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A company really only grows in two ways. The first is organic, whereby it grows existing operations by gaining market share, new product lines, new geographies in which it operates, or maybe even new areas of operation. This is perhaps the more important growth method because if a company cannot grow organically, then either the sector it operates in is dying, or it’s a dying company.
But there is a second way in which a company can grow and that’s by acquiring other companies. These acquisitions may be smaller bolt-on deals that add some efficiencies, or may be large deals such as taking out competition or moving into new sectors or geographies. A good acquisition (or series of acquisitions) can be a real game changer for a company as it can be propelled forward, but it also comes with serious risks.
The risk I want to focus on this week is how much is being paid and, importantly, how the acquisition is being funded.
How much is paid is a real risk because, if a company overpays, then the deal is not great at all and may hurt the company in the long run. Ideally, any deal must be completed at a realistic valuation – hence price-to-earnings ratio (P/E). Different sectors have different P/E ranges, but, for example, in the banking space anything being bought for a P/E of more than 10 times is likely too expensive.
The trick with the acquisition of an unlisted company is that, often, there is no clear P/E available. However, if enough details are provided, the P/E can be calculated: divide the purchase price by the profits that the new company is expected to generate – this will provide the purchase price P/E.
Often, profit warranties will also be included in the deal. In other words, the company being bought has to achieve certain profit levels for the next year or two in order to get the full payment. If the profits come in lower, then the purchase price can be reduced. I am a fan of this concept as it reduces the risk for the acquiring company.
The second part of the process is how the acquiring company is funding the purchase. I am a fan of paying cash, even if this means raising debt. Aspen is an expert at this; the company is very cash generative and can typically pay off the debt fairly quickly. Using debt means paying interest, making the eventual total cost higher due to the interest paid. But it does mean the company pays once for the acquisition.
The other way to pay is to issue shares to the seller. Most companies have shareholder approval (granted at the annual general meeting) to issue a certain number of shares at director discretion. In a sense this means the company is bought for free; no cash changes hands, only new shares are issued.
My problem with this is that these shares reduce my holding in the company, and they have a perpetual claim on profits. Now sure, the profits should rise after the acquisition, but we’re giving part of these profits and part of the other profits of the company to the seller who received new shares. My slice of future profit is permanently reduced.
A last method is a rights issue to raise cash to pay for the deal; this is essentially issuing new shares with the same impact as the issuing of shares to the seller.
So while acquisitions can be great, one has to look out for the possibility of overpaying and be aware of how the deal is being funded. I like cash deals, and I want to pay at a valuation that is at the low end for the industry. Overpaying and giving away future profits adds risk.
This article originally appeared in the 30 June edition of finweek. Buy and download the magazine here.
