Multiple arbitrage is a fancy phrase for a simple idea: increasing the value of a company between buying and selling it absent any operational improvements. The textbook definition of arbitraging is buying gold on one exchange and selling it on another (without even polishing it), simultaneously and at a higher price, pocketing the spread called arbitrage. This supposes that the market for gold is imperfect, abounding with buyers and sellers of disparate capabilities and knowledge accounting for the price disparity. Such information asymmetries lead to inefficient markets in which the most astute participants stand to pull greater profits than in perfect, efficient markets. While there is no such thing as a truly perfect market, one in which all investors have equal capabilities and information, some are more imperfect than others.
Private markets, opaque and absent exchanges, are particularly imperfect and thus ripe for arbitrage opportunities, albeit ones less straight-forward and concrete than the gold example. Multiple arbitrage is a tool private equity firms and strategic buyers use to generate automatic positive returns before even realizing a single synergy or cost cut. Cognizance of the method can help both buy-side and sell-side advisors win fair prices for their clients.
Multiple arbitrage hinges on the fact that an asset will be sold at some point in the future, as opposed to its being held and made more operationally profitable to increase ROI, although the latter is also an aim. It is primarily a tool of private equity, but is also used by strategic buyers.
Below are 3 instances of a multiple arbitrage strategy:
As we discussed in the article “Size Matters”, the larger of two identical companies usually sells at a higher multiple just for the fact that it is larger. If companies with $25M in EBITDA sell at 5x earnings and companies with greater than $100M EBITDA sell at 7x earnings, a company with $100M in EBITDA can hypothetically acquire a $10M EBITDA company for $50M and automatically be able to sell that company, as part of its whole, for $70M. This is multiple arbitrage. Some strategic buyers and private equity portfolio companies build strategies around rolling up industries solely for the purpose of increasing aggregate EBITDA and then being able to sell the whole company for a greater value than the sum of its parts.
Assumed profitability growth is another driver of company and industry valuation multiples. If a consensus of buyers thinks the smart phone market will grow faster than the window pane market because of bullish views on the middle class and bearish views on construction, then they pay more per share of a smart phone manufacturer’s earnings than those of a window manufacturer’s, say 15x and 8x, respectively. A manufacturer of windows may also have the capabilities to turn glass into something useful for smart phones, say their screens. Thus, a financial buyer could purchase the window manufacturer at 8x EBITDA, tweak the strategy and business plan, and flip it back into the market as a smart phone play at 15x EBITDA. Likewise, a smart phone company could buy the window company at the 8x, fit it into the business model, and capture the spread when it sells itself at 15x.
If a public company trading at 20x earnings buys a small private company for 10x earnings, the earnings of the latter automatically trade at 20x as part of the whole entity, given that the transaction is small enough not to be scrutinized. When the public company reports earnings the first time after making the acquisition, the tranche of its earnings from the acquisition naturally trades at the same multiple as the whole entity, 20x instead of 10x, completing the arbitrage.
Being aware of multiple arbitrage and keeping it in mind when doing a deal can benefit your client, regardless if it is a buyer or a seller. As a buy-side adviser, you may be able to identify multiple arbitrage candidates to put in front of your client. As long as a buyer has confidence in the spread and thinks it is priced correctly, he will almost certainly pull the trigger on an arbitrage, as it is essentially free money. This means an arbitrage opportunity can warrant a higher buying price up to a certain point where the risk-reward profile of realizing the spread is still favorable, knowledge of which is beneficial to a sell-side adviser running a sale. Knowing that a potential buyer may be looking at your sale as an arbitrage opportunity allows you greater leverage when negotiating a selling price. No matter on which side of the table you sit, being familiar with multiple arbitrage makes you a more informed and valuable advisor.