Reflections on 40 Years in Middle Market Mergers & Acquisitions – Part 2 of 3
ArticlesOctober 2016

Reflections on 40 Years in Middle Market Mergers & Acquisitions – Part 2 of 3

By Russ Warren,
Managing Director

Experience is what happens while you march toward the front of “Class Notes” in the alumni magazine

Part 1 reflected on how emergence of the leveraged buyout, mezzanine financing, and the ESOP in the 1970s and 1980s multiplied transition options for middle-market business owners. (read Part 1<)

The Diversity of Ownership – Over the last 40 years, the makeup and motivation of business owners has changed in ways that will affect middle-market M&A for decades to come.

The age at which owners are ready to sell has fragmented dramatically from the 60 or 65 year old transitioning for retirement years ago. Today’s founder may want to sell at 45 or 50 and do something else with the rest of life – maybe start another business, “give back” in nonprofit activity, or seek “life experiences.” Forget the hammock; bring on helicopter skiing and Habitat for Humanity!

Yet, overall, data shows the average age of business owners is increasing. For some, the phrase “80 is the new 65” resonates. People act younger, live longer, work smarter and feel less constrained by past retirement conventions.

Few women ran or started businesses in the 1970s. Gradually, that has changed. As one measure, top MBA programs now have 35 to 45 percent women in their ranks, and gender creep is expected to continue. A 2015 study by Womenable and American Express found 30 percent of all businesses in America are women-owned, and revenues of women-owned businesses have increased 79 percent since 1997.

Similarly, the number of Minority Business Enterprises (MBEs) owned by African Americans, Hispanics and Asians grew 60, 44, and 40 percent respectively between 2002 and 2008, according to the Minority Business Development Agency, as many public contracts and large corporations encouraged more inclusiveness. Many of these MBEs are growing into middle-market companies and beyond.

Many owners of successful businesses today say their children have no interest in taking an active role in the company, raising the need to transition the business proactively to employees or an unrelated party.

Consolidation Pressure Cooker – During the 1990s, owners of smaller U.S. companies in many sectors began to feel increasing pressure (beyond the tendency of mature industries to consolidate) on profits and their very existence, from four long-term megatrends:

  • Large customers winnowed suppliers to those with critical mass and scope.
  • The rising cost and pace of technical change required major capital investments more frequently.
  • Globalization increasingly impacted middle-market businesses.
  • Financial buyers launched a wave of strategic initiatives.

The term “Critical Mass” took on a whole new importance. Owners heard, “Get bigger or get out.”

To remain globally competitive, major multinational corporations formed close working relationships with fewer suppliers. It was just too expensive to buy a few items from a whole lot of suppliers. For example, Rubbermaid sought to reduce its supplier base by 80% to achieve a sustainable 15% cost savings. To be a “keeper,” smaller companies had to deliver consistently flawless products, just in time, and be ISO 9000 certified.

Product life cycles and product-to-market cycles became shorter. Each new technological development tended to require a larger investment, and to require such investment more frequently, just to keep up.

Globalization came to the middle market. In 1994, America entered the age of NAFTA, and freer trade globally. Less restrictive trade barriers presented both challenges and growth opportunities, but required more resources from participating companies.

Also in the 1990s, buyers’ strategic “add-on” acquisition initiatives sought more than mere financial return. This meant operational due diligence was more thorough and took longer, but risks to the careful buyer were lower and value-creating opportunities greater.

For all these reasons, many middle-market businesses turned to acquisition, joint venture, strategic alliance or a sale or merger, depending on their situation. “Strategic” became the transaction de rigueur.

Seeking Growth: In the Shoes of The Buyer – The buyer’s view is very different than the seller’s.

A buyer buys the future. “Past performance may not be indicative of future success.”
Forty years ago, articles in the Harvard Business Review and other respected mastheads bore this bleak theme: With hindsight, most acquisitions — yes, most — fail to create value for the buyer’s shareholders. The parade of such articles continues in the 21st Century without let up. Ouch!

A successful acquisition creates sustainable profit growth. The first place a company should look for growth is within its own business—new customers, new geographies, new versions of its products or services. That’s because the more you understand, the lower the risk of failure. But, the desired growth is not always available organically, or it may be faster and cheaper to acquire.

Caveat emptor. To create incremental value, the buyer must have a well-reasoned strategy, understand the acquisition candidate, buy at the right price and terms, and successfully integrate the acquired business into its operations.

In my experience, a successful acquisition begins with “know thyself” and a close understanding of the candidate’s strategic fit and value drivers. Jim Dunstan, CEO turned business professor at UVA’s Darden School, poses two questions: “Why do our customers buy from us?” and “How do we make money in this business?” It is better to overpay (a little) for the “right” business than to land a “bargain” that does not achieve objectives.

What turns a buyer on? Buyers pay a premium for Clarity, Profitability, Predictability and Growth.

  • Corporate Clarity: An understandable business model with sustainable competitive advantage.
  • Profitability: A return greater than comparable companies generate.
  • Predictability: The ability to see future revenues reliably; absence of surprises; pricing power.
  • Growth: Steadily increasing cash profits over a five-year planning horizon

Many strategic buyers use the private-equity pricing model as their starting point, because that’s where competing financial buyers are. (How much can I borrow, plus how much can I invest for a 25% rate of return?). To that value, they may add a bonus for synergy, depending on how important the “target” (notice the military term) is to their plans, and how strong they perceive competition for the deal. A buyer will share some obvious synergy savings (elimination of some administrative costs) if it has to, but will be secretive about any unique “strategic” synergy. In fairness, that is their value-add, not the seller’s.

Many good acquisitions fail after they close. Why? Because they lack a disciplined plan to adhere to assumptions in the valuation model, or because due diligence was incomplete. (Surprise!) If the valuation depends on closing a facility and moving the business into the buyer’s plant in six months, and it takes two years, the buyer will never see the forecasted return on investment.
The Divestiture: When Less Is More – As Harvard’s Michael Porter says, “The essence of strategy is choosing what not to do.” Companies must be good at pruning as well as planting.

Over the years, divestitures have become respectable, and necessary. Years ago, a divestiture might be seen as a past mistake, or that the company was in financial trouble. That is no longer true. In 2013, a Deloitte survey reported, “corporate divestitures are increasingly being driven by companies’ strategies to focus on growth and shed non-core, low-growth assets, and less by financing needs. As the business focus changes, some assets are worth less to their current owners and more to others.”

Each year many middle-market lines of business, divisions, and subsidiaries are divested. Acquirers actively seek these cast-offs, and win-win transactions can be crafted. Sometimes a business is even re-acquired by its founder.

Cross-Border Transactions – Forty years ago, only large companies, it seemed, were multinational. An ambitious growth objective for a middle-market company was to become national. (What’s not to like about a market of 300 million people, all speaking English?) But, as noted earlier, many companies were dragged into international waters by large customers. Others who had sated a niche market in America found that with a little planning, they could sell their products or services overseas to new customers.

An outbound international initiative for a middle-market U.S. company typically begins with an export program, then an outpost in Toronto, and gradually moves into markets with increasing cultural differences and less modernity, such as Kabul. Well, maybe Kuala Lumpur
Globalization also opened middle-market North American companies with a coveted customer base or unique intellectual property to a range of buyers from Europe, Asia and the Middle East. Today, a strong seller can expect to fetch attractive offers from selected overseas buyers.

Middle-Market Glue – Over the last 40 years, The Association for Corporate Growth has played a key role in bringing buyers, financiers and advisors into a middle-market agora. It is the gathering place.

From a small New York clique, ACG reached 500 members in the 1970s, when I joined. Filling an obvious need, the organization has grown to 57 chapters in 11 countries serving more than 14,000 members of the M&A community.

I have fond memories of attending many an InterGrowth, ACG’s global conference held annually at a posh watering hole in a sunny clime, where we rubbed (and bent) elbows with CEOs of fast-growing companies and other members of the business, financial and governmental glitterati. During the 1981 gathering in Boca Raton, Florida, I made an unplanned day trip to New York. That day John Hinckley Jr. tried to assassinate President Reagan in Washington, and suddenly airport security and air traffic control turned upside down. The President survived, and I returned at midnight, missing the cocktail party I was hosting. One year, Michael Milken — the junk bond king and announced keynote speaker — was a no-show, jilting ACG for his own investor-rich “Predators Ball” event. Post script: In 1990, he pled guilty to felony charges for violating securities law, served time and is banned from the securities industry for life.

When I was ACG President (1995), Richard Teerlink, the accountant-biker CEO of Harley Davidson, won the growth award for an amazing turnaround, and an early example of the resurgence in American manufacturing. We also launched a multiyear initiative to expand international chapters, and chose Diane Harris, head of Corporate Development at Bausch & Lomb, as ACG’s first woman president.

In ACG, friendships form; deals spark. My special long-time ACG friends include Bob Coffey (The Coach, Toronto), Alan Gelband (Gelband & Co., New York), Carl Wangman (ACG Global, Chicago) and Tom Smith (deceased).

Speakers at InterGrowth tell great stories. My favorite is this one, told years ago by Jim Balsillie, Co-CEO of Research in Motion (Blackberry). He was seated near Barbara and George Bush at a fancy dinner. Mrs. Bush told him George was addicted to his Blackberry, so Jim confessed that his wife had a rule that he had to leave his on the foyer table when he came home. One night, he snuck it into his pocket, and went upstairs to read his little daughter a bedtime story. The unseen phone buzzed just before his wife came into the room. Their daughter said, “Daddy just farted.” “Now I had a dilemma,” said Jim, “do I confess to the Blackberry or the fart?” With that, President Bush laughed so hard he sprayed red wine all over the tablecloth.

But Wait – There’s More – In the next issue of the EdgePoint Newsletter, Part 3 will conclude with the advisor’s perspective.

(Read: Part 3)

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