Rs 13,00,00,00,000 into a structure secured on Sankalp alone is a different exposure from lending the same amount to Mahasagar, where debt serviceThe interest and the principal a borrower must hand across in a period to stay current. comes out of a much larger and more diversified group. The first is a bet on one company's cash conversion; the second is a bet on a group's.

Somebody working inside a company that is being approached uses it to prepare. If a financial buyer is at the table, the questions coming are about how much cash the business can be made to release and how quickly. Cash is what services the borrowing. If a strategic buyer is at the table, the questions coming are about overlap: contracts, sites and back office functions that exist twice. Knowing which kind of buyer is on the other side settles which set of answers to have ready. Neither buyer will ever state a value for the company, and the preparation is worth doing all the same.