Value in PE (Synergies or Multiples Expansion)
Where is the bulk of value created in PE deals?
I tend to doubt the majority of investors are savvy enough to recognize real synergies and operationally improve a business. My gut tells me that most of the bread is made from buying a company and then selling it to your buddy at a different fund for a higher price.
This is a cynical take, don't get your feelings hurt if you think you're that guy with the magic touch and can fix companies with little operational experience.
If I'm totally wrong here, then tell me what part of the picture I'm missing. Mostly talking about larger deals which garner plenty of sponsor attention (obviously there is more alpha in the unloved assets)
Were you born yesterday? Even WSO's LBO modelling course highlights that the bulk of value creation in PE comes from multiple expansion.
Sweet, that fuels the fire
True but how do you explain the justification of multiple expansion in your underwriting? Hard to just assume expansion
Realized synergies usually lead to multiple expansion, no?
Yes, absolutely. But I'm talking about whether most value is created through synergies or just arbitrarily pricing a company at a higher number. After all, fund cycles are only 5-7 years and when 1 fund's life is up and it is time to sell, then another fund likely needs to deploy their capital.
I'd wager most of the PE return still comes from increasing EBITDA vs. multiple expansion. PE firms don't typically underwrite multiple expansion in their investment case, though I wouldn't be surprised if it's a key factor in home run returns. But for investments that have a positive return, I would assume that's mostly because EBITDA is higher at exit vs. at entry. It's generally atypical to see a CIM from a sponsor-backed company that's being sold to show an EBITDA decline over the past 5 years.
Also, in your bread-and-butter PE deal, I would consider the three buckets of return to be EBITDA growth, debt paydown (i.e. generating levered free cash flow), and multiple expansion. It's not a dichotomy between multiple expansion and synergies.
I can’t just call up my banking buddies and get them to pay a turn or two higher for a PortCo, even when value is created by multiple expansion it is frequently driven by improvements in the business.
E.g. we bought a business a few years ago for 7x that had a concerning degree of customer concentration and through M&A and broadened product offering we were able to sell it for 8.5x with a much lower levels of customer concentration
Seems surprising that you could take customer concentration way down and grow the business (presumably both organically and M&A) and only get another 1.5x. Devils in the details, obviously.
It’s mostly multiple expansion per most analyses of deal returns.
Imo what people miss is that multiple expansion is usually due to some sort of underlying operational improvement / improved positioning. No one in any PE firm is just buying shitcos for higher multiples because “their buddy told them to”. People are in this business to make money.
Also it’s obviously not the PE firm making the operational improvement. No PE investor worth their salt thinks that they are the ones literally driving operational improvements, it’s all about enabling management to drive those improvements. Put another way the operational improvement comes from aligning incentives via option pools, bringing in the right operators, helping management think through a high level growth strategy (which the actual operators then execute), and allowing management to have the financial backing to be able to make step change investments without worrying about keeping the lights on (or in case of formerly public companies meeting their quarterly earnings targets).
I generally agree with the three buckets mentioned above. It's interesting that in the last decade with increasing multiples, debt paydown / LFCF generation has become a smaller and smaller component of returns (4-6x leverage is less meaningful when you're buying companies at 20x EBITDA vs. 12-14x a decade ago). I think this will reverse in the next few years as certain industries' multiples come back down to earth, leaving more room for leverage to once again make a big difference for returns.
At least at my firm (focused on large cap buyouts), we never underwrite multiple expansion, but indeed a lot of our blowout deals (>4x MOIC on $1bn+ check sizes) happened due to good timing in the market and selling at peak multiples. On average we underwrite 3-4x EBITDA multiple compression, but our returns work because we often 2-3x EBITDA during a 4-5 year hold period. Depending on the sector, the way you get to higher EBITDA can be very different. With high growth sectors, revenue growth is often enough to push high EBITDA growth at whatever the base flowthrough margin, whereas in other industries you really have to drive margin expansion via cost cuts and operational changes. Obviously the latter requires more work, which is reflected in those industries' multiples (would be lower on average).
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