Validating the Equity Story

The main reason for acquiring a company is to create value. Potential acquirers must believe that they can reasonably quickly make transformations to the acquired business that will significantly enhance its value* – plus covering the fairly significant transaction costs that will be incurred.

For financial investors, this is a basic fact of life: their entire raison d’être is to grow the funds they manage. The justification for doing a deal (the “equity story”, “investment thesis”, “strategic rationale” or some other label) is essentially an articulation of the precise opportunity for adding value.

The commercial due diligence they undertake then usually has two primary components: assessing firstly, the sustainability of the current business, and secondly, the realism and achievability of the opportunity for value addition – i.e. validating the equity story (see also “What We Do: Validating the Equity Story”)

Exactly the same logic should apply for strategic investors – and indeed identical questions are often explored and with considerable rigour. However the same objectivity and thoroughness are not always evident – for various reasons:

• “Trade buyers” are not under the same time constraints as financial investors – they do not need to resell the business in, say, 3-5 years. Therefore a longer term view can be taken, which in turn encourages “strategic” reasons being presented as at least part-justification.

This logic is flawed: if added value is not visible within five years, it is unlikely that it will ever occur; and “strategic justification” is often a smokescreen for “we cannot quantify the value” and/or “we have not tested it”, and/or even “this is a guess”!

• Financial investors are willing to say “we do not understand this industry” or “we have no preconceptions”. Trade buyers believe they have a good understanding of the industry. Undoubtedly many do, but because they are already in the business, they may be less rigorous in their investigations and also not totally objective; and occasionally they have critical blind-spots.

• The “opportunity” for a “strategic buyer” very often involves integrating the target company with existing businesses, and achieving synergies (of which there are many categories). However synergies are notoriously difficult to realise, their extent is often overestimated, obstacles are not foreseen, and the time and cost involved are underestimated.

• A trait of management teams seems to be that they widely believe they can run a competitors’ business better than its incumbent management. Overconfidence leads to underestimation of the difficulties and constraints faced by the other business.

Why is external validation necessary?

Vendors naturally wish to sell their business for as much as possible: consequently, they encourage management to be optimistic in their projection of future potential. Likewise, agents employed to assist in selling the business will strongly emphasise upside potential, but tend to play down the risks and imponderables. No-one is actually not telling the truth – but it may not be the whole truth: and they look at the future through “rose-tinted spectacles”.

Cogency’s expert team provides rigorous, objective appraisals of management’s view of the future potential, of the strategy they are proposing, and of the assumptions and estimates underpinning (but not necessarily visible in) their projections.

The importance of ‘expert’ deserves clarification. The “market” for many chemicals (particularly specialty chemicals) comprises a string of quite separate niche sub-markets – which function in different ways and are exposed to very different forces. Chemical industry value chains can be complex, and it is often unclear who the real decision-makers are or how purchasing decisions are really made. Finally, outside of bulk commodity chemicals, most companies and their products are differentiated – which means apparently competing products are not identical, and the product + service package that customers buy is far from transparent. Only someone who has had first-hand experience in a particular market will understand the intricacies: many investors have suffered as a result of a superficial understanding of market dynamics, and so making inaccurate assumptions – e.g. underestimating difficulties in winning market share, or not appreciating that immediate customers might block innovations that logically would seem to be of benefit to them.

Cogency’s work in this area is equally relevant to both financial investors/private equity and corporate acquirers/”trade buyers”. The precise scope of our work, how we undertake the work programme and the content and format of the deliverables vary from case to case, and our agreed at the outset with our client.

* This is not quite true. Some private equity houses in the past specifically sought companies with very stable, sustainable cash flows but very little ‘upside’. Many other investors would regard these as unexciting businesses; however the investment case was based on reliable cash flow being used to pay down debt – after a period, the investor would resell, but now owning a substantially higher proportion of the equity in the company. Particularly if this approach could be coupled with playing the economic cycle, returns could be excellent. Cogency’s view is that such opportunities are now much harder to find – or when they do exist, vendors factor this stability into their required multiple.

See Our Service: Equity Story Validation