In previous articles, we discussed earnings multiples and their impact on the M&A 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. Our current economy is much stronger than eight years ago, but we still have some rocks in our path.
Purchase price multiples are post-mortem account; you do not know the number until the transaction has 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 significantly during the latter half of 2008 and the first nine months of 2009. Thankfully, we have seen a recovery in the market multiples have improved, but certainly not to the levels we say pre-Recession.
What drives multiples? There is one key ingredient in the multiple recipe very few outside 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. We call this the “EBITDA to Senior Debt ratio.”
Here is how this works: Company A has EBITDA of $1,000,000. Bank Z has an EBITDA to Senior Debt ratio of 3.0. That means Bank Z would be willing to lend a buyer up to $3,000,000 to acquire Company A.
This assumes Company A has enough assets to support $3,000,000 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 $2.3 million, even though the Bank Z’s own EBITDA to Senior Debt ratio supports higher borrowing.
Historically, during the “go growth” pre-Recession period, we saw the EBITDA to Senior Debt ratio go as high as 3.1 to 3.5 (for companies with less than $5 million of EBITDA; the ratio was higher for larger companies). At the trough of the market in early 2009, we saw the ratio drop to 1.25 to 1.45! Today, for companies with less than $5 million of EBITDA, the ratio is approximately 2.5 to 3.0; for larger companies, the ratio has risen to 3.5 to 4.0, perhaps higher for really large companies.
Using the table above, if Bank Z’s EBITDA to Senior Debt ratio fell to 1.35 like most lenders at the nadir of the Recession, the most a buyer could borrow to acquire Company A is $1.35 million even though Company A’s assets could be leveraged to $2.3 million.
What does this have to do with earnings multiples? As the EBITDA to Senior Debt ratio declines, purchase price multiples for leveraged transactions decline as well because there is less leverage available for buyers to make acquisitions.
Imagine the following scenario: Company B has $2,000,000 of EBITDA and wants to sell its business for $11,000,000 (earnings multiple of 5.5x). Buyer 1 wants to acquire Company B and goes to Bank Z (whose EBITDA to Senior Debt ratio is now at 2.5) for a loan. Bank Z tells Company B it can only borrow $5,000,000. 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 return on equity, or it will have to borrow from a high-priced cash flow (mezzanine) lender, lower its offer for Company B, or walk away.
A buyer who does not have to use leverage to close deals will be unconcerned by this ratio. For the vast majority of buyers of middle-market companies, leverage is a requirement, so this is a fundamental, driving force in valuations.
Having gone through three downturn M&A cycles in the past 25 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.
