Execution Friction: Competition for Deals

In our last newsletter, we broke down the anatomy of an M&A market and introduced our concept of Execution Friction. As a quick reminder, Execution Friction is a measure of how challenging it is to execute add-on acquisitions in a given market, driven by the following four factors:

1. Competition for deals
2. Complexity
3. Known unknowns
4. Idiosyncratic deal factors

Today, we’ll dive deep into competition for deals – our Goldilocks indicator. Competition is best when it isn’t too hot or too cold, but just right. That’s not to say we haven’t had success in hot or cold markets – they’ve been some of our biggest winners – but as we’ll cover, each requires a unique approach. So, what does it mean for deal execution when a market is at temperature extremes, and how does Exit take its temperature?

Hot Markets Move Fast:

• Successful deals move quickly from introduction to close
• Owners often field multiple offers
• Non-price factors can “tiebreak” comparable offers

If temperature measures the average speed and energy of particles in an object (higher equals hotter), then competition temperature is the speed and energy of dealmaking. In the hottest markets, deals move quickly and multiples climb as funds compete on nearly every transaction. When we talk to owners in hot markets, many already have one or more offers on the table. Success is often predicated on the ability to swiftly move from introduction to an at- or above-market offer. Additionally, the deciding factor between two competitive offers is often a clearly communicated, non-monetary value proposition and strong owner/fund relationship. Funds that are not willing or able to compete solely on price should come prepared with a highly differentiated strategy and/or value proposition to ensure success. Being decisive from the first call through to an offer can make a meaningful impact.

Cold Markets Require Patience:

• Owners who are less familiar with the PE process move slowly and may require some handholding
• In markets with structural impediments, funds should be comfortable with the market dynamics going in or avoid the market entirely

Cold markets lack the speed and energy of hot sectors and come in two flavors. The first are markets at the nascent stages of a consolidation push. Markets at this stage present significant upside potential to funds with patience and flexibility. Often, Exit will be the first conversation an owner has had about private capital, so the burden of educating owners on the process and benefits falls squarely on us and the fund we’re working with. It is particularly helpful when funds and the platform’s management team speak the language of owners and can build a strong rapport. Additionally, most targets will not have their financial/data houses in order, which can lengthen both the time to offer and diligence duration.

The second flavor of cold markets exhibits legitimate structural issues. These are industries where the overwhelming majority of targets are not suitable for one reason or another, usually driven by endemic factors. Common examples of industry dynamics we see posing significant challenges for our clients are intense revenue cyclicality, structural customer concentration, lumpy project-based billing, and workforce factors (e.g., union, 1099, etc.). Funds that choose to enter these markets are successful when they are clear-eyed about the downsides and have a unique thesis that specifically addresses the challenges.

Why We Love In-Between Markets:

• Owners are often familiar with the PE process, have their financial house in order, and know exactly what they’re looking for in a transaction
• Many target firms are ready to transact and are waiting for the right partner and/or offer

We love markets that are just right. Moderately competitive markets are a sweet spot with lower dealmaking friction where the heat hasn’t yet been cranked up to ten. The first wave of activity and consolidation primes the market for the dealmaking that follows. Most owners are familiar with the PE process, and there’s demonstrated proof of concept. In these markets, target firms are more willing and more prepared to engage. Oftentimes, they are open to a sale or actively looking for one but are waiting for the right partner and/or offer. Sponsors can still expect to compete for the largest, premier assets, while more easily scooping up the long tail in their consolidation push.

How Exit Measures Market Temperatures:

• Exit compares a range of specific data points from a market to our experience across hundreds of buy-side searches

As with most of our work, we combine our extensive experience operating in private markets with deep analysis of sector-specific factors. These factors include characteristics like total deal volume, valuation levels, the number and profile of buyers (PE vs. strategic), platform formations, process mechanics, and engagement levels (i.e., owner response rates and interest). By comparing a market to our past buy-side work, we’re able to reliably identify hot, cold, and Goldilocks markets, while helping our clients prepare to execute in whichever one they choose to enter. In making challenges visible, Exit helps make them manageable for sponsors.

If you’re evaluating new opportunities and are curious what the level of competition means for your M&A thesis, don’t hesitate to reach out. We’re more than happy to share our perspectives and experience. In our next piece, we’ll continue our coverage of Execution Friction by taking a deep dive into market complexity and what it means for M&A as a growth lever.