Multiple Arbitrage: How it Works in Private Equity
What is multiple arbitrage, and what role does it play in the private equity space? In this post, we discuss what it is, why it happens, and how it works in acquisition markets.
What is Arbitrage?
Before diving into multiple arbitrage, it is important to understand arbitrage itself. Arbitrage is the purchase and sale of an asset in different markets to gain from the difference in price the markets provide. For example, a trader purchases an item in a market where the item is worth less, and then sells it in a market where the item’s value is higher. Arbitrage occurs due to inefficiencies between markets; in other words, market A is unaware that market B is selling the asset for a higher price.
The trader who buys the asset in market A, where it is worth less, and then immediately sells it in market B, where it is worth more, can make a risk-free profit. The more traders that take advantage of this market gap, the more likely market A will catch on and price the asset in question higher. In this way, arbitrage itself resolves the market inefficiencies that cause it.
EBITDA Multiples
Multiple arbitrage, in this context, is arbitrage that profits from the difference in EBITDA multiples from one market to the next. But what are EBITDA multiples?
EBITDA multiples, enterprise multiples, or valuation multiples all refer to the same concept. Simply put, an EBITDA multiple is the value multiplied with a company’s EBITDA to arrive at the enterprise value, or what the company would be worth in a sale. EBITDA multiples can vary widely from company to company and industry to industry. We talk more about EBITDA multiples and the many factors that determine them in this post.
EBITDA Multiple Example
For example, let us say a company’s EBITDA is 10 million, and its EBITDA multiple is 4. That would give the company an enterprise value of 40 million. As you can see, the EBITDA multiple plays a large role in the company’s enterprise value.
Multiple Arbitrage
Putting the two pieces together, multiple arbitrage takes advantage of the difference in EBITDA multiples from one market to another. Generally, companies in the lower middle market sell at a lower EBITDA multiple than companies in the middle market. Following the theory of arbitrage, all a private equity firm would have to do to turn a profit on a company is purchase it in the lower middle market and sell it in the middle market. The higher EBITDA multiple alone would be responsible for a significant return on investment. Reality, though, proves more complicated.
Pure Multiple Arbitrage
In pure multiple arbitrage, the private equity firm does nothing to improve the company before selling it again. What in the private equity space makes this possible? Just as arbitrage is possible because of delayed or minimal communication between markets, multiple arbitrage is possible because different buyers often have different perspectives on what EBITDA multiple a company should have. And, because interested buyers are not broadcasting their opinion on the company’s valuation, there is a gap in knowledge on purchase price from one person to the next.
Therefore, an investor looking to capitalize on arbitrage simply would need to purchase a company at a lower multiple and then resell to a buyer who believes it is worth more. This tactic requires knowledge of the market landscape for the company in question, or, in other words, an understanding of how a variety of prospective buyers would value the company. But even with thorough market knowledge, capitalizing on arbitrage in this way is very difficult. Other factors, like the high transaction costs associated with buying and selling a company, make for narrower margins and less profit.
The Time Gap
When we were discussing arbitrage generally, we mentioned purchasing the asset in one market and selling it immediately in another. This instant buy-sell is, indeed, how arbitrage usually turns a profit. Multiple arbitrage can work this way as well, as explained in the section above. But multiple arbitrage in private equity operates with a time gap. Why is this?
If a private equity firm wants to capitalize on arbitrage due to market differences, the firm must grow the purchased company first. Why is this? Companies in the middle market space generally sell for higher EBITDA multiples than companies in the lower middle market space. This is due to increased competition among buyers, and other factors. Thus, to really capitalize on arbitrage, the firm would need to grow the company’s EBITDA until it falls in the middle market range. Here, the firm gains from the sale in two ways: a higher EBITDA, making the company worth more, and multiple arbitrage, multiplying how much more it is worth.
Beyond Multiple Arbitrage
Arbitrage is not a perfect strategy, however. In periods of economic decline, EBITDA multiples are lowered across markets, making it more difficult to rely on this strategy.
Looking beyond arbitrage can also benefit the private equity firm, as we mentioned above. For example, if the firm provides operational improvements, theoretically the investment will perform well regardless of arbitrage. Indeed, company value increase due to EBITDA growth alone is a much more certain target, while relying on arbitrage is uncertain.
However, if the private equity firm can significantly grow a company’s EBITDA, lifting it from the lower middle market to the middle market, and capitalize on multiple arbitrage, returns can be amplified significantly. Multiple arbitrage is a complex topic; if you have any questions, feel free to contact us.
