Finding Your Edge
July 9, 2021 | Issue #28
Big Deal Small Business: Finding Your Edge
July 9, 2021 | Issue #28
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Programming Note: I’m delayed on publishing the results of my deal costs survey, primarily due to procrastination. I will get to it this weekend and publish next week!
In private equity, we’re always trying to find our “angle” on a deal. The reality is that at our scale ($50M+ EBITDA businesses), private markets are pretty efficient. You’re not going to grab an off-market deal before other firms have a chance to bid as well. The management teams/owners are all sophisticated, the deals are big enough to hire proper financial advisors, etc.
So we do our diligence and come up with a number we’re willing to pay. But before submitting the bid, we always ask the question “If our bid wins, why were we so lucky?”
Unless we have a better answer to that question, the default answer is we missed something in diligence and are therefore overpaying.
But there real answers to that question! Just to give you the flavor, I’ve grouped them up into Value Creation, Smartest Buyer, and Financial Engineering.
“Value Creation” Answers:
We found a dynamite management team who can change the trajectory of this business
We’ve built a great rapport with the existing management team and they want us to win (so our bid may win even if it’s in-line with or slightly below other offers)
We have strategic partnerships (such as key distributors we work with in other deals) that allow us to grow or de-risk this business in differentiated ways
“Smartest Buyer” Answers (shaky given we’re competing with very smart people):
We previously owned a business in this sector, so we can underwrite the industry dynamics better than other buyers
We’ve seen XYZ risk in other deals and know how to manage it better than others
“Financial Engineering” Answers (akin to Smartest Buyer answers as well):
Others aren’t valuing XYZ non-core asset, which we think we can carve out and sell for real value
We are offering a structured bid solution that allows us to pay up in exchange for better downside protection
We have differentiated M&A ideas (vertical / horizontal integration that others haven’t thought about as opposed to a simple roll-up) that can change the business profile
We are bringing in a strategic investor into the deal who can provide strategic benefits
Applying this to SMB
This question “Why Am I So Lucky?” applies to SMB too, but I see it manifest in a different way.
In SMB buying, I see three key edges:
Financing Ability
Operational Ability
Diligence Ability
Let’s take these one by one.
Financing Ability
Unlike in PE, SMB LOIs often fail because the buyer can’t get the financing put together (either equity or debt). That’s rare in PE given we have blind pools of capital and aggressive debt markets.
As a result, being a well-capitalized buyer competing with under-capitalized buyers is a real edge. Brokers & Sellers will value the deal certainty that comes with your LOI.
In theory, there should be a clear hierarchy here: Self-Funded Searcher < Traditional Searcher < Independent Sponsor < Private Equity Fund
In practice, decision-making power also matters — that’s where a self-funded searcher can differentiate themselves even though they’re generally the worst-capitalized buyer.
To brokers, I harp on the fact that I’m the sole decision maker on a deal. I explain that while I will have to raise equity, I’m not beholden to any single investor. So if one investor passes, I can move on to the next one until I find my equity check.
Now in reality, traditional searchers can effectively do this as well, but in speaking to brokers, it sounds like traditional searchers have made a habit of blaming their Board (i.e. their investors) for when they back out of an LOI. The unintended consequence of this is that brokers often view traditional searchers as non-decision makers.
As a self-funded searcher, that swings some of the financing ability power back to me. Or at a minimum, it ensures that it’s not a weakness. But in general, self-funded searchers do not have an edge in financing ability.
Operational Ability
Unlike in PE, SMB deals don’t usually come with a management team and it can be hard to recruit a management team to start on day one. In PE we often find our new management team during diligence and rope them into the process. SMB deals are too small for that.
As a result, the buyer having real operational abilities, especially in that industry, is a real edge.
As a non-operational guy, I might look at a $1M EBITDA business and think, “I have to earmark $65K for a new sales guy on day one".”
Someone with real sales expertise might say, “I’m going to do the sales for the first year, grow the business, and then hire in.”
Between those two examples, the person with real sales expertise has a right to win the deal over the person who doesn’t — they can pay more and still generate the same outcome.
On the flip side, an independent sponsor or PE firm need to find someone to run the business, which can be tough unless they have someone in mind already.
I take advantage of that by painting myself as the best of traditional search & independent sponsor: I have the financing capabilities & decision-making power of an independent sponsor, but I can be the full-time manager like a traditional searcher.
So again, this is not an edge I have, but I have a story to make sure it’s not a weakness.
Diligence Ability
Every SMB deal has complexities, issues, and risks. These can much harder to wrap your arms around than a straightforward PE deal. You also have limited diligence support (consultants, lawyers, accountants), so it really falls on the searcher to figure deals out.
As a result, being good at diligence is an edge. In PE, we call it “racing to turn over stones.” A deal has 100 things you can diligence. If you can diligence 80 of them and take a guess on the other 20, you can more accurately value the business than someone who only diligences 50 of them and guesses on the other 50.
In addition, being good at diligence & business/industry analysis allows you to identify common themes across industries.
Everyone in search loves plumbing, HVAC and landscaping businesses, so they trade at higher multiples. Deservedly so, these are good search deals.
But if you’re able to find other niches that share themes with those industries without actually being those specific industries, you can find great deals at more reasonable multiples. That’s a function of diligence ability.
Given my background as a fundamental, institutional investor, this is the one area where I think I have an edge. It impacts how I search — I’ve left my stated industry filter wide open rather than guiding brokers to specific niches. I’d rather be that filter because I can do it efficiently.
Conclusion
As a searcher, it’s worth reflecting on what your edge is. When your LOI is accepted, ask yourself why you were so lucky to win. For me, it’s never going to be my operational ability. It’s not my financing ability either, but I have a good story to tell to ensure it’s not viewed as a weakness either.
For me, it’ll likely be because I was able to diligence a deal better than others and got comfortable with certain complexities that others couldn’t look past.
What is it for you?
Let me know your thoughts, I’m always curious to hear your reactions & feedback. I’m sure there’s “edges” in SMB buying that I’m missing in my framework above. I’d love to hear them.
Just hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, ideally located in the Northeast, West Coast, or Colorado).