Fierce competition, historically cheap debt and stunning amounts of dry powder have driven buyout multiples to record highs. Therefore, funds must deploy capital despite risk, or even probability, of contracting multiples in coming years. As such, sponsors will continuously need to increase reliance on management teams to accelerate growth in an effort to a.) organically ‘discount the purchase multiple’ and b.) inorganically ‘blend the purchase multiple’ to ensure a strong return. In this Q&A, Rob Huxtable, Partner at Falcon, provides an inside look at the way sponsors think about platform multiples and growth.
The deal-making climate is producing unprecedented purchase multiples. How does that reality impact portfolio company operators?
We are at a historic high for multiples and a historic low for interest rates. Cheaper debt allows a fund to push more leverage onto a deal and pay a higher purchase price with less equity. But buying a company in that environment puts the sponsor at risk of paying a super premium for the asset if multiples contract over time.
Funds are aware of this dynamic which is why they aggressively focus on two things: 1.) Discounting their purchase price by accelerating the portfolio company’s rate of organic growth 2.) Inorganically lowering the blended entry multiple.
Some portfolio company CEOs and CFOs wonder why their private equity sponsor is hyper-focused on growth. It’s because they must often pay a premium EBITDA multiple in order to acquire the business. A higher purchase price multiple often makes an already high-pressure operating environment even more intense for C-Suite leaders.
Are funds transparent with operators about these pain points?
While we don’t believe sponsors intentionally avoid the topic, many miss the opportunity to proactively educate their management teams on these important deal mechanics. We often hear investors complain about management teams – ‘I wish my operators thought and acted more like investors.’ This critique represents an opportunity for funds to bring their operators up the learning curve. Both sponsors and operators would benefit from engaging in these conversations.
How do sponsors use M&A to mitigate entry point risk?
Multiple arbitrage is a key lever for sponsors and management. Larger companies trade for higher multiples. Add-ons can often be acquired for one-third to one-half the platform multiple. Therefore, as soon as a platform makes an acquisition, that additive EBITDA immediately trades for the higher platform multiple. Additional value is generated after post-acquisition synergies are realized. A successful buy-and-build strategy allows a sponsor to achieve a lower, blended acquisition multiple thereby creating the path to a more profitable exit.
This reality explains why sponsors require management teams with the operational chops to effectively integrate culture, operations and systems.
Have record purchase multiples impacted the skills sponsors seek in their portfolio company C-suites?
More than ever, sponsors require teams who can urgently accelerate organic growth and capture post-synergy multiple arbitrage. On the organic side, sponsors depend on their portfolio company leadership to increase or at the very least, sustain the company’s growth rate as the business gets larger – not an easy task.
On the M&A side, C-Suite leaders can augment their integration skills by helping their sponsors identify, attract and close add-on targets in the hopes of doing more deals.
In short, the trend of relying less upon financial engineering and more on operating muscle seems poised to continue unabated as private equity charts its path forward.
Falcon provides C-suite talent solutions for middle-market private equity firms across North America. Follow us on LinkedIn.