Weekly Thoughts: Lemons
Here is something that caught our eye this week:
The focal point of our diligence process is an evaluation of the enduring nature of a particular business. We analyze a wide range of financial, market, and operational data, and complete reviews of internal business processes and organizational chart depth. By creating a mosaic of information, we can then decide whether or not any given company will fit well into the Chenmark portfolio. However, in any M&A transaction, the deal-making process is more art than science, an observation even more true in the small business realm, where data is limited and what is available is often of questionable quality. As a result, a central tenant of our process requires going back to first principles, namely trying to gain an understanding of why, at this particular moment, the longstanding owner of a well-performing business has decided to exit. While there is, of course, the headline reason (retirement), we always wonder what the seller knows that we do not, and how that might impact our ability to replicate historical performance once we actually own the company.
Our reading this week about Akerlof’s Lemons reminded us that the problems presented by information asymmetry are not unique to Chenmark. As a brief refresher on Intro Economics, in 1970, economist George Akerlof published a paper titled “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” for which he was eventually awarded a Nobel prize. The paper, which was “at once simple and revolutionary,” pondered the question as to why cars that are just a few months old generally sell for well below their new-car price. The Economist explains in more detail:
“Suppose buyers in the used-car market value good cars—‘peaches‘—at $1,000, and sellers at slightly less. A malfunctioning used car—a ‘lemon’—is worth only $500 to buyers (and, again, slightly less to sellers). If buyers can tell lemons and peaches apart, trade in both will flourish. In reality, buyers might struggle to tell the difference: scratches can be touched up, engine problems left undisclosed, even odometers tampered with. To account for the risk that a car is a lemon, buyers cut their offers. They might be willing to pay, say, $750 for a car they perceive as having an even chance of being a lemon or a peach. But dealers who know for sure they have a peach will reject such an offer. As a result, the buyers face ‘adverse selection’: the only sellers who will be prepared to accept $750 will be those who know they are offloading a lemon.”
The problem here is that the savvy buyer, knowing nobody with a peach would accept $750, therefore, offers $500, since she knows she’ll only ever be sold a lemon. This asymmetry of information kills market efficiency between buyers and sellers since there are many people who, if they were confident of quality, would happily pay $1,000 for a peach. There is obviously still a market for used cars so clearly there are ways to address the information asymmetry. For instance, Akerlof himself noted that warranties can give buyers assurance as to the quality of the vehicle, which sellers of peaches are generally happy to provide since they know they are not selling a lemon. Independent data can also help solve this problem, which explains the popularity of entities like Carfax, which provide consumers with a repair history.
Of course, small business investing is another space wrought with potential information asymmetry since most companies at our target size lack the audited financials or the business analytics commonplace at larger enterprises. Often, decisions have been made based not on highly detailed data but on the intuition, developed in many cases over an entire lifetime, of the founder/owner. While this tendency virtually guarantees that we will know less than any seller about their business, mechanisms to bridge the gap have also evolved in the small business realm. Seller financing and/or earn-outs are fairly common and serve as a post-transaction trust bridge between the seller and the buyer, independent asset appraisals and third-party quality of earnings help provide an unbiased view of the state of the business, and lower valuations do suggest a “small business risk premium,” allowing any buyer a margin of safety. For Chenmark however, the best way to differentiate between a peach and a lemon is to spend time forming a relationship with the seller. Over time we can build our own intuition, not around any specific business or industry, but around the types of people who would sell businesses that we want to buy. We believe the combination of relationship building and rigorous analysis will help us identify the peaches of the small business market. However, if we do end up with a lemon, we aren’t afraid of making a little lemonade.
Have a great week,
Your Chenmark Capital Team