By  on August 15, 2014

The supply and demand imbalance on the beauty mergers and acquisitions front is changing the dynamics between buyer and seller.

Bankers say it’s still a seller’s market, but they don’t expect the number of transactions to materially increase from a year ago. Moreover, the imbalance between the demand from financial — and now strategic — buyers interested in investing and the limited supply of really good, quality brands that are available for purchase also has changed the M&A dynamics from the size of the potential target to how a deal might be structured, and to even a quicker close of the transaction.

Among the deals completed this year are Farouk Systems Inc.’s purchase of Blowpro, estimated at $10 million; Parfums de Coeur’s acquisition of Dr. Teal’s Therapeutic Solutions for an undisclosed amount, and PZ Cussons plc’s buy of hair-care brand Fudge for $39.9 million. Private equity firm Encore Consumer Capital took a stake in Butter London last month, and Japan’s Kosé Corp. said it is set to acquire a 93.5 percent stake in Tarte Cosmetics for $135 million. Still to be determined is what beauty brands Procter & Gamble Co. might put up for sale as it begins pruning its portfolio.

Andrew Charbin, a vice president at investment banking firm The Sage Group, said, “It’s definitely a seller’s market. There are a number of companies of the right size that are ready to go to market now. Some are young companies that have done very well in little time and have high growth prospects.

Charbin said Sage is working with a couple of “attractive assets” that have drawn interest from both private equity and strategic buyers. “While private equity remains financially disciplined in its criteria, it has become increasingly willing to pay a premium valuation to acquire a unique asset. This raises the competitive dynamic for strategics who can buy a company in its entirety, and offer sellers increasingly creative earn-out structures that may mimic the private equity scenario yet offer greater certainty of achieving predetermined thresholds.”

Arash Farin, a senior vice president who is also at Sage, said this type of structure, which has been used in the past — with the seller’s ongoing stake sometimes referred to as “phantom equity” — helps to level the playing field between the financial sponsors and the strategic buyers in terms of proceeds on the back end of transactions.

With current access to attractive debt capital and abundant uninvested equity capital among private equity firms, financial sponsors may be able to arrive at higher valuations, while still leaving sellers a “second bite at the apple” with an ongoing minority stake in the business, he explained.

Although strategics are known for seeking both cost and revenue synergies, they typically like to purchase entire stakes, potentially leaving sellers with no second exit unless a concept like phantom equity is part of the deal structure, Farin continued.

“This concept, which can be enormously rewarding, allows sellers to benefit from the tremendous value that can be created when they partner with a strategic and reach benchmarks in a few years,” Farin said.

Steven Davis, a managing director at Intrepid Investment Bankers, said, “Buyers are looking at companies that are smaller in size than before, but not necessarily because people believe that younger, faster-growing firms are better than the bigger ones. It’s more about the supply and huge demand imbalance out there on the M&A front. That has created an enormous shift in the beauty space compared with five years ago when the interest was primarily from private equity firms.”

Davis, who also said it is a seller’s market, observed that there is a growing number of strategic buyers who, although they have been quiet for the last few years, are “now dipping their toes back in in a very aggressive way.”

Davis said the strategic buyers typically look only at firms that do over $100 million in revenue, but now are considering companies — most of which are referred to as indie brands — that are less than that. “Some are substantially much less than that, with a few [brands] that are even less than $50 million getting some attention,” the banker said.

To be sure, there aren’t that many brands out there that do over $100 million in volume that are available for purchase.

Ariel Ohana of Paris-based investment banking firm Ohana & Co., who is opening a U.S. office for the firm in Los Angeles, said, “Three years ago, an indie brand at a younger stage doing $15 million in volume wouldn’t see many strategics looking at them. Some strategics are looking and lowering their radar sensitivity so they know what’s coming up later on.”

Ohana said that the competition between financial and strategic buyers is also pushing valuations up over time, which makes buyers want to look at younger firms to “catch them before they reach a very high multiple.”

Bankers noted that the smaller businesses tend to trade at lower multiples, although the average has been 2 to 2.3 times revenues. And while skin care can get a higher multiple on valuations, that is increasing slightly for color cosmetics as financial buyers are becoming more comfortable with the “fashion” risk associated with the seasonal change in color palettes in makeup.

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