Most financial analysts define “alpha” as risk that a prudent investor must be compensated for beyond the risk associated with the market at large. Within the context of a financial due diligence analysis, this unsystematic risk is often referred to as the risk profile of the target company. This leads to important questions: What should the analyst be looking for? Which techniques can they use to identify the alpha within a target company that will help the investor assess the appropriate price and structure of a particular transaction?
In this article, we will look at five types of unsystematic risk and the mitigating factors that an analyst should consider as part of their due diligence. These risks include:
Concentrations
Key man
Revenue volatility/operating leverage
Commodity
Quality of data
Concentrations
While the impact of concentrations may seem fairly obvious, an analyst needs to be aware of the many types of concentration risks a target company may have.
Customer
Risk: A customer representing greater than 10 percent of the company’s revenues or contribution margin presents a possible negative impact on the target company’s ability to provide returns to the buyer. If that customer moves its business elsewhere or that customer’s business begins to decline, the subject company may find it difficult to replace those revenues and earnings. Assessing the stability of the customer and switching costs should be the focus of this analysis.
Mitigating factors: The buyer may feel reassured about the concentration risk if management of the target company has nurtured multiple contacts with the customer at different levels of authority, and if the relationship is a longstanding one.
Additionally, the concentration risk is offset if the target company:
Provides multiple services
Offers proprietary products
Is specifically identified in the customer’s specifications
Owns the tooling necessary to manufacture the product
Has intellectual property that will create significant switching costs for the key customer, or
If regulatory requirements make it difficult for the customer to change suppliers[1]
Products
Risk: The risk of a product concentration lies in the vulnerability of the related revenue and contribution margin to technological obsolescence, expiration of intellectual property rights, and the higher relative economic value of substitutes. Additionally, the cost of the target company’s products relative to the overall cost of the customer’s end product will drive the customer to seek lower cost alternatives.[2]
Mitigating factors: If the target company holds patents or other intellectual property rights with a long remaining life, the revenue stream related to those products or services is more assured, and the target company’s customers would face switching costs in using substitute products from competing companies.
Intellectual property
Risk: We have seen companies with no customer concentration and no product concentration, but are wholly dependent on a single patent that expires in the near term.
Mitigating factors: In this case, the buyer must consider how robust the target’s research and development efforts are and whether the loss of the patent is really a threat.
Services
Risk: A target company whose business is dependent upon a particular service in turn creates a dependence on the internal team that delivers that service. If members of that team leave the company, the value of the service may be affected and important institutional knowledge may become available to a competitor.
Mitigating factors: The target company should have in place enforceable employment agreements with team members that include appropriate non-compete clauses relating to geography, time, and specific services. Additionally, employment agreements should include confidentiality, non-disparagement, and non-solicitation agreements
Channel
Risk: A buyer should be comfortable that the target company has control of its distribution channel and has not completely delegated its key customer relationships to its distributors, dealers, or independent representatives. Such delegation lets the “tail wag the dog” and leaves the company susceptible to losing a customer that is more loyal to the channel relationship than to the target company. This risk is highest if there are multiple supply chain alternatives available to the customer.
Mitigating factors: Beyond contractual constraints and incentives, the analyst should look for instances where management made efforts to establish a partnering relationship with its channel members. These efforts might include frequent relationship-building visits, joint calls with customers, high-quality marketing materials and events, support and training for the channel members, and website links to the partner companies.
In one instance, we found that a subject company had more than 30 percent of its revenue sourced with one manufacturer’s representative. The target’s management team had no direct relationship with any of the customers and relied exclusively on the independent manufacturer’s representative. Obviously, the subject company was totally dependent on this channel, and vulnerable to any demand the representative made.
Vendors
Risk: Having a concentration of vendors providing components represents a potential interruption of the supply chain and, therefore, affects the ability of the target company to deliver quality products on time, putting customer relationships at risk.
Mitigating factors: If management has established alternative vendors, the appearance of risk would be mitigated. However, the analyst still needs to ask why the company has a vendor concentration and does not more evenly distribute purchase orders. If the concentration cannot be avoided (e.g., the vendor holds critical patents), then the stability of the vendor should be the focus of the analysis.
Analysts frequently find target companies sourcing products from Asia. While there may be cost advantages, tariffs notwithstanding, these target companies are vulnerable to being shut down if the supply chain is disrupted. This was the case with the longshoremen strike in California in 2015, which forced companies to fly in materials at a cost that wiped out their savings from sourcing in China.
Key man
When a company is dependent on one person or a small group of people to keep the organization focused and moving forward through their herculean efforts, a key man risk may exist.
Risk: In smaller companies, while delegation of authority may not be possible, we have frequently found that entrepreneurs will hoard key customer or vendor relationships. In other cases, there is just a significant amount of institutional knowledge or know-how tied up in one individual. The loss of that person could create a significant interruption of business.
Mitigating factors: If adequate employment agreements are not already in place, the buyer should include employment agreements as a condition to close. As noted previously, such agreements should include non-compete, confidentiality and non-solicitation agreements. Key man life insurance should also be considered and the related costs included in the pro forma adjustments to EBITDA analysis.
Revenue volatility/operating leverage
Most companies experience some sort of seasonality or cyclicality in revenues. However, volatility in revenues beyond natural cycles induces a level of risk in an organization as the cash flows become less predictable. Add a high level of fixed costs into the equation (operating leverage), and the earnings become even more unpredictable.
Risk: Any company that demonstrates a high level of revenue volatility is by definition risky, as the predictability of earnings is impaired. In addition to revenue volatility, if the company has a relatively high fixed-cost component in its cost structure, the company should be considered particularly risky.
Mitigating factors: If the company under study demonstrates high revenue and high operating leverage (relatively high fixed costs), management can typically only control the company’s exposure to these combined risks through sufficient liquidity. The analyst should investigate the company’s levels of cash, marketable securities and open availability on the line of credit to assess the company’s ability to absorb a downtrend.
Commodity
If a company is dependent upon certain raw materials – copper, oil, titanium, aluminum, wheat, cocoa, etc. – their ability to generate acceptable gross profits is dependent upon their ability to manage a predictable cost of materials.
Risk: Depending on a raw material commodity exposes the company to micro- and macro-economic influences out of its control. A particularly volatile commodity can wreak havoc on the company’s ability to create reasonable profits.
Mitigating factors: The analyst in these circumstances needs to be comfortable with the ways management of the target company addresses this volatility. The company may be using hedging instruments, forward purchase contracts, surcharges and pass-through pricing, or similar techniques. However, the analyst needs to be comfortable with the effectiveness of these methods.
Quality of data
Contributors to poor data quality include:
Information that cannot be easily extracted from the subject company’s systems
Financial records that have not been kept up to date
Antiquated accounting systems
Accounts that are not reconciled in a timely fashion
Important contracts that are not retained
Important transactions that are not fully documented
Incorrect revenue recognition
Weak or non-existent controls over assets
Risk: Unfortunately, many entrepreneurs view the cost of keeping both accurate accounting records on an accrual basis, and IT systems and controls up to date, to be non-value-added costs. Not treating these functions as a strategic component of operations is a critical error that may not surface until management is trying to sell or recapitalize the business. Additionally, such a view generally reflects poorly on management and how they run the business.
Mitigating factors: A buyer, to protect themselves from the inaccuracies in revenues and earnings and the potential for unrecorded or under-recorded liabilities, may have no alternative but to lower the price or change the deal structure. At a minimum the buyer may find it necessary to increase the escrow or offsets, the indemnification amounts, and the length of time the representations and warranties will remain in effect. All of these have a negative economic impact for the seller. In a worst case scenario, a buyer may choose not to close the deal due to the uncertainty surrounding the true economic earnings of the business.
Conclusion
Risk is a critical component of assessing the quality of a company’s earnings. The risk profile provides the buyer insight as to how sustainable the company’s earnings really are. If the earnings of an entity seem impressive, and are even validated, those earnings or the trajectory of those earnings could be easily shattered should one or more of these risks become a reality. The more the unmitigated risk issues pile up, especially if they have not been previously disclosed to a prospective buyer through the Confidential Memorandum or a sell side due diligence, the less likely a transaction will close at the originally agreed to price and structure.
The last risk – quality of data – is often overlooked. The inability of management to produce evidence to support earnings, earnings adjustments, or risk mitigating factors, will result in a nervous buyer, and a nervous buyer always says no.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
[1] Porter, Michael E. (1980). Competitive Strategy. Free Press. ISBN 0-684-84148-7. [2] Ibid.
