The collection industry is always up for a deal, and in the merger and acquisition landscape, there is always a deal to be made. Whether it is a good or bad deal is something entirely different.
The attractiveness of a collection agency as an acquisition target has risen and fallen many times over the years. The 1990s were wrought with acquisition activity as larger market participants gobbled up small to midsize agencies and often paid exorbitant multipliers that led to the downfall of more than one organization.
The drivers of acquisition activity in collections are no different from other markets, and there are four essential questions that potential buyers must ask:
1. Are there synergies - whether geographical, between management and labor, involving technology, clients and markets?
2. What are the financial performance metrics? Buyers should look for certain financial metrics such as how leveraged the organization is, the stability of the balance sheet, the growth and profitability of the business and various trends therein.
3. What is the financial projection for the business? The company pro forma is more nebulous and taken into account far less than sellers would hope. Buyers like to see progressive growth slopes, rather than hockey stick growth projections.
4. What is the noise factor? Does the agency have a solid reputation, are there any legal or regulatory issues looming, how long has the leadership team been in place, etc.?
There are several areas within the industry where acquisition activity could have a net positive effect, but it's important to review what has transpired over the last several years - as well as the significant shifts occurring today. Many new drivers of the M&A market have emerged that are worth contemplating.
Market drivers that may affect future M&A deals:
1. Intellectual property: Simply put, organizations are more mindful to secure intellectual property, and even the collection industry is subject to organizations where the only business model is to secure patents and litigate those patents. This is a microcosm of a larger intellectual property challenge in the United States.
Still, patents and sound IP can make a so-so organization more attractive; or a really profitable and attractive organization less attractive - especially if a chief competitor owns IP and can devalue the opportunity by engaging the buyer in a protracted patent infringement suit or by reducing the bottom line with a royalty arrangement.
2. Fire sales: NCO Financial Systems is the master of buying companies at discounts as evidenced by their acquisitions of OSI Collections Services and TSYS Total Debt Management. What NCO has not done a particularly good job of is integrating these acquisitions to the point that they can materially impact the bottom line, as evidenced by their most recent filing.
However, post-integration valuation is a long cycle, and ultimately, NCO should be able to turn these highly discounted acquisitions into a significant contributor to the organization. It is certainly hard to argue with how NCO has built its organization through acquisitions over the years. There should be plenty of discount acquisitions available over the next few years, and it will be interesting to see how the industry values, integrates and profits from these discounted deals.
3. Regulatory-driven: The regulatory landscape under President Obama is rapidly shifting, so it is too early and difficult to see if these rapid transformations are good or bad for the industry. However, if they can slow the onslaught of court cases and clarify some of the muddy landscape, it's possible these changes might be beneficial.
The flip side of regulating the industry means that there are smaller or less profitable organizations that may not be able to comply, which will put them and/or their assets in a position to be acquired. In addition to the federal- and state-specific bodies of regulation, the courts have seemingly become the de facto regulators and rulemakers of the industry. With mountains of negatively impacting case law, a more educated and collection-savvy consumer and the cottage industry attorneys who make their living from litigating against collectors, the legal and compliance costs of agencies have gone up significantly.
This presents yet another logistical financial reason for some convergence in the industry as the costs and risks of participating become too much to bear.
4. Security and compliance: Similar to number three above, there are increasing requirements for security and other certifications that are extremely costly. The costs of not becoming certified, however, can be even more significant and can lead to loss of business opportunities. Simply put, with the other strains and constraints, there are many small to midsize collection agencies that cannot afford to take on these certifications and may ultimately exit the market and become an acquisition target.
5. Economy: If the economic outlook continues to be dark or gray with high unemployment, as is projected, it is likely that large and small agencies alike will continue to feel long-term financial pressures that will drive some companies out of the market and urge others to merge in order to offset operating costs.
The current market conditions favor those organizations that run a strong bottom-line-oriented organization that has significant economy of scale and the ability to leverage increased flow and opportunity while maintaining effective margins. Many organizations simply are not in a position to do this, and those will likely be distressed acquisition candidates over the next several years.
6. Offshore: The first surge of collections offshoring is well behind us and can only be viewed as having mixed success. However, the offshore market is much more established and mature today, and with the labor arbitrage still hovering between the 30% and 40% range, the value elements of offshore collections will ultimately be too strong to ignore.
If collections in general are significantly down due to consumer strains, the collection business will have to figure out how to drive operating costs lower without negatively affecting performance results. It is highly likely that companies with a strong offshore presence will begin to aggressively acquire more traditional U.S.-based collections operations. Further, it is likely that we will see more non-U.S. investment groups acquire U.S. collection organizations similarly to how ICICI purchased Buffalo, N.Y.-based Account Solutions Group.
7. The capital market: A good idea and a successful pro forma can still get financed, but getting financed is now more difficult than it used to be, and the terms are more onerous. Many organizations withheld M&A considerations because they wanted to continue to invest in themselves and grow to a certain threshold, but that option may no longer be plausible.
Therefore, a new spectrum of seller will open to the M&A market, the successful midlevel player who is growing and demonstrating strong results. In the early 2000s, this was the most sought-after contingency of the collection acquisition targets, and other than a few outliers like the Teleperformance/Alliance One deal a few years ago, this segment of the market has been fairly quiet - growing off of various credit lines or capital investments while waiting for the multipliers in the industry to come back. This phenomenon will actually be a good thing for the collection industry and should begin to drive legitimate interest in the space once again.
8. Debt buying: Debt buying is starting to edge back as a viable business model, but it’s been a rough couple of years, and the storm likely isn't over just yet. There was a time several years ago when being a debt buyer added a nice multiplier and level of attractiveness to a business. Unfortunately, those days will not be coming back very quickly, and, as a general rule, most businesses that have a debt-buying element attached to them will likely be less attractive in the short run.
What is the tale of the tape with M&A? It’s not entirely clear. What is clear, though, is that current market conditions likely will drive greater M&A activity, even if it is not the traditional type of activity that we are accustomed to seeing in the industry.
What about those acquisition scenarios, which could have a net positive effect on the industry if they occur?
Look at the fragmented technology provider space, where there could be significant benefit from consolidation. It is detrimental for early, innovative technology providers to have fragmented competition that cannibalizes price and value, because strong average unit price and value perception allow the businesses to invest in and improve their capabilities.
The alternatives are to operate for a long stretch in the red, or to manage from a shoestring budget and not grow your technology at the right pace. Some good examples in this space are virtual dialing organizations, such as Soundbite, Varolii, Adeptra, Livevox, etc.
Other examples where consolidation may benefit the industry are with software system providers and online payment or self-settlement portals.
Additionally, there are many collection agencies in the $8 million to $15 million revenue range that will be challenged to grow because of the infrastructural, security and other investments needed to expand in a tough capital market. These agencies are primary targets for larger, more scalable organizations, and the industry value is that these companies that maintain roughly 20% EBITDA will help drive up industry multipliers.
Lastly, the data and analytics market is less fragmented than it was when there were significant numbers of regional bureaus. However, this market also has an opportunity to add value to the industry with consolidation of data providers as well as fulfillment partners.
Look for increased M&A activity in the coming months, as the environment is ripe for a smart buyer to capitalize.
Dan Buell is a vice president at Experian.