when capital was free

The team was evaluating an acquisition for a large holding company. It was full of qualified professionals, CFAs, MBAs, lawyers, engineers and analysts; and certain areas such as market research were outsourced. In addition, there were top bankers as investment advisors, and two of the big four accounting firms carrying out financial and tax due diligence. In effect, you could not have asked for a better qualified analyst team.

The holding company (let's call it a private business, although it wasn't) was the investment vehicle for its owners. The capital, all equity, was supplied by the owners. The company was never short of capital as the managers asked and owners gave. The quarterly reporting was filled with colored graphs, charts and presentations, but devoid of any meaningful analysis and action. Nevertheless, it did not matter because such were the owners; may be it was in spite of the owners. Equity was treated virtually free of cost. No wonder then that performance of historical investments, spread across the globe, was not adequate considering the opportunity costs. None cared; whatever was earned on the costless capital was more than adequate. 

The target company was in the commodities business and was exposed to cyclical overtones. The historical performance was very good, and it was majority-owned by private investors. 

The sellers were more pronounced on two matters: Their asking price was fixed and not available for any negotiations. Furthermore, certain key information that mattered was not to be disclosed until the deal was signed. The double whammy was also conspicuous in its absence in the buyers' den. It wasn't laughable; remember, all capital was free. 

As I was discussing with an analyst in the team about how the valuation of the target was going to be done, his reply was obviously based on the discounted cash flows. When I asked what if the value came very different from the seller's price, the reply was that the team did not care about the seller's price and would ensure that their bid would prevail, and the buyers would be able to get a high return on capital. All I did was smile softly from outside and laugh loudly from inside.

The analysts and investment advisors took cash flows and growth rates, obviously supplied by the sellers, that were not only aggressive but also questionable. They were plotted on a complex model and presto, the value was exactly equal to the asking price. Wasn't that magical? Of course, there were meetings with the sellers, and lots of it, to discuss, question, demand and negotiate. Yet, the result was more predictable than any other.

In that paradox, the buyers spent a lot of time, resources and money, and then botched in the name of thorough analysis. They compromised the first principles of investment all through. It appeared that they did not understand the business, for they would not have accepted unrealistic cash flows. They went carelessly and desperately after the business that did not have any durable competitive advantages. It was prone to economic cycles. They did not have a clue about the intention of the incumbent managers, although, it was agreed that they would continue office after the take over on terms that were not in the best interests of the buyers. Finally, the price that was paid was quite incompatible with the value of the business.

What the owners got in the end was a commodity, cyclical business that had no competitive advantages, with debt disproportionate to the size of equity, and price that was outsized.

The epilogue was that cash flows did not meet the projections and goodwill was fully written off. So what, for the owners, this was only one more addition to the existing deteriorated investment portfolio of the holding company. After all, the managers and owners were consistent in their behavior, except that this particular acquisition was a bit heavy on their pocket book.