How to spot great acquirers
Archived article: please remember tax and investment rules and circumstances can change over time. This article reflects our views at the time of publication.
Good acquisitions can be a great way for companies to create value. Conversely, bad deals can easily destroy value, and bring huge risks to boot.
How can you tell the difference?
In my experience, the best acquirers tend to follow a common playbook.
The best acquirers’ playbook
► Acquire well and regularly
Acquirers with a proven track record are more likely to acquire well in the future, in my view. They usually have a well-trodden acquisition framework and have seen what works and what doesn’t.
A business with little to no experience of acquiring doesn’t have that benefit, and its people probably won’t be used to bringing new companies on board. If a business like this decides to acquire, it significantly increases the risks to investors.
► Go for bolt-ons rather than transformational deals
As a general rule, the more significant the acquisition, the riskier it’s likely to be.
‘Transformational deals’ make me especially nervous. They often entail major upheaval to customers and employees – and bring considerable integration risks.
The $165 billion mega-merger of AOL and Time Warner in 2001 is a prime example. Combining AOL’s internet capabilities with Time Warner’s media content was supposed to create a new age media model. It was indeed transformative, but for all the wrong reasons. Not only did none of the intended benefits materialise, but the transition from dial-up services to broadband meant that by 2002, the company had reported a loss of $99 billion. A year later, amidst internal chaos and infighting, “AOL” was dropped from its name entirely.
Smaller, bolt-on acquisitions can usually be assimilated more easily and with less impact on the rest of the business. If they do go wrong, the risk is more likely to be contained. They are also less likely to take the acquirer away from its core area of expertise.
► Choose sellers carefully
I’m generally wary of businesses that acquire from private equity sellers. Information on the target is usually limited and it will have often been ‘dressed up’ for sale. In addition, the acquisition process will normally involve a ‘beauty parade’ of potential buyers, culminating in an auction to the highest bid. This is not conducive to bargains.
Nor am I a great fan of companies acquiring other publicly listed businesses. These acquisitions usually require paying a substantial premium to the prevailing share price to convince existing shareholders to sell.
There is a third and much better way to acquire, in my view. This is by direct negotiation with private, preferably family-run businesses.
Many of the acquirers I respect most have mastered this approach. They nurture relationships with founders over many years and avoid expensive auctions and public premiums.
What’s more, because these companies are illiquid and often not well known, acquisition multiples are generally much lower. Often, valuation isn’t the biggest factor family businesses care about when selling. Promising to keep valued employees on – or enabling the founder to continue running the business with minimal interference – may be much more important. This allows a deal to be struck that suits all parties.
► Do deals for good businesses
A question I always ask is: does this deal enhance the overall quality of the acquiring business? If yes, I’m much more likely to support it, even if the company has to pay up.
Diploma is a specialist industrial distributor that has used acquisitions to enhance the quality of its business, in my view. In 2020 it made the largest acquisition in its history, paying £357 million for Windy City Wire. Windy City complements Diploma’s Controls division, supplying low voltage wiring and cable products to high-growth end-markets, like building automation and data centres in the US. This acquisition has opened up significant new growth opportunities.
On the other hand, if a business is acquiring a lower-quality company in the hope of turning it around, I get nervous.
‘Turnarounds’ are nearly always harder to pull off in practice than they are in theory, and tend to bring unexpected risks. Reckitt Benckiser’s £13 billion acquisition of Mead Johnson in 2017 springs to mind. Reckitt thought it could fix the serially underperforming baby formula company. It couldn’t. Within four years, Reckitt had written off £10 billion of value associated with the deal.
► Execute acquisitions from a position of strength
Businesses frequently believe, rightly or wrongly, that they have to acquire to respond to industry changes or evolving competitive dynamics. Deals like this are usually done from a position of weakness rather than strength – and are more likely to destroy value.
US tobacco giant Altria’s $13 billion investment in vaping-company Juul, in 2018, is an example. The deal was a response to the shift from traditional cigarettes to reduced-harm alternatives. The investment has lost most of its value, as the vaping regulatory landscape shifted rapidly.
Businesses that don’t feel pressured to acquire are much more likely to be successful when they do. They can wait patiently for the right opportunity and only acquire when it makes great financial sense.
► Favour a decentralised business model
With the odd exception, I favour acquirers with decentralised business models. This means acquired businesses are kept largely independent, rather than being tightly integrated.
This approach has several benefits, in my view. It allows the acquired entity to continue doing what made it successful, with no interference or distractions. It should significantly lower integration risk and allow the existing culture to be maintained, while minimising loss of customers and staff. A decentralised business model can also help attract talented business owners, by offering autonomy and independence.
Compare this to a business that must be fully merged and integrated. The challenge of combining IT systems and meshing two distinct cultures is often considerable. At the very least it’s likely to cause a period of disruption for both businesses, and at worst an exodus of talent and impaired customer relationships.
The failed merger of car giants Daimler and Chrysler is a prime example of what can go wrong in integrations like this. It looked sensible on paper, but the cultures were very different. Chrysler believed in empowering employees and wasn’t overly hierarchical; Daimler-Benz was much more bureaucratic and authoritarian. Ultimately, this clash of cultures proved insurmountable.
► Generate strong returns on capital
The simplest way to judge a company’s acquisition credentials, in my view, is to look at its return on capital over time (profit divided by capital employed (total assets minus current liabilities). This informs you of the returns a company is making on its investments, including acquisitions.
Put simply, good acquirers tend to have a high and stable return on capital (at least in the low teens), whereas poor acquirers usually have low and/or declining returns on capital.
A high return on capital is achieved by paying relatively low valuations for acquisition targets, and/or improving acquired businesses (creating a 2+2=5 situation). The best acquirers often achieve both.
Lifco, the Swedish serial acquirer, is one of the more impressive acquirers I’ve come across. It typically pays a modest single-digit multiple of operating profit for companies. Post-acquisition, it provides support and guidance, usually helping the acquired business increase profitability. This, combined with the low acquisition multiples, means Lifco is consistently earning around a 20% return on capital.
Poor acquirers tend to pay high acquisition multiples and often overestimate their ability to improve acquired businesses. Alliance Pharma, the buy-and-build pharmaceutical group, has fallen into this trap, in my view. In 2015 it acquired Sinclair’s healthcare products business for £130 million, paying 26x operating profit. This caused its return on capital to fall significantly, and although it has recovered somewhat, it still remains below 10%.
Alliance Pharma vs. Lifco – return on capital employed (%)
In a nutshell
Putting all this together, I believe the best acquirers tend to:
- Acquire regularly with a proven track record
- Go for bolt-on acquisitions, often within a decentralised organisational structure
- Favour direct negotiation with private sellers and avoid auctions
- Buy already strong businesses and typically improve them further
- Execute from a position of strength, with the aim of optimising returns on capital
My watchlist is brimming with companies that do just this, and I expect several to feature in my portfolio at launch.
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