By JEFFREY W. BAKER
Those familiar with the history of weapons may recognize the term “dry powder” as it relates to the need to keep gun powder dry or risk losing its stored energy. From that origin the term has been adopted to refer to available cash held by private equity firms that has not been invested in the purchase of companies, often called “portfolio companies.”
Private equity, or PE, firms are typically investment companies created by investors with access to sizable amounts of cash and with the contacts and ability to raise much larger amounts of cash for the purpose of purchasing companies. The investors are looking for companies that are successful but have not seen their full potential because of sales volume, geographical limitations, management constraints, and a variety of other limitations that the investors believe they can overcome with the investment and expertise they bring to an acquired company.
According to Bain & Company’s Global Private Equity Report 2018, the 7,775 PE firms they identified invested $440 billion in portfolio companies during 2017. At the end of 2017 those same PE firms had $1.7 trillion available to invest, or enough to fund nearly four years of future acquisitions. With such a large backlog of unutilized funds, PE firms are very focused on identifying and courting companies for acquisition and addition to their portfolios.
A key component of this effort to acquire great companies is urgency and scarcity. There is a significant degree of urgency because, once a PE firm has raised money from its investors, those investors expect it to be deployed and to start producing double digit returns quickly. PE firms who fail to find desirable portfolio companies to acquire are left with displeased investors and can find it difficult to raise cash in the future, threatening their continued success and even existence.
A high level of scarcity has developed because so many of the larger and most desirable companies that were available a decade ago have already been acquired by PE firms. This has precipitated two outcomes in the PE world. First, PE firms have moved “down market” in their acquisition efforts, meaning that they are courting smaller companies. In the recent past the general rule-of-thumb for a company to be desirable to a PE firm was $50 million in revenue and $10 million in Earning Before Interest, Taxes, Depreciation, and Amortization (EBITDA). (If you’re not familiar with it, think of EBITDA as an accounting term that roughly equals cash generated by a business). In recent years, companies with as little as $10 million in revenue and $1 in EBITDA have grown increasingly attractive to PE firms, especially as “add-ons” to companies already in their current portfolios.
The second outcome is a basic economic issue of demand exceeding supply of companies attractive to PEs. Not only did the scarcity of larger desirable companies push PE firms “down market”, but even the supply of available smaller firms is very tight and has increased the value of these companies to PEs.
Factor in nearly historic low interest rates available to these PE firms to “leverage” their acquisitions and the prices PE firms are willing to pay are at historic highs. This matters for business owners and business people in general because it translates into an historically high value for their companies.
In addition to the influences of plentiful cash, scarcity of attractive companies, and historically low interest rates, company value to potential buyer is essentially driven by three factors.
The first is the degree to which an acquirer believes they can grow the business or increase its efficiency. If the acquirer does not envision a way to increase the company’s value, why would they pay today’s fair market value for the business? This factor is often in the eye of the beholder and varies with each PE firm, making it important to identify firms that are interested in and understand the company’s industry.
The second is the amount of earnings (or cash flow or EBITDA) that the business is currently producing for its owner.
And the third is the determination of a “multiple” by which earnings are multiplied to determine today’s fair market value of a company.
Factor 3 is driven primarily by the plentiful cash, scarcity of attractive companies, and record low interest rates mentioned above but, factors 1 and 2 are largely driven by the ownership and management of the business. The fact that the U.S. has enjoyed a record-long period of economic expansion (albeit slow expansion) over the last 10 years that should result in profits being near all-time highs. If that is not the case for your business, the time to address it is right now and time may be very short. The current economic consensus is that the current expansion will meet significant challenges in the early 2020s and so this period is not expected to last more than a year or two. Urgency!
As noted above, there is a scarcity of desirable companies to acquire which has driven multiples up to historic levels. The result of historically high profits multiplied by historically high “multiples” and PE firms with $1.7 trillion to invest, is an ideal time to investigate the value of your business. Now is a great time to contact your business advisors to help you consider ways to maximize your business’ profitability and ways to attract the most appropriate PE firms to gauge their interest. Even if you have no plans to sell your business, it is imperative that you know its value and there is no better way to gauge value than by talking with a buyer. Contact your business advisor to discuss the points raised in this article today. Time may be even shorter than we think!
Jeffrey W. Baker is principal of Executive Freedom Partners, a Swansea-based business consulting firm.
By JEFFREY W. BAKER