5 Tips for private equity firms eyeing add-on deals in the pandemic

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Judging by recent M&A trends during the Covid-19 pandemic, it’s increasingly clear that private equity investors have continued to focus on add-on acquisitions as a growth strategy even more so than they did pre-outbreak. Add-on acquisitions, or transactions that occur when a company acquires another company that complements the acquiring company’s business model, accounted for a record 72.5% of all U.S. private equity buyouts in the first quarter of 2020, up from 2019’s record of 68.1%. “The trend continued in Q2 as add-ons made up the highest percentage of leveraged buyouts (LBOs) on record, and median deal size ticked down for the first time in five years.”But while the private equity industry is enjoying the benefits of add-ons, many operating companies may be missing out on potential opportunities.

Why? It’s not necessarily because the potential strategic acquirers don’t recognize the value of acquiring complementary businesses. It’s often due to lack of internal resources needed to navigate many of the complexities involved in the strategic add-on process.

Add-ons typically occur when the acquired company could provide complementary products, services or technologies that can be easily integrated into the acquiring company’s existing offerings. The target company might offer the same or similar products and/or services, but in a different geographic area. Or the target company might just do the same thing in the same market, but on a smaller scale and with different customers. These are just a few of many reasons a strategic add-on may make sense. In the current Covid-19 impacted environment, add-on deals may represent opportunistic buying opportunities, as potential target valuations may be down.

In any case, add-ons are completed for the purpose of increasing the value of the combined entity going forward. Because the target companies are typically smaller and may lack in certain financial, management and operational infrastructure, they can often be purchased at relatively low multiples compared to the acquiring entity. When combined with the acquiring company, however, the combined enterprise value increase is often greater than the purchase price. In other words, the combined whole may be greater than the sum of the parts. This is an arbitrage effect that the private equity industry has, by-and-large, taken increasing advantage of over the last several years, and especially during the pandemic with many smaller businesses potentially on the brink of closing shop.

Sounds like an excellent strategy, right? The problem for operating companies; however, is add-ons are almost always complicated. Completing an add-on acquisition requires expertise in areas where operating companies don’t often possess expertise, such as valuing potential targets, conducting financial due diligence, bolstering on the ground accounting and operations personnel, and carrying out purchase accounting under generally-accepted accounting principles (GAAP). Private equity firms, who specialize in these transaction processes, thus naturally have a leg up when it comes to add-ons.

Despite this potential challenge for strategic acquirers, this lack of technical and process capability should not be a “deal breaker” for having M&A as a part of strategic growth. It is actually far from it, because add-on acquisitions can be a major driver of value for operating companies, as long as those companies understand where they may need to supplement internal capabilities in order to execute successfully. With that in mind, here are five tips operating companies should consider to increase value through an add-on acquisition:

1. Secure trusted independent valuations of the target
Valuation is a combination of art and science. Many operating companies don’t have the technical expertise on hand to develop detailed valuation estimates for potential targets. Utilizing a trusted third party to evaluate a company’s potential value, organizations can help navigate the process of finding a market-based starting point for M&A discussions. Additionally, the company and the third-party professional should understand – when evaluating entities as add-on targets—there may be company specific synergies that are difficult to quantify, but which an experienced valuation provider may be able to provide insight. A third-party specialist can help a potentially under-manned strategic finance department put strategic investment value numbers around these complex considerations.

Remember, one key rationale for pursuing add-on acquisitions is to achieve enterprise growth at a potential discount. The value of the company being acquired may be higher for the acquiring company than what the general market might place on the target. But a standalone market price should be well understood. Furthermore, add-on targets often display key risk factors, whether it’s management skill and depth, customer concentration, branding-related challenges, lack of critical resources or pandemic-related challenges that have magnified in the last several months, which will impact comprehensive valuations. In these cases, there may be both an opportunity for post-transaction growth as well as an opportunity to properly value the potential target when accounting for identified risks.

2. Financial due diligence is critical
Even under GAAP, financial statements can differ considerably from business to business. Despite the regulations, standards, certifications, best practices, etc. in the field, accounting is still very much a judgment-based practice, and the differences in those judgments can lead to considerably different financial reporting outcomes.

The upshot of this is you likely cannot afford to take an add-on target’s financial statements at face value. It’s important to “check under the hood” of the company’s financial statements, and ensure you’re comfortable with what you find.

More often than not, an in-house accounting team will be unable to handle this kind of due diligence. Your in-house accounting professionals are accustomed to a particular system (namely: yours), and they may not have the expertise or the capacity to digest another company’s entire accounting ecosystem in the fast-moving and unpredictable market in which we find ourselves.

3. Don’t lose sight of tax planning
Proper tax planning can significantly impact the cash outlay required in business combinations, as well as the ramifications post-transaction. Developing a rigorous tax strategy for the acquisition structure, as well as the new combined entity, can pay off in significant reductions to your tax burden. Moreover, in the properly-devised tax planning process you may also find synergies between the two companies that were unavailable to the two companies individually.

4. You may have to hire on-the-ground support
With all the activities associated with completing an acquisition, you may find your current teams at or exceeding their reasonable work capacity. This is generally not sustainable and can break the integration process. First, understand the need for external experienced transaction accounting resources is normal for acquisitions and not a failing of your in-house team. Even groups that frequently conduct M&A activity often find they need additional third-party assistance during the transition period.

With that in mind, don’t be afraid to hire outside temporary operational finance and accounting help. Know there are firms that specialize in precisely this kind of outsourced help and have the flexibility to scale with your business’s short-term spike in needs.

5. Plan ahead for post-acquisition accounting
It’s important to plan ahead for the acquisition, including management, technology, as well as finance and accounting. The post-transaction purchase accounting process is something operating companies often have challenges handling. Once the transaction is set in motion, things move fast. And if your business doesn’t have a game plan for handling GAAP accounting for the transaction, it can quickly become too much for an internal team at an operating company to handle.

If you want to ensure your business is able to successfully follow through on an opportunistic acquisition, it’s essential to have a plan for how you will handle post-acquisition accounting. Determine in advance how you will handle intangible asset valuations and technical accounting around Accounting Standards Codification (ASC) 805 and other related accounting standards. Decide what processes will be put in place for your new combined accounting function and how you will integrate any PPP loans the acquired business may have. All this will contribute to the goal of taking full advantage of the synergistic acquisition and putting yourself in the catbird seat for the next strategic opportunity.

With a proper group of trusted professionals, strategic operating companies can participate in the same strategy that more and more of the top private equity firms are employing with add-on acquisitions, and potentially take advantage of unique opportunities in this time.

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