A lot of ink has been spilled discussing record valuations in the middle market. I’m interested to see if this buy-side “pressure cooker” could lead to a renaissance in M&A itself.
Harvard Business School research puts the failure rate of acquisitions at 70% to 90%. I admit that, as someone who has sold 3 companies as a CEO and witnessed/advised many more as a Broadview/Jefferies investment banker, I’ve seen mixed results. But we also all know of successful cases. I’d like to believe that we can see that failure rate drop dramatically.
In the early days of middle-market private equity, you could make a return with aggressive deal sourcing and financial engineering. Those days are gone. As PE firms seek to avoid commoditization, they are beefing up their operational expertise, narrowing their strategic interests to specific vertical industries, and using “add-on” acquisitions to drive IRR.
Clayton Christensen wrote that there are two kinds of acquisitions: one where the buyer is trying to boost current performance and the other to reinvent the buyer’s business model. The former has lower potential returns but lower risk.
“Boosting current performance” is where we expect most add-on acquisitions to focus. At a simplistic level, these kinds of deals allow investors to ratchet up EBITDA levels while lowering their overall cost of capital, but the reality tends to be both more complicated and more interesting. For example, Mangrove Equity Partners, which has been developing a strong capability around add-on integration, took a heating manufacturing company that had both excessive seasonal and geographic risk, and transformed it by purchasing a cooling company and another firm with broader geographic distribution. They de-risked the company and dramatically increased its EBITDA in the process.
My hope is that we see more PE firms and family offices go beyond acting as a “corp dev service bureau” for their portfolio companies, and get their people actively involved in the transaction integration. You can’t just study this from the outside — not even as a banker, lawyer or accountant, who are closer than most. You need to live through it and see how aligned terms, culture, and mission, as well as a great integration plan, can lead to success. Or conversely, how painful getting it wrong can be.
Christensen’s second type of acquisition, business model reinvention, will continue to be harder. While these deals are increasingly becoming necessary as technology disrupts industry after industry, the brutal fact remains that most non-tech companies haven’t learned how to acquire and retain tech startups.
But necessity is the mother of invention. With the combination of high valuations and increased pressure to grow inorganically, I’m optimistic that we will see an improvement in both the theory and practice of doing deals.
As a buyer, when valuations get rich and terms get seller-friendly, you have two choices — sit out, or get good at the game. At Axial, we think dealmakers are choosing the latter, and consequently we have made changes to both our platform and our pricing to far better support add-on strategies (learn more).
The last decade saw a revolution in the science of startups, led by lean startup and related methods. It’s quite exciting to think that the next decade could deliver a step-function increase in the skills, capabilities, experience, and overall practice of M&A.
 GF Data says that average middle market valuations have risen to a record high 7.4x EBITDA and debt/equity ratios to a record 4.6x EBITDA. Pitchbook, which tends to cover higher in the middle market, reports that median middle market valuations are 10.4x EBITDA.
Giff Constable is the VP of Product at Axial. Cover photo from Concord New York.