Should You be Concentrating on Concentration risk?

Overview

For M&A transactions, customer and vendor concentration can be a challenging hurdle to overcome and may negatively impact valuation. If a meaningful portion (~20% or more) of a company’s revenue is dependent on a single customer, buyers might view an acquisition as riskier and apply a discount to the enterprise value (the purchase price of the business). The same is true when a company is over reliant on a single vendor.

In this article, we explore the nuances of customer and vendor concentration, highlighting how certain factors can lower the risk perceived by buyers to drive value for sellers in an M&A transaction. By using data to tell the story of your business and its relationships, valuation discounts can be mitigated.

Mitigation Factors

• Embeddedness / Tenure: The strength of a business’ top customer and vendor relationships significantly influences the perceived risk, particularly when concentration is a factor. From a buyer’s standpoint, companies that have tenured relationships (5+ years) with their key customers and vendors are deemed less risky compared to a company lacking tenured connections. Similarly, businesses that offer substantial value-add to their top customers and vendors, or are deeply integrated within multiple operational channels, further mitigates concentration risk. By educating buyers on the essential, interdependent nature of the seller’s customer and vendor relationships, discounts to enterprise value can be managed.
• Customer and Vendor Agreements: These documents are a key value driver in all M&A transactions. The strength and term of business agreements, such as a Master Service Agreement, take-or-pay, or supply agreement, is a critical consideration for potential acquirers as it establishes the sustainability of the target company’s revenue and earnings. When pursuing an M&A transaction, strong, long-term agreements will result in a higher enterprise value.
• Counterparty Profile: The counterparties that a business interacts with also impacts the perceived risk. Businesses with known, highly regarded market participants as their top customer and vendor are more attractive to buyers than targets that have concentration with customers and vendors that are less well known and financially stable. Buyers view companies with links to strong, well-known market participants as more stable, lowering the risk of those relationships, and increasing the value of the seller.

Sector Concentration

In addition to company specific factors, industry dynamics play an important role in how concentration is viewed. Certain sectors are more exposed to concentration due to the number of customers and vendors available in the space, as shown by the figure below.

For example, buyers in the communication services or energy sectors are less likely to apply valuation discounts if the concentration is with industry giants like AT&T and Verizon, or Exxon and Chevron, due to the market power of these companies in their industry. Discounts associated with concentration can also be mitigated when both the buyer and seller are concentrated with different market leaders. Acquirers can diversify their own concentration through acquisition, cutting their exposure to concentration risk by building new relationships with other, highly regarded companies within their sector. Additionally, if on a combined basis the seller’s concentration is immaterial, the buyer may apply less of a discount to the enterprise value.

Conclusion

Telling the unique story behind your company’s key customer or vendor relationship with data helps mitigate concentration risk during an M&A process. Industria Partners’ hands-on approach and experience managing concentration risk leads to strong valuations and successful transactions for our industrial, infrastructure, climate, and energy clients.