In a previous series, we covered trading comparables in depth. Trading comparables (or simply “comps”) are one of the three core valuation methodologies that investment bankers use.
In this post, we cover precedent transaction comparables (also called “precedents” or “transaction comps”) – which are also important, especially for an M&A context.
Spreading Precedent Transaction Comps
To compile precedents analysis, investment bankers will generally keep a database on Microsoft Excel of all relevant transactions for their industry. This is compiled by the investment banking industry coverage groups, while the M&A team may keep a database of historical premiums paid for acquisitions.
From the database, let’s say for technology firms, each subsector will have its own database. Accordingly, the software and services team will have a separate database from the hardware and semiconductor teams. Within each database there will be plenty of sort and filter options so that investment bankers can be selective in terms of what story they want to convey. For example, if there is a pitch for what value a company can realize in a sale, bankers can select deals that are only £500MM-1B in enterprise value for Infrastructure as a Service companies only.
Each deal will have a code so that investment bankers can use Excel to populate the data quickly by pulling from the main database in making presentation materials.
A precedents worksheet will have the following key information:
- Date – the older the transaction, the less relevant it is but may have useful notes in terms of rationale and process
- Target – if not a public company, for example a seller divesting of a division or asset that it holds
- Transaction Value Buildup – an enterprise value that will include equity value (below) and any debt assumed
- Equity Value – This will include the funding mix implied depending on whether the transaction was a cash offer, a stock offer or a mix or both
- Debt and Obligations – generally the quick and dirty method is to only consider the face value of debt outstanding for a company with a healthy balance sheet being acquired but in the notes bankers should mention real claims on the firm such as large leasing obligations, pensions, asset retirement obligations etc.
- Cash flow and earnings metrics at the time (and possible forecasted cash flows) or revenue for unprofitable companies – sometimes EBITDA or earnings at the time may not be reflective of the value the firm is paying for so run-rate or expected normalized EBITDA should be noted
- Industry specific metrics that are relevant (for tech firms could be Daily Average Users)
- Investment bank that advised for target and seller
Analysing Precedent Transactions
From these inputs, investment bankers can handily calculate multiples and start piecing together a picture of transactions in the space.
When compiling a list of relevant transactions for a client presentation, investment bankers will look for similar business lines, similar business risks and similar scale and margins.
However, certain transactions will be chucked out or included based on professional judgment. Also, investment bankers have to be able to explain why certain multiples are high or low or at least justify why they are making adjustments to triangulate an appropriate value.
- Forecasted synergies and the perceived value of the target to the buyer – a firm that thinks that they can extract huge synergies via acquisition or sees the target as a core piece of their business may be willing to pay materially more than conventional valuation metrics (especially in unprofitable but high growth companies where a large amount of subjectivity is involved)
- The economic and market environment at the time – if everything was trading at a high or low multiple or if there was a bubble in the sector at the time
- Capital programs in place at the time – for instance, if a transformative spending program was ongoing at time of acquisition, associated EBITDA would not be reflected in multiples; conversely, companies that were set to embark on a large capex program should have more risk priced in
- The sell-side process involved – was it a negotiated sale or a process with high competitive tension with various bidders
- Premiums versus discounts – generally, companies will not be willing to sell at a discount to current value unless they have to – this means companies in distressed firms that need to undergo an expedited process
It is very common during investment banking interviews that candidates are asked what the strengths and weaknesses of precedents and trading comps. The correct answers are that 1) similar to trading comps, there is no perfect comparison for companies; 2) precedents offer a snapshot in time that may no longer be relevant.
For various marketing documents, investors have to be careful when endorsing or rejecting a merger decision. If trading comps are offering a value range that is totally below the precedent transaction range for the investment banker’s football field output, the precedents should basically be thrown out because no one is willing to pay that sort of value anymore.
Likewise, if a firm is marketing transaction comps that are not really good comps, these numbers should be thrown out and a more appropriate set of comps should be selected instead.
In a hostile transaction, expect very different comps provided in the marketing documents for both the potential buyer and the target. The target will point to higher premiums and the buyer to lower ones.