Bergman & Beving: The Capital Allocation Model

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Magnus, I'd like to discuss the M&A process from start to finish. Let's begin at the top. How do you approach sourcing new deals?

To be a successful serial acquirer, you need a well-thought-out M&A playbook. In my view, it starts with the people. You must have the right people with the right profiles on your team. Success in acquisition requires more than just a good strategy and processes; you need the right people driving the M&A activities. Once you have that, the next step is to determine which companies fit into your group. This requires a well-defined M&A strategy. We have outlined our M&A strategy on a one-pager with about 20 different criteria that we apply to all acquisition candidates to ensure alignment with our M&A strategy. Once you identify candidates that fit your M&A strategy, you need to ensure the quality of the company. This involves having a well-thought-out due diligence process, focusing on the right topics, and not getting bogged down in irrelevant details.

Let's walk through that. Firstly, could you remind everyone what type of companies you look for?

We focus on B2B companies, typically technology companies, and preferably product companies. However, we are also interested in acquiring companies with a niche distribution business model. We do not consider service companies. With our very decentralized governance model, we prefer companies with more substance than just people.

I reviewed some of your most recent transactions over the last few years, and many, if not all, are product companies. How has your mindset or approach evolved between product and niche distribution assets in terms of where you plan to deploy your incremental dollars between these two types of companies?

We set a target for the group that 75% of our volume or turnover should come from product companies. We are currently at 74%, so we're close to reaching that goal. This was just the first hurdle, and I expect we will exceed 75% in the future. It all comes down to growth and business opportunities within product companies.

In northern Europe, especially in the Nordic countries, technical applications are well developed. As technology matures, products develop, and northern Europe has a good opportunity to grow in other geographical areas. If you have a competitive product, there are typically good growth opportunities. By investing in growth in new geographies and niche distribution, you can expand across regions. However, this often depends on the companies you represent and whether they allow geographical expansions. Over time, growth opportunities are typically greater in product companies than in niche distribution companies.

Why did you choose the 75% mix as a target now?

When I started four years ago, I thought that was a reasonable target to set, with the aim to achieve it five years from then.

Does that include Luna or Skydda first-party products in the product mix?

Yes, both Skydda and Luna, which are wholesalers, are included in the calculation.

For their private label products?

Yes, but you should be aware that, for example, Luna has some own brands, so they are labeled as own products.

You mentioned people being critical. How do you think about building a system to source and filter new deals?

When discussing acquisitions, we need to separate new platform acquisitions from add-on acquisitions to current platforms. The acquisition work within our current platforms, when looking for add-ons, is typically done by the platform itself. We assist and support in the DD process, price discussions, and so forth.

For new platforms, the process is driven by the holding companies. We have 10 people at the holding level, with three acting as division heads. They play a crucial role in sourcing and nurturing acquisition candidates. These three individuals lead the M&A process when we evaluate potential cases.

So, are they dealing with brokers and internal companies that might be sourcing deals for you within your group?

They are sourcing in two ways. One is that they proactively look into interesting niches, reaching out to companies within those niches that we think would be a good fit with us. That's the proactive work they are doing. We also have incoming deals from the M&A community. We have a person responsible for the M&A activities and handling the legal DDs. This person acts as the funnel for all incoming M&A deals from the community, which are then distributed to the division head.

So, you have a centralized person at HQ dealing with all the brokers. When a deal comes in that potentially fits your profile, they filter it down to the divisional head. At the divisional level, they are also sourcing within their group, within their niches, perhaps with referrals from their subsidiary CEOs and similar sources.

I think this is a very important topic for a serial acquirer. There are different ways of running M&A. I've been in the industry for 20 years and have made up to 100 acquisitions during that period. I've worked in two different ways. One is having a dedicated M&A department responsible from finding deals to closing them, then handing it over to an operational division head.

The other way, which we are doing today, is having the division head take on the case from the start. My experience tells me the latter is much more suitable for a serial acquirer. You don't want to run into situations where the M&A department focuses on making as many deals as possible without considering the cost. It's about the number of acquisitions they make, and not having a division head who feels accountable for the acquisitions and the earnings we expect from them. It also misses the opportunity to build relationships with the candidate and the management team during the DD process. I really favor the way we are doing it now based on my experiences with both methods.

We can discuss the incentives and how you work with divisional heads and divisions later in your focus model. One thing I noticed is interesting. If I study Bergman & Beving and Lagercrantz, which are similar, and then you have Lifco and Addtech. Addtech claims they source the majority of acquisitions, I think up to 80%, internally. What's your split roughly between broker channels and internal channels, and how do you think about that?

You need to separate add-on acquisitions and new platforms. For add-on acquisitions, I would say 95% is from our own search. For new platforms, I would say about 60% is from structured processes and 40% is based on our own proactive activities.

How do you think about changing that mix, or does it even matter to you?

I believe there's a misconception when people think that buying outside processes is easier and less costly. That's not my experience. When you approach a company that isn't in a process, they typically haven't decided to sell and aren't for sale. This means you need to spend a lot of time with them, and to make them want to sell to you, you often need to pay a premium.

Another challenge I've faced in these situations is that they often have a misconception about the value of their companies. They've heard about a neighbor or friend who sold their company for 15 times profit, and they expect the same from our valuation. You typically face challenges bridging these value expectations, and in my experience, you don't end up buying at lower multiples when you're outside processes.

When a company is in a process, they've usually decided to sell and are guided by an M&A consultant who knows the typical market price for that type of company, size, industry, and performance. Of course, you sometimes have competitors, but it's our task to build trust and confidence with the seller. Even if we don't pay the highest multiple, we aim to be the best future owner of their company.

Since we only buy highly profitable companies, we have a hurdle of an EBIT margin of 15%, and that should be sustained over time. These owners have earned a lot of money over the years, so they're typically not focused on maximizing the price of the company. Instead, they're quite focused on finding the right owner who will continue their life's work in a good way. It's about building that trust with the seller.

How true is that? A lot of skeptics would say, "Yes, I understand that's true, but if someone comes in with a massive premium, they're going to sell to the person who pays a massive premium." In your experience, how true is that, or what type of premium really sways people, regardless of whether they want to preserve their legacy?

My experience tells me that in the type of companies we buy, those willing to pay a premium are usually private equity and industrial companies. Industrial companies typically pay a premium because they include synergies, which might mean the seller's company will move from its current location and integrate into a bigger group. Yes, at a certain premium, they may accept that.

There's always a price for everything, right?

But in my experience, many aren't even interested in talking to those types of companies. It's the same with private equity. We typically pay in the range of four to seven times EBIT, while private equity might pay 10 to 11 or even 12 times. However, the companies we usually talk to aren't interested in selling to private equity. They don't like those financial guys who come in with black suits, running into their offices with Excel sheets, only talking about numbers and how the owner can make an exit in a few years. They're really focused on finding a long-term owner who will continue to build on what they've developed over the years.

If you were to describe the persona of the sellers or companies that are swayed by selling to private equity, especially those that pay a premium, what type of companies or people do you think are influenced by that premium?

That's a fascinating aspect of this job. You encounter great entrepreneurs with diverse personalities. Many of them started as engineers who had an idea they wanted to realize. They build their companies around this technology, focusing on product development and customer interaction. This type of profile typically isn't interested in selling to private equity because they don't align with those types of people.

Then there are those who began their careers in sales, realized they could start selling independently, and launched their own companies, often distribution companies. Generally speaking, these profiles might be more attracted to selling to private equity due to higher valuations.

What's the average age of the companies you acquire?

I haven't calculated it precisely, but roughly 20 years, plus or minus 10 years.

It makes me think because the companies you buy are specific B2B industrial businesses, often run by engineers, typically over 20 years old, and based in the north of Sweden or the Nordics, not in big cities like London or Stockholm. I'm considering the persona of that type of person. They're more likely to genuinely care about the legacy of their business and their employees. Therefore, you as an industrial acquirer seem a more natural fit than private equity or anyone with a big check. In contrast, software companies that have been around for four to six years might not have the same level of attachment to their company as those with a 20 to 30-year history.

For them, it has been their life. They are friends with their employees and customers, so there's a lot of emotion involved for those people.

Let's say I've created an industrial business with a niche product in the north of Sweden and go through a brokered process, focusing on the financials. If I approach you with my company, what are the three or four variables you look for? If I provide you with my financials, how many years of financials do you require, and what do you look for in terms of return or margins?

The financial aspect is a crucial part of our strategy and qualifications. We have three other important factors to consider. The first is the type of business they are running. The second is the growth opportunities within the business. The third is the risk involved, and part of that risk is the management capacity because we operate a very decentralized governance model. We are highly dependent on the management team in our platforms.

Regarding the financials, we only acquire companies with an earning capacity of over 15% across a business cycle. To make this assessment, we need several years of data to understand the development over time. Since some companies have been around for 20 years, we prefer to look back 10 years to understand why the top line has varied. This could be due to factors like Covid or significant market changes. Typically, we assess the sustainable profit level and profit margin over the last three to five years.

What about the return on capital?

When considering the financials, our sweet spot is companies with an earning capacity of one to three million euros per year in profit. This range is large enough to exclude small family offices and small enough to avoid too much private equity involvement. We aim for a profit margin of 15%. Our simplified measurement of return on capital employed, which we call profit over working capital, should be at least 45%.

What if these product companies have their own manufacturing plant or fixed assets? Doesn't that make profit over working capital less effective?

We prefer product companies with patents or proprietary IP that typically outsource production, making them asset-light. Most of our companies do not have in-house production. If they do, we consider the return on capital employed (ROCE) during acquisitions. If the ROCE is below 45%, we evaluate whether acquiring a company with fewer fixed assets and a profitable working capital of 45% is better than one with a ROCE of 25%.

Organic growth is one of our main criteria. When assessing growth opportunities in a business we acquire, a common scenario is an owner who started the company 20 years ago and is now over 60, considering who should take over their life's work. They often wish to retire soon and may not have invested in growth opportunities in the last five years. This presents us with opportunities to leverage and invest in growth that the previous owner did not pursue.

So even if a business has been declining 2% organically over the last three or four years, would you still consider it if you believed you could improve its growth and it met all the other metrics?

Yes, we would consider that.

Let's say you find a business that fits your profile. It goes through a brokered process, comes in centrally, and then gets delegated to divisional heads. Can you explain how and when you involve the divisional heads in the M&A process?

Yes, when we receive leads from the M&A community, our M&A person evaluates the opportunity based on our acquisition strategy and rates it. If it's deemed good enough, the M&A team passes the opportunity to a division head. The division head then assesses whether it aligns with the division and group strategy in terms of M&A. They take on the product management of that acquisition opportunity, which typically starts with reviewing an IM, having a management meeting with the company, and then evaluating and building a business case around the acquisition. If the division head decides to proceed and present an indicative bid, then I get involved. We then sit down to agree on valuations, and after that, they proceed with the process based on our agreement.

So the divisional head effectively leads the M&A process?

Yes, that's correct.

And they don't have an M&A person as a core solutions M&A individual within the division. It's actually the M&A head who runs it?

Yes, but our M&A person will handle the legal due diligence if we enter the DD process. We also have someone in our financial department at the group level who manages the financial DD. The division head runs the commercial DD, and if it's a new market for the division and group, and they need assistance, we have a network of external commercial DD experts to help us.

How would you describe the expertise of the divisional heads? These are operational individuals, not former investment bankers or M&A specialists.

We have three division heads. One previously worked at a private equity company with a similar type of business. Another has experience running similar serial acquirer businesses. The third has a more operational background and has grown into the division head position.

How do you think about incentivizing them? If something interesting comes in and gets delegated to the division, they need to really want to buy it since it will become part of their group. Alternatively, they could invest their time and effort in growing organically with their existing resources. How do you incentivize them for either option?

This is somewhat of a philosophical question because I believe it's crucial to have the right caliber for the division head. They need to decide the most efficient way to grow their division, whether through organic growth or acquisition, and typically it's both. They have a target for their division and incentive systems, but it's not based on a specific amount of organic growth or acquisition. It's more about the division as a whole.

So, EBIT?

Yes, EBIT. I think this is also very important.

Without interest and amortization.

You need to establish a follow-up system and incentive system that holds the division head accountable for investments in companies organically, as well as what they pay when buying companies. In our model, they need to account for depreciation in the companies and amortization from acquisitions. We also have a division interest cost based on how much working capital they tie up in the division, as well as the interest rate on the acquisitions they are making.

So if I buy a company for 100, how do you decide on debt and equity? Do you do half and half?

Yes, every year we set that internal interest rate, and this year it is 6%. So they need to pay six million in interest for the acquisition they made for 100, plus the amortization of that acquisition.

So you assume it's all paid in debt. It's an interest rate, effectively a hurdle rate, for them to pay on that acquisition plus the amortization. And what about if they spend on capex?

Money is not free.

Yes, I like it because people often refer to EBITDA, but what does that even mean? So, if they want to reinvest in their business, like a capital project, how do you approach that?

They have to bear the depreciation cost, but we don't impose any cost on the capital needed for that investment.

But they can get capital if they want to undertake a big project, refurbish something, build a new product line, or whatever. R&D, they bear all that cost, including depreciation.

Yes and no. We have a credit line on all our platforms, and if that credit line needs to be increased, it escalates all the way up to me. In practice, they can't make any significant investments without my approval because the company would need to extend their credit lines.

How do you set the credit line, though?

We try to gradually reduce it over time.

Yes, they shouldn't be using too much capital anyway.

That's part of all the board meetings on the platform. What about reducing the credit line? We want to run the companies tightly on working capital, expenses, and investments. It's a way to ensure we're allocating capital in the right situations. We prohibit companies from having excessive cash flow if we don't think they're the best candidates for growth capital. This helps us control cash effectively.

Let's say I have a company with 100 in revenue in my division, and I generate 20 in free cash flow.

Yes.

Typically, that would go up to you. But if I want to ramp up my R&D or spend on a capital project, there's a limit on how much I can spend beyond my operating cost, which you have to approve.

Yes.

And obviously, if I want to pursue M&A, that goes through the M&A process separately.

Yes.

So when do you get involved in M&A?

The first time is when the division head wants to place a bid on a company. We agree on the levels and conditions of that bid. That's when I typically get involved initially. If we proceed, we set up a DD team, and I'm part of that steering group. We have a DD kickoff to ensure we have a unified view on the key focus areas during the DD. We then have a midterm DD meeting to discuss findings and make a go/no-go decision. Finally, we have a final DD meeting to sum up all findings and SPA discussions, leading to an additional go/no-go decision.

Who's in those meetings?

It's the DD team, myself, and our CFO.

And a divisional manager.

Yes, the division manager heads that meeting.

Is there a veto right? Do you all have to agree?

I need to agree.

But does the divisional head also need to agree?

Yes, they won't present it if they don't agree. That's the starting point. They need to want to make the deal and commit to the earnings we've set as a basis for the bid and transaction. I will hold them accountable for that earning capacity going forward.

What are the typical reasons you've said no to acquisitions in the past?

The most frequent reason is discomfort with the earning capacity. In such situations, we may find it uninteresting or consider it interesting at a lower level, necessitating renegotiation. Sometimes we succeed in those negotiations, and sometimes we don't.

So you're not comfortable with the end market or the longer-term earnings growth potential at that price?

Yes, that's part of it. We don't feel comfortable with the earning capacity. This could be due to the underlying market development or the company's performance within the competitive environment. There could be many reasons. It might also be a situation where we lack trust in the management team moving forward, and replacing them would be too risky. But generally, the most common reason is that we don't feel comfortable with the earning capacity.

How do you think about scaling these types of models? Serial acquirer, decentralized acquisition models where you have platforms of divisional heads. Clearly, you're not sourcing and executing every deal. How do you consider the limitations of building more divisions and delegating M&A to scale the number of companies you can acquire over the next 10 to 20 years?

I often talk about serial acquisition and decentralized models. While it is decentralized, to be successful as a serial acquirer, you need to centralize two things. First, the M&A process—from acquisition strategy to running the due diligence, ensuring quality, and pricing companies—must be centralized to maintain quality and control. I'm involved throughout this centralized process.

Second, capital allocation across platforms must also be centralized. Each company and divisional head wants growth investments, so they all seek capital for growth initiatives. Without a centralized structure for capital allocation, you won't be capital efficient over time. These two aspects need to be centralized.

Regarding scalability, if the M&A process is centralized, it's scalable because it's structured. You can add resources to this structured M&A machine, ensuring quality since all steps are synchronized across the group. By adding more resources, you increase the output.

More divisions, you mean?

More divisions or more people within divisions working on acquisitions.

Working with the divisional head, you mean, on sourcing?

Yes, exactly.

The reason I ask is that, for example, Constellation Software buys vertical market software businesses and completes over 130 deals per year. They have a decentralized, formulaic approach with people at the bottom of the organization handling these deals. Clearly, you can't do 130 per year. How do you determine the limits of how many deals you can do per year? When do you hit that limit?

As you were saying, many of our peers, like Constellation, are doing three, four, or five times more acquisitions than we are annually. So I don't see that as a constraint for us moving forward. We can just add resources to our M&A machine, and then we will increase our output.

They're doing one every other day. I guess that's too much for you, right? I'll ask you in 10 years when you've tripled the number.

The number of acquisitions we're doing will increase over time. However, it will be a gradual increase. We will not double the number of acquisitions we do next year compared to this year.

Right, it takes time. It's interesting because Lifco has a similar model with 10 to 12 group managers. They lean on brokers but also handle M&A similarly. So you're saying you need a mix of a decentralized governance structure but a centralized M&A process where you sign it off, and the divisional manager is accountable. You can scale that by building more divisions.

Yes, when we talk about decentralization, it's at the platform company level. They are run by individual management teams and operate completely separate from other companies. We act through the board in those companies. It's centralized because each company is in different places in our capital allocation model with different agendas and strategies. We don't have a group strategy or group priorities that everyone needs to follow.

I want to discuss the focus model in a minute. The word "decentralized" is significant and exists on a spectrum. Everyone claims to be decentralized, but it varies. Let's talk about governance. You've got HQ where you and Peter sit, divisions, and subsidiaries. At the subsidiary level, who's on the board, and how often are the meetings? What's the governance of that subsidiary?

Typically, the division head is the chairman of the platform boards. There is usually one other representative from Bergman & Beving on the board. For example, I'm a member of eight platform boards, the eight biggest companies in the group. The CFO, Peter, is part of roughly 10 company boards. Some platform CEOs are part of other platform boards, and the M&A responsible is part of some boards.

So there are three of you; there's the divisional head, there's you at the HQ or someone else and there's the operational CEO. So three people on the subsidiary board.

Yes, and sometimes we have external resources as well. It depends, but typically it's small boards.

How often do you meet?

We have scheduled quarterly board meetings, so four per year, and typically one strategy meeting per year. If the company deviates from the targets, we have additional board meetings as needed.

The divisional head is limited in the number of companies they can manage because they can't handle 50 companies and attend 50 board meetings each quarter.

We operate under the notion that divisional heads should spend 70% of their time on platform companies and 30% on acquisitions. Based on my experience, you can manage eight to 10 companies in a division. Beyond that, time constraints become an issue.

How does Lifco manage it then? They have over 200 companies, and I doubt they have 20 divisional heads.

To my understanding, they have something called subdivision heads. However, I am not fully aware of the details of their operations. My experience suggests they have a similar setup but with more layers.

How long are these board meetings, and what do you cover? You must already see all the numbers monthly when they send them to you, right?

Yes, each company's management team creates a business plan annually. It's a simple two-page document; one with some figures and one is what we call the strategy sheet. That's a one pager highlighting the five to eight most important strategic initiatives and targets for the year and those are followed up in those board meeting. What type of progress have we had towards those strategic targets that we have? An example could be that we should establish the company in a new geography. What is the status here? We should extend our product offering into a new product area. So that consists of a lot of different things. That's strategy, but that is something we follow up and discussed in the board meetings.

So, with eight to 10 companies per division, when they reach that limit, do you have to create another division?

Yes and no. A crucial aspect of taking on a chairman role in our platform companies is understanding how we operate, allocate capital, and think about allocation. We have brought on previous serial acquirers who have worked with other serial acquirers and Bergman & Beving, who understand our operations and DNA. Some companies spin off from us and operate similarly. We use these experienced individuals on some boards because they know the model and have extensive experience in a serial acquirer context, and as a chairman.

What's the biggest limitation to scaling a model?

I think the platform itself isn't too challenging to calibrate in order to support and challenge the platform companies. If there's one challenge, it's extending your M&A resource capacity to scale up over time. I initially talked about the M&A playbook and the importance of having the right people on board. Most of the division heads and I are engineers who have been operational CEOs of technology companies. They know how to run a company and have an interest in technology, which helps them understand technologies when they meet new companies, building a lot of trust, in my experience.

When you meet an entrepreneur, they know you're interested in their technology. We don't discuss figures at that point; we talk about how they build their business, the challenges in operations, their competitors, and the differences in their technology. The challenge is finding people with technology interest, knowledge, experience in running companies, and the capacity and interest to engage in M&A activities and step up as a chairman. That, I would say, is the biggest challenge.

Does that imply you think you can more easily train someone on M&A if you have the right operator rather than vice versa?

Absolutely, absolutely. We have an M&A machine. You just put that person into the machine, and they will have the support and guidance necessary to deliver high-quality M&A.

Let's say you buy the business and it's part of the group. Explain your focus model.

The focus model is a simple way to explain how we allocate capital and where we're willing to allocate it. All our CEOs and management teams across the platform companies have been trained in the focus model or capital allocation model. They understand why we allocate capital the way we do and why we expect them to have different priorities based on their position in our capital allocation model.

It's a matrix with two axes. One is the X-axis where we have this simplified return on capital employed measurement, profit over working capital. And on the Y-axis we have the profit growth potential in the business. And if you are above 45% and you have a profit growth potential, we label them as a green company. In the green companies, we are willing to allocate growth capital If we are able to allocate growth capital, you need to be in the green buckets.

Is that for M&A and extending credit lines as well?

Yes, all the companies we acquire are, by definition, in the green bucket. We don't buy turnarounds or companies not meeting those criteria. It's also relevant for our platform companies.

So a divisional head does not get any capital to deploy in M&A unless they have a profit of the working capital over 45% at the divisional level.

No, the divisional head can proceed to acquire companies if that company is in the green bucket and qualifies to be there. Typically, the target division has companies in the green bucket. We also have a yellow bucket and a red bucket, and you don't want to be in the red bucket. Typically, you have at least one company in the red bucket.

So it's the add-on acquisitions they can't do. If a divisional manager has a collection of red, yellow, and green, but, for example, if you've got Luna, which might not be green, you can't do add-on acquisitions for Luna because it hasn't met the focus model metrics.

Yes, correct. It's not a secret. Luna is one of our wholesaler businesses, and they are in the red bucket. If you're in the red bucket with a profitable working capital below 25%, you shouldn't even consider making add-on acquisitions. We don't want those companies to grow their top line. We are not willing to allocate capital for those companies to grow. We want them to focus on improving their product mix, customer mix, and reducing costs.

What are the most common reasons why a company might be in that red zone with a profit of working capital below 25%?

I would say we have two categories in that bucket. One is typically companies that have been green or maybe yellow, but as you know, the underlying markets in many construction and industry segments in the Nordics have been tough during the last two years. So they have been sliding down in the capital allocation model on the X-axis. That is then viewed as a temporary position, and those are expected to move to the right again when the market comes back. So that's not a long-term problem. Then we have some companies, for different reasons, that have structural changes, being in the red box, not only fixed by the market coming back, and then you need to do some more structural activities on those.

Let's say you've got a company in the red zone with, hypothetically, 15% to 20% profit over working capital. You have a board meeting. What do you communicate as a strategy to the divisional head or the CEO of that group or company?

We want them to see how they can improve their product and customer mix and how they can reduce costs.

But that could mean shrinking the business.

It could be, but I don't have a problem with that if they're in the red zone because it's so capital-intensive to grow those businesses. We don't want to allocate capital to grow their working capital.

But how do you deal with the subsidiary CEO or operator who wants to grow their business and thinks about revenue growth? How do you communicate that to them so they understand?

That's why we've had all the management teams undergo a training session through our business school, where we explain how it works. It's quite simple. For instance, as a private person, I have two options with a thousand dollars. I can go to the green bank, put it in, and get 10% interest per year, or I can go to the red bank, put in the same amount, and get 5% per year. So, dear CEO, which bank would you choose? One key aspect is that they understand why we do what we do and why we lead in the way we do. It's not pleasant to be in the red zone, but I can tell you that the companies there are eager and determined to get out of that zone.

With the example of the two banks you mentioned, you're effectively explaining the cost of capital at the holding company. You're asking, why would I give money to Mr. Red Company when I can get 5% here and 10% elsewhere? They might say, well, it's my company, and I need to grow.

If you improve and reach 10%, then yes, I will invest there. It's not nice to be in the red zone, but it's crucial for them to understand why we're doing things this way. The simple bank example makes it easy to understand.

What's been the biggest challenge in communicating that to your team, especially those in the red zone?

I've been with the group for nearly four years, and we introduced this concept four years ago. Initially, they thought it would pass, that they could wait a few quarters, and other themes or priorities would emerge. There was resistance, especially from companies in the red zone, to act according to the focus model. There's no workaround for this anymore. The only thing they should and could do is get out of the red zone.

Many people running these companies didn't found them, right? They might say, "It's not my fault; I inherited a declining market." I imagine you've heard these excuses.

Yes, but the allocation will be the same.

So you have to be firm and say, "This is how I'm allocating capital. Why would I allocate capital there when I can get better returns elsewhere?" Therefore, you must do everything possible to achieve over 45% profit over working capital, which might mean shrinking the business by half to focus on the most profitable customers. It's an unusual way to think, but you have the M&A model that drives revenue growth at the top line.

Yes.

So you can afford to do that.

The majority of our companies are in the green zone, so there's no lack of companies where we can allocate and want to allocate capital for growth.

What if a company can't reach 45% profitable working capital?

We have communicated externally that the qualification criteria to be a long-term member of the Bergman & Beving Group is to reach at least 45% on a platform level. We set a time frame for that and communicated one and a half years ago that it should be reached within three to five years. We are on that path now. If we find along the way that a company isn't improving or going in the right direction and we conclude it will never reach 45%, we will need to make structural changes in that platform.

Even if it's still generating cash flow?

Yes, you can argue that it's not growing, so we don't need to allocate more capital and just treat it as a cash cow. That could be one argument, but you can't have too many of those companies.

Why not?

Because we need to have growth over time. Our model and target is to increase profit by 15% per year. That's our track record. It's interesting, Buffett is seen as a great investor, and if you look at the last 20 years, he has a CAGR of 9.8% or something like that. If you look at Bergman & Beving, we have 20%.

Bit of a different scale.

We are like a Buffett Turbo. We want to continue being that, so we can't have too many cash cows.

Very, very, very small relative to Berkshire. I'm not focusing forever on the red ones. But how do you specifically incentivize me if I'm in a red company? What's my bonus plan? How do you encourage me to behave in that way?

That's a very good question. Our bonus program at the CEO level is based on two parameters. One is the EBIT growth and the other one is profit to working capital ratio. So if you are in the green zone, we want to allocate capital, we want them to grow and typically it's about growing the top line because all the other financial parameters are in place. Those CEOs, we incentivize with 80% on their bonuses based on the EBIT profit increase and only 20% is based on the profitable working capital working capital ratio. So we don't typically need to improve the profitable working capital. We just want to make sure they don't slide down to the yellow zone.

If you are in the red zone, 80% of your bonus is based on your improvement of profitable working capital in percentage units and only 20% is on EBIT profit growth. So we have made sure to align the incentive systems with how we allocate capital and what type of priorities we want the platforms to have.

So if I'm at 20% profit of working capital in a red zone, you would set me a target of 25% in one year, and if I hit that, I get my bonus?

Yes, you would get 80% of your bonus. But it won't be as low as 25%.

There are no easy balls in this game. When you look at the green companies, why is it that they have 80% on EBIT growth and 20% on profit over working capital? What is the major reason, in your experience, that you see a company transition from green to yellow, and how do they potentially degrade over time?

One reason I mentioned earlier is the underlying market development. Currently, we have a more temporal set of markets in Northern Europe. There could be structural changes in the market, either on the customer side or the competitors' side. There are many different reasons why they move downwards in our capital allocation model.

Do you have a target in mind for having all of them green? Or is this a cyclical business and market, so you'll always have some red and yellow? How do you envision where you want to be in 2026?

We have communicated a target that the group should be above 45% profitable working capital by the latest fiscal year 2026-2027. That's a little more than two years from now. With that said, there are companies that need to improve their profit over capital ratio to get the group there. As mentioned earlier, within a maximum of three and a half years from now, all companies need to have a fortified profitable working capital of 45%, over a business cycle, to qualify to be within the group long term.

I know every company is different with varying strategies, markets, and customers. But typically, what's the biggest challenge in moving a company from red to yellow? Is it reducing inventory, customer focus, or unprofitable business? What are the typical reasons you find?

Before I joined the group, the focus wasn't much on the working capital elements. Then we encountered the Covid situation, which led us to build a lot of safety stock across the group. We are still working down those inventories because there are very long lead times in some companies. Some companies remain on the left side of our focus model since they haven't reduced their inventory levels to pre-Covid levels.

How much overstock do you think you have from Covid? What's the difference in stock levels roughly?

We had an inventory turnover (ITO) of 2.6 pre-Covid, and now we are at about 2.2 or 2.3. You can calculate backwards from there.

Could that be a structural change in the market, or do you think you should still aim to get your turns back to that level?

No, we should aim to get back to that level as a first step. I believe we can achieve even more after that.

So roughly a 20% difference in stock levels?

Yes, over time. That's one of the reasons. We've put a lot of effort over the last year into optimizing inventory levels. This includes reducing lead times, order sizes, and assortment in the companies. There have been many activities across the group to improve stock processes, and we are now seeing some effects from these efforts. We will continue to see effects going forward.

As you mentioned, these companies don't have many fixed assets since they outsource production. Their main focus is on accounts receivables, inventory, and payables. The working capital is essentially what they have. What about collecting receivables and managing payables? Are those terms ever a challenge in these types of businesses, or do you have a standard like 60 or 30 days?

It varies among different companies. As I mentioned, they need to pay interest on the working capital this year, which is at a 6% interest rate. This, of course, incentivizes management to reduce inventories and optimize payment days.

How does that work? Let's say I have $100 in inventory and a 60% gross margin. If I have $10 of working capital and turn it four times, you're saying you charge them 6% on that $10?

We calculate working capital every month. They need to pay quarterly, based on the average working capital over the last three months, which includes payables, receivables, and inventory.

So they pay 6% of that balance?

Yes, exactly. This incentivizes them to reduce stock and optimize payment terms.

And if they have negative working capital, do you pay them?

Fortunately, we don't have companies with negative working capital. We haven't encountered that issue yet.

That's an additional fee on top of the cost of holding it?

Yes.

Wow, okay.

This is something we introduced. When I joined the group, the companies and the division were initially measured on EBITDA, but we changed it to EBIT. This is the first fiscal year we're using EBT.

So in a couple of years, you'll be focusing on net income?

Not really, as they can't affect the taxes.

You can't go too far. When did you come up with the idea of adding interest costs on the working capital?

We introduced it at the start of this fiscal year. This is new for this year.

Was it historical at Bergman & Beving or Lagercrantz? How did you come up with this idea?

It hasn't been historically done at Bergman & Beving, and I'm not sure what Lagercrantz is doing today. We didn't implement it during my time at Lagercrantz. We didn't face working capital challenges or opportunities there. This is to emphasize the working capital dimension at Bergman & Beving.

And this applies to every company, not just the red companies?

Yes, it's for every company.

Do you think this charge will be permanent for these companies, or is it just until 2026?

No, my expectation is that we will continue with it because I think it keeps the focus on the topic. We'll adjust the interest rate based on the market interest rate. It might decrease a bit next fiscal year since the interest rate is coming down, but no major changes are expected.

How have you observed the behavior change of companies this year after you added that charge?

The interest and focus from the companies have, of course, increased.

Has it made a difference? Have you seen them calculate inventory every week?

Yes, I have some concrete examples where we have seen an increased focus on negotiating supplier payment terms and customer payment terms. However, there is still more to be done.

Last question. When looking at other successful acquirers, you mentioned Berkshire and we talked about Constellation Software, what do you think is the biggest risk with these businesses long-term? Where could they go wrong?

Yes, going back to my two priorities. One is how to allocate capital across the platforms. The second is either they don't have a good M&A playbook, or they have a good playbook, but they divert from that; divert from buying quality and/or pay too much.

Discipline. Why do you think people become undisciplined?

Maybe they get stressed, they don't get the acquisition pipeline they need, or that is necessary to deliver on their targets. Then they start to compromise on quality and pay a bit more to get the deals. For me, having disciplined capital allocation across the platforms you own is more of a discipline question, I think.

How would you evaluate that?

It's something you need to do over time, quarter on quarter. It's not just a quarterly theme. It's something you need to do every quarter, every year. Over time, that will yield results.

On the point of filling the funnel, how do you view the risk of the M&A funnel drying up? If you have negative organic growth, that could put pressure on the organization on the top line. Firstly, how do you see the risk of not filling the funnel?

Currently, we have a target to acquire 50 to 80 million in annual earnings per year through acquisitions. I don't see any reason why we shouldn't be able to achieve this. We already delivered on that target this fiscal year and last year. I don't see any reason why we shouldn't be able to do it next fiscal year. We will most likely increase that target level over time, but not next fiscal year. So, I don't see any risk that we shouldn't be able to buy the right quality at the right price.

When evaluating another serial acquirer and looking at the CEO, what are some things you look for in their personality or behavior? Going back to this discipline question, how do you assess others?

To be honest, I don't typically assess other CEOs. However, if I were to do so, I would consider factors such as the number of years and the type of track record they have within the serial acquisition business model. My experience indicates that while you can find excellent operational leaders, managing a serial acquisition is a different challenge. Having years of experience in this type of business is a significant advantage. Another aspect I would examine is how they allocate capital to the platforms they own and what type of M&A playbook they employ. What does their track record show in terms of M&A achievements?

I think Buffett is about 95 now. Maybe you have another good few decades to go, Magnus.

I have some years left. I've only spent 20 years in the serial acquisition business so far.

How long do you think you can continue?

I haven't set a specific time target. I find this work enjoyable, so I don't see an end in sight.

People have done it for a long time. Maybe you can give Buffett a run for his money. Magnus, this has been great. Thank you very much for your time.

Thank you for being here.

As always, this is for informational purposes only and should not be relied upon for investment decisions. Please conduct your own research.