Ten Ways to Underwrite a Conservative and Realistic Base Case

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When building a model and underwriting an acquisition more broadly, many prospective acquirors understandably struggle with how to balance calculated optimism about the future on one hand, with a sense of what is realistically achievable on the other.

While investing is an inherently optimistic act (after all, you wouldn’t make the investment if you didn’t believe that the future was likely to be better than the present), acquirors must balance that optimism against the company’s historical performance, possible future headwinds outside of their control, and execution challenges common to first-time CEOs, among other considerations.

In the blog post that follows, I present prospective acquirors with ten different ideas on how to underwrite a conservative and realistic base case. Though all of them certainly don’t need to apply to your transaction, the more of them that do, the more likely it is that your base case reflects a grounded view of what’s actually achievable.

As always, note that this represents the opinion of just one person, and reasonable people may reasonably disagree with some or all of what follows:

(1) Don’t Automatically Underwrite to a 35% IRR

In my experience, searchers almost always seem to produce a base case IRR of approximately 35%. On the surface, this makes some degree of sense given that they are structurally incentivized to produce IRRs ranging from 20%–35%. Practically, however, if we agree that a “base case” represents the acquiror’s view of what is most likely to actually happen, it’s not obvious to me why every proposed investment should forecast such world-beating returns. Consider the following:

• Historical search fund data suggests that only a small minority of acquisitions actually achieve returns at or above that level. While the average IRR across the entire asset class is indeed in the thirties, that average is driven by a rather small number of “tail” outcomes (Yale’s A.J. Wasserstein recently published a paper supporting this idea, which you can access here). In other words, a 35% IRR outcome should not be considered a baseline—it is closer to a top-decile outcome

• Going outside of the Search Fund ecosystem and into the public equity ecosystem: Even in one of the greatest decades in modern U.S. equity history (between 2016–2026), less than 5% of current S&P 500 stocks appear to have delivered 35%+ annualized returns over 10 years

• Closer to home in the private equity ecosystem: 35% IRRs are well above even top-quartile fund performance. McKinsey reports that for 2011–2020 vintage private equity funds, the top quartile generated a ~24% net IRR (vs. a 16.4% median), implying that a 35% IRR is meaningfully above what even top-performing funds typically achieve

• Because we can make Excel say almost anything we want it to say, a 35% IRR is often less a reflection of what a searcher actually believes is most likely to happen, and more the result of fiddling with assumptions until that outcome is achieved

In presenting this argument to you, I run the risk of being overly focused on semantics, because I agree that it is indeed quite helpful to understand the set of assumptions that would be required to produce a 35% IRR. But, at the risk of being pedantic, in my opinion these scenarios are most appropriately treated as an upside case—not a baseline expectation.

(2) Base Case Projections are Actually Supported by Historical Performance

Stated plainly: It’s hard (or at least harder) to believe that you’re going to grow the company at 20% per year if historical growth has averaged only 5% per year. While this is possible, growth rates that are 2-3x higher than historical averages are difficult to underwrite as part of a base case, unless there is a lot of concrete evidence underlying that optimism.

More broadly: In my opinion, some prospective buyers spend far more time presenting projections than they do analyzing historical financials. I believe that this is precisely the inverse of how any buyer’s time should be spent. Though there are always going to be exceptions to this, I believe that, more often than not, historical performance is about as good of a predictor as we have of future performance.

As Warren Buffet has said: “In the business world, the rearview mirror is always clearer than the windshield“

(3) Every Metric Does Not Need to Improve Every Year

In my experience, most SMB buyers assume that margins will stay flat or increase in the first year after closing, yet my experience suggests that they very frequently go down due to required investments in people, software & other organizational infrastructure that the previous owners were unwilling to make, unable to make, or didn’t see a need to make. As a result, your 5X entry multiple on paper is often closer to 6X in reality.

This dynamic tends to be most pronounced when looking at particularly small companies (say, $3M or less in revenue) generating high percentage EBITDA margins (often 35% or more). In cases like these, I’m always sure to remind the buyer that the company’s margins under the previous ownership regime won’t necessarily be the same under the new ownership regime.

Sometimes this is because, in particularly small businesses, the founder/CEO gladly occupies several roles that would otherwise necessitate 1-4 incremental hires under a new owner. Founders are often able to simultaneously play these roles due to their decades of company and industry experience, but expecting a new owner (especially if that new owner is a single individual) to do something similar is often very unrealistic.

In other instances, additional operating expenses are necessary both to “catch up” to historical growth, and to position the company for several years of sustained growth still-to-come.

Regardless of the reason, I’d much rather see a base case that reflects this reality than one that assumes that everything needs to be upwards, green and to-the-right under all circumstances.

(4) Multiple Expansion at Exit: To Assume or Not to Assume? That is the Question

While multiple expansion has indeed proven to be a meaningful source of value creation for Search Funds historically, in many circumstances it can be a tricky thing to underwrite in a base case, mostly because it is a) outside of the buyer’s control; and b) largely unknowable.

In certain circumstances, however, assuming some modest amount of multiple expansion isn’t a completely unreasonable assumption. If you do chose to include multiple expansion as part of your base case, it’s worth explicitly showing how much of the transaction’s total IRR is being driven by that assumption (for example: “At a 5.0x exit multiple we’re modelling a 20% IRR, but at a 6.0x exit multiple, that rises to 25%”).

If nothing else, this will substantiate that a) upside to the base case is possible; but b) other assumptions (that are more within the buyer’s control) are driving the bulk of the forecasted returns.

(5) Be Clear on the Specific Investment Thesis

Not all investment returns are created equally, and the path to a given IRR can look incredibly different depending on the circumstances and investment thesis in question.

As an acquiror trying to maximize returns, it is often not enough to simply identify an otherwise attractive company and take comfort in the fact that there are dozens of potential value creation levers for you to pull: This “wide net” approach not only introduces the risk of over- or under-capitalization (discussed below), but can also be indicative of the acquiror not having a sufficiently nuanced understanding of what specific levers they should be pulling to create value within the acquired company.

This is exactly the trap that I fell into when I acquired my own business in 2014. In retrospect, I wasn’t sufficiently clear on my own investment thesis, and as a result, my value creation and capitalization strategy at the time could best be described as “fence-sitting”. Though the ultimate return to my investors was a decent one, I unquestionably lost out on providing them with a higher rate of return due to my lack of true upfront clarity.

To hit a given return threshold, investors might require target companies to rapidly grow revenue by opening new locations, acquiring new customers, entering new markets, or prioritizing inorganic growth (we’ll call these types of opportunities “Type A”). In other cases, to hit that same return threshold, investors might require different target companies to repay heavy debt loads, retain and upsell existing customers, raise prices, or exit unprofitable lines of business (we’ll call these types of opportunities “Type B”).

All else being equal, the investment thesis underlying Opportunity Type A is growth-oriented, with the required value creation initiatives being quite capital-intensive in nature. In contrast, the investment thesis underlying Opportunity Type B is more cash flow-oriented, and the required value creation initiatives will require much less capital.

The specific path towards a target return will impact everything from how you capitalize the acquisition, to how you allocate excess cash flow, to how you will get your investors their money back. If I could go back and do it all over again, I’d be much more explicit about how specifically I was planning to hit my target return, as opposed to listing 10 value creation ideas and hoping that 1-3 of them actually stuck.

Consider the (highly simplified) table below that illustrates some of the very tactical implications to a CEO under these two very different investment theses:

	Type A: The Grower	Type B: The Cash Flow-er
Capitalization	Probably more equity than debt	Probably more debt than equity
Primary value creation levers	Growth	Entry multiple + deleveraging + high free cash flow conversation
Risk/Return	Higher risk, higher return	Lower risk, lower return
What to do with excess operating cash flow	Reinvest in the business	Distribute to shareholders
How Investors get their money back	Likely at exit	Could distribute periodically throughout hold period via dividends, returns of capital, share buybacks, etc.

In 2022, I expanded on this idea (albeit in a software-specific context) in a blog post entitled “Evaluating 5 Very Different Approaches to Acquiring a Software Company”. In it, I profiled 5 investment theses that couldn’t be more different from each other, but all of which have been used to great effect by different acquirors pursuing very different investment theses.

(6) Leverage: Easy to Add, Hard to Take Away

Over the years, I’ve been presented with several investment opportunities with a pitch that sounded something like the following: “Even with modest growth assumptions, flat margins, and no multiple expansion at exit, our base case still produces a 30% IRR”.

Though the headlines were certainly enticing, a quick look under the hood usually revealed that these statements were only true because of how much leverage was being used to finance these acquisitions.

Though I support the use of leverage when it’s a thoughtful and prudent inclusion within a capital structure, if I had to make one of two mistakes as a rookie CEO, I’d much rather under-lever an acquisition at the outset than over-lever it, if for no other reason than adding too little debt is a very easy problem to fix 12 months hence, but adding too much debt at the outset is a much harder problem to fix. On top of this, 12 months’ worth of under-levering is unlikely to make a material difference in the deal’s ultimate IRR. As always, I appreciate when asymmetry works in my favor.

Some other scattered thoughts on the use of leverage include the following:

• If you’ve ever taken out a mortgage to buy a house, you’ve likely experienced a bank offering you a much larger mortgage that you had initially been contemplating. Hopefully you came to the conclusion that you shouldn’t necessarily take that higher quantum of debt just because it was being offered to you. I think financing an acquisition is no different: Be careful of asking your barber whether you need a haircut.

• As a rookie CEO, you’ll likely be surprised by the plethora of reasons to lose sleep at  night. Why add a possible covenant breach to that list, especially in the first 6-12 months when you will know as little about your company and industry as you ever will? A rule of thumb that I often advocate for: Even in a downside case, the company still remains onside with its covenants

• Don’t let investors with diversified portfolios encourage you to take on more leverage than you think is prudent. If the company runs into liquidity (or, heaven forbid, solvency) issues, nobody will have to live with that reality more than you, the holder of a “portfolio” comprised of a single asset.

A Few Thoughts Specific to Acquisitive Growth Strategies

Given that committed capital vehicles seem to be all the rage within the ETA ecosystem of late, I thought it might be worthwhile to also profile a few considerations specific to investment theses that explicitly prioritize inorganic growth:

(7) Be Careful Buying a Company Whose Attractiveness is Contingent Upon its Combination with Another Company

Too many SMB roll-up strategies seem to begin with the acquisition of a platform company whose attractiveness is largely contingent upon its combination with another asset (as my former Strategy professor used to say “two donkeys do not make a thoroughbred”).

Instead, the platform company being purchased ought to be large enough and attractive enough, on its own, to present a compelling investment thesis. Under such a structure, even if you’re completely wrong about the consolidation opportunity within the industry, you at least still have the potential to realize an attractive return on your investment with that single asset.

(8) Don’t Assume 3-5x Entry Multiples for Tuck-Ins If You’re Paying 7x for the Platform

Too often, I see base cases that assume tuck-in acquisitions being consummated at multiples that are half of what’s being paid for the platform asset, despite those tuck-in acquisitions being relatively close in size to the platform.

While multiple arbitrage can be a very real source of value creation in an inorganic growth thesis, and while it’s perfectly reasonable to assume that smaller companies are likely to trade for lower multiples than larger ones, this has always struck me as an awfully convenient assumption to make, especially when the acquisition of the platform asset is itself a market-setting comp.  

(9) Synergies are Great, but Don’t Over-Rely on Them

I appreciate a base case that is relatively clear-eyed about the impact and likelihood of achieving revenue and/or cost synergies. While either can be a perfectly reasonable addition to an upside case, I tend to be wary of base cases that either assume a large number of them, or assume that they will be very high impact.

While I’m perfectly happy to be surprised to the upside, unfortunately the data on synergies is rather bleak: In their book, Billion Dollar Lessons, co-authors Paul Carroll and Chunka Mui partnered with a team of twenty researchers and spent several years studying 2,500 business failures to tease out what was common among them. Unfortunately, one of the most common factors among these 2,500 failures was an over-reliance on synergies when underwriting acquisitions: Among their examples was a McKinsey study that found that only 30% of all acquisitions generated revenue synergies that were even close to initial expectations. While the data was slightly better on the cost side, they still noted that 40% of all acquisitions didn’t deliver on anything near the forecasted cost synergies.

Again this isn’t to say that synergies don’t happen – it’s just to say that, in my opinion at least, buyers should be careful of relying on them too much, especially in their attempts to underwrite a conservative and realistic base case.

(As an aside, entrepreneurs raising committed capital vehicles might want to avert their eyes from Chapter 3 of the book (“Deflated Rollups: Buying a String of Rockbands to Form an Orchestra”), as the historical data on roll-ups is even more bleak than the synergies forecasted in one-off acquisitions).

(10) Economies of Scale are Great, but Don’t Over-Rely on Them

Similar in spirit to the point above, I appreciate a base case that is also clear-eyed about the impact and likelihood of achieving economies of scale.

While scale economies can also be a perfectly reasonable addition to an upside case, I again am wary of base cases that assume that 10% bigger equals 50% better. This is particularly true when one small business buys another small business: 0.2% market share plus 0.1% market share still equals a rather small company, probably with no appreciable difference in purchasing power, bargaining leverage, or the like.

In Sum

If there’s a common thread running through all of the above, I hope it’s this: a conservative and realistic base case should not be mistaken for pessimism, nor does it imply the absence of meaningful upside. By grounding your assumptions in historical performance, being honest about what’s within your control, and resisting the temptation to let Excel do the thinking for you, you give yourself (and your investors) a much clearer view of what success actually looks like—and perhaps even a better chance of achieving it.

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