Issue #16 - Finding "Edge" in SMB Acquisitions
Finding "Edge" in a Competitive Market
Across the search fund and Entrepreneurship through Acquisition (EtA) community, prospective buyers of small companies spend thousands of hours each month sourcing deals, talking to hundreds of owners, and reviewing multitudes of broker CIMs. All generally stick to a pretty strict set of criteria, which makes for a narrow strike zone and the number of deals that will be seriously considered at any moment of time very small.
It isn't hard to buy a company, but buying a good company is. And, it is even more difficult to buy a good company in the typical search fund/EtA size range at a reasonable price. That is exceptionally HARD. Spend almost two years of full-time effort level of hard. And it is getting harder: technology advances make it easier than ever to reach out to business owners, crowding their inboxes with fawning messages of interest; impacts from COVID are skewing financials (for better and worse) and making underwriting and discovering the true earning power of many businesses challenging; a looming recession creates uncertainty and is likely causing some owners to seek an exit now while they still have an information advantage about the future prospects of the business, etc. Point being, being a smart buyer who can wade through all of these facts and signals is essential, but never easy.
There's a concept in investing called 'edge'. An edge is what every investor seeks and is some insight, process, or behavior that advantages them over other market participants. Trading on insider information in public markets is an edge, though illegal. Developing a proprietary algorithm that predicts market behavior better than others is an edge. Having a less expensive source of capital than others can be an edge, allowing the buyer to pay more than other bidders for the same asset. Having or being a world-class operator in an industry is an edge, allowing a company to simply out-execute and outperform its competition.
In fact, if you don't have an edge, what you are doing is much more likely to be gambling than it is investing. Being a smart buyer, one who is able to sort through all of the many factors described above, plus many others, is an edge. The problem with having an edge, is that they usually don't last. As others start to discover that one party does consistently better than everyone else, people work very hard to understand that advantage and then to replicate it. Over time, this is usually successful and erodes or eliminates that edge. Maintaining an edge is a constant game of cat and mouse, with each group trying to always stay one step ahead of the other or to close the gap with - or leapfrog - the leader.
Circling back to search funds, the goal of each effort is to find and close on a good business as quickly as possible. Given the very similar background, approach, and criteria used by each search fund, where's the edge? I've developed a partial list and included, in parentheses, the potential downside(s) to each tactic:
Six ways that a small business buyer can have an edge
Consistently paying more (all else equal, this lowers returns)
Offering greater certainty of closing - for example, by having committed capital, not requiring third-party financing, offering shorter diligence periods (harder to attract investors)
Buying smaller companies (larger opportunity set, but more risky)
Increasing the volume of sourcing activity (requires more overhead)
Loosening business and industry criteria - for example, seeking more complex industries, less recurring revenue business models, or accepting lower margin businesses (brings more operational risk and likely greater variance in financial returns)
Finding overlooked sectors and companies - for example, targeting more remote geographies, lower-growth industries, or by having or developing specialized expertise and networks (requires difficult lifestyle choices or high-confidence, non-obvious insights that less experienced buyers would mostly overlook or mis-diagnose)
I've left out certain things that I believe also create an edge, but which are less replicable across the general buyer population. This would include things like being a great storyteller/having exceptional charisma and having a roster of enthusiastic sellers from prior acquisitions that can provide testimonials about the buyer. The pursuit of acquiring a company is a very competitive endeavor, and as a buyer, unless you are willing to rely heavily on luck, you must have or develop an edge. This list is merely a starting point and each person should analyze their own situation to hone their strategy and determine their own personal edge. Good luck!
Q3 Small Business Market Sentiment Survey
Each quarter, we survey a broad group of participants in the small business ecosystem and then summarize the results in a report. The most recent issue covers Q3 and the link is found below.
During the week of November 1, I surveyed members of the small business community to get a snapshot of current market sentiment. Some reflections and a selection of the responses are provided in this memo.