Is it too late to buy a business?
September 10, 2021 | Issue #40
Big Deal Small Business: Is it too late to buy a business?
September 10, 2021 | Issue #40
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I’m seeing more & more anxiety about searchers’ ability to get a deal done as multiples continue to rise.
Despite the looming threat of capital gains tax increasing, it still feels like a seller’s market. As companies exit the COVID period and start showing real recoveries (not just projected recoveries), their negotiating position will continue to strengthen.
So, is it too late to buy a business? Should we take a pause, wait for the next economic cycle, and then start over?
Be Fearful When Others are Greedy
An oft-quoted Warren Buffet line is “be fearful when others are greedy, and greedy when others are fearful.”
Usually, people are focused on the “greedy when others are fearful” part as it’s a reminder to get aggressive at the right moments (like April 2020).
In today’s market, we’re clearly on the other end of that phrase.
That said, I don’t read “fearful” as “don’t transact” by any means. I read “fearful” as doing your due diligence properly, reducing leverage, and buying high quality assets.
Do Your Due Diligence
In institutional PE, I’ve noticed that processes have gotten faster — the sellers & bankers can push their auction processes harder given they know there’s demand.
What once may have been 3 weeks of exclusivity for confirmatory due diligence is now 2 weeks. What once may have been a 6-week Phase 1 may now be 4 weeks.
In SMB world, this manifests itself with businesses going under LOI only days after the business goes to market. To be frank, I’m not sure why brokers even allow that — a longer marketing period (at least 2-3 weeks) would be drive a better price for their clients.
When that happens, I just take a deep breath and move on. One of two things happened:
Someone knows the space far better than me. They knew exactly what questions to ask to form a view — I was never going to win against them anyway
Someone got greedy and didn’t do their work — I’m okay losing to them
As a result, I’m a strong advocate for taking the time to do your work early on.
Reducing Leverage
A benefit of red hot capital markets is that equity is as cheap as it’ll get. Debt is also as cheap as it gets, but debt will strangle you if the cycle turns.
As a result, I am more & more focused on lowering debt reliance and increasing equity buffer. I’ve written about how purchase price multiple (and therefore quantum of debt) is the ultimate downside protection.
But if I can contradict myself a bit from that post, quantum of debt is not 100% driven by purchase price. It’s driven by your choice to under or over-equitize your balance sheet.
So the slight adjustment I’ll make to that point is IF you are paying a higher price, you should be limiting your debt raise and over-equitizing.
The increase in market multiples lowers your unlevered yield & overall downside protection already — compounding that with increased debt could be a recipe for disaster.
Buying High Quality Assets
Going to contradict (or qualify) my previous post again — purchase price is your ultimate downside protection, but not if you achieve it by buying a low quality asset.
Many searchers look at this way:
Buy business A at 3x with 2.7x leverage
Buy business B at 5x with 4.5x leverage
In reality, you may actually be comparing low & high quality assets. Instead, I’d suggest looking at it as follows:
Buy a low quality business at 3x with 2.7x leverage
Buy a high quality business at 5x with 3.0x leverage
Yes, you have to raise way more equity. Yes, your base case returns will be way lower.
BUT, your downside case will be far less likely to be bankruptcy.
The low quality business is a race against the clock — can you generate enough cash to pay down debt before the music stops and the economy cools off?
The high quality business is the long-term approach — can you weather a storm and come out of it on the front foot, ready to grow & acquire competitors that were over-levered?
Conclusion
The answer to my original question is No. It’s not too late to buy a business.
That said, equity return expectations should be lower in the near-term. Get comfortable with that; otherwise, you risk to over-levering a bad business and throwing an unintended hail mary.
There are two factors at play here:
Forward equity returns will be lower because multiples are higher
I will further reduce equity returns by focusing on higher quality assets and lower leverage levels
The first is just an unfortunate reality, but not one that makes transacting untenable.
The second is a conscious choice to trade risk for return and move up the quality curve as is prudent at this phase of the economic cycle.
I’d welcome your thoughts on this post, particularly disagreement & feedback. Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, ideally located in the Northeast, West Coast, or Colorado).