M&A Advice: Remove Concentrated Risk
By Tom Zucker,
In Michael Porter’s book, Competitive Advantage, he succinctly states his views of risk management with the quote, “Risk is a function of how poorly a strategy will perform if the ‘wrong’ scenario occurs.” The concept that one customer, supplier or even industry downturn can cause irreparable harm to a business was proven quite painfully to many businesses during the last recession. Generally, a business with one customer greater than 20% or the top 5 customers comprising more than 40% of their revenue is considered a concentrated risk. Additionally, a supplier who provides more than 30% of the necessary raw materials or products for a business is also a potential risk position. Additional concentration risk may occur when a business operates in one specific industry (i.e. automotive, oil & gas, agriculture, or construction) or geography (east coast, southwest, west coast, etc.). Many business owners operate comfortably with these risks, but a selling owner with these risks needs to proceed with caution and possibly a revised strategy.
The entrepreneur’s comfort with a customer comprising a large percentage of the business may seem rational and logical to the business leader and outsiders (why go to many customers when you can generate significant business from one or a few?). The owner with concentrated risk positions in their company often have seemingly mastered the many factors that reduces the risk of losing their large customers such as possessing unique capabilities that makes the owner’s company hard to replace, superb on-time delivery, credit insurance, or just better client service. The hidden risk for a business owner with these concentrated positions lies when the owner tries to sell the business.
The harsh reality of the M&A buying marketplace is that concentrated risk positions impact buying demand and purchase price. Lenders have been trained to avoid and/or be extremely cautious when providing credit to companies with customer and/or industry concentrations. Since the banks often provide more than 50% of the cash to support the overall purchase price, this concentration negatively impacts the purchase price for sellers. Additionally, the number of buyers that are willing and capable of accepting the risks associated with a supplier, customer relationship, or industry concentration are significantly less than a company without such risks. Buyers fear that if the large customer or supplier goes out of business or exits the relationship, or a cyclical industry experiences a downturn, the buyer’s investment will be severely impaired. This risk greatly affects how buyers value such businesses.
At EdgePoint, we have advised many clients with concentrated risk positions. The following are just a few recent examples:
- Customer concentration: Metal fabrication business with 95% customer concentration and operating solely in the oil and gas sector
- Supplier concentration: Agriculture processing business with 100% of their grain supply being sourced from one vendor.
- Leadership concentration: Polymer processing business with a business owner solely possessing the sales, technical and operational knowledge necessary to operate the business.
The M&A market for these companies was adversely effected by their respective concentrated positions. Many of the most strategic and high value buyers were unwilling or cautious in participating in the purchase process because of these risks. Although EdgePoint was successful in the sale process, these sellers could have taken strategic actions necessary to diversify and minimize their concentrated risk positions and further increase the buyer interest and positively impact value.
For owners contemplating a sale in the foreseeable-future, the following are a few of the strategies that others have implemented that have limited concentration risks and increased the value of their businesses.
- Acquisition: Evaluate an acquisition of a business prior to the sale of your business. An acquisition with an unconcentrated customer base can greatly reduce an existing concentration in your business. An acquisition is also a great way to acquire potential leadership to enhance your management depth, diversify geography or acquire capabilities to serve a different industry. Additionally, acquiring new customers potentially in different markets can take time and a strategic acquisition is a good strategy to accelerate this process when a sale is contemplated in the nearer term.
- Increase Sales Efforts: The ability to hire additional sales professionals or establish partnerships in alternate markets is a great way to make a customer concentration evaporate. With the proper amount of pre-planning and effort, the supplier or customer concentration within your business can be reduced to acceptable levels. Acquiring new customers diminishes the percentage concentration of larger customers over time.
- Reposition your Business: The likely buyer of a business with a concentrated position is a larger customer who can integrate your business into theirs. The large customer concentration will not impact a significantly larger business. These buyers tend to view the acquisition of a new large customer as a positive event. However, these buyers often want to consolidate your business into theirs.
The existence of concentrated risk positions as described above may not be developed intentionally but rather have evolved over time. As an ongoing operator of a business these risks are acceptable and rational, and have not adversely affected the profitability of the business. As one begins to prepare for the sale of their business, these same concentrated risk positions require additional thought and planning. The involvement of a skilled investment banker and other advisors prior to the sale of your business is essential to making sure the concentration risks that have been a benefit to a business do not unintentionally become a curse when it is time to sell.