What Will a Strategic Buyer Pay?
What is a valuation premium and who would pay one? By definition, a valuation premium is the amount paid that is higher than the average price. But if the market will ultimately determine the price, where do you start?
You start with the notional value. A notional value determination is one in absence of an open market transaction which is, in other words, the intrinsic or stand-alone value. The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e., with a distribution network or sales force). The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a discounted cash flow (DCF) analysis and/or a public company market trading and acquisition comparable analysis.
The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings. Earnings may be generated by levered or unlevered assets. Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.
A premium is the amount a buyer will pay, over and above the notional value. However, the way that the purchaser itself is being valued is also a factor in this equation. Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings. An example of one of these rare, dilutive cases would be the acquisition of a technology. In this example, a patent may be acquired that doesn’t generate any direct revenues or is owned by a company that is presently losing money, but, ultimately, the company and patent are expected to be very profitable in the future. In cases like this, it may make sense to accept short-term dilution to earnings (i.e., an investment in future earnings) from an acquisition in anticipation of a large improvement in future combined earnings once the patent yields the expected profits.
Aside from rare dilutive examples, the norm, however, is that an acquisition needs to be accretive to the purchaser’s earnings. An example of an accretive acquisition is best illustrated by analyzing a publicly traded company. Let's say Company A trades at 12 times TTM EBITDA of $10M (i.e., an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M). The go forward enterprise now generates $11M (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M.
While the example is simplistic, the concept to take home is: what if the notional value of this company is $5M? Perhaps during a divestiture process there would have been several expressions of interest at $5M, but the winning bidder had to pay more. Company A could have paid $10M (10 times EBITDA — as it trades at 12 times EBITDA) and it would still have been accretive. How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.
So what will a strategic buyer pay? They will pay somewhere between the notional value and the value to the buyer. Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.
What Will a Financial Buyer Pay?
Now that we have examined the logic that drives a strategic buyer, what logic drives a financial buyer?
First of all, what is a financial buyer? A financial buyer is one who is buying strictly for a financial return. Financial buyers include individual investors, who have either saved up or cashed out; institutional funds such as venture capital funds for early stage high growth opportunities; and private equity funds, which come in many varieties including leveraged buyout, growth capital, distressed and mezzanine funds. There are more than 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as BlackRock, Onex, Kohlberg and Kravis Roberts.
How does a financial buyer compete in a world with well capitalized strategic buyers? Two ways: leverage and portfolio tuck-in acquisitions.
If cheap credit is readily available (i.e., leverage), then financial buyers can be very competitive. Here is an example. Company A, a stable profitable company, generates $10M of TTM EBITDA per annum and a financial buyer is prepared to pay the notional value, let’s say it is 5 times EBITDA or $50M. In this case, assuming no growth, the financial buyer will expect an ongoing stream of EBITDA of $10M or a 20% return on capital per year.
Let’s say a strategic buyer is willing to pay 6X EBITDA or $60M—how does the financial buyer compete? In a word: leverage. By using 50% debt and 50% equity, the financial buyer can pay $65M and generate a similar risk-adjusted return on capital deployed. Here is how it works. The financial buyer secures $32.5M in debt financing (at 3.25 times EBITDA this will likely include subordinated term debt, or "sub-debt," as well as secured bank operating and capital loans) at a combined rate of 8% per annum. Now the company earns $7.4M after debt interest payments and the net capital (equity) used is only $32.5M, so the return on equity is now 22.8%, on a risk-adjusted basis close to the 20% originally targeted (one could argue that a higher risk adjusted return is required but the point is made). How did this come about? Secured debt is a cheaper (and tax deductible) form of capital than equity and adding debt to a capital structure, while it increases the risk, concentrates the return on equity and can improve equity value.
Another way a financial buyer can compete with a strategic buyer is to look for tuck-in acquisitions. Financial buyers typically look for opportunities where they can make additional acquisitions in the space to grow a platform company to a meaningful market position and enhance value by building a larger, stronger competitor. The financial buyer’s first acquisition in a sector will be for a target financial return, but with the foresight that subsequent acquisitions will build incremental value. In this case, a financial buyer becomes a strategic buyer. It was mentioned earlier that financial buyers buy strictly for a financial return, but in many cases financial buyers envision growth strategies that make them quasi-strategic buyers.
So, Who Will Pay More?
Will a strategic buyer or a financial buyer pay more? There are examples where both financial buyers and strategic buyers paid seemingly exorbitant sums for companies (for example, Goldman Sachs buying into Facebook at a $50 billion valuation—over 30 times run-rate revenues—and HP buying 3PAR for 11 times revenues), but if you were to look at the average transaction, a strategic buyer generally pays more.