Avoid Bad Deals in Q4
Easier access to capital, pent-up demand for transactions, and anticipation for capital gains tax increases made 2021 a haven for private equity transactions.
As eager investors rushed into the market, we saw: 1) exclusivity periods get shorter, 2) bidding processes get more competitive, and 3) transaction multiples get higher. Looking ahead, however, more generous valuations will mean higher pressure to generate incremental value. In other words, profitability now must grow more aggressively than the rate at which valuations have recently grown.
Okay, okay. You don’t need a doctorate degree in finance to realize that becoming more profitable is good for business. However, one common misconception in business strategy is that in order to achieve more, you need to do more and go bigger. Add-on acquisitions, new product launches, and adjacent market expansion are often the cornerstone of any classical organizational growth strategy. No matter how academically defensible these strategies may seem, private equity investors cannot afford to take circuitous and risk-ridden routes to generate profit anymore. To beat today’s elevated valuations and pressures to succeed in compressed investment horizons, the path to growth must be simple and inexpensive. Let us consider whether traditional growth strategies still hold water in today’s market environment.
M&A can often actually feel like brain surgery: complex and expensive.
When companies are more expensive to buy in the first place, don’t try to buy more to grow what you already have. Add-on investments are excellent for growing in size but growing in profitability is an entirely different discussion. One of the most poignant remarks that I have heard is “no sane CEO would wake up one morning and happily choose to go through a transaction process.” While the remark was (mostly) made in jest, M&A can be notoriously disruptive, time-consuming, and costly – the opposite of a simple and inexpensive strategy. Even in the event that a transaction is among the lucky few that get past the 90% failure rate in M&A, months – and often years – of integration must follow. If a transaction is among the luckiest few that survive through the challenges of integration, we often see that while revenue and EBITDA grow larger, they often do so at the expense of increased SG&A and capital expenditure. Add-on acquisitions often require doing more to achieve more even in calm markets. Today’s valuation levels and competitive market conditions make achieving value through inorganic growth much more challenging than before.
Conclusion: Even the best and the brightest add-on acquisitions take a ton of time, money, and effort. Just ask a junior investment banker how relaxing their job is.
Unlike the recent stock market, most product launches don’t go to the moon.
95% of new product launches fail. Even the most prolific market leaders like Google have introduced commercial duds like Google Glass and Google+. So, unless you are a product genius like that British guy from Apple, you need to be really talented to pull off a successful product launch. Don’t bank on introducing more products and making money that way, because you are most likely to fail and just end up making the company more complicated than before.
In failed launches, we often observe the following:
- The company lacks a defensible competitive position as a market leader. Most new products fail to compete against the more established options available in the market.
- The foundations of the customer experience are not solidified. Deficiencies in the existing offerings hinder customer interest in new products.
- The new products target unprofitable audiences. The decision to launch is influenced by a desire to reach a wider market rather than a targeted approach to reach the most profitable customers.
- The existing product line is already far too complex. The additional overhead to market new products ultimately erodes any incremental profitability.
Even in the best of times, new product launches are risky and statistically positioned to fail. Relying on them to create sustainable value in today’s market would take the ingenuity of a product mastermind like Apple’s Jony Ive or the courage of gambling masterminds like Robinhood’s thousands of options traders (not me, of course).
Conclusion: Unless your company-branded vest has a white apple or a red “T,” a new product launch might not be the easiest (and certainly not the cheapest) way to generate value.
Thou shalt not covet your neighbor’s market share…until yours is solid.
Expanding into an emerging market carries considerable risk due to a lack of historical data. On the other hand, established markets tend to have higher barriers to entry due to existing competitive dynamics. The explicit costs of overcoming these challenges are easy to understand. Earn the right to grow and "learn how to walk" in the market that you already have before trying to run in a new market.
However, the truly unconscionable yet underreported risk of market expansion is losing its foothold in the existing markets. Throughout our customer due diligence engagements, we often see aggressive expansion plans as a flagship value creation strategy. Perhaps equally as often, we discover fragile customer loyalty, systemic issues in the customer experience, and soft competitive positions. Diverting resources toward new markets before addressing the existing issues is a critical misstep that could jeopardize whatever value was purchased in the initial transaction – a mistake that is especially harmful with today’s elevated multiples and daring growth strategies.
Conclusion: Check for any cracks in the eggs in your basket before buying another basket. Growing existing customer relationships will almost always be cheaper than acquiring, onboarding, and retaining new customers in new markets.
Chill out, Debbie Downer. What do I do then?
These common growth strategies in private equity share two things in common. First, they universally require more effort to yield more results (both positive and negative). Second, they add complexity to the business. Luckily, there are measures that all investors can use to achieve more by doing less:
- Simplify your customer base: Not every customer relationship is made equal. Segment your customer base and drastically differentiate the level of service and resources that are available to them (prioritize top-tier customers). Only continue working with the smaller and less profitable customers on terms that you dictate (order minimum, price increases, etc.). Use the incremental savings from eliminating your least profitable customers to become more competitive in serving top customers.
- Simplify your product line: Similarly, not every product is made equal. Segment your product line and identify which products are being purchased by customers that are critical for your growth. Eliminate the product offerings that are only being purchased by smaller customers to immediately reduce the margin dilution incurred by having to service them.
- Avoid investments where these two steps are difficult to execute: Traits like ego, pride, and inflexibility may create considerable roadblocks for customer and product line simplification. If you sense hesitation or downright refusal to change, carefully consider whether the deal terms would give you enough governance power to promote it. Don’t be afraid to walk away – your dry powder may be better spent elsewhere than on investments that require expensive growth strategies.
To paraphrase Leonardo da Vinci, simplicity may truly be the ultimate sophistication in today’s private equity market. Doing more and going bigger alone won’t cut it – grow simply and inexpensively.
John Ahn is a Senior Associate for our Customer Due Diligence practice. He works closely with private equity sponsors to strategically mitigate transaction risk and accelerate value creation.Contact John