Private equity firms are aggressive buyers again!
Readers may recall that back in 2006-2007 time-frame, private equity firms were often paying higher prices than strategic buyers for business acquisition opportunities. Well those days are back. Private equity firms are once again bidding aggressively, and in many cases are outbidding strategic buyers for attractive acquisition targets.
This phenomenon is the result of the record amount of private equity capital available – over US$1 trillion worldwide, which needs to be invested in the near term. The unprecedented level of available capital is the result of several strong years of private equity fund-raising (2012 – 2014), coupled with many successful private equity exits that are the result of a strong M&A market. The large amount of private equity capital coupled with the relatively few number of attractive acquisition targets has created a supply-demand imbalance, which has driven up prices. Consequently, in an effort to uncover additional investment opportunities many private equity firms have launched specialty funds, such as those aimed at energy companies who are in distress due to the recent plunge in oil prices.
What are private equity firm preferred target companies?
Private equity firms are particularly interested in target companies that generate EBITDA (earnings before interest, taxes, depreciation and amortization) in excess of US$10 million and which meet their investment criteria. These criteria generally include:
- a leading position in a market niche
- a strong management team
- growth opportunities, either organically or through add-on acquisitions
- exit strategy alternatives, which may include the sale to a strategic buyer, a larger private equity fund, or a public offering
Where there are no apparent operating synergies how are private equity firms able to outbid strategic buyers? The answer lies in the way that private equity firms use financial leverage (i.e. debt) to finance a transaction. It is not uncommon for private equity firms to use significantly more financial leverage than a strategic buyer would utilize when acquiring a business. In the current environment debt financing is not only inexpensive, but many lenders have also become very aggressive in order to place capital at risk. As a result, they are prepared to lend at a higher than normal ratio of debt against the target company’s cash flow (often measured in terms of EBITDA), and with relatively light covenants.
Opportunity for private equity firms to finance acquisition with debt
The ability to utilize debt financing in a transaction helps private equity firms magnify their potential equity returns. However, it also increases financial risk – being the risk to the equity holders that the cash flow from the acquired company will not be sufficient to satisfy its debt obligations (interest expense and principal repayment), thereby eroding or eliminating equity returns. The high levels of debt financing may be placing many private equity firms and their portfolio companies at risk in the event of an economic downturn or tightening credit market, similar to what occurred in 2008. Could we be on the cusp on that happening again?
Managing Director of Toronto based Veracap M&A International Inc. and author of several books on Business valuation, acquisitions and divestitures, Howard Johnson advises business owners and executives on acquisitions, divestitures, financing and shareholder value matters. You can reach Howard at email@example.com, or by telephone at 416 587 4500.