Stacking the deck in your favour in special situations investing

A principle I follow as an investor is to minimise the unknowns. As an investor, there is no way for you to know everything about a particular company. When a company you invest in acquires another, an additional layer of unknown unknowns comes into the mix. This is because there would be asymmetry in information in any M&A where the seller would always know more than the buyer. If the target acquisition is large enough vs. the acquirer, this additional layer of unknowns could derail the financial health and integrity of the acquirer.

 

While the probabilities are stacked against an investor given the two layers of unknown variables, going right has an asymmetric payout. In order to build a thesis around which M&A deals to consider as a potential special situations investment, a look at the twenty largest deals by Indian companies in the past decade is instructive. 

 

The first lesson from the data set is stark- only two of the twenty transactions matched the acquirer’s pre-deal return on capital employed (ROCE). So purely going on numbers, only two deals were good capital allocation decisions. As companies grow large, deploying capital at scale while maintaining ROCE becomes challenging. If one is able to simply beat their cost of equity, we could deem the acquisition to be successful. With this metric of success, the number now rises to four companies of twenty that have successfully acquired at scale. With a 25 per cent chance of success, the odds are against you.

 

There are, however, a few similarities to take note of in the four that did become successful. In all of these transactions, the acquirer already had a large dominant market position, from the largest steel production capacity to the largest agrochemical player in India.

 

On the nature of the sectors where these deals emerged from, all four of the successful transactions emerged from asset-heavy segments of steel, cement, telecom infrastructure and agrochemical production. This lends itself well to the financial conditions of the target companies, that enabled favourable transaction valuations. Two companies were in financial trouble, and two faced a stagnation of profits (but were strategic assets).

 

This allowed for price tags on the target that enabled good capital allocation decisions on the part of the acquirer. All the acquisitions were done at near the bottom of the respective business cycles; i.e. the point of lowest Ebitda per unit was being made. This further ensured favourable prices for the assets.

 

None of the transactions were funded solely by internal accruals. The most successful one did not entail any equity raise to complete the transaction. However, all of the transactions relied on debt funding to bring down the cost of capital.

 

In all but one, the acquirer was much larger than the target (5x+) in revenues. The only case where this was not true saw the highest amount of dilution in RoCE post-acquisition.

 

In the entire data set analysed, the bottom quartile of transactions were those where a domestic consumer-facing brand was acquired- either in e-commerce or media/entertainment spaces. These deals did not create any shareholder wealth at all. This is not surprising given the billion customers potential touted in propping up valuations in the

consumer space in India.

 

In poker, as in investing, table selection can help stack the game in your favour. In special situations, investing while looking at acquirers, buying into market leaders, acquiring at bottom cycle numbers that have the balance sheet strength to optimise cost of capital, is possibly a great starting point to stack the odds in your favour. The most commonly touted narrative of large consumer brands being acquired with an even quicker road to scale and profitability post-acquisition, however, has not been an easy table to play at.  (Harini Dedhia is Head of Research at Tamohra Investment Managers. Views are her own.)