“I’ve heard about merger arbitrage, but what is it?” asks the cashier at your local post office. Smiling, you reply, “it’s a powerful strategy that savvy investors and private equity firms use”. As she handed you a receipt, she inquired, “ok, what is multiple arbitrage?” “Oh, for that”, turning to leave, “you’ll have to go to Event Driven Daily.”
What is Multiple Arbitrage?
Multiple arbitrage is an investment strategy used in mergers and acquisitions and private equity transactions. The strategy structure is to purchase a company at a lower price-to-earnings (P/E) ratio or EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple, then sell the firm at a higher valuation multiple (P/E or EBITDA). The seller profits from the company’s pricing difference between the purchase multiple and the selling multiple.
What is multiple arbitrage and how it works is as follows:
The Acquisition – A private equity firm purchases a target company at a low valuation multiple. Say, the firm is purchased for $50 million and generates $10 million in EBITDA The acquisition multiple is 5x EBITDA ($50 million purchase price / $10 million EBITDA).
Accretive Strategy – The new owner implements initiatives to increase the firm’s value through operational improvements, cost reductions, and strategic acquisitions.
Strategic Exit – Once revenue and margins have improved, the owner sells the enhanced company at a higher multiple. The firm’s EBITDA is now $17 million and is sold for $136 million, yielding an exit multiple of 7x EBITDA and gross sales proceeds of $86 million.
What is multiple arbitrage and what are its advantages?
Multiple arbitrage is to buy low-improve company metrics- then sell higher strategy. The advantages are:
Financial Gain – Generating substantial profits is the primary benefit. Investors can use leverage (purchase-money debt) to magnify their financial returns. Selling the leveraged company at a higher multiple will amplify the returns on the equity portion of the investment.
Strategic Advantages – A multiple arbitrage strategy allows an investor to capitalize on market timing. Savvy merger and acquisition and private equity firms wait for a market downturn in a targeted sector to make their purchase. Through growth initiatives and operational improvements, the company’s value has increased leading to a higher multiple. The firm is held until a market upturn fetches a substantially higher selling price.
Portfolio Management – Investors can diversify their portfolios and mitigate systematic risk by acquiring uncorrelated companies in differing sectors and industries. Through operation improvement efforts, the acquirer can create an economic downturn buffer and lower the adverse effects of market volatility.
Competitive Advantage – An acquirer's competitive advantage can be enhanced by the heightened reputation received from profitably recycling capital through successful arbitrage exit strategies. Being seen as an attractive corporate partner is a positive externality.
What is multiple arbitrage and are there risks? Absolutely, and here are a few:
Market Risk – Markets are unpredictable. An overall investor overreaction to an adverse macroeconomic stimulus can tailspin markets and lower metric multiples.
Operational Challenges – We all are familiar with poet Robert Burns ” best-laid plans of mice and men often go awry.” The successful implementation of operational improvements is subject to this adage. The best-laid corporate plans may not succeed.
Regulatory Risk – Regulatory changes can negatively impact a business and its valuations making an impending acquisition or sale cost-prohibitive.
Imagine buying a company for a bargain and then selling it for a premium, all while transforming its operations and unlocking hidden potential. Multiple arbitrage offers financial, strategic, and competitive benefits by capitalizing on valuation discrepancies, improving company performance, and leveraging market conditions.
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