Buy a Business No One Else Wants to Own
Thoughts on M&A, takeout premiums and compounding
For most people (including myself), when they first are introduced to the investing business, M&A is presented as this super cool thing. What is the best thing that can happen to one of your portfolio companies? Someone buys it and pays a nice premium! What do you want your companies to do? Buy other ones and extract synergies! Deals are fun and exciting, maybe even exhilarating. An investment banker smiles every time a new member of the investing community joins and is inoculated in to the cult of M&A.
As you get a little bit older, wiser, and likely more cynical, the bloom starts to come off the M&A rose. There is academic evidence, highlighted by Mike Mauboussin, that suggests that most of the value in M&A accrues to the seller. Even the more recent data I saw (which I can’t seem to find at present) suggested that M&A can work for the buyer, but only in the right situations. We all remember the disastrous blockbuster, headline-grabbing deals, many of which somehow involved AT&T. Many of us also have war stories about the company we owned that took on too much debt to make acquisitions and, due to bad luck or poor execution—or both—permanently impaired its equity. Of course there are examples of companies that have created an incredible amount of value via M&A. Constellation Software comes to mind. But for every Constellation, there are probably five Valeant Pharmas that end up in catastrophe.
This is not an article on when M&A works—as a buyer—and if engaging in M&A is intrinsically good or bad. But there are a few things I should note. First, it goes without saying that price really matters when making deals. Also, certain roll-ups can work to the benefit of the acquirer. And clearly, the private equity guys have made ridiculous fortunes buying other companies. This is a piece on how to think about acquisitions when they are happening in your portfolio. My basic premise is that I want to own a portfolio of companies whereby I would be mad as hell if another company, especially one in private equity, buys (steals) one from me for a nice 25-33% premium to the VWAP. I also wake up every day hoping not to see the news that one of my companies has made a “transformational” deal. (I am still so mad about this Tapestry buying Kors deal.) Because I know the base rates associated with such deals—and they ain’t great for the buyer. Every single investor and management team is capable of deluding themselves into believing that the base rates don’t apply to them or to this deal. But base rates are kind of like gravity—they are hard to escape.
Ok then, if the sellers are the winners in most deals, so why I am so opposed to watching my portfolio companies get taken out? We’ll get there…
The irresistible lure of the deal
If you had been a fly on the wall at my prior firm in 2021 or 2022, you might have heard something like the following being discussed—with me leading the conversation by the way:
I think NBCU is the best acquirer of the Lionsgate studio. They already have a content deal relationship with Starz and the Lionsgate IP would go great within the theme parks. And heck, why not combine Starz and Peacock and extract the huge technology synergies between the platforms?
What if Elon just wakes up one day and buys Viasat for some huge price so Starlink has the best technology in both LEO and GEO satellites?
Millicom has by far the best cable footprint in South America. There has to be some South American billionaire who would want these assets and pay a premium to the 4x EBITDA multiple the company trades at.
These are just a sampling of the types of conversations I had, over and over and over again. I made the distinct and unforgettable mistake of owning a bunch of “special situations”, along with a stock that always had the risk of a satellite blowing up (or simply not deploying properly). Even better than a holdings a bunch of special situations is owning a company with binary risks. When you own mediocre businesses where it is unclear if they are getting more valuable over time, watching them get acquired represents an extremely attractive exit. In that case, someone else takes over the risks that you had identified and you get a premium. (I am assuming that the boards of most companies won’t approve a take-under, even if it is warranted.) I found myself hoping, almost praying, for these companies to be taken away from me. In some ways, it was the only way out I could foresee. If you are wondering, that is not a healthy state of mind to be in as a PM. It leads you to consider and imagine all kinds of fantastical or just plain unlikely M&A scenarios. In hindsight, I should have sold them all. In one day. Without any regret. Not because they were bad companies that had no chance of being successful, but because they didn't fit how my philosophy on investing had evolved. (This evolutions was covered in my Saying Goodbye to Ben Graham piece.)
What kept me invested was what I saw as optionality. The valuations were so compressed that any positive operational developments would be like rocket fuel for the stocks. Plus, the industrial logic behind consolidation was so strong, it was easy to hold on for what I now see was essentially a Hail Mary. These investments without question violated Buffett’s first two rules of investing, both of which pertain to not losing money. I was seduced by a cheap valuation and what appeared to be asymmetric upside—or at least so I thought. What was missing in the above companies, as well as in Lumen, was the combination of businesses that were getting more valuable over time and exhibited internal business momentum. When you don’t have those, very negative things can happen to your companies and, by extension, to your portfolio. Plus, when the operating results the companies report range from weak to awful, most suitors will be scared away and most boards will anchor to previous stock prices and refuse to sell at $10, then at $8, and then at $6. It takes a fair amount of arrogance to believe that your portfolio companies, which the public market has shunned, are going to be the belle of the ball when it comes to an acquisition. The base case is the vast majority of public companies do not get acquired in a given year. Only someone who had to succumb to a form of the endowment effect/bias could believe otherwise. I have learned the hard way that depending on M&A is a tough way to generate good returns—and to keep clients.
Don’t interrupt the compounding
On a more positive note, I just had a wonderful conversation on Compounders with the PM of a large Denmark-based investment firm that, as far as I can tell, might be one of the original compounder bros—having been a PM since the late 1980s. In the podcast, which will be released in a few weeks, this gentleman discussed the simple power of compounding and how people underappreciate just how long companies can maintain above average growth rates. As an example, this firm has owned Novo Nordisk, the company that has recently become quite famous for its weight loss drugs, for about 12 years. Assuming they bought the shares in sometime in 2011, the stock was likely in the $11 to $12 range at purchase. Just five years later, the stock was around $18 at the end of 2016—a nice return over 5 years but nothing spectacular. Let’s say a big US pharma company would have come in and offered $25 a share in January of 2017. That is a solid premium to relative to an $18 stock. I think many investors would have been excited on the day the news broke that Novo was being acquired for $25. Nice gain. Boosts performance for the year. On to the next stock.
Obviously, with the benefit of hindsight and knowing that the stock is about $100 today, no one would have been excited to let Novo go for $25. The response I would expect is that this example wreaks of hindsight bias. No one could have predicted that Novo would develop blockbuster drugs that combat obesity so effectively and cause the stock to 5x over 7 years. I am essentially cherry picking by using that example. Fine. Maybe this is an extreme example that is not representative of the average company. But I use the Novo example to illustrate a point. What well-run companies that have management teams that exhibit a willingness to suffer—and have a right to win in their end markets—do is surprise to the upside. This firm had followed Novo for 30 years, had owned in the past, and has been smart and lucky enough to own it during a period when the stock chart did this:
This example and chart take me to the title of this piece. The concept I am proposing is that if you have truly constructed a portfolio of compounders that have you paid a reasonable price for, what you really want is to let the compounding happen for as long as possible. The last thing you want is for management to throw in the towel partially into the compounding period in exchange for a “standard” premium to the unaffected stock price. You indeed want to own a company that is either not for sale or that no one else wants to own. The title of this piece is intentionally facetious. Clearly, most strategics and financial buyers would love to own a business that has what my new Danish friend calls a “parament right to win.” What better than to let such a company compound outside of public markets so that the shareholders you stole it from for an X% premium don’t even recognize they got swindled? Further, what might look like “overpaying” in the short run might look like a bargain in 10 years if the buyer chose the right target.
What does all of this mean for portfolio construction? I don’t know if I am going to be able to find the next Novo. I also know that it is almost impossible that all 20 of the companies in the SMID strategy I have been managing since 2016 are going to be true compounders. But I have intentionally assembled a portfolio of companies that I hope I can own for 5, 7, even 12 years. What I don’t want is for the compounding to be truncated by one of the companies being taken private. If that happened, I would have to find a replacement and all of the intellectual capital I had developed over my history with that firm would become far less useful. So yes, I would be upset. I don’t want my companies to be on either side of a transformational deal. I’d be just fine forsaking M&A altogether in my portfolio.
Win by inverting
Charlie Munger is famous for suggesting that people invert problems and questions in order to be able to examine the other side. So, let’s try to the invert the problem here. The issue at hand is that a lot of people underappreciate the power of compounding and therefore are often willing to let go of a good company for a nice, but not game-changing, premium to the current stock price. If that is indeed the case, it presents an opportunity for people with long-term or permanent capital to buy companies from public investors at valuations that do not reflect the what the intrinsic value will be, even a few years hence. With leveraged loan rates as high as they are today, a lot of pure financial engineering types of private equity deals are likely off the table. That leaves New Mountain-style business building PE as the type of private equity that will be successful without the tailwind of a 2000 basis point drop in interest rates (which Howard Marks discussed at length in his most recent letter). Buy good businesses at reasonable valuations from short-term obsessed public company investors, give the companies growth capital to continue to compound, and generate great returns for LPs. Simple, but not easy.
Why in the world is any of this relevant to a guy who has spent the last 15+ years as a public-equity-only investor? Well, I am about to embark on a personal journey to see if any of the above regarding the opportunity in public-to-private transactions is achievable, accurate and realistic. I don’t know where this is going to go or if I will be successful. But I do know that I feel like I have been on the wrong side of most M&A transactions for the last decade-plus. Maybe it is time to be the one doing the M&A as opposed to having it done to me.
Stock halted—news pending,
Ben Claremon
Hey Ben, interesting piece.
I worked in Bain & Co (not Bain Capitals) Private Equity practice the last summer and got to work on 3 deals the first was a PE firm taking a 250-500 Million public company private, the second was a more pure play PE deal, and the last was an M&A deal of a public company buying assets of another public company.
The first Public to Private deal was quite interesting since there was actually a meaningful ability for this public company to cut costs once acquired solely from no longer having to maintain SEC compliance.
The M&A deal I thought was quite interesting as the firm that was selling the assets saw there value diminish greatly with the rising costs of capital but the acquiring firm was going to purchase them using all cash, and would supposedly be able to see further benefit from realizing synergies. I think this environment like you mentioned breaks many PE firms models but actually provides a unique opportunity for consolidation in firms that have significant capital reserves.
Based on your last paragraph, if you are willing to share, are you going to try and take private multiple public companies and consolidate them, or just looking to take one private? Cause if it’s the latter I think there is an interesting opportunity that I realized after attending LD Micro. Many of the good businesses at LD Micro had good products/services and value propositions but lacked expertise in other aspects of the business. Nexgel comes to mind, promising product, supposedly has contracts with medical company’s that will be realized in the next 18 months, but in the meantime has created a direct to consumer line. Majority of his revenue is coming from repeat customers. He has put very limited marketing spend into this line and never considered creating a referral program to allow his devote customers to help him grow his business. To make things even worse his instagram is being following by D1 athletes with large followings because the apparently use his product and the CEO is blatantly unaware. All that to put the point that I think there is a unique incubator opportunity for some of these micro cap firms. For one reason or another do not fit the typical VC mold but would benefit from expertise in running areas of their business outside their core competency. Basically a public company incubator or a consulting firm that generates its revenue through investing in micro-caps and helping them grow.
Not sure if this leads to fruitful discussion or applicable but your commentary made me think of it.
Also this was written on a phone so apologies for any bad grammar.