Acquisition Risks: That Company May Be Good to Own, but Tough to Buy

A Thorough Acquisition Risk Assessment Can Help Avoid Buyer’s Remorse

Sometimes what feels like a once-in-a-lifetime deal can be less lucrative than you thought after weighing the acquisition risks. Acquiring a company may increase customer base or cash flow, but its labor dynamics or opportunities for new markets may not justify the risk of purchase, leading to potential buyer’s remorse.

Take this example:

At a client’s board meeting, we were evaluating making a bid on a rival business worth $100 million. Our management had spent years positioning itself for the opportunity to obtain this business, and now that acquisition was finally upon us. Even though it was an extremely large transaction for the buyer, the bank was prepared to provide financing, thanks to a strong relationship. The transaction would catapult this second-generation business into a higher league. The younger generation was itching for growth. It would be a defining moment for the business.

The natural growth rate of the industry is slightly less than gross domestic product (GDP). The industry is filled with cash cows, but not many shooting stars. It is heavily regulated, and the regulations vary by state, so this was the only attractive target adjacent to the core market, which should allow for economies of scale by combining operations.

What We Found in the Acquisition Due Diligence Process

Our due diligence process revealed material differences in how we ran the same type of business. Labor utilization, management depth and compensation methods were all contrasting. Their differences made for a much more profitable business. But, we also knew that the seller had a reputation for being a substandard place to work, and it was unclear what employment law risks they were taking in order to obtain better financial performance.

But a successful acquisition and integration would produce a dominant market force and significant cash flows for the owners. There would not be another opportunity like this in the buyer’s core market, likely in their lifetime.

How Do We Pay for This? And Should We?

Everyone was enthusiastic about the opportunity until I raised the unexpected question: “What is the internal rate of return (IRR), and how are we going to pay for it?”

The excitement of the opportunity, coupled with the fact that we could fund the acquisition, caused people to forget two basic, but very important, questions: How would we get our money back, plus a profit, for taking the risk? And, how much profit was required to justify the risk? After all, an acquisition of this size effectively bets the company on a single decision, with no way to back out.

When evaluating how we’d get our money back, the acquisition risks became clear. Buying this company was really about buying cash flows and customers, since there weren’t many other ways to guarantee a return:

• It would not take the buyer into new products, new markets or complementary industries.
• The target was already lean, so there were limited cost reduction opportunities.
• The growth rates were nominal, so we could not rely on growth to generate IRR.
• Financial engineering would help, but the buyer did not want too much leverage, since they had experienced severe downturns in the industry in the past.

With these challenges, how else do you pay for an acquisition?

The math just didn’t work. Even though it would be a great business to own, and the financing was available, the deal was underwater. It was a classic case of being a good business to own, but a tough business to buy. Acquisitions can be exciting, but that doesn’t mean they should be executed. Sometimes choosing not to act is the right decision, though inaction may feel less satisfying in the moment.

Questions to Ask In Your Acquisition Risk Assessment

Even if your company has spent years weighing its options as to whether or not to acquire what your managers believe (and hope) to be a lucrative deal, there may still be questions to answer before purchasing. The bigger the price tag, scale and complexity of a deal, the greater need for careful reflection. There may be contrasting methods where the management, compensation and/or labor is concerned, and these contrasts are not to be taken lightly. Before signing on the dotted line, raise the questions:

• What is the IRR?
• How do we pay for it?
• How will we get our money back, plus risk?
• Is the risk too great?
• How much profit is necessary to justify the risk?

If the higher-ups in your company can agree that the acquisition risks are worth it, and everyone draws the same conclusions from the complete data, then congratulations! You have yourself a brand new company. If not, you will most likely be glad you asked the questions you did, subsequently saving yourself a lot of money, time and heartache. The dissatisfaction of choosing not to do a deal is a far better outcome than buyer’s remorse.

[ Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars: Negotiating an M&A Deal and Structuring and Planning the M&A Transaction. This is an updated version of an article originally published on May 1, 2019.]

©All Rights Reserved. July, 2021. DailyDAC TM, LLC d/b/a/ Financial Poise TM

Originally published at https://www.financialpoise.com on July 7, 2021.