A transaction needs to align to an organisation’s strategy and goals – there needs to be reason to do a deal, and it is important that the investment thesis for the transaction (it’s ‘business case’) is clearly articulated.
The investment thesis should not just be supported by a realistic view of the opportunity the transaction presents to create value, but also assess the risks inherent in the transaction.
This requires more than just responding to and debating a pitch presented to the organisation by an investment bank or other advisor. The investment thesis needs to be ‘owned’ and stress tested by both management (who ultimately are responsible to deliver) and the board (who are best placed to play ‘devil’s advocate’). Understanding the investment thesis, and clearly articulating the underlying assumptions or conditions, helps to inform the due diligence process and allows the company to know when to walk away.
As growth alone does not drive value, the investment thesis needs to set out how value will be created, likely to include some or all of the following:
- Improving the target’s performance: through better management or easier and cheaper access to capital. This is a value creation strategy that underpins much private equity investment and diversified conglomerates, and is particularly relevant for growing start-ups and other less mature businesses, but it requires an honest assessment and quantification of what the acquirer can do better.
- Consolidate to remove excess capacity, expand market share and reduce competition. This may make remaining operators more efficient, but may also attract regulatory scrutiny.
- Vertical integration to achieve a more efficient supply chain.
- Achieving a ‘network’ effect, where consolidation in turn drives market growth (think of Uber).
- Facilitate new market access (either for the target or the acquirer).
- Acquire skills or technologies faster or cheaper than they can be developed in-house.
- A roll up strategy which pursues consolidation in fragmented segments.
- Value purchasing, where the target’s situation means it can be purchased at a discount.
- Diversification of revenue streams, potentially stabilising fluctuating or declining earnings.
- A quick ‘go to market’ strategy for new geographies, new markets or new customers.
- Exploiting synergies (covered in more detail in the next blog).
The investment thesis should also consider whether the two businesses will effectively combine and integrate – or will cultural differences, rivalries, conflicting strategies or differing management approaches impact the achievement of the expected value.
In assessing potential transactions, boards should bring an appropriate level of scrutiny and professional scepticism, and ask the following:
- Does this transaction support, or distract from, our core business and strategy?
- Do the numbers and assumptions stack up and support the valuation?
- Does it provide competitive advantage?
- Do we have the capability to undertake the transaction and successfully integrate the target?
- Is it incremental or transformative?
- What is the EPS impact (if listed)?
The board should be clear on the financial rationale for the transaction, and the margin for error provided for in the investment thesis: when new information comes to light during due diligence (as inevitably is the case) management and the board will need to undertake an honest assessment of whether the transaction still stacks up, or needs to be reconsidered.
This article is part two of the ‘Transaction lifecycle’ series.