Deal evaluation 10 failure modes by gsa16110

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North American Middle-Market Review            2005




     PRIVATE EQUITY & VENTURE CAPITAL




                                                      Deal evaluation:
                                                      10 failure modes




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   Deal evaluation: 10 failure modes
    BY TODD ANDERSON AND DAVID FISHMAN




   T    his year marks the fifth anniversary of
        the NASDAQ bubble bursting, mak-
   ing it an appropriate time to review com-
                                                        nies began offering online services, and it
                                                        became nearly impossible for an internet
                                                        only company to compete. The traditional
                                                                                                         5. Failure to understand key uncertainties
                                                                                                         Investors often donʼt include a full set of
                                                                                                         variables that could impact financial results.
   mon deal failure modes. What follows are             grocer already had a distribution system in      Even in cases where a relatively complete
   10 common evaluation mistakes observed               place which could be leveraged with little       set of factors is modeled, analysts rarely
   during the run up of the NASDAQ. These               incremental costs and could buy the technol-     handle risk and uncertainty well. Generally,
   errors fall into three groups: failure to an-        ogy cheaply from failed internet grocers.        inputs are tested using sensitivity. Typically,
   ticipate market changes; financial evalu-                                                              analysts examine a +/-10 percent change in
   ation failures; and failure to execute after         3. Assuming market valuation remains             each input to evaluate how it impacts the
   the investment is made. These mistakes are           constant                                         bottom line. However, this method fails to
   no less common today than they were five              The safest assumption is that market valu-       take into account the variation unique to
   years ago.                                           ation will not be constant over three to five     each uncertainty. For example, an analyst
                                                        years, a typical length of time to hold an as-   may know a fixed cost for a critical com-
   Failure to anticipate market changes                 set before exit. For example, the valuation      ponent, but overall revenue will have wider
                                                        multiples assigned to internet companies         variation. For this reason, we recommend
   1. Failure to anticipate technological               are vastly different today than they were        assessing each variable as a range with the
   change                                               five years ago. The same conclusion holds         low case being a tenth percentile, the high
   Frequently, investors put money in tech-             true in a different industry, the utility sec-   case being a ninetieth percentile, and the
   nologies that represent a paradigm change.           tor. In the late 90s, utilities were looking     base case being a fiftieth percentile. By us-
   There is often a failure to ask when newer           for non-regulated, growth businesses as the      ing common definitions, it then becomes
   and better solutions will eclipse this tech-         market assigned a higher multiple to these       possible to rank each variableʼs impact on
   nology. The length of time that a solution           earnings. In the last 12 months, many utili-     key metrics with their intrinsic uncertainty
   dominates the market should be a key as-             ties have taken huge write-offs in nontra-       taken into account. The next analytic step
   sessment, and a wide range of potential sce-         ditional areas. Today, the market does not       is defining how these variables interact
   narios should be tested. Also, as technolo-          differentiate, and earnings are earnings to a    and determine the range of results given
   gies evolve and mature, margins are likely           utility investor regardless of their source.     all of the uncertainties. A Monte Carlo or
   to be challenged, but projections often fail                                                          some other probabilistic analysis is recom-
   to reflect this reality. Investors assume ei-         Financial evaluation failures                    mended. Failure to capture uncertainty and
   ther constant or slowly decreasing margins,                                                           their correlations generally results in sig-
   whereas a competing solution would likely            4. Applying a uniform discount to financial       nificant underestimating the overall risk for
   have a more deleterious impact.                      projections                                      an investment and is a cause of many deal
                                                        Deal makers focus on projections provided        failures.
   2. Failure to account for competitive                by management. While they know that the
   response by incumbents                               projections are only estimates and inher-        6. Income statement focus
   A company entering the marketplace with              ently optimistic, many investors deal with       Examining only the income statement fails
   a new solution must anticipate its competi-          this bias by discounting earnings. In real-      to focus on the intrinsic value that is being
   torsʼ responses. A common mistake is to not          ity, earnings will not simply scale upwards      created. In the late 90s, most clients focused
   define broadly enough who the competitors             and downwards. Changing just one or two          on some multiple of the income statement.
   will be. Online grocers in the late 1990s felt       critical inputs can entirely eliminate or com-   The most common metric used was some
   their primary competitors were going to              pound future earnings. Thus, it is important     multiple of EPS or EBITDA. However, in
   be other internet grocery delivery services.         to change the underlying inputs to deter-        the most extreme cases, valuation by multi-
   However, it turned out that the greatest com-        mine the overall variability in earnings and     ples of revenue was conducted without any
   petitive threat was from preexisting bricks          cash flow and not just apply a bottom line        regard to cash flows, the balance sheet, or
   and mortar grocers. Large grocery compa-             “haircut”.                                       even earnings. Any of these methodologies 8




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                                                                                                                                                PROFESSIONALopinions




                                                                                                    yse a “home run” deal can cause this home
                                                                                                    run to be only a “single” either by overpay-
                                                                                                    ing or suboptimal management.

                                                                                                    Failure to execute after an investment is
                                                                                                    made

                                                                                                    9. Disconnect between the deal and
                                                                                                    management teams
                                                                                                    Deal and management teams are generally
                                                                                                    incented very differently, which creates in-
“These mistakes are no less common today                                                            herent tension between the two. Deal teams
                                                                                                    want to complete deals, whereas manage-
                                                                                                    ment teams want, understandably, some-
than they were five years ago.”                                                                      thing that can be managed. Also, the deal
                                                                                                    team will, at least, initially know far more
                                                                                                    about an investment than the management
                                                                                                    team. The earlier the management team is
                                                                                                    involved, the smoother the hand-off once
                                                                                                    the investment occurs.

                                                                                                    10. Failure to have a clear exit plan
                                                                                                    Sometimes, investors begin with clear exit
                                                                                                    goals and fail to manage to that goal. How-
                                                                                                    ever, more often, deals are exited early to
failed to take into account the cash crunches      unusual to track 20 or more metrics and not      ensure a steady stream of earnings and cash
that even a successful investment would            just EPS in the exit year. In addition, hav-     flow. Frequently, the deals exited are the
have. These companies had to actively              ing a quality valuation discussion upfront,      relatively successful deals with little or no
choose between growth and cash burn, and,          reveals what the investor will have to pay       thought devoted to the long-term value be-
by the late 90s, with the cash running out,        particular attention to as the deal matures.     ing sacrificed or the optimal exit timing. As
growth slowed and income statement mul-                                                             a result, investing companies can quickly
tiples declined.                                   8. “Home Run” deals donʼt need to be             create a portfolio of very lackluster invest-
                                                   analysed                                         ments with very little potential upside.
7. Over-reliance on just one valuation             The best deals require analysis. In fact, they
approach                                           require more analysis because it is highly       In the late 90s, many investors become
Triangulation provides a much better es-           likely that they are actually going to get       caught up in the excitement of the NASDAQ
timate of overall value, at investment and         done. A careful analysis upfront will sug-       bubble. While some of the most egregious
exit, than any one valuation approach. In          gest how these deals can be most effectively     errors have been corrected, more work is
addition, cash and debt levels must be an-         managed. Also, very attractive deals may         required to ensure success or avoid invest-
nually tracked in any model to ensure that         come via a competitive bidding process. It       ments that are unlikely to be successful.
a company is meeting their financial cov-           is critical to careful analyse how much a
enants in all the years and not just in the        percentage of equity is worth to your com-
                                                                                                    Todd Anderson is a Senior Engagement Manager and can be contacted on +1
exit year. It is relatively easy to automate       pany rather than getting caught up in the        (617) 478 7621 or tanderson@sdg.com. David Fishman is a Managing Director of
tracking these critical variables, and it is not   competition. Thus, failure to properly anal-     Strategic Decisions Group and can be contacted by email: dfishman@sdg.com




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