The White Paper is Almost Done
If you remember our joke about being in the business of shaving hair, then you probably remember the business we reached out to that had botched an acquisition and gone through some rough years as a result. The reason we did that was because what was oddly impressive about this situation was that despite years of losing money trying to integrate a botched acquisition, the core business had been able to fund those losses for so long. Ergo, the core business might actually be a good one.
So we reached out and floated a valuation and structure to suss out interest and receptivity. The valuation, we thought, was competitive and down the middle, but the structure was admittedly conservative since the valuation baked in righting the botched acquisition and then also refocusing on the core business to grow it.
As for what made the structure conservative, our offer was to pay half of the consideration at close and the other half a few years later contingent on those things (righting the botched acquisition and growing the core business) coming true. Our rationale was that the business was worth one amount if the obvious problems were fixable and a different, lesser amount if they weren’t.
Of course, 50% is a pretty big haircut and the upfront consideration probably undervalued the core business on a standalone basis. But the reason we weren’t comfortable offering a consideration equal to the standalone fair value of the core business upfront is because the core business wasn’t standing alone. Its management was distracted, its cash flow wasn’t 100% distributable, there was the potential for conflict in deciding what to do next, and taking steps to help the core business stand alone would be expensive (severance and lawyers and liquidation processes add up).
All of these things are risks and if you are going to take them, our view is that you need to be compensated for doing so. How do you do that?
In our line of work we see a lot of what academics would call “idiosyncratic risk.” These are risks that are unique to a situation and so therefore aren’t captured in the risk premia assigned to more widespread factors such as illiquidity, small-size, or equity risk. Examples include:
Inaccurate information risk: We’ve seen businesses that track their inventory in a spiral notebook and also lost track of inventory “back in the 90s.”
Slow feedback loop risk: We’ve seen businesses that don’t close their books until six to eight weeks after the end of the month and others that only do reconciliations quarterly.
Whim risk: We once saw a business whose sole supplier was wholly-owned by a hostile foreign government and another whose sole customer was a big box retailer. In either case, the reversal of course by the counterparty would cause the business to disappear overnight.
Rural risk: It’s really hard to relocate talent to small towns.
Relationship risk: Are customer relationships with the business or with an individual?
The list goes on…
Now, some of these, like whim risk, could metastasize overnight, while others, like rural risk, manifest themselves as more incremental long-term headwinds. But you can take any of them (and we have taken some, but not all of these) provided you are compensated for taking them. Now, if you asked a firm to do an independent valuation, they might look at these idiosyncratic risks and bucket them into an “Additional Risk Premium” that they add to the discount rate when valuing a projected stream of cash flows. And that’s one way to do it, and we do increase our required rate of return as we identify more and more idiosyncratic risks.
But structure is another useful tool in making sure investors are compensated for taking odd risks because thoughtful structures can more effectively account for the potential timing and magnitude of the impact of a specific risk materializing.
For example, in the case of whim risk, the business might disappear overnight. To be compensated for that might mean negotiating a deal structure with a shorter payback period and perhaps attaching a put option as well.
For something longer-term like rural risk, you might ask for some kind of hurdle or preferred return that bakes in the expected growth rate in the event it doesn’t materialize.
To return to our offer of 50% guaranteed at close and 50% contingent and deferred to invest in a turnaround project, we felt that our offer was fair because it compensated the seller appropriately for what had been achieved to date, but also recognized that they were offloading significant risk to us. But offers aren’t made in a vacuum, and in this case we got blown out of the water by someone who offered more than us all guaranteed at close.
Now, that’s a great offer if you want to get a deal done, and in terms of immediate feedback loops, mission accomplished. But is that buyer being compensated for the longer-term risks they are taking or is it the case that we wrongly perceived more risk than was real? Only time can tell on that.
-Tim