By Joanne Baginski, partner, EKS&H
After years of record corporate profits and inexpensive credit, the price of nearly all middle-market acquisitions — from manufacturing to technology and healthcare — has soared. For private equity investors, that has made the diligence process more important than ever.
Thanks to favorable macroeconomic conditions and the dry powder available to invest, acquisition multiples are above 2007 levels, before the financial crisis. Companies are being acquired at average multiples of 10.9x EBITDA, compared with 9.7x a decade ago, according to Bain & Co’s Global Private Equity Report.
Economic conditions suggest there will be no slowing in deal prices. Economist Alan Beaulieu, president of ITR Economics, forecasts that the U.S. economy will grow at a pace of 2.5 percent to 3.5 percent annually for the next few years, buoyed by advances in manufacturing, improvements in the energy sector, and strong global economic conditions.
That makes pricing deals correctly critical, especially for PE investors who hope to substantially increase the value of their investments before sales in three to seven years.
Getting due diligence right starts with going beyond the surface metrics and scrutinizing the details that will paint the most complete picture of any company’s future value.
PE investors should consider these six areas, among others, to maximize their return on investment:
- Look deeply at variable costs: A company’s variable costs which one expects to move with sales often reveal significant ways to capture savings and efficiencies. For example, our team recently worked on a deal for a West Coast manufacturing firm that struggled with high distribution costs. Moving its production facility to the Midwest cut the firm’s real estate and labor costs, and significantly reduced nationwide freight both on the procurement of materials and sales sides.
- Look at fixed costs just as closely: Fixed costs such as occupancy can suggest where production facilities might be consolidated to maximize capacity utilization of capital equipment. Such data can also highlight future issues. For example, a company with excess capacity of just 10 percent at its manufacturing facilities may soon need a significant capital infusion if the business is to grow. Likewise, an investor buying several firms may find significant excess capacity that could suggest that one or more manufacturing facilities could be closed to capture significant savings.
- More than customer concentration — understand churn: Understanding a company’s customers reveals a great deal about how vulnerable the business may be to shocks. When a company relies on one customer for 10 percent of either its revenue or profit, it’s a concern, but once that number creeps past 25 percent, it can be a deal breaker. Overreliance on customers in one region or on one particular product also raises concern. Investors should also learn about customer retention to understand how much churn, and risk, there is in future revenue.
- Look at the management team, but also at process: A company that can grow as quickly as private investors expect needs a strong management team as well as strong business processes. Is the firm producing its financial statements timely and accurately? What is the quality of financial and operational reporting? How are prospects and pipeline managed? Are roles and responsibilities and chain of command clearly defined? Is there over-dependence on any key personnel? Any firm without these capabilities in place will need significant investment before the operation can scale for growth.
- Look at the pipeline, and also R&D roadmap: Great companies conduct detailed analysis to make decisions and chart their future growth, whether that’s figuring out where to add new products or how to expand into new markets. PE investors should avoid buying companies where the management team is, figuratively speaking, falling over the finish line. A comprehensive examination of accounts will reveal whether there has been steady investment in such things as research and development and new-product development which can suggest future opportunities.
- Look for a platform and add-ons: Getting the best deal goes beyond merely understanding everything about a great company, but researching the broader market to gauge which firms could be added to the acquired platform company to produce an enterprise that will be more valuable than the sum of its parts. For example, a PE investor could buy a manufacturing firm with $7 million of annual earnings for a 6x multiple and then purchase another three firms each with $1 million in profits for the same multiple. However, once those firms are consolidated with the original platform, the larger operation may command a valuation of 8x earnings — a compelling proposition.
A recent Harvard Business Review article reveals that negotiators tend to bring insufficient discipline to the evaluation of deals, which “in turn, leads bidders to overpay.”
Avoiding that mistake goes beyond just conducting due diligence, but requires a deep understanding of the relevant business sector and some common sense, too. As famed investor Charlie Munger says, “In the corporate world, if you have analysts, due diligence, and no horse sense, you’ve just described hell.”
The good news is that companies that stand up well to the type of scrutiny detailed above are worth premium prices. Whether a middle-market company is in the manufacturing, technology or healthcare sector, the spread on great companies outperforming peers has never been greater and can be as much as 2x EBITDA.
With that much at stake, for private equity investors forensic accounting is crucial.
Joanne Baginski is a partner with EKS&H and leads the firm’s Transaction Advisory Services area, overseeing buy-side due diligence, sell-side transition planning, business valuation, financial planning and analysis, and post-close integration services. Joanne works with a wide variety of clients, including private equity, closely held, and public companies and is passionate about helping business owners and executives achieve success through the best possible merger and acquisition strategies. Reach Joanne at [email protected].
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