Acquiring growth

13 November 2015 / Published in Business

This article originally appeared in the National Business Review.

Fergus Lee, ASB Head of Capital Solutions, looks at the benefits of acquisition as a way to achieve a business’ growth targets, and the pitfalls and benefits you might meet along the way.

Involve your banker in your growth plans. As well as providing your funding, they can introduce you to owners of potential acquisitions, and be on your side of the table in negotiations.

In business, growth is health. Investors demand it, founders depend on it. So how do you achieve it?

  • You can build your business over time.
  • You can borrow growth in partnerships.
  • You can buy growth through acquisition.

Each approach is valid, if it suits your underlying strategy. This article focusses on accelerating your growth through acquisition. It works as long as there’s a strategic fit, it’s well-implemented and appropriately funded.

Many industries rely on acquisition to reach their strategic goals. The chart below shows the sectors most involved in acquisitions, that are disclosed to market. There are far more smaller, non-notified purchases.

Up, across, or out?

The most common acquisition strategy is horizontal integration: growing by acquiring your competitors. It’s a faster way to reach a growth goal, compared to organic growth.

But size is just one goal. You might want their national or international distribution agreements. You might be buying their operating processes, patents or research. You might want their key leaders and employees.

The second type of growth is vertical integration. You take over businesses in your value chain, either upstream or downstream.

Upstream are your key suppliers. Acquiring them can give you security of supply, control your cost of goods sold, or limit the supply of resources to your competitors.

Downstream are your key distributors. Acquisitions here can give you better coverage or reduce costs. You can also take over middle man or retailer profits, or control retail prices.

The third acquisition strategy is diversification: going outside your industry. You might be buying them as a stepping stone to a bigger goal. For example, they might have contacts in an important distribution channel. Their healthy cash and equity position could be your leverage for another acquisition. Or, they might represent a complementary revenue stream to balance your seasonal or cyclical income.

So what’s your strategy?

No acquisition will achieve a strategy you can’t define. It’s the most important part of the acquisition process.

Don’t be afraid to ask for advice. Talk to your board and your bank, as well as advisors and customers. They can be a rich source of insight into your competitive environment, and into your real strengths and weaknesses.

Once you’ve defined your strategy, there are some important questions to ask:

  • Does it meet your strategic objectives?
  • Does it exceed your required ROI?
  • Does it enhance your competitive position?
  • Are there any quantifiable synergies?
  • How will you fund it?

Do your homework

There is no best single approach to your first contact with a potential acquisition. Sometimes a direct board-to-board level discussion is best. At other times a quiet approach from an intermediary is better.

You need to be able to start valuation and negotiation, without alerting the market. Confidentiality is essential.

Be sure you have a good, experienced advisor or lawyer. He or she will know what to focus on as key deal issues. Taking a commercial approach reduces delays.

You also need to know your financial position. That means deciding on funding.

Three funding partners

The first source of funding is equity. If you have funds on hand, your equity holders may need to agree to forgo dividends or commit more funds, and to agree to the acquisition.

Your equity providers will be the last in line to recover their funds if the business fails, so they will expect returns in line with the risk they take.

Another option is attracting new share-holders with new equity. This can provide more growth capital and deepen your investor pool and connections. But it will dilute your existing equity, and can also signal your plans.

The alternative to equity is debt, and your first source of debt finance is your bank. Banks typically provide ‘senior debt’. They’re first in line to recover funds, so interest rates reflect this. They also generally offer simple financing terms, with flexible repayment structures.

Any funding gap between equity and bank debt means you may need subordinated or ‘mezzanine’ debt. It typically has higher interest rates. They might also offer different terms. For example, capitalising the interest (payment in kind), or giving the lender equity return as well as interest (warrants or options).

Give it a WACC

It’s important to calculate your Weighted Average Cost of Capital (WACC). It indicates the rate of return required for your funders, taking into account the risk of the acquisition.

Equity has a cost based on expected shareholder returns.

Debt carries an interest cost, offset by your standard tax deduction.

Weighting these costs by the amount of each type of funding gives you your WACC. It usually shows senior debt as a good source of growth funding, as it’s cheaper than equity.

The positive side of debt

Debt has many benefits despite its cost. It doesn’t dilute your shareholder equity. It is tax deductible. It improves your immediate cash position. It currently has low interest rates.

You can use debt tactically, for example as bridging finance until you can raise equity.

Finally, it lets you make acquisitions without signalling your intentions to public markets.

But debt needs a management plan to optimise your balance sheet.

Stay close to your debt

Your loan will have an agreed review date. If your financial position has improved, you’re in a stronger position to improve your terms. A weak position can lead to higher rates.

Smart businesses reduce their re-financing risk by staying close to their bank. Start your review process 18 months out. Meet your bankers regularly and discuss your wins and setbacks. Work with them to find solutions early. Then, when it’s time for your review, there are no surprises for either party.

Acquisition is just the beginning

Debt is a small risk compared to integrating your new acquisition. Failure here can make a successful acquisition stumble after it crosses the finish line.

You may be merging an existing culture into your own, or forming a new hybrid culture. You need to actively manage the change, but keep an open mind to opportunities. Always keep your underlying strategy in mind.

Resource your post-acquisition plan with people and time. Aim to over-communicate with staff, customers, suppliers and shareholders. If they complain about hearing too much, you’re probably doing enough.

Get the bank on your team early

Too often, organisations call the bank once all the decisions are made.

Your bank can be a valuable resource. Talk to them early about your strategy. They’ve been through this process with many other businesses. They can share their expertise and lessons learned. They can even introduce or approach the owners of potential acquisitions.

They supply your transaction banking services and working capital. Most importantly they have a vested interest in your success, and that puts them on your side of the negotiating table.

If your strategy calls for growth, call for your banker.

ASB Capital Solutions work with organisations to find the best ways to fund strategic growth. They connect people, ideas and capital.

If you’d like to discuss your capital needs or your growth strategy, contact ASB’s Fergus Lee on fergus.lee@asb.co.nz


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