Negative Equity, Positive EBITDA in Private Equity

In a previous post, I talked about the amplifying effect of diminishing sales. I gave a short example in which a company had sales of $100m. This company had variable costs of $40m and fixed costs of $40m; hence, EBITDA of $20m. A 20% loss equals sales now of $80m, variable costs of $32m (using the same gross margin), fixed costs of $40m (because they’re fixed), and EBITDA of $8m. In short, a 20% drop in sales led to a 60% drop in EBITDA.

I want to take this example a little further to show the amplifying effects of debt. So let’s use our two scenarios from above; Scenario 1 is the business with $100m sales and $20m EBITDA, while Scenario 2 represents some period later when sales drop to $80m and EBITDA is $8m. (Quick note: see how EBITDA margin dropped from 20% to 10%? That’s due to the fixed costs staying… fixed. And this isn’t an extreme case; it’s actually based on conservative numbers.)

Let’s assume the market is paying 5x EBITDA for this type of business. In Scenario 1, that means enterprise value (EV) is $100m, while in Scenario 2, enterprise value has fallen to $40m. When we made our investment into this business, we were quite conservative by employing debt of 3x EBITDA; so let’s assume net debt for the business is $60m. In Scenario 1, we invested $40m of equity with the $60m of debt to buy the business. But, now that sales have dropped, we’re worried about the value of our equity investment.

Well, you can probably see where this is going. With a drop in sales of 20%, which hypothetically led to a drop in EBITDA of 60%, we now have a business with an EV of $40m, with net debt of $60m, and hence, a negative equity value of $20m. That’s right, our investment is worth less than zero; it’s worth negative $20m. All of this, just from a 20% drop in sales. Quite a sobering thought.

Negative Equity, Positive EBITDA in Private Equity