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Visible Alpha
Visible Alpha

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Welcome, everyone. This is a new initiative from us. We will be releasing weekly free podcast episodes, discussing insights we've gained over the past week or two from our internal research, as well as discussing some of the interviews we've published and significant earnings. This week, our topic is serial acquirers, a term that broadly defines companies that use M&A or accretive M&A as a key value driver. This includes companies like Constellation, Danaher, TransDigm, Heico, Halma, Judges Scientific, and many companies in Sweden. A few weeks ago, we were in Stockholm for a serial acquiring event. This episode will explore what we've learned and provide a framework for how we evaluate these companies. We welcome your feedback and remind you to conduct your own research. Nothing here constitutes investment advice.

This episode is sponsored by Visible Alpha, a platform designed for institutional investors to analyze consensus data for thousands of publicly traded companies. Instead of having to sift through models individually, Visible Alpha generates consensus data for every line item in sell-side models. This allows for a better understanding of expectations on metrics, not just earnings or revenue, but also many non-GAAP metrics. For instance, I was examining Ryanair and various airlines, and they have excellent data on RPMs or revenue passenger miles, load factors, available seat miles, and cost per seat. Listeners are invited to try Visible Alpha for free by visiting I'm confident you will find the metrics very useful compared to what's available elsewhere.

Now, onto the topic of serial acquirers. I must admit, I'm not fond of the term.

What does it mean exactly? It's a bit of a buzzword. Looking at their trading, there doesn't seem to be much to like. There are a few quality businesses in this space, but over the last couple of years, we've had a lot of fun examining a range of relatively or highly acquisitive businesses. These include Danaher, TransDigm, Constellation Software, Heico, Halma, Judges, Diploma, SDI Group. We also spent a week in Sweden meeting management teams from Bergman & Beving, Roko. What has drawn your interest to businesses that frequently acquire other businesses and do it well?

It's interesting that you mention that, as I just received an email from Diploma, stating they're planning to purchase a large business and are in the process of raising capital. However, there are a couple of things to consider. Firstly, it's challenging to value accretive M&A, particularly consistent accretive M&A. These businesses tend to trade valuations that don't reflect the value that sustainable accretive M&A generates over a long period of time. This was before they all traded at 30 and 40 times, and perhaps some of these businesses, if purchased at 30, 40 times, could still yield decent returns if you have a skilled capital allocator and a long runway.

The difficulty in analyzing, understanding, and calculating the value of accretive M&A makes it a fruitful area if you can identify those skilled capital allocators. Studying the best ones, such as Constellation, and going back to the know, and of course, Berkshire is its own type, we're going to work on a framework for evaluating these. But one question that I've been exploring over the last six to 12 months, which seems to be one of the most important if you're going to invest in some of the scaled operators or businesses today, is how do you scale M&A without destroying the returns?

Typically, these companies, like Danaher, Halma, Indutrade, and some of the other Swedish ones, when managing or having a small amount of capital, can go and buy several small businesses that generate three, four, five million in revenue. You can purchase these at four to five times EBIT that are earning stable earnings, and you can get your cash back relatively quickly. You also get the nice multiple arbitrage when your listed equity is trading at 20 to 30 times.

This approach works great in the early days, and you can compound operating income fairly quickly. However, there's a certain point, if you look at Halma in the early 2000s, even Lagerkrantz to a certain extent, where they reach a scale that makes it very hard to breach. They can't deploy all the free cash flow they have at the same economics.

The ideal scenario, which is why Constellation is so interesting, is that you can allocate the same amount of increased dollars at the same term invested capital. Constellation is unique and the purest version of this model, in my opinion. They've gone from allocating $80 million in 2008, 2009, even lower before that, to approximately 1.23 billion last year, at the same economics, which is incredible. They're acquiring 130 companies, up from 20 companies to 130 companies a year, which is almost unthinkable.

However, if you study some of these other businesses that see what we could call mean reverting returns, they reach a point where they can't scale the human capital to allocate the free cash flow at the same returns. They can't do double or triple the amount of smaller acquisitions or same size acquisitions, and therefore, they go and buy a larger business. For instance, I just got an email from Diploma; they're buying another sizable business, Tennessee Industrial, for 76 million sterling.

Under Bruce Thompson, they were acquiring businesses valued under 10 million. This could still be a good and accretive deal, but when you're buying these types of businesses, it's typically auction-based. Private Equity is usually interested in them, and you end up paying a high price. For instance, the new executive at Diploma bought a business called Windy City for 10 times its EBIT. So, the economics are worse. However, you're allocating more capital.

What I've been exploring is why Constellation can do 130 deals, or one deal every other day. They're buying hundreds of small companies with revenues below five million. It's remarkable. How do they build an organization that essentially functions as an M&A machine? Why can they do this when others can't?

Even companies like Halma and Diploma, which are incredible businesses and have been phenomenal investments, can't manage to scale with the same unit economics, returns, and capital as Constellation. And Constellation seems to be the only one capable of doing this. That's the line of questioning we've been exploring, with the aim of identifying the next Constellation. After years of work, it seems that Constellation is the next Constellation.

You've described Constellation as a very pure model. How would you classify Constellation, Danaher, TransDigm, Bergman & Beving or Lifco in the Nordics, or Berkshire, within a framework?

Berkshire and Buffett represent a version of serial acquisition. He acquires public securities and private companies. However, he is obviously unique in his approach.

I've noticed your enthusiasm for Berkshire has grown as we've delved deeper into these variants of serial acquirer business models. It seems your respect for Berkshire has only increased as we've explored further.

Berkshire and Constellation have a peculiar similarity. I've been revisiting every Berkshire AGM I could find since 1997, and I'm currently on 2007. Before we go to Omaha, I've covered about 25, which is quite odd. I've practically had them in my ear for the past month. One thing I undervalued about him was a statement he made in an annual meeting that resonated with me. He said, not all businesses are supposed to grow. This seems so unusual because very few businesses, especially publicly listed ones, would admit they shouldn't be growing.

This is more common in private markets where family-owned businesses are content with growing at GDP plus. He has a unique ownership structure where he purchases cash-generative businesses with decent ROEs and imposes a high cost of capital if those businesses were to retain the money. This trains the managers to return the money to Buffett if they can't allocate at a required return. He then reallocates it elsewhere.

Mark Gunner has implemented a similar capital retention scheme at different business unit levels. The managers of Volaris and the portfolio managers of the operating groups at Constellation have to meet the same cost of capital. They also have to meet higher hurdles to acquire businesses. This stems from a rigorous and disciplined philosophy that it's fine if they don't grow.

Constellation purchases what we might call "legacy on-prem software" that doesn't need to grow if it can maintain 20% margins for ten years and they pay five times for it. Similarly, Buffett doesn't need some of his old manufacturing businesses to grow if he's paying a decent multiple and it lasts for 20 years, allowing him to extract 20 years of free cash.

Accepting that not all businesses have to grow can prevent major mistakes in capital allocation and unnecessary spending for growth's sake, which typically doesn't work. Buffett is unique in that he allocates it everywhere. He's the greatest capital allocator of all time. He's invested in silver, commodities, junk bonds, private companies, public securities, and more.

Mark Leonard has established an institution that can scale and make around 130 small VMs acquisitions per year, possibly more. Other businesses fall somewhere in between that spectrum, with different flavors of the same, but slightly different.

I believe Constellation is the purest form of redeploying free cash flow into small profitable businesses with higher recurring revenue. They don't necessarily grow quickly, but they generate free cash flow. Other industrial businesses, like the ones we met in Sweden and some distributors or Halma or Diploma, started off similarly but diverged, either making larger acquisitions with worse economics and taking more risk, or misallocating capital.

How do you perceive a business like Lagercrantz in that context?

Swedish companies like Lagercrantz are almost pure models. Let me clarify what a pure model is. It's a structure that reinvests all the free cash flow generated into acquisitions at high rates of return.

Take Constellation for example, they don't have a policy to pay out a dividend regardless of the situation. Even Mark Leonard could have done that, right? David at Judges does that. Both Mark and David own stock. Mark doesn't have a dividend policy; David does. That's fine. But to me, it seems like it's not necessarily structured for minority shareholders. It's not truly structured for shareholder value.

Buffett doesn't have a blanket dividend policy. He doesn't pay out 40% of earnings no matter what. Many Swedish companies do that because they have old family owners that fund their family offices from the dividend, which is fine, but there is a downside. If you're paying out 40% of your earnings every year, you're reducing the free cash flow that you can invest in new acquisitions, therefore you limit the growth, and consequently, you limit the multiple and I guess the ultimate equity value of the business.

Obviously, we have to reinvest that dividend. The cash we receive from a dividend. The purity of the model lies in the reinvestment of the free cash flow at high rates of return. So there is a governance structure around it that has to be pure. Buffett is pure. Leonard is pure. The Swedes are not so pure.

However, what they do well is they allocate capital effectively in small businesses, mainly industrial engineering businesses and distribution companies. Companies like Lagercrantz and Addtech have done very well. They've found ways to scale the dollars deployed without buying bigger businesses.

But they're only allocating a certain amount. Lagercrantz allocated 750 million SEK last year, which is about €70 million. So they're only buying around eight or nine businesses a year. This is a different league, 130 to 10.

When companies reach a certain scale, let's say 20 or 30 acquisitions, and they're making two or three acquisitions a month, it becomes necessary to institutionalize the M&A process. This is simply a matter of mathematics. For instance, if a company is generating a billion in revenue and aims to grow 5% organically and 10% inorganically, it needs to acquire around 100 million. Typically, companies buy at one times revenue, which is four or five times EBIT.

If you're acquiring businesses worth four or five million euros, you'll need to acquire around 20 businesses. So, how do you increase from acquiring seven, eight, or nine businesses a year to 20 a year? How do you double your team's acquisition rate from one a month to two? It's a different ballgame altogether.

The problem with this investment thesis is that if you buy Lagercrantz for 30, 35, 40 times earnings, or free cash, and they reach a billion in revenue, or even two or three billion, and they can't grow inorganically, you end up with a slower growing organization. Consequently, it's not worth 35 or 40 times, it might be worth 20 times, and your investment gets crushed.

We've been focusing on identifying managers who understand the need to scale, recognize the importance of human capital, and can organize these humans to allocate capital effectively. We're trying to learn from those who have done this well before and understand how they prepare and think about these issues.

This can get messy quickly. If you're acquiring 20 companies a year, you're also dealing with 20 succession plans. If half of those go wrong, you need to find 10 new CEOs. On average, you might need to replace 10% of your other CEOs, which means finding 20 people a year. This turns you into a recruitment agent as well as an M&A company.

While we're on the topic of succession, it's interesting to note that Warren Buffett doesn't seem to have this problem. He typically buys 100% of private companies, and the founders stay on and work for him at Berkshire or at the operating company. He doesn't seem to have a succession problem, at least not to the same extent as other companies. This could be due to the allure of working for him.

What has been some of the most interesting work for you? We've discussed themes and core research questions around conducting M&A at scale, the quality of capital allocation, and disciplining capital allocation. What content has been formative for you in the development of your ideas? What do you believe matters for these businesses?

There are two crucial aspects to consider, really. It's how much capital can you deploy and at what rates of return? In my opinion, everything that I do is around those two questions. And what happens is the capital deployment, just the law of large numbers means it becomes a problem pretty quick.

Last Tuesday, I met with the CEO of Lagercrantz. We discussed a Swedish competitor that has been leveraging and acquiring smaller companies to compete, aiming to replicate Lagercrantz's and Indutrade's and Lifco's success. This competitor has raised substantial capital, levered up, and has been acquiring small businesses at a premium.

We asked the CEO about the multiples for these small businesses, those with a value of less than 10 million euros, and generating one to two million EBIT of operating income per year. He stated that these multiples haven't changed since the 80s. These businesses are typically worth between four and seven times, maybe eight times at theThe point is, the return is consistent. You need to know what you're buying and ensure it's a decent business with good products. However, the multiple on small SMEs hasn't materially changed over the last 20 to 40 years. These businesses aren't as valuable as larger, diversified ones due to key man risk, lack of infrastructure, and often a single product line. Therefore, they're not worth more than five to six times. This doesn't change, so the returns are always there for these small companies. This applies to slower-growing, mission-critical software or engineering and industrial businesses, not the high-growth SaaS businesses.

It surprises me that people don't try to buy hundreds of these businesses. The challenge is figuring out how to scale up and acquire five a year, then 10, then 20. Historically, companies have spun out when they've become too large or complex, like Addtech and Lagercrantz were spun out of Bergman & Beving.

So, the returns on capital over the last 40 years haven't changed much for SMEs. The challenge is deploying the capital. Anyone can deploy five to 10 million, perhaps even 20 million a year for a few years. There are plenty of businesses out there doing this, like Judges, but to go from a 200 to 300 million market cap to a 30 billion, you need to solve the human capital question.

Some of my favorite interviews on the platform are with executives who explain how Constellation has decentralized the process. They've pushed decision-making into the lower hierarchies of the organization while maintaining quality, which is unique.

Indeed, there are not many companies that are as rigorous and disciplined. If a potential IRR is 24.5% and the asking price is 25, you're not buying it. The question here is, you can pay 30 times for it, but can they deploy double the amount of capital at the same returns? Can they manage 200 acquisitions a year?

Or the occasional larger deal? That remains uncertain. What should we expect in the next few months from these businesses?

I plan to write about what we've learned from Stockholm, which I found quite interesting. I will put down some thoughts on the framework we discussed, which revolves around the pure version of this model.

There can be serial acquirers, as we discussed in a previous podcast. For instance, Ashtead, they acquire a number of businesses every year, around 10 to 20. These would traditionally be classified as roll-ups.

There are businesses within sectors that use inorganic growth or M&A to create value. We are going to explore some of those. IDEX, Ashtead, insurance brokers Brown & Brown do the same, with around 700 to 800 acquisitions. So, there are interesting businesses out there that don't traditionally have the serial acquirer tag associated with them.

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