Buying a business in the Baltics: how to avoid a "pig in a poke"

  • 2005-09-21
  • By Martins Mellens and Kristine Kolosovska
The merger and acquisition market in Latvia is in a phase of rapid development. Major M&A transactions were completed in recent years, with notable deals in retail (Rimi & Kesko), textile (Lauma), financial services (RD), food production (Spilva). The potential in M&A is still present in such sectors as banking, food, transportation and logistics. If experience is any indication, the most lucrative targets in the Baltics are those companies with a sufficient market share and a solid brand name. About 50 percent of Latvia's top 100 companies already have a foreign strategic or financial investor.

The challenge for companies planning to attract a strategic or financial investor is to offer a business with significant value. On the other end, potential bidders face a challenge to understand what exactly they are acquiring.

Strategy. As a rule, financial investors who are more oriented to the stable profitability and efficient financial structure of the target company may face some difficulties in finding a company with satisfactory long-term contracts with key employees, suppliers, as well as with clients. The most sensitive issue is the future management of the company: often the outstanding performance of a company in Baltics is more dependent on the personalities of key managers and to a lesser extent the structured processes in a company.

Strategic investors who focus on the competitive advantages resulting from an acquisition may still benefit from location, operational synergies and tax considerations. The crucial aspect is to have a clear understanding of core competencies and an ensured sustainability of operations of the target company.

Valuation. During the valuation process the potential bidder should be aware of widespread malpractices typical of the locality. Not all companies in Latvia follow international accounting standards to the letter due to a lack of adequately trained staff. It is important to ensure that financial statements are properly audited and the peculiarities of local accounting standards are clear.

Local companies' balance sheets may be overfilled with assets that do not create any substantial value. The "problematic" liabilities are often a problem. It is important to make sure that the potential target company is not an "asset-heavy monster."

A company's reported profitability may also be quite misleading from the point of view of "real profitability." In order to reduce taxable income and, subsequently, decrease income tax, companies tend to load their profit and loss statements with non-existing "marketing strategy workouts," "presentation costs," etc. Moreover, suspicious employee remuneration schemes may still take place. Due diligence should identify these issues clearly in order to understand the target company's real cost structure.

The essential issue in evaluating a company is sustainability of future cash flows. However, there are cases when local companies fail to prove them with signed long-term contracts with all parties involved.

Price. Most business owners in the Baltics greatly overvalue their business, not so much because of greed but because of a lack of awareness as to what really makes a company valuable in the eyes of potential buyer. Owners also tend to boost their price on the overall wave of M&A transactions in the region. The "cleaning" of financial statements may help to bid a more adequate price.

Commonly, the price setting in an M&A transaction is based on multiples over EBITDA. The multiples are usually the industry average based on similar transactions in the past. The problem is that there have not been many such transactions in the Baltics, and there are too few "similar companies." In addition, the multiples might be somewhat lower for the Baltics, reflecting still higher country risk (despite being part of the EU).

Martins Mellens

and Kristine Kolosovska

are analysts at Bridge Capital