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August 26th, 2015

Too Clever by a Chaff

Too clever by a chaff succinctly describes the current state of the Confidential Information Presentations (CIP) distributed by investment bankers today as the primary document to sell a company to a private equity buyer or to a corporate buyer. Chaff, a bloom of aluminum fibers, is one of the metallic countermeasures ejected by fighter jets to “fool” radar trying to detect the actual position of a fighter jet. Flares, magnesium pellets emitting a 2000 degree heat signature are also ejected as passive countermeasures to act as decoys against infra-red sector missiles. A written version of chaff and flairs has come to dominate the presentation of the target company’s forecast by intermediaries. Chaff and flares masquerade under the label “EBITDA addback” in the CIP.

At its core, the purchase of a company by a private equity buyer begins by determining a prospective portfolio company’s historic and probable future cash flow. Earnings before interest, taxes depreciation and amortization (EBITDA) serve as the best starting point for evaluating cash generation. As we have seen occur in the public market when non-GAAP earnings are regularly reported instead of GAAP earnings, a similar bit of accounting legerdemain is appearing in the CIPs. Rather than present EBITDA, adjusted EBITDA is now the featured data point. A series of “adjustments” to EBITDA are crafted by the seller and his investment banker creating a financial Potemkin Village which the PE firm needs to deconstruct one brick at a time to determine what real cash flow is.

An examination of a handful of addbacks seen in recent CIPs visibly illustrates the games being played. In its simplest form an addback is private equity’s version of retaking your SAT with the same test questions as the first SAT. If your reported EBITDA was $20 MM and you posit a $3 MM addback your adjusted EBITDA, on which you want buyers to value your company, is $23 MM. The adjustment that follows were in CIPs published in the last several months.

A retailer wanted to addback lost profits for a “one time snowstorm” in Buffalo, NY they argued would never occur again.

A manufacturer wanted to addback losses for a decline in foreign currency on the theory it was once higher.

A distributor wanted to addback prior year’s performance bonuses paid to management on theory management might no longer expect them.

A fast food chain wanted earnings credit for stores not yet opened, in some cases not yet built.

A multi-national manufacturer wanted credit for cost savings on an acquisition they hoped to make 6-12 months in the future.

A regional manufacturer wanted earnings credit for capital expenditures not yet spent that the buyer would have to finance and spend.

None of these involved a bridge in Brooklyn, but the heights of Fantasy Earnings continue to grow with each new CIP. Savvy investors in funds, who receive reports of the EBITDA multiples their managers are paying, are learning to ask what is being divided by what to determine the multiples. Careful buyers separate the wheat from the chaff in the addbacks to determine actual run rate EBITDA and bid accordingly.

I’m Rob Morris and I approved this blog.

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