Iain Campbell is a director of FC Corporate Finance, a mergers and acquisitions boutique specialising in the IT channel industry.
This is the first of a series of articles I have written based on my experience of making acquisitions in the IT channel industry. Today I am looking at acquisition target selection, ie how do you put together a list of target companies for your acquisitions programme and how do you prioritise them in terms of which ones are best? There are a lot of factors in the mix here – it will be at least as much about your company’s profile as that of the potential target.
How important are acquisitions to your corporate strategy?
It could be that acquisitions are vital. There is a big private equity presence in the IT channel in the UK and it’s becoming more prevalent. PE-backed companies as well as many of their listed counterparts are likely to be expected to deliver a continuous programme of acquisitive growth to drive shareholder value. But depending on your acquisitive growth strategy, responding to this pressure to acquire will be more difficult the narrower you specify your criteria. I cut my teeth in buy-side M&A in the passenger transport sector in the 1990’s as a director of an acquisitive, PE-backed bus and train operator, at a time when the whole bus industry in the UK was consolidating and we were one of six or seven companies buying everything we could. At one point, our chairman decided that our acquisition strategy was that we would acquire the dominant bus operator in Cambridge. I made multiple approaches to them over a period of six months, nine months or more, but they weren’t interested in even speaking to us. (In fact they eventually told us firmly where to go.) Not long afterwards, they sold to Stagecoach plc. For whatever reason they didn’t want us in their process. We wasted a whole load of time and limited M&A resource pursuing too narrow a strategy whilst other companies that would have still fitted very well were snapped up by the competition. I do see this point a lot with clients. If you want acquisitions to happen, you need to concentrate on what’s there to be had, and that may mean you have to look at stuff that is a less obvious fit and, as I shall come on to, riskier. Fortunately, the IT channel is a broad church there’s plenty of businesses available or potentially available to acquire if you go looking and your criteria are adaptable.
Sector and activity alignment.
Successive studies over the years I have been doing this have highlighted the staggering extent to which corporate acquisitions are unsuccessful. (Where lack of success is usually defined as where the acquiring company subsequently believes that the objectives of the acquisition were substantially not met and/or management regret the acquisition and wouldn’t do it if they had their time again.) The failure rate is usually recorded as at least two-thirds and in 2019 Harvard Business Review measured it as high as 70% to 90%. The recurring theme in the studies and something that’s been borne out too many times in my own experience is that the further away the business profile of the target is from the acquiror, the greater the risk – a curve that really does rise quite sharply. If a UK company whose sole business is manufacturing flux capacitors in red in the UK acquires another UK company that manufactures flux capacitors in the UK in red then that should be very low risk. If the flux capacitors are green, then risk is starting to come in. If the target is in Europe and it is fitting green flux capacitors rather than manufacturing them then… you get the idea. In terms of the IT channel, these issues abound. Even if you take vertical integration out of the equation (again, I will come back to that), there’s a whole range of different things on each level of the channel. The mix between product, services and value-add varies widely across the channel and even within that the nature of services offered and how they are procured and delivered is virtually unique to each company in my experience. Then there are sub-sectors like MSP, cyber, all different shapes of integrators. The risk isn’t just that you might not understand the drivers of the business and the factors that will drive its success in the future – you might be fundamentally misunderstanding the numbers and information you are being given in target evaluation and due diligence. You might have decent M&A resource at your disposal and be confident you know what you are doing, only to find afterwards you didn’t really. No matter how much pressure you are under to deliver acquisitions, avoiding a mess will be much, much better than clearing one up afterwards.
I mentioned vertical integration. In the IT channel, we generally don’t do this. The reasons should be obvious to anyone who gets why the channel exists in the first place though I have found it surprising how many players in the corporate finance community don’t seem to. If your target list includes your customers or your suppliers you are almost certainly doing it wrong.
Size and stage of development
Size does matter in the M&A game. If you have serious traction going in an acquisitions programme then small stuff that isn’t going to shift the dial in terms of earnings contribution will usually be a waste of scarce execution resource. It is also in my experience much more likely to bring problems – like unsophisticated and unrealistic seller valuation expectations (often created or acquiesced in by unsophisticated and unrealistic advisers), due diligence and deal structuring issues, dogged resistance to boilerplate sale and purchase documentation (I’ve had a good few fall over at the end because of that) and major systems and financial control issues that have to be sorted out in integration. If you’re going to go for something small then there has to be a good reason. Maybe it’s something very niche that’s a particularly good fit for what you need or where you see the market going. Or maybe it’s the only opportunity available in a particular geography. All of that’s OK but remember if you do it you are still very likely to have more problems getting the deal over the line and then integrating it than you would have had with something bigger and more developed.
That’s size, so what about stage of development? Generally speaking, you would expect a business to get more structured, systemised and professionalised the bigger it gets, but in my experience the curve isn’t linear. There are some small businesses that have a professional, big-business feel (usually because the founder(s) came from that background) and very many owner-managed businesses that get to be really quite sizeable without worrying very much at all about corporate governance, risk management and financial control and that have horrendous legacy systems that have mutated over the years. I’ve seen many such OMB’s that have achieved fantastic growth and decent critical mass despite or because of the owners running them their own way. Unless it’s a rare-these-days family succession situation, or an also-rare-these-days genuine management buyout, the only viable exit route for these type of business owners when the time comes is a trade sale to a direct competitor or someone closely aligned to the business activity. There is some fantastic value-for-money in these retirement sale deals, but you need to understand and have a plan for what you are taking on, including a plan for what will happen when the vendors leave, which they almost certainly will, probably early on, even if everyone’s intention is otherwise.
Geography
Going off your patch geographically is up there with going out of your industry space in terms of the highest risk of failure or serious problems. It’s something you should only be looking to do if you have good reason – either because you need to have international, pan-European or whatever presence to satisfy your vendors, customers or investors, or because you have run out of decent-sized similar businesses to buy on your own patch and going further afield to find the right type of business is preferable to buying business in an unfamiliar space on your own patch. I’ve done a lot of M&A and related stuff in Europe and the Middle East and it has been vastly more challenging that doing deals at home. You are going to need some local professional advisers to help you. This is a challenge. My experience is that, even if you go branded and expensive, you may end up battling as much with your own team as you do with the other side.
Europe is friendly in one sense from our legacy EU days in that there are few barriers to M&A and good transparency, but their corporate law (with its codified civil law approach) is something that takes a lot of getting used to and, I find, painfully slow and inflexible in terms of finding solutions to the issues that always come up trying to get deals over the line. Also, my experience is that the modern way we do structured/leveraged M&A deals in the UK is something the mid-market advisers in Europe haven’t grasped yet and you will spend a whole load of time explaining and arguing about stuff we do every day over here.
The US legal system and business culture are much more similar to ours of course, and much of the way we structure and fund M&A deals we adapted from theirs, so in theory there are advantages over Europe. US acquisitions certainly represent a large chunk of outbound M&A by UK companies measured by total deal value but that is driven by deals at the largest end in terms of size. For me there are entry barriers that, absent a very compelling strategic reason, make it unattractive for mid-market acquisitions. It’s very far away, for one thing. The legal and regulatory system, although based on similar principles to ours, incorporates onerous over-regulation and exposure to draconian liabilities and for me, given the US’s standing in the world economy, it’s remarkably protectionist and hostile to foreign businesses. Over the years I have looked at a good few UK-based acquisition targets that we have had to say no to because they had spoiled a perfectly good business by expanding into the US (usually for vanity reasons) and creating all sorts of problems I didn’t fancy me or my clients having to try to clear up.
There are many other aspects of international acquisitions I could write about but there’s only space briefly to mention a few more:
Business culture: As soon as you go east of Kent, it’s very different and varied. Buying a business with a view to changing and integrating it is always a major challenge, particularly if the founders/sellers are still around in the immediate aftermath (which is why so many acquisitions fail). Resistance within the target to this process will be significantly harder to manage if you just don’t understand where each other is coming from. The “them and us” perception you have to overcome in integration will be much harder if it’s set in a culture-war background. Anyone who has done much acquisition integration will know how much target management tell you about how you don’t understand the business, and that the things you want to are not possible or won’t work. This is an even bigger issue when you go cross-border.
Language: Beware the “everyone speaks English” trap. My experience in the IT channel overseas is that lots of people do speak English and 95%-plus of key contracts are in English. But what language do the target’s IT systems speak? What about other key parties (like the guy who wrote and maintains that key piece of bespoke software)? What about stuff that has to be done in the local language? (Like tax filing, data protection compliance or, in France, everything.) Your due diligence, integration and management teams need to factor these issues in and have a plan how to deal with them.
Travel: You’ve got to do a lot of it to integrate acquisitions. I think if I had any doubt about that, Covid proved it. Quite likely a good few of your team will have to travel regularly to the target at some stage. Before you get too far in, look at the end-to-end journey time and costs. For an IT channel business you are likely to find, for example, that this issue will render Scandinavia unattractive because although the people and the culture are a good fit and it’s really close on a map, it’s too sparsely populated and spread out to be all that attractive a market, the travel is expensive and if you aren’t right next to the right airport at both ends it takes ages to get there.
Revenue profile
This is another one that could be a lengthy article in itself. To some extent, the revenue profile of the target in terms of hardware/software/services split, margins, net revenue retention rate, proportion of contractually recurring revenue will be inherent in the type of business it is and will flow from the “sector and activity alignment” stuff I addressed above. However, there may well be sub-sets within your target sectors where different revenue models operate and this may colour your choice of target and impact your planning and deal structuring. In my time doing deals in the IT channel industry (and looking at loads of others we didn’t do) I have been struck by the premium so many people ascribe (in terms of acquisition target attractiveness and valuation) to contractually recurring income. I’m not sure where that came from. If you are very risk-averse then I would say that shareholder value creation through M&A strategy and execution probably isn’t for you. Depending on your risk appetite, for me you have to chase the value. In the IT channel, corporate sellers and their advisors do in my experience tend to focus value perception on contractually recurring income, and the private equity players want that and good growth too (though they are often to a degree mutually exclusive). For me, the best value usually lies elsewhere – good or excellent growth and good or excellent non-contractual net revenue retention, but at a fraction of the price. It doesn’t matter if you are buying a company or something else – the most expensive option that everyone aspires to will very rarely be the best value for money.
Vendor commitment to the sale
I hesitate to compare the sale of a mid-market sized company with residential real estate sales, but one of the things that has always struck me over the years is that business owners sometimes put their companies on the market (or entertain an approach from an acquiror or intermediary) when they don’t really have any firm intention of selling them. Just like your house, it’s like they get a warm rosy feeling getting confirmation that if they ever wanted to sell their prized asset they could do so and what the offers would be. This isn’t to deny, of course, that there are time-waster company buyers too, but they are easier to spot (usually by their absence of funding and/or track record) and avoid.
If you have an acquisition programme going and you are acquiring owner-managed businesses, you need to watch out for the non-committed vendor. Most OMB owners only sell a business once so they go into a process (whether initiated by them or by an approach from someone else) not knowing what’s involved. It doesn’t help that there are plenty of sell-side advisers out there who don’t seem to attach much importance to taking the client through the process at the outset and making sure he/she understands it and is committed to it. Or perhaps they just don’t care. Either way there are plenty of vendors out there who get into a sale process unprepared for what’s involved.
Why does this matter? Well, there are going to be things happening that the vendor isn’t going to like, for example:
- There are plenty of unrealistic price aspirations around in the OMB space. In the IT channel these often sit around the extent to which earnings quality (and therefore the valuation multiple) is enhanced by the presence of recurring income. If you are the prospective acquiror you are going to have to make sure you get on the same page on valuation before you get too far into the process and that the vendor really does agree that the price is right;
- The due diligence process is going to be highly time-consuming and intrusive; and
- The share purchase documentation is going to contain all sorts of stuff that is alien to the vendor and looks like it’s horrendously onerous. It won’t help that their lawyer will inevitably tell them it is horrendously onerous and they should on no account sign it, even though the lawyer probably knows it’s just normal. (After all these years I still don’t get why they do that.) If it’s a deal in Europe, this issue will probably descend to the farcical.
In mid-market deals there are almost never going to be any kind of break fee arrangements – I’ve certainly never seen them – so you have no meaningful protection against the other side pulling out of the deal. This will be particularly harmful if it comes at or towards the end of the process after you have expended lots of scarce execution resource and professional fees. Plus, of course, the opportunity cost of not doing some other deal that you could have got over the line. Here’s some tips to try to avoid this:
- Suss out the vendor(s). If it’s just one person, or mostly just one person, and it’s a person who, having built a successful business, thinks he/she knows everything there possibly is to about every subject and/or can become an expert in the intricacies of transnational M&A through 30 minutes googling (and both such beasts do exist in in my experience) that spells trouble. Try to test their understanding of what’s going to happen. It might be best just to pass if you don’t get a good feeling;
- Suss out the advisors. In my experience all accountants think they know about corporate finance. (Like it’s not a real skill, just something that you get from being an accountant.) And most legal firms say they can do M&A even though they may not have proper experience at the right level. If they don’t have advisers or good advisers, suggest tactfully that they get good ones. It is better to have the price talked up slightly by the vendor’s good advisers than have the deal fall over because of the vendor’s bad advisers;
- Be more careful to assess vendor commitment if the discussions result from your unsolicited approach rather that from a properly planned and executed sales process via a full-service adviser (rather than a broker);
- Consider carefully the reasons for sale. If the reason for sale is “the vendors feel the company would benefit in the next stage of its development by a move to new ownership” or any such similar rubbish, then try to establish and evaluate the real reason. On the other hand, if vendor is in his/her nineties and has serious health problems then you probably have a committed vendor;
- Beware extra vigilant as to vendor commitment in earnout/deferred consideration deals. The best way to deal with vendor resistance to contractual terms in finalising the share purchase documentation as completion nears (whether attributable to the vendors or their advisers) is to dangle the large cheque that they could have next week but won’t be getting if you don’t resolve the impasse. If all or most of the money is deferred into the future, that tactic isn’t available and the vendor is always more likely to pull out;
- In the IT channel, a really challenging issue I see all the time is vendor and customer concentration. Over-dependence on one or a small number of either means that a business that might have fantastic profitability and growth is highly vulnerable to the loss of a vendor or customer account or, more likely, the renegotiation of the relationship, for example after the vendor or customer has been acquired by private equity. Often this can be an issue to an extent that if something happens to the key relationship post-completion, it could decimate shareholder value and even, in an extreme case, threaten the viability of the acquired business. The options you have as a buyer in a deal structure to protect yourself post-completion if the worst happens will be so unpalatable to the vendors that even if they initially seem to agree the principle, they may well change their mind before you get the deal over the line. If the vendors’ advisers aren’t experienced in IT channel deals – and by that I mean the actual team advising the vendor is experienced, not someone else in a big firm – then they may not appreciate how concentration risk affects valuation and deal structure and may have conditioned their client to highly unrealistic expectations based on comparables to different businesses that have good vendor/customer spreads. I honestly see this quite a lot – you would be surprised. Based on my experiences, lately I have been taking the view that if there is a big concentration risk just say no and move into the next opportunity. If they don’t then try hard to persuade you not to say no then that’s telling you the answer?
Fundability
I will conclude this instalment with a brief mention of a factor which is unlikely to be particularly important if you are a large acquisitive company with plenty of debt and equity funding already available for your M&A programme but is vital if you are just starting out and have no funding arranged yet. How are you going to fund an acquisition? You are probably too small for venture capital/private equity and anyway it’s too slow and probably too expensive. At this end of the market, there’s a lot to be gained by focussing on what you can fund with debt (maybe mixed with vendor equity). Businesses that have a high inventory requirement are generally unattractive as almost no lender will want to fund that these days. If there is too much existing debt in the business then there will be no debt capacity left to leverage the target balance sheet. If there’s virtually nothing on the balance sheet at all (say it’s a subscription software/SaaS-based MSP that gets paid monthly) then maybe you can’t get any debt in at all and it’s going to be very difficult getting an acquisitions programme going unless you focus on a different profile of business. If, instead, you find the right profile of business to acquire then, to the extent there is equity-type risk, you can get others to take most or all or most of it while you get the equity return. Old-fashioned M&A shareholder value creation but it still works.
This article is part of a series focussing on aspects of acquiring businesses in the IT channel industry. If you would like to explore any aspects further, please get in touch.
FC Corporate Finance Limited
Iain Campbell (Director) – email ic@fccorporatefinance.com
Ben Brierley (Director) – email bb@fccorporatefinance.com
FC Corporate Finance Limited is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants of Scotland. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.