M&A 101 - 20 hacks to reveal the pig under all that lipstick
TLDR
We have entered a time when hundreds of thousands in the Baby Boomer and GenX cohorts are looking to sell their businesses, and every street corner has a facilitator trying to side hustle a fee out of you.
Part of what’s driving this is demographics/age, part is COVID lockdown navel gazing/work life balance recalibration and the opportunity to invest proceeds in riskless yield investments that have recently emerged over the past 12 months.
Another reason for the selling is strategic/creative disruption and the requirement/cost to automate, and yet another part is greed, which equally applies to the indiscriminate shilling.
The rest has to do with 14 years of money creation (from QE/issuance) that’s debased currencies making valuations and multiples look high - in other words, a macro tailwind that’s got nothing to do with business fundamentals nor the acumen of managers that have accessed cheap money to over hire people and wallpaper over the cracks.
Whatever the mix of these ingredients, make no mistake there’s a literal smorgasbord of businesses available to be bought and there’s trillions in liquidity stacked up to buy them along with squadrons of dubious ‘facilitators’ waiting to explain why their deal is the best you’ve ever seen.
But we all know that businesses are not created equal, and no matter how much lipstick you spray on a pig, it’s still a pig, and pigs bloated by QE can’t fly when interest rates go to 5%.
So today, I wanted to share 20 simple hacks to determine whether the pig you’re being shilled is actually a dog on fire that you don’t want to pat.
20 hacks to expose the pig
Declining or saturated industry: Imagine trying to sell typewriters in the age of computers. If the target operates in an industry that's either fading away or being barbequed by technology, you don’t want to be that buyer. Keep walking.
Stagnant growth: A target needs to show potential for growth. Zero growth companies are like plants that never grow even though you water and fertilise them. They might give you stable income for a short time, but if there’s no growth your profits will be debased over time as expenses and competitive pressures crowd out your margins. Avoid.
No competitive edge or USP: Not every business can claim sustainable competitive advantage, but the business needs to at least have an edge over the competition and a clearly defined unique selling proposition. Otherwise, it’s like opening a cafe on a street with twenty others. It can be hard to stand out. Run away.
Owner/key person dependency: When a physical business relies too much on one person’s skills, presence, name/reputation, it's like trying to buy a magic show that only one person knows how to perform. You want a business that can run smoothly without the magician. Pass.
Revenue concentration risk: Think of a lemonade stand that makes all its money from just one person who loves lemonade. If that person stops buying lemonade, you’re toast. That's revenue concentration risk. It means too much of the target income comes from just one or a few customers, making the business vulnerable and not possible to value as a going concern. In most cases (apart from boutique cases like royalty, lease and contractual style businesses) extreme concentration results in an unsellable business, or a valuation based on a DCF of the contract/s. Yep, unsellable.
Quality of earnings and unit economics: High margins can look attractive, but they’re not always real. Think of a high margin business servicing risky/unbankable customers that are forced to pay the higher margin because no one else will service them. No bargaining power. Risky businesses propping up risky customers is not a good formula. They often collapse once their customer base collapses, typically once the 3–5-year business cycle draws to a close. Equally, poor unit economics can be terminal. Peel back the accounting lipstick and examine customer quality. Facade.
Inadequate financial records: Financial records are like a corporate treasure map. If the map is messy or incomplete, it's hard to follow and find the treasure. Avoid.
Macroeconomic regimes: Imagine trying to justify the acquisition of a capital/fuel intensive industrial business in a high interest rate/high oil price environment. It can be a challenge. Economic ups and downs can affect a business's value and its appeal to investors and while a business might have been exciting yesterday, it can become a ‘pass’ on the flick of a central banker’s pen, today. Be careful.
Employee issues: If employees are unhappy, it's like inviting competitors onto the payroll. Employee problems, like high turnover or low morale typically expose management’s inability to build a strong team. Tread carefully.
Fading customer base: If customers are leaving, there’s something wrong. Losing key customers or having several shrinking customer wallets are signs of bad cx, and probably a symptom of one or more of the other deficiencies in this list. These can take years to fix, if ever.
Poor customer contracts: Imagine trying to sell a car or a Van Gogh without any paperwork showing its provenance. Businesses with weak or unclear customer contracts are problematic if you want to understand the future income that you are buying, and its longevity/security. At best, impacts valuation.
Lack of innovation or defensible IP: If a business is using outdated ideas while others are inventing new things, it's like using an old flip phone when everyone has smartphones. Staying current is essential for investability. Equally, if a business relies on patents, trademarks, or copyrights and there are legal disputes or uncertainties around those assets, it's like a puzzle missing a critical piece. You should pass if you can't be sure you’ll get the full rights to the IP. Tricky.
Legal or regulatory issues: They’re like a car with a history of speeding tickets and no brakes. Legal troubles or breaking the rules can make a business unattractive and that also goes for a business which requires consents from a jurisdiction that’s under global sanction, i.e., you may never get the consents you need. Forget about it.
Inefficient operations: Inefficiency leads to lower productivity; profit margins and equity returns. Always benchmark. Tread carefully.
Obsolete methods and assets: Imagine an Industry 3.0 factory competing in an industry that’s already embraced robotics and automation. Output will be inefficient and comparatively more expensive than the competition. Outdated methods lead to impending capex and can often be the reason for the sale in the first place. Well, that extra cost needs to come off price.
No succession plan: If there is no plan for who will run the show after the magician leaves, it's like writing a fairytale without an ending. You want a business that will continue smoothly. Probably avoid.
Unrealistic valuation: Imagine going to your investment committee to justify why they should let you pay 10x EBITDA when the peer group trades (or comps have sold) at 6x - 8x. You’ve got a lot of explaining to do. Good luck. Not saying it can’t occur in unusual circumstances, but overpaying delivers into the seller’s agenda, not yours. These usually end in tears not beers.
Negative reputation: Think of business reputation as the popularity score. If it's got a bad reputation (in the market) due to problems or unhappy customers, it’s like buying the rights to an unloved movie. Look elsewhere.
Complex ownership structure: Many, many offenders! Imagine trying to solve a puzzle with a thousand pieces that don't fit together. A complicated or multi-entity ownership structure won’t work for you (or your bankers) if you value simplicity and transparency. Avoid.
Unmanageable debt: This one is finance 101 but some buyers don’t see the issue until they can’t refinance the combined debt stack due to higher interest rates and/or tighter lending requirements/unavailability of credit. Leave it alone.
Learnings
I do a lot of buy-side and invest-side work for clients and let me just say that finding a business that’s worth buying doesn’t just happen.
On top of the 20 points above, it takes equal parts of strategic alignment with the acquirer, deep analytical and valuation expertise, methodical planning and diligence as well as a trusted network of active industry insiders.
Oh, and a big investment in time because 99% of what you’ll be shown will not be the right acquisition for you.
If you’d like to discuss any of the above, feel free as ever to call or hit send.
But in the meantime, if you’re pealing the lipstick off a target and you uncover any of the warning signs in hacks 1 to 5, take a leaf out of this little guy’s book.
Mike
Next Level Corporate Advisory is a leading Australian M&A, capital and corporate development advisor with a dealmaking track record spanning three decades. We help family, private and publicly owned companies find, build and realise value in their businesses, assets and investments.
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