Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Sourcing Agents Hide Bad Debt in Mergers
Transcript
- Lucas: We talk a lot about legal liability and tax exposure in M&A, but there is one area that consistently slips through the cracks of even the most rigorous due diligence process. It is not some complex derivative position or a buried pension obligation. It is the quiet, informal relationship between a company's sourcing team and its major suppliers. Luna: You mean like personal kickbacks? I thought those were pretty rare in modern corporate environments with all the compliance layers. Lucas: They are rare in the blatant sense, but what we see more often is something subtler. Contingent commission structures or off-book rebate agreements that effectively bypass the official procurement ledger. These arrangements can artificially inflate reported margins for years, creating a valuation bubble that pops the moment the new owner steps in. Luna: So the buyer sees great margins, pays a premium based on those numbers, and then suddenly the costs jump because the informal discount disappears? Lucas: Exactly. And it is not just about the price shock. It is about the trust deficit. When you find out that your chief procurement officer was getting a fifteen percent override on every order from a specific steel supplier, you do not just lose money. You lose your entire operations team. Luna: That sounds like a nightmare for integration. How do you even detect something that is designed to leave no paper trail? Lucas: You stop looking at the spreadsheets and start looking at the behavior. Most auditors check if the invoices match the contracts. They rarely check if the relationship between the buyer and seller feels unusually cozy. We found this pattern in a mid-market industrial distributor last year, and the clues were all behavioral. Luna: Behavioral clues? Like what specifically? Lucas: The purchasing manager refused to let anyone else attend the quarterly business reviews with their top three suppliers. He insisted on handling all negotiations alone. That is a classic red flag. If you have nothing to hide, why are you terrified of having a second pair of eyes in the room? Luna: Because he did not want anyone to notice the side deals. But wouldn't the finance team catch the margin discrepancies eventually? Lucas: Not if the rebates are structured as post-payment adjustments. The initial invoice looks normal. The payment goes out. Then six months later, a credit memo arrives from the supplier, credited back to the buyer's account, but routed through a third-party consulting firm that happens to be owned by the purchasing manager's brother-in-law. Luna: Okay, that is clever. And almost impossible to trace unless you are digging into the corporate structure of the consulting firm itself. Lucas: Precisely. Standard forensic accounting looks at the main entity. They see a legitimate service fee for 'strategic sourcing advice.' They do not see that the advice was simply ensuring the purchase orders kept flowing to that specific supplier. It is legal on the surface, but it distorts the economic reality of the business. Luna: So the valuation is based on inflated EBITDA, but the real cash flow is being siphoned off through these consulting fees. That changes the entire investment thesis. Lucas: It does. And the worst part is that when the acquisition closes, the new management usually tries to clean house. They fire the old sourcing team or bring in a new VP of Procurement. And suddenly, those consultants stop sending credit memos. The margin drops by ten percent overnight. The buyer thinks they bought a lemon. Luna: But they didn't buy a lemon. They bought a company that was running on a subsidy from the supplier. What should buyers be doing differently to catch this? Lucas: First, demand full transparency on all related-party transactions. Not just the obvious ones. Ask for the organizational charts of your top five vendors. Check who sits on their boards. Check who owns their minority stakes. Luna: That seems like a lot of work for a mid-market deal. Is it really worth that level of scrutiny? Lucas: If you are paying two times sales, yes. The cost of due diligence is a fraction of the potential loss. Second, run a sample test on the credit memos. Pick twenty random credit memos from the last three years. Trace the recipient of the funds. See if they match the strategic partners listed in the general ledger. Luna: And if you find a mismatch, you dig deeper into that specific vendor relationship? Lucas: You immediately suspend any further payments and freeze the related accounts. You also interview the purchasing staff. Not aggressively, but casually. Ask them how long they have worked with that supplier. Ask if they ever felt pressure to keep volumes high even when prices were rising. Luna: Pressure to keep volumes high... that would definitely happen if someone is getting a commission based on volume tiers. Lucas: Right. Volume-based contingent commissions are common in many industries. But they become problematic when they are undisclosed. If the buyer knows about the commission, they can negotiate a lower base price to offset it. If they don't know, they are paying double for the same goods. Luna: So it is less about fraud and more about information asymmetry. The seller knows the true cost structure, the buyer does not. Lucas: Exactly. And in M&A, information asymmetry is where value gets destroyed. The seller leverages that knowledge to extract a higher multiple. The buyer accepts it because they believe the margins are organic. When the truth comes out, the deal often breaks or the valuation takes a massive haircut. Luna: I wonder if this happens more in family-owned businesses where the founder has deep ties to the suppliers, or if it is more common in professionally managed companies. Lucas: It happens in both, but the mechanics differ. In family businesses, it is often personal loyalty. The founder trusts the supplier because they went to school together. In professional firms, it is usually career advancement. The procurement VP wants to look good by securing 'special terms' without revealing the complexity. Luna: Career advancement driving bad decisions. That sounds familiar. So, how do sellers protect themselves if they are innocent? Lucas: By documenting everything. If you have a legitimate contingent commission agreement, put it in writing. Disclose it to your board. Include it in the financial projections. Transparency kills suspicion. If you are hiding something, no amount of documentation will save you. Luna: Simple advice, but hard to follow when ego is involved. Do you think regulators are starting to pay more attention to these types of structural risks? Lucas: They are. The SEC has been cracking down on off-balance-sheet arrangements for years. But private equity deals are different. There is less regulatory oversight, which makes these hidden structures more attractive to opportunistic sellers. Luna: Which puts the burden squarely on the buyer's due diligence team. It is not enough to check the boxes anymore. You have to actually understand the business. Lucas: Absolutely. You need operators on your due diligence team, not just lawyers and accountants. An operator will ask why the purchasing manager won't let anyone else talk to the supplier. A lawyer will just check if the contract is signed. Luna: That is a crucial distinction. The human element reveals the financial reality in ways that spreadsheets never can. Lucas: Right. Because people lie. Spreadsheets do not. But spreadsheets only show what you put in them. If the input is biased by hidden incentives, the output is garbage. Luna: So the lesson is to verify the inputs by talking to the people who control them. Lucas: Yes. And if they resist, that resistance is your answer. You do not need a confession to know something is wrong. You just need to observe the fear. Luna: Fear is a very loud signal. I guess we should always listen for it. Lucas: Always. Especially when the numbers look too good to be true. Because in M&A, they usually are. Luna: Before we go further, if today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Lucas: Yeah, it helps us keep digging into these messy, unglamorous corners of business where the real lessons live. Thanks for keeping the lights on. Luna: Let's get back to the practical side of spotting these issues. What are the specific questions an operator should ask during site visits? Lucas: Start with the warehouse floor. Ask the floor managers about delivery frequency. If a supplier claims to deliver weekly, but the inventory levels suggest monthly deliveries, there is a disconnect. Luna: Or maybe they are holding phantom inventory to justify the purchase orders? Lucas: Exactly. Or maybe the purchases are being diverted to another entity. Physical verification is still the best audit tool. You cannot fake the weight of steel or the volume of chemicals. Luna: So you combine digital forensics with physical boots on the ground. Lucas: You must. One tells you what happened in the books. The other tells you what actually happened in the world. When they align, you have a clean deal. When they don't, you have a story to investigate. Luna: And that story is usually where the hidden value or the hidden danger lives. Lucas: Always. Next time you see a company with suspiciously stable margins in a volatile commodity market, ask yourself who is really paying for that stability. Luna: Probably someone who doesn't want you to know. Lucas: Likely. And that uncertainty is exactly why we do the work.