Strategies & Analysis
while earning a return greater than or
equal to its WACC.
The Private Equity Buyer
The operative word in Private Equity is
“private.” The firms which comprise a PE
fund’s portfolio are not publicly traded,
and therefore standard capital budgeting
theory is replaced with project finance.
Simply put, each entity is a singular investment that is financed independently
from other entities. Therefore the balance
sheet structure cannot be ignored by the
private equity buyer when valuing the asset. It becomes paramount that financing
considerations such as cost of debt, leverage ratio, interest costs, etc. are factored
into the valuation process.
An example of a prototypical proj-
ect finance scenario for FantasyChem is
presented in the rose colored box above.
Our private equity buyer must not only
look at the cash flow performance of
FantasyChem, but it must also apply its
project-specific parameters and look at
the balance sheet simultaneously with the
discounted cash flow analysis. In its proj-
ect finance analysis, our PE buyer also be-
gins with FantasyChem’s basic financial
performance and historic growth rate,
factors in specific targets for return on
equity (ROE), cost of debt, and beginning
and ending leverage ratios, and calculates
that it can pay up to $161 million, 6.4x
EBITDA, while meeting or exceeding its
ROE minimum.
Conventional Wisdom
Comparing the results of the two different treatments of the valuation of
FantasyChem, we see that the base case
scenario for both buyers delivers essentially the same result: FantasyChem has
an enterprise value of roughly $160 million. But, based on what we hear when we
talk with people in the real world, such
a similar result is not what most people
would likely expect. On the contrary,
most owners have very strongly held
preconceived notions as to which type of
buyer they might be willing to engage.
Why is this? And what is the prevailing conventional wisdom?
Let’s start with two of the most com-
mon perceptions that we hear, in no
particular order. On the one hand some
business owners believe that strate-
gic buyers are evil purveyors of cash in
search of companies that can be sub-
sumed and wiped from our collective
memory. While, on the other hand, some
say that private equity firms are bottom
feeders that exist only to strip companies
to the bone so that they can flip them for
a profit. Where any one individual might
fall on this continuum is largely a func-
tion of his/her personal goals and indi-
vidual values.
Frankly, we are skeptical of either
position, but likely within every cliché is
buried a nugget of truth. Rather than inherent evil, bad intentions, or malformed
personalities driving buyer behavior, we
believe that it is much more reasonable
that strategic and private equity buyers must manage different value drivers,
process control knobs if you will, at their
disposal in order to satisfy their stakeholders. Their behaviors can be interpreted more rationally and sellers can help
themselves at the negotiating table with
an enhanced understanding of the specific
needs of each type of buyer.
Impact of Value Drivers /
Sensitivity Analysis
To get a better understanding of how the
value drivers influence the behavior of
strategic and private equity buyers, we
can use the prototypical analyses presented above and look at some sensitivities.
Profitability, growth rate and capital intensity are inputs that impact both
classes of buyer in the same manner.
Obviously, higher profit margins and
higher growth, more than anything else,
increase the value of any company because the impact on cash flow is both
positive and immediate. The same is true,
although the impact is less dramatic, for
capital intensity. Since the DCF analysis
in either case is based on free cash flow
(FCF) which takes into account the capital spending required to support future
growth, the less capital investment required the higher the FCF and the greater
the value of the enterprise.
The impact on financial expectations,
and consequently on buyer behavior,
diverges with the final four parameters
highlighted in green and dark red in the
table above. Strategic buyers can derive
tremendous value if they acquire businesses that are synergistic with their existing footprint. The effect is less meaningful
to PE buyers since they are assembling
portfolios of independent entities with
separate infrastructures. Synergy opportunities include enhanced raw materials
