Part 4: EBITDA - The BAEA (Be All End All)
Thrive Blog Series: Private Equity is not a Black Box
Investors,or private equity firms, buy companies based on multiples of EBITDA, Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is essentially the cash the business has available for debt service, aka, money the company has available to pay interest and principal back on any debt it assumes. EBITDA does not take Capital Expenditures (CapEx) into consideration which makes it a better measure in private equity to compare businesses to other businesses. It cancels out any differences between companies with significantly different capital equipment profiles (higher CapEx numbers) and gives more of an apples to apples picture than using "Free Cash Flow” which is the number you get after deducting Operating Expenses and CapEx. EBITDA is the industry standard measuring stick across private equity. Firms live and die by hitting or missing their EBITDA targets.
Private equity firms use leverage in buying their portfolio companies - a portion will be cash or “equity” and the rest, the majority, will be loans they take to support the sale, aka the “leverage” or the “debt”. Making sure a company can pay those loans and the interest on them is the first measure of importance. EBITDA is the be all and end all in private equity since it only makes sense to buy a company that generates enough cash to support the debt on that sale. Sure, other numbers and metrics are also significant, but truly it all comes down to EBITDA.
Multiples of EBITDA, or the measures of a company’s worth, in a macro view are primarily driven by the cost and availability of credit, the specific industry and the return on investment (ROI) for that particular industry at that specific point in time. The micro view is just like selling your house, companies that take good care of themselves and have solid foundations sell for higher multiples than companies that are in need of repair. If your house is well-maintained and well-kept, it will bring you a better sale price than the house next door that needs a new roof and has pitiful landscaping.
When the economy is strong and credit is cheap, there’s typically a lot of money chasing deals, aka, private equity firms have been able to raise more money to invest than there are companies available for acquisition. The competition for companies drives multiples on EBITDA up which makes it more expensive to buy those companies that are available. In a down economy where companies’ performances aren’t as strong, EBITDA numbers come in lower, and multiples are also often lower which can make it less attractive for a company to sell and better to wait it out until their numbers improve, multiples go up, and they can get a better price. You get every scenario in between as well.
As an example, although it is tightening, lately credit has been cheap making acquisitions attractive for private equity firms. At the same time, PEs have raised a lot of money, but there are a lot of them competing for a limited number of available attractive companies, all the moreso in specific high demand industries. This has driven today’s multiples to record highs and created a very strong seller’s market (again, similar to real estate). As credit becomes more expensive, it gets less attractive to buy companies; this often combines with a softening economy putting downward pressure on companies’ EBITDAs. This presumably shifts things to more of a buyer’s market. While there might be less companies for sale, there are always companies that have to sell for one reason or another - just like houses on the market. When there are more companies looking to be acquired than investors looking to acquire, the companies with better financials, stronger balance sheets and more upside opportunity attract the money while the companies with less stellar profiles pay higher interest for investor money, or they don’t attract the sale prices they are targeting or don’t attract investors at all. Just like in real estate, those with higher credit ratings get the best deals, those with less than perfect credit pay higher interest rates or are unable to get mortgages at all.
For context on where we are today in 2022, FirstPageSage presents an interesting analysis of EBITDA multiples in companies with less than $250MM in revenues, drawing from research published over the past 2 years (Q2 2020-Q2 2022) in M&A and private equity publications (https://firstpagesage.com/seo-blog/ebitda-multiples-by-industry/#1649799099090-18d2dba9-33da). Their reporting indicates that Industrial IOT companies with low key employee turnover and high recurring revenues are commanding the highest EBITDA multiples of 25.3X across all of the tracked industries. Translated, that means if a company had $25 million in EBITDA, and it sold for 25.3X, the sale price would be $632.5 million! As a comparable data point, back in 2010 the median EBITDA multiple for the Technology, Media and Telecom (TMT) sector was 7.7X. It’s not apples to apples since tech industries in particular have evolved and shifted significantly since then, but it’s pretty interesting nonetheless. Industrial IOT was not tracked as an industry on its own but was lumped into TMT which was a big pot that included many related tech or telecom sub-industries that are well-established in their own rights today.
On the opposite end of the spectrum, Addiction Treatment companies with low revenue growth and high key employee turnover command the lowest multiples at 2.9X. If you look at the picture as a whole across the board, according to Pitchbook, the median EBITDA multiple in the 3rd quarter 2021 was 12.8X. That is pretty darn healthy! We will probably see today’s multiples soften as the COVID backlog eases and as credit becomes more expensive with the Fed raising rates. Still, no one sees any drastic drop in pricing or deal flow coming anytime soon.