Buy or Build Considerations in M&A

Text Version of the Interview

Deal Origination

We think of origination as three pillars. 

There's a classic intermediary bucket. Most people think of that as investment bankers, depending on where you play in the market, buy-side brokers or sell-side brokers, which are little boutique banks that are less competitive. A lot of value in intermediaries developing those relationships.

The second is events—things like conferences that bring together founders and investors and, of course, direct outreach. 

And, of course, direct outreach. I've had a lot of success with a system called SourceScrub, which is an M&A origination tool. It's got great data. I've never been a big fan of just cold calling. I haven't done it at all in my career, but I think there's a lot of value to pounding the pavement. 

One thing that I've seen that had a lot of success is buy-side brokers where you sign a success fee agreement. If they bring you something and close a deal with them, you pay them some a fee percent.

And I think if you can find five or 10 of those guys or gals that you connect with and they do a great job, they can be your outsource origination team. And that's more scalable if you're trying to lead deals and lead diligence and execution. It's hard to do the development work upfront. 

I love getting on the phone or meeting with a founder and pitching them, but finding ones interested in selling is a lot of work, and it's great if you can outsource it one way or another. 

What's the Best Approach?

Volume-wise, I had the most success with buy-side brokers, and it's also where I play in the market. GE is probably going to use buy-side brokers less cause they're looking for massive deals. 

But your average PE firm doing a roll-up or the buy and builds in retail health and healthcare services, and then you're trying to do a lot of small deals, buy-side brokers are helpful. 

When you get into that meeting, the most important is how you connect with the owner, being incredibly respectful, congratulatory of what they've achieved, and most importantly, treating them as a friend. That yields positive results. 

How do you move forward?

I have a comprehensive M&A pipeline of active targets. I stack them up in columns by:

• Name  
• Geographical priority 
• Quality of real estate 
• Financial metrics 
• Name of owner 
• Is it a competitive process?
• Asking price 

Having around 15 columns where you're can look at them all side-by-side and start to prioritize. And you're looking at a lot of it simultaneously, so you got to stay organized, and you have to prioritize. 

And so having buckets to help you think about that, whether it's how important geography is to you or how difficult it is to recruit a doctor, or your ability to build a new clinic in that site based on real estate availability or demographic or geographic data. You have to have a way to rack and stack side-by-side.

Buy and Build Considerations

When you're building new clinics, you're looking at:

• Real Estate - You might need an analytic tool to help you analyze real estate locations and identify:

• Competitive Density - How far are you from the population, and divide it by the number of competitors in the market. 
• Demographics - Who are your potential customers
• Economic Data - Percentage of insured people, what's their median income, and poverty rates.
• Spend Indexes - How much does the population spend on your industry. 
• Trade Area - Where are your potential customers are going to come from
  

• Brand Awareness -  If you've got 20 locations in Wisconsin and you've got zero in Missouri, it will be a lot easier to do a De Novo the next town over in Wisconsin. You build that brand awareness, and it helps lower customer acquisition costs, and then it's a moat too. I think it's harder to come in, and you have density like that, of course. 
  

And then, on the acquisition side, you're looking at the cultural fit. You're looking at financials and the willingness of the owner to stay on for a transitionary period.

Doctors are hard to recruit. If you acquire someone and want to retire tomorrow, you have to find a way to fill that gap quickly. 

If it's an existing market where you've got a lot of locations, it's a lot easier to build a new, to build your own location. 

It takes a year or two years for a new location to ramp. But when you're entering a new market, you get to buy a base, almost like a platform in that region where you save sales ramp time. You get to eliminate a competitor. You can either start with something, and hopefully, you start with a couple of doctors as well.

Also, a huge component of real estate is anchoring yourself at a store nearby that provides daily needs. Many of the leading retail healthcare brands want to be on the out lot of Walmart. So every person that's driving to Walmart sees your location. 

You're getting free drive by, you're getting free marketing, or if it's not Walmart, it's the local grocer. And then, the quality of your co-tenants. You'd much rather be next to a Starbucks than a dying family video.

So How do You Decide Whether to Buy or Build?

If it's a new market, an acquisition is better, mainly if you can buy a few clinics. Because it's a pretty significant risk building your own location in a brand new market where you have no brand awareness, you don't really know the patients. There's just a risk that they may not come as much if you start with something. 

If you're in your hometown and you're at your strongest market, it makes more sense to build an adjacency the next town over because there are not many risks associated with that. You can share with providers; you can share staff; you already have the operational framework, regional managers. There's a lot of advantages to that. 

But it's not in either of those spectrums, and it's more into the gray; you have to look at both. You can always build, but you can't always acquire. There might be five owners in town, and all five of them have absolutely zero interest in selling. 

And sometimes, they're not mutually exclusive. Maybe you find a clinic where the doc wants to retire, or the quality of the real estate is relatively low, and you acquire it and then tuck it into a De Novo. 

So you're starting with that foundation of patient files with some of the supportive staff. And you build it very close to the old clinic, and you have the doctor reach out to those patients and have a continuity plan with marketing.

Engaging Targets

The initial lead comes through either an intermediary direct out in each or an event. Once you have a foot in the door, even if they're not interested, you're getting a chance to meet them; typically first meetings are on the phone.

My approach is I try a personal, humanistic approach. The average owner of a small business doesn't care about which PE firm you're backed by or how much capital you have, or what your business is. 

A lot of it is empathy. I try to put myself in their shoes constantly. If I was the owner and I started this business when I was 30 and today, I'm 65, this was my life's work. And this is my baby. I've been living and breathing it for 35 years. What do I care about? I'd care about really connecting and trusting someone.

And to me, establishing that is the most important thing. It's the connection and its culture. Is this someone who's going to take care of my staff and my patients? Is this someone who I can trust with a transition like this?

And so really trying to treat him like a friend, be funny, be personable, listen, it's the basics.

Real-Life Example

There's a couple of doctors that I'm working with now. Coincidentally, both have kids that are getting married in the same week or two. And during this courtship process, when I call them, I don't talk about the deal. I ask questions about the wedding. 

Genuinely be interested. Over the years, they have become a real friend of mine, and I'm really interested in their life. 

I also made sure not to send them any questions during that week because they've got a big personal thing going on. I wasn't going to hassle them. 

And when there's nothing left to talk about, I would ask if he has any questions about the next steps of the deal. 

M&A Process

I want to say that if I am paying a 2% or 3% fee for a broker that will help me get an asset that ends up being non-competitive, I'll do that all day long. I don't know that it's worth the time for me to be emailing all day, calling all day to try to find somebody interested.

But in terms of getting folks interested in moving them along in the diligence, it always happens on the first call, but it's at the very end. So if it's a 30 minute or an hour call, we're getting to know each other for 90% of that.  

And before the call ends, I would offer them what a partnership with us might look like. And if they're not interested, no harm, we can stay friends and stay in touch. But I will tell them that I will send them an NDA together with a list of three to five questions after the call. Things that you should all be on their shelf. 

And people almost always say yes if it's just three to five questions. Owners are usually worried that it can get taxing for their business, so if you can reduce the number of questions that you need to get to an LOI, that will allow you to get more deals. 

Since I'm in healthcare, there are always some nuances that come with it because these doctors are not businessmen. There's more handholding. You have to be a little more patient. I usually ask:

• Financials - understanding revenue mix. So in Optical, what percent of that revenue is coming from services and eye exams or lenses and frames and context. A little more revenue detail. 
• Are they willing to stay on and keep working for a little bit? At least for a transition to allow us to find a new doctor.
• Is there a location owned or leased? If it's a lease, can you send us the lease? 
• Owner's compensation.

Then I offer a target price over the phone but also send it via email. We'll walk them through it. And honestly, even if someone doesn't want to sell, they're very interested in seeing what the offer is if you get them past that point. It might be their first time getting an offer like this. They've had this business for 30 years. It's really exciting for them.

And from there, there is usually a lot of legal questions, like what's indemnification and what's escrow. So getting them comfortable with the legal jargon is important. And course, what they care most about is price. What percent is upfront? What percent is an earnout? Will they have to keep working?

Then after that, most of them go quiet and they talk to their families about the offer. The last thing I want to do is pester someone, and I don't want to be ever seen as aggressive or pushy, but if I haven't heard anything for a long time, I'll give him a ring and just check-in.

Alternatives to Acquisition

I think in some industries, it is joint ventures. You see a lot in urgent care, which is an interesting in-between strategy. In the more traditional partnering with a family practice, there's a legal structure called an MSO PC. 

It's prevalent in healthcare services where you sign a managed services agreement with a doctor, that doctor owns a hundred percent of the PC, but the PC rolls up to the corporate through this managed services agreement. 

They have a fee-sharing arrangement, but that doctor still has a lot of autonomy and ownership at the local legal entity level. It is different than just buying a hundred percent of their practice and employing them and they're just an employee doctor.

So this is you create another level in the legal structure, and that person becomes like a local regional owner. And you need the right candidate for it. You wouldn't just choose anyone for that. 

You need to choose someone who has financial savvy, a strong businessman who's also a leader, who you can trust, set that person to manage several other clinicians and clinics. 

When you're choosing someone who maybe already proven that they can be a successful entrepreneur or business owner, maybe they've scaled from one clinic to five clinics on their own with their capital.

And they've built a nice business, and they've proven maybe they've already stepped out into clinical role and already functioning as a business owner. Someone like that would be a terrific candidate.

Integration

We haven't closed any deals yet here at ShopKo, I've only been here for a hundred days, but we will do full integration. Integration planning needs to start really early. It needs to be in lockstep with diligence. 

You need a comprehensive integration plan. That's the document that needs to be completed a couple of weeks before the deal closes so everyone and their teams have signed off on it. Everyone's ready to hit the ground running a week or two weeks before the deal closes. 

Best Practices on Integration

You need to have a round table with all the leaders. Let's say you have a signed LOI and let's say the deal is going to close in two months, call a meeting, that's called integration planning, and it has the leader of every function, maybe the CEO of the business too.

This is a weekly meeting, and every function needs to add the items that they need to do, and everyone needs to see it. It can't be isolated and siloed. 

Hardest Part of Doing Deals

The hardest part is always the people. Whether it's rallying or coordinating with your people, or handling the seller. One way or the other, it's always personal. 

Selling the business can be emotional for people, and you also get incredibly overwhelmed folks by diligence. I've been on calls where people are getting choked up by diligence and they are getting overwhelmed. 

They're struggling to run their business, maybe their employee just quit, they're not very tech-savvy and they're having a lot of trouble getting everything on systems.

Surprises during Diligence

I've had two deals that fell apart at BelHealth. Billing and payers and reimbursement is obviously something that's unique to healthcare. You have to be aware of it. 

With one particular deal, we saw their reimbursement was very high. We thought there's maybe a risk of them upcoding or billing for a higher level of complexity. If it's a more complex visit, more dollars, less complex, fewer dollars. 

This person does seem to have above-average complexity consistently over the years. And they were in a state that had regulations that allow them to use lower-level providers. In most 48 states, you have to use nurses for this procedure, but you can use medical assistance in this one state. 

And what if the state regulation changes? What if they get dinged for upcoding? So the combination of those two things felt like too much risk. So we walked away. 

Another one was related to shared services, which is a pretty interesting one. This business, we thought, had 4 million of EBITDA. And this guy was an entrepreneur who owned a few different businesses. 

And essentially, when the quality of earnings came back, it was like they had 2 million of EBITDA because a lot of this corporate leadership team, and some of it is even mid to low level employees, was shared amongst the different businesses.

So it's like he was allocating their costs or their salary onto a different business or sharing their costs and he's dividing their salary and the four businesses he owned. 

And I don't think he was trying to do anything misleading per se, because the employees really do only spend 25% of their time in this business. But we can't really invest in a platform where half of the employees are part-time. 

Quality of Earnings

Yes, we do Quality of Earnings even on smaller deals. These small little mom-and-pop businesses risk that things are just not accounted for properly. It's almost like there's more risk in certain ways. When you buy some giant business, everything is going to be clean. 

They're going to be sophisticated enough to present an EBITDA that is probably not fully real in various ways, but they know what they're doing and you can have that back and forth.

But in a small deal, this person might just be off because their office manager, who's also their wife, is doing their books, so I think it's important.

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