Best Practices in Acquisition Search
By Paul Chameli,
Warren Buffett has long advised investors to “be fearful when others are greedy and greedy when others are fearful.” While many questioned Buffet’s adherence to those principles in March 2020, his advice has been widely used as a framework for smart investment – including by participants in the private company merger and acquisition market. While Buffett with his words is essentially daring investors to exert risk in turbulent times, we at EdgePoint don’t think that corporate development teams have to necessarily be “Robinhood investors” that throw caution to the wind when considering acquisition candidates in times like the current. Instead, there are some best practices to consider in acquisition search that can reduce transaction risk to the Buyer while also ensuring the search is efficient, focused, and compelling to candidates who even in this market have several options. This article is a refresher on some of those best practices.
Pursue Small Investments with Strategic Value
While the motivation of strategic buyers over the past several years has been to make acquisitions that “move the needle” in terms of financial performance, in the current environment, EdgePoint believes significant strategic value can be achieved through acquisition of smaller investments that do not consume significant capital. Smaller companies that possess strategic attributes and operate in niche markets are particularly attractive because many of these targets did not receive much attention from investment bankers, strategic buyers, and private equity firms in strong markets – creating, likely, more anxiety during this uncertain time. While these targets are harder to locate, they represent the best opportunity for value creation due to lower seller expectations and lower risk from the perspective of capital deployment. While some observers will say that smaller companies have less strength to survive in a downturn, we think this is exactly why they represent great investment opportunities, as association with the larger buyer will better secure the viability of the smaller organization. When that fact is understood by the Seller, the environment for a solid partnership is cultivated.
Small company acquisition involves a slightly different frame of mind when compared to larger transaction efforts. A professional strategic buyer will have to understand that the motivations of a small private business owner are much different than for larger, institutionally or publicly traded companies. Limited financial information, tax deferral strategies, high levels of owner perquisites, guarding of trade secrets, and other similar dynamics will likely be present in these smaller companies. But, these smaller companies are also agile, nimble, and in many cases, industry-leading in terms of emerging technologies. As discussed below, these smaller companies may also be intimidated by larger buyers and may require someone with an appropriate “bedside manner” to help facilitate the approach.
Seek Desired Attributes
This goes without saying, but we recommend that an acquisition strategy in this environment be focused on key strategic attributes that relate to long-term goals and objectives of the Company. With the market expectation for softer financial results expected, EdgePoint considers this to be an ideal opportunity for larger strategic buyers to consider investments in niche areas that are forward-thinking and ultimately beneficial to the Company, but that were lost in the mix when larger acquisition pursuit was the motivation. We view the current environment as a good time to consider new emerging technologies that may be speculative, but that may represent the future of the industry, and using the downcycle to determine if a Seller vulnerability creates an opportunistic buying scenario. Seeking targets with new capabilities or intellectual property that represents the future direction of your organization will properly establish the long-term framework for the investment.
The other consideration around focused attribute search is to keep the acquisitions search manageable. For most companies and in most industries, there are very few “perfect fit” acquisition targets. As a result, any acquisition search is likely to have some attractive attributes and some less attractive attributes. To prevent the acquisition search from getting too large, unfocused, or unruly, we recommend any acquisition search process involve a narrowing of the potential acquisition pool by a Target Attribute Mapping (“TAM”) exercise. The TAM involves a mapping of desired attributes against the potential universe of attractive targets for priority and ranking. Scores can be assigned to certain attributes to provide an overall “score” for the respective target. This mapping and scoring exercise enables the acquisition search team to communicate amongst themselves about the attractiveness of each respective target and also to prioritize the targets. This is important for buyers that are tracking several hundred potential acquisition candidates but can only make a couple of acquisitions in a given time period. However, to do this and to keep it reasonably focused, EdgePoint recommends the establishment of at least one “anchor attribute,” something that is an absolute must-have in the acquisition target. This could be as simple as size of the Company, but it could also include some operational characteristic that gives definition to the search.
For a current acquisition search, EdgePoint established with the client an anchor attribute and built out a list of 200 potential targets that possessed the anchor attribute. In a fragmented industry, the absence of the anchor attribute would have resulted in an initial population of nearly 800 targets. From the list of 200, we underwent an exercise of determining the presence or absence of a variety of other characteristics to score each potential target and rank them. This tool became effective and necessary as the acquisition team prioritized those targets that were receptive to our advance.
Because of the volume of calls, letters, and other messages from investment bankers, private equity buyers, business brokers, etc., we recommend that an acquisition search effort include best practices to ensure that you stand out from the masses. The first recommendation is that the pitch disclose the name of the buyer. Too often, acquisition candidates receive letters from brokers that indicate there is a “buyer” that is interested in their company. It is our recommendation that a buyer disclose their identify, at a minimum. We recommend that an acquisition search campaign include crisp marketing materials that provide an overview of the Buyer company that explains a variety of characteristics that may be questions on the mind of a target seller. It is important to make statements about cultural fit, how the target will be treated as a division / subsidiary of the Buyer, and why the target would benefit from association with the Buyer. Presenting acompelling and strategically thoughtful rationalefor investment works well to get Seller attention, particularly nowadays, when companies are inundated with thoughtlessly compiled letters and calls that do not share specific acquisition intent.
As opposed to being very aggressive in the pursuit of financial information from a newly contacted acquisition target, we recommend the first step to be a non-threatening video conference in which both parties present an overview of their Company. While the Buyer can certainly express the rationale for acquisition interest, we recommend giving time for the acquisition target to become comfortable sharing information. This will enable the Buyer to distinguish itself from financial investors that have a singular focus on financial results. Understanding first the strategic motivation – as opposed to a pure financial analysis – will help the acquisition target get more comfortable with disclosure. Pending a positive outcome from that initial meeting, the standard process of value-determinative due diligence, letter of intent presentation, and confirmatory diligence can occur.
Our recommendations on the initial contact being by video conference was preliminarily driven by the realities and logistics of social distancing; however, we have found that video conferencing can have benefits even beyond that of time and logistics savings. In our view, a phone call in which you cannot see the face of the participants is a difficult environment for which to create rapport. And while an in-person visit is best for establishing rapport, it can be a little too intense for an initial dialogue wherein trust has not yet been established. We find that the current video technology is so good that it can create a perfect atmosphere for these initial exploratory meetings – not as invasive an on-site meeting, but still interactive enough to create rapport and good impressions among the participants. Because of the effectiveness, we expect that video conferencing will remain a very prominent tool to use for initial pitch conversations in acquisition search work as social distancing initiatives subside.
Consider Non-Cash Mergers
In response to the obvious and very rationale perspective that a company in this environment should preserve cash until there is more visibility, the old ideas of some amount of stock-for-stock exchange again becomes a very logical consideration. While earn-outs are always suspect to sellers, even in a depressed market, we find the stock-for-stock exchange to be an increasingly acceptable structure for Sellers in this environment. If the client has publicly available shares to tender in exchange, that is of course a much easier sell than for a private company. Even without a more liquid security, we do see in our lower middle market a motivation and willingness of sellers to accept shares of another industry participant, so long as (1) the Buyer structures the combination in a fair and transparent manner, (2) there are fair and reasonable put and call features in the combination that enables the seller to eventually monetize the rest of the shares in cash, and (3) this structure creates an alignment between the two and enables the Seller to benefit from association with the Buyer. There are other benefits from the cash-for-cash exchange, including the possibility of tax deferral on the amount of the shares that are not immediately converted into cash. These structures can be tricky, but in our experience, there is more willingness to consider this structure when the parties become more comfortable with each other as strategic complements and as the synergy scenarios are fully understood.
So go be greedy in the M&A market now that others are fearful, but use the above principles and considerations to ensure you are being prudent in your investment, taking the correct perspective, and presenting the best pitch to attract quality targets. And as always, please contact EdgePoint if we can help with your transactional needs.