Friday, 23 September 2011
What Will a Financial Buyer Pay?
Now that we have examined the logic that drives a strategic buyer, what logic drives a financial buyer?
First of all, what is a financial buyer? A financial buyer is one who is buying strictly for a financial return. Financial buyers include individual investors, who have either saved up or cashed out, and institutional funds such as Venture Capital Funds, for early stage high growth opportunities, and private equity funds, which come in many varieties (including Leveraged Buyout, Growth Capital, Distressed and Mezzanine Funds). There are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as BlackRock, Onex and Kohlberg, Kravis Roberts.
How does a financial buyer compete in a world with well capitalised strategic buyers? Two ways: leverage and portfolio tuck-in acquisitions.
If cheap credit is readily available (i.e. leverage) then financial buyers can be very competitive. Here is an example. Company A, a stable profitable company, generates $10M of EBITDA per annum and a financial buyer is prepared to pay the notional value, let’s say it is 5 times EBITDA or $50M. In this case, assuming no growth, the financial buyer will expect an ongoing stream of EBITDA of $10M or a 20% return on capital per year.
Let’s say a strategic buyer is willing to pay 6 times EBITDA or $60M.... how does the financial buyer compete? In a word... leverage. By using 50% debt and 50% equity, the financial buyer can pay $65M and generate a similar risk-adjusted return on capital deployed. Here is how it works. The financial buyer secures $32.5M in debt financing (at 3.25 times EBITDA this will likely include subordinated term debt (“sub-debt”) as well as secured bank operating and capital loans) at a combined rate of 8% per annum. Now the company earns $7.4M after debt interest payments and the net capital (equity) used is only $32.5M, so the return on equity is now 22.8%, on a risk-adjusted basis close to the 20% originally targeted (one could argue that a higher risk adjusted return is required but the point is made. More about the risk-return equation later). How did this come about? Secured debt is a cheaper (and tax deductable) form of capital than equity and, therefore adding debt to a capital structure – while it increases the risk - concentrates the return on equity and can improve equity value.
Another way a financial buyer can compete with a strategic buyer is to look for tuck-in acquisitions. Financial buyers typically look for opportunities where they can make additional acquisitions in the space to grow the company to a meaningful market position and enhance value by building a larger, stronger competitor. The financial buyer’s first acquisition in a sector will be for a target financial return but with the foresight that subsequent acquisitions will build incremental value. In this case, a financial buyer becomes a strategic buyer. I said earlier that financial buyers buy strictly for a financial return but in many cases financial buyers envision growth strategies that make them quasi strategic buyers.
So who will pay more? A strategic buyer or a financial buyer? I can think of examples where both financial buyers and strategic buyers have paid seemingly exorbitant sums for companies (for example Goldman Sachs buying into Facebook at a $50 billion valuation (over 30 times run-rate revenues) and HP buying 3PAR for 11 times revenues) but if I were to look at the average transaction, I would say strategic buyer.
Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.