Unlike most areas of finance, private equity goes some way to acknowledging a business has many different values. It has a range of values to different strategic buyers, a range of values to financial buyers, and a range of values to its owners. Transaction multiples or EBITDA multiples are simply a heuristic that encapsulates the various individual drivers of enterprise value.
So rather than getting caught up in complex valuation models, since few of them account for a business’s many values, private equity firms tend to ascribe a valuation range and spend more time focusing on the big potential risks to that range.
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), deeper bench depth (generally) and is more attractive to buyers. 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. The rationale for this is that the eventual buyer will also ascribe some value to it.
- 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 realize 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 private equity deal 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 especially when debt is as cheap as it is today.
- Deal terms: a private equity deal 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 cognizant 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 private equity deal multiples (most valuation analyses begin with average EBITDA multiples by industry), 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 on private equity deal multiples, please leave a comment.