Financing growing purchase price multiples
29 November 2006
I met with a former colleague recently who works for one of the Canadian Chartered Banks. Our discussion revolved around the current market for non public companies and what was being paid for same. He had a client that was recently purchased for in excess of 8 times trailing cashflow. Now while I’m not an expert in the frothy world of Mergers and Acquisitions, I did find this quite high for a manufacturing business with sales of less than $50MM. As it turns out it was a strategic purchaser in that it was another company in the same line of business located in a different city that wanted to enter the Toronto market and I guess calculated it was cheaper to purchase a company rather than start one.
So how does one get that kind of deal financed? I will assume that the Company wants to utilize as much debt as possible due to the cost of capital. However leverage does come at the price of flexibility.
Sticking to the middle market and let’s call it a purchase price of 5 times trailing cashflow, how does one get the deal closed? It really depends on the type of cashflow that is produced by the target Company. Is this a “hockey stick” acquisition where you pay a big multiple for whatever reason (actually you know the reason ergo the high multiple you paid) and the company turns into a cash cow, or is it a more steady growth company that will benefit from your expertise over time?
My colleague Mark Usher outlined the various sources of capital and the accompanying cost for same.
So let’s look at some alternatives and base it on turns of cashflow versus dollars.
Chartered banks through their operating line products historically have provided up to 3 – 3.5 times trailing cashflow. Asset coverage is “key” with some room for lending against the cashflow of the Company.
Pros: reasonable rate and is based on security coverage over all of the assets.
Things to consider: Lines of credit are on a demand basis and usually are utilized to finance the working capital needs of the Company. When the Bank has to stretch in order to put out more capital, its tolerance for fluctuations in the operations of the Company and/or the business climate decreases, naturally, exponentially.
Banks have always been asset-backed lenders in the mid market (i.e. collateral coverage and guarantees to shore up any shortfalls), while providing capital on the basis of leveraging historical cashflow is more common with the larger corporate type (+$100MM sales) market. In our example the additional capital required to close the deal would be provided by either a sub debt or mezzanine debt provider. These providers know and understand this market and charge a level of return commensurate with the level of risk in the deal. They are also more likely to have a tolerance for fluctuations in the company’s performance and with the business climate.
Recently I have heard that some of the Banks are increasing their exposure, and going as high as 5 times trailing cash for a transaction with a NEW client.
The classic caution is to weigh the perceived “cheaper” cost of the Bank debt with the flexibility that is available from other more “expensive” debt providers. As purchase multiples climb, and Banks provide a greater number of turns (+4.5x versus 3.5x) of historical cashflow, do you really want to have your entire capital structure with a group that: A) typically doesn’t play in this area, and B) your capital is provided at the pleasure of your provider (See A)?
Specialty finance firms such as Wellington provide capital for a set term with set parameters, which are established and agreed to by all parties up front. We work with chartered banks on many opportunities, and are delighted to do so. But just as equity and debt co-exist, entrepreneurs are often well served when senior lenders have more of a cushion than less; and that often comes in the form of subordinated loans.
Entrepreneurs sleep better at night knowing that:
i) they have more capital around than less;
ii) should there be a bump with the business plan, the term nature of a subdebt deal will be crucial;
iii) as a stakeholder, we will try to help solve problems before they get in the way of you running your business; and
iv) more supporters are always helpful, in good times and bad.
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