It’s clear that the economic and geopolitical environment of the past three years has created an unconventional set of circumstances for investing in and acquiring businesses.
If you’re a portfolio manager in venture capital or private equity, or a programmatic acquirer, you likely have already adjusted your mindset about how to create and preserve value in this economic climate. Revisiting your thesis on previous investments (especially growth and profitability targets) and de-risking new investments will very likely require more rigor in uncertain times.
Different Times, Different Measures
Your mandate as a steward of investor capital, in a nutshell, is value creation throughout the holding period; guiding portfolio companies or senior leadership teams (SLT) to ensure the M&A strategy creates a meaningful competitive advantage. Driving accretive financial results and protecting the downside is more important in challenging economic times. Relying on creating value through a ‘growth premium’, low cost of capital, and achieving cost synergies is a risky proposition when customers are reducing and deferring non-discretionary spending, and when you’re grappling with reduced leverage, higher cost of capital, and increasing costs due to labour shortages and inflation.
In the years leading up to 2020 and through the pandemic, buyers faced highly competitive processes, challenges getting to know management and performing detailed due diligence, and condensed closing periods. That environment prompted many acquirers to make decisions that go against their well-established diligence and risk management principles.
Deeper Due Diligence to Mitigate Risk
Today, after an almost complete reversal in the market, smart acquirers are broadening their due diligence well beyond financial due diligence. They’re considering commercial and operational aspects like end market risks and growth rates, completing deeper competitive, customer, and quality of revenue analyses, and heightening functional, HR, IT, and cyber diligence. Discounting revenue forecasts, testing gross margin assumptions, and reducing cost synergies to adjust for inflation are just a few of the areas buyers are focusing on to create risk-adjusted theses.
Here are some examples of questions you can consider in this process:
- Are there investment trade-offs the target business can, or should, be making regarding spending in sales, R&D, marketing, or other departments?
- Are there quick wins that unlock value in the target business that are quantifiable to an investor?
- Is the total revenue of the target business coming from a relatively small number of clients? If so, do those clients actually represent the market?
- Have you looked closely at their products and determined if there’s a good market fit?
- Are there dis-synergies that need to be added back related to integration in the proforma period?
- Have you conducted proper customer analysis when considering cross-sell, upsell revenue synergies?
- Is gross attrition or churn analysis separated from net attrition rates?
- Are revenue sources accurately classified as recurring, reoccurring, or one-time revenues?
- Have you properly assessed HR, key persons, IT, technical debt, source code, IP, and cyber risks?
- Can traditional price increases still drive value in light of higher inflation?
- How will supply chain and labour challenges limit revenue growth or reduce gross and EBITDA margins?
- Have products, technology platform technical debt, or integration costs been effectively addressed and budgeted for?
Although this is not an exhaustive list, many of these diligence areas were likely not prioritized in M&A playbooks and diligence trackers at the height of deal competition over the past few years. You should prioritize them in investment thesis assumptions, and in base and downside financial modeling and forecasting. These more advanced areas of diligence are becoming increasingly important as overall M&A process maturity extends to mid-market and lower-mid market deals.
Return of Pre & Post-close Integration Planning
In many mid-market deal processes over the last few years, buyers eliminated pre-close integration planning, and limited post-close integration and value creation tracking to achieving cost synergies. Deals with revenue synergies rarely implemented a post-integration plan to meet their often aggressive growth forecasts. Shared service integration items were not prioritized in SLT and board meetings — the focus was more often on overachieving booking forecasts or advancing the next deal.
Many well-understood risk management and governance principles received little attention in monthly and quarterly board meetings as managing growth took centre stage. If HR, IT, and cyber diligence didn’t happen pre-close, they were often not fully ratified due to lack of budgets and attention.
Managers were often too busy fighting fires and managing short-term growing pains to complete diligence requests, or thoughtfully approach synergy achievement and risk management.
Adopt a Mature Approach
Developing a programmatic and scalable M&A methodology that protects the downside should not be reserved for mega deals or mergers of equals. Mid-market and lower-mid market acquirers, whether strategic or financial in nature, will benefit from deeper diligence and adopting a more mature approach to M&A, integration, and equity value creation planning.
For financial sponsors that continue to deploy capital on new platforms and support portfolio companies with M&A, engaging third-party consultants and advisors to help resource deeper due diligence may be the most effective way to protect downside risk. Depending on the maturity and pace of the transaction, strategic acquirers can mature their corporate development function by learning from the collective experience of an M&A advisory firm — ideally one with experience across multiple disciplines, industries, and all aspects of the M&A and value creation cycle.
To learn more about how you can create value through the entire M&A continuum in the current economic environment, contact: