M&A Insights

Much Bigger Factors to Affect M&A than Trump vs. Biden

Many people, including M&A peers of mine are sending around analysis that suggests a heavy tax bill for sellers under a Biden administration, that looks something like the following:

While this analysis suggests an initial sticker shock when comparing the potential before and after (potentially 2x cap gains tax and needing 33% higher valuation to achieve the same after tax proceeds), a few things to consider:

  • While Biden states his plan is to raise capital gains tax rates to a max of 39% for those with earnings >$1mm, I question the reality of these levels as the rate has NEVER been this high over the last 100 years as seen below, especially considering he’s more of a centrist than radical left type like a Bernie

  • Further, as it relates to strategic planning, such as the most optimal time to sell your company to bypass this potential hike, please consider the most likely timing of the tax increase to take effect. If the bill passes in 2021, it will likely not be in effect until 2022. This timing/sequencing was similar to the Clinton, Bush and Trump administrations. This means you have all of 2021 to complete a sale of your business to realize the existing tax treatment
  • The worst case scenario is this tax hike would take effect the day the bill is passed, as early as Q1 2021, which suggests you want to sell before Biden takes office, which is challenging for those not already in a sale process. More practically and realistically plan for a sale in advance of Q2 2021

Much Bigger Factors than Biden Tax Hike

  • While clearly no one is excited about the possibility of paying 2x the cap gains taxes on a sale, the more important factors to consider and hope for, are as follows:
    • Continued macro/micro-economic rebound, including more stimulus in the near term
    • Continued record breaking capital raising of private equity funds, which sustains if not increases the investment/acquisition activity, driving demand, and thus increasing valuations
      • ~$1.5 trillion of dry powder that these funds need to deploy in a finite period of time
    • 2020 M&A activity lull to create pent up demand into Q4 2020 and 2021, correlated to Covid-19 getting fully under control
    • Low interest rate environment and lending for acquisitions to continue to loosen inline with the economic recovery. Expect to see a full rebound to pre-Covid-19 levels
    • Public market valuations continue to break records, trickling down the private markets
      • Public SaaS companies are trading at ~20x+ ARR (annual recurring revenue), with the outliers (Zoom & Snowflake) at 50-100x
      • Private market investors and acquirers understand they can comfortably pay 10x+ for a private SaaS provider (that’s of scale with strong financial performance) knowing the strong potential for a value pop in the public markets, or the ability to sell to a larger private equity acquirer or strategic, where such buyer can then take the company public to receive their pop

Takeaways

  • The Biden proposed maximum capital gains tax increase is concerning, yet should not be the end all be all as a key driver while strategic planning
  • We feel it’s unlikely that this level of tax will be instated, as the highest its ever been in the last 100 years was 35%, especially considering Biden is more left center than extreme left (and would require a blue wave)
  • The more impactful drivers to sustain the level of M&A and financing activity as well as valuation froth is tied to the record levels of private equity and VC capital raised, the $1.5 trillion of dry powder needing to be deployed within a finite period of time, and the pent up demand for activity once Covid-19 subsides
  • Further banks are continuing to lend, in a low interest rate environment. The loosening of the leverage multiples enables acquisitions and valuations. The more leverage and the lower the cost (rate), the higher the valuation a buyer can afford
  • Business owners seeking to exit in 2021, should begin to prepare, and lay the groundwork for a sale next year

For those seeking to exit in the coming years, with a sale-ready business (based on size of revenue, profitability and growth), we are entering a unique and arguably unprecedented time-frame to realize a favorable valuation, while taking advantage of existing low capital gains tax rates. We are happy to learn more about your opportunity and provide candid feedback, as well as strategic insights. Feel free to reach out to us to discuss.

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Debt, Equity or Both: Financing Add-on Acquisitions

Debt, Equity or Both: Financing Add-on Acquisitions

In the roll up example below, the acquirer would be seeking $11.2mm of capital to finance two acquisitions, which grows EBITDA from $2mm to $5.25mm. Based on the below scenario, we explore different financing options, to enable the most value creation.

  • Debt (Mezzanine) – also known as 2nd lien, sub-debt, uni-tranche, mezz, is the debt that is raised when you can’t raise cheaper senior debt, which is usually limited with asset-light cash flow-based businesses. The cost, or the interest rate of 12% seems steep, yet when equity value is likely to grow quite dramatically over time, the 12% becomes a drop in the bucket compared to equity dilution. The other benefit is debt is a lot more systematic, as the lenders are seeking their principal and interest to realize their return profile, so as long as they’re comfortable with the cash flow coverage, such as a modest Debt/EBITDA ratio, they will be comfortable to lend (usually lenders want to be <3x this ratio). Further, while the cash pay interest is pricey, mezz lenders usually defer principal payments to support cash flow of high growth companies. Its quite common to see an interest-only loan, with a bullet amortization payment as the end of a 5 year term.
  • Growth Equity – or equity financing is a different animal as you’re bringing on a partner to support the execution of the growth plans. This investor joins the board (or creates one if one doesn’t exist), and is active from a strategic perspective, relating to finance, accounting, M&A, and in some cases supporting operational improvements. This is the costliest capital by far, as firms are seeking to generate 3x their money in 3-5 years. While on the surface this appears much less appealing than debt, equity firms do offer positive attributes and are more suitable to certain profiles of companies. This includes breakeven or money-losing companies who may be in hyper-growth mode, as growth equity does not have cash-pay interest. Also, a growth equity partner can institutionalize the company, with proper governance, controls, reporting, a board of directors, financial audits, guidance and support on acquisitions, and ultimately helping maximize value in an exit, 3-5 years later. Lenders offer some of this but much less. Also, given how much capital is in the market today, and for those growing fast while being very profitable, growth equity firms can offer shareholder liquidity as part of the investment, in addition to the growth capital.
  • Hybrid – in a scenario where the amount of capital required is above and beyond what a debt provider can provide, the company can explore raising both, debt and equity. This is a common dynamic in today’s financing environment, and a strong preference for many mezz lenders, as it gives them significant comfort knowing there’s a private equity partner for the company and borrower, so if things go sideways, the equity firm can bail the company out. There are however a subset of mezz lenders who do not require an equity sponsor.

In conclusion, when seeking to finance add-on acquisitions, using debt and limiting equity dilution can create the most value long term. However an equity partner can add intangible value despite its cost. Often companies will require and be able to raise both types of financing to execute on highly synergistic acquisitions.

 

Please note, the strategy, as depicted above only applies to stand-alone acquirers with ~$2mm+ in EBITDA for service companies, or $5mm+ in ARR for SaaS companies, with >10% growth. If you have an interest in an add-on acquisition or roll-up strategy, have a target or two in mind, and would like to discuss the particulars, please contact us to set up a time to discuss.

 

Harbor Ridge Capital has deep add-on acquisition and financing experience over the last 15 years, across direct private equity investing, investment banking and C-level management. Notable add-on acquisition transactions include a technology service business that grew from $25mm to $250mm in revenue by way of 7 acquisitions and organic growth, and an ad-tech business that was $3mm in EBITDA which acquired its much larger competitor doing $20mm in EBITDA.

Understanding Value Arbitrage from Tuck-In Acquisitions

Understanding Value Arbitrage from Tuck-In Acquisitions

While private equity and strategic acquirers are fully aware of the immediate value creation and arbitrage from add-on acquisitions, which Harbor Ridge Capital frequently sells companies to such parties, I repeatedly have discussions with founders that are interested in being the acquirer, where they can capture such value arbitrage themselves, yet seek support across the board to execute on such an initiative, especially with first-time acquirers.

Where the discussion gets especially intriguing from my perspective, is an M&A opportunity born out of a CEO having a relationship with a peer CEO in an overlapping or complementary business, who perhaps they have known and respected for years, and understand their business to a certain degree given the overlap. This existing relationship, the deep understanding of the space, offering and operations, coupled with strong financial performance, significantly de-risks the opportunity. To put it in perspective, private equity firms acquire businesses every day, which in most cases they did not even know the company’s name or industry three months prior to the acquisition. They expect to make between 2-4x their money on every deal, and 80-90% of the time this is the case.

This is why we call such acquirers “strategic”, as there’s inherent synergies across the board in addition to the financial aspect of the deal. Harbor Ridge Capital advises companies pursuing add-on acquisitions, where the entrepreneur can capture the vast majority of the upside, while often maintaining control. The buy-side advisory services include deal structuring, financing, and post-deal integration. Further, we seek to participate with our clients in the equity, to align interests and being bullish on the future upside potential. Below is a buy-side acquisition template we use for clients pursuing add-on acquisitions, to map out long term objectives and to assess feasibility.

As you can see, if executed properly, this can yield significant value creation for the equity, within a much shorter time frame. There’s quite a bit of variability with the inputs in this model, except what’s generally consistent across different business types, whether its software or service, is the multiple arbitrage that comes with size, which you can see from the Stand-Alone Acquirer Multiple to the Pro-Forma Combined. Once integrated, and if you apply some modest growth over a three-year period, the multiple is likely to increase even further.

The natural follow-up question to the above model, is how to best get this strategy financed, with the cheapest, most flexible type of capital. Please stay tuned for Part 2 of this series, which I will share the specifics of various acquisition financing options, cost of capital, and the different attributes of each.

If you have an interest in an add-on acquisition or roll-up strategy, have a target or two in mind, and would like to discuss the particulars, please email cmaghami@harborridgecap.com to set up a time to discuss. Please note, the strategy, as depicted above only applies to stand-alone acquirers with ~$2mm+ in EBITDA for service companies, or $5mm+ in ARR for SaaS companies.

Harbor Ridge Capital has deep add-on acquisition and financing experience over the last 15 years, across direct private equity investing, investment banking and C-level management. Notable add-on acquisition transactions include a technology service business that grew from $25mm to $250mm in revenue by way of 7 acquisitions and organic growth, and an ad-tech business that was $3mm in EBITDA which acquired its much larger competitor doing $20mm in EBITDA.

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