A seller’s market?

The market is in a state of flux that has not been seen for many generations. The conspiring impacts of a multitude of factors, including Brexit, the pandemic, and the situation in Ukraine have made the market a volatile place to engage in from a transactional perspective. Despite this, there are opportunities, and the same transactional principles shine through during a time of significant risk to potential acquirers.

From a seller’s perspective, particularly for SMEs, the magnitude of the change involved in selling a business cannot be underestimated. Polly Powell, owner of Batsford Books flags that for many people “when they’re family owned, it’s their baby, and therefore selling it is a significant event.” However, irrespective of the emotional connection, the underlying point of being aware of market developments against business performance and strategy to understand the right time to sell is critical.

Often the opportune time to sell is when things are going well which, conversely as an owner, is often when you are feeling most confident and therefore least likely to consider exiting. However, as Alistair Compton, MD of Stovax attests to, SME business owners should consider where they are from a growth perspective in the corporate life cycle as “at some stage it probably meets a saturation point of what you can manage as an entrepreneurial business.” When this tipping point occurs, considering an exit strategy may be more prudent than attempting bolt-on acquisitions that may stray strategically away from what is considered beneficial or complimentary to the business at hand.

Understanding the buyer side and where the market is going is crucial. The current “volatility of the market means there are little viable targets” (Polly Powell, owner of Batsford Books) and for high performing businesses who are bucking market trends (or at least placating the perceived risk), there is of course an opportunity to sell, exploiting this supply and demand issue and preparing their business proactively for potential suitors. Market awareness will help articulate your business position against your peers but also give you valuable speculation on which larger businesses will be looking for bolt-on opportunities. This is particularly pertinent in a market where organic growth is potentially stifled by a downturn and therefore larger businesses will be looking for opportunities to use their scale to offset this impact on their existing business via targeted M&A.

Despite these opportunities for potential sellers to entice an acquisitive player into a courtship strategy, the buyers’ market is fraught with difficulties that will curb or force greater due diligence on their transactional strategies for market and organisational development.

Supply chain – an uncertain world

Supply chain volatility is a big issue for potential acquirers both in the short term of their transactional aspirations but also when considering a target’s relative value following an acquisition.

Alistair Compton, MD of Stovax anticipates that for many the “supply chain is going to remain constrained” which will have an impact on deriving value that we’ll consider in the report later. Competitive pressures from a macro-economic perspective are putting supply chains under considerable pressure and are leading many businesses to conclude that “economies of scale are becoming more crucial” (Polly Powell, owner of Batsford Books). The knock-on effect of supply chains under pressure are inevitable - with rising costs, labour restrictions and lead times for goods becoming more punctuated. The impact in turn further downstream on product, overheads and profit will of course become an increasingly important area for acquirers to stress-test as part of their transactional due diligence.

It’s worth noting that supply chain issues are inevitably varied according to the respective size of an organisation. Smaller and mid-size players are traditionally not as diversified from a supplier perspective and are instead using a small number of providers with a small book value of orders. This presents a problem in the current environment as when supplier availability is finite, cracks begin to appear in a business’s supply chain strategies as “diversification of suppliers becomes hard as you don’t have enough volume to keep them interested” (Alistair Compton, MD of Stovax). The impact of this increased competition for suppliers is that those suppliers can increase cost (and be more selective on who they supply to) which can result in a decreasing net profit for those they supply goods to. Smaller-sized businesses have some protection in their suppliers’ relative scalability which will make their contracts with bigger businesses whilst attractive, largely unattainable without investment. Suppliers reviewing and renegotiating their position therefore has a larger impact on mid-size businesses as they are dependent but not yet achieving the economies of scale that their competition may plausibly be able to achieve.

Conversely, larger players have longer term volume-based agreements in place which will protect their business models. They’re also protected from a storage perspective where they “can take risks with stock holding where smaller businesses and owner-managed businesses probably don’t have that luxury” (Alistair Compton, MD of Stovax). The net result is clear – the supply chain issue has more of a demonstrable impact on smaller players than larger businesses, and as a result, smaller business models may necessitate a sale. Similarly, these businesses may appear more attractive to larger players to leverage their business model and their bargaining power to develop viable acquisition strategies.

Depending on how successfully this position is managed, there are opportunities that affect the buyers’ and sellers’ negotiation position. Simon McMurtrie, Chairman of Virgin Experience Days, points out that even “for businesses which are not dealing with lots of physical goods being shipped around the world, there is still a massive shortage of assets” and therefore there are business opportunities for those who review and package up their business models to create an attractive proposition for a potential acquirer. Interestingly, CSR considerations and overtures on “buying local from a sustainability perspective remain high on the agenda” (Polly Powell, owner of Batsford Books). This may become even more pronounced where businesses can tweak their business models to a more local provision to protect themselves and attract acquirer attention.

Another option for businesses is vertical integration of suppliers and manufacturers. This of course requires capital and is therefore more realistically viable for bigger businesses, but there are opportunities for smaller players to consider this and thereby mitigate their supply chain risk. Guy Blaskey, founder of Pooch and Mutt points out that “if you’re a product company and a complimentary business with their own manufacturing came up it might be worth looking at” given these pressures. Alistair Compton, MD of Stovax also sees “insourcing as one way to combat the pressures and bring more of the manufacturing in-house” but notes that such a strategy will take investment.

Regardless of the tactic deployed, supply chains are pressurised and will create problems for businesses to overcome and in turn create opportunities for potential acquirers. This needs to be factored into an investment strategy and is further complicated with the availability of debt and the relative (and increasing) conservatism within the financial market.

Financials – valuations and debt access

Transactional activity is subject to supply chain pressures but goes deeper that that. The underlying impact on valuations is further complicated by the debt market, which beginning to put a “break on what has been a post-pandemic boom for private equity” (Keith Bushnell, CEO of HCML) as accessing capital accordingly becomes more problematic and subject to greater scrutiny.

Despite this, the view of those interviewed as part of this report is that the ‘debt shadow’ has yet to hit markets to the level it can. This is particularly relevant in the UK market which remains very strong with multiples of 12-15 compared to five years ago when many PE acquisitions were running at multiples of 10. This is important as despite the macro-economic conditions and the tightening of the debt markets there will still be opportunities for selling businesses on the assumption the business has been performing well against a challenging environment.

Businesses will be assessing their risk of destabilisation and the impact on securing investment to grow their business as is. For many the assessment will be based on where the entity is in the corporate life cycle. As Guy Blaskey, founder of Pooch and Mutt points out, “if I was an ultra-fast growth, high loss market company now I’d be scenario planning for what happens if the investment money doesn’t come in” to potentially weather the storm as it is clear that “no-one is of the view that the world has become more certain” (Alistair Compton, MD of Stovax). However, the debt position may not be as much of a problem for some businesses, as “if you’ve got pricing power, then the fact that your costs are going up is not that bad as you can pass them on to your customers and still maintain competitiveness” (Keith Bushnell, CEO of HCML). Acquirers need to therefore scrutinise where the target’s pricing power sits and what the impact of that position now and in the future will be on the long-term viability of any such transaction.

For larger companies that are susceptible to the economy slowing down, a prudent investment strategy may be “to push further bolt-on acquisitions to get the growth targets within the same time frame if it can’t be done organically” (Keith Bushnell, CEO of HCML). This may be an option as despite questionable returns and availability of viable assets, an existing business may be able to limit macro conditions via this route. As well as looking at their own business performance, it is also wise for businesses to refresh their transactional playbook and shortlist of viable targets. Acquirers will recognise that some businesses have struggled for the last couple of years and given the market position it may take them a couple of years to get the valuation at which they want to exit. Tactically therefore, if you have a platform that you can build on whilst “keeping costs down by spreading overheads then it’s a good time to buy” (Keith Bushnell, CEO of HCML). Critical here is complementary acquisitions, not diversification, as the latter can give opportunities for difficulties to develop in a challenging market. If you’re a seller, the emotional connection may be a hindrance here; if your EBITDA has gone backwards compared to what you felt it was, you’ll either need to reset your expectation on your exit price and sell, or wait for the potential rebound of your business to the highs it previously operated at.

Most investors come from a background of “identifying the value, grabbing it with both hands, integrating it quickly and then moving on” (Alistair Compton, MD of Stovax), but with some of the underlying problems mooted above many potential acquirers are considering some changes to their investment analysis models. The due diligence here is of course vital for businesses to understand what they are getting and working out the value of a business. However, as Alistair Compton, MD of Stovax right points out, “forecasting for a business is very, very difficult at the moment as there is so much uncertainty and volatility out there.” Whilst there are measures available, such as “warranty indemnity insurance which we are seeing more of in acquisition strategies” (Simon McMurtie, Chairman of Virgin Experience Days), the general consensus is that the valuation needs to focus more on where the value is “in 6 months rather than 12 months as was the plan before” (Alistair Compton, MD of Stovax) to enable another layer of protection for acquirers.

These changes in investment analysis are symptomatic of the changes in the economy and the impact of global developments which is resulting in “both buyers and sellers making sure things are a bit tighter without necessarily stifling speed” (Simon McMurtrie, Chairman of Virgin Experience Days) as part of their transactional processes. Some of the underlying issues that the market presents on both sides of a transaction require systemic analysis of business strategy but also, if an opportunity occurs, can create more scrutiny when running a transaction.

Competitive tension vs collaboration

The strategic merit of adopting a transactional strategy now for buyers and sellers inevitably has a myriad of assessments behind it. However, increasingly those involved in transactions must pay more attention to the underlying psychological factors affecting competitive tension with often diverse views and options.

We touched on some of these psychological factors in a previous piece in conjunction with Bayes Business School (formerly Cass); whilst some of these still hold true, a number of themes have emerged from the seismic change and adaptations that have been forced on businesses over recent years.

From a seller’s perspective as alluded to earlier “most people get one chance at selling their company and they don’t do it repeatedly” (Edward Hoare, Partner, RWK Goodman) and as such the pride a seller has in what they’ve built is unquestionable. However, for many harnessing the enthusiasm of a seller is critical to deal success. Polly Powell, owner of Batsford Books, points out that those individuals are working from a starting position of “I care about it, I want it to work” and acquirers should consider transactional playbooks to harness that energy. Utilising this pride can also translate to a deeper level as incumbent leaders “can take a holistic view and understand what is working and what is not” (Guy Blaskey, founder of Pooch and Mutt) and convey that to the acquirer which will give integration plans a boost. Utilising the target’s workforce in the transition, integration and future-proofing of the business is something that will be discussed in due course but as a starting point, the view is unanimous that ‘bad chemistry’ between buyer and seller is often a significant contributory factor to deals failing.

The tension that can occur when the deal is being negotiated is often a net result of the adversarial nature of M&A, starting inevitably with price, and should there be a bidding war, an anticipation thereafter when you get to the detail (particularly when an acquirer overspends) to reconcile these early projections. Simon McMurtrie (Chairman of Virgin Experience Days) is an advocate for being aware of these limitations. For potential buyers he recommends that they “be prepared to pay slightly more in order to make sure you’ve got the terms you want and the alignments you want.”

Unfortunately, the general perception is “that everyone has to leave feeling slightly unhappy about the whole thing for an accord to be reached” (Polly Powell, owner of Batsford Books) when in fact, a more productive starting point would be an acceptance that “you’re not going to win every battle” (Guy Blaskey, founder of Pouch and Mutt). This is of course where advisers are critical; their role being to support the aim to reach an early equilibrium and to establish a relationship and rapport within the transactional team, and focus not on the minutiae but instead the on the principles that matter. Arguably, the key symbol to this strategic intent is the preparation of the initial heads of terms.

Instead of early attempts to negotiate better terms, and particularly noting some of the issues presented in the previous chapter, it’s plausible that “looser heads of terms probably allow everybody to make some decisions without too much investment” (Alistair Compton, MD of Stovax) and therefore set the foundations for good transactional execution. However, whilst this represents a tactically astute approach, caution is to get agreement on the principles as “it is very easy to rush into a set of heads that ignores the key issues and then they build up and they come at the end of the process” (Keith Bushnell, CEO of HCML). Whilst looser heads of terms may engender relationship confidence, the view is unanimous that where there are disagreements it is in the interests of both parties to manage them “comprehensively so there is no confusion” (Simon McMurtrie, Chairman of Virgin Experience Days).

Interestingly, against a backdrop of economic destabilisation, several advisers have mentioned the curious impact of Covid on transactional process and the underlying relationships. The movement of dialogue to the virtual world has strangely been a relationship enabler, causing people to feel “more connected via Zoom than in person” (Polly Powell, owner of Batsford Books), which has the potential to break down barriers and engender greater collaboration in the early stages of negotiation. Guy Blaskey, founder or Pooch and Mutt, has also seen the efficiency by-product of WFH play out in deal making with the view that “everyone is probably a bit slicker now working remotely” which helps once a deal’s terms have progressed to managing the transaction to completion. Whilst there is a current feeling of a more collaborative mindset in transactional processes, it’s not necessarily going to be a lasting trend. In fact, Alistair Compton, MD of Stovax, anticipates this trend will subside over time and “it will move back to the competitive mindset” for deal negotiation.

Regardless of the negotiation and the terms that buyers and sellers settle on, represented parties always note that these considerations are largely about people and culture and critically “you’re spending a lot of time with these people over a number of years afterwards, so you don’t want to burn those bridges for the sake of some small print” (Guy Blaskey, founder of Pooch and Mutt).

Workforce as a driver for integration

As is often voiced in management studies on business, organisational DNA is critical to business success and so it’s to be anticipated that the “the key on integration is always culture” (Keith Bushnell, CEO of HCML).

The cultural aspects of integration and the variances between styles from one jurisdiction to another is an important consideration leading Polly Powell, owner of Batsford Books, to state that “if we were to set up a US operation, we’d need a US person on the ground to do that due to the cultural variances.” Guy Blaskey, founder of Pooch and Mutt, agrees that it’s often “not a logistics thing, it’s more an understanding of the brand and an understanding of the market” and how that plays out in the jurisdiction concerned that can be vital to integration.

However, whilst the UK market is attractive to potential international acquirers due to the notion that “our employment laws are pretty easy to understand compared to other jurisdictions” (Alistair Compton, MD of Stovax), some of the economic changes alluded to in this report and the impact of a period of enforced home working during Covid present a new dichotomy for integration. At its centre is talent. We touched on a number of these issues in our recent workforce campaign; viewed through a transactional prism, one of the key areas of focus is protecting the deal value via the workforce. Keith Bushnell, CEO of HCML, sees this as a step change in transactional processes with “people paying more attention to succession planning – not just in the next 18 months but three to four years out.” This recognition and this change are increasingly important given the accessibility of workforce now and when the equally important integration begins.

The perception is that the end of the pandemic lockdown also brought with it a surge of people moving roles as employees reflected on their employment and employer, their work/life balance, and their aspirations for the future. This has put pressure on integration planning as “it’s unlikely the target company will have all the talent and horsepower to fulfil the longer-term ambition of the acquirer” (Keith Bushnell, CEO of HCML). As a result, talent acquisition plans to support the transaction need to be considered against a recognition on availability of resource to “recognise that you might not be able to get as many people as you’d like” (Alistair Compton, MD of Stovax). Guy Blaskey, founder of Pooch and Mutt agrees, and sees the notion of “hiring the best people for the role as opposed to just the best we can afford is definitely a shift change” which acquirers will need to factor into their playbooks alongside underlying shifts in the employee-employer relationship and hybrid working.

The changing perception of workforce has posed questions that were less pronounced before the pandemic such as “do you want someone who is less good at their job just because they live closer to the office?” (Guy Blaskey, founder of Pooch and Mutt). This is particularly relevant when considering the inflationary pattern on wages which is leading to an ever-increasing overhead model where employers are putting “salaries up to attract people and the impact is that existing employees see that which drives inflation” (Alistair Compton, MD of Stovax). Despite these workforce considerations that may impact decisions on transactional integration and thereby should take more prominence in early-stage planning, those we interviewed felt that an integration process will not be a success without the ‘water cooler moment’ with many seeing “being in the office as critical to integration” (Polly Powell, owner of Batsford Books).

Despite the emerging workforce trends, the key is for acquirers to be measured in their integrations and not “chew off the hardest piece of the integration first, instead test first and build trust around the business - keeping things separate unless the acquisition rationale is cost reduction not growth until it is the right time for their integration” (Keith Bushnell, CEO of HCML). This is where a buyer’s advisers are critical as they can use their knowledge from similar transactions to recommend courses of action.