My Approach to Serial Acquirers

  • “A standard acquisition involves only a concentrated investment at above market prices with high transaction costs. It makes little or no business sense.” - Bruce Greenwald, Competition Demystified

  • “I have 53 stocks in my portfolio, and I have one trigger that will lead me to sell the stocks right away. You do a big acquisition, I’m out of your stock. I don’t care what justification you give me. Because I know my history. If you do a big acquisition, the odds are loaded up against you.” - Aswath Damodaran, Acquirers Anonymous

Given the above statements, it’s worth asking “If an acquisition is so value destructive to shareholders, why invest in companies that do any acquisitions, yet alone ‘Serial Acquirers’?

For most companies, acquisitions will almost certainly destroy value for shareholders. Cash may be better directed to other activities, promised synergies may never materialize, integrating the acquired business may take longer and be costlier than previously expected. For some companies, however, acquisitions can make sense; either through a disciplined acquisition process or where the underlying economics of the business make acquisitions prudent.

My own thinking on serial acquirers is heavily influenced by 'Studying Serial Acquirers' (Archive), which, in turn, draws from Scott Management's piece on Serial Acquirers (Archive). The remainder of this essay will draw from both of these pieces, and I would strongly encourage the reader or anyone with an interest in serial acquirers to read both these articles.

The primary reason investors are drawn to serial acquirers is their ability to, hopefully, reinvest large amounts of cash at a high rate of return for a long period of time in a tax efficient manner. To quote a famous investor

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” - Warren Buffett

Some important considerations must be made to separate the next Constellation Software from the next Valeant Pharmaceuticals.

Top Down vs Bottom Up

One of the most important factors to be considered when analysing a serial acquirer is whether or not acquisitions are conducted on a top-down, i.e., by senior management, or on a bottom-up basis, by acquisition teams operating autonomously. It is not an issue if acquisition decisions are made by senior management initially, but, as a company grows, if executives are required to be involved in every acquisition decision, it will quickly become a bottleneck on future acquisitions and also speaks to their inability to effectively scale their operations. In addition, if management is unable to delegate the acquisition process, it likely means that their acquisitions are not programmatic.

Transaction Volume

A 2021 study by McKinsey & Company found that companies pursuing a ‘programmatic’ M&A strategy outperformed ‘selective’, ‘organic’, and ‘large deal’ approaches. Programmatic was the only M&A strategy that provided positive excess returns to shareholders. This ties into my point about bottom-up vs top-down. If a company cannot implement a programmatic strategy, if senior management must weigh into every acquisition, the company will be constrained on the number of acquisitions they can complete per year and will not be able to scale their operations efficiently. As serial acquirers grow, their deal sizes will grow with them. Acquisitions will become more competitive. Multiples paid will go up and IRRs will go down. There are diminishing marginal returns to capital as companies grow and how efficiently companies scale their operations will determine how long before their size becomes an impediment to earning above their cost of capital.

Source: McKinsey & Company

Not depend on synergies

An acquirer being dependent on post acquisitions synergies can represent a bottleneck as the company continues to grow. If a serial acquirer is continually forced to find ways to integrate acquired business, they mind find themselves being forced to devote time that may be better spent seeking out acquisition targets.

I have no issue with companies acquiring other companies where there are real synergies between the combined entity. Ideally, due to occupying some niche or being the buyer of first choice, the multiple paid would be low. However, if the numbers only work because of synergies, it should be noted as a negative mark towards the company.

Pipeline

Another important consideration is the pipeline of potential investments. While there may be many suitable target companies for a serial acquirer to take over, it will only produce so much free cash flow over a given period of time. Management must be selective in choosing which companies to acquire at what time. A long acquisition pipeline gives flexibility in choosing when a company can be acquired. You may even argue that cultivating a relationship prior to acquiring a company may impact the purchase price. Acquirees may feel more comfortable being acquired by a parent-co that they know and trust, and this may end up being reflected in the purchase price. Getting to know a company over a longer time period can be considered a form of due diligence, with unethical or incompetent management being allowed to fall to the wayside and honest and competent management continuing to be cultivated. These long-term cultivations of relationships also serve to minimize integration costs post-acquisition. By the time an acquisition is finished, how the acquired company operates and how it fits into the acquirer should be well known.

Capital Intensity

In in his 2015 letter to shareholders, Mark Leonard breaks down two metrics he uses when evaluating ‘High Performance Conglomerates’

  • EBITA Return = EBITA

Average Total Capital

  • ROIC = NOPAT

Invested Capital


ROIC is a measure of operating efficiency. EBITA return also measures efficiency but is influenced by leverage of the company.

The study conducted at Constellation Software found that EBITA Returns tend to start out modest initially, 21% was the average, before inflecting upwards. In capital light businesses, no additional capital was required to fund new growth and returns improved. The numerator increased while the denominator stayed the same. The life cycle phases appear to be moderate returns initially, then high returns, and finally declining returns.

The above should highlight the difference between ‘Capital Light’ and ‘Capital Intensive’ serial acquirers. This might seem like a curious distinction at first. All serial acquirers are capital intensive by nature. All free cash flows, I hope, are reinvested in future acquisitions at attractive IRRs. Whether or not the underlying businesses are capital intensive or not is another matter. It is important for a prospective investor in a serial acquirer to understand whether or not future growth is going to come at a cost.

Metrics

Finally, we come to metrics. Good corporate governance and proper compensation are important regardless of whether the company being analysed is a serial acquirer or not. Due to the acquisition intensive nature of serial acquirers, the incentive structure deserves additional scrutiny. An executive may be compensated for reaching an EBITDA target by year-end. Facing the prospect of falling short of this target, they may undertake several badly executed and poorly thought-out acquisitions to reach their goal.

“When you divide Adjusted Net Income by Invested Capital, you get a measure of the return on our shareholders’ investment (i.e.ROIC). If you add Organic Net Revenue Growth to ROIC, you get what we believe is a proxy for the annual increase in Shareholders’ value.” - Mark Leonard, Constellation Software

I am a fan of ROIC + Organic Growth, or the ‘Combined Ratio’ as Mark Leonard calls it. ROIC is hard to manipulate and is a good measure of financial performance. The numerator, Net Operating Profit After Tax (NOPAT), is used in the calculation of free cash flow (subtract CapEx and increases in working capital) and in the calculation of economic value added (subtract WACC x Invested Capital). ROIC + Organic Growth forces acquirers into a balancing act. Pay a high multiple for an organically growing company and ROIC falls. Continually invest in cheap, value-traps and Organic Growth falls.

The ideal Serial Acquirer – What does it look like?

Given all of the above, what would an ideal serial acquirer candidate look like?

I believe it would have some or all of the following characteristics:

  • A decentralized, bottom-up acquisition process.

  • A programmatic acquisition process.

  • Large transaction volume with low acquisition size. In other words, a large number of small acquisitions.

  • Not dependent on post-acquisition integration or synergies.

  • Long acquisition pipeline.

  • The businesses underlying the serial acquirer are capital light.

  • Careful selection of proper financial targets and metrics, especially in relation to compensation.