07 June 2012

The Phantom Value Creation

There is nothing more exciting than watching creative entrepreneurs start something from scratch and build them into a successful business.  The very good ones quickly get to a crossroad in which they seek external capital either to accelerate growth or as an exit strategy.   Whether it be through private or public equity,  the mere transaction  itself somehow seems to increase the value of the enterprise.   While there certainly are benefits for bringing sophisticated investors in, does this incremental gain diminish the hard work and success that got the business where it is?  Are we undervaluing the entrepreneur and overvaluing the equity markets?
I’ve written about how private equity firms can generate returns merely by bringing in financial leverage. Another lever they pull relates to their savvy in buying and selling companies.  They generally can sell companies higher than what they buy them for.  In a simple example, lets say a company sells to a PE firm for $500M based on cash flow (EBITDA) of $100M (5x multiple).  The PE firm will then try to exit for 7-8x down the road.  So even if profits stay the same, the company is now worth $200-$300M more just by “multiple expansion”.  The financial sponsor knows how to negotiate deals and has a much wider network of potential buyers than the company did on its own. I don't want to diminish the value of private equity because strong firms do improve operating performance in addition to adding smart financing and deal sophistication.  But in this crude example, is the financial maneuvering worth $300M relative to the $500M the founder who built the business from the ground up?
Public markets are no better.  Since the 1870's, the average P/E ratio of the S&P 500 has been around 15.  If a small company sells to a publicly held one, they don't usually get the double digit multiple the public one commands.  Again, the enterprise value gets stepped up to the publicly traded multiple upon closing of the transaction..  The entrepreneur could try to take the company public itself, but it is very cumbersome to do so.  They usually rely on VC or PE firms to help them get there (If Facebook couldn’t do it, then who can?).  While doing so, the entrepreneur usually gets significantly diluted (although valuations typically rise at the same time).  Certainly there is a value to the liquidity and compliance that public markets bring, but it begs the question of why strong private companies are not worth close to 15 times earnings?

Entrepreneurs rightly spend their time building businesses instead of worrying about how much their company is worth.  They typically don't think about valuation until they have either decided to sell or in a poor bargaining position (i.e. cash flow problems).  If the net number is big enough to meet their lifestyles and monetary goals, they probably don't worry too much about any money they are leaving on the table.  Perhaps it is the entrepreneur's fault for selling the company too early or not seeking appropriate advice.  I wonder over time if the arbitrage opportunity for institutional investors diminishes as private companies gain more financial savvy or bargaining power.  You see some of that in today's bubble valuations as there are now over 20 privately held tech companies with billion dollar valuations according to the WSJ.   
The value creators are company founders that have trailblazed their way to successful business models.  In an ideal world, entrepreneurs would be able to bring in some of the intrinsic value that comes with equity sales of the company.  Certainly the use of debt (vis a vis PE firms) is one way but also much riskier to individuals.  Using advisors to market the company better can help but is virtually impossible to get to the level of sophistication that firms have.  In the end, the financial system is a certainly a valuable piece of the puzzle, but you can’t have the game without the pawns to play with.    

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