Those of us who took corporate finance classes in college or graduate school were taught that the best way to create value was to capitalize a business in such a way as to minimize its cost of capital. This generally means maximizing the use of lower cost borrowed money (debt) and minimizing the use of higher cost equity. This notion has been further supported by the US tax code that allows businesses (at least in part) to deduct the interest expense related to the debt on their tax returns. In fact, most private equity firms that focus on acquiring family and management-owned businesses (buyout investing) typically finance the majority of the purchase price with debt provided by banks and other finance company sources.
While the theory on minimizing a firm’s cost of capital is straight forward enough, in our view it has not been the best way to create equity value in a sustainable fashion. While the use of debt leverage can certainly heighten returns on invested equity, it only does so if the underlying business succeeds and grows (debt is useful so long as “everything works out”). In other words, if the business cannot execute on its strategic growth plan because it does not have enough liquidity or it is close to violating a debt covenant with the lenders, then the prospect of creating equity value through a low-cost-of-capital balance sheet goes out the window.
This is especially true for smaller and mid-sized family and management-owned businesses. In our experience, such businesses have been successful in growing by carving out a niche where they can differentiate themselves and add value for their customers. While a smart strategy, it oftentimes leaves the business with a more concentrated product portfolio, customer base or geographic region that it serves. Such characteristics combined with what is commonly viewed as a “smaller business” (typically EBITDA less than $10 million) has resulted in many cash-flow lenders (the primary lenders to private equity transactions) to only support such companies during relatively good times. So, when a recession hits, your new ERP implementation is dragging on and costing a lot more than expected or an add-on acquisition integration is causing inefficiencies or reduced production, all times when a business needs room to operate, many lenders to these “lower middle market” companies get nervous and can restrict access to credit. So, making sure you have enough cushion in your capital structure in very important.
Further, as valuations for private businesses have risen to high levels, the amount of debt being used by most private equity firms has generally risen. This situation is putting enormous pressure on two key drivers of equity value creation: (1) EBITDA growth and (2) being able to sell the company in the future at the same high valuation multiple. In our view, it is hard to predict where valuation multiples for private companies will be in the future. But, one thing we know is that the selling multiple will be better (all else being equal) if EBITDA does grow.
So, the best thing a private business can do to protect itself against a potentially cautious lender during more difficult times, and improve the prospects of creating equity value, is to grow EBITDA. The best way to achieve EBITDA growth is to enable the company’s management team to execute on a strategic growth plan with minimal or no interruption (caused by changes in the economy or other unforeseen issues). In our experience, a key way to achieve this is to moderate the use of debt leverage and structure the company’s capital in a way to maintain strong liquidity.
For example, we acquired two businesses prior to the Great Recession. The first was a supplier of replacement parts for the heavy-duty truck market. After closing the transaction whereby we acquired a majority of the business, the debt used to finance part of the purchase stood at about 2.7x EBITDA. The business grew nicely from 2005 thru the spring of 2008. Then, like a lot of businesses, orders started to soften. By the fall of 2008, everyone was downright scared. Rather than pull back on inventory levels and stretch out payables to improve liquidity (like a lot of businesses started to do), the management team stayed focused on running the business the way they always did. They kept inventory levels flush and fill rates high to customers and they kept paying suppliers on time. These simple things further endeared the company to its customers and suppliers at a time when they needed it most.
While the company’s sales and EBITDA declined during the recession by 25%, debt leverage never exceeded 3.3x and excess availability under the company’s revolving line of credit was never in jeopardy. This is what empowered management to stay focused on the plan and what they do best and not to have to pivot to a cost cutting mind set or shift into squeeze working capital mode.
As demand began to grow, the company started to realize that it had picked up market share with its customers as the company was growing faster than the overall industry. In fact, the business grew so fast coming out of the recession that the owners were able to sell the company at a higher valuation multiple than they initially paid for it.
Similarly, the second company (acquired in the summer of 2008) was capitalized heavily with equity (>65% of the capital structure). It was a linen distribution business serving primarily hospitality and healthcare facilities. It didn’t take long after the transaction closed to realize that demand from hotels and cruise lines were turning down. As before, management stayed focused on the plan, which included seeking to acquire other businesses that could help broaden the company’s customer base and product portfolio.
As a result, after meeting and evaluating several prospects, the company was able to acquire a company in 2010 that meaningfully increased combined EBITDA, added several higher quality customers, added a new product line that could be cross sold into other accounts and brought access to a new geographic region the company had not historically serviced. Further, this business was acquired at a relatively attractive valuation as many other potential competitors for the business were not actively acquiring at the time.
Coming out of the recession, both businesses grew quite nicely as the business had evolved into a more diversified platform serving a wide array of commercial accounts. The business model caught the eye of a business development executive looking to add a turn-key distribution capability to his business to help fuel their growth. We ended up selling the business to that group at a higher valuation multiple than we initially paid.
While cost of capital considerations are important, they should not be made in a vacuum. A management team’s ability to run the company based on its strengths and to stay true to a strategic plan are key drivers to value creation. A lower-debt structure is a smart way to support this focus.