Making an Acquisition

What if I told you

£4m + £1m = £6m

Accountants like our numbers to add up but sometimes strange things can happen in business and finance. The strange arithmetic above can be the result of an Acquisition.

Imagine there is an SME that is worth £4m that buys a smaller SME that is worth £1m. The value of the combined company might be £6m after acquisition – how can that be?

There are two factors at play that cause the distortion in the numbers.

1. Synergy - There can be value created by merger as the combination allows real synergies in cross selling and better ways of working and combining duplicate tasks both companies do. With the right plan there can be obvious added value that will be realized leading to additional profits after the integration.
2. Less Risk - The larger combined company is also worth more as it is less risky. It has more customers, offers additional services and has a stronger management team. As any potential buyers will value the reduced risk they will apply a higher multiple to the consolidated earnings.
   

Therefore, an acquisition really can create value if the conditions are right in both companies and those driving the deal know what they are doing.

Large Corporates seek acquisitions.

Many FTSE 250 companies will have a team dedicated to M&A activity. They wouldn’t invest in a team unless it makes sense for them to carry out acquisitions.

Private Equity firms invest in sector Roll-ups

Very often Private Equity firms will back a strong management to carry out a “roll up” in their sector. This initiative is purely driven by the realization that the mergers will deliver synergies but the other major interest in the project is that the smaller companies can be bought for a low profit multiple of perhaps three or four. However, the ultimate group might be listed on AIM using a much higher multiple of profit, perhaps ten.

There is potential for the “roll up” to generate high returns through synergies and the higher multiple used to value the larger company.

Large SMEs should consider bolt on acquisitions.

Small companies, with profits under £250k, will not attract the bigger active buyers. Private equity and Venture Capitalists would rarely look at any business that generated less than £1m profit.

Similarly, most of the larger trade buyers, say FTSE 250 companies, will not be interested in smaller deals as they have to satisfy high standards of corporate governance etc. they will have to do significant due diligence before any deal.

The costs of making a transaction are too large to make smaller transactions worthwhile.

They actually say it is a similar amount of work to make an acquisition of a £50m company as it would be for a £5m acquisition. You can see why they are more interested in the bigger deals.

Larger healthy SME’s can benefit significantly from an acquisition.

As a Portfolio FD I have helped my clients make seven acquisitions.

As noted above FTSE 250 companies, Private Equity firms and Venture Capitalists will not be actively looking at small companies.

This gives some interesting opportunities for the larger SMEs to pick up some smaller SMEs and carry out bolt on acquisitions. These can be used to allow companies to expand into related services and expand geographically.

Acquisitions are risky so the acquirer must be in a good position before taking on an acquisition project. For example, I’d suggest the following conditions: -

1. The acquirer’s core business is in good shape and has excess funds available.
2. The acquirer has a strong management team, including an experienced FD.
3. The acquirer has a good understanding of the target’s business.
4. The acquirer can see a clear list of “synergies” from the merger.

Small businesses are often heavily reliant on the owners and don’t have a diversified customer base. They also have a smaller pool of potential buyers. This makes them risky for an acquirer and therefore in any valuation the business will only justify a low multiple of profits.

Often the multiple might be increased to “4” but only if the owners agree to stay in the business for two years post completion in an “earn out”.

Acquisitions can be considered as it should increase the profits of strong SMEs. In the run up to an Exit event for the larger company it can be a good way to boost profit and value.

The acquisition can also be used to strengthen the management team. For example, the owner of the acquired business can sometimes be groomed to lead the MBO that allows the original owner to retire from the business.

Looking for an MBO leader might be a key reason to look for an acquisition.

Acquiring businesses can also require far less cash than may at first seem likely. Quite often the target might have excess cash or assets that can be borrowed against.

The initial payment on completion might only be 60% of the value of the company as the buyer sets up an earn out deal. Also as noted above the owner of the target business might be interested to stay in the company to lead a MBO Exit. In this case part of the deal on completion could be a “share” swap and thereby reducing the cash that the acquirer needs to pay up front.