No risk it, no biscuit?

March 26, 2021

by a searcher from University of Denver - Daniels College of Business in Boston, MA, USA

I'm close to submitting an LOI for a B2B service firm. I've talked to some fellow searchers and CPAs, and frankly it seems like they could nitpick every deal, and due diligence themselves out of a turkey sandwich.

At what point do you eventually acknowledge every deal has some risk and go for it versus waiting on the sideline??

I'd love to hear from searchers who have actually closed an acquisition. Were there major skeletons in the closet post close? What are the deal breakers for you pre LOI and in due diligence? Any searchers with major regret in their current business?

In the words of coach Bruce Arians who won the super bowl this year, 'no risk it, no biscuit.'

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Reply by a searcher
from Massachusetts Institute of Technology in Miami Beach, FL, USA

Partially, it's the "secretary problem" (https://en.wikipedia.org/wiki/Secretary_problem). A searcher has to DD the first few interesting deals and reject them all, just to build up an understanding of the average quality of businesses. Now, I know I'll have to accept a business with some hair on it.

However, I do think there are searchers who are looking for the perfect business and a zero-risk deal. Those searchers are bound to be disappointed. I'm looking for a deal that's at least an 90% likelihood of success - say success means doubling the intrinsic value of the company in a couple years. And there's a 10% chance of failure - here, a total loss of investment. Maybe I'm unlucky in the first deal. So I save up and do another 90/10 success/failure deal a second time. Since each deal independently has a 1-in-10 chance of failure, the chance of BOTH deals failing is 1-in-100.**

You need guts to pull the trigger on a purchase but you don't need to be a gambler!

**P.S. I got this concept from Mohnish Pabrai's book The Dhando Investor. Put another way, it's "heads I win, tails I don't lose much." Here's a pretty good summary of the section on dhando and the motel-mogul Patel clan: https://www.gurufocus.com/news/862082/the-dhandho-investor-why-the-patels-owned-so-many-motels

Reply by a searcher
from University of Illinois at Urbana in Naperville, IL, USA

I think the key is to focus on consequentiality. There's lots of hair on every deal, you have to put all that through a filter of what problems you are prepared to solve reasonably and how much room does the deal leave financially to either resolve or just eat the consequences of the problems that you are spotting. If the debt service coverage ratio is aggressive then you really have to think closely about lots of risks. If you have good financial room then you can start making buckets out of the risks. In one bucket goes everything you think you could fix or swallow given the deal parameters. In another bucket goes stuff that you are worried about truly tanking the deal or causing the business to fail. For both of these buckets I think it's helpful to really think about your own personal ability to handle the issues. Some problems have seen big and scary to advisors may feel like just another Tuesday to you. Take all that stuff you came up with and label it as something you should clear up before an LOI, something you should clear up right after the LOI but before you engage professional services and start eating deal costs, and things you will resolve through the full due diligence. Being explicit about the timing of the risk exploration may help you clearly separate what you have to handle before the LOI versus after. Now think about the things that are in the consequential bucket. Things that could tank the whole deal or take down the business. Focus your attention there and make a judgment call on the important things.

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