Impact of Bid-Ask Spread for Buyouts
I have previously written a bit about the difference in buyer/seller expectations as one reason for the slowdown in buyouts. Scott Sperling, co-CEO of THL Partners was on CNBC recently and discussed this very issue saying that he has expected opportunities “to buy companies in the 5-7x cash flow range” with the public market expectations of “7-9x [sales price] in most sectors” ( http://www.cnbc.com/id/15840232?video=1249086465&play=1). I am going to trust Scott at his word on this and generally enjoy the perspective he brings in his interviews. The next question is, now what does this really mean?
Well first off, EBITA is the proxy for cash flow multiple that was noted by Scott in his interview. Students of finance would understand it is not exact since it does not account for working capital concerns, but those are secondary costs when using valuation multiples. Next, while a 2x difference may seem small, it has a large impact on the rate of return for an investment. Using oversimplified math and holding all other factors constant, assume you could purchase a company with a multiple of 7x using 4x debt and 3x equity, that same company at a 9x multiple with the same 4x debt (credit markets are tight) requires 5x equity. If you sell that same company for the same purchase multiple, your invested rate of return for the second scenario is 65% less since you had to put in 65% more equity into the deal, losing the advantage of leverage. The second scenario puts more pressure on the PE firm to reduce more costs and to gain more revenues to ensure more equity for the owners upon sale after the debt is paid off to meet their target rate of return. It is not impossible, just more risky and is why the greater use of debt is preferred in the event those best case scenarios are not fully realized. The ideal scenario is to purchase the company at 7x with a sale at 9x to realize outsized returns, it is just that modeling that type of exit based on the current uncertainty regarding asset worthiness, makes a big bet much more difficult. As we continue to climb out of the slow down, it will be interesting to see which direction valuations move, towards the sellers or buyers. What do you think?
