M&A Blog #11 – buy-side acquisition
Thus far in the last 10 blog posts, we have discussed what M&A is, its success metrics, types of acquirers and value creations, capital structure, debt, and equity. In this post, we will discuss what it takes to set a good acquisition program, best practices on acquisition criteria and sourcing, and challenges with any acquisitions program.
An acquirer will want to (1) achieve excess return (to the cost of capital), (2) mitigate downside risk while maximizing return on capital, (3) minimize friction from the acquisition (with personnel, customers, etc.), and (4) support long-term business strategy. It is ABSOLUTELY crucial that a corporate acquisition program is aligned with the corporate strategy. In Blog #02 of the M&A series, we discussed SWOT analysis. Once the strengths and weaknesses of a company are identified, the overall acquisition goal will become clear. The goal should be focused and limited, with a narrow range of potential acquisition targets. Potential targets should offer additional profit, new customers, new markets, new products for offering diversification, new technical capabilities, or other value that improve the acquirer’s current standing.
Despite this strategic rationale, many acquirers approach M&A from a purely opportunistic stance. They react to opportunities from external sources (investment bankers, deal brokers / advisors, investors, analysts, or potential targets’ senior management) who came to peddle deals; rather than acquire to support overall strategy, leverage strengths, and reduce weaknesses. The best way to nip opportunistic tendency in the bud is to develop a set of predetermined acquisition criteria to evaluate potential targets. A range of both financial and strategic criteria will filter out “noises” (inappropriate acquisitions) and reduce wasted efforts while focusing management’s attention to reasonable opportunities. Examples of those financial and strategic criteria are listed below:
Financial Criteria:
Size: Smaller transactions are more likely to create value for acquirers, while larger ones are more likely to “move the needle” - especially for public company acquirers with shareholders’ demand for growth.
Gross Margin: persistent high margins are an evidence of competitive moat and represent high customer demand, differentiated product offerings, or unusually appealing service / product.
Growth: Target’s historical and projected growth.
Business Criteria:
Product / Service: What is the target selling?
Customers: Who is the target serving? B2B, B2C, or mixed?
Distribution: What is the target’s channel? Wholesale, retail, or direct?
Branding: Does the target produce brands or private label?
Geography: What is the target’s footprint? International, national, regional? Proximity to the acquirer’s geography (within / near / far)?
Management: How strong is target’s management? Will they be a part of the acquisition (stay) or leave after the transaction?
Employees: What are the target’s labor relations policies? Any unions?
Culture: What is the target’s corporate culture looks like (hierarchical, decentralized, formal, informal, etc.)
Transaction Criteria:
Valuation: Is there a targeted floor and ceiling to transaction multiple used to value the target?
Profitability: What is the targeted return on invested capital (ROIC), return on assets (ROA), or return on equity (ROE) - along with the payback period.
Integration: How big is the challenge to integrate a potential target? Focusing on acquisitions with no more than ¼ of acquirer’s size usually brings a reasonable amount of integration challenge.
It is important that these evaluation criteria are ranked based on importance and weighed relative to each other. Like the accretion / dilution analysis from the last post, it will show if a target is favorable or not. Some industries may have additional evaluation criteria, i.e.: retail with same-store sales trends, number of stores, etc. These criteria, in addition to the capital structure and debt-equity considerations we covered in blog posts #4 through #10, should be completed ideally BEFORE any efforts to sourcing deals and building a deal flow pipeline are initiated.
Once the criteria have been identified, the next step is to source in deals and build an acquisition pipeline. This step is by far, in my humble opinion, one of the most time-consuming steps in acquisitions. The volume of work is huge and typically takes 1-3 years to build properly. Large companies are approached for deals in their respective industries, but few have invested the time to properly build an acquisition pipeline (or program in that matter). Similar to not having a predetermined criteria, not having an acquisition pipeline may lead to opportunistic acquisitions that don’t really support the company’s strategy and increase shareholders’ value.
Building an acquisition pipeline requires good communication with acquisition sources. These parties include board members, CEOs, CFOs, corporate development officers, salespeople, marketing staffers, vendors, suppliers, attorneys, accountants, bankers, and investment bankers. Each of these parties can be tasked with identifying potential acquisition targets; which themselves can be identified through trade shows, industry associations, online databases, customer interactions / introductions, discussions with end users, interviews with employees, and more. The multiple leads that come in should be evaluated against the predetermined acquisition criteria. This huge-volume work, time-consuming activity, patience-required 1-3 year process may look like:
As we can see above, it takes a lot of work (and resources, internally and externally) to do one acquisition. Companies who aren’t equipped with the right resources and time availability may want to re-think doing acquisitions - especially if other growth alternatives exist.
For acquirers with limited acquisitions experience or resources (personnel), using outside consultants (advisory services / investment bankers) might be a good start. This approach has the advantages of:
Freeing up company’s resources.
Producing an ongoing deal flow.
Consultants’ broad market coverage or industry expertise.
Consultants’ deal-solicitation expertise with potential targets’ executives.
Consultants’ valuation, deal-structuring, and deal-financing expertise.
The approach also comes with some disadvantages:
Consultants’ lack of knowledge of the acquirer’s business and executives.
Consultants - seen as mere brokers - being excluded from potential acquisitions.
Consultants’ control over the acquirer’s reputation as a buyer.
Consultants’ fees can be expensive in the long run.
Due to transaction-fee compensation structure, consultants may not have their client’s best interest and present unfavorable deals just to do a deal.
Lack of contact with potential targets means that the acquirer lose opportunities to establish long-term relationships.
Since a successful strategic acquisition program is a long-range commitment over five years or more, a consultants-led structure is best used as a starter engine. In the long run, a consultants-led structure is likely to be too expensive and unsatisfactory to sustain.
So, to re-cap, in this buy-side M&A post, we have discussed the importance of SWOT analysis and having a solid selection criteria to nip opportunistic tendencies, sourcing and building an acquisition pipeline, the pros and cons of using outside consultants, and more. In the next post, we will discuss the sell-side of M&A in great details.
