Upward pressure is continuing in food industry M&A transactions, as demonstrated by some large public deals in 2014. However that has not fed through to smaller, non-public deals, which make up the bulk of M&A deals. Stefan Kirk draws attention to one potential driver of higher-equity values, and thus higher transaction volume, in so-called main-street M&A – changes in valuation methodology, forced over the line by long-term low interest rates.
Ten-year M&A cycle welling up for big capital…
Since the 1980s the global economy has been subject to decade-long cycles. From the Reagan/Thatcher de-regulation that led to over-heating in the late eighties; through the ‘goldilocks economy’ that ended with the bursting of the dot.com bubble in the late nineties; to the horrors of the financial system’s crisis in the late 2000s.
There is little doubt in 2014 we are at the beginning of the next boom, as reflected in M&A valuations in the food industry, at least in the world of large transactions involving public companies.
Look no further than the 27x EBITDA paid by General Mills for Annie’s in September, or the 3.5x sales paid by Mizkan for Unilever’s Ragu and Bertolli brands in May, or the 30x EBITDA Hain Celestial is said to have paid for the Tilda rice business in January.
…but main-street deals lagging behind
At the same time, valuations of deals involving small and mid-sized companies, especially in the world of non-public equity, continue to be in the range of mid- single-digits to low- double-digits in terms of EBITDA multiples. Maybe that won’t change much from an enterprise value perspective.
However, we predict a highly-warranted change in valuation methodology would allow more main-street deals to happen, by increasing the proportion of equity value within enterprise value. Put simply, more owners would agree to sell because they would pocket more money out of the deal.
By necessity we go technical at this point. In order to get more owners of main-street businesses to sell, we must challenge the valuation convention which says that short-term debt should be subtracted from enterprise value, to arrive at equity value.
Challenge to conventional valuation method
The convention says a company’s enterprise value should be calculated by multiplying its EBITDA by a factor which reflects its sector, size, growth rate and other value -drivers. So for example, a small distributor of third-party spirits is only worth 5x EBITDA, whereas a large producer of branded functional foods might be worth 12x EBITDA.
We do not have any problem with that. What we do challenge, however, is the convention also says ‘net debt’ should be removed from enterprise value, in order to arrive at the equity value which is payable to the sellers of a business. We say: long-term debt yes, but short-term debt no.
As M&A practitioners, Glenboden sees too many transactions fail to happen, because the target business has a level of short-term debt which, after being subtracted from enterprise value, leaves too little value for the owner. We believe a justified change in conventional valuation methodology would allow those rightful deals to close.
No valuation method is set in stone
Any valuation methodology is questionable. You only have to participate in an arbitration process, where the buyer and seller are in dispute over a gone-wrong acquisition, as Glenboden has done as an official expert, to know valuation methodology is not at all set in stone from a tribunal’s perspective.
What we might call the ‘net debt convention’, within the EBITDA consensus, says all financial debt, net of cash and equivalents, should be subtracted from enterprise value in order to arrive at equity value. We believe that convention to be wrong, with respect to short-term financial debt, on two counts – one of principle and the other of environment.
On a count of principle, short-term debt exists to finance a company’s working capital, and as such is part of its operations and not its capitalisation. With regard to the environment, we are living in a world of permanently low interest rates, so the risk factor of holding debt is much lower for a company.
Short-term debt is not capital…
When Glenboden started working in M&A in the early nineties, ‘net debt’ wasn’t part of the valuation consensus anyway. Back then, only long-term debt – i.e. that which sits alongside equity to constitute a company’s capitalisation – was subtracted from enterprise value to arrive at equity value.
The rationale is simple and robust. Short-term debt is part of the operations of a business; it utilises short-term debt in the same way as it does trade payables – positions that feed its working capital, the cost of which should be treated as costs of generating EBITDA.
So yes, EBITDA should be reduced by the cost of short-term debt but, after the multiple is applied, the seller still gets a better equity value than if they had included short-term debt in net debt – especially in deals valued at a low EBITDA multiple, and especially when interest rates are low.
…and cost of debt at long-term bottom
We are living in a world of long-term low interest rates, with no sign of that changing. The financial crisis in 2008 did not lead to higher interest rates. In fact base interest rates for example in the eurozone have been significantly below 5% for over a decade – the statistical definition of long-term.
This interest rate reality should be reflected in valuation methodology in M&A transactions. Buyers might argue that okay, short-term debt might be a cost of operations, but it is also secured by the company’s assets so must be treated as a lump to be removed in valuation.
But sorry, with permanently low interest rates, the cost of debt is not a risk to the seller’s business. It’s not going to spike up and eat all of the company’s profitability and liquidity. So, risk -based arguments for the inclusion of short-term debt in net debt are no longer valid.
To support this argument with real-world experience is an M&A deal in the food and beverage distribution industry Glenboden worked on this year. A company with EBITDA growth, supported by short-term debt finance (STD) whose cost grows less than the EBITDA. There’s a willing buyer and seller, an obvious consolidation play, but a question mark over valuation.
Valuing the business in two scenarios
Net debt convention: 4 mln EBITDA x5 = 20 mln minus 13 mln STD = 7 mln equity value
After STD cost: 3 mln EBITDA x5 = 15 minus 0 mln STD = 15 mln equity value
Why sell the business for 7 mln equity value, which would give the buyer a three-year payback even before the upside of growth and synergies? That’s an egregiously bad deal for the seller – the deal didn’t happen, but could have happened had STD been treated as we argue it should be.
So what of food industry M&A in 2015?
There will undoubtedly be M&A hot-spots, in terms of large public deals with high valuations, in 2015. One can predict for example the following: a Danone acquisition of Mead Johnson; Unilever selling its spreads business to a BRIC champion; or Sainsbury’s or a lame-duck Tesco to be acquired by sovereign wealth-fund money.
Deals like those will happen in the >25x EBITDA stratosphere. But what about the myriad of main-street M&A deals that could and should happen, to the greater economic good of consolidation and efficiencies? Glenboden’s distribution company client is an example we’re sure occurs around the world.
Our proposed answer is to subtract short-term debt from net debt, in order to increase equity value within enterprise value, and thus encourage sellers to sell. For reasons that have always existed, but are now reinforced by the permanent low-interest rate environment that we live in.
Towards that, we take heart from another deal in Glenboden’s M&A practice this year, where the buyer agreed to subtract factoring – a form of short-term debt – from net debt, exactly for the reasons that we argue for.
We hope that’s a thin end of the wedge towards the broad, sunlit uplands of greater main-street M&A activity and the greater economic good of consolidation, efficiencies and an end to beggar-thy-neighbour price competition in the food industry around the world.