Category: Value Building
Multiple Arbitrage: A Primer
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:
1. Stringing together bolt-ons to grow size
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.
2. Repositioning the target in a more buoyant industry
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.
3. Rolling a private company into a public one
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.
Should You Buy Your Biggest Competitor?
Organic Business Growth vs. Growth Through Acquisitions
Growth through acquisition is a very viable option for small and medium-size businesses. Should you buy a business?
The question is, is it the right growth strategy for your company? Or are you better off expanding in more organic ways – by opening up satellite locations, franchising, or focusing exclusively on aggressive sales and marketing tactics?
There’s an interesting conversation to be had around this topic for every unique business situation, and there’s truly no “right” answer that fits every circumstance. Let’s look into some of the pros and cons of growth through acquisition versus more organic business growth so you’re in a better position to make that decision yourself.
The pros of organic business growth
Growing your business organically – in the most natural, progressive way possible – offers the most control over how that growth occurs. That doesn’t mean you’re going to completely avoid unexpected setbacks or even the stress of “too much success” at times. But, generally speaking, if you’re focused on continually improving your marketing efforts, improving your product or service, and identifying new or more profitable markets you can successfully enter, you’re going to find that growth is more predictable and controllable over the long term.
There’s also a real sense of pride and accomplishment that comes with growing a business from the ground up with your own (and your team’s) efforts to account for its success. Many entrepreneurs couldn’t imagine doing it any other way.
The cons of organic business growth
The biggest potential negative aspect of relying on strictly organic growth is that it’s usually very slow. It may take years for the market to evolve enough – and for your business to be able to afford – to justify a second location or expansion into a new geographic area. Getting to the point of opening a third location will probably take less time than the second one did, but it could still require years of planning and effort to get there.
This isn’t a hard-and-fast rule, of course. There are plenty of examples out there of restaurants, clothing stores, and specialty service businesses that seemed to appear out of the blue and suddenly explode across the map as they took over the market. But oftentimes, apparently explosive expansion – when it’s sustainable – is actually far more controlled and organic than it appears from the outside. And there are plenty of other stories of companies that went after aggressive organic growth and ended up biting off more than they could chew, collapsing before they could realize the rewards of the strategy.
The pros of growth through strategic acquisition
Unlike slow and steady organic growth, growth through acquisition or merger is generally much faster and – if done right – can yield a number of other almost instant benefits that can help make that rapid growth sustainable.
David Annis and Gary Schine, authors of the book, “Strategic Acquisition: A Smarter Way to Grow a Company,” explain the benefits of acquisition this way:
“Growth through acquisition is a quicker, cheaper, and far less risky proposition than the tried and true methods of expanded marketing and sales efforts. Further, acquisition offers a myriad of other advantages such as easier financing and instant economies of scale. The competitive advantages are also formidable, ranging from catching one’s competition off guard, to instant market penetration even in areas where you may currently be weak, to the elimination of a competitor(s) through its acquisition.”
So this method of growth offers a two-fold growth process:
Grow your company’s market, brand reach, audience, sphere of influence, and supply chain while also eliminating or overtaking your biggest competitor, either by acquiring them directly or by acquiring one or more smaller competitors until your company is the largest in your competitive market.
The cons of growth through acquisition
Growth through acquisition is rapid and can yield quick results. But the internal atmosphere that develops in the time immediately preceding and following an acquisition or merger can present a number of management challenges that could hinder that rapid growth or plant the seeds of future failure.
If the merger or acquisition requires reorganizing of the workforce and/or management team in one or both companies, you may have a significant amount of stress and hard feelings to work through in the minds of those who stay. There can also be a latent sense of betrayal or disappointment on the part of employees, partners or owners of a company that has been acquired, especially if they agree to the arrangement because they’re facing a do-or-die situation.
Merging two distinct company cultures and methods will always present challenges, but a successful acquisition needs to get through these and other potential problems quickly and effectively if it’s going to successfully grow and evolve from the process.
How to choose what’s right for your business
The question of whether to buy your competitor or open up a satellite location – to grow organically or inorganically – must be answered individually by each business owner based on their own unique circumstances.
In both cases, thorough, strategic planning is required to ensure growth is both attainable and sustainable over a long enough period to achieve the company’s goals and justify the expense and effort required.
It’s usually best to explore both options thoroughly before heading too far down either path. Discuss your options with your lawyer, business broker and other trusted advisors to make sure you’re considering all the pertinent details.
Then research businesses for sale in and around the areas you’re considering for expansion and determine whether buying one or more of these businesses will help or hinder progress toward your growth goals. Keep a sharp eye on your competition – both large and small – and look for where synergies can be identified or created so that a merger or acquisition creates added value for everyone involved.
Once you’ve done your due diligence and you’ve settled on the best path, move ahead decisively. “Luck favors the bold,” as they say, and business growth certainly follows that axiom.
Working Capital: Why Does it Matter
You are selling your business, and all of your ducks are in a row. You hired an investment bank, they wrote an investment memorandum, solicited bids, and found a buyer willing to pay you a hefty sum for all of the blood, sweat and tears you invested in the business over the last umpteen years. You passed all of the tests during due diligence, and are negotiating the finer points of the purchase agreement. The finish line is in sight. And now you learn about the working capital peg.
The working capital target (also known as a “peg” or “true-up”) is an important part of an acquisition where millions of dollars are at stake, is poorly understand by many, and is typically left until later stages of the deal. Very often, sellers leave significant amounts of money on the table (to the benefit of the buyer) as a result of not understanding and addressing the working capital issue earlier in the acquisition process. In fact, sellers would be best suited to understand the impact of working capital well before they begin the process of selling their company. Below I explain the ins and outs of how working capital can have a big impact on how much cash you take home after you sell your business.
WHAT IS WORKING CAPITAL?
This is not a trick question. We all generally know what working capital is. In general, it is a measure of operating liquidity available to a business at a given point in time, and is calculated as current assets less current liabilities. For practical purposes, there are typically four balance sheet accounts that represent the largest entries: cash, accounts receivable (“A/R”), inventory (“INV”) and accounts payable (“A/P”). I will dive into further detail on these four accounts, but will touch on other potential areas as well.
Working capital is required to run the day to day operations of a business. It is as essential to running a business as the employees and physical assets. While some businesses can operate on negative working capital (current liabilities greater than current assets), such as subscription-based media companies or other firms that require large up-front payments from their customers, most firms have positive working capital requirements that grow along with the business.
Most acquisitions are structured as acquisitions of stock or assets on a cash-free, debt free basis. In other words, the buyer acquires a business that typically has no financial debt and limited or no cash in the operating account. Buyers often require that a minimal amount of cash be left in the business so that short term needs can be met without drawing on an interest-bearing revolving facility or potentially delaying vendor payments or payroll. Net working capital (“NWC”) is working capital less excess cash.
Why does working capital matter?
From the buyer perspective, working capital has two important implications, one relating to the acquisition purchase price and the other relating to the ongoing cash flows of the business. I’ll handle the second issue first.
CASH FLOW IMPLICATIONS
Working capital is a real investment in the business and, like the important machinery or computer hardware, cannot be fully liquidated without a serious negative impact on the business. Also, working capital accounts tend to grow as the company’s revenues increase.
For example, let’s assume that in year 1, I generated $100 of revenue and $20 of EBITDA, and I had $30 of AR, $30 of INV and $20 of A/P, for NWC of $40. That’s $40 of value locked in NWC that I need for my business to run properly. Now let’s assume that in year 2, my revenues and EBITDA double to $200 and $40, respectively. What should I expect to happen to the NWC? All else equal, NWC should increase at a similar rate as revenues, so NWC should double to $80. That’s an additional $40 investment in the business. A/R and A/P should increase assuming that payment terms from customers and vendors have not changed. Inventory levels typically increase in line with revenues as businesses require more stock to service their customers without risking stockouts. As a result, while revenues and profits have increased materially over the course of the year, one has to consider the impact of NWC to understand the cash flow result. So while I am now making $40 in annual EBITDA, I had to invest an additional $40 in NWC to get to that level. Staying at the same level in year 3 will not require additional investment, but it did cost me an investment in NWC to obtain the growth.
In light of the above, it is critical for business owners to understand the impact of working capital on their cash flows. Through monthly tracking of collections, payments, and inventory levels, business owners can minimize the amount of money locked up in working capital and obtain higher prices for their businesses. Sophisticated buyers will factor NWC needs into their models and, all else equal, will pay more for businesses that require less NWC.
PURCHASE PRICE IMPLICATIONS
In most all cases, net working capital stays with the business in an acquisition and is acquired by the buyer. A purchase price is determined at a certain point early in the negotiation, yet closing typically takes many months after that agreement on price. Working capital levels fluctuate over time for a variety of business reasons, such as seasonality, changes in customer demand, changes in payment terms, addition of new product lines, and geographic expansion, to name a few. The buyer wants to ensure that on the day of closing, there is sufficient working capital to run the business, and that there will not be a need to invest additional money into the business soon after closing as a result of irregular activity by the seller in the months leading up to closing.
The level of working capital in a business can change for legitimate business reasons as well as artificial manipulation by the seller. The goal of the working capital mechanism is twofold: (a) to ensure that the business had the appropriate level of working capital based on the average working capital needs of the business throughout course of a year, and (b) to prevent the seller from manipulating working capital accounts to drain the business of its critical NWC assets.
Below, I walk through the major working capital accounts and what could cause a buyer to become concerned.
CASH
Cash is typically excluded from the sale of the business, and the seller is permitted to take all cash out of the bank account some point prior to or at closing. Sometimes, the buyer may request that some amount of operating cash be left in the business for day-to-day needs. Cash is controlled completely by the seller until the day of closing, and relates to activities prior to closing, so is typically excluded from the purchase as well as from the working capital mechanism altogether.
ACCOUNTS RECEIVABLE
A/R represents outstanding customer invoices. A/R typically rises and falls simultaneously with revenues, assuming static average payment terms from customers. If the business is sold in a particularly busy time of year, one would expect a higher level of A/R in the business; the converse is true for slow periods of the year. Sellers have the ability to pursue outstanding A/R more aggressively or offer discounts for quick payment in the interest of collecting more cash prior to closing, which would increase cash proceeds.
INVENTORY
A business typically has an equilibrium level of inventory required to provide a satisfactory level of service to its clients. Businesses typically increase inventory levels in advance of increases in revenue. A seller wishing to maximize cash proceeds would stop replenishing inventory stock in the weeks leading up to a closing so as to minimize the cash investment and maximize cash proceeds at closing.
ACCOUNTS PAYABLE
Accounts payable rise with overall business activity. A seller seeking to maximize cash could simply stop paying creditors, or pay more slowly than they would like, running the risk of damaging supplier relationships and being cut off from key suppliers.
OTHER ACCOUNTS
There are also other accounts that are included in a working capital calculation, such as prepaid expenses, deposits, accrued expenses and accrued taxes, but they are typically smaller accounts and less likely to be manipulated. Depending on the type of business, they may be included or excluded, but often have a lesser impact on the negotiation.
THE WORKING CAPITAL PEG
In light of the ability of a seller to manipulate the various working capital accounts in the months leading up to a transaction closing, buyers insist on setting up a working capital target, or peg. A peg is typically a fixed dollar amount that is determined based on historical levels of working capital in the business. Shortly after closing, a third party is hired to assemble a closing balance sheet, and then the actual net working capital delivered at closing can be calculated. To the extent that the actual net working capital exceeds the target, then the seller is owed the difference in a cash payment. If the business shows a deficit relative to the target, then the seller owes the buyer the difference. Due to unpredictable nature of sales, billing, and collections, there is always a payment one way or another, also known as the post-closing “true-up”.
The goal with a working capital peg is to determine the appropriate level of working capital that the business needs – no more, no less. Reasonable people can disagree about what is fair, but as a business owner, you know better than anyone what the business requires. The buyer, however, only has one source of reliable information – the monthly historical balance sheets that show what you actually booked over time. Therefore, the historical monthly accounts are used to set the peg.
However, there is still a lot of room for negotiation in two areas: how to define NWC, and how to calculate the peg. There is seldom controversy around the definition of NWC, but it should be carefully defined to exclude any accounts that are not current accounts or are not related to the ongoing business. It should also exclude interest-bearing liabilities, even if short term. Sometimes, buyers wish to exclude A/R over a certain age or old inventory that is no longer useful to the business to focus on what is most valuable to the buyer.
HOW TO SET THE PEG
There are a number of methods that can be used to set the peg, and, in general, the more detailed information you have, the better prepared you can be to agree on a fair peg. The most common method for determining a peg is a 12-month historical average. Looking at an average of the monthly NWC over the past year should give a fair view of the NWC required to run the business since this timeframe takes into account any seasonality and abnormally high or low individual months.
There are a few special cases where an annual average may not be appropriate:
HIGH GROWTH BUSINESSES
If a business has been growing very rapidly, then taking a simple average of the latest twelve months may understate the amount of working capital needed to run the business. In that case, it may make sense to use a 12-month weighted average, or an average based on the latest 6 month period, or even latest 3 month period.
NEGATIVE WORKING CAPITAL BUSINESSES
In many publishing or media businesses, there is negative NWC, which grows more negative over time. In this case, the parties can agree to set the target at zero, with a true-up payment from the buyer to the seller post-closing to make up the difference.
GETTING TO A FAIR SOLUTION
As is the case with most deal points, the seller has the most leverage prior to LOI stage, when there are multiple bidders, and sellers lose significant leverage after granting exclusivity to a single buyer. Therefore, to the extent that some agreement can be obtained around the general parameters of the NWC mechanism upfront, that will avoid confrontation and/or value-loss down the road.
To stay ahead of the issue, a seller and its advisers should analyze historical monthly balance sheets and calculate rolling multi-month averages over the past 24 months. Calculate averages based on 2, 3, 4, 5, 6, etc, all the way through 24 month historical averages to see which averages result in the lowest (most favorable) and highest (least favorable) results. This way, you can control the negotiation and enter it knowing which methods will produce the most favorable results. Also, sellers should forecast the major balance sheet accounts to see how NWC is trending and what the true-up might be at closing. This will hopefully help you avoid surprises and keep you focused on maximizing your operating efficiency all the way through closing.