​The ASX has been red hot for takeovers in recent months, as we have highlighted in several articles covering the reasons why takeovers occur, the different strategies that companies employ for takeovers, and several specific takeovers of interest. We also recently released a white paper outlining several ASX companies that we believe are prime candidates for a future acquisition given their strategic assets and current valuation.

​With the exception of Lionstown Resources (ASX: LTR), which is currently the subject of interest from the likes of U.S.-listed Albemarle (NYSE: ALB) and Gina Rinehart’s Hancock Prospecting, there’s something each of these takeover targets has in common. They’re small. In the next part of our takeover series, let’s dig into why small companies are most often the target of acquisitions.

​As we highlighted in our recent article with the example of Alphabet (NASDAQ: GOOG) acquiring Fitbit, corporations often make acquisitions to enter or accelerate their growth in a new product category. This can be an offensive move like Alphabet, or a defensive move, such as when book store operator Barnes & Noble (NYSE: BNED) acquired Nook. Physical book sales had entered a phase of structural decline (that is, they were likely to keep on declining) and Barnes & Noble management believed that the most effective way to combat this trend was to acquire an existing eBook business (rather than developing its own).

Whether offensive or defensive, the acquirer almost always has a much bigger business than the company it is acquiring. This is because the existing business is more mature and looking for future growth. Over time, the business has expanded and become highly profitable. In a capitalist society, these profits attract competition–whether direct (such as online and then digital book sales replacing in-person purchases of physical books) or indirect (YouTube viewing replacing people watching TV). It is usually the large and profitable company that needs to defend its existing turf, or expand into new categories as it seeks to continue its growth momentum.

​We also discussed how public companies can take advantage of the so-called public-private arbitrage: the difference between the valuations of public and private companies. The reason that public companies can implement this strategy is based on the success of a large number of small entrepreneurs in an industry. After many years of running a business (whether in childcare, software or automotive smash repairs), these entrepreneurs might be looking to retire and not have a family member or business partner to take over the operations.

Business owners might also simply want some liquidity–that is, to reward their hard work and sell part of the business to raise some funds for a house, boat or holiday. This is easy for public managers to do (as we recently saw with Dicker Data [ASX: DDR] Chairman David Dicker’s share sales to fund his automotive enthusiasm), but it is quite challenging for a private business owner to find a buyer for part of their business. This is one of the reasons why Steadfast Group’s (ASX: SDF) business model has been so successful: it allows entrepreneurial insurance brokers to initially sell part of their business to the company (say 50%), with an agreement to sell the remainder over a period of years (or even a decade) as they transition to retirement.

​Another reason the “roll-up” strategy can be so successful is the economies of scale that come from a larger business. This relates to the fact that many businesses have large fixed costs, including physical footprint (e.g. warehousing), technology or purchasing of materials. As a business gains size, this fixed cost does not increase proportionally with the size of the business. The perfect example on a personal level would be the fixed costs associated with utilities (the daily charges of water, gas and electricity), internet and to a certain extent, rent or mortgage. If you choose to share your house with another person, you can save a material amount on these fixed charges.

There is probably no better example of the power of economies of scale than the performance of Tele-Communications, Inc. (TCI)–the U.S. cable television provider operated by Dr John Malone that was described in William Thorndike’s outstanding investment book, The Outsiders. Dr Malone conducted a decades-long acquisition spree across the country and was able to generate substantial growth in operating profit that far outpaced the increase in sales–because the company’s fixed costs did not increase proportionally as the company expanded.

Many industrial companies have a similar advantage, in that when they gain scale, they can achieve better terms when purchasing input materials (such as ingredients for paint or building materials). This is the same concept as buying “wholesale” rather than “retail”, and can be an added benefit in a roll-up strategy: the company can first take advantage of the public-private arbitrage and secondly reduce the (previously) private company’s costs using its buying power. This is a type of “synergy” as the investment bankers would refer to it.

​There are also the almost “physical” (metaphorically speaking) challenges of a small company buying a large company. The smaller entity must be financially capable of making the transaction. Smaller companies do not typically have great access to the debt markets, particularly in Australia and especially if they do not have much in the way of hard assets (that would be useful collateral for a bank). Shareholders may also be not particularly willing to front up for an equity raise that is substantially larger than the existing company, with the risk that the visionary CEO is wrong about the future.

Large companies on the other hand, often have access to more capital on better terms. For example, large publicly-listed companies are often able to raise substantial funds from the bond market, particularly in the U.S. Here, the debt can be fixed rate (it does not fluctuate with movements in interest rates) and the company is only required to make interest payments (and refinance the debt when it matures, often in 10 years or more). This was a clear advantage during the pandemic, when many large companies were able to issue substantial amounts of long-term, fixed rate bonds at highly favourable interest rates. Many of these were to keep business going during lockdowns, such as The Walt Disney Company (NYSE: DIS) during park and cinema closures.

Lastly, there are simply more buyers for small companies. In the same way that there are a greater number of buyers for a $1 million house than there are for a $100 million house, there are literally more companies (or individuals) with the financial capacity to take on the transaction. This creates more opportunities that one of these potential buyers is interested.

​The growth of leveraged buyouts (now known as private equity) has certainly expanded the size of acquisitions that have become possible by smaller companies. Yet most of the laws of physics continue to apply. Generally speaking, smaller companies grow faster, are more readily available in the private markets, and are in emerging industries or sectors that are in demand. Larger companies, on the other hand, are usually more profitable, have economies of scale that they can implement to acquired businesses, and have greater access to funding on more favourable terms. This combination inevitably leads to large companies acquiring their smaller peers. So when looking for possible takeover targets, it pays to start small.

Disclaimer: TAMIM Asset Management does not own any of these companies at the time of publishing.