What is Multiple Expansion?
Multiple Expansion is when an asset is purchased and later sold at a higher valuation multiple relative to the original multiple paid.
If a company undergoes a leveraged buyout (LBO) and is sold for a higher price than the initial purchase price, the investment will be more profitable to the private equity firm.
Multiple Expansion: Private Equity LBOs Returns Driver
When it comes to leveraged buyouts (LBOs), pricing is arguably the most important consideration.
Simply put, the objective behind multiple expansion is to “buy low, sell high”.
Once a financial sponsor acquires a company, the firm seeks to gradually pursue growth opportunities while identifying operational inefficiencies where improvements could be made.
Some common examples of potential value-add opportunities are:
- Reducing Employee Headcount
- Closing Redundant Facilities
- Eliminating Unnecessary Functions
- Divesting Non-Core Assets
- Negotiating Longer-Term Customer Contracts
- Geographic Expansion
If the changes implemented are successful, the post-LBO company will have higher profit margins and higher-quality revenue (i.e. recurring, stable), which is essential in the context of leveraged buyouts (LBOs) due to the highly levered capital structure.
While not a guarantee by any means, the odds of exiting at a higher multiple improves if the private equity firm is able to implement strategic adjustments such as the ones mentioned above.
The inverse of multiple expansion is called multiple contraction, which means the investment was sold for a lower multiple than the original acquisition multiple. In such cases, the buyer likely overpaid and subsequently took a loss when selling the company.
However, for larger-sized LBOs, minor multiple contraction can be acceptable (and often be expected). This is because the number of potential buyers is reduced as fewer buyers can afford to purchase the asset.
LBO Purchase Multiple and Exit Multiple Assumptions
In practice, the majority of LBO models use the conservative assumption of exiting at the same multiple as the entry multiple.
Given the amount of uncertainty regarding the market conditions and unforeseeable events that could have a significant impact on the exit multiple, the recommended industry best practice is to set the exit multiple assumption equal to the purchase multiple.
Even if the private equity firm expects to take actions during its ownership period that could increase the exit multiple (and returns), the most important takeaway is that the private equity firm’s thesis and expected returns should not be overly reliant on selling at a higher valuation.
Multiple expansion can frequently be caused by favorable secular trends and market timing (e.g. COVID-19 and telemedicine).
US Buyout Purchase Multiples Trend (Source: Bain Global PE Report)