Deal making in M&A
A discussion with my colleague reminded me of what I learned about deal-making during my time in private equity, so I’d like to share some thoughts on the subject. I’ve been away from the sector for over a decade, so this entry does not claim to be entirely accurate.
The returns from private equity investments can be broken down into three components:
EBITDA growth
Multiple growth
Net debt reduction
This stems from a straightforward valuation formula:
Equity Value = EBITDA x EBITDA Multiple - Net Debt
Component #3, net debt reduction, primarily involves financial engineering and risk appetite. To maximize returns, you can increase leverage as long as you are comfortable taking on more risk and can raise the necessary debt. In other words, excess returns from net debt reduction result from taking additional risk (though there is a tax shield), so from a risk-adjusted return perspective, #3 does not add substantial value.
Therefore, the focus typically lies on #1 and #2.
EBITDA Growth
This aspect depends on how confident you are in the company’s ability to grow its profits. It comprises:
A. Market outlook
B. Management capability and strategy
C. The GP company’s value-add capabilities
Some GP companies focus on specific sectors because this specialization provides a clearer market view, enables better judgment of management’s capabilities, and enhances value-creation opportunities. Many firms even have dedicated teams for improving portfolio companies.
As a serial acquirer in financial inclusion, Gojo has some attributes of a sector-focused buyout fund (though we don’t use EV/EBITDA valuation in finance business). In our case, additionally, alignment in vision, mission, and values is also crucial. We’ve learned that without this alignment, we cannot effectively add value to our group companies.
Multiple Growth
Multiple growth is equally significant for value creation and consists of two factors. The first point is relatively straightforward, but the second is often overlooked.:
A. Low entry price
B. Risk management and execution capability
How do we find underpriced companies? If I had to highlight one key lesson from private equity, it would be this: entry price determines the success of investments. Granted, if we subscribe to the Efficient Market Hypothesis (and I do), identifying underpriced companies in public markets is extremely challenging, but most MFIs are not publicly listed, which makes such pricing gaps easier to identify.
In countries without active stock markets (in the Global South, exceptions include India and Indonesia), multiple ranges tend to be narrow. As a result, top performers are often undervalued (and vice versa).
Risk management is critical to improving multiples because multiples are essentially the inverse of the risk premium. If the company’s performance shows volatility, that is considered high risk, and the discount rate gets higher and thus multiple lower. . A company that consistently delivers results, regardless of macroeconomic conditions, enjoy higher multiples.
Sourcing Considerations
When sourcing investments, these principles should always be kept in mind. Although many countries lack active stock markets, finding underpriced companies with growth potential remains a challenging task.
I have yet to find a clear, replicable pattern. That said, all great investment managers develop their own unique sourcing methodologies, leveraging their specific strengths.
For example, I know a person with a great interpersonal skill who focuses solely on relationship development with shareholders and the management of the target companies. The rapport sometimes works to lower the entry price. Another, who is a deep thinker, carefully looks at all the details of the target companies (to the extent that the others don’t do) to find mispriced companies.
This sourcing process is more of an art than a science, and thus it is interesting.