The formulas, tricks and trade secrets of Private Equity

Cyclical Businesses

Sample Chapter

We all know multiples have fallen, and, we know that for most businesses, earnings have fallen too (see correlation vs causation: industry analysis if you’re hearing otherwise). But, the problem is that vendors don’t always have to sell and so it isn’t so easy to make cheap investments in a downturn. Sure, distressed businesses may not have a choice, but solid quality businesses often do have a choice and they can wait and trade back to previous levels before selling.

For vendors still eager to sell now (for whatever personal reasons), they seem prepared to take a haircut, but not always in the order of the buyer’s expectations. This raises an issue with the typical private equiteer. Do I pay the higher price because the business has traded very well for the past 5 years, or do I pass on the deal since the performance hit could be indicative of other problems? Maybe earnings will be back to $50m next year, but just maybe they’ll drop further to $10m and stay down there.

I don’t have any hard and fast answers, but I will say that great businesses can experience arrhythmias too. If due diligence (DD) on the business is favourable, it’s a great opportunity to get in at an unprecedented price. I’m the first to acknowledge private equity is all about risk mitigation, but there’s something said for buying a great business at an average price compared to an average business at a great price, especially when the average price would represent a great price in normal economic conditions.

We’re looking at three separate deals like this now, two in the States and one in Europe, and we’re currently pondering this very issue. The vendors want more than we’d normally pay for the latest earnings (and sure there’s some room for negotiation), but conceivably the most recent earnings don’t represent maintainable earnings. There’s great potential here, enough to make a material difference to fund performance, but there’s also a lot of risk, which is hard to stomach for an ultra-risk-averse firm.

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