The ins and outs of mergers and acquisitions

If recessions have upsides, one must be that successful companies have learned to be more disciplined in their financial management. Some will have built cash reserves that enable them to leapfrog the competition and grow through merger or acquisition.

According to research from asset-based lender ABN AMRO Commercial Finance, 47% of UK SMEs are holding cash reserves that exceed their working capital requirements. This is money that could be invested in people or technology, or go towards executing a well-conceived deal.

The right time

However, many of these companies are showing some reluctance at the notion of investing. The study found 45% arguing that economic conditions are too uncertain for them to invest in growth.

Richard Feltham, corporate finance partner with Leeds accountants Garbutt & Elliott, says deal activity is undeniably still down. He believes that many of the owner-managed businesses he sees are focused on improvement and restructuring. They are also conscious of the perception that M&A (mergers and acquisitions) handled poorly can destroy shareholder value and consequently see deals as risky.

The flipside, however, is that now is a very good time for cash-rich businesses to merge or acquire another player. Deal values are still down and there are plenty of owner-managers ready to retire.

A good match

For growth businesses, geographical expansion heads the list of reasons to acquire or match. Richard has seen Leeds-based businesses successfully take on market share by acquiring competitors in the Midlands. “A target company with an attractive customer base that the acquirer believes they can leverage with their own products or services would be another good match,” he says. “Over 2010 and 2011, builder Travis Perkins improved market share and profitability by acquiring small distributors and building merchants, for instance.”

“Other deals come about simply because the numbers stack up. A customer base that can be rationalised, increased buying power – these deal features can increase margins and profitability providing the post-deal integration is well-managed.”

A less frequent driver, but an attractive one for M&A nonetheless, is the possibility of acquiring new people. “A strong management team that would assist in taking the buyer forward can be the basis for a deal,” Richard says.

Then there is vertical integration. Buying a distributor or supplier gives access to that company’s supply margin. Richard highlights the fact that these kinds of deals can also bring intellectual property value, for example, in the form of manufacturing rights. Taking on more debt in the short-term to fund this kind of investment could be beneficial to the smaller entrepreneurial business, making it more attractive for a sale further down the line.

Reasons to back away

“Businesses that are over-reliant on one customer or a small group of customers should not make the buyer’s short list,” says Richard. “Target companies should also be scrutinised for issues such as poor management, declining margins, lack of intellectual property protection or too much focus on hard-pressed markets, such as the public sector or the consumer market. Niche businesses – perhaps in technological or science markets like pharmaceutical or aerospace – are more likely to have growth markets currently,” he says.

Due diligence

Due diligence falls under four main headings: financial, commercial, legal and management.

Financial due diligence is all about making sure the company’s performance is verifiable and the exercise should identify trends in product margins, underlying profitability and financial risks. It should also uncover any tax issues or other longstanding liabilities.

Commercial due diligence is typically carried out by owner-managers themselves and, as a minimum, should include talking to customers as well as probing existing relationships and contracts to ensure they are locked into the business and not dependent on an individual who may be looking to exit. The exercise should also assess whether key people are tied into the business.

Legal due diligence involves a thorough look at employment and property contracts. It should assess any claims against the company as well as its insurance position.

Management due diligence is an assessment of capability and fit, not just for the existing businesses but for the combined entity.

“Where you have two teams coming together, you will need to assess whether the culture is going to work,” says Richard.

“The significance of this is frequently overlooked. Essentially, you are scaling up, so you are going to have greater management challenges.”

Due diligence should be properly resourced and thorough. Richard believes that problems typically arise where you don’t act early enough. For example, if you don’t talk to customers early enough or you proceed on the assumption that a particular contract is watertight. “It’s a contradiction, but sometimes sellers can be very careful with the information they hold and don’t always readily provide access to details of the commercial aspects of the customer base.”

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John Carroll - Helping businesses achieve International success. Head of Product Management & International Business, Santander UK