KUHN CAPITAL Tuesday, October 17, 2017
Dispatches from the front

Were Buyers Overpaying?
(1/22/2008)

In contrast to common perceptions, a recent study by consulting firm McKinsey concludes that buyers over the last several years have not been overpaying for acquisitions.

One would like to believe that, if this is true, the hot M&A market of the last several years won’t come back to haunt the targets or their new owners.

McKinsey tracked the 2007 share prices of target companies the month before a takeover was launched and noted that the bid premiums paid at closing averaged 18% versus 19% in 2006 and 32% in 2000 during the height of the dot com bubble. In addition, the proportion of buyers overpaying was 55%, materially below the 10-year average of 61% for the third year in a row.

We’re not sure about McKinsey’s conclusion. Premium calculations are based on share prices that may already be high as determined by such traditional indicators as price/earnings or enterprise value/EBITDA multiples. In other words, the whole market or sector could be overpriced despite the fact that the premium is low by historical standards.

But we have another deeper problem with the term “overpaying”. We’d rather define it as an instance where the capital deployed got less than the anticipated return on investment.

One of the reasons that deal prices rose substantially in the last several years (and they did) is because of the extraordinary amounts of debt utilized by larger PE firms. The market saw many monster transactions sporting 80% debt/total capital ratios at close or after dividend recaps.

In these deals, you could argue that the PE firms who engineered such thin equity slices weren’t overpaying even if the purchase price was high. After all, their ROI models were largely based on cheap access to other people’s money. Conversely, it was the banks that may have been “overpaying” in relationship to the risk they undertook even if the purchase price was low.

So if the widely-feared recession comes to pass, we’ll truly find out who was overpaying for what. Hint: we don’t think it’s likely to be the PE firms.

Ryan Kuhn


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