Let’s parse through various deal elements as a percent of the total enterprise value (a.k.a. TEV or the purchase price). That’s a fairly wonky column topic, but buyers of LBM businesses are overwhelmingly private equity groups, and they think of deal elements (like senior debt, subordinate debt, seller’s notes, earn-outs, and escrows) as a percent of the total they pay for your company.
We subscribe to GF Data Resources, and today we’ll focus on a recent report on “lower middle market” companies (which for LBM businesses is $10 to $100 million in revenues). The GF Data report shows what portion of the purchase price has been represented by the debt portion of the deal, expressed as a multiple of the purchase price.
Sounds complicated, but it is not.
For ease of math, say you sell your company for $10 million, and the company operates at a 10% EBITDA margin. Our readers know that buyers often borrow a substantial portion of the TEV, and if there were $1 million in debt as part of the deal, the debt portion would be expressed as 1X.
What portion is typical today, and how is it changing with rising interest rates?
GF Data reports that across recent deals in multiple industries, 53.4% of the purchase price was a combination of subordinate debt and senior debt. That debt, expressed as a multiple was 3.9X EBITDA, out of TEVs that were 7.3X EBITDA. (Side note, most LBM deals are being valued as ~5X.)
So, for that $10 million deal, the buyers would have borrowed $5.34 million, broken out as 0.7X of the entire deal value as subordinate debt ($960,000), and 3.2X of the entire deal value as senior debt ($4,380,000).
In a year-over-year comparison, using the common metric of “debt divided by EBITDA,” the total debt is down just slightly from past transactions surveyed, likely reflecting higher interest rates. This indicates that buyers are using slightly more cash instead of debt.
With these ratios on that $10 million deal, $5.34 million is the total debt load, which the NewCo created by the acquisition will service going forward. Of the $4.66 million left to make up, the buyer may lay on additional “seller leverage” like a $2 million seller’s note, or a $1 million earn-out. (It’s common for earn-outs to be 1X of the deal value). This further reduces how much of the buyer’s equity (cash) they put into the deal. Why such a complicated structure? The private equity group is trying to guard cash and reduce the number of years it takes to earn back their equity (the cash they put in). How many years is that typical earn-back period? Well, let’s see how the $10 million purchase price works out this respect, based on that 10% EBITDA margin.
Of the $10 million purchase price, $5.34 million is a blend of the two types of debt, and $2 million is a seller’s note, and $1 million is an earn-out. If the buyer risks $1.66 million, at 10% EBITDA margins, the private equity group would recover that in less than two years. And that’s assuming the NewCo doesn’t grow at all, which is unlikely. The buyer will probably grow the company, so the effective time to recover its equity could be less than two years.
Even if you were to knock out the seller’s note in this hypothetical deal, the buyer would be putting in $3.66 million of equity. At 10% EBITDA margins, assuming no growth, the private equity group would make back its equity in the fourth year, well within the “swim lanes” of good performance.
Finally, private equity firms often express their success as an IRR, or internal rate of return. The IRR takes into account the size and timing of its cash flows (in and out) and its net asset value at a certain point in time. You can imagine that earning back the equity portion of a deal in less than two years (rather than five years) only boosts the IRR, a chief goal of any private equity group. That’s why, when reviewing deal structures, you (the seller) will see the buyer probing with ways to reduce their equity contribution, attempting to leverage you to reduce their risk. Don’t take these efforts personally. As they make clear in “The Godfather,” “it’s strictly business.”
John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at email@example.com