Many distribution verticals are seeing consolidation; those that haven’t are ripe for it. This article, the second in a three-part series, will help buyers avoid common pitfalls that can derail M&A transactions.
Part 1 discussed how distributors can prepare for the inevitable by understanding the landscape, their place in the consolidation cycle and the new measures of shareholder value.
Indian River Consulting Group is MDM’s co-host for the October Distribution M&A Executive Workshop. Learn more at distributionMAworkshop.com.
In many of our merger and acquisition engagements over the past 30 years, Indian River Consulting Group has been retained to fix situations that came off the rails. Here are eight M&A flaws that we’ve encountered that will likely lead to transaction failure.
1. Failing to pay a multiple appropriate for where the transaction is in the consolidation cycle.
Consolidation cycles take years to occur. There are typically two rounds, with the initial consolidators acquiring each other in the second round. Industry disruptions can greatly compress these cycles. For example, a recession or another concurrent surprise acquisition may mean a deal never gets above water. Getting this wrong can cost as much as overpaying by two multiples.
The best way to avoid this mistake is to study the history of past transactions going back multiple years and pay attention to the external forces operating on the vertical. Management guru Peter Drucker said when looking to the future, anchor your study by looking back as far as you need to look forward. In today’s terms that means that looking at a deal requires understanding deal history and structure starting in 2010, based on the typical private equity firm investment horizon of five to seven years from initial-platform acquisition to divesture.
2. Failing to know when to walk away (or suffering from “Crazy to Win”).
When evaluating a potential purchase, a responsible seller will invest tens of thousands of dollars in due diligence. Imagine that you make a fair bid based on the market and what you have in your value-creation plan. Then the seller’s investment banker comes back and tells you, “My client really likes you as a buyer, but your number is too low and needs to increase by 16 percent.”
You know that 16 percent more puts you a bit higher than the higher market range but it is still in the market window. And, after all, they are only estimates anyway. So you adjust some of your assumptions in your value-creation plan. You have already invested close to $100,000 in the deal, so you want to move forward.
But what happens when there is a third round of bidding?
We have seen really large firms fall for this, especially PE firms struggling to find good companies to acquire. Over the next several years they will sell off strategic parts of the business to try and get back above water. In our experience, this is the No. 1 driver of zombie investment funds – those so underwater that the shareholders can never get an acceptable return.
3. Failing to understand variation and mass customization.
The generic MBA playbook teaches that variation is bad and processes must be standardized to gain economies of scale and efficiencies. But this approach destroys shareholder value in a distributor. Six Sigma and lean processes are valuable to a manufacturer to get into flow (think plant utilization and no exceptions). Consistency is valuable for a retailer to create a predictable customer experience (think Nordstrom and McDonald’s). But distributors operate with a generic customer intimacy strategy, and their margins are directly linked to customer-switching costs.
The value-creation play for any distribution business is to develop processes to manage variation with accountability, not eliminate it. For example, a PE firm interviewed us to help fix a large industrial distributor where the value-creation plan had failed on an epic scale. They were 18 months into the transaction, and it had become a poster child for how not to acquire a distributor. The operating managers were seriously at odds with the PE firm, revenues and margins had declined as the managers were forced to standardize practices, and EBITDA was basically gone. We told them that the managers were correct, and they were wrong. They needed to get back to the beginning and have the managers own the value-creation plan.
We didn’t get hired. They chose a good Six Sigma consulting firm. The firm is still there, but they have changed out all of the senior executives, and the firm has never regained the performance it achieved before the acquisition.
4. Failing to recognize and capture the strong talent being acquired.
The typical playbook answer in an acquisition is to lock up the senior executives in the acquired firm with contractual agreements, options and money while treating everyone else as fungible. There is also an effort to ask managers to determine other key contributors further down in the organization.
The critical flaw in this process is that the manager answering the question might be marginally competent and mostly concerned for their own job when they are answering. Good distribution organizations are flat, and much of the real talent is closer to the customers than to the executive offices.
We had a PE firm that acquired a large distributor that successfully sold to blue-collar workers using sales representatives that looked and acted like blue-collar employees. After the acquisition, they put in new executives that were polished and sophisticated. The new team immediately decided to turn the “losers” into professionals or replace them. They put in lots of rules and a CRM system. All the best sales reps left. The process took six months. It has taken five years to get EBITDA back to the levels they had at the beginning.
The key to avoiding this is to never base talent judgments on a single source and invest significant time to get wide and deep into the organization immediately after the acquisition is announced. The most important staff to retain are those that want to do good, rather than those who want to look good.
5. Failing to have a strong and deep communication plan.
After a deal goes down, the acquirer feels like they just won the tournament and they want to celebrate while building relationships with their new senior executive team. In a show of trust, the acquirer lets the existing management team handle the bulk of the employee, customer and supplier communications.
This is a mistake. Those stakeholders already know the existing executive team; what they want to know now is the new ownership team and their values, intentions and planned actions.
Good communication plans involve both the new owners and the existing management team. Give key stakeholders the opportunity to share concerns about the transaction and even around existing managers. One-on-one access must be provided, even if it is never used.
The communication program needs a feedback loop so the acquirer can get unbiased information on how changes are experienced in the field. Care must be taken to not undercut the existing management, but frequent informal visits to field locations should be built into the plan. Leverage the existing HR department.
We once worked with an acquirer who was a genuine 1 percenter with considerable personal wealth. But no one in the acquired firm had any idea as he spent time in the warehouse learning how to pick and pack orders. He spent the first week after the announcement working with first-level staff in purchasing, sales and finance. With what he learned, the value-creation plan was fine-tuned and the CFO was replaced.
Target-company competitors will aggressively go after top talent on the first day after the announcement. Uncertainty is not the friend of the acquirer.
Arrow Electronics has been the poster child of effective acquisition integration plans; they’ve successfully integrated more than 60 firms in less than 10 years. They changed their CFO three times over the period as they found stronger ones in acquisitions. They got so good that it only took 60 days to go from announcement to being fully integrated. Their communication plan was widely shared so everyone knew the timeline and what would happen. These practices were documented in a research project we conducted on behalf of the National Association of Wholesaler-Distributors.
6. Failure to recognize that culture always trumps strategy.
If the value-creation plan is shared fully and early in the integration process, like with Arrow’s best practices, the team will improve on it and support its execution. This requires that hard decisions like staff reductions and organizational changes be made early and quickly. It’s a rookie mistake to say, “Nothing is going to change.” Starting with a lie does not build trust. At some point, something will change and the response will be, “I told you so. They were lying. What’s next?”
A new owner that works exclusively through the senior team in a command-and-control style runs the risk of creating passive – perhaps even active – resistance to change. In decentralized customer-intimacy businesses, it is fairly easy for the field to ignore corporate, for both strategic and PE buyers. Participation creates commitment. As early as possible, bring lower staff into the value-creation plan and clearly explain why specific actions were chosen. Once they understand the “whys,” the staff will improve on the plan and execute. Every employee wants to work for a winner that is going places.
In the U.S., a common cultural trait is to respect performance more than hierarchy or position. Many non-U.S. acquirers have had issues with this. There are just as many cultural mistakes when U.S. firms acquire distributors overseas – the major sin in this case is American arrogance. There are many global distributor consolidators, and some do it better than others. Wolseley and Sonepar stand out as global firms that have learned to respect these differences.
7. Failure to understand the market during due diligence.
There are no good surprises in an acquisition. Industry practices are often so ingrained that they are assumptive. It is not that the target fails to inform the acquirer; it is just “how things are done and everyone already knows.”
There is so much variation within distribution that the smartest thing an acquirer new to a vertical can do is involve an industry insider as part of the due-diligence team. There are many one-man band consulting firms in each vertical where the principal was a long-tenured senior executive who knew everyone. They will often not be polished or capable of generating a report or readout acceptable to a PE firm, but they are cheap insurance.
Listed below are some idiosyncratic industry practices that have cost acquirers millions of dollars over the years.
- Many suppliers to distributors have agreements that allow them to terminate the relationship if the ownership changes. Some even have a permanent lien on the distributor’s inventory that may have been documented back in the 1980s that can destroy the acquirer’s ability to access debt.
- Some markets are changing very rapidly with nontraditional competitors. United Stationers (now Essendant) and Staples destroyed the office-product wholesaler vertical; Amazon Business is taking aim at facility supplies and other industrial products. Most of the existing industry incumbents typically stay in and ride it down, often unaware of the new threats until it is too late.
- Market power is always taken – never given – in channels. In some cases, the primary power is held by the suppliers or customers. How well is a value-creation plan that leverages scale to get supplier price concessions going to work with the largest distributor in the industry making up a fraction of 1 percent of the supplier’s revenue? On the other side, how much margin improvement can be generated when a vertical typically has two or three customers that represent 50 percent of a distributor’s volume?
8. Failure to take an acquisition seriously enough.
An owner-operator distributor decides to make an acquisition and fails to get professional advice to save money. They don’t know what they don’t know, especially about market value, deal structure, warrants, escrow accounts and contingencies. They frequently say that nothing will change and really mean it. The net result is that they commit all the fatal flaws listed above and pay too much for a business, which then rapidly falls off the rails. The acquired CEO finds it hard to become a prince when he was once a king. (We have stopped two of these deals this year that didn’t even have a documented value-creation plan.)
There are many more things that can go wrong in a distributor acquisition. What we shared are those you can specifically avoid. If you can do this, your chances of achieving your value-creation plan are much higher. When the focus is on increasing shareholder value instead of old-school revenue growth, it is almost always cheaper to buy than to build.
Part 3 will cover best practices in acquisition integration and also when it is critical not to integrate.
Join MDM and IRCG for the Distribution M&A Executive Workshop Oct. 9-11, 2017, in Austin, TX. Learn more at DistributionMAworkshop.com.
Mike Marks is managing director of Indian River Consulting Group and specializes in helping distributors and manufacturers accurately diagnose problems and identify risk-bound alternatives so they can take their next steps confidently. Call IRCG at 321-956-8617 or visit ircg.com.