Mind the Gap
Thoughts on valuation
We recently had the opportunity to put in an offer for an interesting company in an industry in which we have some familiarity. The company had strong and defensible earnings but growth had stagnated and it seemed like the owners had some personal industry connections that might be difficult to replace. Furthermore, the assets were old, so we foresaw significant capital expenditures coming downhill that would impair future free cash flow generation. Still, it was a decent company, and based on the information at hand, we submitted what we thought was a reasonable offer. The business broker kindly let us know that other bids were roughly two to three times higher, so to put it mildly, we were way off-market.
Being the low bid, particularly in a brokered process, is not uncommon for us. Because we intend to own our companies for the long term, the first thing we need to do is make sure we are in a position to own them for the long term, which means not taking too much risk in our underwriting models. Collectively, we care more about steady earnings and “hitting singles” than risking our operations by making big bets. We are aware that this approach means that we may leave money on the table; there is an inherent tradeoff between risk and reward and we understand the bet(s) we are making. Without external investors, we feel the downside risk more than most, and we like it that way.
When underwriting, we are typically conservative with our assumptions. Basically, we ask ourselves if this company just keeps doing what it’s doing, what price are we comfortable paying? And what level of debt do we feel is manageable, even in a downside scenario? This is in contrast to a more traditional approach which would give more weight to higher future growth scenarios and would take into consideration post close operational improvements, both of which would allow for more aggressive initial leverage ratios. In short, we want to pay for the earnings we are actually inheriting, avoid giving ourselves too much credit for what we may or may not be able to achieve in the future, and then orient capital structure accordingly.
In the situation we referenced in which our bid was way too low, it was helpful to hear feedback on what other parties were thinking when they put together their numbers. It seems that most were simply much more aggressive in modeling out potential earnings expansion (there were a fair number of low-hanging operational changes that could improve the business) and were willing to rely more on the defensible nature of the business, both of which are fair points. Again, it’s risk vs. reward.
So where does that leave us? We are competitive people and it sucks to “lose” even though we don’t think we did anything wrong and if offered the opportunity again, we would bid the same way. The whole situation was a good reminder that we are playing an entirely different game than many other buyers — different time horizons, different operational approaches, and different definitions of success. Going forward, we’ll continue to remain disciplined in our underwriting even if it means some awkward conversations with a broker or two. In short, we don’t mind the occasional (valuation) gap.
Have a great week,
Your Chenmark Team