Selling a Business: Private Equity and Valuations
16 January 2023: Selling a Business: Private Equity and Valuations
In a couple of recent posts (here and here), we discussed the impact of certain economic conditions on business valuations. From the business’ ability to service acquisition debt to the return on investment required by buyers, interest rates and inflation directly impact such valuations.
The rise in interest rates increases the interest that must be paid on any loan and that impact must be consider when selling a business. In the case of a business being acquired, the funding for the acquisition generally includes debt. Therefore, the annual interest expense the business will incur will be greater in a time of high interest rates than it will be when interest rates are low. All other things being equal, this would result in lower discretionary earnings of the business and, thus, a lower valuation.
Aside from any acquisition funding, many businesses carry existing debt for everything from equipment and real estate leases to revolving and self-amortizing obligations. This indebtedness is often tied to what is referred to as the Wall Street Journal “prime” rate and, as such, fluctuates; it will move up or down in concert with rate moves made by the central bank.
As I write this, last week’s inflation report has analysts predicting further rate increases in 2023, albeit at a slower rate of increase (1/2 point pops rather than a continuation of the 3/4 point pops we saw in 2022). This would seem to continue to put downward pressure on valuations if for no other reason than that the operational interest expenses of most businesses would be expected to increase. Add in the costs of acquisition funding and we would likely see valuations impacted. We have, in fact, witnessed this during 2022.
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This phenomenon would seem to apply across the board. But there is another phenomenon that may offset this downward pressure and that phenomenon involves private equity groups (PEGs).
PEGs are investment groups that raise capital from private, public or institutional investors for the purpose of investing that capital. A private equity group is essentially an investment manager that raises funds to invest in private companies. The typical private equity investment process lasts around 10 years.
What that “10 years” means is that the PEG has to return the capital to its investors – hopefully with a handsome return on their investment – within 10 years.
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PEGs buy businesses, in whole or in part, with the objectives of growing them – increasing their value – and then ultimately selling them. This ultimate sale could be to a larger PEG, a strategic acquirer – possibly one that the PEG already owns – or to the public in an initial public offering, or IPO.
The management teams of PEGs usually include really smart folks who feel they have the horsepower – the smarts or the money or the connections – to increase the value of the businesses they buy to a level – and within a limited time frame – that will result in significant gains for the PEG and its investors.
So, how does this impact value?
If they don’t invest the capital they’ve raised, they gave to return it. PEGs are loathe to return uninvested capital for two reasons: first, because it would be difficult to charge a “management fee” on capital that was not invested and, second, because the fund’s management team generally participates in the fund’s gains. If there are no gains, the management team may have to find more productive ways of making a living.
The raison d’etre of a private equity group is to invest the capital it has raised, realize a profit on any such investments and return its investors’ capital within a specific time, generally no more than 10 years. Over the past five or so years, PEGs have been raising investment capital with the fervor of a politician in a race for reelection. But in the past year, rising inflation and interest rates have made finding good businesses to buy difficult.
As a result, PEGs are awash in investment capital. One report has them sitting on nearly US$2 trillion in uncommitted capital, capital that they need to put to work.
The Bottom Line
Though the traffic has slowed a bit, we’re still contacted two or three time every week by small private equity firms seeking opportunities.
The firms contacting us are looking for companies with revenue as low as US$2 million and as little as US$500,000 in discretionary earnings or EBITDA. With $2 million at the low end and $25 million at the high end, this happens to be where most businesses are.
PEGs have money they need to invest by acquiring all of – or at least a controlling interest in – well-run companies and a calendar that pressures them to get that money gainfully employed. This suggests that this demand will offset, at least to some degree, the downward pressures we’re seeing on valuations in general.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at joe@WorldwideBusinessBlog.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
We’ve been contacted by a technology executive who is looking for an opportunity to acquire a small business in that field – one with between roughly US$500,000 and $1 million.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 500 in the world. He can be reached at joe@WorldwideBusinessBlog.com