This is a follow on from my post about the amplifying effects of diminishing sales, which was just a simple explanation about how a 20% earnings drop could lead to a 60% value drop. A likely consequence of this phenomenon is that a plethora of vendors under earn-out agreements will now be counting their chickens and discounting their eggs. Whereas not long ago they had visions of majestic chateaux on la Côte d’Azur, they now mostly have visions of decimated pension funds and impossible earn-out targets. 

There are a number of ways to look at unpaid earn-out targets, some optimistic and some pessimistic. Firstly, unpaid earn-outs can still be a boon for private equity firms because, in an absolute sense, they’re paying less for the business than otherwise (although, in a relative sense they could be paying a higher multiple if earnings fall enough). However, this is only beneficial if sales return to budgeted levels and a track record of maintainable earnings is restored. 

Unfortunately, the probable reality is that maintainable earnings have dropped and earn-outs may not have been large enough to protect private equity firms. The saving grace is that this should be a short-term issue for great businesses and they should be able to pick up market share and return to status quo. But, this is reserved only for great businesses; it’s all about product/service differentiation, financial discipline, low-moderate gearing, a dynamic management team and a proactive private equity partner. Without all of these qualities, investees may find these are tougher times than expected.

With all of that said, this is business and business is cyclical. I could insert many clichés here about wheat and chaff, men and buys, good and bad apples, etc., but there’s not much point dwelling. The most beneficial take away is that private equity firms must always invest in the best businesses if they want to maintain reputation and edge.