Not all capital is the same. When thinking about capital allocation in your private company, there are three critical aspects:
- Cost
- Supply
- Accessibility
An acquisition is normally a significant capital allocation decision for any company. Many compare themselves to others when making these decisions, but that is a mistake since companies have different capital profiles and bring different levels of resources to an acquisition.
Here are three capital profiles to consider:
- Public capital (public stock and bond markets) is the capital available to large public companies. It is comparatively inexpensive, in great supply, and easy to access. One only needs to look the record number of public bond offerings between March 2020 and June 2020 at the onset of the pandemic. With a high degree of uncertainty, large companies went to the capital markets to bolster their balance sheets with cheap capital. Buyers have abundant resources to pull of an acquisition due to their size and scale. There are regularly many merger and acquisition transactions in the public markets.
- Institutional private capital is the private capital that has been raised by private equity funds and other investment firms to purchase businesses. At present, there is an immense amount of this capital being deployed. This capital is expensive, as private equity firms must provide the capital to their investors with a solid return. It is also plentiful and relatively easy to access. With access to large amounts of capital, these buyers also have resources and expertise to execute a transaction.
- Private/family/employee capital includes most of our clients and represents the capital that private owners, families, and ESOPs build up in their business over long periods of time. It is hugely expensive, in short supply, and difficult to access. Part of the reason it is so expensive is that there is not a store of excess funds in the background if the business makes a large-scale mistake. Plus, most private companies have a long list of priorities in addition to financial commitments such as the company’s legacy, its employees, and the community. Additionally, most private companies that take on acquisitions are using existing human resources to execute the transaction, which can drain already-stretched resources.
Let’s take a closer look at how these factors play out in real terms. A public company typically has significant resources and capital to deploy in an acquisition. It has a team of experts working on the transaction’s structure and price as well as an integration team. With an abundance of resources, a public company has more flexibility if things don’t go well.
Institutional investors also have an advantage because acquisitions are their business, they often have a backstop of capital, and they typically have large financing resources.
These two buyers can approach a transaction from a vastly different point of view than a private company, which often has expensive capital and limited resources.
If you are a typical private company, your management team will be doing the heavy lifting on the acquisition while simultaneously working their day job. In this respect, the size of the undertaking is very important because it can distract management’s time from taking care of the core business, which can negatively impact the company. And since private companies normally have limitations on their own capital, they must borrow to fund acquisitions which involves risk not only to the new venture but also potentially to the existing business.
When considering your cost of capital, I suggest asking yourself what the cost of being wrong would be. A fair assessment should be made about the size of the deal relative to your existing business and capital position. Size matters since acquisitions are often hard to execute successfully. If the amount you are putting at risk is large enough to harm your core business if the acquisition isn’t successful, you should be very conservative and cautious.
Ultimately, the average private company is a more conservative buyer than the other players because the cost of being wrong is much higher. Understanding that your capital structure and attributes are different is an important part of assessing these decisions. It requires discipline since you may not be able to match the resources and capital profile of another buyer.
The best private company clients that we work with that are active in the M&A market maintain a high degree of price discipline and don’t fall in love with a deal. They set limits and don’t get into a bidding war with another party that may have different capital and resource attributes. Understanding your own limitations and risks and recognizing that your case is unique compared to other buyers is the key to making good M&A decisions.
You may also like: