This is CFO Secrets. The weekly newsletter that puts the ‘fine’ in finance.

5 Minute Read Time

In Today’s Email:

• 🍖 Putting the meat on M&A Theory

• 😡 PwC payroll pantomime

• 🤮 The EBITDA of ESG?!

THE DEEP DIVE

Unlocking Value Through M&A: How to Succeed Where Most Fail

This is week 1 in an 8 week season covering the world of M&A from the seat of the CFO

"They are time wasters. Throw them out of the process."

I was in an argument with the MD of Global Investment Bank™️. Let's call him Andrew.

Andrew was running a divestiture for us. We’d received round one bids. The debate was whether we should let this one party into the second round or not.

We’d already decided to keep the two highest bidders in. We ruled out the third bidder.

The debate was on the forth highest bidder.

They'd put in a low ball offer. 20% lower than even the third bidder, who we had just dismissed.

Andrew was adamant we leave them in the process. It made no sense to me.

Andrew made his case:

"Forget the bid. This is Round 1. They are the correct owner for this business. There is no organization in the world that makes more sense as a buyer for the business than they do.

They just haven’t realized it yet. Which means we haven’t done a good enough job of showing them. They are smart, rational, and well funded. I’m confident they will be at the top of the pile at the end of the process."

Well... he’s the expert. I deferred to Andrew. I told him that if he was wrong he could kiss his discretionary fee goodbye.

He accepted the terms, putting $500k of his fee structure at risk.

Fair enough ... he is serious about this, I thought.

What followed was a masterclass.

Andrew reversed engineered every bit of valuation math behind the derisory offer. He used his relationships, reputation and experience, to build a total picture of the bid. All without ever seeing their model.

He had his team rebuild the model bottom up, to get back to their bid. He established the core issue being their revenue growth assumption was undercalled. And the accompanying marketing cost was too high (even for a lower level of growth).

He needed to prove to the bidder they had got these crucial assumptions wrong. Through a piece of vendor side commercial due diligence he was able to convince them of the mistake.

After some to-ing and fro-ing the party increased their bid by 30%. The other two bidders reduced their offers through the same stage of the process

The bidder I wanted to cut ended up winning the auction by 15%. Andrew's faith and skill had been worth tens of millions of dollars for our shareholders. He got his $500k, and my future loyalty.

He is still the first call I make for any M&A.

Some bidders start high and then chip. Some work the other way, building up their confidence in their valuation basis.

Andrew had seen through the noise, and predicted a rational outcome to the auction. That the best suited buyer, with the right funding should win the process. And if they should … it was his job to make sure they did.

He had picked the signal from the noise…

This week, we will discuss M&A from first principles.

Exactly as Andrew approached it that day.

Let’s start with the firstest of all the first principles:

Why do we need M&A?

M&A is necessary in order for a business to find its best possible owner.

The best owner is the one who is able to capture most value from a business or asset.

In theory the party able to capture the most value, is the one who should justify the highest price, but still earn their return.

It was this principle that drove Andrew to his belief that he could force the underbidder up through the next round of the M&A process.

What does captured value mean?

Captured Value = (Current Value + Value Creation) * (1 - Value Leakage Ratio)

Value Creation = Synergies (much more to come on those)

Value Leakage = Inefficiencies, poor execution, financial costs

Consider this example:

Potential Owner 1 creates more value, due to a higher synergy rate, but sees more leakage.

Potential Owner 2 captures more value (bigger dark red bubble). This is despite having less total value creation

In this example, you would expect Owner 2 to win the process, as they have the ability to pay more.

Minimizing value leakage is the essence of the private equity model (also known as ‘sponsors’).

Sponsors create a competitive advantage through improved value capture. They are wizards with the balance sheet and below EBITDA in the Income Statement.

Meanwhile they are competing with ‘strategic’ buyers who have greater value creation potential. The magic of good strategic buyers comes from what they can do above EBITDA in the income statement.

The very best buyers do both of course.

What is value?

We will be discussing valuation in great detail next week.

For these purposes we can think of value as the strength, certainty and timing of future cashflows.

When we dive into the due diligence process, it’s essence is the validation of those cashflows assumptions.

Does M&A Work?

In 2021 global M&A value was over $5.7tn. So something must be right.

But 70-90% of M&A deals are abject failures (according to Harvard Business School).

Think about that.

We spent the first part of this piece talking about value creation.

But 40,000 or so of the 50,000 deals done every year DESTROY shareholder value.

That leaves management and Boards with an awful lot to explain.

Why does M&A fail?

At it's core, for one of the following reasons:

1. Wrong Target; Bad fit, poor strategic rationale.

2. Wrong Deal; Overpaying, poor diligence, wrong timing, bad advice, poor contractual protections

3. Wrong Execution; Bad integration, unrealized synergies, cultural issues, blow back into core business.

How do management get it so wrong?

This is the important question.

My experience is that most bad M&A goes wrong somewhere between the deal and execution.

Often it manifests as poor execution or integration.

But maybe those execution issues were inevitable, and therefore it was the target or price that was wrong?

Does it even matter?

Brent Beshore said all “businesses are loosely functioning disasters that sometimes make a profit."

This might be the most accurate description of business I’ve heard.

At the heart of businesses, even huge mega corps, are a small number of fallible human beings. (Elon anyone?)

M&A decision making is twisted up in agency issues, conflicts and biases.

It’s why Boards have such an important role to play.

Execs know their pay check and status gets linked to the size and complexity of the business they run. Buying a business increases size and complexity.

Then there is the ego CEO who believes they have the midas touch.

Newsflash. 90% of the time it’s way harder to fix a business than you imagine it will be from the outside. Heckling from the cheap seats is easy.

Operating is brutal, and executing well is tough.

In business the natural order of things is for everything to break and go to sh*t.

Great execution is about stopping that from happening, consistently. And when you can stop that from happening for long enough, the compound effect of stability helps you earn a good return.

Is it a surprise that most M&A fails then?

A marriage of two self igniting oil tankers. You better hope the fire hose is big enough. The data says 70-90% of the time, it is not.

Going back to our earlier principles: many acquirers underestimate their ‘value leakage ratio.’

The value creation equation is often not the issue, it is a failure of integration, and operational execution. We will hit this point in more detail over the course of the series.

When is M&A right?

Enough of the bad news. I’m depressing myself thinking about it.

Let’s talk about the 10-30%.

How do you ensure you get it right?

4 ingredients:

1. Strong core business

2. Solid acquisition case

3. Lean expert deal team

4. Excellence in integration and execution

1. Strong Core Business

You cannot use M&A to fix a broken core business. Bold is not enough for that point. I’m just going to shout it again…

YOU CANNOT USE M&A TO FIX A BROKEN CORE BUSINESS.

I learned this from a former CEO who described such transactions as ‘two drunks propping up a bar’.

M&A is for solving strategic problems, not execution problems.

An M&A transaction is all consuming during the deal, and even more so after. You better hope you’re core cash engine is stable.

A stable management team is vital too. If things go wrong (which they definitely will), you need to know the team have their guns on the problem. Not each other. A team that flys to self-preservation at the first sign of trouble will seal the fate of any deal.

It takes a lot of discipline and humility to pass on the ‘perfect deal’ because the timing is wrong in your own business.

Many execs fail at this hurdle.

2. Solid acquisition case

You can reduce M&A risk through the due diligence process, increasing certainty of valuation assumptions.

The more certain the assumptions in the valuation are, the more robust the business case.

We will tackle this in much more detail in the coming weeks.

3. Lean expert deal team

There is a lot of value won and lost through the deal.

None of this ‘win-win’ bullsh*t. Not in M&A at least.

A $ in your pocket, is a $ out of the other side.

And vice versa.

That’s the nature of an auction.

Getting the deal team and process set up right will be worth a huge amount of value. A lot more to come on this later in the series.

4. Excellence in integration and execution

A good board will hold your feet to the fire to deliver the acquisition case you built to justify your deal.

The trope on integration is that ‘planning it early’ is the key.

It is important, but it’s not what matters most.

Having rockstars executing the plan is what matters most. You need your A players out front; role modeling culture, ways of working, and making impact on the target.

This is why point 1; a solid core business is so important.

How many acquisitions fail because the core business falls apart due to distraction?

I bet its huge.

And most of the rest will fail due to cultural / integration issues

We will talk more on this in the final week of the series.

What are the different types of M&A?

I made another picture to explain (you’re welcome):

My favorite types of acquisition are horizontal and vertical. These are underpinned by cost synergies which are more reliable.

Portfolio M&A can work too if that portfolio has the ability to extract financial synergies. Or reduce value leakage. (Private Equity)

Adjacent M&A tends to be built on revenue synergies. Revenue synergies must not be used to justify a valuation. We’ll come back to why in a future post.

Acquihires have been a big feature in tech over the last ten years, as a way of acquiring engineering talent. It’s possible that this is a function of bloated salaries fueled by cheap funding. We’ll see if they last.

Takeaways

Mergers and Acquisitions (M&A) can be a game-changer for businesses seeking growth and value creation. However, the high failure rate of M&A deals is a stark reality that cannot be ignored.

Every force will at every stage be trying to break your M&A deal. Great M&A execution is constant firefighting.

To succeed in M&A, focus on four key ingredients: a strong core business, a solid acquisition case, a lean expert deal team, and flawless integration and execution. Boards must ask themselves the crucial questions:

1. Why this deal?

2. Why us?

3. Why now?

Next week we will dive into the real meat of this series, with Valuation. I’m excited already.

THIS WEEK ON TWITTER

Pee-Dubbs didn’t pay their interns on time. Whoops.

The best thing about working in a PE backed biz is that you don’t have to deal with corporate bull sh…………….

Honestly, wtf does that even mean.

BOOK CLUB

Blue Ocean Strategy by W. Chan Kim and Renee Mauborgne changed the way I thought about strategy.

Before this book, most strategic thought leadership focused on how to compete harder. This book asks how to find your own space so you don’t have to compete.

Since then we’ve seen countless tech businesses follow this playbook successfully.

There is a tool called the ‘Strategy Canvas’ explained in the book, which has been a critical part of my exec toolkit ever since I discovered it.

FEEDBACK CORNER

A review of the last edition:

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CASHFLOW TIP OF THE WEEK

Anyway …

That’s all for this week. As always you can find me here:

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We are getting to the fun stuff next week; valuation 🥰

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.