Decisions made at the Federal Reserve can profoundly affect the equity of your business. If you are considering a loan to purchase a company or property, or to refinance your existing business, be sure you understand how the debt to equity mix affects your company’s return on equity.
When the Federal Reserve determines that money should be cheap and plentiful it lowers interest rates and increases the money supply, which has an enormous effect on the value of companies that are coveted acquisition targets. This action by the Fed encourages intense competition for good acquisitions and makes it possible for buyers to structure deals based on higher multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) than otherwise would have been possible.
Private equity firms have a lot of capital that needs to be invested, and they prefer making highly leveraged transactions to maximize return on investment in the shortest time possible. The ability to do this depends on the availability of cheap debt, especially senior debt (which is most appealing at a lower interest rate since it gets paid off first in the event of a liquidation).
Prior to the financial crisis, Fed policy made senior debt widely available and inexpensive. Banks were keen to lend 5x+ of EBITDA as part of a private equity deal. The senior debt could be combined with junior debt so that 80% of a deal’s financing would come from debt. This led to a temporary madness in hot industries, driving multiples of EBITDA to near double-digits.”
When the financial crisis unfolded, the risk of deals became an acute consideration. Although the Fed kept interest rates low and the money spigot open, banks became much more cautious. In leveraged deals they now put up, say 2x of EBITDA, instead of 5x+, and cap the total amount of debt allowed. Recently banks have eased up a bit but remain very, very cautious. This amounts to the “old” norm and cannot be considered an aberration. It is unlikely we will see monster multiples again.
So what does this mean if you are acquisition-minded? When leverage decreases, more equity is required to do a deal. When you buy a company using 80% debt the value of your equity investment increases much faster than it does when you use mainly equity. Assume you are acquiring a business for $5 million using 80% debt, or $4 million in debt and $1 million of equity. The value of your equity will increase about 8.5x when the business doubles in size (assuming the multiple does not change). In comparison, if you used 100% equity your equity value would only increase about 2.5x when sales doubled.
|Gross Margin (50%)
|Increase in Value
|Increase in equity value
|Growth in equity
CFO-Pro can help you create the best leverage mix for your business acquisitions.
The Wisdom of Henry Hazlitt (1894 – 1993)
In the history of mankind the essence of economic progress has consisted of getting more production with the same amount of labor. This is the reason that humans began putting burdens on the backs of animals instead of on their own backs, and the reason that thousands of labor-saving devices have, and continue to be, developed.
Translated into national terms, this principle means that our real objective is to maximize production. In doing this, full employment becomes a necessary by-product, although production is the end and employment merely the means. We cannot continuously have the fullest production without full employment but we can very easily have full employment without full production. Nothing is easier to achieve than full employment once it is divorced from the goal of full production. Hitler provided full employment with a huge armament program. Prisons and chain gangs have full employment.
Our legislators do not present Full Production bills in Congress, but Full Employment bills. Wages and employment are discussed as if they had no relation to productivity and output. The conclusion is drawn that a 30-hour week will provide more jobs and will therefore be preferable to a 40-hour week. A hundred confusing make-work practices of labor unions are tolerated.
It would be far better to have maximum production with part of the population supported in idleness by undisguised relief than to provide “full employment” by so many forms of disguised make-work that production is disorganized. The progress of civilization has meant the reduction of employment, not its increase. We have been able to virtually eliminate child labor (in the US), and to remove the necessity of work for many of the aged.
We can clarify our thinking if we put our chief emphasis where it belongs — on policies that will maximize production.
— Paraphrased From Economics in One Lesson (1946