12 Mar How to Justify a Buy-Side Premium in M&A
In a world awash in capital, finding a good deal among savvy sellers aware of today’s premium valuation multiples is beyond difficult. Gone are the days when slick financial engineering and aggressive buy-side sourcing tactics precluded buyers from offering any differentiation in investment mandates. Unlike the LBOs of the 1980s, the pendulum has swung fully the other direction: sellers are now commanding the driver’s seat for valuations, almost to a fault.
Apart from resetting expectations, buyers will need to readjust from traditional strategies to ensure the sustainability of above market returns for their LPs. In the unfortunate, but inevitable commoditization of private equity, there remain a few areas where private equity groups can differentiate to some degree.
Platform vs. Bolt-on
The strategy in acquiring a platform company can differ greatly from a typical bolt-on acquisition. A true platform has typically garnered more scale and notoriety and has other factors that can help mitigate the risks of a consolidation play in a particular sector. That is, such a private equity target deal is likely to include pre-packaged systems and processes for a turnkey business once the acquisition has been made. Ideally such a target would also provide a good basis for bringing in other similar industry players for consolidating the sector.
Bolt-on, add-on and tuck-in acquisitions–on the other hand–present a very different beast for making assessment. While each needs to be considered on a case-by-case basis, most other buys are not only going to be smaller and less significant, they typically also present more risk to the buyer. Harvard Business School Professor Clayton Christensen summed up the acquisition strategy nicely–especially when it comes to differentiation for bolt-on, tuck-in and add-on acquisitions. His claim was that lower risk and lower return acquisitions come from firms looking to boost current performance (he calls these “leverage business model” or LBM acquisitions) among existing companies in a portfolio, while those looking for higher risk and higher return will seek acquisitions that attempt to reinvent the current business model (he calls these “reinvent my business model” or RBM acquisitions) of a platform or existing portfolio company.
Boosting Performance vs. Model Reinvention
It can sometimes be difficult to find a good, growing and disruptive bolt-on acquisition that truly includes a business model that disrupts the current status quo within a large strategic parent in the industry or a private equity platform. Targets that are a good fit often include some type of new breakthrough technology, method, process or intellectual property. However, as previously outlined above, such a target presents a higher risk/return scenario.
Clay Christensen states is well:
If a firm finds itself being commoditized [by a disruptive business model or technology], acquisitions won’t improve the output of its profit formula. In fact, nothing will. Firms in this situation should instead migrate to “where the profits will be”—the point in the value chain that will capture the best margins in the future. Right now, the business models of major pharmaceutical companies are floundering for a host of reasons, including their inability to fill new-product pipelines and the obsolescence of the direct-to-doctor sales model. Industry leaders like Pfizer, GSK, and Merck have tried to boost the output of their troubled business models by buying and integrating the products and pipeline resources of competing drugmakers. But in the wake of such acquisitions, Pfizer’s share price plummeted 40%. A far better strategy would be to focus on the place in the value chain that is becoming decommoditized: the management of clinical trials, which are now an integral part of the drug research process and so a critical capability for pharmaceutical companies. Despite this, most drugmakers have been outsourcing their clinical trials to contract research organizations such as Covance and Quintiles, better positioning those companies in the value chain. Acquiring those organizations, or a disruptive drugmaker like Dr. Reddy’s Laboratories, would help reinvent big pharma’s collapsing business model.
Buyer competition and capital supply has increased (while capital cost has decreased). This has, in turn, created the perfect storm where valuations are up across the board. Regardless of where you stand on how this will play out into the future, it creates psychological barriers toward perceived overpaying when a premium is had for a given business acquisition. The data strongly suggests that the RBM acquisition strategy significantly bolsters shareholder returns in the long-term, enough to justify significant premiums over traditional valuations, particularly among the most disruptive targets. But there is a paradox outlined by Christensen:
Given our assertion that RBM acquisitions most effectively raise the rate of value creation for shareholders, it’s ironic that acquirers typically underpay for those acquisitions and overpay for LBM ones.
The stacks of M&A literature are littered with warnings about paying too much, and for good reason. Many an executive has been caught up in deal fever and paid more for an LBM deal than could be justified by cost synergies. For that kind of deal, it’s crucial to determine the target’s worth by calculating the impact on profits from the acquisition. If an acquirer pays less than that, the stock price will increase, but only to a slightly higher plateau, with a gentle upward slope representing the company’s weighted-average cost of capital, which for most firms is about 8%. In contrast, consider the exhibit “How the Market Rewards Disruptors,” which charts the average earnings multiple of 37 companies we’ve determined to be disruptive in the 10 years after they went public. Annual P/E ratios for this group are far higher than historical levels, leading analysts to believe their shares were overpriced. Yet investors who purchased at the time of the IPO and held the stock for 10 years realized an astounding 46% annual return, indicating that the shares were persistently underpriced, even at these “high” multiples.
By traditional business valuation methods, disruptive companies seem highly overvalued and it can be argued that a strategic buyer looking to make a disruptive investment with above market returns is taking on more risk with an RBM transaction than with an LBM deal. RBM deals are not only more risky by nature, the fact that they should and do command some of the higher premiums further amplifies the fear (and reality) of overpaying.
This paradox psychologically tweaks valuations of RBM deals to look more like this than the previous graph:
Overcoming this paradox is not easy, particularly when you take integration and M&A execution risk into consideration. However, the Pareto Principle (80/20 rule), dictates that the largest gain/return in acquisitions is dictated by a smaller portion of the targets. The trick is not to drink the ethereal “synergy” Kool-Aid by mistaking an LBM deal with an RBM deal, an oft repeated scene played out in middle market M&A deals. The data suggests that premiums are worth it, but knowing when overpaying is not overpaying requires deep expertise and is an area if the world’s most successful CEOs have missed. Disruptive, high-ROI models appear in both platforms and add-ons, but assessing which are truly worth the desired synergy premium remains one of the more difficult pieces to nail in assessing target company acquisition value. The second botch is integration, but that’s a topic for another day.