The most basic definition of inflation is “too many dollars chasing too few goods.” As witnessed through many cycles, inflation has a tendency to hide in—and rotate among—various sectors, whether it is oil prices, wages or real estate. At this time, we believe too many dollars are chasing “private equity” investments, especially in the case of leveraged investors buying control of entire companies. We applaud entrepreneurs who are taking advantage of this effervescence by selling their companies at a premium but urge care as they reinvest proceeds to preserve and grow those precious assets into the future.
The historic up-and-down cycles in private equity valuations have affected Hamilton Point on many fronts –including the fact that many of our largest individual clients have sold their companies for high valuations during the last 30 years and now look to our methodical investment approach to provide financial sustenance and growth. Our objective is to see that those who sell their companies avoid investing after-tax proceeds in securities at even higher relative valuations—thus suffering from a “sell high, buy higher” syndrome.
A Wise Parent Knows Their Own Child
Before elaborating further, please allow some background regarding the market for companies targeted for a LBO, or leveraged buyout. LBOs took off in the 1970-80s, picking up on a growing trend of MBOs, which stood for “management buyout.” Classically, a family-owned business leader determined, often with much consternation, that their offspring were uninterested and/or incapable of running the company and therefore an outright sale would maximize value for all family members. As former investment bankers, and now wealth advisors, both of your writers have walked through this process with many owners of private companies and attest to how difficult these decisions can be.
Rather than merge with a competitor, many family owners preferred to sell the business to their current management team who, in most cases, lacked the financial wherewithal to make a bonafide offer. Investment bankers would be engaged to help the company’s future managers raise the funds (equity and debt) to complete a natural transition in ownership. In many cases the selling family would reinvest some proceeds in the new company and often made more money on that sliver of ownership than on the first transaction.
To Tax, or Not to Tax
Historic tax policy was a big factor for early MBO and LBO transactions—and in the 1970s and early 1980s the IRS provided a tailwind. In those years, many private companies piled up large excess cash balances on their balance sheets rather than pay bonuses or dividends which could be taxed at federal rates approaching 70%.1 The IRS was not keen on this tax-deferring tactic and threatened to tax excess corporate cash even if it was not distributed. As a reminder, this cash was already taxed at the corporate level but was escaping double taxation, while awaiting distribution.
Of great importance back then, if, instead of distributing the cash, the family sold the entire company (with commensurate value received for the cash), the entire transaction was treated as a “capital gain” and therefore taxed at much lower rates (generally 20-40%).1 Moreover, fully depreciated assets could be newly appraised and “written up” by the new buyer without tax recapture consequence, thus sheltering even more profits going forward. All other things being equal, private companies were sometimes worth more if sold than if the family held on.
Coupling yesteryear’s tax policy with the fact that high interest rates necessitated fairly low buyout multiples in that period—three times operating cash flow2 was a common enterprise valuation—created lucrative opportunities for investors. They bought at low valuations, sheltered income, paid down debt and then “flipped” the company to the public market (IPO) or to a strategic buyer (i.e. a larger, public company). High annualized returns of 30-40% by LBO investors in those days were not surprising since buyers were “shooting fish in a barrel,” owning wonderful companies for low multiples of earnings.
All That Glitters Is Not Gold
These exceptional historic LBO investor returns drew attention from substantial institutional investors and banks. Accelerant was added to the financial fire as investors poured money into new private equity funds, banks agreed (pun intended) to loan more money with looser terms and Congress reduced dividend and capital gains tax rates. Meanwhile the multiples of operating cash flow paid for companies increased from ~3x in the 1970s to 9.0x in 2006—falling to just 5.6x cash flow after the recession in 2009. Currently, the average multiple is a healthy 10.7x,3 perhaps indicating that now is as good a time to sell as ever.
With around one trillion dollars of uncommitted private capital chasing deals in the U.S. at this time3, we believe power has shifted to the sellers of businesses—who can demand high prices—and away from most institutional investors who, being more bureaucrats than capitalists, think they must invest in the private equity category even though the upside has been mathematically minimized on a risk-adjusted basis, especially given the illiquidity. Naturally, competition from private equity has forced strategic buyers to pay high valuations for companies too, again benefiting sellers.
Incidentally, the fundraising by private investment firms and their thirst for deals creates a nice “backstop” for public market investors since, theoretically, a public company will not remain undervalued but so long before a buyout group steps in to shake things up. In recent years, Hamilton Point portfolios have benefitted from a number of such takeovers.
What’s Done Cannot Be Undone
As with most market phenomenon, private equity valuations and returns are cyclical and tend to correlate highly with public company values. Therefore, it follows that when it is a good time from a valuation standpoint to sell your company it may be a bad time to reinvest too much of the after-tax proceeds into public equity markets right away.
In one final nod to Shakespeare, he wrote, “Money is a good soldier, and will on.” Put into more modern, if less elegant language, we have a quiet slogan at Hamilton Point that we are here to “keep wealthy people wealthy.” Paying attention to swings in valuation among all sectors, even in private capital markets, is one way we attempt to accomplish that for clients.
1) Tax Policy Center. (2017). “Historical Highest Marginal Income Tax Rates” and “Historical Capital Gains and Taxes.” Retrieved from: www.taxpolicycenter.org/statistics/
2) Operating Cash Flow is often defined as “EBITDA” or Earnings Before Interest, Taxes, Depreciation & Amortization.
3) McKinsey & Company. McKinsey Global Private Markets Review 2018: “The Rise and Rise of Private Markets.”