The Middle Market Review Insights on the Middle Market.
The private capital markets are notoriously opaque. Their tendency for confidentiality and less rigid regulatory standards make them particularly complex for the inexperienced. Although this opacity can be difficult — adding layers of convolution to deal sourcing and relationship management — it can also create lucrative opportunities, particularly in the form of multiple arbitrage.
Multiple arbitrage is the practice of increasing the value of a company without having made any operational improvements to it. In other words, you are arbitraging the multiple at which the company is bought and sold.
Successfully realizing a multiple arbitrage strategy can be extremely tricky and is most often used by private equity firms and strategic buyers to generate automatic positive returns even before realizing a single synergy or cost cut.
Multiple arbitrage hinges on the fact that asset valuations vary widely for different types of buyers, allowing there to be a buy-sell spread for savvy acquirers. Knowing that simple changes can have significant effects at a future sale date allows private equity firms, and some strategic buyers, to assume a certain ROI based on the value inherent in a given company.
An understanding of the method can help both buy-side and sell-side advisors win fair prices for their clients. Below are 3 primary uses of a multiple arbitrage strategy:
1. Merging add-ons to grow size
The larger of two identical companies usually sells at a higher multiple because it is simply 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. Since the acquirer did nothing to change the operational workings of the acquired business, 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. This practice has become more common as competition has driven larger firms to look into the lower middle market for add-ons to accelerate growth in their existing platform companies.
2. Repositioning the target in a more buoyant industry
Assumed profitability growth is another driver of company and industry valuation multiples. Take for example the story of a glass business. If a group of buyers believe that the smartphone market will grow faster than the window pane market — because of bullish views on the middle class and bearish views on construction — then they may be willing to pay more per share of a smart phone manufacturer’s earnings than those of a window manufacturer’s, say 11x and 9x, respectively.
A manufacturer of windows may also have the capabilities to turn glass into something useful for smart phones, say their screens, without having to make any manufacturing changes. 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 all parties in a negotiation. As a buyer, you may be able to identify multiple arbitrage candidates to solidify a stronger IRR. If you have confidence in the spread and think it is priced correctly, there are few reasons you should not pursue the arbitrage. On the flip side, a sell-side advisor can push for a higher purchase price for their client. Knowing that a potential buyer may be looking at your sale as an arbitrage opportunity allows you greater leverage when negotiating a selling price.