The idea of the Investment Thesis is to take the guesswork out of acquisitions used to create value and growth.  It also has another purpose in planning your eventual business exit in that it helps you understand how your eventual acquirers will view your expanded business.

How to Develop the Investment Thesis

Once the Investment Ideas are clear, they are embodied into the Investment Thesis. The final Investment Thesis might be as short as a half a page in length, or as long as two or three pages.  It sets out detail that can be acted upon and that can be reviewed from time to time as the investment proceeds.  Critically, it answers the question:

• “Why now? What is the impetus to invest in this sector? Is buying this company the right pathway to invest in this sector and is now the right time?”

Four Elements of Your Investment Thesis

There are four elements to an Investment Thesis:

1. Look at the target company in detail.
2. Assess it in relation to the overall outlook of that sector.
3. Analyse the current state of play with the company.
4. Map out the strategy for the newly acquired company to win after acquisition.

These are explained in more detail below.

1. Company Elements
   

Unless you are looking at a turnaround situation, the company should exhibit the characteristics of a successful company:

• It has, or has the capacity to have, high return on capital.
• It has three years of increasing profits, or other demonstrated performance that can be relied upon.
• It operates in a sector or sub-sector with high barriers to entry, or has created high barriers to entry with long-term contracts, etc.
• It has high margins relative to the competition and more importantly, relative to the hurdle rates set out in the Investment Thesis.
• It has high relative “bench strength” – that is, a management team that will win. This is often a product of long experience in the industry, respect from their peers and preferably equity participation.
• There are solid reasons to expect that the company will win out in the future by reason of clearly enunciated value drivers.
• It has desirable characteristics such as a platform capable of high growth, a sustainable and scalable business model, a highly differentiated strategy, recurring revenue streams and defensible position/barriers to entry.
• There is a “catalyst” for your expected expansion in earnings for the company post-acquisition, such catalyst preferably not being your acquisition alone.

When considering the company elements:

• Set out all the things that could go wrong with mitigating actions post-acquisition and assign a probability to each.
• Be realistic about your valuation and your target acquisition price. Using the appropriate valuation method, estimate the value of the business, then estimate the highest amount you would pay for it. Without detailed financial forecasts, a discounted cash flow might be hard to calculate, so preliminary valuations would probably be on multiples of EBITDA, EBIT, EV/Sales, or other relevant industry multiples. Comparables should also be used where the information is known.

2. Sector Elements
   

Businesses operate firstly on a national and international level.  You then need to drill down from there to the local factors affecting the business to determine “industry attractiveness.”

Financial buyers are known for turning down all investments in a sector because of a lack of industry attractiveness. Strategic buyers, on the other hand, are usually already in that sector, so are more committed to it and more open to making an acquisition in it.

Sector analysis (industry attractiveness) involves answering questions such as:

• How do national and international elements including interest rates, currency rates and sovereign risk affect enterprises in the sector and sub-sector?
• At a sector level, what are the current trends and issues? How concentrated is ownership of competitors? The sector mature or expanding? How many firms compete in the sector? What are the key drivers of activity in the sector?

• At a sub-sector level, what is the total market worth? How many competitors are there and what is the quality of those competitors? Who is taking market share, why are they doing it and who are they taking it from? What substitute products or services are available? Who controls pricing in the sub-sector and in the company’s market?

3. Current State of Play
   

Now look closely at the current state of play within the company.  Examine it closely and ask:

• How long can the company’s competitive advantage be maintained after acquisition?
• Can the company’s customers switch easily?
• What are the cyclical issues in the sub-sector and sector?
• Is the company in play at the moment?
• If so, are there other buyers?
• If there are other buyers, what stage are they at? Do you have to act now, or can you play a waiting game to drive the price down because you are confident the asking price is too high or the other buyers won’t proceed?
• If the company is not in play, are you confident that all the shareholders will agree to entertain your offer?
• Is there a catalyst in the offing that will increase the value of the company in the near future post-acquisition (i.e.: long term or high value contracts, new product launches, new IP)?
• Is there a “special situation” within the company that you can take advantage of (i.e.: shareholder dispute, owners retiring, pressure from the bank)?
• Are the shareholders widely spread, or are there one or two key shareholders that will influence the rest to sell?
• Is the company currently underperforming its peers?
• Are there rapid changes in the company or the sub-sector which you are not aware of that would influence your investment decision?

4. Strategy to Win
   

Following your acquisition, what is your strategy to win?

• Are you contributing cash and balance sheet strength (i.e.: a financial acquirer) or are you also providing management expertise, time and leverage of product distribution or volumes (i.e.: a strategic acquirer)?
• What is the management team’s strength, depth and management philosophy? Will you bolster this?
• How has management allocated capital, driven sales and handled product development?
• Will your new ownership unleash management’s potential or will the management cripple your ownership?
• Does management have “skin in the game”? How are they rewarded? Is the reward system tied to revenue, profits or return on investment? How does each of those reward structures affect management’s short term and long term decision making?

Summary

The role of the Investment Thesis is to separate the facts from a founder’s usual enthusiasm, prejudices or concerns about companies or sectors. It is an invaluable tool to preserve the wealth created in your company and to propel it to new heights.  Importantly, the Investment Thesis puts some controls in place in considering acquisitions and helps you understand how potential acquirers of your company think about the bigger picture.