What is a J-Curve and How to Push Through It

A J Curve is an M&A Term used to describe an initial dip in profits post-acquisition, followed by a gradual re-gaining of profits, then a more accelerated profit gain. The curve resembles the letter J, hence the name. Time is on the “X” axis and Profits / Cash Flow is on the “Y” axis. Not all J curves have the same shape. Some acquisitions may have longer profit recovery periods and some acquisitions may have profit gains on day one.

A J Curve is caused by multiple reasons including the business’s absorption of integration costs, post-acquisition disruptions, and in the Private Equity space, capital calls.

We have a stance that J Curves can and should be managed rather than solely accepted.

How to manage J Curves

Buy Side Due Diligence & The 30-60-90 day plan

Not learning about the business being acquired during due diligence phase and its gaps is the number one reason for a J curve. Rightfully so, a significant portion of due diligence is spent on Legal, Quality of Earnings (QOE), and Lender Underwriting. Buyers are excited about the deal and a lot of their energy is spent to ensure it closes. This leaves Buyers to complete the Operational Due Diligence on their own while quarterbacking Legal, QOE, and Underwriting. Simultaneously the Buyer should not stop their acquisition sourcing processes because, as we all know, deals fail to close all the time. That is a huge lift for a Buyer when they want to complete the deal in 60 to 90 days.

Once the, the business is acquired, the learning and planning begins. From an ROI perspective, this is a disaster as recovery can take one to two years. Sometimes the situation is worse, and the business only recovers much deeper into the acquisition. The Operational Diligence is, in reality, pushed to post close.

A better way to approach the J curve is to properly conduct Buyside Operational Due Diligence during the actual DD phase. During the DD phase, the Buyer, or a trusted professional, must conduct a thorough review of the business to understand its strengths and weaknesses. As cash is king in all businesses, particular attention must be paid to Sales and Marketing to not lose momentum. Additionally, additional attention must be paid to risks around key man, concentration, and talent.

As part of the Operational Due Diligence, you should always have a 30-60-90 day plan with prioritization on measures to reduce the J curve as much as possible. For example, what are the critical positions where you cannot afford to have employee leave? You should have a back-up plan, if the employees do leave. How do you ensure critical clients remain with the business and how do you engage them? Has there been a scale back of lead generation to boost profitability? Have you allocated working capital to ensure the lead generation has been scaled up again? Even if the previous owner is retained during a transition period or there is an earn out, you are the new Owner and you must have a well formulated 30-60-90 plan.

Understanding Your P&L and Key Drivers

Not understanding the P&L of Your Acquired Business is one of the top reasons for the dip in the J curve. As an Operator, you must not only understand Your P&L, but you must also understand the key drivers. It’s likely that the P&L of the business you’ve acquired was reviewed during the Quality of Earnings review process. In these reviews, year over year trends are presented, revenue make up is shown, and expenses are categorized.

We promise you that simply knowing year over year percentages or revenue make-up is not knowing a P&L. During the Due Diligence phase, you must understand the whys? Why did expenses in each category increase year over year? Why was revenue in one product category flat while another product category’s revenue increased? Simply accepting the P&L “as is” is a trap that doesn’t allow you to manage through gaps and discover opportunities that can be leveraged.

As the new Owner you must be able to understand in the P&L the cash flow drivers that are most at risk during the acquisition and focus on ensuring the curve is flattened. It is much better to understand the drivers during the diligence phase and incorporating them into the 30-60-90 post-acquisition plan.

Post Close Resourcing

One of the biggest mistakes we see Buyers make in the lower middle-market is only resourcing their new acquisition with employees from the acquired organization. For professional investors in the Private Equity space, the Private Equity firms have teams of Operators and Advisors to guide the Acquisition, so time is not lost. Even in larger deals where there is a complete management team in place, Operators and Advisor are still utilized to ensure the correct culture is met.

The same should be true for acquisitions in the lower-middle market. During the acquisition phase, a lot of momentum is lost because the Buyer is learning the business, dealing with transitions, and navigating through the new team. In many cases, there may be talent gaps and the Buyer’s vision might be realized until much later. Fractional talent support should be relied upon as a bridge. Fractional talent can be used to set operating cadence, establish important KPI’s, begin operating meetings, work through the P&L, synergies, and establish the sales funnel.

We understand that cash might be tight at the start of an acquisition, but if you think your acquisition as an investment, the sooner you right the ship, the faster the ROI. It’s easy to get caught into a trap of dealing with a lot of back-off and learning. By spending on fractional support, like any consulting, it helps to catalyze change.

Conclusion

While a J curve cash flow dip in any acquisition is normal, it doesn’t have to be accepted. In fact, it should be challenged. There are many actions that can help flatten the curve and drive profitability. Buyer must Ensure correct Operational Due Diligence is completed, have a 30-60-90 day plan for the acquisition, understand key P&L drivers, and utilize fractional talent.