Learning from the private equity acquisition of Selle Royal Group
The bicycle industry has benefited from record business volumes in the last two years despite bottlenecks in manufacturing and logistics forcing performances to taper a bit. Dynamics related to the COVID-19 and the rise of products like e-bikes, have allowed many players involved in the manufacturing and sale of bicycles and components to experience record sales and strong year-over-year growth. The trend does not seem to be slowing down, companies are still forecasting similar sales upticks for the next few years. When similar trends occur and the market is served mainly by relatively small and medium companies, indications of interest to invest from private-equity firms are likely to be sent to the current owners. That is what happened in 2021 to Selle Royal Group, a group owning major brands focused on bicycle saddles and shoes - racing brand Fizik, more classic brand Brooks, etc. The investment we are discussing originates from an Italian private equity firm that had previously invested in a leader when it comes to bike tires, Vittoria. The deal on Selle Royal Group closed for the purchasing of a 33% stake. This article wants to extrapolate three main corporate-finance concepts from the deal because believed to represent fundamental tools to effectively evaluate and negotiate an investment. We will see that, while many are probably correct in discussing the importance of the entry point of an investment, a good approach to identify that entry price is to start from the exit, the sale price.
Please note: we will not be implying any judgment on the specific deal. We are confident everything went well and everybody was satisfied. Moreover, we do not know the details, therefore, we cannot and we do not want to provide specific comments. We just want to use a real example to provide effective tools or different views.
Moreover, the reader should not give too much importance to remembering numbers and details because they will be summarized in a final table clearly showing the dynamics of the deal and our highlights. We may want to focus on the strategic discussion.
Let us start with the overarching objective of an investor, which is not always the same. We must be specific, and in the case of our private equity firm, it usually consist in closing deals returning about x3 or x5 times the acquisition price in 2 or 5 years. The reader could easily verify through the compounding math (1 + return) ^ (# of years) that those numbers imply a required return on the investment of about 25-35% per year. While those returns may seem extremely good opportunities, readers should note that they also represent a high risk. In general, the riskier the investment, the higher the return required to it.
Having set the objective of our specific investor, we can check whether Selle Royal Group qualifies. We will use a few numbers publicly available on the deal, and other official numbers from Selle Royal Group and their financial reports (here). Since the deal is usually based on “adjusted numbers” derived from the official accounting ones, our figures will be as well slightly off the reported ones – we will try to directly build the strategic view an investor would focus on.
Let us quickly summarize the main numbers of Selle Royal Group and provide some critical assumptions on our calculation (no need to remember the specific numbers that will be repeated then below in a summarizing table):
2021 sales were about 200M EUR, and Adjusted EBITDA was about 37M EUR – we can consider here the EBITDA as a good estimate of earnings (profit) before interest, taxes, depreciation, and amortization; we will comment on that and the “adjusted” version of the EBITDA.
Key is the growth experienced by the group and leading to those 200M EUR in sales. From 2020 to 2021, sales grew more than 50% from about 130M EUR to 200M EUR.
We will assume the acquisitions price at about 7 times the EBITDA. The acquisition price would be the result of a more complex calculation, however, for sake of this article, we are summarizing that price in terms of how many times the profitability of the company, represented by the Adjusted EBITDA, must be multiplied to get to the valuation. That is similar to what the Price Over Earnings ratio (PE ratio) represents when discussing the stock price of public corporations (e.g. Apple trading at 25 times its earnings). In some way, they all represent the annual return the investor is getting from an investment paid say 10 times the profitability, therefore returning about 10% every year before taxes and reinvestment.
We will also assume the operating leverage - how costs are divided between variable and fixed ones - to arrive at the 37M EUR adjusted EBITDA from the 200M EUR in sales. From the financials of the company, we have an idea of the actual split of costs regarding the “standard” and reported EBITDA but, we need slightly different values for our “Adjusted” EBITDA. We will use a 37% variable margin and a 37M EUR fixed costs – derived from some industry experience and comparison with similar companies.
Important note on company and equity valuation
Even if we are trying to capture 80% of the solution in this article and we are summarizing a more complete valuation model with a value derived through a multiplier of the Adjusted EBITDA (as mentioned above), the very final value of the equity of the business would still require the subtraction of the outstanding debt. More precisely, we will need to subtract the net financial position (i.e. net debt), which is debt minus cash and other liquidity. Here is the possible calculation:
Equity Value = ( Adjusted EBITDA x EBITDA multiplier ) – Net Financial Position =
= ( Adjusted EBITDA x EBITDA multiplier ) – ( Outstanding Debt – Cash & Other Liquidity )
That is because any debt already on the balance sheet of the business, would either have to be repaid before the sale, decreasing the “wealth” of the company because of the use of cash on hands or new debt, or, it will have to be repaid by the new owner eventually. Therefore, the value of the equity of the business should be penalized by that amount. Conversely, cash & other liquidity already in possession of the company increase the overall value because representing wealth immediately available to offset part of the debt to be repaid. It is important to note that the cash and other liquidity to be included in this calculation should be only the portion over the amount needed for normal operations. This is not always done in practice, however, trying to be strategic, we should always estimate the portion over normal business needs, the only portion which we could use to offset existing debt without disrupting the normal course of business. The reader can think about the following: if we used all the cash on hand to offset the existing debt, we should then raise new debt to purchase inventory or pay salaries the next day …
1) First concept: understanding the EBITDA and its Adjusted version
The difference between an Adjusted EBITDA and a “more realistic” or marginal EBITDA could be summarized as being the aggregation of all the accidental expenses incurred during a given year by the business (e.g. specific litigation, specific investment to solve a manufacturing anomaly … ). Those expenses are usually added back to compute the “adjusted” value and avoid penalizing the financials of the business by outflows which should not repeat during a normal course of business. However, in general, we are personally wary of add-backs. A lot could be deemed accidental depending on how it is presented. We will keep this short and add the following.
The ultimate role of the “standard” EBITDA is to show the real profitability of a business before the needed yearly reinvestment (i.e. depreciation & amortization / CAPEX), before any tax payment, and before any interest payment. That is because we would like to present the profitability of the business before specific effects of managerial decisions like a particular capitalization requiring a precise interest plan. The “adjusted” EBITDA then adds back to the standard one other expenditures considered accidental. However, there could be the argument for the “adjustments” to be often “stretches” of the original concept – it may also depend on which side of the table the adjustments are calculated from. At least in our mind, we should always compute a “real” Adjusted EBITDA adding back only those few expenditures really exceptional and unlikely to repeat in the future. Conversely, for example, if the company spent in a given year $100k for a specific litigation unlikely to repeat in the future, but which also represents a common legal expense that the company would usually sustain every year towards lawyers, courts, or even just for having lawyers assist with corporate contracts, the profitability of the company should still be penalized by that and it should not be added back to the Adjusted EBITDA.
In the case of Selle Royal Group, from an EBITDA in 2021 of about $30-33M they seem to get to an adjusted value of $37M – official sources already referenced above. Those do not seem outrageous add-backs.
2) Second concept: understanding the dynamics of the EBITDA
Once we have a fair Adjusted EBITDA, it is time to assign it a multiplier to reach a final value of the company – again, this view is a summary of the valuation which should come out of a more complete model that a Discounted Cash Flow could represent. Anyway, let us assume that the industry is efficiently pricing that kind of company at about 7 times the Adjusted EBITDA. Meaning, even working on a complete and complex model, we would finally get a valuation rounding to about 7 times the Adjusted EBITDA.
To some, it may appear that a multiplier of 7 means we are requiring the investment to return about 14% annually (i.e. 1/7) which is below the usual 25-35% the private equity industry would command, which in turn lead to the mentioned value of x2 or x5 the acquisition price in 5 years. However, we should not be stuck on the current year with our view. The positive business trend is unlikely to suddenly terminate. In our case, we have briefly mentioned above that the bicycle industry is likely to experience continuous growth in the following years – that is what is suggested by the numbers of the market and the actual ones of the company summarized immediately below. Higher sales can have a compounding positive effect. First, higher revenues would increase the EBITDA, therefore the valuation of a company, simply because the entire P&L (profit & loss statement) would improve – same EBITDA margin applied to higher sales. Second, the EBITDA is likely to receive a further boost because of the operating leverage. Since it seems Selle Royal Group is already profitable, fixed costs are already covered, therefore, higher sales would only be subject to the ”operating tax” of the marginal costs. The EBITDA will then increase also as a percentage of sales. We can clarify this with the following table summarizing the numbers of 2021 and the ones the company is reporting for the current year, 2022 – we comment then below:
Among the values of the table above, we only have the actual numbers on the sales of 2021 (200M EUR) and the Adjusted EBITDA for the same year (37M EUR) which was obtained from public information on the deal. Also, as anticipated, we make assumptions on the variable margin and the fixed costs of 2021 because we want to obtain directly the 37M EUR in Adjusted EBITDA. From the corporate documents we can also perceive that, despite supply chain bottlenecks, the group is growing at about 18% this year, implying 2022 sales at about 236M EUR. Assuming the same variable margin of 2021 - though some economy of scale often arises within variable cost, contrary to the theory - and assuming an investment in fixed costs of about 13% to sustain that growth (e.g. hiring of salespeople, etc.) we would get a final EBITDA margin of 23%, which is 54.4M EUR (column 2022 F1). Had we considered an EBITDA margin stuck at 20221 levels, we would have obtained an Adjusted EBITDA growing only to 43.7M EUR on 236M EUR sales (18.5% x 236M EUR; column 2022 F2). The discrepancy in the final valuation of the 33% stake of the investment in one year after the closing amounts to 24.8M – after multiplying the Adjusted EBITDA times its multiplier and after subtracting the net debt.
It is important to understand that by using the xEBITDA multiplier to compute the valuation, we need to base our calculation on the current value (i.e. 2021 at the time of the deal). Otherwise, if we wanted to propose a value of 110.5M EUR (i.e. 2022), we should then discount that value to bring it back to today’s value. That means for example that, if an investor required a 51.5% required return – exactly what the value appreciates as per the last line of the table - the value in today’s money would be exactly equal to $72.9M (i.e. $110.5 / (1 + 51.5%) ^ 1 ). Anyway, that is not the way to do it either. In that case, it would be more correct to conduct a proper Discounted Cash Flow model.
Note: our personal view is that the true numbers of the deal are likely to be somewhere below the 72.9M EUR value corresponding to 2021. Again, we focus on the quantitative dynamics here.
The view on 2022 allows us to check that the business has indeed the potential to return double-digit annual returns. Scenario 2022 (F1) would imply a 55% return in one year, while scenario 2022 (F2) would imply a 21% return. Since we already mentioned that the former could be a better estimate by including more precise EBITDA dynamics, the return in excess of the 25-35% required by the prospective investor could constitute argument of negotiation Higher initial valuations imply lower returns for the investor who is paying more for the same stake. Knowing the margin we have on the numbers becomes crucial. Again, that is a reason why comparing the required return of the investor (i.e. where s/he needs to take the investment) with the actual potential of the investment (i.e. possible business trend) can be strategic.
3) Third concept: understanding the new business opportunities allowed by the new ownership (the institutional investor)
When an institutional investor like a private equity firm enters the ownership of a company like Selle Royal Group, it is unlikely to be willing to wait several years to realize long organic programs. For sure it will focus on having its new investment organically grow through higher sales given by existing and new products, however, it will also capitalize on possible M&A activities (Mergers & Acquisitions). In this specific case, incentivized by Selle Royal Group being already a leader of the market, even a minor acquisition could immediately bump up sales without increasing costs too much. Especially at medium-sized corporations, people already handling operations or sales could almost seamlessly handle additional business coming from an acquired company. We could picture that, of the total headcount of the two original companies, only about 70 to 50% is needed then to run a combined entity – rough estimate but not unimaginable. Of course, it is not so simple. A lot depends on the possible commercial, operating, and manufacturing synergies. However, we wanted to highlight how, in general, opportunities lurk. The reader can research private equity deals and verify that the majority of them involved acquisitions of main competitors after the private equity firm had entered the ownership of a company.
Expansion by acquisition is possible even without a financial partner like a private equity firm. However, for sake of this article, we simply say that an institutional investor is likely to increase the focus on growth through M&A. Moreover, related to the Corporate Finance Note mentioned initially: funds would be needed for such acquisitions and that would play against the higher valuation implied by a higher EBITDA. However, here is where the new institutional investor plays an important role. We could show that the return on the acquired assets can easily surpass the cost of the new debt. An acquisition would increase the EBITDA of the company, it would also less-than-proportionally increase the operating costs (thanks to the synergies mentioned above), and it would increase the outstanding debt (or decrease the liquidity on hand). As long as the first factor can offset the last two, the value of the business would increase. The positive result is unlikely to reveal itself if only one or two years ahead are analyzed; focusing on a 3 to 5 years view, possibly including the repayment of the new debt, should better describe the net opportunity.
While the numbers above may suggest that the evaluation of an investment is something easy to conduct because numbers quickly and easily show the opportunity, that is seldom the case. The “opportunity” may indeed be fairly clear; looking at the numbers above, Selle Royal Group clearly shows to be a very good business able to return a 50%+ return year-over-year at good times like these. However, “opportunities” imply possibility rather than certainty. We have personally experienced something similar on an investment in the USA in a company in the Oil & Gas industry. The investment was flying high at the end of 2014 with the oil barrel at $80, to then fall at the very beginning of 2015 mostly due to the barrel dropping to $20.
Again, those high absolute margins (i.e. 51.5%) or the ones in excess (i.e. difference between 51.5% possible return and 25 or 35% required return) represent also the risk associated with the investment. The players usually involved with such investments have the opportunity to bear heavy single losses thanks to a diversified portfolio where a few successful investments more than offset the bad ones. Those dynamics are allowed by the long-tailed distribution of returns across those portfolios.
Finally, as per the case of Selle Royal Group, sometimes a good investment means joining another good investor. While we are sure the existing owner of the group is already extremely good considering the results that the Group has reached, retaining part of the equity while being joined by another skillful investor is likely to constitute an opportunity. The new participation (33% acquired stake) may facilitate for example access to additional liquidity needed for the M&A activity mentioned above (mergers & acquisition) – the investment firm could directly loan money to the company and acting as a bank towards its own investment. Moreover, having already discussed the objective that such institutional investors are likely to have 2 or 5 years down the road, the existing owner may have the opportunity to join that sale at a good valuation, realizing then further capital gain.
As the saying goes, “if you cannot beat them, join them”.
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