By Dennis Kebrdle
When Chikol Equities, Inc. began in the early 1980’s, we did our first of about 15 leveraged transactions. Most were in the manufacturing or retail spaces, with our last transaction exit from this cycle having occurred in 1999.
You may recall that at that time, many parties had to rely on about 90%+ debt and paying 13%++ interest for senior financing and mezzanine carried a higher rate along with the usual “equity kicker.” This was considered a good deal at the time. The prices paid then reflected the value & cost of funds being used in the marketplace, with 3-5X EBITDA being the norm.
The high cost of debt back then is a dramatic contrast to the last ten years, during which borrowings have been in the low single digits—and prices for enterprises have escalated dramatically. Buyers have been paying multiples of EBITDA unheard of only a few years ago, with 8-15 times EBITDA being commonplace. This has certainly been a great run for sellers.
Looking back historically, and then reflecting on today’s marketplace, we find some similarities. In the 1980’s & 1990’s, private equity firms moved into the middle to lower market at a pace unlike anything before it. Instead of assets driving sales, EBITDA multiples brought value to cash flow rather than just real estate and equipment. During the last ten years, with its lower interest rates, this approach has returned with a supercharger!! Indeed, it has been a great time for selling to PE firms, which have loads of equity and access to borrowing from lenders to enhance the return on capital employed. An additional current driver for PE firms is the amount of capital that has been raised and the need to get it employed.
Once again, the easiest path for businesses owners wishing to cash-in is to sell to outsiders who have access to funds that aren’t there for owners to use, and who can pay more than the insiders can! This has stimulated the rate of transactions again, much like it was in the 1980-90’s, to the benefit of sellers. So, the question is, how can business owners who are considering a sale maximize the sale price?
We find many similarities with the earlier period—a drive to reduce the amount of capital employed for each dollar of revenue generated. Where there was the 1980’s focus on “lean,” starting with the large manufacturers that moved down to every “tier” of the supply chain—the need for more efficient processes and asset management has once again returned. What is driving the demand for higher returns on capital employed today is the amount paid rather than what the capital costs. Whereas cutting costs to make a profit was the thing back in the 80’s and 90’s, enhancing velocity and improving volume per hour is now the preferred path. While the targeted end result may be the same, this time the rates aren’t on a downward path but on a rising trajectory in the cost of funds. That cushioning effect of dropping rates helped to cover some excesses of the buying spree. Today, just the opposite effect is happening.
Where in the past businesses received the benefit of bank rates dropping from 17% or so to 6-8% (before the recent cycle of 2-4%), which reduced debt service back then by 50%, today we are faced with a likely doubling of debt service requirement with just a few percentage points of increase of the cost of funds. The recent Fed announcement of another base rate increase this year will mean up to a 25-50% increase in the cash necessary to service revolving debt. Investors will face dramatic cost increases that will surely mirror what happened at the end of the last cycle, brought on by inflation and the dollar movements.
So, for those of us in the operational improvement & turnaround business, we foresee abundant opportunities to again assist our investors, lenders and owner friends. There will again be the need to reduce the amount of borrowed funds tied up in the production process. While there have been operational improvements over the years, companies are now often getting lax, and we’re again seeing inventory/sales ratios approaching amounts we saw in the 1980’s. That means increased inventories to ensure quick delivery, and many larger customers demanding & enjoying 3-10-month payment terms. Couple this with the lack of investment in the next generation of equipment to reduce the time to produce, and you have companies right back where they were in 1985! Companies rationalize this because they believe it is less expensive to maintain higher inventories and spend a few more hours producing product at what has been stagnant wage rates.
This demands a coordinated approach for the savvy investor. They have to invest to generate greater cash flow than the original purchase brought—in order to cover the increased debt service—which, if the Fed-watchers are correct, will probably continue to increase in the years to come. The PE player with access to cash is in a better position than the individual business owners, BUT to sustain value they must move NOW to upgrade operations and get tight control of capital employed for every dollar of sales.
Although this cycle will have many similarities to the ‘80’s, there aren’t hundreds of surplus workers to lay off, nor is there room to cut most wages, like there was back then. It will take a more measured path to make sure lenders get paid as required, some potential additional investment to ensure that the leverage ratios are being met, and plans to deal with the impact on the multiple for the next sale!
And as us “seasoned” professionals know, “We’ve been there—we can help!”