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Sea Change: Beauty’s Historic Opportunity

By: Andrew M. Apfelberg
Posted: November 9, 2009, from the November 2009 issue of GCI Magazine.

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Beginning around the fall of 2008, it became much more difficult to obtain financing, and the yields required by the lenders who would extend credit forced the institutional investors to use more of their own cash. At the same time, the partners of the private equity firms were getting nervous about the economy and their own portfolios, so they were more reticent with the money they were willing to throw at a deal.

The fall of 2009 is seeing the EBITDA multiple in the beauty industry range between five and six. To put that into perspective, the same $10 million EBITDA company that sold two years ago for $100 million will today, using a 5.5 multiple, cost only $55 million. This is much more in line with historic multiples over the past 25 years, and a return to fundamental principles of valuation. In fact, it is almost 10% lower than the industry multiple in 1993. This cost savings puts many more target companies squarely in the sights of buyers who could not have purchased the same company when it was overvalued a short time ago. The cost savings can also be used for capital expenditures, hiring top quality human capital or an extensive marketing campaign. In an industry where building and maintaining brand and securing prime location at retail is paramount, this extra cash can make all of the difference.

Because of the favorable financing that was available, during the past few years there were many more buyers than sellers. This meant that it became a sellers’ market. Sellers were demanding substantially all of the consideration in cash at the closing and looking less favorably on other forms of consideration or delayed payouts. If money was to be paid after the closing, it was often a short-term holdback (i.e., money put in escrow at the closing solely to fund indemnity obligations). Many potential buyers could not compete in this environment because they needed, or felt it more prudent, to pay for the target company over time.

Then the recession hit. The institutional investors headed for the hills. Many of the strategic investors did too. That has left many more sellers than buyers and deal flow has dropped. According to the Houlihan Lokey Howard & Zukin study, there were 270 announced mergers and acquisitions transactions in the consumer products industry (which includes beauty) in 2007 but less than 100 announced year-to-date in 2009. As you might expect, it is now a buyers’ market. Almost all of the deals getting done now have a significant portion of the purchase price paid after the closing. Often this is coming in the form of promissory notes and earn-outs (i.e., the seller is entitled to receive $X per year for a couple years if the net income of the target company is greater than $Y for each of those years). Because notes and earn-outs are completely dependent upon the actual performance of the target company after the closing in order to get paid, they are much less of a safe bet.

One recent transaction I worked on was structured as one third cash at closing, one third promissory note and one third earn-out. Applied to the same $10 million EBITDA company example from above, with a 2009 multiple of 5.7 and valuation of $57 million, the buyer only needs to put up $18.8 million at the closing. The rest gets paid out of cash flow if, and only if, the target company succeeds during the earn-out period or term of the note. This forces the seller to share in the risk and gives the buyer the power to self-finance (in the case of an earn-out) or seller-finance (in the case of a note) the deal. While the structure of the transaction mentioned above is at an extreme, it is safe to say that most buyers in the next few months will not need to put up more than 50% of the total consideration at the closing.

On the Selling Side