After several dry starts, Tom settled on trying to acquire All-American Packaging Company. Three fairly young managers owned all-American. These managers had started All-American ten years earlier, after they had worked together for an industry giant. They had each previously taken a division through a period of hyper-growth, but as is often the case, they eventually felt stifled by the larger company’s culture. Each manager now oversaw a critical functional area: administration, marketing and sales and operations.
All-American had positioned itself as niche player in the packaging industry, such that it received higher margins on its $40 million in sales than would normally be the case. All-American had just implemented a state-of-the-art enterprise computer system that Tom believed would support a five-fold growth of the company.
All-American showed recast earnings before interest, taxes, depreciation and amortization (EBITDA) of nearly $6 million. This was expected to increase to roughly $7.5 million in the following year. A deal was finally struck after several months of negotiations. Corrugated Acquisition company offered to purchase 80% of All-American for $30 million. This put the enterprise value of All-American at $38 million, or roughly 6.3 times the current EBITDA and 5.1 times projected EBITDA. The All-American managers kept 20% of their stock because Tom wanted and needed them to be motivated to help build the empire. A letter of intent was executed, which left Tom with only one problem: he was short $29 million ($30 million purchase price minus $1 million in his equity). Additionally, transaction fees would add another $1 million to his capital requirement.
A paradox of the private capital markets is that it’s far easier to raise $30 million than it is to raise $3 million. This is because institutions such as banks and mezzanine firms incentivize their personnel to lend or invest large amounts of money, as opposed to smaller sums. There is a rationale for this bigger-is-better thinking – larger companies tend to employ professional management teams, who typically have good control over the companies’ operations. Both these factors decrease the risk of lending/investing. Tom knew that his deal was in the strike zone.
Tom’s investment banker created a financing memorandum that told the story of the capital need, as well as the future plans for the new company. Tom noted that banks historically lent 3-4 times EBITDA for deals of his size. Using the higher lending multiple, this would amount to roughly a $24 million senior loan ($6 million EBITDA times 4). This left Tom still $6 million short of his capital goal.
Next he turned to the mezzanine capital market. Mezzanine capital is subordinated debt that provides borrowing capability beyond senior debt while minimizing the dilution associated with equity capital. Since it forms an additional layer of debt, it carries more risk for the lender than normal or senior debt. It ranks behind senior debt for the purposes of principal and interest repayment. Compared to a bank loan, it contains a fairly loose covenant package. These factors make mezzanine debt more expensive than senior debt for the borrower. Nevertheless, it remains cheaper than institutional equity investment and may be available when the supply of equity is limited.
Tom learned that mezzanine providers would typically not lend more than 2 times EBITDA. Even though he only needed $6 million, Tom decided to get a commitment for $12 million. He would use the first $6 million tranche to close the deal, and the next $6 million would not be funded until needed.
Tom figured his all-in cost to access mezzanine was nearly 23%: this was comprised of an 11% coupon rate, plus warrants that exercised into 5% of Corrugated’s stock. Repayment of principal was deferred for two years, which met the needs of his cash flow projections.
Source of Funds
Percent of Capital
Tom negotiated a price of 5 times his company’s EBITDA at the time of exercise times 5%. Tom figured that Corrugated Acquisition Company would yield an EBITDA of about $15 million in 4 years. This meant that he would have to pay the mezzanine source about $3.75 million for the warrants at the end of the fourth year. This $3.75 million was on top of the interest payments and repayment of the $6 million loan!
Tom was concerned with the high cost of the mezzanine, but he knew that he could not close the deal without it. He also knew that his company’s weighted cost of capital was fairly high. He calculated that the all-in cost of bank financing was about 5%. This accounted for 58.5% of his capital structure. The all-in cost of the mezzanine was about 23%, and this accounted for about 15% of total capital. The remaining 26% of the capital structure represented Tom’s original investment of $1 million plus the manager’s $8 million rollover into Corrugated Acquisition Company (the amount that they didn’t sell). Tom and the managers wanted compounded returns of at least 35% on their investment.
Some quick math showed that Corrugated Acquisition Company’s weighted cost of capital was about 15%. Tom knew that this was an important number. Basically he would not begin creating value until returns on invested capital exceeded 15%. After months of messing around with lawyers, CPAs and various governmental agencies, the deal finally closed.
Now Tom could get to work creating value via his consolidation strategy. With his platform company in place, Tom immediately began to implement what he called his “buy left, sell right” strategy. This was another way of saying that he would not pay more than 5 times recast EBITDA for an acquisition. He hoped to grow the company so he could eventually sell-out for close to 10 times EBITDA
The first round of acquisition candidates all had one thing in common: they were not creating value for their owners. Tom discovered that most companies in his industry with annual sales in the $5-7 million range were not creating value. This was because margins had fallen to the point where owners could earn a living, but not create business value.
The following table summarizes an income statement for the first acquisition candidate – Smith Packaging. Jim Smith had owned Smith Packaging for 15 years. During the last 5 years his company’s gross margins had fallen six points, down to 23%. Larger regional competitors had created a more efficient production process, and Jim knew that eventually the company would not be able to pay his $250,000 annual salary. Jim was still relatively young and wanted to work for at least five more years, so he was amenable to selling-out when Tom called.
Smith Packaging Company
With only $500,000 EBITDA, why would Tom be interested in acquiring Smith Packaging? First, Jim Smith had a reputation as a great salesman. Tom knew that freeing up Jim to sell would add millions in annual sales.
Secondly, almost all of the administrative costs that Smith Packaging was spending would not be incurred by All-American. All-American personnel would handle functions such as accounting, human resources and sales management. Tom figured this would save about $1 million per year.
Tom needed to determine how much to pay for Smith Packaging. A big part of the answer was found in Smith’s balance sheet:
Smith Packaging Company
Summarized Balance Sheet
Machinery & Equipment
|Total Liabilities & Equity|
Tom would limit his offer to the amount he could borrow from the bank. In this case the bank agreed to lend 70% of Smith’s accounts receivable and 50% of its inventory and machinery and equipment. This amounted to about $1.2 million. Tom wanted to lock-in Jim Smith for five years. So instead of offering Jim $1.2 million in cash at the close, Tom offered $1 million at the close plus a $500,000 seller note. The note would pay 8% interest and would fully amortize over 5 years. Corrugated would also assume Smith Packaging Company’s debt. Finally, Jim Smith would be retained to sell to major accounts.
At first blush, it might seem expensive to pay $1.5 million plus assume another $1 million in debt for a company with a $500,000 EBITDA. But the deal accomplished several things for Tom. He added another $8 million in sales to All-American’s business. In so doing, he would save about $1 million a year in G&A expenses. This meant he could expect a payback of about 2 years from the investment. He picked up an experienced national accounts salesperson, who he figured would sell an additional $3-5 million each year. Finally, he didn’t use any cash to make the acquisition.
Tom originally identified about 20 acquisition candidates that fit his profile. He bought six more companies in the next 18 months. Together with the organic growth of All-American, Corrugated had annual revenues of more than $100 million and an EBITDA of more than $15 million within two years of the platform acquisition. Corrugated stayed aggressive in its third year, closing several more deals. Beyond the platform buyout, Corrugated never paid more than ‘5’ times EBITDA for any acquisition.
At the end of the fourth year, Tom sold Corrugated to a large industry player for $150 million, plus the assumption of about $60 million in debt. This sale correlated to about ‘8.5’ times EBITDA. Tom’s partners – the original All-American managers – received about $30 million from the sale, which was the same number they earned on the original sale 4 years earlier. Tom received about $100 million from his initial $1 million investment.
REASONS FOR ACQUISITION SUCCESS
The Consolidation Game aggressively grows business value by exploiting the market’s tendency to pay higher multiples for larger companies. This strategy can be replicated in most industries. To be successful, several steps should be followed:
- The implementer must be quite knowledgeable about the industry segment in which the consolidation will occur. This is important because a seasoned manager spots niches that can be exploited. Secondly, the capital markets support a veteran manager. And third, owners of acquisition candidates are more likely to participate in a consolidation that is being led by a credible manager.
- The implementer must make sure that the market will pay proportionately more for larger companies in the proposed segment. A few lunches with investment bankers who are familiar with the industry should clear this up.
- This strategy requires that a platform company must either be owned or acquired. The platform must have open capacity relative to systems and management time. Just as importantly, the key managers must be experienced in managing hyper-growth situations.
- The implementer should study the industry to determine which companies are not creating business value. This strategy works best if fair numbers of candidates can be identified and purchased within a fairly short period of time.
- Add-on acquisitions should be synergistic with the platform and must be purchased at reasonable multiples. Ideally, all acquisitions would be purchased for less than ‘5’ times EBITDA.
- The implementer should contract with add-on company owners to keep them involved. This can be accomplished with employment agreements, seller notes, earn-outs or some combination of the three.
- The implementer should not fall in love with the consolidated result. Timing is important here. This strategy tends to work best when initiated at the tail end of a recession; the implementer then sells the entire company within 5 years.
The Consolidation game is not for the faint of heart. Success requires an industry track record, the formation of a team that can help raise capital and identify potential targets and the ability to integrate companies. Tremendous value can be generated, however, for those with the vision and courage to play this game.
The Phil Mickelson manager is equivalent to the PGA Masters Tournament, a new breed in the M&A game.
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