The art of ac­qui­si­tions One way in which com­pa­nies can grow is through the ac­qui­si­tion of other com­pa­nies. While this can prove lu­cra­tive, there are also risks to con­sider. We show share­hold­ers what to look out for.

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­

acom­pany re­ally only grows in two ways. The first is or­ganic, whereby it grows ex­ist­ing op­er­a­tions by gain­ing mar­ket share, new prod­uct lines, new ge­ogra­phies in which it op­er­ates, or maybe even new ar­eas of oper­a­tion. This is per­haps the more im­por­tant growth method be­cause if a com­pany can­not grow or­gan­i­cally, then ei­ther the sec­tor it op­er­ates in is dy­ing, or it’s a dy­ing com­pany.

But there is a sec­ond way in which a com­pany can grow and that’s by ac­quir­ing other com­pa­nies. These ac­qui­si­tions may be smaller bolt-on deals that add some ef­fi­cien­cies, or may be large deals such as tak­ing out com­pe­ti­tion or mov­ing into new sec­tors or ge­ogra­phies. A good ac­qui­si­tion (or se­ries of ac­qui­si­tions) can be a real game changer for a com­pany as it can be pro­pelled for­ward, but it also comes with se­ri­ous risks.

The risk I want to fo­cus on this week is how much is be­ing paid and, im­por­tantly, how the ac­qui­si­tion is be­ing funded.

How much is paid is a real risk be­cause, if a com­pany over­pays, then the deal is not great at all and may hurt the com­pany in the long run. Ide­ally, any deal must be com­pleted at a re­al­is­tic valu­a­tion – hence priceto-earn­ings ra­tio (P/E). Dif­fer­ent sec­tors have dif­fer­ent P/E ranges, but, for ex­am­ple, in the bank­ing space any­thing be­ing bought for a P/E of more than 10 times is likely too ex­pen­sive. The trick with the ac­qui­si­tion of an un­listed com­pany is that, of­ten, there is no clear P/E avail­able. How­ever, if enough de­tails are pro­vided, the P/E can be cal­cu­lated: di­vide the pur­chase price by the prof­its that the new com­pany is ex­pected to gen­er­ate – this will pro­vide the pur­chase price P/E.

Of­ten, profit war­ranties will also be in­cluded in the deal. In other words, the com­pany be­ing bought has to achieve cer­tain profit lev­els for the next year or two in or­der to get the full pay­ment. If the prof­its come in lower, then the pur­chase price can be re­duced. I am a fan of this con­cept as it re­duces the risk for the ac­quir­ing com­pany. The sec­ond part of the process is how the ac­quir­ing com­pany is fund­ing the pur­chase. I am a fan of pay­ing cash, even if this means rais­ing debt. Aspen is an ex­pert at this; the com­pany is very cash gen­er­a­tive and can typ­i­cally pay off the debt fairly quickly. Us­ing debt means pay­ing in­ter­est, mak­ing the even­tual to­tal cost higher due to the in­ter­est paid. But it does mean the com­pany pays once for the ac­qui­si­tion.

The other way to pay is to is­sue shares to the seller. Most com­pa­nies have share­holder ap­proval (granted at the an­nual gen­eral meet­ing) to is­sue a cer­tain num­ber of shares at di­rec­tor dis­cre­tion. In a sense this means the com­pany is bought for free; no cash changes hands, only new shares are is­sued.

My prob­lem with this is that these shares re­duce my hold­ing in the com­pany, and they have a per­pet­ual claim on prof­its. Now sure, the prof­its should rise af­ter the ac­qui­si­tion, but we’re giv­ing part of these prof­its and part of the other prof­its of the com­pany to the seller who re­ceived new shares. My slice of fu­ture profit is per­ma­nently re­duced.

A last method is a rights is­sue to raise cash to pay for the deal; this is es­sen­tially is­su­ing new shares with the same im­pact as the is­su­ing of shares to the seller.

So while ac­qui­si­tions can be great, one has to look out for the pos­si­bil­ity of over­pay­ing and be aware of how the deal is be­ing funded. I like cash deals, and I want to pay at a valu­a­tion that is at the low end for the in­dus­try. Over­pay­ing and giv­ing away fu­ture prof­its adds risk.

Of­ten, profit war­ranties will also be in­cluded in the deal. In other words, the com­pany be­ing bought has to achieve cer­tain profit lev­els for the next year or two in or­der to get the full pay­ment.

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