Prevent Deal Erosion With a Holistic Approach to Finance Integration

Prevent Deal Erosion With a Holistic Approach to Finance Integration

Why it’s important to move beyond traditional M&A-related compliance matters and approach a transaction with a holistic suite of accounting and finance services that are applicable throughout the deal lifecycle

September 05, 2022

Seemingly immune to economic, pandemic, and geopolitical influences of the early 2020s, M&A players, whether strategic or financial (PE) buyers, remain flush with dry powder and challenged to deploy capital as efficiently as possible. The overabundance of capital and limited supply of targets is creating an era of investing characterized by:

  • Companies paying unprecedented multiples for investments
  • Investors seeking growth potential over profitability
  • Compressed diligence periods and intense pressure to close
  • Sellers driving the process more than buyers
  • Investors buying “strategically” vs. buying “cash flow”
  • Investors buying to exit vs. to embrace and absorb

What’s the upshot of all this? Capital begets capital, and it needs to get deployed. The principles of value investing that stress a strong balance sheet, cash flows, and low price-earnings multiples were abandoned decades ago. Even within private equity where EBITDA (earnings before interest, taxes, depreciation, and amortization) reigns supreme, a fundamental strategy is to buy EBITDA at a platform company, bolt on additional EBITDA with subsequent tuck-in acquisitions, then package and sell to the next buyer. The return on investment is not realized through strong earnings and distributions, but by exiting at a larger multiple than the effective blended multiple of platform plus bolt-ons.

As more and more PE and strategic buyers search for viable and desirable companies to buy, they are forced to find firms that fall outside of their classic investment criteria. This is especially true in mid-market PE. Multiples of EBITDA continue to strain credulity and traditional measures of profitability like net income or even operating income.

So what can an investor do to protect their capital or at least implement some form of guard rails? Today’s market participant must deploy a broader set of tools than the traditional commercial, tax, and financial due diligence arsenal of the past.

Minimizing value leakage during the hold period

Today’s market participant must minimize value leakage after the transaction close. Many deal costs are either part of the purchase price or characterized as non-recurring or “below the line.” However, the costs and effort to fix broken business processes and rationalize the IT landscape and non-optimal human capital across the enterprise are very much charges to EBITDA and are difficult to “normalize” out to future buyers or current stakeholders.

Evaluating the acquisition operating model

Accordingly, how does an investor evaluate the people, process, and technology (the operating model) of an acquisition to determine whether it will be a source of value leakage or a potential multiplier on exit price as it evolves throughout the hold cycle? The answer is, of course, “it depends” but also “start early.” Let’s discuss how we think about identifying sources and uses of value across the operating model.

People

People are the trickiest aspect of the operating model to properly evaluate. Individuals at the Target are often playing multiple roles, which is common for those fulfilling back-office functions (e.g., your office manager is also the AP clerk). If there are gaps between current performance and required performance post-transaction, do these gaps reflect deficits in competency or capacity? Buyers typically assume the former, but experience shows that lack of capacity manifests in issues and challenges that are interpreted as lack of competency (e.g., an accounting closing process that is protracted and does not produce complete, accurate, or timely information for decision support).

Processes

Processes employed by the incoming business are generally poorly understood or concentrated in the hands of a few key individuals. Buyers do not need to commission consultants to create desktop procedures or process flows, but they do need to understand who does what process (e.g., “billing and invoicing,” “purchases and payables,” or the “accounting and reporting”). Once the Buyer understands the end-to-end core business processes and who does what, the Buyer can begin to document what is necessary, identify critical points of failure (e.g., the inability to reconcile bank accounts if a key individual goes on vacation), and begin de-risking and improving the most important business processes.

Technology

Technology at mid-market PE portfolio companies generally sits in two buckets: 1) rudimentary or 2) excessive. Companies are either operating on a technology stack that is woefully insufficient to meet current requirements or have built out an application stack with functionality that far exceeds anything the company requires.

A savvy operator understands that assessing the operating model upon the letter of intent allows them to better assess in several key areas:

  • Ability of the organization to turn around financial and operational data for decision-making
  • Readiness of the organization to integrate into a new environment
  • Ability of the organization to scale
  • Magnitude of post-close integration costs

Deeper insight into these areas at the front end of a transaction can strengthen negotiations and help drive healthy or more reasonable multiples.

Hindsight is 20/20, but many acquirers identify issues well after transaction close (i.e., during the hold period). Acquirers can assess, diagnose, remediate, stabilize, and optimize the operating model of a Target during the hold phase.

However, beginning the operating model assess-to-optimize process after Day 100 often has negative ramifications, including the irrevocable loss of value or non-realization of deal synergies. In addition, beyond six to nine months, external stakeholders of the acquirer, whether “the Street” or limited partners, will focus on deal value realized vs. the realization process.

So “start early” and assess the entire operating model to prevent deal value loss.