A widely accepted maxim in value investing is the notion that acquisitions destroy value. Indeed, few topics seem to enjoy such a cheery consensus among analysts, experts, and academics.
Berkshire Hathaway’s Warren Buffett and Charlie Munger have regularly been quoted on this topic.
“Far too little attention is given to the terrible effects on shareholders (or other owners) of the worst examples of corporate acquisitions,” Mr Munger once said.
Yet despite the evidence that acquisitions in aggregate fail, there is a cohort of acquisitive small-cap companies that counterintuitively have consistently managed to outperform for decades. On average, the “acquisitive compounders” identified by Fairlight have delivered shareholders a return of 34 per cent per annum for the past decade.
In fact, a recent report from the Harvard Business Review(1) suggests economic downturns can be an opportune time for businesses to undertake acquisitions. Evidence from the global financial crisis (GFC) from late 2007 through to early 2009 shows companies that made significant acquisitions outperformed those that did not.
Why acquisitions fail
To understand how a group of acquisitive small-cap companies can produce spectacular returns in the face of widely accepted wisdom, it is worth revisiting the key reasons why acquisitions fail.
Firstly, there is information asymmetry. When pursuing an acquisition target, the buyer is often at a structural informational disadvantage. The seller generally has intimate knowledge of the business built over years of operating, which is difficult for the buyer to replicate during a limited period of due diligence.
There is also the matter of pricing. In a competitive bidding process, it is common for buyers to lose sight of the underlying value of the asset and overpay to secure the “win”.
Acquisitions can also result in a loss of focus in the business being acquired, with management getting distracted and neglecting the existing business. During the integration, culture clashes and redundancies to meet “cost synergy” forecasts can result in high employee turnover. This can lead to critical institutional knowledge built over many years walking out the door.
Traits to look for
Fairlight’s acquisitive compounders operate across an array of disparate industries and geographies; however, the most successful ones tend to share many of the same traits.
Firstly, for their management teams, making acquisitions is not an occasional fancy. Their day job involves tracking and evaluating hundreds of small acquisition targets, often following businesses for years before finally making a deal. The experience gained over hundreds of transactions over many years can neutralise or reverse informational asymmetry.
In addition, these businesses often undertake a high number of acquisitions each year. Once a value-added acquisition process has been established, it is important to remove luck from the equation by ideally engaging in enough small deals to generate a normal distribution. For the owner of a loaded dice, the optimal game is one with many rolls.
Finally, an intangible, but equally important factor, is the culture of the acquirer. At Fairlight, we look for acquirers with reputations built over decades as a good home for businesses. Usually this is built through a track record of minimal disruption of the acquiree (i.e. full autonomy, no integration, no “cost synergies” or redundancies).
This approach has the dual benefit that sellers will often prefer these businesses over others when they choose to sell, and will also continue to work in the business, helping maintain continuity and institutional knowledge.
The small-cap advantage
The above characteristics can be amplified within the small-cap universe, providing investors a combination that can deliver spectacular shareholder outcomes.
Small-cap companies with systematic acquisition processes are generally identifying and acquiring businesses far too small to interest equity markets, usually family-owned businesses. These small companies tend to escape the attention of larger bidders (private equity, etc.) resulting in lower purchase multiples and less auction-like processes.
Acquisitive business models are often seen as higher risk. However, acquisitive compounders tend to have hundreds of businesses, all operating independently, within their stable. The low correlation of these multiple earnings streams can provide an underappreciated degree of resilience to the overall business.
Additionally, acquisitive growth can be relied on during times of economic stress, offsetting organic declines and smoothing revenue volatility through the cycle.
As an example, Constellation Software, which has been held in the Fairlight portfolio since January 2019, is a Canadian domiciled collection of software companies operating across a variety of industries. Constellation’s track record of creating economic value for shareholders belongs in the equity hall of fame with revenue and earnings per share having compounded at 26 per cent and 3 5 per centper annum for the past decade respectively (Constellations’ share price has even outpaced that of Amazon over this period).
Since the company was founded in 1995 Constellation has acquired over 250 companies resulting in a wealth of experience to draw on when evaluating potential targets. Constellation maintains a proprietary database with base rates for organic revenue growth, typical margins, and potential market share improvements in specific niche markets. This gives the business a sustainable informational edge when bidding for targets.
Constellation also maintains a database of over 30,000 potential acquisition targets with each target assigned to a Constellation employee who is expected to stay in contact several times a year. Constellation’s reputation for buying and holding forever, track record for improving businesses under their ownership, and the degree of autonomy that they offer management teams means they are often the preferred choice for vendors, particularly compared to private equity alternatives.
So, despite the conventional wisdom that acquisitions are risky and on balance destroy value, there is evidence of an underappreciated subset of small caps that can deliver exceptional returns on capital from acquisitions, with below-average risk.
(1) Harvard Business Review: The case for M&A in a downturn, May 2020
Will Dowd, analyst and partner, Fairlight Asset Management