ACQUISITION MATHEMATICS

There are many drivers of acquisitions. For example, strategic buyers (companies in the same or related industries to the target company) can derive benefits from the target company that might include IP, technology, talent, access to new markets and others. Strategics also benefit from cost synergies and economies of scale.

But strategic buyers have one other important incentive for buying other companies which might not be immediately obvious: the valuation multiple. Because of the way valuation multiples work, growing via acquisition can be a powerful way to add value.

VALUATION MULTIPLE MATHEMATICS FOR STRATEGIC BUYERS

In business valuation the size of a company has the greatest impact on its valuation multiple. A publicly listed company may trade at 30x earnings, a smaller company in the same industry (with revenues of say £20m) might be valued at 7x earnings and a very small business in this industry might be valued at 2-4x earnings, depending on its exact size and the other factors that affect its valuation.

Let’s say the small business has revenues of £20m, EBITDA of £4m and is valued at a 7x multiple of EBITDA (£28m). The public company mentioned above has revenues of say £500m and pre-tax earnings of £50m. With a 30 x valuation multiple the company would be valued at £1.5Bn. Now if the public company acquired the small business, it would add £20m to its revenue and £4m to its earnings. Adding that £4m in EBITDA at a 30x multiple adds £120m to its valuation – in other words, it has added £120m in value through a £28m acquisition.

Remember that this is before any cost synergies are rinsed out, economies of scale are realised, or other strategic benefits achieved. Successful acquisitions will boost profits further through these means, and increase the acquirer’s value even more, via its favourable valuation multiple.

“Remember that this is before any cost synergies are rinsed out, economies of scale realised, or other strategic benefits achieved”

FINANCIAL BUYERS

Acquirers can also sometimes increase their own valuation multiple through acquisition. As companies grow in size their valuation multiple rises.

The owners of a £10m turnover company will be aware of the fact that growing revenues to above the £50m mark will typically result in an increased valuation multiple (eg: the multiple might currently be 5x, but companies in this industry with revenues over £50m become interesting to completely different buyers and trade at 10-12 x multiples). In order to get to the £50m turnover mark the company will have to grow to 5x its current size – a gargantuan task through organic growth alone. However, if the owners pursue a roll-up strategy, buying competitors in the same industry using a combination of external debt and equity capital, it is possible for the combined entity to get to this size relatively quickly. The acquisition of four businesses averaging £10m in sales, at above-market 7x valuations, would require £56m in capital (assuming 20% net margins) with a further £12m for transaction costs, integration expenses and other costs. Before rinsing out any synergies and with zero net profit growth, the combined entity would be generating profits of £10m per annum. Once the businesses are integrated, an exit at a 10x multiple would yield £100m assuming no profit growth or £120m assuming 20% growth in the bottom line. This provides an outstanding return on the £78m investment (the original business being valued at £10m plus the £68m invested).

 Consolidation plays like this are typically the realm of institutional capital (private equity). As with all acquisitions by “financial buyers” like these (who intend to sell the acquisitions again within a short time frame), timing the economic cycle is critical: valuation multiples are influenced by the whim of the business cycle so buying during a boom and selling the combined entity in a downturn will make things difficult. But PE multiple arbitrage provides a powerful incentive.

LEVERAGE

Since strategic buyers can typically derive more benefit from a given acquisition than financial buyers can, and can therefore afford to pay more, how do financial buyers compete? One way is to use leverage.

Let’s say a target company is turning over £40m with net earnings of £8m. The appropriate valuation multiple for this business will be dependent on its industry, the economic cycle and other factors, but let’s say it is a multiple of 8, giving a valuation of £64m. Assuming no growth, an acquisition at this price would give a return on equity of 12.5% to the private equity buyer. On the other hand, a strategic buyer, understanding the cost synergies, economies of scale and other benefits it can achieve through the acquisition, might be willing to pay £70m for the same company. How does the private equity firm compete? Leverage: it incorporates some debt into the capital structure for the acquisition, allowing it to generate the same return on equity while paying a higher price. Rough guideline figures might be as follows. The private equity fund could pay £72m for the acquisition, funded via £32m equity and £40m debt (a combination of debt structures with a combined interest rate of 10%). The earnings of the business would now be £4m after interest payments, giving a 12.5% return on the £32m equity. The buyer has met its required rate of return, despite the higher acquisition price, through the use of leverage. Strategic buyers can use debt in capital structures too of course, but this kind of acquisition is more typically associated with financial buyers.

SUMMARY

Strategic buyers can benefit in a multitude of ways from acquisitions and, all things being equal, can afford to pay more than other buyers as a result. However, financial buyers can compete for acquisitions by using leverage more aggressively in their capital structures. In a roll-up strategy the greatest driver of value is PE multiple arbitrage, and even for strategics, multiple arbitrage plays an important role in the value created by the acquisition.