The capital stack on nearly every deal should lead one to conclude that private equity investing is a complete misnomer. Not unlike most business buyers, private equity groups will leverage their acquisitions to the uttermost. Consequently, the capital stack on most deals is comprised (at least at the outset) of more debt than equity. That blend will obviously diminish as complete loan amortization occurs over months and years of repayment, but initial investments are fueled mostly by OPM (other peoples’ money).
Understanding this fundamental principle is critical to fully comprehending the valuation gap between buyers and sellers AND issuers and investors in capital transactions. Fundamental deal structure, which typically includes debt, helps one gain a more holistic picture in gauging the true cost of capital–analyzing a given opportunity against the kaleidoscope of alternative investments available in today’s colored markets.
Two fundamental principles exist in capital transactions. First, leverage enhances investment returns. Thus, private equity investors will almost always seek to finance a deal to the maximum extent possible.
But leverage cuts like a double-edged sword. On the one hand it can enhance yield in a deal, but leverage also multiplies investment risk, particularly if there are personal guarantees attached, like in the case of SBA financing for an acquisition.
Second, there is an opportunity cost of capital. The question both the investor/buyer (i.e, from an introspective viewpoint) and the seller/issuer (i.e., from an extrospective viewpoint) should be asking is:
What does the return look like for my/their next best investment opportunity?
I have found that understanding the fundamentals contained in this basic question will do more to bridge the seemingly ever-present valuation chasm, regardless of the type of deal in which any of these parties may engage.
We will explore these fundamentals further by attempting to answer the following questions:
I have discussed the business valuation gap at length and will continue to do so. It remains one of the most difficult gulfs to bridge between various parties to a deal.
On the seller/issuer side, the valuation gap exists for at least one (usually more) of the following reasons:
On the buy-side, the following are a few reasons a value chasm continues to block deal closings:
Here are a couple very keen observations I have learned over the years that also impact value. First, smaller deals = less sophistication on fundamentals. That equates to more difficulties on bridging the gap between buyers and sellers. It’s one big reason why investment bankers typical have EBITDA, cash flow and enterprise value minimums when doing deals.
Second, and perhaps more importantly, value is not ethereal. That is, value is based off of sound financial fundamentals–at least in the case of the middle and lower middle market. Public company valuations need not apply as wild gains and P/E ratios continue to baffle even the most sound fundamental analyses.
One area investors and their lenders use to gauge the fundamental valuation analysis is using something called the Debt Service Coverage (DSC) ratio. This ratio is calculated similar to cap rate in real estate deals.
The Net Operating Income (NOI) is a simple calculation that is akin to EBITDA and cash flow (although all can be wildly different). NOI is Revenue less COGS (cost of goods sold), less operating expenses. Like EBITDA, NOI excludes taxes, interest, amortization and depreciation.
Annual Debt Obligation includes all debt servicing the company will be required to make, including those post-transaction with acquisition financing leverage attached. This number will include all current long term debt obligations, all up-coming obligations (including any new debt), loan fees, loan interest, loan principal and lease payments (if applicable).
A basic analysis of the DSC calculation would give you the following:
We have discussed this at greater length before, but most lenders, including both private and SBA will require a DSC of 1.5 to 1.7 before they will lend against a business in an acquisition financing scenario.
In making “next best” investment comparisons, it can be helpful to start from the riskless end of the spectrum and move outwardly.
Historically, there is ample suggestion that a bit more risk can bring on a higher yield:
However, as the expected returns morph, so too will incentive structures as the risk profile transforms (along with the weighting of portfolios, particularly among HNW and UHNW investors):
Image/Graph Source: KKR.
When I look at these graphs, the question that burns in my mind is:
What is the next best comparative (historically and in the future) with which to liken to one’s current deal?
The debt service coverage ratio is a great barometer for private equity deals that are similar in size, structure and industry. This gauge works whether the deal is smaller ($5M or less) and funded by an SBA loan or larger ($10M+) and funded by a good mix of financing.
However, it is also helpful to do comparable opportunity cost analysis with wholly non-related sectors, if only to provide a gut-check on value vs. expected return. Let’s take the easy route of using DSC-based ROI compared to real estate cap rates and the S&P 500 index.
The S&P 500 or any standard basket of public equities can provide an expected long-term return with a given amount of risk.
How does your expected return compare to the expected annualized return of the S&P 500?
Sadly, and even in today’s massively-inflated P/E ratio environment, many of the expected returns touted by private deal makers do not even compare to what is being had in the public sector. Thanks to the most recent long bull market, future returns in the mid-term are expected to be lower than in the past.
In real estate, the opportunity cost of capital can be measured by simply looking at the capitalization rate (most often referred to as “cap rate”):
Depending on the market, cap rates in today’s world range from 3% to 10% for both commercial and residential real estate investment opportunities.
How does your deal’s expected ROI, given your cash flow, stack up against a typical real estate cap rate? How does it compare with the risk profile?
Such comparisons are relatively easy. Use your current offered deal to provide a cash-on-cash return comparison between the following:
The saddest part about this type of a situation is that when an issuer is rejected by an investment banker in such scenarios, they can be offended and tell the banker they “just don’t see the value.”
Here are some examples of those who have not considered the opportunity cost principle as it relates to the other party in a transaction.
The Business Seller with Unrealistic Valuation Expectations
I could provide a half a dozen examples in the wild of the individual middle and lower middle market business owner who thinks his/her business is worth more than the market. We have discussed unrealistic valuation expectations previously here.
There is an impression with some business sellers that business buyers should be the one that pay for potential and that such risk should be shouldered entirely by the buyer.
Similarly, sellers often will demand buyers value a business above market and simply justify the premium by telling the buyer not to use leverage where they can, but to bring the rest in equity. As we have discussed previously, leverage cuts both directions. Increasing the equity in the capital stack, but not adjusting the valuation to market, certainly makes the business more affordable per the DSC calculation, but also greatly dips the expected return on the deal, usually well below comparable opportunity cost scenarios.
The Business Buyer with Excess Equity
We have worked with first-time business buyers in the past who have yet to perform an in-depth analysis on whether a business acquisition is a good deal or bad deal. They may have grown their own companies to $3M+ EBITDA, but in the case of one client, he had not yet had to value a business in the acquisition process. Our client said:
I know their valuation is a bit rich, but I am willing to put up to $3M equity into this deal.
My gut-check valuation was about $3M less than the asking price, even with his added equity, he did not get to a DSC that seemed reasonable. In such cases, after further review, we have found DSC ratios well below 1 and cap rates that look like over-inflated real estate markets like Seattle or San Francisco.
While there are conservative investors who like to lean on all-equity deals, using debt as the yard stick for value helps create discipline. More equity in a deal = less yield and a lower return on investment. In the case of this particular client, we went through the DSC valuation using several assumptions and discussed how his money would be better put to use in an indexed mutual fund rather than this deal and that in doing so, he would be taking on a significant reduction in his risk profile.
The Growth Capital Seeker with Skewed Pre-Money
Growth equity and startup situations are the most egregious. Without an understanding of pre and post-money valuation metrics, combined with their current revenue and profitability metrics, many founders are looking for equity capital at excessive valuations. Such valuations not only far exceed what an investor would value the business for now, but even expected returns often look lower than the simple comparison of a real estate deal.
One prospective deal in particular comes to mind. A company was seeking some $5M for 10% of the business. The anticipated annualized profit that was coming back to the business (i.e., not current profit, but the promised ROI in the future), made the business look less interesting than a single family investment property with a terrible cap rate in an over valued market. When we shared with the issuer the level of analysis we had conducted, which led to a natural conclusion of why we would not be pursuing the deal, they were initially offended. Not surprisingly, we heard back from these prospects eight months later: Their comments:
You were right. We massively over-valued our deal and priced ourselves out of the market when we went to both accredited investors and venture capitalists. We have adjusted our deal to meet what your analysis originally concluded to be more in-line with market expectations. Are you ready to be our investment bankers?
Prospective deals generally have only one shot at nailing proper market valuations. Going back to the market as an investment banker with the same stale deal at a massively adjusted valuation is embarrassing for both the issuer and investment banker. This prospective deal likely would have been a pass even if the issuer had adjusted the valuation at the outset. But going to the market with “sloppy seconds” was not a scenario we were willing to undertake.
Business buyers are typically not greenhorns to the capital process. They are long-time experienced business buyers, acquiring many companies over the lifetime of deal making. When you come to the other side of the table of a deal inadequately armed with effective data, relevant questions, thoughtful structured and experienced technique, one can lack the third party gauge as to whether or not the deal would value-enhancing for both parties. At that point, it can sometimes be difficult to choose the right private equity group as a partner.
In my experience, closed transactions usually include elements where both parties have felt like they’ve received a fair deal, or at most, both have felt stretched a bit in their valuation expectations. That is, the buyer wished the valuation had been a bit lower and the seller had wished the valuation had been a bit higher.
Going to market with an “ask” that is completely out-of-market does more than just embarrass the inexperienced. It burns the bridge for further discussions. Getting the attention of investors should be treated like a single pistol duel: you only have one shot—make it count. When it comes to figuring out the best “ask” for buyers and investors on your deal, do you self a favor, do a quick reality-based gut check to see if the next real estate or indexed mutual fund opportunity would beat your deal with less risk.