In a previous post, I talked about vendor financing. In this post, I am going to give a numerical example of how it may work from the point of view from a private equity firm. Let’s start with a few assumptions.

• My private equity firm is interested in buying TPE Healthcare
• TPE Healthcare has FY09 EBIT of $10m
• Based on previous analysis, I decide that the highest multiple I will pay is 7x
• The owner of TPE Health care wants $85m for the business

So, the highest price I can pay (and justify to my investors) is 7x $10m, which is $70m. However, the owner (or vendor) wants $85m. In preliminary talks I explain the concept of vendor financing and that it may help to get the deal done. The vendor wants to retire and I think TPE Healthcare is a great business, so we really want to come to an agreement.

I start with the idea of paying $50m initially and $35m in three years. The total is $85m, which the vendor wants, but the deferred $35m is worth less when considering a dollar today is worth more than a dollar tomorrow (let’s assume we don’t have a deflating value through currency trading). Say I use a 20% discount rate as the opportunity cost of my funds. (So, I’m inferring that I think I can invest my money for 20% elsewhere if I had to.) Discounting the $35m back to today’s money results in a present value of 35/(1.2)^3 = $20.25m. So the real value of the proposed deal is $50m + $20.25m = $70.25m, which is close enough to the $70m limit that I hoped to pay.

If we agree on this structure, I’ll pay $50m upfront with a combination of equity and debt. Then in three years’ time, hopefully the business is performing much better, and I can decide to pay the $35m in either cash or completely with debt (since earnings should be much higher). The risk, of course, is that the business goes backward and I can’t afford the $35m. In this case, I’d have to call on equity from the fund, which would be a very bad outcome. So, there is certainly risk with vendor financing, but it’s important to remember that the present value of the deal is still $70m, which I was fine with paying (as long as I believe in my discount rate too).

In deals involving the complete sale of a business, the owner (or vendor) can agree to a partially deferred payment. For example, if you wanted to buy my business for $100m, we could come to an arrangement whereby you pay $60m now and another $40m next year. Depending on who’s pulling whose levers, interest may be charged on the deferred payment. Also, there’s no rule to say it has to be paid in one year; it could be paid in instalments over three years, it could be paid in a lump sum in five years, or it could be paid when the new owner exits. 

In private equity, vendor financing is another way to make a deal achieve the separate goals of the vendor and the investor. For example, if the vendor wants to sell for $100m, but the buyer thinks that is too much, he/she can suggest a deferred payment in the form of vendor financing. This isn’t because the buyer doesn’t have the pesos, it’s to reduce the real value of the deal. Remember time value of money? So, if the vendor finance amount is due in five years, it’s obviously not worth as much as what the same amount would be if paid today.

One other thing to remember is that vendor financing isn’t the same as an earn-out. If the payment is at all contingent on future future, it’s an earn-out, not vendor finance. In the other case where interest applies, the rate can be any amount that the parties agree. The private equity firm will usually insist on a rate that makes the deal right for them on an economic basis (remember, time value of money).

It’s not exactly news that multiples are heading south. Data from Preqin and many other sources showed 2007/2008 purchase multiples being north of 8x, often with debt representing 5x. Now however, purchase multiples are more likely to be around 5x, with debt representing about 3x (if you’re lucky). This is a major issue for funds that made purchases at 8x, because they need to use regular value creation tools (heaven forbid), such as sales growth and cost cutting, to keep value from plummeting.

But, that’s another story for another day; I would rather talk about what drives valuation multiples. This can refer to multiples used in fund valuations, deal negotiations, or for whatever purpose. So, the following list describes the individual drivers for proposed purchase multiples of businesses:

• Business size: a larger business has a larger market share (usually), more stability (mostly) and is more attractive to buyers (generally). Therefore, a larger business demands a premium.
• Stability: revenue and earnings stability drives confidence in forecasts and more bankable forecasts demand a premium. Unstable businesses are riskier and require a higher required return, hence a lower multiple.
• Diversification: a business with a diversified product range, customer base and supplier list is less risky. These all affect earnings stability (see above) and hence, influence the multiple.
• Capex: this is often forgotten when just looking at EBITDA, which is why some people use multiples of EBIT (using depreciation as a proxy for capex) or good ol’ FCF (free cash flow, which accounts directly for capex). Capex represents a large portion of costs that don’t hit the P&L (until depreciated), so it’s important to consider capex in your valuation. Reduce EBITDA multiples for high capex businesses.
• Intellectual property: in private equity, we tend not to pay extra for IP because it is often needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP represents greater differentiation, more stability, higher barriers to imitation and less risk.
• Growth: revenue growth is important to private equity because it’s one of the main tools to achieve value creation. So, a business with higher (and realistic) growth forecasts demands a higher multiple. However, it’s important to be pessimistic about management forecasts because 90% of the time they don’t eventuate.
• Synergies: a buyer that has the potential to realise synergistic benefits from an acquisition can generally pay a higher multiple because the acquisition represents a greater value to them. This is one of those drivers that mean the ideal multiple for me can be different to the one for you.
• Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also amplifies returns and reduces the overall cost of capital. The ability to add more debt commands a premium.
• Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is 100% cash up-front, the multiple will be lower than if some of the purchase price is contingent on future earnings. Be very cognisant of the time value of money and that contingent payments have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A much higher multiple can be shown on paper through deal manipulation.
• Comps: although comparable transactions are the most common drivers of multiples, they are often the least appropriate. Even if exactly the same business sold at exactly the same time, synergies and other buyer-related drivers (deal terms, debt capacity, etc.) can affect the real value of the business. But in saying that, you’ll almost never see the same business for sale at the same time, so many other variables are introduced. So, it’s best to be more objective and concentrate on the more fundamental drivers that I’ve listed above.

As always, if you have anything else to add or disagree with my points, please leave a comment.

See this chart of the LPX50 for the past 12 months… wow is all I can muster. The LPX50 is an index of the largest 50 liquid listed private equity funds. The LPX50 is obviously affected by market sentiment and market movements, so to be fair, it’s not the best representation of large unlisted funds. But to be fairer, we’ve seen endowment funds writing down their unlisted private equity investments by similar magnitudes.

The LPX50 has dropped some 60-70% in 12 months. That’s dystopia in anyone’s language. But, I find myself asking why values have dropped so much in such a short period if the world still has a relatively strong pulse. Here are the few off-the-cuff reasons why large funds are having a harder time:

1. High purchase multiples: by paying a high multiple, you’re assuming rapid value creation. When this doesn’t happen, there’s rapid value decimation. A high price also usually means a higher debt/EBITDA multiple.
2. Over-gearing: I’ve seen purchases with a debt/EBITDA multiple of 9x. This implies it would take nine years to pay the debt off… that is, if there were no interest charges. Any minor drop in sales can magnify the issues to the point of instant bankruptcy. This 9x business is now more like 15x as a result of falls in sales.
3. Media exposure: these funds are contemptuously scrutinised on a minute-by-minute basis by the media. Especially with listed funds, this creates negative sentiment and cliff-like price falls. One could argue that smaller funds would experience the same fate with the same level of media exposure.
4. Revenue falls: I explained in a previous post the amplifying effects of revenue falls. I’ve even referenced it in a range of other posts because while it’s so fundamental, it’s so easy to forget. Businesses are risky and sales can be volatile. This hasn’t changed, so there should be mitigation and contingency for these falls.

Mega-buyouts enjoyed a period of higher and higher multiples and easier and easier debt up to 2007. But, that’s finished. The fallout from being overly optimistic is much worse than most of us thought it would be (including me). If there’s anything to learn here, it’s that low purchase multiples and low gearing are key to sustainable private equity investing. Also, businesses are always going to be sensitive to falls in sales when they’re even only moderately geared.

I’m not talking about us, private equiteers (although that argument probably has merit too), I’m talking about our investees. We were gearing them to 2-4x EBITDA (in mid-market deals) but today’s EBITDA isn’t yesterday’s EBITDA and hence the multiple may not be 2-4x anymore. On top of that, we geared to the point where covenants were tight and now, well, let’s just say they’re not tight anymore because they’ve been smacked out of the park. Okay, maybe that’s an exaggeration, my firm’s covenants are borderline, as long as borderline means safely into breaching territory (see insert of orca breaching).

So going through a similar example from a previous post, consider a business that is doing sales of $100m, has a gross margin of 60%, EBITDA of $20m, debt of 4x EBITDA ($80m) and interest payments of 7% ($5.6m). Let’s say sales drop 20%, so there’s an instant loss of gross profit of $12m. So EBITDA is now $8m and you still have interest payments of $5.6m. On the positive side, you still have the paper earnings to potentially pay your interest. On the downside, your debt is now 10x EBITDA (Breach!), your EBITDA is less than 2x interest payments (Breach!), and you can almost be certain your FCF won’t cover principal and interest payments (Breach!). You know what they say about three strikes…?

I don’t mean to sound like a killjoy, but this is the landscape of private equity now. This even goes for the mid-market managers that have lamented high gearing ratios and are self-professed conservatives. A drop in sales from an economic downturn can have serious consequences and that’s before thinking about debt covenants. Throw a covenant or two into the mix and the result isn’t pretty. Here’s hoping for more sales and fewer whales (the breaching variety).

An investor in a private equity fund invests on the pretence of relatively high returns (usually 25%+ per annum). When a potential investee learns of this target, he/she often adopts a look of, “There is no way I’m guaranteeing that.” This is because when many fledgling entrepreneurs see these growth targets, they don’t fully understand the value creation themes that private equity firms have in mind.

The following three points discuss the major themes for value creation in private equity. I would like to think they’re exhaustive and all encompassing, but please let me know if you believe otherwise.

1. Earnings growth: this is achieved either through organic revenue growth, acquisitive revenue growth, cost cutting (thus, improved margins), reduced taxation, variablising the cost base, etc. Earnings growth links to value creation by creating a higher implied exit price and higher cash flow, which can lead to higher dividends and quicker debt repayment.
2. Increased gearing: this refers to an increase in interest-bearing debt, which can amplify the gains (and losses) to equity holders. A business with no debt can be conservatively geared and subsequently provide much higher returns to equity holders. Additionally, private equity firms pay down debt as quickly as possible with excess cash to decrease risk and increase proceeds to equity holders at exit.
3. Multiple uplift: this is a simple arbitrage between the purchase multiple and sale multiple. Even with the same earnings, if market conditions become favourable and/or risk decreases, a higher sale price results from a higher multiple. While it is difficult to control the market, decreased risk results from reaching a greater size, reducing debt, diversifying the offering, increasing customer/supplier fragmentation, implementing exclusive arrangements and contracts, and/or anything else that may lead to more stable earnings.

Although my analysis of value creation seems simplistic, I can’t think of any value creation initiative that doesn’t apply to these three themes. If there’s anything I’ve missed, please let me know through the comments section for this post.

A recapitalisation (recap) is one of many potential ways that a private equity firm can exit an investment (see this post for an overview of exit strategies). It involves a business borrowing money to fund a repurchase of equity from an investor that wants to exit. A recap is usually marketed as a way for an owner/manager to continue running the business if they do not want to sell when the private equity firm does.

There are a few points I’d like to make about recaps:

1. A recap is unlikely if the firm owns all/most of the business. If the investor owns most of the business, then it is unlikely the bank will lend enough to buy the entire equity stake. The only way this would work would be if the expected sale multiple was the same or lower than the lending multiple. That is, if the bank would lend 3x earnings and the investor only wanted 3x earnings for their stake. But, this would be highly unlikely.
2. A recap will rarely involve the natural buyer. The buyer in a recap is the business itself and one would imagine that the most natural buyer of a business wouldn’t be the business itself. The natural buyer is the buyer that can rationally pay the most for the business due to synergies, opportunities and other areas of value uplift. This is why sellers most commonly seek to sell to the most natural buyer, because in theory they can pay more.
3. A recap represents increased risks and costs. Even though we’ve learnt that capital structure shouldn’t influence our valuations, in reality, the remaining owners of a recapitalised business will incur increased risks and costs due to increased debt. This can only negatively affect the price a rational buyer is able to pay. The counter argument to this is that gearing also represents the potential for increased value creation, so in some ways it offsets risk, but in reality the risk is still there.

Overall, I’d say that a recap would represent a less than ideal outcome. It may be necessary when a private equity firm must exit, but it would rarely be the ideal plan prior to the initial investment. This is simply for the fact that a recap doesn’t represent the most natural buyer and hence it wouldn’t represent the highest possible price. For this reason, I would say that a recap isn’t a compelling exit strategy and is only a saving grace in unfavourable circumstances.

As we all know, senior debt is at the head of the line when we talk about subordination. That is, if a company is wound up, senior debt lenders receive their pesos before most other lenders, and certainly before equity holders. Inherent in this concept, is that providers of debt are mostly concerned with risk rather than growth prospects. You may read from this that debt providers are typically bitter, cynical and pessimistic, and you’d mostly be correct.

If I may talk out of turn, debt providers don’t like much in life (certainly not cute puppies, walks on the beach or the dulcet tones of jazz), but they absolutely love debt covenants. It gives them a chance to apply a tight grip to their customers’ proverbials. As disparaging as this may sound, debt providers are the source of much value for private equity firms. With that tight grip in mind (and of course the team’s carry), we need to do everything we can to maintain healthy reports and measures against these Machiavellian covenants. 

There are three typical covenants used:

1. Debt/Earnings: this provides a multiple or value that suggests how many years of earnings will pay back the debt principal (this measure is also called the gearing ratio). The earnings number may be EBIT or EBITDA, depending on the preferences of the provider. A typical multiple for this covenant is between 2-4x, although for larger deals a multiple of 5x isn’t unusual.
2. Earnings/Interest: this provides a multiple that suggests how many times the current earnings could pay back the interest on the debt (also called interest cover ratio). The idea being that earnings could fall X% before the business couldn’t pay the interest on its debt. A typical multiple for this covenant is at least 2x, the higher the better. 
3. Cashflow/Repayment: this is similar to the interest cover ratio, except it uses free cash flow (FCF) in the numerator to bypass the obvious downfalls of using an accounting earnings number. It also adds the compulsory principal repayments to the denominator (so the denominator = interest + principal repayments). The reason for this is that the expected repayment often contains a principal component.

There are many other debt covenants in use around the world, but these three are typical in the US, EU and in Asia. Private equity firms, amongst other consumers of debt, report on these covenants quarterly, with a more detailed report expected upon the receipt of audited accounts.

A private equity firm receives the lion’s share of its returns upon exit of an investment. (The remainder is realised along the way as dividends, distributions, management fees and capital returns.) The exit of an investment is typically in the form of one of the following:

1. Trade sale: this is the most common exit for private equity. The reason being that trade buyers in the same industry are often more likely to have synergies with the business. Therefore, they are the most natural buyers of the business and, ipso facto, trade buyers can pay the highest price.
2. Public listing: in the right market conditions, an IPO can lead to very fruitful outcomes for business owners. The major benefit of an IPO is that the business owners don’t need to subscribe to a raft of warranties and earn-out conditions, which are usually present in a trade sale. The downside is that the process is relatively costly and the results are acutely sensitive to market movements.
3. Recapitalisation: in some cases, the management team and other shareholders may decide they want to continue running the business after the private equity firm exits. Recapitalising the business (usually with debt) and using the new capital to buyout the private equity owner can achieve this.
4. Secondary sale: this involves selling the business to another financial investor (usually another private equity fund). Although this seems perverse, (you’d imagine if one private equity firm didn’t want the investment, others wouldn’t either), a deviation from a firm’s investment mandate can drive it (e.g. the business is getting too large for the fund to support).

Best regards,

the Private Equiteer