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- The decline in earnings before interest, taxes, depreciation and amortization translate to cost savings on acquisitions and puts more target companies squarely in the sights of buyers.
- Current cost savings can be used for capital expenditures, hiring human capital or an extensive marketing campaign.
- The speed with which revenue, market share and brand/reputation can grow through an acquisition is significantly greater than through an internal growth strategy.
- While the economy emerges from the recession, brands can enhance and solidify relationships with the retailers whose limited shelf space is at a premium.
The next quarter or two are one of the few times that true fortunes will be made or lost. This period of emergence from a recession is presenting a historic opportunity for mergers and acquisitions in the beauty industry. Those who fight against the tendency to hibernate until sunnier skies appear will find that the wind is actually at their backs and, correctly harnessed, will accelerate them out of the current downturn and into the most plentiful waters they may ever see.
The coming months are a perfect storm of: (i) valuations coming back down to Earth, (ii) deal structures becoming buyer-friendly, (iii) a significant number of owners needing or wanting to sell, (iv) fewer buyers in the market and (v) financing starting to be available again.
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When I graduated business school in 1993, beauty companies were typically getting bought for approximately six times their earnings before interest, taxes, depreciation and amortization (EBITDA). During 2007, the median EBITDA multiple for the industry swelled to around 10. To put that into perspective, the same $10 million EBITDA company that sold for a 10 multiple instead of a six multiple cost the buyer an additional $40 million. This is an increase of more than 65% from the 1993 purchase price.
The jump in EBITDA multiples being paid was not due to the target companies becoming more attractive. Instead, it was largely a result of the overwhelming amount of money that institutional buyers (i.e., private equity firms) were willing to spend in order to beat out their competitors and the ease with which multiple layers of financing could be obtained to lever up the target company. The activity of strategic buyers (i.e., existing companies in the industry) has remained more or less constant. The addition of the institutional investors was what changed the game.
Willing to Deal
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
Despite it being a buyers’ market, there is no lack of eager, or at least willing, sellers. Some business owners do not have the stomach for the current climate of uncertainty. Others are at or approaching an age of retirement and do not have a likely successor in place or in the horizon. In either case, these business owners have been eagerly waiting for the climate to change. Many have tried to hold out as long as they could, hoping that the change would have come by now. For the most part, it hasn’t yet arrived (though it does appear to be on the way).
The end of 2009 looms, and waiting is no longer an option for many. For others, it is a health condition that adds urgency. Still another group worries whether capital gains tax rates will be raised. Some are doing fine but know that they have taken the business as far as they are able and that it requires the skills or resources of another to take it to the “next level.” Others are fatigued from battling the economic climate these past 12 months, and others remain skeptical about a quick end to the recession. Yet another group is struggling and needs new management, a capital infusion or extreme cost savings to survive.
Regardless of the motive, the effect is the same—even though business owners would prefer to wait until valuations and deal structures were better (not to mention the financing markets), they are realizing that delay is no longer an option and that stagnation could result in death.
Even with more favorable valuations and deal structures coupled with reduced competition for each deal, many buyers still need some form of financing in order to have the resources to do the deal. For most of 2009, lenders were not interested in putting out new money—or when they were, it was at unaffordable rates. Many shied away from providing financing toward the beauty industry due to concerns over whether reductions in consumers’ disposable income would hit it disproportionately. Others expressed a concern about the ability to liquidate foreclosed upon collateral that was a branded product for fear that purchasers would be unwilling to pay anything close to standard prices for the product at that point.
In the third quarter of 2009, that seems to have been changing. While far from the free- flowing leverage of two years ago, senior and mezzanine lenders are getting involved in new deals. It takes a while to get through the credit committee, and the standards are higher. The diligence process is more intense and personal guaranties are the norm. However, these are not necessarily bad things. A second set of eyes reviewing the financials and operations of the target company never hurts. The moments of pause that come with the consideration of a personal guaranty are excellent moments of reflection/consideration and gut-checks for the buyer.
CEOs can use this confluence of factors to their benefit by acquiring those competitors (in a horizontal strategy) or suppliers and vendors (in a vertical strategy) that fit well into their company’s business model. It is often cheaper to “buy” than it is to “build,” and this is especially true right now. The speed with which revenue, market share, barriers to competition and brand/reputation can grow through an acquisition strategy is significantly greater than through an internal growth strategy.
Profitability can almost always be enhanced because an acquisition forces the buyer to assess its own operations for inefficiencies and redundancies.
While competitors are hunkered down and focused on simply weathering the storm until it is clear that the recession is over, take advantage by intelligently making the bold moves required to grow your company beyond the point at which the same competitors can pose a meaningful threat. While the economy emerges from the recession, you can corner the market on the best suppliers and vendors, and enhance and solidify your relationship with the retailers whose limited shelf space is at a premium. Just because waters are choppy does not mean that they cannot be navigated. In fact, those with the vision and steady hand at the tiller to keep moving forward instead of dropping anchor will find themselves in favorable waters much more quickly. They will likely also find themselves so far out ahead of their competition, that the laggards will never catch up.
Andrew M. Apfelberg is a corporate transactional attorney for privately held middle-market companies and specializes in working with the beauty industry. He is a partner of Rutter Hobbs & Davidoff Incorporated, a full-service law firm in Los Angeles and can be reached at 1-310-789-1824.