Multiple Mania: Part 2 of 2
Previously, (Multiple Mania: Shortcutting Success) we had discussed earnings multiples and their value to the Mergers & Acquisitions process. As previously discussed, we tend to view earnings multiples as shortcuts which, when properly applied, can be useful as sanity checks, but we certainly would never recommend acquiring or selling a privately-held business strictly based upon an earnings or purchase price multiple.
Of course, there are many factors which influence multiples, as we discussed previously. One factor is the prevailing or current economic condition. We all know how bad the economy got in 2008 and 2009. We hope we are on the road to recovery, but there are still some rocks in our path.
Purchase price multiples are post-mortem account; you do not know the number until the transaction is closed. That is one of the problems with reviewing multiples. However, we do know during the period of 2006 to the middle of 2008, purchase price multiples were higher than they had been in the 2003 to 2005 timeframe. Those of us in the M&A business watched as purchase price multiples declined during the latter half of 2008 and the first nine months of 2009. Thankfully, we have seen a recovery in the market and a slight increase in multiples.
So what drives multiples? There is one key ingredient in the multiple recipe very few outside of the M&A industry understand or recognize, but this ratio is the driving force in almost all leveraged transactions. What is this mystery formula?
When analyzing credit requests (a/k/a loan requests by buyers), banks review and calculate myriad ratios. One such calculation includes measuring the ratio of a company’s Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) against the debt being borrowed. In our terms, we call this the “EBITDA to Senior Debt ratio.”
Here is how this works: Company A has EBITDA of $2,000,000. Bank Z has an EBITDA to Senior Debt ratio of 3. That means Bank Z would be willing to lend a buyer up to $6,000,000 ($2,000,000 times the multiplier ratio of 3) to acquire Company A.
Of course, this assumes Company A has enough assets to support $6,000,000 in leverage (debt). If Company A does not have enough asset value to support the leverage (both term debt and/or a revolving line of credit), regardless of the cash flow, Bank Z will only lend what is supported by the asset value. The table below illustrates this example:
We have used Advance Rate to be the measure for what percentage of the underlying value of the asset Bank Z will lend to a borrower.
As you can see from the table above, a buyer looking to borrow money from Bank Z would only be able to borrow approximately $2.2 million, even though the Bank Z’s own ratio can support higher borrowing.
Back in 2006 to 2008, we saw plenty of senior lenders who would lend on what we call “air balls,” that is, the gap between the total debt available for leverage and the maximum amount the bank would allow on its EBITDA to Senior Debt ratio. However, with the crash of the economy in 2008, very few senior lenders, if any, are willing to lend on cash flow.
Historically, during the “go growth” period of 2005 to 2008, we saw the EBITDA to Senior Debt ratio go as high as 4.1 to 4.4 (for companies who had at least $10 million of EBITDA; the ratio was lower for smaller companies). At the trough of the market in early 2009, we saw the ratio drop to 1.75 to 1.85! Today, for companies with less than $5 million of EBITDA, the ratio is approximately 1.85 to 2.25; for larger companies, the ratio has crept up to 2.5 to 2.8, perhaps a little more for really large companies.
Using our table above, if Bank Z’s EBITDA to Senior Debt ratio fell to 1.85 like most lenders at the nadir of the Great Recession, the most a buyer could borrow to acquire Company A is $1.85 million (1.85 times $1 million of EBITDA) even though Company A had assets which could be leveraged to $2.2 million.
What does all of this have to do with purchase price or earnings multiples? As the EBITDA to Senior Debt ratio declines, purchase price multiples for leveraged transactions have to decline as well because there is simply less leverage available for the buyers to make acquisitions.
Imagine the following scenario: Company B has $2,000,000 of EBITDA and wants to sell its business for $10,000,000, which is an EBITDA multiple of 5. Buyer 1 wants to acquire Company B and goes to Bank Z for a loan, whose own, depressed EBITDA to Senior Debt ratio is now at 2. Company B is told it can only borrow $4,000,000 from Bank Z. To fill the $6,000,000 gap between what Company B wants for its business and what Buyer 1 can borrow from Bank Z, Buyer 1 will either have to increase the equity it puts into the deal, thus significantly lowering its own return on equity, borrow from a high-priced cash flow (mezzanine) lender, lower its offer, or walk away.
A buyer who does not have to use leverage to make an acquisition will be unconcerned by this ratio. But, for the vast majority of buyers of middle-market companies, leverage is a requirement in all their transactions, so this is a fundamental, driving force in valuations.
Having now gone through three downturn M&A cycles in the past 21 years, we are very familiar with the ebb & flow of the EBITDA to Senior Debt ratio. When the ratio increases, purchase price multiples increase; when it declines, so do acquisition prices.
Unfortunately, no banker will really disclose this number to you, it is not published anywhere, and most banks seem to use the same ratios. However, if you recognize the importance of this ratio, you will understand why purchase price multiples are so heavily dependent on the availability of leverage.
posted by Jim Zipursky